Chapter 9, Problem 48P

Comparative Income Statements and Management Analysis

EZ-Seat, Inc., manufactures two types of reclining chairs, Standard and Ergo. Ergo provides support for the body through a complex set of sensors and requires great care in manufacturing to avoid damage to the material and frame. Standard is a conventional recliner, uses standard materials, and is simpler to manufacture. EZ-Seat’s results for the last fiscal year are shown in the statement below.

EZ-Seat currently uses labor costs to allocate all overhead, but management is considering implementing an activity-based costing system. After interviewing the sales and production staff, management decides to allocate administrative costs on the basis of direct labor costs but to use the following bases to allocate the remaining costs:

Required

1. a.      Complete the income statement using the preceding activity bases.
2. b.      Write a brief report indicating how management could use activity-based costing to reduce costs.
3. c.       Restate the income statement for EZ-Seat using direct labor costs as the only overhead allocation base.
4. d.      Write a report to management stating why product line profits differ using activity-based costing compared to the traditional approach. Indicate whether activity-based costing provides more accurate information and why (if you believe it does provide more accurate information). Indicate in your report how the use of labor-based overhead allocation could cause EZ-Seat management to make suboptimal decisions.

To determine

Complete the income statement using preceding activity bases.

Explanation of Solution

Activity-based costing:

Activity-based costing refers to the method of costing where the overhead cost is assigned to various products. This costing method identifies the relationship between the manufacturing overhead costs and the activities. This relationship is then used to allocate indirect costs to the products.

Complete the income statement using preceding activity bases:

Particulars	Ergo	Standard	Total
Sales revenue	$2,925,000	$2,760,000	$5,685,000
Direct materials	$550,000	$500,000	$1,050,000
Direct labor	$400,000	$200,000	$600,000
Overhead costs:
Add: Administration $\left(\begin{array}{l}\text{Percentage of direct labor }\left(1\right)\\ \times \text{ Direct labor}\end{array}\right)$	$312,000	$156,000	$468,000
Add: Production setup $\left(\begin{array}{l}Rate\text{ per setup }\left(2\right)\\ \times \text{ Number of setups}\end{array}\right)$	$360,000	$720,000	$1,080,000
Add: Quality control $\left(\begin{array}{l}Rate\text{ per inspection }\left(3\right)\\ \times \text{ Number of inspections}\end{array}\right)$	$360,000	$360,000	$720,000
Add: Distribution $\left(\begin{array}{l}Shipping\text{ c}ost\text{ per unit }\left(4\right)\\ \times \text{ Units shipping}\end{array}\right)$	$288,000	$1,152,000	$1,440,000
Total overhead costs	$1,320,000	$2,388,000	$3,708,000
Operating profit $\left(\begin{array}{l}\mathrm{Re}venue\\ -\text{ Total overhead cost}\\ -\text{ Direct materials}\\ -\text{ Direct labor}\end{array}\right)$	$655,000	($328,000)	$327,000

Table: (1)

Working note 1:

Compute the percentage of direct labor applicable:

$\begin{array}{c}Percentage\text{ applicable =}\frac{\text{Administrative costs}}{Direct\text{ labor costs}}\times 100\\ =\frac{\text{\$468,000}}{\$600,000}\times 100\\ =0.78\times 100\\ =78\%\end{array}$

Working note 2:

Compute the rate per setup:

$\begin{array}{c}\text{Rate per setup = }\frac{\text{Production setup costs}}{\mathrm{Pr}oduction\text{ runs}}\\ =\frac{\$1,080,000}{150}\\ =\$7,200\end{array}$

Working note 3:

Compute the rate per inspection:

$\begin{array}{c}\text{Rate per inspection = }\frac{\text{Quality control costs}}{Number\text{ of inspections}}\\ =\frac{\$720,000}{400}\\ =\$1,800\end{array}$

Working note 4:

Compute the shipping cost per unit:

$\begin{array}{c}\text{Shipping cost per unit = }\frac{\text{Distribution costs}}{\text{Number of units shipped}}\\ =\frac{\$1,440,000}{7,500}\\ =\$192\end{array}$

To determine

Write a brief report indicating how management could use activity-based costing to reduce costs

Explanation of Solution

Activity-based costing:

Activity-based costing (ABC) refers to the method of costing where the overhead cost is assigned to various products. This costing method identifies the relationship between the manufacturing overhead costs and the activities. This relationship is then used to allocate indirect costs to the products.

ABC method for reducing the cost:

Reduction in the cost of activities may not be the direct result of implementing the ABC method of costing, but it can highlight the activities where the cost reduction can be made. Reducing the setup costs or other overhead costs specifically from the perspective of cost reduction can be identified using the ABC method of costing.

To determine

Restate the income statement according to the information given in the question.

Explanation of Solution

Recompute the income statement according to the information given in the question:

Particulars	Ergo	Standard	Total
Sales revenue	$2,925,000	$2,760,000	$5,685,000
Direct materials	$550,000	$500,000	$1,050,000
Direct labor	$400,000	$200,000	$600,000
Overhead costs $\left(\begin{array}{l}Overhead\text{ rate }\left(5\right)\\ \times \text{ Direct labor costs}\end{array}\right)$	$2,472,000	$1,236,000	$3,708,000
Operating profit	($497,000)	$824,000	$327,000

Table: (2)

Working note 5:

$\begin{array}{c}Overhead\text{ rate = }\frac{Over\text{head costs}}{Direct\text{ labor costs}}\times 100\\ =\frac{\$3,708,000}{\$600,000}\times 100\\ =6.18\times \text{ 100}\\ \text{= 618\%}\end{array}$

To determine

Write a report to management stating why product line profits differ using activity-based costing compared to the traditional approach. Indicate whether activity-based costing provides more accurate information and provide a reason for the same.

Explanation of Solution

Purpose of the report:

To explain the difference between the implementation of ABC costing and traditional labor-based costing method for the computation of the product line profits.

The implication of both methods:

Direct costs do not differ in both the methods implemented. While using the labor-based method, all the overhead costs are computed under one single head, and while using ABC the bifurcation of cost drivers is relevant to their respective cost of allocation

Result using the traditional labor-based method of costing:

The result shows that the product Ergo has incurred a loss of $497,000 which is 17% percent of the sales revenue. And the product standard has attained a profit of $824,000 which is 30% of sales revenue.

Result using the ABC method of costing:

The result shows that the product Ergo has attained a profit of $655,000 which is 22% percent of the sales revenue. And the product Standard has incurred the loss of $328,000 which is 11% of sales revenue.

Conclusion:

The choice of the method adopted should be ABC costing as the results computed from the traditional labor-based method are very high as compared to ABC costing.