CHAPTER 5
Activity-Based Costing and Cost Management Systems
Answers to Review Questions
5-1In 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.
5-2Aerotech Corporation's 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.
5-3An 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.
5-4A 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.
5-5The 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.
(d)Facility-level (or general-operations-level) activities: Required for the entire production process to occur.
5-6An activity-based costing system alleviated the problems Aerotech Corporation 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.
5-7Product-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.
5-8In 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.
5-9A cost management system (CMS) has the following objectives:
(a)To measure the cost of the resources consumed in performing the organization's significant activities.
(b)To identify and eliminate non-value-added costs. These are costs of activities that can be eliminated with no deterioration of product quality, performance, or perceived value.
(c)To determine the efficiency and effectiveness of all major activities performed in the enterprise.
(d)To identify and evaluate new activities that can improve the future performance of the organization.
5-10Non-value-added costs are the costs of activities that can be eliminated with no deterioration of product quality, performance, or perceived value. Some examples of potential non-value-added costs are as follows: time spent unnecessarily moving raw materials, work in process, or finished goods between operations; unnecessary time spent by raw materials or work in process waiting for the next operation; storage of unnecessary inventories of raw materials, parts, or partially completed products; costs incurred in repairing defective units when the defects could be eliminated with better quality control systems.
5-11Time is spent in a manufacturing process in the following five ways: process time, inspection time, move time, waiting time, and storage time. There is the potential for non-value-added costs in any of these five areas. Inefficient or unnecessary steps in the production process may result in non-value-added costs. Other potential non-value-added activities include unnecessary inspections, unnecessary movement of materials and goods between operations, unnecessary time spent waiting by materials or partially completed goods, and excessive inventory in storage.
5-12Two 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.
5-13Activity-based management means the use of an activity-based costing system to improve the operations of an organization.
5-14Three 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.
(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.
5-15A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each cost object (e.g., product line).
5-16An 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.
5-17Designing and implementing an ABC system requires a large amount of data from all facets of an organization's operations. A multidisciplinary team will be more effective in obtaining access to this data, and the result will be a better ABC system. Moreover, a multidisciplinary team typically helps in gaining acceptance of the new product-costing system.
5-18Tipoffs that a new product-costing system may be needed include the following (eight required):
(a)Line managers do not believe the product costs reported by the accounting department.
(b)Marketing personnel are unwilling to use reported product costs in making pricing decisions.
(c)Complex products that are difficult to manufacture are reported to be very profitable although they are not priced at a premium.
(d)Product-line profit margins are difficult to explain.
(e)Sales are increasing, but profits are declining.
(f)Line managers suggest that apparently profitable products be dropped.
(g)Marketing or production managers are using "bootleg costing systems," which are informal systems they designed, often on a personal computer.
(h)Some products that have reported high profit margins are not sold by competitors.
(i)The firm seems to have captured a highly profitable product niche all for itself.
(j)Overhead rates are very high, and increasing over time.
(k)Product lines are diverse.
(l)Direct labor is a small percentage of total costs.
(m)The results of bids are difficult to explain.
(n)Competitors' high-volume products seem to be priced unrealistically low.
(o)The accounting department spends significant amounts of time on special costing projects to support bids or pricing decisions.
5-19Line mangers 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 mangers may have a "gut feeling" for this situation, even if the cost-accounting system suggests otherwise.
5-20Diverse 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.
5-21Activity-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.
5-22At Braintree Hospital, an activity-based costing system has enabled management to measure and track the cost of providing nursing care to each individual patient. The wide variety of patient ailments requires a wide variation in the amount and type of nursing care provided to patients. This variation in ailments is analogous to the product-line diversity in a manufacturing firm.
5-23As 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.
Solutions to exercises
Exercise 5-24 (15 minutes)
1. / Material-handling cost per lens:*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:
*The total number of units (of both types) produced.
2. / Material-handling cost per mirror = $1,000. The analysis is identical to that given for requirement (1).
3. / Material-handling cost per lens:
*The total number of material moves.
†The number of material moves for the lens product line.
4. / Material-handling cost per mirror:
*The number of material moves for the mirror product line.
Exercise 5-25 (15 minutes)
1. / a. / Quality-control costs assigned to the Satin Sheen line under the traditional system:Quality-control costs / = / 14.5% direct-labor cost
Quality-control
costs assigned to
Satin Sheen line / = / 14.5% $27,500
= / $3,988 (rounded)
b. / Quality-control costs assigned to the Satin Sheen line under activity-based costing:
Quantity for / Assigned
Activity / Pool Rate / Satin Sheen / Cost
Incoming material inspection / $11.50 per type / 12 types.. / $ 138
In-process inspection.... / .14 per unit / 17,500 units / 2,450
Product certification..... / 77.00 per order / 25 orders. / 1,925
Total quality-control costs assigned...... / $4,513
2. / The traditional product-costing system undercosts the Satin Sheen product line, with respect to quality-control costs, by $525 ($4,513 – $3,988).
Exercise 5-26 (20 minutes)
There is no single correct answer to this exercise. There are many reasonable solutions.Cost pool 1:
Raw materials and components...... / 2,950,000 yen
Inspection...... / 30,000 yen
Total...... / 2,980,000 yen
Cost driver: raw-material cost
exercise 5-26 (continued)
Cost pool 2:Depreciation, machinery...... / 1,400,000 yen
Electricity, machinery...... / 120,000 yen
Equipment maintenance, wages...... / 150,000 yen
Equipment maintenance, parts...... / 30,000 yen
Total...... / 1,700,000 yen
Cost driver: number of units produced.
Cost pool 3:
Setup wages...... / 40,000 yen
Total...... / 40,000 yen
Cost driver: number of production runs.
Cost pool 4:
Engineering design...... / 610,000 yen
Total...... / 610,000 yen
Cost driver: number of parts in a product.
Cost pool 5:
Depreciation, plant...... / 700,000 yen
Insurance, plant...... / 600,000 yen
Electricity, light...... / 60,000 yen
Custodial wages, plant...... / 40,000 yen
Property taxes...... / 120,000 yen
Natural gas, heating...... / 30,000 yen
Total...... / 1,550,000 yen
Cost driver: for costs allocated to support departments, square footage; for costs assigned to products, number of units produced.
Exercise 5-27 (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 5-28 (30 MINUTES)
Answers will vary widely, depending on the web site chosen. In general, though, activity-based costing could be a useful tool in helping any governmental unit understand what its cost drivers are for the various activities in which it engages.
Exercise 5-29 (25 minutes)
1.Use of a single predetermined overhead rate averages all manufacturing-overhead costs together. Every production job is assigned the same amount of overhead cost per unit of the single, volume-based cost driver.
Dividing overhead into cost pools enables Hewlett-Packard Company to assign overhead costs to products more accurately. The production manufacturing-overhead cost pool is assigned to products on the basis of direct labor. Products that require large amounts of direct labor will be assigned relatively larger amounts of the overhead costs in this pool, such as production supervision and indirect labor. The procurement manufacturing-overhead cost pool is assigned to products on the basis of direct-material cost. Products that require larger amounts of direct material will be assigned relatively larger amounts of such overhead costs as purchasing and raw-material inspection.
2.The benefits of using multiple cost drivers stem from the increased accuracy in product costs. This improved accuracy helps management to make better decisions about pricing, bidding, product mix, and adding or dropping product lines.
- The costs of using multiple cost drivers include the time spent dividing overhead costs into pools, selecting cost drivers, and measuring the amount of each cost driver used by each product line; and increased data management requirements.
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 A22 wheel at a price lower than Wheelco's reported manufacturing cost. In contrast, Wheelco is selling its specialty D52 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 A22 and a substantially higher cost for wheel D52.
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 A22. The prices of the specialty wheels probably will need to be raised. It is possible that Wheelco should discontinue low-volume products.
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.
Exercise 5-31 (continued)
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 activity of the Finger Lakes Winery may be classified as follows:
U: Unit-level
B: Batch-level
P: Product-sustaining-level
F: Facility-level
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
Exercise 5-33 (20 minutes)
The definitions used by Carrier Corporation for each of the activity levels are as follows:*
- Unit: This activity or cost occurs every time a unit is produced. An example is the utility cost for production equipment. This level of activity usually relates directly to production volume.
- Batch: This activity is performed for each batch produced or acquired. Examples include moving raw material between the stock room and production line or setting up a machine for a run.
- Product-sustaining: This activity is performed to maintain product designs, processes, models, and parts. Examples include expediting parts, maintaining the bill of materials, or issuing orders for product changes. Sustaining activities are required for supporting a key manufacturing capability or process.
- Facility: These activities are performed to enable production. They are fundamental to supporting the business entity at the most basic level. Examples are managing or cleaning the building.
These definitions are consistent with those given in the chapter. An argument for the ABC project team's classification would be that the activity or account in question was characterized by the definition of the activity-level classification given above. An argument against the team's classification would be that the particular activity or account did not satisfy the definition.