Holly Manufacturing Company produces two cello models. One is a standard acoustic cello that sells for $600 and is constructed from medium-grade materials. The other model is a custom-made amplified cello with pearl inlays and a body constructed from special woods. The custom cello sells for $900. Both cellos require 10 hours of direct labor to produce, but the custom cello is manufactured by more experienced workers who are paid at a higher rate. Most of Holly’s sales come from the standard cello, but sales of the custom model have been growing. Following is the company’s sales, production, and cost information for last year: Cello Standard Custom Sales and production volume in units 900 100 Unit Selling Price $600.00 $900.00 Unit costs: Direct materials $150.00 $375.00 Direct labor $180.00 $240.00 Manufacturing overhead* $135.00 $135.00 Total unit costs $465.00 $750.00 Unit Gross Profit $135.00 $150.00 Direct Labor Hours $10.00 10.00 Direct Labor Rate Per Hour $18.00 $24.00 *Manufacturing overhead costs: Building depreciation $ 40,000 Maintenance 15,000.00 Purchasing 20,000.00 Inspection 12,000.00 Indirect materials 15,000.00 Supervision 30,000.00 Supplies 3,000.00 Total manufacturing overhead costs $135,000.00 These manufacturing overhead costs are fixed in nature: they do not vary with the volume of manufacturing activity. The company allocates overhead costs using the traditional method. Its activity base is direct labor hours. The predetermined overhead rate, based on 10,000 direct labor hours, is $13.50 ($135,000 ÷ 10,000 direct labor hours). Johann Brahms, president of Holly, is concerned that the traditional cost-allocation system the company is using may not be generating accurate information and that the selling price of the custom cello may not be covering its true cost. Questions To Be Answered 1. The cost-allocation system Holly has been using allocates 90% of overhead costs to the standard cello because 90% of direct labor hours were spent on the standard model. How much overhead was allocated to each of the two models last year? Discuss why this might not be an accurate way to assign overhead costs to products. 2. How would the use of more than one cost pool improve Holly’s cost allocation? Use the data below for the questions which follow. Holly’s controller developed the following data for use in activity-based costing: 3. Use activity-based costing to allocate the costs of overhead per unit and in total to each model of cello. 4. Calculate the cost of a custom cello using activity-based costing. 5. Why is the cost different from the cost calculated using the traditional allocation method? 6. At the current selling price, is the company covering its true cost of production? Briefly discuss 7. What should Holly Manufacturing do about the situation? 8. What should Holly Manufacturing do if the quantity of custom cellos sold at the new price falls to 50 per year? 9. What should Holly Manufacturing do about the situation if the price of the custom cello cannot exceed $900? 10. At a selling price of $1,000 each, what is the breakeven unit volume for the custom cello? 11. What are the lessons learned from this case?

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PART A

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1. Consumers typically pay a higher real interest rate to borrow than they receive when they lend
(by making bank deposits, for example). Draw a consumer’s budget line under the assumption
that the real interest rate earned on funds lent, r L , is lower than the real interest rate paid to
borrow, rB . Show how this consumer’s budget line is affected by an increase in the initial wealth.
2.
I) Draw the budget line and the relevant indifference curve for a consumer who is initially a
borrower. Indicate the no-borrowing no-lending point (label it as N) and the optimal
consumption point (label it as A).
II) Show the effect of an increase in the real interest rate on the budget line and the consumer’s
optimal consumption. Using an intermediate budget line, show the income effect and the
substitution effect on the current consumption and the future consumption. Specify whether these
effects work in the same direction or the opposite directions?

3. Specify whether each statement is TRUE or FALSE. If you specify it as a FALSE statement,
then briefly explain your reason.
a) If the future income increases, then the current consumption, saving, and the future
consumption increase.
b) The slope of the budget line depends on the real interest rate and does not depend on the level
of income.
c) There is a certain bundle of current consumption and future consumption which lies on the
budget line at any rate of interest.