Activity-based Costing And Management

CHAPTER 5

Activity-Based Costing and Management

Answers to Review Questions

5-1 In a traditional, volume-based product-costing system, only a single predetermined

overhead rate is used. All manufacturing-overhead costs are combined into one cost

pool, and they are applied to products on the basis of a single cost driver that is

closely related to production volume. The most frequently used cost drivers in

traditional product-costing systems are direct-labor hours, direct-labor dollars,

machine hours, and units of production.

5-2 Management was being misled by the traditional product-costing system, because

the high-volume product lines were being overcosted and the low-volume product

line was being undercosted. The high-volume products essentially were subsidizing

the low-volume line. The traditional product-costing system failed to show that the

low-volume products were driving more than their share of overhead costs. As a

result of these misleading costs, the company’s management was mispricing its

products.

5-3 An activity-based costing system is a two-stage process of assigning costs to

products. In stage one, activity-cost pools are established. In stage two a cost driver

is identified for each activity-cost pool. Then the costs in each pool are assigned to

each product line in proportion to the amount of the cost driver consumed by each

product line.

5-4 A cost driver is a characteristic of an event or activity that results in the incurrence

of costs by that event or activity. In activity-based costing systems, the most

significant cost drivers are identified. Then a database is created that shows how

these cost drivers are distributed across products. This database is used to assign

costs to the various products depending on the extent to which they use each cost

driver.

5-5 The four broad categories of activities identified in an activity-based costing system

are as follows:

(a) Unit-level activities: Must be done for each unit of production.

(b) Batch-level activities: Must be performed for each batch of products.

(c) Product-sustaining activities: Needed to support an entire product line.

Managerial Accounting, 8/e 5-1

(d) Facility-level (or general-operations-level) activities: Required for the entire

production process to occur.

5-6 An activity-based costing system alleviated the problems management was having

under its traditional, volume-based product-costing system by more accurately

assigning costs to products. Products were assigned costs based on the extent to

which they used various cost drivers that were determined to be closely related to

the incurrence of a variety of overhead costs.

5-7 Product-costing systems based on a single, volume-based cost driver tend to

overcost high-volume products, because all overhead costs are combined into one

pool and distributed across all products on the basis of only one cost driver. This

simple averaging process fails to recognize the fact that a disproportionate amount

of costs often is associated with low-volume or complex products. The result is that

low-volume products are assigned less than their share of manufacturing costs, and

high-volume products are assigned more than their share of the costs.

5-8 In traditional, volume-based costing systems, only direct material and direct labor

are considered direct costs. In contrast, under an activity-based costing system, an

effort is made to account for as many costs as possible as direct costs of

production. Any cost that can possibly be traced to a particular product line is

treated as a direct cost of that product.

5-9 The pool rate is calculated by dividing the budgeted amount of an activity cost pool

by the budgeted total quantity of the associated cost driver. The pool rate is the cost

of a particular activity that is expected per unit of the associated cost driver.

5-10 Two factors that tend to result in product cost distortion under traditional, volume-

based product-costing systems are as follows:

(a) Non-unit level overhead costs: Many overhead costs vary with cost drivers that

are not unit-level activities. Use of a unit-level cost driver to assign such costs

tends to result in cost distortion.

(b) Product diversity: When a manufacturer produces a diverse set of products,

which exhibit different consumption ratios for overhead activities, use of a single

cost driver to assign costs results in cost distortion.

5-11 Three important factors in selecting cost drivers for an ABC system are as follows:

(a) Degree of correlation between consumption of an activity and consumption of

the cost driver.

(b) Cost of measurement of the cost driver.

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(c) Behavioral effects, that is, how the cost driver selected will affect the behavior of

the individuals involved in the activity related to the cost driver.

5-12 An activity dictionary lists all of the activities identified and used in an activity-based

costing analysis. The activity dictionary provides for consistency in the terminology

and level of complexity in the ABC analysis in the organization’s various subunits.

5-13 Line managers are close to the production process and may realize that a complex

product, which is difficult to manufacture, is undercosted by a traditional, volume-

based costing system. Because of the cost distortion that is common in such

systems, the undercosted product may appear to be profitable when it is really

losing money. Line managers may have a “gut feeling” for this situation, even if the

cost-accounting system suggests otherwise.

5-14 Diverse products typically consume support activities (such as purchasing, material

handling, engineering, and inspection) in differing degrees. When there are

significant differences among product lines in the ways that they consume support

services (and thereby cause overhead costs), a traditional, volume-based costing

system may distort product costs. Some products are overcosted; others are

undercosted. An ABC system can eliminate (or at least alleviate) such cost

distortion.

5-15 Activity-based costing is just as appropriate in the service industry as in the

manufacturing industry. Just as in manufacturing firms, diverse services typically

consume support activities in varying degrees. ABC systems are more accurate in

tracking the usage of these support activities to the services (products) that are

produced than are traditional, volume-based costing systems.

5-16 As indicated in the chapter, Pennsylvania Blue Shield, like many manufacturers,

classifies activities as unit level, batch level, product-sustaining level, or facility

level. Maintenance of the medical-services provider network (i.e., the physicians and

hospitals that provide medical care to claimants) is a product-sustaining-level

activity because it benefits an entire product line (service line, in this case) of

personal health insurance policies.

5-17 Management could use the ABC information about the cost of various types of

patient appointments for determining charges for appointments, making

appointment staffing decisions (e.g., physician versus nurse practitioner), and

justifying reimbursements from insurance companies or government agencies.

Managerial Accounting, 8/e 5-3

5-18 At Patio Grill Company, every unit of each product line manufactured requires all

eight of the support activities covered by the ABC system. In contrast, at Delaware

Medical Center, each patient sees a physician, or a nurse practitioner, or an intern, or

a resident. Moreover, each patient is either a new patient or a continuing patient, but

not both. Therefore, in determining the cost a patient appointment, the cost analyst

would include only the relevant activity costs in the cost of a patient appointment.

5-19 The two-dimensional activity-based costing model provides one way of picturing the

relationship between ABC and ABM. The vertical dimension of the model depicts the

cost assignment view of an ABC system. From the cost assignment viewpoint, the

ABC system uses two-stage cost allocation to assign the costs of resources to the

firm’s cost objects. These cost objects could be products manufactured, services

produced, or customers served.

Depicted in the horizontal dimension of the model that follows is the process

view of an ABC system. The emphasis now is on the activities themselves, the

processes by which work is accomplished in the organization. The left-hand side of

the model depicts activity analysis, which is the detailed identification and

description of the activities conducted in the enterprise. Activity analysis entails the

identification not only of the activities, but also of their root causes, the events that

trigger activities, and the linkages among activities. The right-hand side of the model

depicts the evaluation of activities through performance measures. These processes

of activity analysis and evaluation constitute activity-based management.

The two-dimensional ABC model is depicted in the diagram on the next page.

5-20 Activity analysis is the detailed identification and description of the activities

conducted in an enterprise. Activity analysis entails the identification not only of

activities, but also of their root causes, of the events that trigger them, and of the

linkages among them. Three criteria for determining whether an activity adds value

are as follows:

(a) Is the activity necessary?

(b) Is the activity efficiently performed?

(c) Is the activity sometimes value-added and sometimes non-value-added?

5-4 Solutions Manual

Diagram of two-dimensional ABC model (from review question 5-19 on preceding page):

Managerial Accounting, 8/e 5-5

Cost Assignment View

RESOURCE COSTS

Assignment of resource costs

to activity cost pools

associated with

significant activities

Process View

Activity analysis Activity evaluation

PERFORMANCE

MEASURES

ROOT

CAUSES ACTIVITY

TRIGGERS

Assignment of activity

costs to cost objects

using second-stage

cost drivers

COST OBJECTS

(products or services

produced; customers)

ACTIVITIES

5-21 An activity’s trigger is the preceding event that indicates that the activity should be

performed. The activity’s root cause is the event or activity that, if it had not

occurred, would have prevented the activity in question from happening. For

example, the event that triggers the activity of rework is the identification of a

defective part during inspection. However, the inspection is not the root cause of the

rework activity. The root cause of the defective part, and hence the need for rework,

could lie in erroneous part specifications, in an unreliable vendor, or in faulty

production.

5-22 Customer profitability analysis refers to using the concepts of activity-based costing

to determine how serving particular customers causes activities to be performed and

costs to be incurred. Examples of activities that can be differentially demanded by

customers include order frequency, order size, special packaging or handling,

customized parts or engineering, and special machine setups. Such activities can

make some customers more profitable than others.

5-23 Activity-based costing is used to analyze customer-related costs and determine the

cost drivers for these costs. This ABC data then forms the basis for the customer

profitability analysis by assigning the appropriate amount of customer-related costs

to each customer.

5-24 A customer profitability profile, usually expressed in graphical form, shows the

company’s cumulative operating income as a percentage of total operating income.

The customers included in the profile generally are ranked either by operating

income or by sales revenue.

5-25 In a just-in-time (JIT) production system, raw materials and parts are purchased or

produced just in time to be used at each stage of the production process. This

approach to inventory and production management brings considerable cost

savings from reduced inventory levels.

The key to the JIT system is the “pull” approach to controlling manufacturing.

The diagram on the next page displays a simple multistage production process. The

flow of manufacturing activity is depicted by the solid arrows running down the

diagram from one stage of production to the next. However, the signal that triggers

more production activity in each stage comes from the next stage of production.

These signals, depicted by the dashed-line arrows, run up the diagram. We begin

with sales at the bottom of the exhibit. When sales activity warrants more production

of finished goods, the goods are “pulled” from production stage III by a signal that

more goods are needed. Similarly, when production employees in stage III need more

inputs, they send a signal back to stage II. This signal triggers production activity in

5-6 Solutions Manual

stage II. Working our way back up to the beginning of the process, purchases of raw

materials and parts are triggered by a signal that they are needed in stage I.

The “Pull” Method in a JIT System

This pull system of production management, which characterizes the JIT

approach, results in a smooth flow of production and significantly reduced inventory

levels.

Managerial Accounting, 8/e 5-7

Demand for raw materials and parts is signaled when

there is a need in stage I for more inputs.

Demand for production activity in stage I is signaled

when there is a need in stage II for more inputs.

Demand for production activity in stage II is signaled

when there is a need in stage III for more inputs.

Demand for finished goods is signaled when sales

activity warrants more finished units. This signal

triggers manufacturing activity in the final stage of

production (stage III).

Purchasing

Production

Stage I

Production

Stage II

Production

Stage III

Sales

Denotes flow of materials, parts, partially finished goods, and finished goods.

Denotes a signal that more goods are needed at the next stage of production.

Solutions to exercises

EXERCISE 5-26 (15 MINUTES)

1. Material-handling cost per mirror:

$1,500 250

*(30)(250)] [(30)(250)

$90,000 



*The total number of direct-labor hours.

An alternative calculation, since both types of product use the same amount of the

cost driver, is the following:

$1,500

*60

$90,000 

*The total number of units (of both types) produced.

2. Material-handling cost per lens = $1,500. The analysis is identical to that given for

requirement (1).

3. Material-handling cost per mirror:

$600

30

†

4

*16)(4

$90,000







*The total number of material moves.

†The number of material moves for the mirror product line.

4. Material-handling cost per lens:

$2,400

30

*16

16)(4

$90,000







*The number of material moves for the lens product line.

5-8 Solutions Manual

EXERCISE 5-27 (20 MINUTES)

There is no single correct answer to this exercise. There are many reasonable solutions.

Cost pool 1:

Raw materials and components…….………..………..………..….…..…..…....…..…. 3,835,000 yen

Inspection …………………………………………………………………………………………… 39,000 yen

Total……………………………………………………………………………..…….………………. 3,874,000 yen

Cost driver: raw-material cost

Cost pool 2:

Depreciation, machinery……………………………………………………………….……… 1,820,000 yen

Electricity, machinery………………………………………………………….……….………. 156,000 yen

Equipment maintenance, wages……………………………………………………….…… 195,000 yen

Equipment maintenance, parts……………………………………………………..………. 39,000 yen

Total……………………………………………………………………………..…….………………. 2,210,000 yen

Cost driver: number of units produced.

Cost pool 3:

Setup wages………………………………………………………………………………….…….. 52,000 yen

Total……………………………………………………………………………..…….………………. 52,000 yen

Cost driver: number of production runs.

Cost pool 4:

Engineering design………………………………………………………………………………. 793,000 yen

Total……………………………………………………………………………..…….………………. 793,000 yen

Cost driver: number of parts in a product.

Managerial Accounting, 8/e 5-9

EXERCISE 5-27 (CONTINUED)

Cost pool 5:

Depreciation, plant……………………………………………………………………………….. 910,000 yen

Insurance, plant…………………………………………………………….….…………………. 780,000 yen

Electricity, light…………………………………………………………………………………….. 78,000 yen

Custodial wages, plant…………………………………………………………..….…………. 52,000 yen

Property taxes…………………………………………………………………………..…………. 156,000 yen

Natural gas, heating………………………………………………………………………….….. 39,000 yen

Total……………………………………………………………………………..…….………………. 2,015,000 yen

Cost driver: for costs allocated to support departments, square footage; for costs

assigned to products, number of units produced.

EXERCISE 5-28 (5 MINUTES)

Cost pool 1: unit-level

Cost pool 2: unit-level

Cost pool 3: batch-level

Cost pool 4: product-sustaining-level

Cost pool 5: facility-level

EXERCISE 5-29 (15 MINUTES)

1. a. Quality-control costs assigned to the enamel paint line under the traditional

system:

Quality-control costs = 16%  direct-labor cost

Quality-control

costs assigned to

enamel paint line = 16%  $98,000

= $15,680

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EXERCISE 5-29 (CONTINUED)

b. Quality-control costs assigned to the enamel paint line under activity-based

costing:

Quantity for Assigned

Activity Pool Rate Enamel Paint Cost

Incoming material inspection....... $23.00 per type..... 24 types…...... $ 552

In-process inspection..….............. .28 per unit...... 35,000 units... 9,800

Product certification……………....… 144.00 per order... 50 orders....... 7,200

Total quality-control costs assigned………………………………………………..… $17,552

2. The traditional product-costing system undercosts the enamel paint product line, with

respect to quality-control costs, by $1,872 ($17,552– $15,680).

EXERCISE 5-30 (20 MINUTES)

Wheelco’s product-costing system probably is providing misleading cost information to

management. A common problem in a traditional, volume-based costing system is that

high-volume products are overcosted and low-volume products are undercosted. There is

evidence of this in the exercise, since Wheelco’s competitors are selling the high-volume

DC16 wheel at a price lower than Wheelco’s reported manufacturing cost. In contrast,

Wheelco is selling its specialty JY16 wheel at a huge markup above the product’s reported

cost. An activity-based costing system probably would report a lower product cost for

wheel DC16 and a substantially higher cost for wheel JY16.

The president’s strategy of pushing the firm’s specialty products probably will

aggravate Wheelco’s problem even further. These products probably are not as profitable as

the firm’s traditional product-costing system makes them appear.

Recommendation: Install an activity-based costing system. If the new reported

product costs shift as suggested in the preceding comments, then lower the price on the

high-volume products, such as wheel DC16. The prices of the specialty wheels probably will

need to be raised. It is possible that Wheelco should discontinue low-volume products.

Managerial Accounting, 8/e 5-11

EXERCISE 5-31 (15 MINUTES)

1. Key features of an activity-based costing system:

(a) Two-stage procedure for cost assignment.

(b) Stage one: Establish activity cost pools.

(c) Stage two: Select cost drivers for each activity-cost pool. Then assign the costs

in each cost pool to the company’s product lines in proportion to the amount of

the related cost driver used by each product line.

2. As described in the answer to the preceding exercise, the new system probably will

reveal distortion in the firm’s reported product costs. In all likelihood, the high-volume

products are overcosted and the low-volume specialty products are undercosted.

3. Strategic options:

(a) Lower the prices on the firm’s high-volume products to compete more effectively.

(b) Increase the prices on low-volume specialty products.

(c) Consider eliminating the specialty product lines. This option may not be desirable

if there is a marketing need to produce a full product line. Also, the specialty

wheels may give Wheelco prestige.

EXERCISE 5-32 (20 MINUTES)

The activities of the Seneca Falls Winery may be classified as follows:

U: Unit-level

B: Batch-level

P: Product-sustaining-level

F: Facility-level

5-12 Solutions Manual

EXERCISE 5-32 (CONTINUED)

Activity Classification Activity Classification

(1) P (11) B

(2) P (12) B

(3) P (13) U

(4) P (14) U

(5) P (15) U

(6) P (16) U

(7) P (17) B

(8) B (18) F

(9) B (19) F

(10) B

Managerial Accounting, 8/e 5-13

EXERCISE 5-33 (30 MINUTES)

1. ZODIAC MODEL ROCKETRY COMPANY

COMPUTATION OF SELLING COSTS

BY ORDER SIZE AND PER MOTOR WITHIN EACH ORDER SIZE

Order Size

Small Medium Large Total

Sales commissionsa

(Unit cost: $675,000/225,000

= $3.00 per box)………………………………….…………

box)…………………………………………………………………

$ 6,000 $135,000 $534,000 $ 675,000

Catalogsb

(Unit cost: $295,400/590,800

= $.50 per catalog)……………………………….………..

catalog)………………………………………..………………...

127,150 105,650 62,600 295,400

Costs of catalog salesc

(Unit cost: $105,000/175,000

= $.60 per motor)………..………..……..…..…..…....…

skein)……………………………………………………………...

47,400 31,200 26,400 105,000

Credit and collectiond

(Unit cost: $60,000/6,000

= $10.00 per order)………..………..…..…..…....…..…

order)………………………………………………………………

4,850 24,150 31,000 60,000

Total cost for all orders of a

given size………..………..………..………..….…..…..…..…...$185,400 $296,000 $654,000 $1,135,400

Units (motors) solde……………..……..…..…..…..…....…..103,000 592,000 2,180,000

Unit cost per order of a given