Week 3 Case 2: Greetings Inc.

: Activity-Based Costing
Course: Managerial Accounting (ACC 560)

1. Answer:
Two reasons why an activity-based costing (ABC) system may be appropriate for Wall Décor
would be as follows.
(1.) ABC system leads to more accurate product costing. By breaking costs down into more
refined categories, product costing will be even more accurate. That is, ABC system can
lead to more cost pools being used to assign overhead costs to products, and then costs can
be assigned more directly on the basis of the cost drivers used to produce each product.
However, in this case of Wall Décor, traditional overhead allocation, which is based on the
cost of print and volume of expected units sold to assign overhead costs, often results in that
the unframed prints are being allocated too much overhead costs and framed prints too little
overhead costs.

(2.)ABC system leads to enhanced control over overhead costs. The reason is that using the
ABC system, companies can trace many overhead costs directly to activities – allowing
some indirect costs to be identified as direct costs. In the Wall Décor, the information
technology (IT) department has the highest overhead costs including two out of the four
activities occurring, which are website optimization and framing and matting. ABC system
can reflect that a large portion of overhead costs is associated with the framing and matting
component of the production area. This allows manager to better track the activities that lead
to costs.

2. Answer:

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The activity-based overhead rate per cost drivers is computed by dividing the estimated overhead
per activity by the number of cost drivers expected to be used per activity. The formula for the
activity-based overhead rate is:
Estimated Overhead per Activity ÷ Expected Use of Cost Drivers per Activity
= Activity-Based Overhead Rate

Compute the activity-based overhead rates for each of the four activities.
Activity Cost Pools Estimated Expected Use Activity-Based
Overhead ÷ Of Cost Drivers by = Overhead Rates
Activity

Picking prints $30,600 102,000 prints $0.30 per print

Inventory selection and $91,700 131,000 components $0.70 per component
management
Website optimization Unframed: Unframed: Unframed:
$25,800 100,000 print capacity $0.258 per print
Framed: Framed: Framed:
$103,200 25,000 print capacity $4.128 per print

Framing and matting cost $123,900 59,000 components at $2.10 per component
capacity

Thus, the activity-based overhead rates are as follows.

a. Picking prints is $0.30 per print,

b. Inventory selection and management is $0.70 per component,
c. Website optimization (unframed print) is $0.258 per print capacity, and website
optimization (framed print) is $4.128 per print capacity,
d. Framing and matting is $2.10 per component capacity.

3. Answer

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Compute the product cost for the following three items using ABC.

(a) Lance Armstrong unframed print (base cost of print $12):

Direct Materials = Print = $12
Direct Labor = Pick Labor = $12 x (10/60) = $2
Manufacturing Overhead = Picking Prints + Inventory Selection and Management
+ Website Optimization
= $0.30 + $0.70 + $0.258 = $1.258
Total Cost per print = Direct Materials + Direct Labor + Manufacturing Overhead
= $12 + $2 + $ 1.258 = $15.258
Thus, the product cost for Lance Armstrong unframed print is $15.258
(b) John Elway print in steel frame, no mat (base cost of print $16)
Direct Materials = Print + Frame and Glass = $16 + $4 = $20
Direct Labor = Picking Labor + Matting and Framing Labor
= [$12 x (10/60)] + [$21 x (20/60)]
= $2 + $7 = $9
Manufacturing Overhead = Picking Prints + Inventory Selection and Management
+ Website Optimization + Framing and Matting
= $0.30 + ($0.7 x 2) + $4.128 + ($2.10 x 2) = $10.028
Total Cost per Unit = Direct Materials + Direct Labor + Manufacturing Overhead
= $20 + $9 + $10.028 = $39.028
Thus, the product cost for John Elway print in steel frame, no mat is $39.028
(c) Lambeau Field print in wood frame with mat (base cost of print $20)
Direct Materials = Print + Frame and Glass + Matting = $20 + $6 + $4 = $30
Direct Labor = Picking Labor + Matting and Framing Labor
= [$12 x (10/60)] + [$21 x (30/60)]
= $2 + $10.5 = $12.50
Manufacturing Overhead = Picking Prints + Inventory Selection and Management
+ Website Optimization + Framing and Matting
= $0.30 + ($0.7 x 3) + $4.128 + ($2.10 x 3) = $12.828
Total Cost per Unit = Direct Materials + Direct Labor + Manufacturing Overhead
= $30 + $12.5 + $12.828 = $55.328
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Thus, the product cost for Lambeau Field print in wood frame with mat is $55.328

4. Answer:
(a) Why is this the case?

In Case 1 for Greetings, under job order costing, the high-volume prints consumed the greatest
amount of overhead because it was assumed all manufacturing overhead was driven by print cost
combined with sales volume, regardless of the mix of unframed prints and framed prints. Since
the volume of unframed prints sold was much greater than the volume of framed prints sold,
most of the overhead was allocated to unframed prints. Thus, the overhead allocation rate for the
unframed Lance Armstrong print under a traditional volume-based approach is higher, compared
to the amount of overhead that was allocated under ABC system.

(b) What are the potential implications for the company?

ABC system first provides an analysis of how resources were consumed by activity. Next, in the
second step of allocation, activity costs are allocated to unframed prints and framed prints using
different types of drivers. These drivers are designed to model how manufacturing overhead
resources were consumed at the product level. Thus, under ABC system, the costs of unframed
prints allocated will be lower since the activity of framing and matting is not involved in
unframed prints. This will lead that the unframed prints are sold at a lower, more competitive
price to increase sales. The potential implication for the company is that the product costs will
be more accurate, which will result in better product pricing and more accurate evaluation of the
relative profitability of the products.

5. Answer:

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The website optimization was first divided into unframed and framed prints because one-fifth of
the time optimizing the website was spent on unframed prints and the other four-fifths of the
time on framed prints, even though more unframed prints were substantially sold than framed
prints. That is, in order to reflect the significant difference between the amount of time spent on
web optimization by the IT staff on unframed prints versus on framed prints, the total cost of
web optimization was first split between these two categories. In addition, it made more sense to
further allocate overhead costs related to website optimization to each unframed or framed print,
based on the number of prints, because the website had integrated the production of the prints
with the amount of prints purchased by consumers online.

6. Answer:
The pros and cons of splitting the cost related to website optimization between two categories
rather than three are as follows.
Pros:
(1.) It allocates a smaller overhead to unframed prints which require a lot less work than the
framed prints. Allocating the cost of website optimization into two categories reflects the
fact that the majority of the time was consumed on this activity related to framed prints.
(2.) Dividing the cost related to website optimization into two categories creates less work
and easier computations for the accounting department.
Cons:
(1.) Allocating the same overhead to both steel-framed prints with no matting and wood-
framed prints with matting is not accurate. The reason is that the wood-framed prints
with matting require more labor, compared to steel-framed prints. Thus, the wood-
framed prints should be allocated more overhead related to website optimization than
steel-framed prints.
(2.) Dividing the cost related to website optimization into two categories will not be able to
tell how much overhead goes into the matting.

7. Answer:

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The implications of using operating capacity as the cost driver rather than the expected units sold
when allocating fixed overhead costs would be as follows.

(1.) Using operating capacity as the base can keep the fixed overhead costs consistent.
If fixed overhead costs are allocated using the expected units sold, which change from
period to period, then the cost per unit will change from period to period. Thus, it’s
better to use a base that doesn’t change so much, such as operating capacity, in order to
keep the fixed cost per unit stable over time.

(2.) Management can manage costs based on a standard, when using operating
capacity as the cost driver to allocate fixed overhead costs. An activity cost at a
standard is what is necessary for measurement, resource allocation, and evaluation. By
allocating fixed overhead costs using operating capacity as the basis, management can
see how much, approximately, each item costs at capacity. Although this is somewhat
arbitrary, it does provide a benchmark for comparability and improvement. Therefore,
the use of operating capacity for allocating fixed overhead costs can result in better
decision making.

(3.) Using operating capacity as the base can avoid a vicious cycle. If expected units sold
are used to allocate fixed overhead costs, then the allocation rate will fluctuate as sales
fluctuate. This reduces the usefulness of analysis across years and makes planning very
difficult. In fact, it can result in a vicious cycle: As sales volume decreases, the fixed
cost per unit goes up, so product cost goes up. In response, management raises prices,
since the product cost has risen. When the price rises, sales volume falls even further,
and the cycle starts over again. Thus, by allocating based on capacity these fluctuations
can be eliminated.

8. Answer:

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 (a) The allocation of the overhead to unframed prints, steel-framed prints, and wood-framed
prints with matting would be as follows.

Product categories Manufacturing Overhead x Number = Sub Total Total

( from Answer 3) of Units costs assigned
Sold assigned costs per
product
Unframed prints Picking prints: $0.30 80,000 $24,000 $100,640
Inventory selection &
management:$0.70 $56,000
Website optimization: $0.258 $20,640

Steel-framed prints Picking prints: $0.30 15,000 $4,500 $150,420

Inventory selection &
management:$1.40 $21,000
(=$0.7 x 2 components)
Website optimization: $4.128 $61,920
Framing and matting: $4.20 $63,000
(=$2.10 x 2 components)
Wood-framed Picking prints: $0.30 7,000 $2,100 $89,796
prints Inventory selection &
with matting management:$2.10 $14,700
(=$0.7 x 3 components)
Website optimization: $4.128 $28,896
Framing and matting: $6.30 $44,100
(=$2.10 x 3 components)

Total allocated overhead = $100,640 + $150,420 + $89,796 = $340,856

Thus, total amount of for the three product categories are as follows.
Unframed prints is $100,640
Steel-framed prints is $150,420
Wood-framed with matting is $89,796
Total amount of overhead allocated is $340,856

(b) Why the total overhead of $375,200 was not allocated, even though the estimate of sales was
correct? What are the implications of this for management?
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From the calculation listed above, we know that the total amount of overhead allocated is
$340,856. The total estimated/actual overhead of $375,200 was not allocated, even though the
estimate of sales was correct. The reason is that the overhead rates for website optimization and
framing and matting were both determined using the operating capacity amount rather than the
expected units sold. Therefore, since expected/ actual sales were less than capacity, the overhead
is under applied. The overhead being under allocated by $34,344 (= $375,200 - $340,856), can
be viewed as the cost of operating at less than capacity. It also means that the prints cost too
much to produce and cannot make any kind of profit.

Thus, the implication for management is that for reducing this cost of $34,344, management
should either figure out ways to increase sales or reduce fixed costs by shifting resources to other
products. In addition, management must re-examine the activity cost pools, the cost pool drivers,
or even go back to a traditional job cost accounting system to determine overhead costs and
rates.