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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.