CHAPTER 5
ACTIVITY-BASED COSTING AND ACTIVITY-BASED MANAGEMENT
5-1 What is broad averaging, and what consequences can it have on costs?
Broad averaging (or “peanut-butter costing”) describes a costing approach that uses broad
5-2 Why should managers worry about product overcosting or undercosting?
Overcosting may result in overpricing and competitors entering a market and taking market share
5-3 What is costing system refinement? Describe three guidelines for refinement.
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.
5-4 What is an activity-based approach to designing a costing system?
An activity-based approach refines a costing system by focusing on individual activities (events,
5-5 Describe four levels of a cost hierarchy.
Four levels of a cost hierarchy are
(i) Output unit-level costs: costs of activities performed on each individual unit of a product or
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5-6 Why is it important to classify costs into a cost hierarchy?
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
5-7 What are the key reasons for product cost differences between simple costing systems
and ABC systems?
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
5-8 Describe four decisions for which ABC information is useful.
Four decisions for which ABC information is useful are
1. pricing and product mix decisions,
5-9 “Department indirect-cost rates are never activity-cost rates.” Do you agree? Explain.
“Department indirect-cost rates are never activity-cost rates.” Do you agree? Explain.
No. Department indirect-cost rates are similar to activity-cost rates if (1) a single activity
5-10 Describe four signs that help indicate when ABC systems are likely to provide the most
benefits.
“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.
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5-11 What are the main costs and limitations of implementing ABC systems?
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
5-12 “ABC systems only apply to manufacturing companies.” Do you agree? Explain.
No, ABC systems apply equally well to service companies such as banks, railroads, hospitals,
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
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
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5-16 Conroe Company is reviewing the data provided by its management accounting system.
Which of the following statements is/are correct?
I. A cost driver is a causal factor that increases the total cost of a cost object.
II. Cost drivers may be volume based or activity based.
III.Cost drivers are normally the largest cost in the manufacturing process.
1. I, II, and III are correct.
2. I and II only are correct.
3. I only is correct.
4. II and III only are correct.
SOLUTION
Explanation Choice “2” is correct.
The question asks which of a series of statements is/are correct. “None of the above” is not
available, so one of the statements at least is correct.
Statement I says that a cost driver is a causal factor that increases the total cost of a cost object.
Statement I is correct.
5-17 Nobis Company uses an ABC system. Which of the following statements is/are correct
with respect to ABC?
I. Departmental costing systems are a refinement of ABC systems.
II. ABC systems are useful in manufacturing, but not in merchandising or service industries.
III.ABC systems can eliminate cost distortions because ABC develops cost drivers that have a
cause-and-effect relationship with the activities performed.
1. I, II, and III are correct.
2. II and III only are correct.
3. III only is correct.
4. None of the listed choices is correct.
SOLUTION
Explanation Choice “3” is correct.
The question asks which of a series of statements is/are correct with respect to ABC.
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5-18 Cost hierarchy. Roberta, Inc., manufactures elliptical machines for several well-known
companies. The machines differ significantly in their complexity and their manufacturing batch
sizes. The following costs were incurred in 2017:
a. Indirect manufacturing labor costs such as supervision that supports direct manufacturing
labor, $935,000
b. Procurement costs of placing purchase orders, receiving materials, and paying suppliers
related to the number of purchase orders placed, $650,000
c. Cost of indirect materials, $234,000
d. Costs incurred to set up machines each time a different product needs to be manufactured,
$392,000
e. Designing processes, drawing process charts, and making engineering process changes for
products, $236,900
f. Machine-related overhead costs such as depreciation, maintenance, and production
engineering, $865,000 (These resources relate to the activity of running the machines.)
g. Plant management, plant rent, and plant insurance, $498,000
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 elliptical machines made by Roberta, 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
Roberta needs the same number of machine hours to make each type of elliptical machine and
that Roberta 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 Roberta in managing its business?
SOLUTION
(20 min.) Cost hierarchy.
1. a. Indirect manufacturing labor costs of $935,000 support direct manufacturing labor
b. Batch-level costs are costs of activities that are related to a group of units of a product
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c. Cost of indirect materials of $234,000 generally changes with labor hours or machine
d. Setup costs of $392,000 are batch-level costs because they relate to a group of units
e. Costs of designing processes, drawing process charts, and making engineering
f. Machine-related overhead costs (depreciation, maintenance, and production
g. Plant management, plant rent, and insurance costs of $498,000 are facility-sustaining
2. The complex elliptical machine made in many batches will use significantly more
batch-level overhead resources compared to the simple elliptical machine that is made in a few
batches. In addition, the complex elliptical machine will use more product-sustaining overhead
3. Using the cost hierarchy to calculate activity-based costs can help Roberta to identify
both the costs of individual activities and the cost of activities demanded by individual products.
Roberta can use this information to manage its business in several ways:
a. Pricing and product mix decisions. Knowing the resources needed to manufacture and
b. Roberta can use information about the costs of different activities to improve
c. Roberta management can identify and evaluate new designs to improve performance
d. Roberta can use its ABC systems and cost hierarchy information to plan and manage
5-19 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
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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.
3Explain 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?
SOLUTION
(25 min.) ABC, cost hierarchy, service.
1. Output unit-level costs
a. Direct-labor costs, $146,000
b. Equipment-related costs (rent, maintenance, energy, and so on), $350,000
Batch-level costs
c. Setup costs, $430,000
d. Costs of designing tests, $264,000.
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2.
Heat Testing (HT) Stress Testing (ST)
Total
(1)
Per Hour
(2) = (1) 40,000
hrs
Total
(3)
Per Hour
(4) = (3) 30,000
hrs
Direct labor costs (given) $100,000 $ 2.50 $ 46,000 $ 1.53
Equipment-related costs
Setup costs
setup-hours
setup-hours
Costs of designing tests
*$350,000 (40,000 + 30,000) hours = $5 per test-hour
At a cost per test-hour of $17, the simple costing system undercosts heat testing ($20.50) and
3. The ABC system better captures the resources needed for heat testing and stress
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.
5-20 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:
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WG has just prepared the May 2017 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
2017?
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 2017? 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?
SOLUTION
(15 min.) Alternative allocation bases for a professional services firm.
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
$640
26
$16,640
30%
$4,992
$21,632
AMSTERDAM
ENTERPRISES
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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
AMSTERDAM
ENTERPRISES
Requirement 1 Requirement 2
Both clients use 70 hours of professional labor time. However, San Antonio Dominion uses a
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
b. Analysis of tasks undertaken for selected clients. For example, if computer-related
5-21 Plant-wide, department, and ABC indirect cost rates. Roadster Company (RC) designs
and produces automotive parts. In 2017, actual variable manufacturing overhead is $280,000.
RC’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
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regularly complained of being charged noncompetitive prices, so RC’s controller Matthew
Draper 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
1Compute the manufacturing overhead allocated to each customer in 2017 using the
simple costing system that uses machine-hours as the allocation base.
2Compute the manufacturing overhead allocated to each customer in 2017 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 RC use the information available from its department-by-department
analysis of manufacturing overhead costs?
5. RC’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?
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