The Watts Company is a publicly traded corporation thatproduces different types of commercial food processors. My name isAlan Smith and I have worked for this company for the last tenyears in the controller’s office. I was both an accounting andfinance major in university. The company currently produces 300products and does not anticipate any new products coming out overthe next three years. I have previously mentioned to my superiorsthat it is not appropriate for our firm to use a traditionalaccounting system (where overhead costs are allocated acrossproducts at a rate of $100 per direct labor hour) when differentproducts require different amounts of indirect overhead resources.For example, under the traditional system all costs associated withtesting of products for quality assurance purposes are part ofoverhead costs and therefore allocated across products based ondirect labor hours. Yet, some of our products require as much as 5hours of testing whereas some products require less than 1 minuteof testing with no connection to direct labor hours. Given thattraditional costing systems result in significant cost distortionswhen determining products costs and given that the firm now hasrevenues of over $100 million a year, Watts has decided to adoptactivity based costing over the next year or two.

Watts’s management has hired Deloitte Consulting to helpus implement activity based costing. I will be acting as theliaison between our firm and Deloitte. As part of the initialimplementation phase, I have asked Deloitte to derive the costs andproduct margins associated with two of our products, Classic andArtisan, so that these costs and product margins could be comparedwith the costs and product margins under our current traditionalaccounting system. I picked these products since Watts managementbelieve they have very different demands on indirect overheadresources. Further, Classic is sold in large quantities whereasArtisan is sold in small quantities and traditional accountingsystems can cause large cost distortions in different directionsfor products sold in large and small quantities.

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

Exhibit 1

	          Classic	          Artisan
Direct material	$120	$200
Direct labor hours	1.2	1.5
Direct labor wage rate per hour	$20	$20
Sales price per unit	$300	$450

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

Exhibit 2

	Total Costs	Allocation Base	Level of Allocation Base
Equipment setups	$24,000,000	number of setups	60,000
Purchase orders	$72,000,000	number of purchase orders	300,000
Machining	$25,000,000	number of machine hours	1,250,000
Testing	$42,000,000	number of testing hours	600,000
Packaging and shipping	$50,000,000	number of containers	1,000,000

Although fixed costs are lumped in with variable costsacross the five different cost pools, I am aware that machiningrelated costs consists almost exclusively of depreciation costs.Hence, with respect to all questions asked in this case, machiningcosts will be treated as entirely fixed with respect to machinehours. Each machine is used in the production of multiple productlines. The resale value of machines is only affected by the passageof time and not by how much they are used in a givenyear.

In all questions asked in this case, the firm willassume that costs associated with equipment setups, purchaseorders, testing, and packaging & shipping are variable withrespect to their respective activity measures. Currently, webelieve our assumptions on cost behavior patterns are quitereasonable.

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

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

Further information on our two products is provided inExhibit 3

Exhibit 3

	        Classic	               Artisan
annual sales and production in units	400,000	50,000
number of units per batch	400	80
number of purchase orders	600	300
number of machine hours per unit	0.4	2
total number of testing hours	8,000	100,000
total number of containers	5,000	20,000

REQUIRED:

1. (20 Points) Prepare an income statement for Classicand an income statement for Artisan using the traditionalaccounting system where overhead is applied at a rate of $100 perdirect labor hour. (For simplicity, SG&A expenses for the firmare not included in the income statement for the two products.) Theincome statements should be prepared on a total basis and then showthe average net operating income per unit using the followingtemplate for guidance:

     Classic  Artisan

Sales $$$ $$$

Direct materials    $$$    $$$

Direct labor    $$$    $$$

Manufacturing overhead    $$$    $$$

Total Costs     $$$ $$$

Net operating income $$$ $$$

Average net operating income

   per unit $$$ $$$

2. (20 Points) Calculate the five activity rates underactivity based costing.