Choosing cost drivers, activity-based costing, activity-based management

Pastel Bags (PB) is a designer of high-quality backpacks and purses. Each design is made in small batches. Each spring, PB comes out with new designs for the backpack and for the purse. The company uses these designs for a year and then moves on to the next trend. The bags are all made on the same fabrication equipment that is expected to operate at capacity. The equipment must be switched over to a new design and set up to prepare for the production of each new batch of products. When completed, each batch of products is immediately shipped to a wholesaler. Shipping costs vary with the number of shipments. Budgeted information for the year is as follows:

Other budget information follows:

Required:
1. Identify the cost hierarchy level for each cost category.
2. Identify the most appropriate cost driver for each cost category. Explain briefly your choice of cost driver.
3. Calculate the budgeted cost per unit of cost driver for each cost category.
4. Calculate the budgeted total costs and cost per unit for each product line.
5. Explain how you could use the information in requirement 4 to reduce costs.

1.
Direct materials—purses Output unit-level costs
Direct materials—backpacks Output unit-level costs
Direct manufacturing labor—purses Output unit-level costs
Direct manufacturing labor—backpacks Output unit-level costs
Setup Batch-level costs
Shipping Batch-level costs
Design Product-sustaining costs
Plant utilities and administration Facility-sustaining costs

2.
Direct materials—purses Number of purses
Direct materials—backpacks Number of backpacks
Direct manufacturing labor—purses Number of purses
Direct manufacturing labor—backpacks Number of backpacks
Setup Number of batches
Shipping Number of batches
Design Number of designs
Plant utilities and administration Hours of production

Direct material and direct manufacturing labor are costs that can be easily traced to output, which in this case is the number of purses or backpacks produced.

Setup and shipping are both a function of the number of batches produced.

Design is related to the number of designs created for each product.

Plant utilities and administration result from general activity level in the plant. Thus, hours of production seems to be an appropriate cost driver.

3.
Direct materials—purses $319,155 ÷ 3,075 purses = $103.79 per purse
Direct materials—backpacks $454,995 ÷ 6,175 backpacks = $73.68 per backpack
Direct manufacturing labor—purses $99,000 ÷ 3,075 purses = $32.20 per purse
Direct manufacturing labor—backpacks $113,000 ÷ 6,175 backpacks = $18.30 per backpack
Setup $64,000 ? 200 batches = $320 per batch
Shipping $73,000 ? 200 batches = $365 per batch
Design $169,000 ÷ 4 designs = $42,250 per design
Plant utilities and administration $221,000 ÷ 4,250 hours = $52 per hour

4.
Backpacks Purses Total
Direct materials $454,995 $319,155 $ 774,150
Direct manufacturing labor 113,000 99,000 212,000
Setup
($320 × 120; 80 batches) 38,400 25,600 64,000
Shipping
($365 × 120; 80 batches) 43,800 29,200 73,000
Design
($42,250 × 2; 2 designs) 84,500 84,500 169,000
Plant utilities and administration
($52 × 1,665; 2,585 hours) 86,580 134,420 221,000
Budgeted total costs $821,275 $691,875 $1,513,150
Divided by number of backpacks/purses ÷ 6,175 ÷ 3,075
Budgeted cost per backpack/purse $ 133.00 $ 225.00

5. Based on this analysis, more than 50% of product cost relates to direct material. Managers should determine whether the material costs can be reduced. Producing in small lots increases the setup and shipping costs. While both are relatively small components of product cost, management may want to evaluate ways to reduce the number of setups and the cost per setu