5-1
CHAPTER 5
ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT
5-1 Broad averaging (or “peanut–butter costing”) describes a costing approach that uses broad
averages for assigning (or spreading, as in spreading peanut butter) the cost of resources uniformly
to cost objects when the individual products or services, in fact, use those resources in non-uniform
ways.
5-2 Overcosting may result in overpricing and competitors entering a market and taking market
share for products that a company erroneously believes are low-margin or even unprofitable.
5-3 Costing system refinement means making changes to a simple costing system that reduces
the use of broad averages for assigning the cost of resources to cost objects and provides better
measurement of the costs of overhead resources used by different cost objects.
Three guidelines for refinement are
1. Classify as many of the total costs as direct costs as is economically feasible.
2. Expand the number of indirect cost pools until each of these pools is more homogenous.
3. Use the cause-and-effect criterion, when possible, to identify the cost-allocation base
for each indirect-cost pool.
5-4 An activity-based approach refines a costing system by focusing on individual activities
(events, tasks, or units of work with a specified purpose) as the fundamental cost objects. It uses
the cost of these activities as the basis for assigning costs to other cost objects such as products or
services.
5-5 Four levels of a cost hierarchy are
(i) Output unit-level costs: costs of activities performed on each individual unit of a
product or service.
(ii) Batch-level costs: costs of activities related to a group of units of products or services
rather than to each individual unit of product or service.
(iii) Product-sustaining costs or service-sustaining costs: costs of activities undertaken to
support individual products or services regardless of the number of units or batches
in which the units are produced.
(iv) Facility-sustaining costs: costs of activities that cannot be traced to individual
products or services but support the organization as a whole.
5-6 It is important to classify costs into a cost hierarchy because costs in different cost pools
relate to different cost-allocation bases and not all cost-allocation bases are unit level. For example,
an allocation base like setup hours is a batch-level allocation base, and design hours is a product-
sustaining base, both insensitive to the number of units in a batch or the number of units of product
produced. If costs were not classified into a cost hierarchy, the alternative would be to consider all
costs as unit-level costs, leading to misallocation of those costs that are not unit-level costs.
5-7 An ABC approach focuses on activities as the fundamental cost objects. The costs of these
activities are built up to compute the costs of products, and services, and so on. Simple costing
systems have one or a few indirect cost pools, irrespective of the heterogeneity in the facility while
ABC systems have multiple indirect cost pools. An ABC approach attempts to use cost drivers as
the allocation base for indirect costs, whereas a simple costing system generally does not. The
5-2
ABC approach classifies as many indirect costs as direct costs as possible. A simple costing system
has more indirect costs.
5-8 Four decisions for which ABC information is useful are
1. pricing and product mix decisions,
2. cost reduction and process improvement decisions,
3. product design decisions, and
4. decisions for planning and managing activities.
5-9 No. Department indirect-cost rates are similar to activity-cost rates if (1) a single activity
accounts for a sizable fraction of the department’s costs, or (2) significant costs are incurred on
different activities within a department but each activity has the same cost-allocation base, or (3)
significant costs are incurred on different activities with different cost-allocation bases within a
department but different products use resources from the different activity areas in the same
proportions.
5-10 “Tell–tale” signs that indicate when ABC systems are likely to provide the most benefits
are as follows:
1. Significant amounts of indirect costs are allocated using only one or two cost pools.
2. All or most indirect costs are identified as output-unit-level costs (i.e., few indirect
costs are described as batch-level, product-sustaining, or facility-sustaining costs).
3. Products make diverse demands on resources because of differences in volume, process
steps, batch size, or complexity.
4. Products that a company is well suited to make and sell show small profits, whereas
products that a company is less suited to produce and sell show large profits.
5. Operations staff has significant disagreements with the accounting staff about the costs
of manufacturing and marketing products and services.
5-11 The main costs and limitations of ABC are the measurements necessary to implement the
systems. Even basic ABC systems require many calculations to determine costs of products and
services. Activity-cost rates often need to be updated regularly. Very detailed ABC systems are
costly to operate and difficult to understand. Sometimes the allocations necessary to calculate
activity costs often result in activity-cost pools and quantities of cost-allocation bases being
measured with error. When measurement errors are large, activity-cost information can be
misleading.
5-12 No, ABC systems apply equally well to service companies such as banks, railroads,
hospitals, and accounting firms, as well merchandising companies such as retailers and distributors
when products make diverse demands on resources because of differences in volume, process
steps, batch size, or complexity.
5-13 No. An activity-based approach should be adopted only if its expected benefits exceed its
expected costs. It is not always a wise investment. If the jobs, products, or services are alike in
the way they consume indirect costs of a company, then a simple costing system will suffice.
5-14 Increasing the number of indirect-cost pools does NOT guarantee increased accuracy of
product or service costs. If the existing cost pool is already homogeneous, increasing the number
of cost pools will not increase accuracy. If the existing cost pool is not homogeneous, accuracy
5-3
will increase only if the increased cost pools themselves increase in homogeneity vis-à-vis the
single cost pool.
5-15 The controller faces a difficult challenge. The benefits of a better accounting system show
up in improved decisions by managers. It is important that the controller have the support of these
managers when seeking increased investments in accounting systems. Statements by these
managers showing how their decisions will be improved by a better accounting system are the
controller’s best arguments when seeking increased funding. For example, the new system will
result in more accurate product costs, which will influence pricing and product mix decisions. The
new system can also be used to reduce product costs, which will lower selling prices. As a result,
the customer will benefit from the new system.
5-16 (20 min.) Cost hierarchy.
Forrester, Inc., manufactures karaoke machines for several well-known companies. The machines
differ significantly in their complexity and their manufacturing batch sizes. The following costs
were incurred in 2014:
a. Indirect manufacturing labor costs such as supervision that supports direct manufacturing
labor, $825,000
b. Procurement costs of placing purchase orders, receiving materials, and paying suppliers related
to the number of purchase orders placed, $525,000
c. Cost of indirect materials, $160,000
d. Costs incurred to set up machines each time a different product needs to be manufactured,
$365,000
e. Designing processes, drawing process charts, and making engineering process changes for
products, $287,500
f. Machine-related overhead costs such as depreciation, maintenance, and production
engineering, $950,000 (These resources relate to the activity of running the machines.)
g. Plant management, plant rent, and plant insurance, $512,000
Required:
1. Classify each of the preceding costs as output unit–level, batch-level, product-sustaining, or
facility- sustaining. Explain each answer.
2. Consider two types of karaoke machines made by Forrester, Inc. One machine, designed for
professional use, is complex to make and is produced in many batches. The other machine,
designed for home use, is simple to make and is produced in few batches. Suppose that
Forrester needs the same number of machine-hours to make each type of karaoke machine and
that Forrester allocates all overhead costs using machine-hours as the only allocation base.
How, if at all, would the machines be miscosted? Briefly explain why.
3. How is the cost hierarchy helpful to Forrester in managing its business?
SOLUTION
1. a. Indirect manufacturing labor costs of $825,000 support direct manufacturing labor and
are output unit-level costs. Direct manufacturing labor generally increases with output
units and so will the indirect costs to support it.
5-4
b. Batch-level costs are costs of activities that are related to a group of units of a product
rather than each individual unit of a product. Purchase order-related costs (including
costs of receiving materials and paying suppliers) of $525,000 relate to a group of units
of product and are batch-level costs.
c. Cost of indirect materials of $160,000 generally changes with labor hours or machine
hours which are unit-level costs. Therefore, indirect material costs are output unit-level
costs.
d. Setup costs of $365,000 are batch-level costs because they relate to a group of units of
product produced after the machines are set up.
e. Costs of designing processes, drawing process charts, and making engineering changes
for individual products, $287,500, are product sustaining because they relate to the
costs of activities undertaken to support individual products regardless of the number
of units or batches in which the product is produced.
f. Machine-related overhead costs (depreciation and maintenance) of $950,000 are output
unit-level costs because they change with the number of units produced.
h. Plant management, plant rent, and insurance costs of $512,000 are facility-sustaining costs
because the costs of these activities cannot be traced to individual products or services but
support the organization as a whole.
2. The complex karaoke machine made in many batches will use significantly more batch–
level overhead resources compared to the simple karaoke machine that is made in a few
batches. In addition, the complex karaoke machine will use more product-sustaining
overhead resources because it is complex. Because each karaoke machine requires the
same amount of machine-hours, both the simple and the complex karaoke machine will
be allocated the same amount of overhead costs per karaoke machine if Forrester uses
only machine-hours to allocate overhead costs to karaoke machines. As a result, the
complex karaoke machine will be undercosted (it consumes a relatively high level of
resources but is reported to have a relatively low cost) and the simple karaoke machine
will be overcosted (it consumes a relatively low level of resources but is reported to have
a relatively high cost).
3. Using the cost hierarchy to calculate activity-based costs can help Forrester to identify both
the costs of individual activities and the cost of activities demanded by individual products.
Forrester can use this information to manage its business in several ways:
a. Pricing and product mix decisions. Knowing the resources needed to manufacture and
sell different types of karaoke machines can help Forrester to price the different karaoke
machines and also identify which karaoke machines are more profitable. It can then
emphasize its more profitable products.
b. Forrester can use information about the costs of different activities to improve
processes and reduce costs of the different activities. Forrester could have a target of
reducing costs of activities (setups, order processing, etc.) by, say, 3% and constantly
seek to eliminate activities and costs (such as engineering changes) that its customers
perceive as not adding value.
c. Forrester management can identify and evaluate new designs to improve performance
by analyzing how product and process designs affect activities and costs.
d. Forrester can use its ABC systems and cost hierarchy information to plan and manage
activities. What activities should be performed in the period and at what cost?
5-5
Using the cost hierarchy to calculate activity-based costs can help Forrester to identify both the
costs of individual activities and the cost of activities demanded by individual products. Forrester
can use this information to manage its business in several ways:
a. Pricing and product mix decisions. Knowing the resources needed to manufacture and
sell different types of karaoke machines can help Forrester to price the different karaoke
machines and also identify which karaoke machines are more profitable. It can then
emphasize its more profitable products.
b. Forrester can use information about the costs of different activities to improve
processes and reduce costs of the different activities. Forrester could have a target of
reducing costs of activities (setups, order processing, etc.) by, say, 3% and constantly
seek to eliminate activities and costs (such as engineering changes) that its customers
perceive as not adding value.
c. Forrester management can identify and evaluate new designs to improve performance
by analyzing how product and process designs affect activities and costs.
d. Forrester can use its ABC systems and cost hierarchy information to plan and manage
activities. What activities should be performed in the period and at what cost?
5-17 (25 min.) ABC, cost hierarchy, service.
(CMA, adapted) Vineyard Test Laboratories does heat testing (HT) and stress testing (ST) on
materials and operates at capacity. Under its current simple costing system, Vineyard aggregates
all operating costs of $1,190,000 into a single overhead cost pool. Vineyard calculates a rate per
test-hour of $17 ($1,190,000, 70,000 total test-hours). HT uses 40,000 test-hours, and ST uses
30,000 test-hours. Gary Celeste, Vineyard’s controller, believes that there is enough variation in
test procedures and cost structures to establish separate costing and billing rates for HT and ST.
The market for test services is becoming competitive. Without this information, any miscosting
and mispricing of its services could cause Vineyard to lose business. Celeste divides Vineyard’s
costs into four activity-cost categories.
a. Direct-labor costs, $146,000. These costs can be directly traced to HT, $100,000, and ST,
$46,000.
b. Equipment-related costs (rent, maintenance, energy, and so on), $350,000. These costs are
allocated to HT and ST on the basis of test-hours.
c. Setup costs, $430,000. These costs are allocated to HT and ST on the basis of the number of
setup-hours required. HT requires 13,600 setup-hours, and ST requires 3,600 setup-hours.
d. Costs of designing tests, $264,000. These costs are allocated to HT and ST on the basis of the
time required for designing the tests. HT requires 3,000 hours, and ST requires 1,400 hours.
Required:
1. Classify each activity cost as output unit–level, batch-level, product– or service-sustaining, or
facility- sustaining. Explain each answer.
2. Calculate the cost per test-hour for HT and ST. Explain briefly the reasons why these numbers
differ from the $17 per test-hour that Vineyard calculated using its simple costing system.
3. Explain the accuracy of the product costs calculated using the simple costing system and the
ABC system. How might Vineyard’s management use the cost hierarchy and ABC information
to better manage its business?
5-6
SOLUTION
1. Output unit-level costs
a. Direct-labor costs, $146,000
b. Equipment-related costs (rent, maintenance, energy, and so on), $350,000
These costs are output unit-level costs because they are incurred on each unit of materials
tested, that is, for every hour of testing.
Batch-level costs
c. Setup costs, $430,000
These costs are batch-level costs because they are incurred each time a batch of materials
is set up for either HT or ST, regardless of the number of hours for which the tests are
subsequently run.
Service-sustaining costs
d. Costs of designing tests, $264,000.
These costs are service-sustaining costs because they are incurred to design the HT and ST
tests, regardless of the number of batches tested or the number of hours of test time.
2.
Heat Testing (HT)
Stress Testing (ST)
Total
(1)
Per Hour
(2) = (1) 40,000
Total
(3)
Per Hour
(4) = (3) 30,000
Direct labor costs (given)
$100,000
$ 2.50
$ 46,000
$ 1.53
Equipment-related costs
$5 per hour* 40,000 hours
200,000
5.00
$5 per hour* 30,000 hours
150,000
5.00
Setup costs
$25 per setup-hour† 13,600 setup-hours
340,000
8.50
$25 per setup-hour† 3,600 setup-hours
90,000
3.00
Costs of designing tests
$60 per hour** 3,000 hours
180,000
4.50
$60 per hour** 1,400 hours
84,000
2.80
Total costs
$820,000
$20.50
$370,000
$12.33
*$350,000 (40,000 + 30,000) hours = $5 per test-hour
†$430,000 (13,600 + 3,600) setup hours = $25 per setup-hour
**$264,000 (3,000 + 1,400) hours = $60 per hour
At a cost per test-hour of $17, the simple costing system undercosts heat testing ($20.50) and
overcosts stress testing ($12.33). The reason is that heat testing uses direct labor, setup, and design
resources per hour more intensively than stress testing. Heat tests are more complex, take longer
to set up, and are more difficult to design. The simple costing system assumes that testing costs
per hour are the same for heat testing and stress testing.
3. The ABC system better captures the resources needed for heat testing and stress testing
5-7
because it identifies all the various activities undertaken when performing the tests and recognizes
the levels of the cost hierarchy at which costs vary. Hence, the ABC system generates more
accurate product costs.
Vineyard’s management can use the information from the ABC system to make better
pricing and product mix decisions. For example, it might decide to increase the prices charged for
the more costly heat testing and consider reducing prices on the less costly stress testing. Vineyard
should watch if competitors are underbidding Vineyard in stress testing and causing it to lose
business. Vineyard can also use ABC information to reduce costs by eliminating processes and
activities that do not add value, identifying and evaluating new methods to do testing that reduce
the activities needed to do the tests, reducing the costs of doing various activities, and planning
and managing activities.
5-18 (15 min.) Alternative allocation bases for a professional services firm.
The Walliston Group (WG) provides tax advice to multinational firms. WG charges clients for (a)
direct professional time (at an hourly rate) and (b) support services (at 30% of the direct
professional costs billed). The three professionals in WG and their rates per professional hour are
as follows:
WG has just prepared the May 2014 bills for two clients. The hours of professional time spent on
each client are as follows:
Required:
1. What amounts did WG bill to San Antonio Dominion and Amsterdam Enterprises for May
2014?
2. Suppose support services were billed at $75 per professional labor-hour (instead of 30% of
professional labor costs). How would this change affect the amounts WG billed to the two
clients for May 2014? Comment on the differences between the amounts billed in
requirements 1 and 2.
3. How would you determine whether professional labor costs or professional labor-hours is
the more appropriate allocation base for WG’s support services?
5-8
SOLUTION
1.
Direct Professional Time
Support Services
Amount
Client
Rate per
Hour
Number
of Hours
Total
Rate
Total
Billed to
Client
(1)
(2)
(3)
(4) = (2) (3)
(5)
(6) = (4) (5)
(7) = (4) + (6)
SAN ANTONIO
DOMINION
Walliston
Boutin
Abbington
$640
220
100
26
5
39
$16,640
1,100
3,900
30%
30
30
$4,992
330
1,170
$21,632
1,430
5,070
$28,132
AMSTERDAM
ENTERPRISES
Walliston
Boutin
Abbington
$640
220
100
4
14
52
$2,560
3,080
5,200
30%
30
30
$768
924
1,560
$ 3,328
4,004
6,760
$14,092
2.
Direct Professional Time
Support Services
Client
Rate
per
Hour
Number
of Hours
Total
Rate per
Hour
Total
Amount
Billed to
Client
(1)
(2)
(3)
(4) = (2) (3)
(5)
(6) = (3) (5)
(7) = (4) + (6)
SAN ANTONIO
DOMINION
Walliston
Boutin
Abbington
$640
220
100
26
5
39
$16,640
1,100
3,900
$75
75
75
$1,950
375
2,925
$18,590
1,475
6,825
$26,890
AMSTERDAM
ENTERPRISES
Walliston
Boutin
Abbington
$640
220
100
4
14
52
$2,560
3,080
5,200
$75
75
75
$ 300
1,050
3,900
$ 2,860
4,130
9,100
$16,090
Requirement 1 Requirement 2
San Antonio Dominion $28,132 $26,890
Amsterdam Enterprises 14,092 16,090
$42,224 $42,980
5-9
Both clients use 70 hours of professional labor time. However, San Antonio Dominion uses a
higher proportion of Walliston’s time (26 hours), which is more costly. This attracts the highest
support-services charge when allocated on the basis of direct professional labor costs.
3. Assume that the Walliston Group uses a cause-and-effect criterion when choosing the
allocation base for support services. You could use several pieces of evidence to determine whether
professional labor costs or hours is the driver of support-service costs:
a. Interviews with personnel. For example, staff in the major cost categories in support
services could be interviewed to determine whether Walliston requires more support
per hour than, say, Abbington. The professional labor costs allocation base implies that
an hour of Walliston’s time requires 6.40 ($640 ÷ $100) times more support-service
dollars than does an hour of Abbington’s time.
b. Analysis of tasks undertaken for selected clients. For example, if computer-related costs
are a sizable part of support costs, you could determine if there was a systematic
relationship between the percentage involvement of professionals with high billing
rates on cases and the computer resources consumed for those cases.
5-19 (20 min.) Plantwide, department, and ABC indirect cost rates.
Automotive Products (AP) designs and produces automotive parts. In 2014, actual variable
manufacturing overhead is $308,600. AP’s simple costing system allocates variable manufacturing
overhead to its three customers based on machine-hours and prices its contracts based on full costs.
One of its customers has regularly complained of being charged noncompetitive prices, so AP’s
controller Devon Smith realizes that it is time to examine the consumption of overhead resources
more closely. He knows that there are three main departments that consume overhead resources:
design, production, and engineering. Interviews with the department personnel and examination
of time records yield the following detailed information.
Required:
1. Compute the manufacturing overhead allocated to each customer in 2014 using the simple
costing system that uses machine-hours as the allocation base.
5-10
2. Compute the manufacturing overhead allocated to each customer in 2014 using department-
based manufacturing overhead rates.
3. Comment on your answers in requirements 1 and 2. Which customer do you think was
complaining about being overcharged in the simple system? If the new department-based rates
are used to price contracts, which customer(s) will be unhappy? How would you respond to
these concerns?
4. How else might AP use the information available from its department-by-department analysis
of manufacturing overhead costs?
5. AP’s managers are wondering if they should further refine the department-by-department
costing system into an ABC system by identifying different activities within each department.
Under what conditions would it not be worthwhile to further refine the department costing
system into an ABC system?