ACTIVITY BASED COSTING

Shaw Wallace makes 2 wines: a regular wine and a premium wine. Shaw Wallace
distributes the regular wine and the premium wine through different distribution
channels. It distributes 2,40,000 cases of regular wine through 10 general
distributors and 1,60,000 cases of premium wine through 30 specialty
distributors. Shaw Wallace incurs Rs.42,60,000 in distribution costs. Under its
existing costing system, Shaw Wallace allocates distribution costs to products on
the basis of cases shipped.
To understand better the demands on its resources in the distribution area, Shaw
Wallace identifies 3 activities and related activity costs.
a. Promotional costs- Shaw Wallace estimates it incurs Rs.16,000 per
distributor.
b. Order handling costs- Shaw Wallace estimates costs of Rs.600 pertaining to
each order. Shaw Wallace records show that distributors of regular wine place
an average of 10 orders per year, whereas distributors of premium wine place
an average of 20 orders per year.
c. Delivery costs Rs.8 per case.
Required:
1. Using Shaw Wallace existing costing system, calculate the total distribution
costs and distribution cost per case for the regular wine and the premium
wine.
2. Using Shaw Wallace activity based costing system, calculate the total
distribution costs and distribution cost per case for the regular wine and the
premium wine.
3. Explain the cost differences and the accuracy of the product costs calculated
using the existing costing system and the ABC system. How might Shaw
Wallace management use the information from the ABC system to manage its
business better?

Problem 1

Required:
1. Using Shaw Wallace existing costing system, calculate the total distribution
costs and distribution cost per case for the regular wine and the premium
wine.
2. Using Shaw Wallace activity based costing system, calculate the total
distribution costs and distribution cost per case for the regular wine and the
premium wine.
3. Explain the cost differences and the accuracy of the product costs calculated
using the existing costing system and the ABC system. How might Shaw
Wallace management use the information from the ABC system to manage its
business better?

Problem 1
Nirula decides to apply ABC analysis to 3 products lines; Ice-creams, Milk shakes
with ice-creams and Food products. It identifies 4 activities and activity cost rates
for each activity as








Problem 2
Activity Cost per activity
Ordering Rs.1,000 per purchase order
Delivery and receipt of merchandise Rs.800 per delivery
Shelf-stocking Rs.200 per hour
Customer support and assistance Rs.2 per item sold

Inder the previous costing system, Nirula allocated support cost
Problem 2
Ice-creams Milk shakes
with ice-creams
Food
Products
Financial data:
Revenues Rs.5,70,000 Rs.6,30,000 Rs.5,20,000
Cost of goods sold 3,80,000 4,70,000 3,50,000
Store support 1,14,000 1,41,000 1,05,000
Activity area usage (cost allocation
base)
Ordering (purchase orders 30 25 13
Delivery (deliveries) 98 36 28
Shelf-stocking (hours) 183 166 24
Customer support (items sold) 15,500 20,500 7,900
The revenues, cost of goods sold, store support costs & activity wise usage of the 3
product lines are:
Under the previous costing system, Nirula allocated support costs to products at the rate of
30% of the cost of goods sold.

Required:
1. Use the previous costing system to prepare a product line profitability report
for Nirulas.
2. Use the ABC system to prepare a product line profitability report for Nirulas.
3. What new insights does the ABC system requirement 2 provide to Nirulas
managers?
Problem 2
State Bank of India (SBI) is examining the profitability of its Premier
Account, a combined savings and checking account. Depositors receive
a 7% annual interest rate on their average deposit. SBI earns an interest
rate spread of 3% (the difference between the rate at which it lends
money and the rate it pays depositors) by lending money for home loan
purposes at 10%. Thus, SBI would gain Rs.60 on the interest spread if
a depositor has an average Premier Account balance of Rs.2,000, that
is, Rs.2,000 x 3% = Rs.60.
The Premier Account allows depositors unlimited use of services such
as deposits, withdrawals, checking accounts, and foreign currency
drafts. Depositors with Premier Account balances of Rs.1,000 or more
receive unlimited free use of services. Depositors with minimum
balances of less than Rs.1,000 pay Rs.20 a month service fee for their
Premier Account.
SBI recently conducted an activity based costing study of its services. It
assessed the following costs for six individual services. The use of these
services in current year by 3 customers is as follows:
Problem 3












Assume Nitin and Sanjay always maintain a balance above Rs.1,000,
whereas Arvinder has a balance below Rs.1,000.
Particulars Activity based
Cost per
Transaction
Nitin Arvinder Sanjay
Deposit/ withdrawal with teller Rs.2.50 40 50 5
Deposit/ withdrawal with
automatic teller machine (ATM)
0.80 10 20 16
Deposit/ withdrawal on
prearranged monthly basis
0.50 0 12 60
Bank checks written 8.00 9 3 2
Foreign currency drafts 12.00 4 1 6
Inquiries about account balance 1.50 10 18 9
Average premier account balance
for current year
Rs.1,100 Rs.800 Rs.25,000
Problem 3


Required:
1. Compute the current year profitability of Nitin, Arvinder and
Sanjays Premier Accounts at SBI.
2. What evidence is there of cross-subsidization among three
Premier Accounts? Why might SBI worry about this cross-
subsidization if the Premier Account product offer in is
profitable as a whole?
3. What changes would you recommend for SBIs Premier Account?
Problem 3
Sony Electronics, a division of Sony Corporation, manufactures two large
screen television models the Flatron, which has been produced since 1998 and
sells for Rs.45,000 and Wega, a newer model introduced in early 2011 that sells
for Rs.57,000. Based on the following income statement for the current year
ended March 31, senior management at Sony have decided to concentrate
Sonys marketing resources on the Wega and to phase out the Flatron model.

Income Statement for the Current Fiscal Year Ended March 31

Particulars Flatron Wega Total
Revenues Rs.1,98,00,000 Rs.45,60,000 Rs.2,43,60,000
Cost of goods sold 1,25,40,000 31,92,000 1,57,32,000
Gross margin 72,60,000 13,68,000 86,28,000
Selling and administration
expenses
58,30,000 9,78,000 68,08,000
Operating income 14,30,000 3,90,000 18,20,000
Units produced and sold 440 80
Operating income per unit
sold
Rs.3,250 Rs.4,875
Problem 4
Unit Cost for Flatron and Wega are as follows:
Particulars Flatron Wega
Direct materials Rs.10,400 Rs.29,200
Direct manufacturing labor
Flatron (1.5 hours x Rs.600) 900
Wega (3.5 hours x Rs.600) 2,100
Machine costs#
Flatron (8 hours x Rs.900) 7,200
Wega (4 hours x Rs.900) 3,600
Manufacturing overhead
other than machine costs*
10,000
(8 hours x Rs.1250)
5,000
(4 hours x Rs.1250)
Total costs 28,500 39,900
# Machine costs include lease costs of the machine, repairs and maintenance
Manufacturing overhead was allocated to products based on machine-hours at the rate of
Rs.1,250 per hour.

Sonys controller, Mr. Thomas, is advocating the use of activity-based costing and activity based
management and has gathered the following information about the companys manufacturing
overhead costs for the current year ended March 31
Problem 4
Units of the Allocation Base
Activity Center (Cost-
Allocation Base)
Total Activity
Costs

Flatron Wega

Total

Soldering (number of solder
points)
Rs.9,42,000 11,85,000 3,85,000 15,70,000
Shipments (number of
shipments)
8,60,000 16,200 3,800 20,000
Quality control (number of
inspection)
12,40,000 56,200 21,300 77,500
Purchase orders (number of
orders)
9,50,400 80,100 1,09,980 1,90,080
Machine power (machine
hours)
57,600 1,76,000 16,000 1,92,000
Machine setups (number of
setups)
7,50,000 16,000 14,000 30,000
Total manufacturing overhead 48,00,000
Problem 4
After completing his analysis Thomas shows the result to friend Sam,
the Sony division president. Sam does not like what he sees. If you
show headquarters this analysis, they are going to ask us to phase out
the Wega line which we have just introduced. This whole costing stuff
has been a major problem for us. First Flatron was not profitable and
now Wega.
Looking at the ABC analysis, I see two problems. First, we do, many
more activities than the ones you have listed. If you had included all
activities, maybe your conclusions would be different. Second, you used
number of setups and number of inspections as allocation bases. The
numbers would be different has you used setup-hours and inspection-
hours instead. I know that measurement problems precluded you from
using these other cost-allocation bases, but I believe you ought to make
some adjustments to our current numbers to compensate for these
issues. I know you can do better. We cant afford to phase out either
product.
Problem 4
Thomas knows his numbers are fairly accurate. On limited sample, he
calculated the profitability of Wega and Flatron using more and
different allocation bases. The set of activities and activity rates he had
used resulted in numbers that closely approximate those based on more
detailed analyses. He is confident that headquarters, knowing that Wega
was introduced only recently, will not ask Sony to phase it out. He is
also aware that a sizable portion of Sams bonus is based on division
revenues. Phasing out either product would adversely affect his bonus.
Still, he feels some pressure from Sam to do something.

Required:
1. Using activity-based costing, calculate the profitability of the Wega
and Flatron models.
2. Explain briefly why these numbers differ from the profitability of
the Wega and Flatron models calculated using Sonys costing system.
3. Comment on Sams concerns about the accuracy and limitation of
ABC.

Problem 4
Citizen Company produces mathematical and financial calculators. Data related
to the two products is presented below:








Both products pass through Department 1 and Department 2. The
departments combined manufacturing overhead costs are:


Required:
1. Compute the manufacturing overhead cost per unit for each product.
2. Compute the manufacturing cost per unit for each product.

Mathematical Financial
Annual production in units 50,000 1,00,000
Direct materials costs Rs.1,50,000 Rs.3,00,000
Direct manufacturing labor costs Rs.50,000 Rs.1,00,000
Direct manufacturing labor-hours 2,500 5,000
Machine-hours 25,000 50,000
Number of production runs 50 50
Inspection hours 1,000 500
Machining costs Rs.3,75,000
Setup costs Rs.1,20,000
Inspection costs Rs. 1,05,000
Problem 5
Nicholas Pharma Ltd specializes in the distribution of pharmaceutical products.
Nicholas Pharma Ltd. buys from pharmaceutical companies and sells to each 3
different markets:
a. General supermarket chains
b. Drugstore chains
c. Ma & Pa single store pharmacies
Anand, the new controller of Nicholas Pharma, reported the following data for
August:





For many years, Nicholas Pharma has used gross margin percentage (Revenue-Cost
of goods sold) / Revenue to evaluate the relative profitability of its groups
(distribution outlets).

Particulars General
Supermarket
Drugstore
Chains
Ma & Pa
Single Stores
Average revenue per delivery Rs.15,450 Rs.5,250 Rs.990
Average cost of goods sold per delivery 15,000 5,000 900
Number of deliveries 120 300 1,000
Problem 6
Activity Area Cost Driver
Customer purchase order processing Purchase orders by customers
Line item ordering Line items per purchase order
Store delivery Store deliveries
Cartons shipped to stores Cartons shipped to a store per delivery
Shelf stocking at customer stores Hours of shelf stocking
Anand recently attended a seminar on activity based costing and decides to
consider using it at Nicholas Pharma. Anand meets with all the key managers and
many staff members. Generally, these individuals agree that there are five key
activity areas at Nicholas Pharma










Each customer purchase order consists of one or more line items. A line item
represents a single product (such as Extra Strength Tylenol Tablets). Each store
delivery entails delivery of one or more cartons of products to a customer. Each
product delivered in one or separate cartons. Nicholas Pharma staff pack cartons
directly onto display shelves in a store. Currently, there is no charge for this
service, and not all customers use Nicholas Pharma for this activity.
Problem 6
Activity Area Total Costs in
August
Total Units of Cost
Allocation base
Used in August
Customer purchase order processing Rs.40,000 1,000 orders
Line item ordering 31,920 10,640 line items
Store deliveries 35,500 710 store deliveries
Cartons shipped to stores 38,000 38,000 cartons
Shelf stocking at customer stores 5,120 320 hours
1,50,540
The August operating costs (other than costs of goods sold) of
Nicholas Pharma are Rs.1,50,540. These operating costs are
assigned to the 5 activity areas. The costs in each area and the
quantity of the cost allocation base used in that area for August are
as follows:

Problem 6
Required:
1. Compute the August gross margin percentage for each of its three distribution
markets. What is the operating income of Nicholas Pharma? Also determine its
operating income margin.
2. Compute the August rate per unit of the cost allocation base for each of the
five activity areas.
3. Compute the operating income of each distribution market in August the
activity based costing information. Comment on the results. What new insights
are available with the activity based information?
Other data for August include the following:
Particulars General
Supermarket
Drugstore
Chains
Ma & Pa
Single
Stores
Total number of orders 70 180 750
Average number of line items per order 14 12 10
Total number of store deliveries 60 150 500
Average number of cartons shipped per store
delivery
300 80 16
Average number of hours of shelf stocking per
store delivery
3 0.6 0.1
Problem 6
The Birla Company manufactures and sells two products, A and B. The
manufacturing activity is organized in two departments. Manufacturing costs at its
Portland plant are allocated to each product using a plant-wide rate of Rs.170 per
direct manufacturing labor-hour. This rate is based on budgeted manufacturing
overhead of Rs.34,00,000 and 20,000 budgeted direct manufacturing labor-hours.






The number of direct manufacturing labor-hours required to manufacture each
product is



Manufacturing
department
Budgeted manufacturing
overhead
Budgeted direct
manufacturing labor-hours
1 Rs.24,00,000 10,000
2 10,00,000 10,000
Total 34,00,000 20,000
Manufacturing department Product A Product B
1 4 1
2 1 4
Total 5 5
Problem 7
Per unit cost costs for the two categories of direct manufacturing costs are






At the end of the year, there was no work in progress. There were 200 finished
units of product A and 600 finished units of product B on hand.
Birla sets the selling price of each product by adding 120% to its unit
manufacturing costs; that is, if the unit manufacturing costs are Rs.1,000, the
selling price is rs.2,200 (Rs.1,000 + Rss.1,200). This 120% markup is designed to
cover costs upstream to manufacturing (R&D and design) and costs downstream
from manufacturing (marketing, distribution and customer service), as well as to
provide a profit.

Direct Manufacturing costs Product A Product B
Direct materials costs Rs.1,200 Rs.1,500
Direct manufacturing labor costs 800 800

Required:
1. How much manufacturing overhead cost would be included in the
inventory of products A and B if Birla used (a) a plant-wide overhead
rate and (b) department overhead rates?
2. By how much would the selling prices of product A and product B differ
if Birla used a plant-wide overhead rate instead of department overhead
rates?
3. Should Birla Company prefer plant-wide or department overhead rates?
4. Under what conditions should Birla company further subdivide the
department cost pools into activity cost pools?