Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 69

ABC versus Traditional Approaches to Control of Batch-Related Overhead Costs The Bangor Manufacturing Company makes mechanical toy robots that are typically produced in batches of 250 units. Prior to the current year, the company’s accountants used a standard cost system with a simplified method of assigning manufacturing support (i.e., overhead) costs to products: all such costs were allocated to outputs based on the standard machine hours allowed for output produced. You have recently joined the accounting team and are developing a proposal that the company adopt an ABC system for both product-costing and control purposes. To illustrate the benefit of such a system in terms of the latter, you decide to put together an analysis of batch-related overhead costs. You chose these costs because a previous investigation indicated that there is both a variable component to these costs (materials plus power) plus a fixed component (depreciation and salaries). Last year’s budget indicated that the variable overhead cost per setup hour was $20 and that the fixed overhead production setup costs per year were $20,000. Output was budgeted at 10,000 units for the year. Typically a batch takes four hours of setup time. For cost-control purposes, assume that the flexible budget is based on the budgeted number of setup hours for the output of the period.

You have also collected data regarding actual results for the past year. Specifically, the company produced (and sold) 9,000 toy robots, which were produced in an average batch size of 200 units. The actual setup hours per batch last year turned out to be 4.25 hours and the actual variable overhead cost per setup hour was $19. Actual fixed setup-related overhead costs were $21,000 last year.

Your discussion with the company controller indicates that under the previous accounting system, all setup-related overhead costs were allocated to production based on machine hours. The standard machine hours allowed per unit produced was 1.50 hours. The denominator activity level assumed for applying fixed manufacturing support costs to units produced was 15,000 machine hours.

Required

1. Under the ABC approach, what was the (a) spending variance, and (b) production-volume variance last year for the fixed setup-related overhead costs described above? How would you explain these results to management?

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2. Under the ABC approach, what was the (a) spending variance, and (b) efficiency variance last year for the variable setup-related overhead costs described above? How would you explain these results to management?

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3. Write a brief statement outlining the projected costs and benefits of using an ABC approach for the day-to-day control of the overhead costs referred to above as compared to the use of a more traditional cost system.

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4. The Bangor Manufacturing Company is currently experiencing severe cost-based pressure from foreign competitors. As such, top management of the company is interested in improving the existing financial-control system in the organization. What other recommendation might you have for management in this regard? That is, what do you recommend to accompany the type of financial analysis referred to above?

Step 1 of 4

ABC versus Traditional Approaches to Control of Overhead Costs(50-60 minutes)

Additional information needed to solve this problem (highlighted in bold):

	Budgeted	Actual
	Results	Results
Units produced and sold	10,000	9,000
Batch size (units)	250	200
No. of batches	40	45
Set-up hours per batch	4	4.25
Total Set-up hours	160	191.25
Variable OVH cost per set-up hour	$20.00	$19.00
Total set-up-related variable overhead costs	$3,200	$3,633.75
Fixed set-up-related costs per year	$20,000	$21,000
Fixed set-up-related costs/set-up hour:
$20,000/160 hours	$125.00
$21,000/191.25 hours		$109.804

Note that the control (flexible) budget for set-up-related variable overhead costs should be based in this case on set-up hours (the controllable factor). Thus, given an output last year of 9,000 units, the company should have used 36 batches (9,000 units/250 units per batch). At a standard of 4.0 set-up hours per batch, the 9,000 units produced equates to 144 set-up hours.

(1) (a) Fixed overhead spending variance = Actual fixed setup-related costs – budgeted fixed setup-related costs  = $21,000 – $20,000 = $1,000U

?    (b) Production-volume variance = budgeted fixed setup-related costs – applied fixed setup-related overhead costs= $20,000 – (36 batches x 4 setup-hours/batch x $125.00/setup hour) = $20,000 – $18,000 = $2,000U

???Total fixed overhead variance = fixed overhead spending variance + production-volume variance = $1,000U + $2,000U = $3,000U

?As the name implies, the fixed overhead spending variance means that last spending on setup-related fixed overhead costs was $1,000 more than what was envisioned when the master budget was prepared. The production-volume variance in this context means that capacity, measured in terms of budgeted setup hours, was not fully utilized during the period. Specifically, the standard allowed setup hours (for this year’s production), 144, was 16 less than capacity available (160 hours). Thus, $2,000 = 16 hours x $125/hour.