Design an activity-based cost system for Assembly and draw the associated cost system diagram. You do not need to calculate the OH rate for each pool, but you must indicate the allocation base you would use to allocate the OH traced to each cost pool.

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Final Exam Case Managerial Accounting Term 2, WEMBA25 The final exam is an individual assignment. It is considered a violation of Fuqua Honor Code to discuss any part of the exam, including the case or the questions, in any form, with anyone before Jan. 22, 2024. Should you find the case information to be unclear, state your assumption and move on. 1 RicciMechanical Incorporated Antonio Ricci graduated from technical school in 1994 with a degree in engineering. In 1996, having quickly grown tired of his engineering job, Antonio started a small welding business. He purchased a welder, a pickup truck, and a few tools. The business was brisk, and Antonio found himself working between 10 and 12 hours per day repairing equipment for local farmers in southeast Marche. Wheat seed wagons were a common piece of farm equipment that was attached to a tractor and used to plant wheat. These wagons broke down often, and Antonio found that most of his business came from repairing this one piece of equipment. Recognizing the opportunity, Antonio used his engineering background to design a more reliable wheat seed wagon. Demand for Ricci wheat seed wagons grew quickly and before long, Ricci seed wagons became famous for their reliability. When they did break down, Ricci's service department repaired them free of charge.1 By 2015 Ricci Mechanical had become one of the largest producers of farm equipment in the region, and a major employer in southeast Marche. The company had evolved into seven separate business groups, each of which was organized as an autonomous investment center.2 The Press and Machining (PM) Group converted raw steel into parts necessary for wheat seed wagons. The Assembly Group purchased parts from the PM Group and from outside sources, assembled those parts together, and finally painted Ricci's famous wheat seed wagons. The Repairs Group was a full-service machine shop. Their primary responsibility was to service warranty requests on previously sold seed wagons. The group was also permitted to provide other machine and mechanical services to outside customers (usually local farmers). The Services Group was split off from the Repairs Group in 2004 because demand for mechanical repair services at shoe factories in north Marche had become so strong that Ricci feared the Repairs Group would not focus sufficiently on the demands of farmers and would instead chase the lucrative repair and service contracts awarded by the shoemakers. The Fluids Group was purchased in 2006 to develop and supply metalworking fluids to the PM Group. The Fluids Group also sold about 30 percent of its output to external customers. Finally, there were two retail units. Each retail unit sold completed wheat seed wagons, and each was also a retail outlet for a variety of other farm equipment and supplies. The Northern retail group was located in Senigallia, Marche, while the Southern retail group was located in Ascoli Piceno, Marche. Antonio and a small staff monitored the activities of each of these autonomous businesses from an office building near the foothills of the Appennini Mountains in Montelparo, Marche. Antonio held quarterly meetings with the managers of each of the seven business units. During these meetings, he encouraged cooperation between units, discussed overall corporate strategies, consulted with the managers regarding local business conditions, and helped to resolve conflicts. Furthermore, he and his staff acted as consultants to the units (at the request of the units) in areas ranging from contract 1 See Figure 1 for an example of a typical wheat seed wagon. 2 See Figure 4 for a diagram of the corporate structure. 2 management to information technology. Finally, they also provided some consulting services to other small businesses in Southeast Marche. Press and Machining (PM) Stella Tidei, manager of the Press and Machining (PM) group, requested a meeting with Antonio and the staff at company headquarters in Montelparo. Stella's former college roommate, Angelo Biondi, operated a small welding shop in the area and had offered to supply PM with tongue assemblies for the seed wheat wagons manufactured by Ricci. 3 At the time of the meeting, Stella's group manufactured the tongue assembly and then welded it to the seed wagon frame before selling the frame to Assembly. Stella gathered data (presented in Exhibit 1 and Exhibit 2) and brought it to the meeting with Antonio. Antonio looked over the data. "Do you still allocate overhead using direct labor dollars?" "Yes," Stella responded, "we have been using $DL to allocate overhead for years." "Do you have any idea how your costs vary with production volume?" Antonio continued. "I have been estimating some regressions using monthly data from the past two years. Would you like to have a look?" said Stella, as she handed the information contained in Exhibit 3 to Antonio. "How will your 2021 costs compare to those in 2019 and 2020?" asked Antonio. "Our overhead costs will be about the same, but our direct labor costs are increasing because of the new minimum wage requirements," replied Stella. "Even so, these regressions should help us determine which costs are fixed and which costs are variable. We can then use that information to help us understand our 2021 budget." "If you purchase the tongue assemblies from Angelo Biondi, what can you do with the freed-up capacity in the PM group? And what will you do with the employees who work on tongue assemblies?" asked Antonio. "We will not be able to eliminate any fixed costs, but we can lay off the employees who work on tongue assemblies," Stella explained. "We might also be able to use some of our freed-up capacity for alternative, profitable projects." "Let's go to Il Gufo e la Civetta Trattoria. We can talk about these data over some pecorino cheese and a glass of Verdicchio," said Antonio. 3 See Figure 2 for a drawing of a typical tongue assembly. 3 At lunch, Antonio expressed concern that laying off employees would be hard on families in the local community. Stella countered by arguing that the old employees might be able to find work at Angelo Biondi' facility and that if Angelo offered the tongue assemblies at the right price, Stella could increase PM's profits. Assembly The Assembly Group had also been consulting with Antonio and his staff. Roman Ricci, manager of Assembly, was confused. His costs did not make sense. Assembly calculated the cost of its products by tracing direct material and direct labor and allocating overhead. All overhead was bundled into a single cost pool, based on direct labor dollars. The problem began in 2012 when Antonio asked Roman to diversify the business beyond wheat seed wagons. Roman realized he could use some of the parts manufactured by PM and combine them with purchased parts from outside sources to assemble utility trailers. These trailers were simpler, made of fewer parts, and required much less work to assemble. They also had broad appeal in the agricultural market, although the market was highly competitive. Antonio was not worried about the competition. He knew that if Assembly worked with customers to create custom paint designs for their utility trailers, they would find a niche in the market. Though it didn't seem that the customers were willing to pay a premium for custom paint, Antonio argued that since the equipment had to be painted anyways, Assembly should paint it to the customer's specifications because it would set Ricci apart from the competition. In his most recent meeting with Antonio, Roman shared some troubling news. Wheat seed wagons were no longer profitable for the assembly group, even though the group still managed a small profit overall, thanks to the utility trailer business. Roman had never liked the utility trailer business, but as it continued to grow, he was becoming more willing to tolerate it, especially now that utility trailers were driving his profits. "It looks like you aren't very efficient at assembling those wheat seed wagons," commented Antonio. "When we first started making them forty years ago we could assemble them, get them painted in our standard Azul color, and out the door making a very good profit. What's going on?" Roman left the meeting feeling frustrated. He needed some time to think. The next week he spent most of his time interviewing employees and observing their work habits. He thought he might find that the workers were lazy, spent too much time looking at Instagram on their smartphones, or took breaks too often. But he observed the opposite. His workers were very busy and seemed to take shorter breaks than they were allowed. Roman carefully observed the operation. The work started in the large receiving warehouse, where workers sorted parts purchased from the PM division and from outside vendors into complete "kits." Those kits were then loaded onto transportation carts so that when pull tractor operators 4 arrived, all they had to do was attach the transportation carts to the pull tractor and drive it to the assembly location. Each transportation cart contained only one set of kits with all parts necessary for one seed wagon or one utility trailer. The pull tractor and transportation carts were designed so that up to three kits/carts could be delivered in a single load, forming a small train, similar to those used by airports to transport luggage from the terminal to the aircraft.4 If an order contains no more than three pieces of equipment, the tractor operator made only one trip. If it contained four or more pieces of equipment, the operator made multiple trips. In addition, since each customer may require some customized features on either seed wagon or utility trailer, it was not practical to mix orders from different customers. So if a customer orders 4 pieces of equipment, the pull tractor will have to make two separate trips. The kits were then delivered to the assembly location, where three employees assembled trailers and wagons. The process of assembling was labor intensive, more so for products with more parts. Once assembled, the wagons and trailers were functional and could be pulled by the tractor to the paint room. A system had been created to attach up to three pieces of equipment together so that they could be pulled to the paint room in a single load. The same tractor that was used to retrieve the kits from the receiving area was used to pull the completed wagons and trailers to the paint room. In the painting area, Roman employed a part-time graphic designer to help customers create their original paint designs. Once created, those designs and color schemes were rarely changed by customers. The room where the painting takes place required a separate set-up for customer orders that included both seed wagons, which were painted in the standard Azul color, and utility trailers, which were painted according to customers' specifications. After painting, the wagons and/or utility trailers were again attached to the tractor, up to three pieces of equipment at a time, and moved to the outdoor storage area. From there, they were eventually delivered directly to the customer or to one of the company's two retail outlets. After spending several days observing the process and his employees' considerable effort, Roman returned to consult with Antonio. "Did you find any clues as to why Assembly has become so inefficient?" Antonio asked. "I still don't understand why it costs us so much to assemble the wagons," responded Roman. "The utility trailer business has helped us operate near our capacity, so it is not like we have wasted space. We have overheads in the receiving and sorting room, but the parts for wagons and utility trailers use the same amount of space in the warehouse. We incur high overhead costs in the paint room. Just setting up the paint room seems like an expensive process, not to mention designing the paint jobs for each customer. And then there is the pull tractor - that thing is all over the place, 4 See Figure 3 for an example of the pull tractor with three transportation carts. 5 going back and forth. But we know how much the pull tractor costs, and we can track the hours it operates fairly easily. There are also administrative costs. And that's pretty much it. Everything else is a direct cost. The strange thing is that we have had this structure for years, yet only over the past several years have our seed wagon costs been going up." "Mmm... Let's talk about it over some pecorino cheese and a glass of Verdicchio at Il Gufo e la Civetta," said Antonio "Sounds good," Roman responded, though he was not excited at the prospect of yet another wineinduced headache. The Retail Outlets Ricci Mechanical had two retail outlets. The outlet located in Senigallia, Marche was called Northern, and the outlet located in Ascoli Piceno, Marche was called Southern. Antonio had recently asked his staff to evaluate the performance of the managers of the two stores. Southern had higher net income, but the divisions weren't that equal in terms of size and capital structure. Maria Vittori, manager of the Northern division was very conservative and feared debt. As a result, she preferred to lease her showroom, and always paid for her inventory in cash upon delivery. She was also afraid of the tax authorities because her best friend had spent time in jail for tax evasion. In contrast, Floriana Simonella, manager of the Southern division, was more risk-tolerant. She often carried a payables balance and she preferred to own the showroom, even though it required carrying a substantial debt load.5 She was also a very sophisticated tax planner. In the end, Antonio didn't care how his managers made a return, as long as it was legal and ethical, but he believed firmly in holding them responsible for the authority they had been granted. Antonio's staff collected the financial information shown in Exhibit 4. In 2018 Northern began a new advertising campaign, spending $20,000 throughout that year.6 The response was positive and Northern continued increasing advertising expenditures by $5,000 per year throughout the next two years. In 2019 Southern began a similar campaign, spending $50,000 for the year and increasing their investment by $10,000 in 2020. Advertising expenditures, which were incurred evenly throughout the year, were expected to generate benefits for two years. As was common in the industry, "occupancy" costs were included in the costs of sales and were essentially the depreciation and lease costs associated with the buildings occupied by the divisions. Northern's occupancy costs were $37,500 per year while Southern's occupancy costs were $25,000 per year. Northern provided Antonio with the information in Exhibit 5 related to the lease on its buildings. Antonio used a 10% discount rate because he knew he could get that rate of return on his capital 5 Southern's payables balance was $100 thousand at the end of 2018 and $105 thousand at the end of 2019. There was no interest charge associated with the payables balance. 6 Advertisements were run daily at equal amount during the year. 6 if he invested it in the stock market. He also used net income and beginning investment as the benchmark in all of his performance evaluations. The Repairs Group and the Services Group The Repairs Group had developed an efficient information technology (IT) system. The Services Group, in contrast, used a very primitive IT system. At the most recent quarterly meeting in Montelparo with Antonio, Services approached the Repairs Group with a proposal that it provides support in the form of server time for some of Services' billing and administrative work. After an analysis of the demands that Services would place on the system with an estimated usage of 1,500 machine-hours, the IT manager at the Repairs Group noted that they would have to lease a new server because of the additional load. The existing server had a maximum usage of 3,000, and the Repair Group was already using 2,800 hours. The lease rate for the existing server required an annual payment of $1,750, but it could be canceled at no cost if the Repairs Group leased a more expensive machine. The new server would lease for an annual rate of $4,500 with a capacity of 4,000 hours. However, because the new server would be a faster machine, the Repairs Group could complete its current requirements in only 2,000 hours. In addition to leasing a new server, the Repairs Group would have to upgrade its server support position. The IT manager estimated that it would cost an additional $25,000 per year to hire an employee with the necessary advanced training to support the new server. In addition, the Repairs Group had a contract for maintenance support from the machine vendor. The support contract was a fixed price of $0.75 per hour of machine usage, regardless of the type of machines leased by the Repairs Group. The Fluids Group The Fluids Group developed several effective metalworking fluids used by the PM Group. In addition, the Fluids Group sells a special odorless fluid that meets the food safety standards used by manufacturers of pasta machines. The internal transfer price for fluids sold to the PM group was $40 per barrel in 2020, based on average market prices for similar fluids. The Fluids group wanted the same transfer price in 2021. However, Stella Tidei had found a Chinese supplier who was willing to sell the metalworking fluids for $30 per barrel. Stella preferred to continue purchasing from the Fluids Group, but Pietro Monaldi, manager of the Fluids Group, did not want to match the $30 price because he thought that the margin was too small. In their last meeting, Antonio became fed up with their bickering, and told Stella and Pietro to solve their problems, saying he would support whatever decision they made. The information in Exhibit 6 relates to the Fluids Group. 7 Consulting Ortezzano Food Company (OFC), located in Ortezzano, Marche, was owned by Antonio's second cousin, Giancarlo Ricci. Among other things, OFC produced extra-virgin olive oil bottles. Giancarlo often used Antonio and his staff in Montelparo when he needed help interpreting his financial data. Giancarlo called Antonio in a state of frustration, "Overall, we did well in sales, although I don't understand our variances. We exceeded our sales budget by $4000. I think it is because of our promotion during the holiday season when we lowered our price by $1 per bottle from our budget. We ended up selling 500 more bottles than the budgeted volume of 6000 bottles. What I don't understand is our overhead costs. We had budgeted $48,000 in fixed overhead and $24,000 for variable overhead last year. Our actual overhead numbers were exactly what we expected, but the production manager is arguing that he deserves a bonus because he has been efficient this year." "Why does the production manager think he has been efficient?" probed Antonio. "The production manager claims he helped meet our promotion goal by producing 500 more bottles of olive oil than we budgeted. Moreover, he claims that he produced them more efficiently. To back up his claim, he showed that he was able to produce 0.52 bottles of olive oil per direct labor hour, which was 0.02 more than the standard rate of production," responded Giancarlo. "Are you using full absorption costing? And how do you allocate your overheads?" asked Antonio. "Yes, we use full absorption costing. We allocate the variable overhead based on the budgeted volume of direct labor hours. We allocate the fixed overhead based on our plant's maximal feasible capacity, which is 7000 bottles of olive oil. I think our sales manager deserves a bonus. But I don't see why the production manager should get a bonus if his numbers came in right on target. I believe he only deserves a reward if he can exceed expectations, and he certainly doesn't appear to have done that!" "I think we will need to look a little deeper," said Antonio. "As you know, I do my best thinking at Il Gufo e la Civetta over some pecorino cheese and Verdicchio wine, so let's meet there at noon." 8 Exhibit 1 Press and Machining 2021 Budget Press and Machining 2021 Budget Sales $2,250,000 Cost of Goods Sold $2,114,000 Direct Material $275,000 Direct Labor $475,000 Overhead $1,364,000 - Depreciation $350,000 - Indirect Labor $281,000 - Small Tools $162,000 - Fringe Benefits $56,000 - Machine Set-up $170,000 - Administrative $200,000 - Other $145,000 Gross Margin $136,000 Exhibit 2 Additional Data Related to the Tongue Assembly7 Tongue Assembly Budgeted Unit Data 2021 Unit Volume 775 Direct Labor per Unit $ 75 Direct Materials per Unit $ 55 7 PM produces multiple products. Exhibit 2 only relates to Tongue Assembly production. Exhibit 3 Regression Analysis Press and Machining Overhead Cost Analysis - Monthly data 2019-2020 Dependent Variable Estimates Depreciation Indirect Labor Small Tools Fringe Benefits Machine Set-up Admin Other Intercept 28,854.167* 1,257.76 -163.272 912.271* 4,963.11* 16,730.30* 8,453.95* Coefficient on $DL 0.041 0.509* 0.321* 0.0829* 0.216* 0.009 0.0633* N 24 24 24 24 24 24 24 Adj. R-Squared 0.94 0.68 0.72 0.87 0.59 0.92 0.61 *Statistically significant at the 1% confidence level. Exhibit 4 Results for Southern and Northern Retail Stores Income Statement Southern Northern 2019 2020 2019 2020 Sales $1,125,640 $1,236,319 $976,223 $1,005,681 Total Cost of Sales $895,320 $977,465 $834,359 $822,537 Gross Margin $230,320 $258,854 $141,864 $183,144 Total Operating Expenses $139,350 $173,682 $107,897 $117,165 Allocated Corporate Overhead $15,000 $17,000 $15,000 $17,000 Selling Commissions $74,350 $96,682 $67,897 $70,165 Advertising $50,000 $60,000 $25,000 $30,000 Pretax Income $90,970 $85,172 $33,967 $65,979 Tax Expense $18,194 $17,034 $10,190 $19,794 Net Income $72,776 $68,138 $23,777 $46,185 Total Assets (balance at beginning of each year) $475,000 $450,000 $260,000 $265,000 Exhibit 5 Additional Data Related to Northern's Leases Year Capitalized Value of Lease at End of Year Annual Lease Payment Lease Amortization for the Year 2017 $500,000 $37,500 $16,417 2018 $483,583 $37,500 $17,109 2019 $466,474 $37,500 $17,831 2020 $448,643 $37,500 $18,583 2021 $430,061 $37,500 $19,366 2022 $410,695 $37,500 $20,183 11 Exhibit 6 Information Related to the Fluids Group The Fluids Group 2020 Results To PM Group To External Customers Number of Barrels Sold 1,750 750 Sales ($) 70,000 40,500 Variable Costs 42,000 21,000 Fixed Costs 5,250 2,250 12 Figure 1 Typical Wheat Seed Wagon Figure 2 Typical Tongue Assembly Figure 3 Pull Tractor and Carts 13 Figure 4 Ricci Mechanical Organization Ricci Mechanical PM Fluids Assembly Retail Repairs Northern Southern Services