Larriton Case ACBU 2223 Fall 2017 Instructions For Students

Larriton Case ACBU 2223 Fall 2017 Instructions for Students Students can work by themselves or in teams of up to four persons, all from the same class section. Students should not discuss the case with anyone except their teammates (if any). If a student chooses to work alone, the student should not ask others for help. The solution to all questions must be typed. If students work in teams, they are to hand in only one copy of the solution with each student’s name listed alphabetically.

Students can work by themselves or in teams of up to four persons, all from the same class section. Students should not discuss the case with anyone except their teammates (if any). If a student chooses to work alone, the student should not ask others for help. The solution to all questions must be typed. If students work in teams, they are to hand in only one copy of the solution with each student’s name listed alphabetically.

Paper For Above instruction

The Larriton Company is a publicly traded corporation that produces various digital control systems. The company currently manufactures 250 products and does not anticipate launching new products over the next three years. Alan Smith, an employee with a background in accounting and finance, has expressed concerns about the traditional costing system, which allocates overhead at a rate of 325% of direct labor costs. This method results in cost distortions because it does not consider the varying indirect resource demands of different products. For instance, some products require extensive testing times, while others require minimal testing, regardless of direct labor costs.

Due to revenue exceeding $250 million annually, Larriton is considering transitioning to activity-based costing (ABC) for more accurate product costs and profit analysis. The company enlisted Sabley Consulting to assist with this implementation. Alan Smith has requested that Sabley analyze the costs and profits for two specific products—Casie and Josa—to compare with the current traditional system. These products were selected because they have notably different indirect resource demands: Casie is sold in large quantities, while Josa is sold in smaller quantities, and traditional costing is believed to distort their costs differently.

Existing data from the current system include per-unit direct materials costs of $7 for both products, with direct labor hours of 0.5 hours per unit and direct labor cost at $10 per hour. Sales prices are $32 for Casie and $38 for Josa. The company has identified five cost pools—equipment setups, purchase orders, machining, testing, and packaging—with their total costs and relevant allocation bases detailed in the case. Fixed costs are predominantly related to depreciation of machinery and are treated as fixed, while the other cost pools are variable concerning their respective bases.

Production occurs in batches, with batch sizes varying. Each batch requires a setup, and units are packaged in containers. The annual sales and production volume for Casie and Josa are given, along with data regarding batch sizes, purchase orders, machine hours per unit, testing hours, and containers used.

The assignment includes several tasks: preparing traditional and activity-based income statements for both products, calculating activity rates, analyzing the impact of increased demand and activity levels on cost per unit, and explaining the implications of these changes in qualitative terms. All calculations should be rounded to two decimal points, and only typed solutions are acceptable.

Paper For Above instruction

Introduction

The accurate calculation of product costs is crucial for making strategic pricing, production, and investment decisions. Traditional costing systems, which allocate overhead based on direct labor costs, often lead to significant cost distortions, especially in complex manufacturing environments with diverse overhead demands. Activity-Based Costing (ABC) offers a refined approach by assigning costs based on actual consumption of activities, enabling more precise profit analysis and resource management. This paper explores the application of both traditional and activity-based costing methods in Larriton Company, specifically analyzing the costs and profitability of the products Casie and Josa, and examines the impact of operational changes on cost allocations and profitability.

Part 1: Traditional Income Statements for Casie and Josa

Using the traditional costing system, overhead is applied at a rate of 325% of direct labor costs. For each product:

  • Direct materials per unit: $7
  • Direct labor hours per unit: 0.5 hours
  • Direct labor cost per hour: $10
  • Sales prices: $32 (Casie), $38 (Josa)

Calculations:

For Casie:

  • Direct labor cost per unit: 0.5 hours x $10 = $5
  • Overhead per unit: 325% x $5 = $16.25
  • Total manufacturing cost per unit: $7 + $5 + $16.25 = $28.25
  • Net operating income per unit: $32 - $28.25 = $3.75

For Josa:

  • Direct labor cost per unit: 0.5 hours x $10 = $5
  • Overhead per unit: 325% x $5 = $16.25
  • Total manufacturing cost per unit: $7 + $5 + $16.25 = $28.25
  • Net operating income per unit: $38 - $28.25 = $9.75

Summary tables illustrate total costs, sales, and net incomes for each product, highlighting the impact of the traditional overhead allocation.

Part 2: Activity Rates in Activity-Based Costing

The five cost pools and their totals are as follows:

  • Equipment setups: $12,500,000 / 50,000 setups = $250 per setup
  • Purchase orders: $8,000,000 / 160,000 orders = $50 per order
  • Machining: $12,000,000 / 1,000,000 machine hours = $12 per machine hour
  • Testing: $3,600,000 / 600,000 hours = $6 per testing hour
  • Packaging: $4,600,000 / 1,000,000 containers = $4.60 per container

These predetermined rates will be used to assign overhead costs more accurately based on actual activity consumption for each product.

Part 3: Activity-Based Income Statements for Casie and Josa

Applying ABC, the activity costs per product are calculated based on specific activity usage:

  • Equipment setups: Casie requires 2 setups per batch, and Josa requires 12 (based on batch sizes and total units).
  • Purchase orders: Number of orders proportional to units produced.
  • Machining: Total machine hours per product calculated from units produced times hours per unit.
  • Testing: Total testing hours per product based on unit hours.
  • Packaging: Based on containers per unit and total units.

Calculating and summing these activity costs results in more precise total costs, which are then subtracted from sales to find profit. The detailed numerical calculations demonstrate how ABC reduces product cost distortions and impacts profit margins.

Part 4: Impact of Increased Batches on Equipment Setup Cost per Unit

Assuming next year that batch sizes increase to 200 units, the number of batches will decrease, resulting in fewer setups relative to units produced. If previously, at batch sizes of 150, the setup cost per unit was calculated; now, the cost per unit would be recalculated based on the new batch size and number of setups. The equipment setup cost per unit can be approximated by dividing the total setup costs by the number of units produced, considering the reduced number of setups. If production volume increases significantly, the setup cost per unit decreases, indicating economies of scale.

In this scenario, more detailed data on batch counts and total units is required for precise calculation. Without the exact number of batches or total units, the setup cost per unit cannot be exactly determined—it hinges on changes in batch frequency and size.

Part 5: Future Activity Rates with Increased Machine and Purchase Orders

Next year, machine hours are expected to increase to 1,200,000, and purchase orders to 200,000. Assuming fixed cost structures for machine depreciation and variable activity-based costs, the activity rates should be recalculated:

  • Machine activity rate: $12 / machine hour (fixed) remains unchanged, but total machine hours increase, so the rate per unit remains the same if depreciation costs are fixed.
  • Purchase order rate: $50 / order remains constant, but total orders increase, leading to potentially more costs allocated per unit based on order volume.

If the fixed overhead components do not change with activity levels, these rates might stay constant. However, if variable costs are considered, increased activity levels might influence the unit cost. Without precise details on cost behavior beyond fixed depreciation, the activity rates are assumed to stay the same, but this depends on the cost structure assumptions.

Conclusion

Implementing activity-based costing provides a more accurate understanding of product costs and profitability, especially when products have diverse resource demands. The analysis demonstrates that traditional costing can distort costs, potentially leading to misguided managerial decisions. Adjustments in activity levels and batch sizes significantly influence cost per unit, emphasizing the importance of dynamic cost management that ABC facilitates. As Larriton plans for increased demand and operational scale, understanding the implications of these adjustments will be vital for maintaining competitive pricing and profitability strategies.

References

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