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Chapter 5: Activity-Based Costing and Management: Questions 5-1
Chapter 5: Activity-Based Costing and Management: Questions 5-1
QUESTIONS
5-1 Product costs are likely distorted when a firm uses a volume-based rate if the
plant has more than one activity in its operations and not all activities consume
overhead in the same proportion. The more diverse the product mixes of the
plant are in volume, sizes, manufacturing processes, or product complexities, the
greater the cost distortions are likely to be in using a volume-based rate.
5-2 Undercosting a product may appear to have increased the reported profit the
product earned (assuming the firm did not lower its selling price because of the
reported lower product cost). However, the increased profit is, at best, a twist in
truth. Costs of the product not charged to the product itself are borne by other
products of the firm.
5-3 Overcosting does not increase revenues. A firm can increase the selling price of
a product, thereby increasing the total revenue from the product only if the
market allows. Increases in the selling price of a product without experiencing
noticeable decrease in the sales quantity of the product is likely an indication that
the product was not priced properly, which might be a result of undercosting of
the product.
When a firm sets a high selling price that is a result of overcosting, competitors
also are likely to enter the market and take away the firm’s market share. A firm
also may drop or de-emphasize an erroneously overcosted product when it
erroneously believes the product is either unprofitable or having a low-margin.
5-5 Based on the activities of most manufacturing firms, the general levels of cost
hierarchy of an activity-based costing system are:
Unit-level cost;
Batch-level cost;
Product-level cost; and
Facility-level cost.
5-7 All firms should use an ABC system when the benefits of such a system exceed
the costs of implementing it. It is especially beneficial to firms with product
diversity and/or process complexity.
Examples of unit-level activities are using direct materials, using direct labor
hours, inserting a component, inspecting each unit, and consuming power to run
machines.
5-9 Batch-level activities are activities performed for a group of units of products or
services rather than for each individual unit of product or service. The frequency
of batch-level activity is determined by both the size of the group and the total
number of units to be manufactured or provided.
5-11 Facility-level activities are activities performed for the entire organization or
division to meet the required operating procedure or support the operation of the
organization or division.
5-12 A product-costing system that uses a single volume-based cost driver is likely to
overcost high-volume products because high-volume products do not consume
support resources in proportion to their production volumes. As a result, a
product-costing system that uses a single volume-based cost driver often
overcosts high-volume products or services and undercosts low-volume products
or services.
5-23
Materials Cost = $3,000,000 / 100,000 = $30 per camera
Labor Cost = $500,000 / (100,000 x .5)
= $10 per camera
Inspection Cost = $1,000,000 / (100,000 x .2)
= $50 per camera
Packaging Cost = $500,000 / 100,000
= $5 per camera
5-24
Direct Labor = $8 x 5 = $40
Copying = $0.05 x 1,000 = $50
Total Job Cost = $50 + $40 = $90
5-25
Data Entry = $2,000,000 / 100,000 = $20 per hour
Data Analysis = $3,000,000 / 30,000 = $100 per hour
5-27
$150 x .2 = $30 million
500,000 x 20 = 10 million
5-28
6 x 10,000 x $.50 = $30,000
1. Cost Hierarchy
a. Unit-level f. Product-level
b. Unit-level g. Facility-level
c. Facility-level h. Facility-level
d. Unit-level i. Batch-level
e. Unit-level j. Batch-level (one bag per
customer).
2. Cost Driver
a. Number of hamburgers
b. Number of hours
c. Square feet
d. Number of hamburgers; Size of hamburgers
e. Number of hamburgers
f. Number of times the advertising is run
g. Number of hours store is open
h. Square feet
i. Number of coupons redeemed; Number of multiple orders; Number
of hamburgers
j. Number of customers
2. Cost Drivers
a. Machine hours
b. Number of setups or setup hours
c. Number of production orders
d. Number of material receipts; Number of purchase orders
e. Number of products
f. Number of machine hours
g. Number of engineering change notices; number of modifications;
Number of products
h. Number of parts; Number of products; Number of purchase
orders
i. Number of inspection hours; Number of units; Number of batches
j. Number of loads; Number of material moves; Material weights
1. Activity Levels
a. Product-level f. Batch-level
b. Product-level g. Unit-level
c. Product-level h. Facility-level
d. Product-level i. Product-level
e. Batch-level j. Facility-level
2. Cost Drivers
a. Number of products
b. Number of products
c. Number of products
d. Number of products
e. Number of batches or setups
f. Number of batches
g. Number of units
h. Purchase costs; Replacement costs; Book values
i. Number of purchase orders; Number of products; Number of
suppliers
j. Square feet
These costs are likely to vary with the number of test-hours, which are
functions of the output units (test).
Batch-level costs:
c. setup costs $240,000
Setup costs are incurred each time a batch of tests is setup for either
ST or PRT, regardless of the number of hours of the tests.
Product-level costs:
d. Costs of test designs $360,000
These costs are incurred in designing ST and PRT tests, regardless
of the number of test-hours or number of batches tested.
*Equipment-related
costs $300,000
Test hours 10,000 20,000 30,000
Per test hour $10
Total 100,000 200,000
#
Setup costs: $240,000
Setup hours 8,500 11,500 20,000
Per hour $12.00
Total 102,000 138,000
&
Test design costs: $360,000
Test design hours 5,800 4,200 10,000
Per hour $36.00
Total 208,800 151,200
*Equipment-related
costs: $300,000
Test hours 2,500 5,000 7,500
Per test hour $40
Total 100,000 200,000
#
Setup costs: $240,000 $360,000 $600,000
Setup hours 8,500 11,500 20,000
Per hour $30.00
Total 255,000 345,000
&
Test design costs: $360,000 $540,000 $900,000
Test design hours 5,800 4,200 10,000
Per hour $90.00
Total 522,000 378,000
The cost per test-hour increased from $95.08 to $404.80 for ST and from
$57.46 to $217.60 for PRT. Platte Valley needs to reexamine the
appropriateness for using test-hours as the basis for costing. The bulk of
the cost is for setup and test-design and the direct cost related to test-hour
is only a fraction of the setup and test-design costs. A costing system
based on the direct test-hour is likely to distort the true cost of testing.
a. Inventory Valuation
Meets external reporting requirements for aggregate balance sheet
valuation and income determination.
Provides monthly and quarterly reporting.
b. Operational Control
Evaluates operations to quickly detect problems to allow for
implementation of corrective action.
Compares costs against budget for monitoring variances.
c. Activity-based costing
Differentiates costs between high-value added and low-value-added
activities.
Costs products according to activities involved in the production
process.
A B .
Direct materials $40,000 $50,000
Direct labor 24,000 40,000
Factory overhead:
Machine setup $120 x 200 = 24,000 $120 x 240 = 28,800
Materials handling $4 x 1,000= 4,000 $4 x 3,000 = 12,000
Electric power $1 x 2,000 = 2,000 $1 x 4,000 = 4,000
Total product costs $94,000 $134,800
Production units ÷ 4,000 ÷ 20,000
COST PER UNIT $23.50 $6.74
1. The information gathering program are a logical fit for the luxury type
hotels described here. These firms compete on their ability to attract high-
paying customers to their luxury hotels. These additional services can
give the hotel a competitive edge.
3. Some will argue there is not ethical issue with the information
gathering. Others might argue that the guest should be informed that the
information is being obtained and used throughout the hotel chain’s
system. For example, Marriott has guests fill out a form to participate, so
the program is entirely optional. Other ethical issues arise, for example, if
the hotel chain chooses to sell the information to third parties, such as
magazine publishers, retail stores, or other businesses.
(all figures in £)
Price 20.525
Total Revenue 205,250
The results suggest that the trouser line is more profitable than previously
thought (using volume-based costing). This is likely due to the common
situation in which the high-volume products are overcosted using volume-
based costing.
A: $0.15 x 30 = $ 4.50
C: $35.50 / 5 = $ 7.10
3. Both baked goods and fresh produce have a drop in profitability when
ABC is used. The decrease in profitability of fresh produce is most
noticeable. The profitability of fresh produce decreases from 10.43
percent of the sales revenues under the current system, the highest of
the three products, to 2.10 percent under ABC, the lowest of the three.
This is because fresh produce requires more support activities than the
other two products.
Requirement 1
Jerry Inc. Donald Co.
Customer unit-level cost -
Sales returns(40x5;175x5) $200 $875
Customer batch-level costs:
Order processing(5x300;30x300) $1,500 $9,000
Sales returns(2x100;5x100) 200 500
Delivery(5x500;30x500) 2,500 15,000
Customer sustaining costs:
Sales calls(12x1000;4x1000) 12,000 4,000
TOTAL $16,400 $29,375
Requirement 2
Jerry Inc. Donald Co.
Sales(5x1000x200;200x30x200) $1,000,000 $1,200,000
Sales return(40x200;175x200) 8,000 35,000
Net Sales $992,000 $1,165,000
Cost of goods sold(75%) 744,000 873,750
Gross margin(25%) $248,000 $291,250
Sales support cost (from req. 1) 16,400 29,375
Operating income $231,600 $261,875
Net profit per unit at $700 selling price per unit to preferred
customers:
Preferred Customer
Selling price per unit $700.00
Manufacturing cost $600.00
Order-filling cost/unit + 1.00
Total cost per unit 601.00
Net Profit per unit $ 99.00
Profit margin 0
2.
Value Quality Luxury
Direct Materials $ 80.00 $ 50.00 $ 110.00
Direct Labor 48.00 60.00 84.00
Overhead 152.77 190.97 267.35
Cost per unit $ 280.7729 $ 300.9661 $ 461.3525
Total Cost $ 4,211,593 $ 1,504,831 $ 230,676
Practical
Budgeted Cost Practical Capacity-Based
Cost Driver Capacity Rates
Materials handling $ 349,600 Number of Parts 990,000 $ 0.353
Product Scheduling 160,000 Number of Production orders 800 200.00
Setup Labor 216,000 Number of setups 200 1,080.00
Automated Machinery 1,750,000 Machine hours 100,000 17.50
Finishing 619,500 Direct labor hours 123,900 5.00
Pack and Ship 285,000 Number of orders shipped 5,000 57.00
$ 3,380,100
Note that the rates have changed significantly from the calculations in part
1 above, because there is a significant level of unused capacity in many of
the activities. This information could be used by management to calculate
unit ABC-based costs using the practical capacity rates, and thereby
identify the cost of unused capacity. Moreover, the information about
capacity utilization can be used to help bring resource spending in line with
resource usage. As the firm plans to grow (particularly in the Luxury line),
some additional capacity will be needed, but careful planning will allow a
balance of planned future capacity needs versus current spending on
these resources, probably allowing some capacities to be reduced. The
potential for overcapacity appears to be greatest in product scheduling and
pack and ship.
4. The ABC costing shows clearly how expensive the Luxury line is to
produce. The volume-based approach fails to account for the activity
usage of the Luxury line, and undercosts it significantly. ABC allows HPI to
better understand how its costs will increase with the expected increased
production of the Luxury line, and how it will have to adapt its pricing
practices accordingly. Continued use of the volume-based approach at a
time when sales of the Luxury line are increasing would mean significantly
under-pricing the Luxury line, and undermining the profitability of the entire
firm.
Note: However, the problem indicated that the firm uses machine
hours as the base for assigning facility-level costs. An
alternative solution is to combine cost pools 3 and 4.
2. Overhead Rates:
Cost pool 1: Total cost $33,000
Number of purchase orders 6
Cost per purchase order $5,500
Manufacturing overheads:
Unit level:
Cost pool 3 – Cost per machine hour $ 0.90
Number of machine hours x 4,250 $ 3,825
Product-level level:
Cost pool 1 – Cost per purchase order $5,500
Number of purchase orders x 1 5,500
Facility-level level*:
Cost pool 4 – Cost per machine hour $ 1.50
Number of machine hours x 4,250 6,375
Total manufacturing overhead $19,980
Number of units ÷ 4,000
Manufacturing overhead per unit $4.995
Unit level:
Cost pool 3 $ 3,825
Cost pool 5 280
Batch level:
Cost pool 2 1,000
Product-level level:
Cost pool 1 5,500
Cost pool 6 3,000
Facility-level level:
Cost pool 4 – Cost per unit $ 1.50
Number of units x 4,000 6,000
Total manufacturing overhead $ 19,605
Number of units ÷ 4,000
Manufacturing overhead per unit $4.90125
Strategic implications:
(1) Knowing the full cost of a product including upstream and
downstream costs allows the firm to be aware of all costs
attributable to the product.
(2) The amounts and proportions of upstream, manufacturing, and
downstream costs facilitate comparisons with competitors.
(3) The company should consider ways of spending less cost in the
manufacturing activity, and more on upstream and downstream
activities in order to improve its competitive position by pursuing
the differentiation strategy in both the new product design and the
customer service.
3. The total value chain cost provides the firm a long-term perspective
of the product cost, in addition to the short term manufacturing cost.
Different industries have different cost structures. For example, firms
in the computer software industry are likely to have high upstream
costs while firms in the retailing industry tend to have high
downstream costs.
Under volume-based costing, CCO will likely see its order mix shift to
G23 and away from P5, as competitors that use ABC costing will use
proper pricing and get the most profitable orders. The result might be
that CCO’s sales will continue to increase (lots of G23), but its
profitability will decline (G23 is not priced properly). This is a good
signal of a firm that needs ABC costing – sales up but profits down, in
this case, because of an unprofitable shift in the product mix due to
cost distortions in volume-based costing.
Based on the current cost data, it is true that product B is the least
profitable product with a gross margin per unit of $54.00 (21.6%) and
product C is the most profitable product with a gross margin per unit of
$167.00 (55.67%). However, the validity of this conclusion is based on
the accuracy of the reported product costs.
Notes:
(a) Setups:
Cost per setup: $8,000 / (2 + 5 + 3) = $800 per setup
Product A = 2 x $800 = $1,600; $1,600 /1,000 = $1.60 per unit
Product B = 5 x $800 = $4,000; $4,000 /5,000 = $0.80 per unit
Product C = 3 x $800 = $2,400; $2,400 /500 = $4.80 per unit
(e) Utilities:
Cost per MH = $60,000 / (2,000 + 7,000 + 1,000) = $6.00 per MH
Product A = 2,000 x $6 = $12,000; $12,000/1,000 = $12.00 per unit
Product B = 7,000 x $6 = $42,000; $42,000/5,000 = $ 8.40 per unit
Product C = 1,000 x $6 = $ 6,000; $ 6,000/500 = $12.00 per unit
Deluxe % Speedy %
Price $475.00 100 $300.00 100
Cost
Prime cost $180.00 $110.00
Overhead 267.20 447.20 94 122.70 232.70 78
Unit gross profit $27.80 6 $67.30 22
Budgeted Budgeted
Cost Pool OH Cost Cost Driver Overhead Rate
Machine depr./maint. $135,000 27,000 $5.00 per MH
Factory depr./util./insur. $120,000 30,000 $4.00 per MH
Product design $504,000 42,000 $12.00 per Design hour
Materials purch./stor. $147,000 $980,000 15.00% DM cost
Total overhead $906,000
1. The activity based cost pools are determined from the percent-of-use
information; for example, total setup cost = $157,500 = .15 x $850,000
+ .2 x $150,000.
Inspect &
Factory Costs Setup Assembly Finishing Packaging
Salaries $ 850,000 $ 127,500 $ 467,500 $ 170,000 $ 85,000
Supplies 150,000 30,000 90,000 30,000 -
Factory Expense 550,000 - 440,000 110,000
$ 1,550,000 $ 157,500 $ 997,500 $ 310,000 $ 85,000
3. The per unit activity-based costs are $14.18 for Safe-V and $18.63 for
the Safe-T
1. The resource consumption cost driver rates and the activity cost polls
are determined as follows. For example the activity cost pool, setup, is
$115,000 = 1 x $50,000 + 1 x $15,000 + 2,000 x $25.
2. The new activity consumption rates are shown in the right column, using
the same activity drivers as before, with the new activity cost pool amounts.
3. The new ABC product costs are shown below; there is very little
change from the solution in 5-56 above.
3. The above profitability analysis indicates that the Luxury Pendant is not
as profitable as the vice president of marketing thinks it is.
Note that the only cost that remains the same for both cost methods
is the cost of direct materials. Under the ABC method, direct labor
cost becomes part of the manufacturing manual insertion overhead
cost.
ABC cost data also point out that the reason for the Malaysian
Coffee to have a higher unit cost is not because of high-priced
ingredients. In fact, Malaysian Coffee has a lower cost of direct
materials than that of Mona Loa Coffee. The costs of roasting,
blending, and packaging are $0.16 per pound for both coffees. The
higher cost of Malaysian is because of the way in which it is
processed. The batch-level cost per pound is $0.16 for Mona Loa
and $3.80 for Malaysian. CBI can increase its profit margin or lower
its price on Malaysian Coffee if it can change the way in which it
handles purchasing, material handling, and quality control functions
of Malaysian coffee.
1. The calculation of the new activity rates and the cost of unused capacity
is determined below.
Practical
Usage- Capacity Practical Cost of
Driver Based at Current Usage Capacity Unused Unused
Usage Cost Rate Spending Percent Rate Capacity Capacity
Purchasing 1,158 $ 579,000 $ 500 1,400 83% $ 413.57 242 $ 100,084
Materials Handling 1,800 720,000 400 2,400 75% $ 300.00 600 180,000
Quality Control 720 144,000 200 1,200 60% $ 120.00 480 57,600
Roasting 96,100 961,000 10 100,000 96% $ 9.610 3,900 37,479
Blending 33,600 336,000 10 36,000 93% $ 9.333 2,400 22,400
Packaging 26,000 260,000 10 30,000 87% $ 8.667 4,000 34,667
$ 3,000,000 $ 432,230
1 2 3 4 5 6 7 8
Capacity Step: Number Cost per Step
Driver at Current of Employees Unused Step Size Steps
Usage Cost Spending or Machines Capacity =(2)/(4) =(3)/(4) Not Used
Purchasing 1,158 $ 579,000 1,400 8 242 $ 72,375 175 1.38
Materials Handling 1,800 720,000 2,400 20 600 36,000 120 5.00
Quality Control 720 144,000 1,200 4 480 36,000 300 1.60
Roasting 96,100 961,000 100,000 10 3,900 96,100 10,000 0.39
Blending 33,600 336,000 36,000 10 2,400 33,600 3,600 0.67
Packaging 26,000 260,000 30,000 3 4,000 86,667 10,000 0.40
2. Service Costs
Omega International City of Albion
Requisition Handling $3,000 $ 7,000
(300 requisitions x $10/requisition) (700 requisitions x $10/requisition)
Warehouse Activity 750 7,500
(50 cartons x $15.00 per carton) (500 cartons x $15.00 per carton)
Pick-Packing 1,350 3,150
(900 pick-pack lines x $1.50) (2,100 pick-pack lines x $1.50)
Data Entry 900 2,100
(900 lines x $1.00/line) (2,100 lines x $1.00/line)
Freight Out 3,450 8,260
($10 x 300) + ($0.30 x 5 x 300) ($10 x 700) + ($0.30 x 6 x 700)
Total Service Costs $9,450 $28,010