class 05 --the problem of overhead

Managerial Accounting

Product Costing:The Problem of

Overheadmyeducator.co

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Today’s Agenda• The price of wedding announcements

– Setting prices based on costs– Opportunity costs

• Making Airplanes• Lily Ice Cream Company

– Allocating overhead based on business activities– Activity-based Costing (ABC)

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What SHOULD You Have DoneBefore the Start of Class Today?

1. Done the MyEducator preparation for Quiz 5a.

2. Completed the pre-class Quiz (5a).

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Helping a Friend

Wild Horse Wedding Announcements

• “Fair” price = Cost + $50• 40 orders per month• Loses $3,000 in a typical month

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Helping a Friend

Wild Horse Wedding AnnouncementsMonthly Income StatementRevenue $16,000

Cost of Goods Sold: Direct materials cost (10,000) Direct labor cost (4,000)Gross profit $2,000

Operating expenses Electricity (300) Rent (1,000) Insurance (400) Bookkeeping (800) Equipment depreciation (2,500)Total operating expenses (5,000)

Operating income (loss) ($3,000)

Income taxes (40%) 0

Net income (loss) ($3,000)myeducator.co

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Helping a Friend


Your friend calculates that the production cost of each wedding announcement order is $350 ($14,000 ÷ 40). Accordingly, your friend is setting the price at $400 ($350 + $50).

• What mistake is your friend making?

• What price would you suggest?

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Helping a Friend

Wild Horse Wedding Announcements• Better cost estimate

Direct materials cost $10,000 Direct labor cost 4,000 Overhead cost 5,000Total $19,000

÷ 40 orders per month $475

Plus $50??

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New Selling Price = $475 + $50 = $525Monthly Income StatementRevenue $21,000



Operating income (loss) $2,000

Income taxes (40%) (800)

Net income (loss) $1,200

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Helping a Friend


Your friend has invested her life savings of $300,000 to buy the equipment and get this business going.

• Does this change your advice about a reasonable selling price per order?

• Explain.myeducator.co

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Helping a Friend


Assume that your friend can earn, after income taxes, an average of 12% per year (1% per month) by relaxing and just investing her $300,000.

Monthly “opportunity” cost of having the money tied up in this business:

$300,000 × 0.01 = $3,000myeducator.co

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Helping a Friend

Wild Horse Wedding Announcements40 orders × $600 each

Revenue $24,000




Income taxes (40%) (2,000)

Net income (loss) $3,000myeducator.co

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Helping a Friend


Your friend has a couple of part-time employees who work a total of 200 hours per month. Your friend herself works in the business about 60 hours per week.

• Does this change your advice about a reasonable selling price per order?

• Explain.

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Helping a Friend


Assume that your friend can earn, after income taxes, $60,000 per year ($5,000 per month) by shutting down Wild Horse and getting a job.

“Opportunity” cost of using your time to run the business:

$5,000 per month

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Helping a Friend

Wild Horse Wedding Announcements40 orders × $808.33 each

Monthly Income StatementRevenue $32,333




Income taxes (40%) (5,333)

Net income (loss) $8,000 myeducator.com

Helping a Friend


• $808.33 per order!!!• Quite a bit more than $400

Does it now pay Dugway people to drive to Grantsville, Tooele, or even Salt Lake to get their wedding announcements?

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Key Points• When products are specialized, cost is

an important input into determining price.

• Someone has to pay your overhead costs … either you or your customers.

• Don’t forget your opportunity costs.

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What Causes Overhead?

Boeing1. How does a design change create extra

overhead?

2. If Boeing allocates overhead based on direct labor hours, do customers order too many design changes? Explain.

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What Causes Overhead?

Boeing3. If Boeing allocates overhead based on direct labor

hours, which mistakes will Boeing make?a. Highly customized aircraft are sold at a price that

is too low.b. Generic aircraft are sold at a price that is too high,

reducing demand.c. Some unprofitable orders are accepted.d. Some potentially profitable orders are rejected.e. Allow Airbus to take over the aerospace industry.

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More Practice with Product Costs

Lily Ice Cream Company• Lily manufactures ice cream• Traditionally she has produced and sold just

plain vanilla• In the past, Lily has made solid profits

• Lily has decided to start making and selling her own flavors of gourmet ice cream

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Lily Ice Cream CompanyNew overhead costs• Flavor chemist• Many new quality control inspectors

– Inspection at start and end of every batch• New machine workers, setup for the many new

batches• Machines need to be cleaned more frequently• Accounting costs have gone up

– Ordering different ingredients– More reports

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Lily Ice Cream CompanyTraditionally, Lily has had a very simple method of overhead allocation.

• Total overhead divided by number of gallons of ice cream produced

• Each gallon of ice cream allocated the same amount of overhead

This was fine because everything was VANILLA.

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Lily Ice Cream CompanyHere are Lily’s problems.• Overall profitability has slipped since the

introduction of the new flavors.• The vanilla ice cream is now being sold at a

loss.

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Traditional Profitability Report

Lily Ice Cream Company Double

Marshmallow Gingerbread Strawberry Dutch PeanutCaramel Cheesecake Banana Chocolate Butter

Vanilla Delight Supreme Surprise Brownie Swirl TotalNumber of gallons 500,000 250,000 200,000 50,000 400,000 100,000 1,500,000

Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000

Production cost:Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000Overhead ($1.16 per gallon) 580,000 290,000 232,000 58,000 464,000 116,000 1,740,000

Total f lavor production cost 905,000 590,000 582,000 123,000 964,000 316,000 3,480,000

Flavor gross profit ($155,000) $35,000 $18,000 $2,000 ($164,000) $34,000 ($230,000)

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Lily Ice Cream Company

Lily is considering dropping

vanilla ice cream!!!(and chocolate )

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Activity-Based Costing

Batches and Flavors

Vanilla and Chocolate – LARGE Batches

----------V----------- ---------- C ----------

6 Flavors – small Batches VCSGMPVCSGMPVCSGMPVCSGMPVCSGMPV

Vanilla and Chocolate – small BatchesVCVCVCVCVCVCVCVCVCVCVCVCVCVCVCVCVC

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Lily Ice Cream CompanyFive Steps in implementingand using an ABC system

1.Identify overhead cost activities2.Analyze individual overhead costs in terms of

cost activities3.Identify measurable cost drivers4.Assign overhead5.Use the ABC data to make decisions

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Lily Ice Cream CompanyComplete Analysis of Overhead Cost Items

Overhead Cost Activities

Overhead || Ice Cream Ice

Cream Ice

Cream Keeping Factory

Overhead Cost Items Costs || Production Batches Flavors Open Electricity $200,000 || $200,000 $0 $0 $0 Machine depreciation 400,000 || 400,000 0 0 0 Factory cleaners 300,000 || 90,000 210,000 0 0 Machine repairpersons 100,000 || 15,000 85,000 0 0 Production supervisor 200,000 || 30,000 100,000 70,000 0 Flavor chemist 170,000 || 0 0 170,000 0 Accounting department 150,000 || 15,000 45,000 30,000 60,000 Building depreciation 80,000 || 0 0 0 80,000 Security guards 90,000 || 0 0 0 90,000 Building insurance 50,000 || 0 0 0 50,000 Total $1,740,000 || $750,000 $440,000 $270,000 $280,000

Cost Pools myeducator.co

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Lily Ice Cream Company Cost Cost Activity Driver Operating the Gallons of ice cream ice cream production process produced Producing Batches produced a specific batch of ice cream

Servicing Number the special needs of ingredients of each individual ice cream flavor Keeping the factory open Not applicable

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Lily Ice Cream Company Overhead Cost Number of per Overhead cost activity Cost Pool Amount Cost Driver Events Cost Driver Event Ice cream production $750,000 1,500,000 gallons $0.50 per gallon Ice cream batches 440,000 500 batches $880 per batch Ice cream flavors 270,000 100 ingredients $2,700 per ingredient Keeping the factory open 280,000 not assigned not assigned

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Traditional Profitability Report

Lily Ice Cream Company Double



Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000

Production cost:Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000Overhead ($1.16 per gallon) 580,000 290,000 232,000 58,000 464,000 116,000 1,740,000


Flavor gross profit ($155,000) $35,000 $18,000 $2,000 ($164,000) $34,000 ($230,000)

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ABC Profitability Report


Using the detailed overhead analysis data, recompute gross profit for each of the 6 flavors.

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Lily Ice Cream Company Number of Number of Number of Flavors Gallons Batches Ingredients Vanilla 500,000 25 5 Marshmallow Caramel Delight 250,000 50 20 Gingerbread Cheesecake Supreme 200,000 235 25 Strawberry Banana Surprise 50,000 60 10 Double Dutch Chocolate Brownie 400,000 30 10 Peanut Butter Swirl 100,000 100 30 Total 1,500,000 500 100

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Lily Ice Cream CompanyABC overhead calculation: VANILLAProduction

500,000 gallons × $0.50 = $250,000Batches

25 batches × $880 = $22,000Flavors

5 ingredients × $2,700 = $13,500myeducator.co

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Lily Ice Cream Company (VANILLA)Traditional ABC

Vanilla VanillaNumber of gallons 500,000 500,000

Sales $750,000 $750,000

Production cost:Direct materials 200,000 200,000Direct labor 125,000 125,000

Overhead (traditional) 580,000

Overhead (using ABC):Gallons of ice cream 250,000Number of batches 22,000Number of ingredients 13,500 Total 285,500

Total f lavor production cost 905,000 610,500

Flavor gross profit ($155,000) $139,500

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Lily Ice Cream CompanyWhat is ABC GROSS PROFIT for•Gingerbread Cheesecake Supreme ice cream?

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Lily Ice Cream CompanyABC overhead calculation:Gingerbread Cheesecake SupremeProduction

200,000 gallons × $0.50 = $100,000Batches

235 batches × $880 = $206,800Flavors

25 ingredients × $2,700 = $67,500myeducator.co

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Lily Ice Cream CompanyDouble



Sales $750,000 $625,000 $600,000 $125,000 $800,000 $350,000 $3,250,000

Production cost:Direct materials 200,000 200,000 250,000 50,000 300,000 150,000 1,150,000Direct labor 125,000 100,000 100,000 15,000 200,000 50,000 590,000Overhead (using ABC):Gallons of ice cream 250,000 125,000 100,000 25,000 200,000 50,000 750,000Number of batches 22,000 44,000 206,800 52,800 26,400 88,000 440,000Number of ingredients 13,500 54,000 67,500 27,000 27,000 81,000 270,000


Flavor gross profit $139,500 $102,000 ($124,300) ($44,800) $46,600 ($69,000) $50,000

Facility support costs 280,000

Company gross prof it ($230,000)

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Lily Ice Cream CompanyGingerbread Cheesecake Supreme lost $124,300.

What can we do to make this flavor profitable?

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Lily Ice Cream CompanyGingerbread Cheesecake Supreme

Use of cost drivers:• 200,000 gallons• 235 batches• 25 ingredients

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Further investigation reveals the following:

The large number (235) of Gingerbread Cheesecake Supreme batches is the result of one customer, an ice cream retail chain, that insists on having its Gingerbread Cheesecake Supreme ice cream produced fresh daily.

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What would the flavor gross profit of Gingerbread Cheesecake Supreme be if the number of batches could be cut to approximately one per WEEK (50) instead of one per working DAY (235)?

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Lily Ice Cream Company 235 batches 50 batches Gingerbread Gingerbread Cheesecake Cheesecake Supreme Supreme Number of gallons 200,000 200,000 Sales $600,000 $600,000 Production cost: Direct materials 250,000 250,000 Direct labor 100,000 100,000 Overhead (using ABC): Gallons of ice cream 100,000 100,000 Number of batches 206,800 44,000 Number of ingredients 67,500 67,500 Total flavor production cost 724,300 561,500 Flavor gross profit ($124,300) $38,500

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A good managerial accounting measure

• Reflects economic reality• Motivates correct behavior

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Today’s Agenda• The price of wedding announcements

– Setting prices based on costs– Opportunity costs

• Making Airplanes• Lily Ice Cream Company

– Allocating overhead based on business activities– Activity-based Costing (ABC)

myeducator.com

For Next Time1. Launch QUIZ 5b by Friday at 11:59 p.m.2. Study website topics for Day 6 in preparation

for Quiz 6.3. Decide whether you need/want to come to

class on Tuesday. 4. Launch QUIZ 6 on MyEducator by WEDNESDAY

at 11:59 p.m.

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class 05 --the problem of overhead

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