Download Prof. Bentz Activity Based Costing Nestec Company

Prof. Bentz
Activity Based Costing
Nestec Company
Nestec Company allocated its manufacturing support activity costs (SUPPCOST) as
178% of its direct labor cost (DLCOST):
SUPPCOST = 1.78 X DLCOST
Alan DeLeone recently joined the company as an assistant plant controller. He
analyzed in detail the activities performed at the plant and recognized that support costs
were incurred to perform activities related to supervising direct laborers (DLCOST,
direct labor cost); setting up the machines (SETUPS, number of setups); handling
customer orders (ORDERS, number of customer orders); and inspecting and shipping
finished products (SHPMNTS, number of shipments). Therefore, he developed the
following equation to allocate manufacturing support activity costs:
SUPPCOST = (0.9  DLCOST) + ($180  SETUPS) + ($60  0RDERS) + ($80 
SHPMNTS)
In the general format used in this course, the cost allocation formula would be:
ya = 0.90x1 + $180x2 + $60x3 + $80x4,
where ya is the total cost allocated, x1 is the direct labor cost, x2 is the number of setups, x3 is the number of orders, and x4 is the number of shipments during the period.
Planned activities for May and June are as follows:
Month
DLCOST
SETUPS
ORDERS
SHPMNTS
May
June
12-month average
$85,000
91,000
80,000
212
208
200
132
104
120
386
312
340
Required
1. Compute the amount of manufacturing support activity cost that would be allocated
in May and June using the single-variable equation based on direct labor cost only.
2. Compute the amount of manufacturing support activity cost that would be allocated
in May and June using the equation developed by Alan DeLeone.
3. Why is there a difference between the two allocations? Explain why you believe one
allocation should be better than the other.
4. Repeat requirements (a) and (b) using the averages for the year. Why are your
comparisons different in this case?
Adapter from Anthony Atkinson, et. al., Management Accounting (2nd), problem 3-40.
Prof. W. Bentz
Solution to Nestec Company
1.
Based on direct labor as the cost driver, the computation of the allocation of
indirect manufacturing cost would be:
May: $151,300 [1.78  $85,000]
June: $161,980 [1.78  $91,000]
2.
Based on the revised equation using four cost drivers, the computation of the
allocation of indirect manufacturing cost would be:
May: $153,460 [0.9  $85,000 + $180  212 + $60  132 + $80  386]
June: $150,540 [0.9  $91,000 + $180  208 + $60  104 + $80  312]
3.
There is a difference in the two allocations because the mix of activities varies from
month to month, and because setups are relatively much more costly than direct
labor, orders, or shipments. The four cost drivers do not appear to be moving up
and down together (i.e., are uncorrelated), so the single driver, direct labor cost,
does not capture all the information contained in the four drivers. With respect to
cost, there are two relationships to notice. First, the indirect costs are high relative
to the direct labor, so the potential allocation effect is significant. Second, the cost
coefficients in the revised allocation equation differ significantly. They range from
$0.90 to $180. In fact, we can generalize: We would expect the multiple cost
drivers to lead to more accurate costs under two conditions. First, the less
correlated the activity levels, the greater the potential benefit of using multiple cost
drivers. Second, the more the costs of each component activity differ from each
other, the greater the potential difference in the allocations.
4.
Using the two equations to allocate average manufacturing support costs yields
equal total allocation amounts in this case, but this is a misleading result.
Original equation: $142,400 [1.78 x $80,000]
Revised method: $142,400 [0.9  $80,000 + $180  200 + $60  120
+ $80  340]
Focus on the mix of the support activities. Regardless of the allocation method
used, total indirect cost must be forecast based on a planned level of production
volume and the expected costs of operating at that volume. Once total indirect
cost has been forecast, then one or more drivers must be selected to allocate the
indirect cost total. If a single driver is used to allocate the indirect costs, then some
assumptions must be made about the mix of support activities involved. If the
actual mix of driver activities approximates the forecast mix, then the allocated cost
would be about the same, regardless of the number of cost drivers used. On the
other hand, if the mix of driver activities varies materially from the forecast mix,
then one would expect the total cost allocated using one driver rate to vary
materially from that allocated using four different driver activity rates. Because the
mix of activities in May and June varied from the annual average, we would expect
that to continue throughout the year, resulting in different allocation totals for the
year. We would expect to see a difference as between the two methods.
Adapter from Anthony Atkinson, et. al., Management Accounting (2nd), problem 3-40.