Larriton Case

Larriton Case
The Larriton 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 250 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 325% of direct labor costs) when different products require different amounts of indirect 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 $250,000,000 a year, Larriton has
decided to adopt activity based costing over the next year or two.
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Larriton’s management has hired Sabley Consulting to help us implement activity based costing. I will be acting as the liaison between our firm
and Sabley. As part of the initial implementation phase, I have asked Sabley to derive the costs and profits associated with two of our
products for this past year, casie and josa, so that these costs and profits could be compared with the costs and profits under our current
traditional accounting system for this past year. I picked these products since Larriton management believe they have very different demands on
indirect resources. Further, casie is sold in large quantities whereas josa 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
casie
josa
Direct material
$7
$7
Direct labor hours
0.5
0.5
Direct labor cost per hour
$10
$10
Sales price per unit
$32
$38
My staff has identified for Larriton five cost pools. Information on those cost pools and the related allocation bases are provided in Exhibit
2.
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Exhibit 2
Total Costs
Allocation Base
Value of Allocation Base
Equipment setups
$12,500,000
number of setups
50,000
Purchase orders
$8,000,000
number of purchase orders
160,000
Machining
$12,000,000
number of machine hours
1,000,000
Testing
$3,600,000
number of testing hours
600,000
Packaging
$4,600,000
number of containers
1,000,000
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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 the 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 allocation bases. 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 work in process inventory or a beginning finished goods inventory. (Hence, the firm never has ending inventories.)
Further information on our two products are provided in Exhibit 3
Exhibit 3
casie
josa
annual sales and production in units
240,000
4,800
number of units per batch
150
40
number of purchase orders
450
80
number of machine hours per unit
0.40
0.8
testing hours
12,000
8,400
number of containers
1,400
600
REQUIRED: Students can work by themselves or in teams of up to four persons, all from the same class. Students should not discuss the case with
anyone except their teammates (if any). If a student chooses to work alone, the student should not seek help from other students, faculty or
other persons. The solution to all problems must be typed. Round off all calculations to two decimal points.
1. (20 Points) Prepare an income statement for casie and an income statement for josa using the traditional accounting system where overhead is
applied at a rate of 325% of direct labor costs. 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:
casie josa
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 (predetermined overhead rates) under activity based costing.
3. (35 Points) Prepare an income statement for casie and an income statement for josa using activity based costing. 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:
casie josa
Sales $$$ $$$
Direct materials $$$ $$$
Direct labor $$$ $$$
Equipment Setups $$$ $$$
Purchase orders $$$ $$$
Machining $$$ $$$
Testing $$$ $$$
Packaging $$$ $$$
Total Costs $$$ $$$
Net operating income $$$ $$$
Average net operating income
per unit $$$ $$$
4. (10 Points) Assume next year that the activity rates (predetermined overhead rates) remain the same as you calculated in question (2).
Assume that the demand for casie is expected to increase significantly. Consequently, the firm expects to produce more batches of casie next
year than this year and the firm plans to produce in batch sizes of 200 rather than 150. Calculate what the equipment setup cost per unit of
casie 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
casie 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.
5. (15 Points) Question 5 is independent of question 4. Next year, because of an expected increase in product demand, machine hours are
expected to increase from 1,000,000 to 1,200,000. The company will not need any new machinery since the current machinery is highly
underutilized. Also, the number of purchase orders will increase from 160,000 to 200,000. 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 for the 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.
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