LCRC :MS 08_ ACTIVITY BASED COSTING & TOTAL QUALITY MANAGEMENT BATCH MAY 2020

Calamba Review Center - Laguna (LCRC)

2F MMCO Building, 8000 Lakeview Ph3 Angela Street, Halang, Calamba City Laguna, Philippines
Tel No. (02) 330-8617, (049) 523-6031; (02) 330-6057
CPA REVIEW (May 2020 Batch)
MAS Karim Abitago, CPA

MS08–ACTIVITY BASED COSTING & TOTAL QUALITY MANAGEMENT

TOPIC OUTLINE

Definition

Advantages &
Basic Concepts Limitations

Traditional vs. ABC When to use ABC?

Activity-based
Costing (ABC) Unit Level

Product Level
Cost Level
ACTIVITY-BASED COSTING
(ABC) & TOTAL QUALITY Batch Level
MANAGEMENT (TQM)
Facility level
Basic Concepts
Total Quality Conformance Costs
Management (TQM)
Quality Costs
Non-Conformance
Costs

LECTURE NOTES
ACTIVITY-BASED COSTING (ABC)
BASIC CONCEPTS
Definition
Activity-based costing is an accounting costing method that collects financial and other data on the basis
of the underlying nature and extent of cost drivers.
Nature of ABC
• The MAIN ISSUE of this topic is ALLOCATION of fixed factory overhead costs and other indirect costs.
• This costing system is a TWO-STAGE procedure that uses MULTIPLE DRIVERS to predict and allocate
costs to products. Thus, ABC is based on the concept that ACTIVITIES DRIVE OVERHEAD COSTS.
• Most organizations that use ABC have two-costing systems. The official costing system that is used for
preparing external financial reports and the ABC system that is used for internal decision making and for
management activities.

UNDER ABC
OVERHEAD COSTS ACTIVITIES/COST DRIVERS PRODUCTS
1 STAGE ALLOCATION
ST
2ND STAGE ALLOCATION
The steps or activities required in designing an ABC system are:
(1) Process Value Analysis (PVA) (4) Selecting appropriate cost drivers
(2) Identifying activity centers (5) Assigning costs to products
(3) Assigning costs to activity centers

Activity center can be defined as a part of the production process for which management wants a separate
reporting of the cost of the activity involved.

Advantages & Limitations of ABC

ADVANTAGES:
(1) More accurate product costing (3) Better management decisions
(2) Better control to costs (4) Elimination of Non-value adding activities
LIMITATIONS / DISADVANTAGES:

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LCRC :MS 08_ ACTIVITY BASED COSTING & TOTAL QUALITY MANAGEMENT BATCH MAY 2020
(1) Costly to implement (3) Some arbitrary allocations continue
(2) Does not conform with PFRS
When to use ABC?
(1) When there are signs of poor cost data. Examples are:
(a) Competitors prices for low volume products are high.
(b) Customers don’t balk at price increases for low volume products
(c) The company seems to have a highly profitable niche all to itself.
(2) Overhead costs constitute a MAJOR portion of total costs.
(3) Complexity of operations.
(4) Products and services vary significantly in terms of volume.
(5) Costs are subject to management distortion.
TRADITIONAL COSTING vs. ACTIVITY-BASED COSTING
ABC TRADITIONAL
Assume that products consume activities Assume that products consume costs
Uses drivers at various levels Uses volume-based cost drivers
(e.g. direct labor hours and machine hours)
Process-oriented Structure-oriented
Accurate cost information Inaccurate or misleading cost information
NOTE: In traditional costing, high volume products are being assigned with high costs also because the driver
used is volume based (peanut-butter costing). But, if the company implements ABC, these high volume
products will be assigned with low costs only. This phenomenon is known as CROSS SUBSIDIES.
COST LEVELS
COST LEVELS DEFINITION ACTIVITY DRIVERS
performed each time a unit is Direct labor hours, direct labor peso,
Unit Level
produced machine hours, units output
set-up time, number of batches, material
performed each time a batch
moves, orders processed, number of
Batch Level of goods is handled or
receipts, number of inspections, number
processed
of production orders
performed as needed to desing time, testing time, number of
Product Level support the production of engineering change orders, number of
each different type of product categories of parts, design changes
sustain a facility's general
Facility Level square footage occupied
manufacturing process
TOTAL QUALITY MANAGEMENT (TQM)
BASIC CONCEPTS
Definition
Total quality management is an approach to continuous improvement that focuses on serving customers
and uses front-line workers to identify and solve problems systematically.
Nature of TQM
• The purpose of TQM is to ensure that the firm’s products and services exceed customer’s expectations.
• The purpose above is achieved by eliminating non-value adding activities.
• Quality is important because this is what the customers want.
QUALITY COSTS
(1) Conformance costs – incurred to keep defective products from falling in the hands of customer. These
costs are incurred so that products “CONFORM” to its specified quality.
(a) Prevention costs – costs relating to any activity that reduces the number of defects (preventive
costs). EXAMPLES: Employee training, equipment maintenance, quality engineering.
(b) Appraisal costs – cost incurred in activities relating to inspection to make sure that products meet
standards of quality (detective costs). EXAMPLES: Inspection, product testing, statistical quality
control
(2) Non-conformance costs – incurred because defects are produced despite efforts to prevent and detect
them.
(a) Internal failure costs – result from identification or discovery of defects during the appraisal process.
EXAMPLES: Cost of scrap, spoilage, rework, production downtimes.
(b) External failure costs – result when a defective product is delivered to a customer. EXAMPLES:
Product warranty, repair costs, liability lawsuits, lost reputation.
NOTE: The company must invest with PREVENTION COSTS to minimize non-conformance costs

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LCRC :MS 08_ ACTIVITY BASED COSTING & TOTAL QUALITY MANAGEMENT BATCH MAY 2020

DISCUSSION EXERCISES
STRAIGHT PROBLEMS:
ACTIVITY-BASED COSTING
1. DORAEMON CORP. produces flat-screen computer monitors. Consider the following selected costs that
arose during the current year:
(1) Direct materials used: P3,640,000
(2) Plant rent, utilities, and taxes: P1,229,000
(3) New technology design engineering: P2,040,000
(4) Materials receiving: P318,000
(5) Manufacturing-run/set-up charges: P115,000
(6) Equipment depreciation: P92,000
(7) General management salaries: P1,564,000
REQUIREMENT: Determine the cost of the firm's unit-level, batch-level, product-sustaining, and facility-
level activities.
2. NOBITA INC. manufactures several types of microbrew beers. Malt has identified the following activities:
a. Inventory control e. Machine setups
b. Purchasing f. Brewing
c. Receiving g. Packing and shipping
d. Employee training
REQUIREMENT: Classify each activity as value-added or non-value-added.
3. GHOSTFIGHTERS CORP. produces two products, Product KK and GG, and uses a costing system in which
all overhead is accumulated in a single cost pool and allocated based on machine hours. The company's
management has decided to implement ABC because a cost study has revealed significant amounts of
overhead cost related to setup activity and design activity. The number of setups and the number of
design hours will be the activity drivers for the two new cost pools, and machine hours will continue as the
base for allocating the remaining overhead. Selected information follows the San Juan Company's most
recent year of operations:
Product KK Product GG Total
Units produced 500 15,500 16,000
Direct material cost:
Per unit P200 P20
Total P100,000 P310,000 P410,000
Machine hours 3,000 47,000 50,000
Direct labor cost P50.000 P350,000 P400,000
Setups 120 80 200
Design hours 6,000 4,000 10,000
Overhead:
Setup-related P250,000
Design-related 350,000
Other 900,000
Total overhead P1,500,000
REQUIREMENTS:
1. Compute the total and per-unit costs reported for the two products by the existing costing system.
2. Compute the total and per-unit costs reported for the two products by the ABC system.
4. The following data are for the two products by ONE PIECE INC:
PRODUCT A PRODUCT B
Direct materials P15 per unit P24 per unit
Direct labor hours 0.3 DLH per unit 1.6 DLH per units
Machine hours 0.1 MH per unit 1.2 MH per unit
Batches 126 batches 225 batches
Volume 10,000 units 2,000 units
Engineering modifications 12 modifications 58 modifications
Number of customers 500 customers 400 customers
Market price P30 per unit P120 per unit
The company’s direct labor rate is P20 per direct labor hour (DLH). Additional information follows:
Costs Driver
Indirect manufacturing:
Engineering support P24,500 Engineering modifications
Electricity 34,000 Machine hours
Set-up costs 52,500 Batches
Non-manufacturing:
Customer service 81,000 Number of customers

REQUIREMENTS:
(1) Compute the manufacturing cost per unit using the plant-wide overhead rate based on direct labor
hours. What is the gross profit per unit?

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LCRC :MS 08_ ACTIVITY BASED COSTING & TOTAL QUALITY MANAGEMENT BATCH MAY 2020
(2) How much gross profit is generated by each customer of Product A using the plant-wide overhead
rate? How much gross profit is generated by each customer of Product B using the plant-wide
overhead rate? What is the cost of providing customer service to each customer?
(3) Determine the manufacturing cost per unit of each product line using ABC. What is the gross profit
per unit?
(4) How much gross profit is generated by each customer of Product A using ABC? How much gross
profit is generated by each customer of Product B using ABC?
TOTAL QUALITY MANAGEMENT
5. Following is a list of activities that pertains to quality. Classify each as either: external failure, internal
failure, appraisal, or prevention.
External Internal
Failure Failure Appraisal Prevention
1. In-process inspection
2. Warranty expenses
3. Worker training
4. Downtime on machinery due to rework
5. Product returns
6. Product design
7. Preventive maintenance
8. Wages for field repair workers
9. Quality laboratory
10. Customer complaints
MULTIPLE CHOICE: (THEORIES)
1. Which of the following is not a benefit of activity-based costing?
A. More accurate product costing C. Better management decisions
B. Enhanced control over overhead costs D. Less costly to use
2. The presence of any of the following factors would suggest a switch to ABC except when
A. product lines differ greatly in volume.
B. overhead costs constitute a minor portion of total costs.
C. the manufacturing process has changed significantly.
D. production managers are ignoring data provided by the existing system.
3. Examples of batch-level activity drivers include:
A. number of batches and material moves
B. units of output and direct labor hours
C. number of products and design changes
D. square footage occupied
4. Which of the following is considered a value-added activity?
A. B. C. D.
Idle Time Yes No Yes No
Inspection Time Yes No No Yes
Transfer Time No No Yes Yes
5. Non-value-added activities
A. should be reduced or eliminated.
B. involve resource usage customers are willing to pay for.
C. increase both the cost and market value of a product.
D. cannot be differentiated from value-added activities.
6. Which of the following is not a facility-level activity?
A. Plant depreciation C. Engineering changes
B. Property taxes D. Utilities
7. Assigning overhead using ABC will usually
A. decrease the cost per unit for low volume products as compared to a traditional overhead allocation.
B. increase the cost per unit for low volume products as compared to a traditional overhead allocation.
C. provide less accurate cost per unit for low volume products than will traditional costing.
D. result in the same cost per unit for low volume products as does traditional costing.
8. Evaluate whether the following statements are true or false:
I. Any activity that increases the cost of producing a product is a value-added activity.
II. ABC is particularly useful when overhead costs are an insignificant portion of total costs.
III. ABC eliminates all arbitrary cost allocations.
A. B. C. D.
Statement I True False False True
Statement II False True False True
Statement III True False False True
9. Vanguard combines all manufacturing overhead into a single cost pool and allocates this overhead to
products by using machine hours. Activity-based costing would likely show that with Vanguard's current
procedures,

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LCRC :MS 08_ ACTIVITY BASED COSTING & TOTAL QUALITY MANAGEMENT BATCH MAY 2020
A. all of the company's products are undercosted.
B. the company's high-volume products are undercosted.
C. all of the company's products are overcosted.
D. the company's high-volume products are overcosted.
E. the company's low-volume products are overcosted.
10. Which of the following is least likely to be classified as a batch-level activity in an activity-based costing
system?
A. Shipping. D. Property taxes.
B. Receiving and inspection. E. Quality assurance.
C. Production setup.
11. A cost driver is defined as: (E)
A. The largest cost in a manufacturing process.
B. The significant factor in the development of a new product.
C. An indirect cost that cannot be traced to a particular cost objective but is essential to the business.
D. A causal factor that increases the total cost of a cost objective.
12. Activity-based costing is based on two principles. First, activities consume resources. Second, (E)
A. these resources are consumed by business units.
B. these resources are consumed by products, services, or other cost objectives.
C. these resources are consumed in direct portion to Direct Labor.
D. these resources are consumed batch size.
13. The cost to repair a unit of product that fails after it is sold is a(n)
A. appraisal cost. C. internal failure cost.
B. external failure cost. D. prevention cost.
14. If goods are inspected and found to be defective, any rework costs related to these units before the units
are transferred to the finished-goods warehouse would be classified as a(n):
A. external failure cost. D. prevention cost.
B. internal failure cost. E. appraisal cost.
C. production inefficiency cost.
15. Statement 1: The acceptable quality level is the point where internal failure costs are minimized.
Statement 2: The cost of downtime on machines while rework is being performed is an external failure
cost.
A. Only the first statement is true. C. Both statements are true.
B. Only the second statement is true. D. Both statements are false.

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