Managerial accounting

Question

Worley Company buys surgical supplies from a variety of manufacturers and then resells and delivers these supplies to hundreds of hospitals. Worley sets its prices for all hospitals by marking up its cost of goods sold to those hospitals by 5%. For example, if a hospital buys supplies from Worley that had cost Worley $100 to buy from manufacturers, Worley would charge the hospital $105 to purchase these supplies.
For years, Worley believed that the 5% markup covered its selling and administrative expenses and provided a reasonable profit. However, in the face of declining profits Worley decided to implement an activity-based costing system to help improve its understanding of customer profitability. The company broke its selling and administrative expenses into five activities as shown below:


Activity Cost Pool (Activity Measure) Total Cost Total Activity
Customer deliveries (Number of deliveries) $ 500,000 5,000 deliveries
Manual order processing (Number of manual orders) 248,000 4,000 orders
Electronic order processing (Number of electronic orders) 200,000 12,500 orders
Line item picking (Number of line items picked) 450,000 450,000 line items
Other organization-sustaining costs (None) 602,000


Total selling and administrative expenses $ 2,000,000




Worley gathered the data below for two of the many hospitals that it serves—University and Memorial (both hospitals purchased a total quantity of medical supplies that had cost Worley $30,000 to buy from its manufacturers):



Activity
Activity Measure University Memorial
Number of deliveries 10 25
Number of manual orders 0 30
Number of electronic orders 15 0
Number of line items picked 120 250


Required:
1.
Compute the total revenue that Worley would receive from University and Memorial.



2.
Compute the activity rate for each activity cost pool.



3.
Compute the total activity costs that would be assigned to University and Memorial.



4.
Compute Worley’s customer margin for University and Memorial. (Hint: Do not overlook the $30,000 cost of goods sold that Worley incurred serving each hospital.) (Loss amount should be indicated with a minus sign.)

Answer 1

Each hospital purchased supplies that cost Worley $30,000.

Since Worley marks up cost by 5%:

$30,000 × 1.05 = $31,500

So University and Memorial each generate $31,500 of revenue.

1. Revenue

University: $31,500

Memorial: $31,500

2. Activity rates

Customer deliveries:

$500,000 ÷ 5,000 = $100 per delivery

Manual orders:

$248,000 ÷ 4,000 = $62 per order

Electronic orders:

$200,000 ÷ 12,500 = $16 per order

Line items picked:

$450,000 ÷ 450,000 = $1 per line item

The $602,000 of organization-sustaining costs are not assigned to individual customers.

3. Activity costs assigned

University

Deliveries:

10 × $100 = $1,000

Electronic orders:

15 × $16 = $240

Line items:

120 × $1 = $120

Total activity cost:

$1,000 + $240 + $120 = $1,360

Memorial

Deliveries:

25 × $100 = $2,500

Manual orders:

30 × $62 = $1,860

Line items:

250 × $1 = $250

Total activity cost:

$2,500 + $1,860 + $250 = $4,610

4. Customer margin

Customer margin = Revenue − COGS − Activity costs

University:

$31,500 − $30,000 − $1,360 = $140

Memorial:

$31,500 − $30,000 − $4,610 = -$3,110

So the answers are:

University customer margin: $140

Memorial customer margin: -$3,110

This shows why the ABC system is useful: even though both hospitals buy the same dollar amount of supplies, Memorial requires much more service activity and is actually unprofitable.