Reference no: EM131442726

Lambert Case

The Lambert Company is a publicly traded corporation that produces different types of digital control systems.  My name is Alan Smith and I have worked for this company for the last ten years in the controller's office.  I was both an accounting and finance major in university.  The company currently produces 300 products and does not anticipate any new products coming out over the next three years.  I have previously mentioned to my superiors that it is not appropriate for our firm to use a traditional accounting system (where overhead costs are allocated across products at a rate of 450% of direct labor costs) when different products require different amounts of indirect overhead resources. For example, under the traditional system all costs associated with testing of products for quality assurance purposes are part of overhead costs and therefore allocated across products based on direct labor costs.  Yet, some of our products require as much as 5 hours of testing whereas some products require less than 1 minute of testing with no connection to direct labor costs.  Given that traditional costing systems result in significant cost distortions when determining products costs and given that the firm now has revenues of over $600,000,000 a year, Lambert has decided to adopt activity based costing over the next year or two.

Lambert's management has hired Deloitte Consulting to help us implement activity based costing.  I will be acting as the liaison between our firm and Deloitte.  As part of the initial implementation phase, I have asked Deloitte to derive the costs and product margins associated with two of our products, alpha and beta, so that these costs and product margins could be compared with the costs and product margins under our current traditional accounting system.  I picked these products since Lambert management believe they have very different demands on indirect overhead resources.  Further, alpha is sold in large quantities whereas beta is sold in small quantities and traditional accounting systems can cause large cost distortions in different directions for products sold in large and small quantities. 

Current information from our existing system on a per unit basis is shown in Exhibit 1.

Exhibit 1 -

	alpha	beta
Direct material	$15	$15
Direct labor hours	1	1
Direct labor wage rate per hour	$30	$30
Sales price per unit	$210	$230

My staff has identified for Deloitte five activity cost pools.  Information on those cost pools and the related activity measures are provided in Exhibit 2.

Exhibit 2 -

Activity cost pool	Total costs	Activity measure	Activity level
Equipment setups	$24,000,000	number of setups	60,000
Purchase orders	$18,000,000	number of purchase orders	40,000
Machining	$90,000,000	number of machine hours	1,800,000
Testing	$13,500,000	number of testing hours	500,000
Packaging	$22,000,000	number of containers	2,000,000

Although fixed costs are lumped in with variable costs across the five different cost pools, I am aware that machining related costs consists almost exclusively of depreciation costs.  Hence, with respect to all questions asked in this case, machining costs will be treated as entirely fixed with respect to machine hours.  Each machine is used in the production of multiple product lines.  The resale value of machines is only affected by the passage of time and not by how much they are used in a given year.

In all questions asked in this case, the firm will assume that costs associated with equipment setups, purchase orders, testing, and packaging are variable with respect to their respective activity measures.  Currently, we believe our assumptions on cost behavior patterns are quite reasonable. 

All products are produced in batches, where the size of a batch differs across products. For example, if we produce 80 units of a product in batch sizes of 40, then the product will be produced in two batches. An equipment setup must be performed before producing each batch of a product. Hence, in the example above, two equipment setups would be performed.  Units of product are packaged in containers and sent to distributors.

Production volumes are set equal to sales volumes since the company only produces products that they have orders for.  Consequently, the firm never has a beginning or ending work in process inventory, and it does not have a beginning or ending finished goods inventory. 

Further information on our two products is provided in Exhibit 3

Exhibit 3 -

	alpha	beta
annual sales and production in units	1,000,000	20,000
number of units per batch	250	200
number of purchase orders	500	160
number of machine hours per unit	0.5	4
total number of testing hours	6,000	23,000
total number of containers	5,500	1,800

REQUIRED:

1. Prepare an income statement for alpha and an income statement for beta using the traditional accounting system where overhead is applied at a rate of 450% of direct labor costs.  (For simplicity, there are no SG&A expenses for the firm.)  The income statements should be prepared on a total basis and then show the average net operating income per unit using the following template for guidance:

                                                         alpha                                beta

Sales                                                          $$$                                    $$$        

Direct materials                            $$$                                       $$$                        

Direct labor                                  $$$                                       $$$                        

Manufacturing overhead                $$$                                       $$$                        

Total Costs                                                  $$$                                    $$$                        

Net operating income                                   $$$                                    $$$                        

Average net operating income

per unit                                                      $$$                                    $$$

2. Calculate the five activity rates under activity based costing.

3. Prepare an income statement for alpha and an income statement for beta using activity based costing.  (For simplicity, there are no SG&A expenses for the firm.)  The income statements should be prepared on a total basis and then show the average net operating income per unit using the following template for guidance:

                                             alpha                                     beta

Sales                                                 $$$                                         $$$        

Direct materials                    $$$                                         $$$                        

Direct labor                          $$$                                         $$$                        

Equipment Setups                 $$$                                         $$$                        

Purchase orders                   $$$                                         $$$                        

Machining                            $$$                                         $$$                        

Testing                                $$$                                         $$$                        

Packaging                            $$$                                         $$$                        

Total Costs                                         $$$                                         $$$                        

Net operating income                           $$$                                         $$$                        

Average net operating income

per unit                                              $$$                                         $$$

4. Can you help Mr. Smith explain to his colleagues why the unit cost for beta differs so much under traditional costing system versus under activity-based costing system? Your explanation should not be more than 1/2 page double spaced with a 12 font size.

5. Assume next year that the activity rates remain the same as you calculated in question (2).  Assume that the demand for alpha is expected to increase significantly.  Consequently, the firm expects to produce more batches of alpha next year than this year and the firm plans to produce in batch sizes of 400 rather than 250.  Calculate what the equipment setup cost per unit of alpha will be next year if it can be calculated.  If it cannot be calculated, then explain in words why the equipment setup cost per unit of alpha cannot be determined in the absence of more information.   Excluding your quantitative analysis if any, your explanation should not be more than 1/3 page double spaced with a 12 font size.

6. Question 6 is independent of question 5.  Next year, because of an expected increase in product demand, machine hours are expected to increase from 1,800,000 to 2,000,000.  The company will not need any new machinery since the current machinery is highly underutilized. Also, the number of purchase orders will increase from 40,000 to 60,000.  Assume that these new levels of operations are within the firm's relevant range. Calculate what the activity rate for the cost pool of machining would be next year if it can be calculated.  Also, calculate what the activity rate forthe cost pool of purchase order would be next year if it can be calculated.  If one or both rates cannot be calculated, then explain in words why the calculations cannot be determined in the absence of more information. Excluding any quantitative analysis, your explanation should not be more than 1/3 page double spaced with 12 font.