CHAPTER 5
Activity-Based Management and
Activity-Based Costing
Questions
1. Activity-based
management
is
a
management approach that associates
the activities executed by an organization
with the value customers derive from
products. Efficiency and effectiveness are
achieved by reducing the level of activities
that do not create value for the customer
and by improving execution of activities
that do create customer value.
multiple cost drivers. Also in traditional
systems, volume-based cost drivers are
more the norm than non-volume-based
(e.g., square footage) cost drivers.
Finally, traditional accounting stresses
finding
an
allocation
base
that
demonstrates strong statistical correlation
to the cost, but ABC emphasizes
searching for multiple cost drivers that
bear cause-and-effect relationships to the
cost.
Specific tools beneath the ABM umbrella
include activity analysis, cost driver
analysis,
activity-based
costing,
continuous
improvement,
operational
control, performance evaluation, and
business process reengineering.
5. Activity analysis is used to separate
activities into two groups: those that add
value to the product or service and those
that do not add value. Once the nonvalue-adding activities are identified,
managers seek to reduce or eliminate the
level of the drivers of those activities. If
such efforts are successful, non-valueadding costs will be reduced without
impairing the value of products or services
to the consumer. The result should be an
increase in profits.
2. Value-added activities are viewed from the
customer's perspective because it is the
customer who is the end evaluator of the
“worth” of a product or service and,
therefore, the activities involved in creating
that product or service.
3. In a televised football game, the valueadded activities are the actual game plays.
Non-value-added activities consist of
commercials and the time between plays.
Activities such as “moving the chains,”
measuring to determine if a first down was
made, moving the ball from the end of one
play to the point where it will be put in play
next are all non-value-added activities.
People who believe that the commercials
are informative and interesting and that
the time between plays allows them an
opportunity to examine the strategies of
the teams and project what each team is
likely to do play may disagree with this
assessment.
6. By using a single cost pool and a single
cost driver to allocate overhead, the more
traditional
methods
of
overhead
assignment ignore the influence on cost of
the different activities that occur to make a
product. In this manner, low-volume
specialty products, which cause a
disproportionate amount of overhead, are
only assigned an average charge for
overhead, thereby shifting costs to the
standard product lines. ABC does a better
job of tracing costs to the products that
caused the various costs by using multiple
cost pools and multiple cost drivers.
4. Yes, cost drivers exist in traditional
accounting systems although they are
called "bases for allocation."
7. All companies are not likely to benefit
equally from adopting ABC. The greatest
benefits are likely to be gained by firms
with complex production processes; firms
that produce products that vary relative to
cost, complexity, and volume; and firms
In traditional systems, a single cost driver
such as direct labor hours or machine
hours is commonly used rather than
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Chapter 5
that have a high level of overhead costs
that are fixed relative to production
volume.
8. Implementation of ABC requires a
significant commitment of time and
resources. Significant time is consumed
identifying cost drivers and determining
how to split production costs into pools that
are relatively homogeneous relative to a
particular cost driver.
Identification of
these cost drivers typically requires
internal surveys and interviews with
company personnel. Additional time is
consumed evaluating, selecting, and
implementing the software to manage the
ABC data collection and cost assignments.
Exercises
9. No solution provided; each student will have a different answer.
10. No solution provided; each student will have a different answer. However, it is
likely that students will determine that quality inspection is non-value-added for
the clothing manufacturer and value-added for the pharmaceutical company.
11. No solution provided; each student will have a different answer.
12. a. None of the items are value-added activities; products should be designed
so that schedule changes should not be needed.
b. Number of factory schedule changes is the driver.
c. Eliminate factory schedule changes except for those asked for by a
customer (in which case the customer should be charged for the cost of the
change) or for critical changes necessary to realize significant quality
improvements and cost reductions.
13. a. Receiving ingredients
Moving ingredients to stockroom
Storing ingredients in stockroom
Moving ingredients from stockroom
Mixing ingredients
Packaging ingredients
Moving packaged seasoning to warehouse
Storing packaged seasoning in warehouse
Moving packaged seasoning from warehouse to trucks
Total minutes of cycle time
60
40
3,580
40
180
75
50
10,000
60
14,085
b. The value added functions are (1) mixing ingredients and (2) packaging
ingredients. (180 min + 75 min = 255 min)
c. MCE = (180 + 75)  14,085 = 255 ÷ 14,085 = 1.8%
d. The company could do many things to improve its MCE. The biggest areas
to concentrate on are the time spent storing ingredients in the stockroom
and the time spent storing packaged seasoning in the warehouse. Probably
the most significant improvement in MCE would come from adopting JIT
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89
(just-in-time) management of all inventories, which would allow the firm to
concentrate on reducing total cycle time by not purchasing materials until
they are needed and not producing finished goods until they are demanded
by customers.
14. a. Cycle time = 2 + 36 + 1 + 3 + 2 + 2 = 46 hours
b. Value-added processing time = 3 hours of mixing and cooking plus 2 hours
of bottling
MCE = (3 + 2) ÷ 46 = 5 ÷ 46 = 11% (rounded)
15. a. number of transactions processed (volume measure), number of service
calls (for usage), number of installations (for usage), number of
viruses/worms (for usage), pages of documents printed (volume)
b. pounds of material processed (volume of work processed), number of
different types of material handled (complexity of material handling), number
of purchase orders (volume of work processed by staff and number of
suppliers used)
c. amount of investment in factory machinery and buildings (total cost basis
for depreciation)
d. number of engineering changes (volume of engineering changes), number of
process changes (volume of changes to the manufacturing processes),
number of engineering change orders (number of requests for changes to
products and processes)
e. pounds of materials received (volume measure), distance of average
shipment received (cost driver for commercial freight carriers)
f.
machine hours (for maintenance related to the volume of usage of
machinery), average age of equipment (for obsolescence and age-related
maintenance)
g. number of product defects (volume of quality defects), pounds of scrap and
waste (volume of quality defects), number of quality inspections (number of
batches)
h. average amount of material inventory (volume of material stored), square
footage of storage area (storage capacity)
i. number of setups (volume driver), total time of setups (alternative volume
measure)
j.
machine hours (for machine-driven usage), outside air temperature (for
weather-related usage)
k. number of print ads (volume measure), seconds of air time (cost measure),
number of new ads developed (measure of professional time)
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16. a. machine hours (for maintenance related to the volume of usage of
machinery), average age of equipment (for obsolescence and age-related
maintenance)
b. machine hours (for machine-driven usage), outside air temperature (for
weather-related usage)
c. number of transactions processed (volume measure), number of service
calls (for usage), number of installations (for usage), number of
viruses/worms (for usage)
d. number of product defects (volume of quality defects), pounds of scrap and
waste (volume of quality defects), number of quality inspections (number of
batches)
e. pounds of material processed (volume of work processed), number of
different types of material handled (complexity of material handling), number
of purchase orders (volume of work processed by staff and number of
suppliers used)
f. average amount of material inventory (volume of material stored), square
footage of storage area (storage capacity)
g. assessed value of factory building (cost measure)
17. a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
U
B
O
U (could be product/process if left on all the time)
O
P
O
P
U
P
18. a. It is obvious that the production process in this company has a significant
amount of non-value-added time built into the cycle time. The most likely
cause of this non-value-added time is one or more bottleneck processes that
create long wait periods when no production is occurring and goods are
simply stored or stacked until they can pass through the process.
A fairly simple way to determine where the bottlenecks are is to walk through
the plant and see where materials or partially completed units are being
stacked in sight or being brought back into the production area from a
storage location. Another indicator of a bottleneck is where labor is waiting
for a machine to complete a process so that additional materials can be
input.
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In addition to bottlenecks, the company could be engaging in rush orders
that remove regularly scheduled production from processing. Always trying
to catch up on backorders will create delays in processing current orders. It
is possible that if all backorders were filled, the current orders could be
processed at a much more rapid pace. Finally, defective units caused by
rushing to complete orders will have to be reworked, thereby causing an
even longer delay in processing time.
b. A value chart allows a company to analyze all activities that comprise total
cycle time. The role of the value chart is to identify those activities that do
not add value in the eyes of the consumer. By focusing managerial attention
on reducing or eliminating such activities, total cycle time is reduced and
total costs are reduced.
19. a. Allocation rate = Cost ÷ Allocation base
Contracts rate = $360,000 ÷ 300,000 = $1.20 per contract page
Regulation rate = $500,000 ÷ 500 = $1,000 per review request
Court rate = $825,000 ÷ 5,000 = $165 per professional hour
b. Contracts: 8,000 × $1.20
Regulation: 25 × $1000
Court: 210 × $165
Total
$ 9,600
25,000
34,650
$69,250
c. The rates will be used to bill other departments for the costs incurred in the
legal department. If the legal department operates efficiently, its billings
should equal or exceed the costs it incurs.
The firm can hire an outside law firm to perform the legal work rather than do
the work internally. It is difficult to determine, without more information,
how this action would affect total costs. However, it would tend to make the
legal costs much more variable and less fixed.
20. a. $200,000 ÷ 200,000 calls = $1 per call
$100,000 ÷ 25,000 purchase orders = $4 per purchase order
$90,000 ÷ 15,000 receiving reports = $6 per receiving report
Cost assignment:
150 calls × $1
40 purchase orders × $4
20 receiving reports × $6
Total cost assigned
$150
160
120
$430
b. $430 ÷ 80 units = $5.38 (rounded) per unit
21. a. $1,000,000 ÷ (85,000 + 15,000) = $1,000,000 ÷ 100,000 = $10 per machine hour
Total OH assigned to regular dictionaries = $10 x 85,000 = $850,000
Total OH assigned to hand-sewn dictionaries = $10 x 15,000 = $150,000
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b. Utilities-related: $400,000 ÷ 100,000 = $4 per machine hour
Inspection-related: $600,000 ÷ 30,000 = $20 per inspection hour
Total OH assigned to regular dictionaries = ($4 x 85,000) + ($20 x 5,000) =
$340,000 + $100,000 = $440,000
Total OH assigned to hand-sew dictionaries = ($4 x 15,000) + ($20 x 25,000) =
$60,000 + $500,000 = $560,000
c.
Regular
Revenues
$3,200,000
Direct costs
(2,500,000)
Overhead assigned (440,000)
Profit before tax
$ 260,000
Hand-Sewn
$2,800,000
(2,200,000)
(560,000)
$ 40,000
Management should not stop producing the regular dictionaries as these are
generating a rate of return on revenues of 8%, while the hand-sewn
dictionaries are only generating 1.4%.
22. a. Overhead rate = $2,211,000 ÷ 220,000 units = $10.05 per unit
Revenue
Less:Direct material
Direct labor
Overhead*
Profit (loss)
Less:Admin. expense
Income before tax
Number of units
Profit per unit
Mowers
$13,000,000
(2,000,000)
(1,200,000)
(2,010,000)
$ 7,790,000
÷ 200,000
$38.95
Tractors
$11,900,000
(1,800,000)
(4,000,000)
(201,000)
$ 5,899,000
Total
$24,900,000
(3,800,000)
(5,200,000)
(2,211,000)
$13,689,000
(3,612,000)
$10,077,000
÷ 20,000
$294.95
*Mowers: $10.05 × 200,000 = $2,010,000; Tractors: $10.05 x 20,000 = $201,000
b. Mowers: $1,200,000 ÷ $20 per hour = 60,000 direct labor hours
Tractors: $4,000,000 ÷ $20 per hour = 200,000 direct labor hours
Overhead rate = $2,211,000 ÷ 260,000 = $8.50 per DLH (rounded)
Revenue
Less:Direct material
Direct labor
Overhead*
Profit (loss)
Less:Admin. expense
Income before tax
Number of units
Profit per unit
Mowers
$13,000,000
(2,000,000)
(1,200,000)
(510,000)
$ 9,290,000
÷ 200,000
$46.45
Tractors
$11,900,000
(1,800,000)
(4,000,000)
(1,700,000)
$ 4,400,000
Total
$24,900,000
(3,800,000)
(5,200,000)
(2,211,000)**
$13,689,000
(3,612,000)
$10,077,000
÷ 20,000
$220.00
*Mowers: $8.50 × 60,000 = $510,000; Tractors: $8.50 x 200,000 = $1,700,000
**Off due to rounding of rate per DLH
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c. Rate per DLH: $1,300,000 ÷ 260,000 = $5.00
Rate per MH: $911,000 ÷ 100,000 = $9.11
Revenue
Less:Direct material
Direct labor
Overhead*
Profit (loss)
Less:Admin. expense
Income before tax
Number of units
Profit per unit
Mowers
$13,000,000
(2,000,000)
(1,200,000)
(573,300)
$ 9,226,700
÷ 200,000
$46.13
Tractors
$11,900,000
(1,800,000)
(4,000,000)
(1,637,700)
$ 4,462,300
Total
$24,900,000
(3,800,000)
(5,200,000)
(2,211,000)
$13,689,000
(3,612,000)
$10,077,000
÷ 20,000
$223.12
*Mowers: ($5.00 x 60,000) + ($9.11 x 30,000) = $300,000 + $273,300 = $573,300
Tractors: ($5.00 x 200,000) + $9.11 x 70,000) = $1,000,000 + $637,700 =
$1,637,700
d. The profit per unit in part (c) provides the best picture. The solution to part
(a) does not recognize the difference in direct labor time and the solution to
part (b) does not recognize the difference in machine time. Costs should be
attached to products using the most rationale and measurable bases of
activity. However, given that the profits per unit are not significantly
different, the allocation base in part (b) would be acceptable if the additional
tracking of machine hours is not easily nor inexpensively handled.
23. a. As variety in products increases, costs will also increase. Thus, the shift to
small special orders will increase costs in purchasing (more orders, more
calls to get prices, more space required for catalogs, etc.), receiving (more
orders and receipts to handle and account for), storage (different products
must be grouped together and differentiated from other products for easy
accessibility), accounting (more inventory to account for, potentially more
suppliers to pay), customer service (new larger catalogs, possible
complaints from customers receiving wrong or slightly wrong orders, more
time for sales calls), production scheduling (variety in setups, increase in
movement of materials depending on production run), and laboratory work
(research and development tests incurred to make certain that the products
meet the appropriate environmental and technical requirements).
b. Yes, it is very possible that management is correct in its belief because total
overhead costs are typically allocated to products based on some single
allocation base such as direct labor hours or machine hours. These single
allocation bases do not reflect the actual cause-and-effect relationships
between cost drivers and overhead costs.
c.
The memo should suggest that management consider the use of multiple
overhead allocation bases and activity-based costing. This method of
overhead allocation attempts to more fairly attach costs to the products
and/or services that actually caused the costs to be incurred.
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Chapter 5
24. a. Outlined below are the purpose and several characteristics of the two noted
cost systems:
1.
Inventory measurement
 Meets external reporting requirements for aggregate balance sheet
valuation and income determination.
 Provides monthly and quarterly reporting.
2.
Activity-based costing
 Differentiates costs between value-added and non-value-added
activities.
 Assigns costs to products according to activities involved in the
production process that cause these costs.
b. A cost system developed to value inventory may distort product cost
information because that system
 was designed to value inventory in the aggregate and not relate to
product cost information;
 uses a common departmental or factory-wide measure of activity,
such as direct labor hours or dollars (now a small portion of overall
production costs) to distribute manufacturing overhead to products;
 deemphasizes long-term product analysis (when fixed costs become
variable costs); and
 causes managers, who are aware of distortions in the traditional
system, to make intuitive, imprecise adjustments to the traditional
cost information without understanding the complete impact.
c. The benefits that management can expect from activity-based costing
system are that such a system:
 Leads to a more competitive position by evaluating activity costs,
i.e., costs associated with the complexity of the transaction rather
than the production volume and the cost drivers that cause the
activities.
 Streamlines production processes by reducing non-value-added
activities, thereby creating reduced setup times, optimal plant layout,
and improved quality.
 Provides management with a more thorough understanding of
product costs and product profitability for strategies and pricing
decisions.
 Highlights interrelationships among activities.
 Provides feedback for opportunities for improvements in product
design and production processes.
 Encourages use of nonfinancial measures of activity and performance.
 Provides a more appropriate means of assigning overhead to products.
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d. The steps that a company, using a traditional cost system, would take to
implement activity-based costing include:
 Identify activity centers and cost drivers.
 Assign costs to activity center cost pools using appropriate
first-stage cost drivers.
 Assign activity center cost pools to products, services, or other cost
objects using appropriate second-stage cost drivers, according to
level of cost (unit, batch, products, process, and organizational
levels).
(CMA adapted)
25. a. In the modern competitive environment, firms must be willing to relinquish
unprofitable customers so that the highest quality of service is provided to
the most profitable customers. Small customers are not able to provide the
same economy of operations that are available from larger customers.
b. There are ethical obligations in ending all business relationships. This is
particularly true for firms that are sole suppliers of parts or materials that are
critical to their customers. At a minimum, an ethical "firing" of a customer
should
 involve an explanation as to why service is being discontinued;
 be announced well in advance of discontinuing services to the
customer;
 be accompanied by suggestions of alternative sources of supply; and
 be sensitive to all negative effects that will be suffered by the
customer when service is ended.
c. Activity-based costing is a financial management tool. It is not a tool for
ethical management of a firm, nor is it a tool that can expressly impound
nonfinancial, qualitative information. To the extent that factors such as
customer goodwill and market reputation are involved in decisions driven by
ABC prescriptions, those factors will be ignored by activity-based
management. However, it is important to acknowledge that these qualitative
factors should not be ignored and, in fact, may be important enough to
overturn the activity-based prescriptions.
Problems
26. a. Value-added activities
Remove sod and level site
Build forms
Mix and pour concrete
Level concrete and smooth
Remove forms
Total
Time
10
12
5
2
1
30 hours
96
b.
Chapter 5
Non-value-added activities
Purchase materials
Obtain rental equipment
Drying time
Return rental tools
Clean up
Total
Time
5
3
22
1
2
33 hours
c. Total cycle time = 30 + 33 = 63 hours
MCE = 30 ÷ 63 = 47.6%
27. a. Value-added activities
Measuring and cutting
Assembling
Building fireplace
Pegging logs
Cutting & framing
Sealing joints
Total value-added time (days)
Time
3
7
9
4
2
4
29
b. Non-value-added activities
Time
Receiving
1
Storing
5
Handling
7
Setting up & moving scaffolding
6
County inspections
3
Total non-value-added time (days) 22
c. Total cycle time = 29 + 22 = 51 days
MCE = 29 ÷ 51 = 56.9%
d. The value-added activities are those that increase the worth of the product or
service in the eyes of the customer and for which the customer is willing to
pay. Non-value-added activities are those activities that do not increase the
value of the product in the eyes of the consumer.
28. a. Umbrellas ($16 × 200,000) $3,200,000
Gazebos ($120 × 20,000)
2,400,000
Lawn chairs ($40 × 60,000) 2,400,000
Total
$8,000,000
b. Allocation rates:
Quality control: $400,000 ÷ 280,000 = $1.43 per unit (rounded)
Setups: $400,000 ÷ 2,000 = $200 per setup
Materials handling: $1,200,000 ÷ 4,000,000 = $0.30 per pound
Equipment operation: $6,000,000 ÷ 2,000,000 = $3.00 per machine hour
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Chapter 5
Cost allocation:
Umbrellas
Quality control
$1.43 × 200,000
$ 286,000*
$1.43 × 20,000
$1.43 × 60,000
Setups
$200 × 400
80,000
$200 × 800
$200 × 800
Materials handling
$0.30 × 800,000
240,000
$0.30 × 2,000,000
$0.30 × 1,200,000
Equipment operation
$3.00 × 400,000
1,200,000
$3.00 × 800,000
$3.00 × 800,000
Total overhead
$1,806,000*
Number of units
200,000
Cost per unit
$9.03
Total cost per unit:
DM
DL
OH
Total
$ 8.00
12.00
9.03
$29.03
Gazebos
$
Lawn Chairs
28,600*
$
85,800*
160,000
160,000
600,000
360,000
2,400,000
2,400,000
$3,005,800*
60,000
$50.10
$3,188,600*
20,000
$159.43
$ 80.00
90.00
159.43
$329.43
$ 8.00
30.00
50.10
$88.10
* rounding
c. If prices are set based on product costs, activity-based costing would
generate lower prices for umbrellas and higher prices for the other two
products.
29. a. Indirect labor
Dept. 1 ($681,000 - $375,000)
Dept. 2 ($462,000 - $200,000)
Machine ($400,000 + $800,000)
Power
Building
Purchasing
Total
$ 306,000
262,000
1,200,000
400,000
1,000,000
100,000
$3,268,000
b. Total DLHs = Dept. 1 + Dept. 2 = 25,000 + 10,000 = 35,000
$3,268,000 ÷ 35,000 = $93.37 per DLH
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c.
Product A
DM:
(1/2 to each for X; all Y to B) $ 400,000
DL:
Dept. 1 (4/5, 1/5)
$300,000
Dept. 2 (1/2, 1/2)
100,000
400,000
OH(@ $93.37 per DLH)*
2,334,250
Total cost
$3,134,250
Number of units
÷ 10,000
Cost per unit
$313.43
*Product
Product B
$ 600,000
$ 75,000
100,000
175,000
933,700
$1,708,700
÷ 10,000
$170.87
A = 20,000 + 5,000 = 25,000; Product B = 5,000 + 5,000 = 10,000
d. Building Occupancy: $1,000,000 ÷ 500,000 = $2 per sq. ft.
Purchasing (10,000 × $2) $ 20,000
Power (40,000 × $2)
80,000
Dept. 1 (200,000 × $2)
400,000
Dept. 2 (250,000 × $2)
500,000
Purchasing: Direct costs ($100,000) + Allocated building occupancy
($20,000) = $120,000; $120,000 divided by 500 purchase orders = $240 per
purchase order
Material X: 200 × $240 = $48,000
Material Y: 300 × $240 = $72,000
Power: Direct costs ($400,000) + Allocated building occupancy ($80,000) =
$480,000, divided by 10,000,000 kW = $0.048 per kWh
Department 1: 1,500,000 × $0.048 = $ 72,000
Department 2: 8,500,000 × $0.048 = 408,000
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e.
Product A Product B
Indirect labor
Department 1 ($306,000)
(Total ind. LHs for A = 2,500 + 5,000 + 200 = 7,700)
(Total ind. LHs for B = 2,500 + 10,000 + 200 = 12,700)
Total indirect labor hours = 20,400
(7,700 ÷ 20,400 = 38%)
$116,280
(12,700 ÷ 20,400 = 62%)
$ 189,720
Department 2 ($262,000)
(Total ind. LHs for A = 2,500 + 1,000 + 200 = 3,700)
(Total ind. LHs for B = 5,000 + 4,000 + 400 = 9,400)
Total indirect labor hours = 13,100
(3,700 ÷ 13,100 = 28%)
73,360
(9,400 ÷ 13,100 = 72%)
188,640
Power
Total MHs in Dept. 1 = 5,000 + 10,000 = 15,000
Department 1 = $72,000 (Product A, 1/3; Product B, 2/3) 24,000
48,000
Total MHs in Dept. 2 = 5,000 + 20,000 = 25,000
Department 2 = $408,000 (Product A, 1/5; Product B, 4/5) 81,600
326,400
Machinery-related (same basis as Power)
Department 1 (1/3, 2/3)
Department 2 (1/5, 4/5)
Building occupancy (same basis as Power)
Department 1 (1/3, 2/3)
Department 2 (1/5, 4/5)
Purchasing
Total lbs. of X = 50,000 + 50,000 = 100,000
Total lbs. of Y = 100,000
Material X $48,000 (Product A, 1/2; Product B, 1/2)
Material Y $72,000 (all Product B)
Overhead cost
f.
Raw material X (1/2, 1/2)
Raw material Y (all B)
Direct labor - Dept. 1 (4/5, 1/5)
Direct labor - Dept. 2 (1/2, 1/2)
Overhead (from part e)
Total product costs
Number of units
Cost per unit
Product A
$ 400,000
0
300,000
100,000
845,906
$1,645,906
÷ 10,000
$164.59
133,333
160,000
266,667
640,000
133,333
100,000
266,667
400,000
24,000
24,000
0
72,000
$845,906 $2,422,094
Product B
$ 400,000
200,000
75,000
100,000
2,422,094
$3,197,094
÷ 10,000
$319.71
[Adapted from Roth and Borthick, "Getting Closer to Real Product Costs,"
Management Accounting (May 1989), pp. 28-33.]
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30. a. Predetermined rate using MHs: $6,000,000 ÷ 1,000,000 = $6 per MH
b. Direct material
$100,000
Direct labor
300,000
Applied overhead (10,000 × $6) 60,000
Total cost
$460,000
Divided by number of stores
÷ 5,000
Cost per door
$92
c. Predetermined rate per activity per unit of cost driver:
Electric power: $500,000 ÷ 100,000 = $5 per kilowatt hour
Work cells: $3,000,000 ÷ 600,000 = $5 per square foot
Material handling: $1,000,000 ÷ 200,000 = $5 per material move
Quality control inspections: $1,000,000 ÷ 100,000 = $10 per inspection
Product runs: $500,000 ÷ 50,000 = $10 per production run
Cost per door:
Direct material
Direct labor
Applied overhead
Electric power ($5.00 X 1,000) $ 5,000
Work cells ($5.00 X 8,000)
40,000
Materials handling ($5.00 X 100) 500
Quality Control ($10.00 X 50)
500
Product Runs ($10.00 X 25)
250
Total cost
Number of doors
Cost per door
$100,000
300,000
46,250
$446,250
÷ 5,000
$89.25
d. The activity-based costing method allocates the cost pools of manufacturing
overhead to various cost drivers and then to products based on the amount
or number or other bases that each product consumes in various cost
drivers. Assume that Up-and-Out Door Company's policy is to add 40% to
manufacturing costs as gross profit to cover costs such as administrative
expenses, selling expenses, financial expenses and research and
development expenses, and the remainder will be a profit. In determining the
selling price of the door under both methods, add 40 % of total
manufacturing costs:
Present System
Unit costs
$ 92.00
Plus gross profit at 40%
36.80
Selling price
$128.80
ABC System
$ 89.25
35.70
$124.95
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It is evident that a selling advantage results from the ABC method. As
illustrated in this case, the ABC method should result in a pricing decision
that makes the company more competitive in the marketplace. Savings in
applying manufacturing overhead costs to products will enable the company
to sell its products at a lower price than competitors while maintaining the
same gross margin ratio. [Copyright 1990 IMA (formerly NAA)]
31. a. Base wages: $42,000,000 ÷ 2,100,000 = $20 per DLH
Health care: $7,000,000 ÷ 1,400 = $5,000 per worker
Payroll taxes: $3,360,000 ÷ $47,800,000 = $0.07 per dollar of total wages
Overtime: $5,800,000 ÷ 192,000 = $30.2083 per overtime hour
Training: $1,250,000 ÷ 200 = $6,250 per new hire
Retirement: $4,600,000 ÷ 1,400 = $3,285.71 per worker
Workers' comp.: $800,000 ÷ 1,400 = $571.43 per worker
b. Although more labor-related items are driven by the number of factory
workers, the number of regular labor hours accounts for most of the labor
cost, $42,000,000.
c. It can be inferred that the use of overtime hours minimizes some cost
drivers. In this example, use of overtime hours would help contain health
care costs, training costs, retirement costs, and workers' compensation.
32. a. Professional salaries: $1,800,000 ÷ 30,000 = $60 per hr.
Building costs: $900,000 ÷ 15,000 = $60 per sq. ft.
Risk management: $640,000 ÷ 1,000 = $640 per patient
b. Surgery = (6,000 × $60) + (1,200 × $60) + (400 × $640) = $688,000
Housing = (20,000 × $60) + (12,000 × $60) + (1,000 × $640) = $2,560,000
Outpatient care = (4,000 × $60) + (1,800 × $60) + (600 × $640) = $732,000
c. Surgery: professional hours (this is an activity base that would drive many
costs related to surgery and would be easy to track)
Housing patients: days in hospital (this activity base would be easy to
follow and would account for use of time and space)
Outpatient care: professional hours (this would capture service provision to
outpatients); or expected patient volume (this would capture those costs that
are more related to capacity to provide service)
33. a. Allocation rates:
Utilities: $1,200,000 ÷ 60,000 = $20 per MH; assigned to products using
30,000, 10,000, and 20,000 MHs, respectively
Scheduling & setup: $1,092,000 ÷ 780 = $1,400 per setup; assigned to
products using 130, 380, and 270 setups, respectively
Materials handling $2,560,000 ÷ 1,600,000 = $1.60 per lb.; assigned to
products using 500,000, 300,000, and 800,000 pounds, respectively
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A
Direct costs
$ 80,000
Utilities
600,000
Scheduling & setup 182,000
Material handling
800,000
Total
$1,662,000
Units produced
÷ 40,000
Cost per unit
$41.55
Products
B
$
80,000
200,000
532,000
480,000
$1,292,000
÷ 20,000
$64.60
C
$ 90,000
400,000
378,000
1,280,000
$2,148,000
÷ 60,000
$35.80
b. Total overhead = $1,200,000 + $1,092,000 + $2,560,000 = $4,852,000
Total DLHs = 32,000 + 18,000 + 50,000 = 100,000
Overhead rate = $4,852,000 ÷ 100,000 = $48.52
1.
A
Direct costs
$ 80,000
Overhead*
1,552,640
Total
$1,632,640
Units produced
40,000
Cost per unit
$40.82
*Assigned
2.
Products
B
$ 80,000
873,360
$953,360
20,000
$47.67
C
90,000
2,426,000
$2,516,000
60,000
$41.93
$
at 32,000, 18,000, and 50,000 DLHs, respectively, times $48.52.
Conventional
Product A: $40.82 × 1.20 = $48.98
Product B: $47.67 × 1.20 = $57.20
Product C: $41.93 × 1.20 = $50.32
ABC
Product A: $41.55 × 1.20 = $49.86
Product B: $64.60 × 1.20 = $77.52
Product C: $35.80 × 1.20 = $42.96
c. The conventional approach to product costing used only one allocation
base, direct labor hours. This allocation base was unable to fully capture the
causes of overhead cost incurrence. The ABC approach developed better
overhead allocation because of the superior relationship between the cost
pools and the cost drivers used to allocate the overhead cost.
To the extent that there is error in determining costs, there will also be
mispricing when prices are set based on costs as is evident in this problem.
Although Product A is relatively unaffected by the choice of costing system,
Products B and C have substantially different costs and prices under the two
systems. The traditional costing system would result in underpricing
Product B and overpricing Product C. This would affect both sales volume
and company profitability.
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34. a. Although difficult to quantify, some costs are associated with just carrying a
part number in the database. Each part number must be originally set up in the
system, built into the structure of a bill of materials, and maintained until it is no
longer used. Moreover, each part must be planned, scheduled, negotiated with
vendors, purchased, received, stored, moved, and paid for. Having two parts
similar enough that one could be used for both applications requires
unnecessary duplication of these activities and, therefore, unnecessary costs.
Standardizing parts results in several indirect benefits. Fewer unique part
numbers usually means fewer vendors and greater quality of delivered parts.
It also means smoother JIT production, fewer shutdowns of manufacturing
lines, and greater field reliability.
b. To appropriately influence the behavior of design and cost-reduction
engineers, the MOH allocation method should assign little cost to products
for each high-usage common part and more cost for each low-usage unique
part, in proportion to the total usage of the parts.
Annual cost to carry each part # = Budgeted MOH Cost ÷ # of Active Part #s
MOH rate for each part # = Annual cost to carry each part # ÷ Annual usage of
each part #
Annual Cost to Carry = $5,500,000 ÷ 8,000 = $687.50
MOH Rate for High-Usage Part = $687.50 ÷ 35,000 = $.02
MOH Rate for Low-Usage Part = $687.50 ÷ 200 = $3.44
The MOH cost for each product is based on the part numbers in its bill of
materials. The rate for each part number is multiplied by the number of
times the part is used in the product. The resulting amounts are then
aggregated for all part numbers in the bill of materials. The greater the
number of parts in a product and the higher the percentage of unique parts,
the greater the amount of allocated cost.
c. Students will discuss the appropriateness of the allocation bases they
selected, the ways in which their methods would communicate accurate
information to design and cost-reduction engineers concerning the indirect
costs of engineering products with unique versus common parts, and the
need to provide those engineers with incentives to use the information in
their part selection decisions.
Regarding the latter point, engineers at Tektronix, are in fact evaluated on
the costs of the products they design. Although they are driven by emerging
technologies and other considerations such as quality and customer needs,
the evaluation process motivates them to seek minimum cost designs
consistent with these considerations.
With the part number-based MOH allocation method, engineers will tend to
design products differently. The product costing system will tell them that
engineering low-volume unique parts into products causes overhead.
Having the material overhead cost associated with each individual part
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number will help engineers to evaluate the use of a new part versus an
existing part. Knowing the previously hidden costs of components, the
engineers can properly assess not only the tradeoffs between parts
proliferation and direct labor reduction but also the cost of selecting a
unique component to satisfy a specific functional requirement of a customer.
d. A MOH allocation method should provide accurate estimates of the long-run
variable costs of all of the demands made on the organization's
material-related overhead resources by each product in the product line. To
approach 100% accuracy, the MOH cost pool would have to be decomposed
into smaller homogeneous cost pools in which cost variations could be
explained by a single cost driver. The resulting costing system would be
marginally more accurate but substantially more complex, difficult to
understand, and more costly to maintain than the single-cost-pool method
that was decided on in this situation. Also, adding more cost drivers to the
system would probably have initially created confusion and definitely would
have been resisted by manufacturing, engineering, and marketing personnel.
Manufacturing costs are a crucial element of profitability in highly
competitive markets of complex products. It is therefore very important that
the benefits of more accurate tracing of costs to products exceed the cost of
achieving the incremental accuracy (for example, the costs of determining
and measuring additional cost drivers). It would be counterproductive to
implement an elaborate overhead allocation system to cost products with
very high accuracy if the system would cost so much to maintain that the
companies would become less, not more, competitive. A single-cost-driver
method may be a compromise that reflects the costs and benefits of
achieving additional accuracy.
A final consideration related to accuracy is the proper interpretation of
computed rates. The $687.50 annual cost to carry each part number is not a
short-term variable cost. Most of the costs in the MOH cost pool are fixed in
the short term on a unit volume basis. Elimination of one part number in the
database therefore will not immediately reduce the total material-related
overhead cost by this amount. Nor in the case of the low-usage part will
using one less save $3.44 in out-of-pocket costs. These rates reflect a
long-term perspective; the company believes that, by supporting the
manufacturing strategy, the allocation method will lead a to real cost savings
over time as the next generation of products is designed with fewer different
part numbers.
e. The costs of all demands made by products on both manufacturing and nonmanufacturing resources are proper elements of product costs used for
management decisions, whereas inventory values for external reporting
consist of manufacturing costs only. The MOH cost pool includes some or
all of the costs of three types of cost areas. Because all such costs areas
are manufacturing related, their costs are appropriately assigned to
inventory, and the accurate MOH allocation method is an appropriate
technique for making the assignments.
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The company, however, decided to use the MOH rates as "management costs"
only and to continue to use the old allocation method to compute "financial
costs." One factor that led to this decision was the company's desire to value
inventory consistently. If the new method were used to compute financial
costs, the reported inventory valuations would change because, among other
reasons, more manufacturing support costs would be allocated to products.
A more compelling reason for the "two sets of costs" approach is the need
to maintain flexibility in product costing. The part number-based MOH
allocation method was developed to modify behavior to enact the strategy of
parts standardization. It will cease to be an effective behavioral tool when
design and cost-reduction engineers fully understand the costs of part
number proliferation and naturally design products with common parts to
the extent each situation allows. After parts standardization becomes
second nature to engineers, management will change its strategy and the
accounting staff will develop a new product costing method to support the
new strategy. In this way, product costs can continue to be effective
management tools for influencing behavior without affecting the
accountants' ability to value inventory on a consistent basis.
[Michael A. Robinson, ed. Cases from Management Accounting Practice No.
5 Instructor's Manual (Montvale, NJ: National Association of Accountants,
1989). pp. 7-11, adapted.]
35. a. Advantages associated with activity-based costing systems include:
 highlighting non-value-added activities so that they can be reduced or
eliminated;
 improving the accuracy of product costing by tightening associations
between costs and their causes;
 better decision making in setting prices; and
 improving processes by highlighting the associations among production
activities.
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b. VOH rate = $1,120,000 ÷ 280,000 = $4 per DLH
TV Board
Direct material
65,000 × $80
40,000 × $140
Direct labor
65,000 × 1.5 × $14
40,000 × 4 × $14
Variable overhead
65,000 × 1.5 × $4
40,000 × 4 × $4
Machine charge
65,000 × 0.5 × $10
40,000 × 1.5 × $10
Material handling charge
65,000 × $80 × 0.10
40,000 × $140 × 0.10
Total cost of production
Sales
Total costs
Contribution
c.
PC Board
$ 5,200,000
$ 5,600,000
1,365,000
2,240,000
390,000
640,000
325,000
600,000
520,000
$7,800,000
560,000
$9,640,000
$9,750,000
(7,800,000)
$1,950,000
TV Board
$12,000,000
(9,640,000)
$ 2,360,000
PC Board
Direct material
65,000 × $80
$5,200,000
40,000 × $140
Material Overhead
Procurement ($0.10 per part)
162,500
Prod. Scheduling ($2 per board)130,000
Pack. and Ship. ($4 per board) 260,000
Variable overhead
Machine setup ($1.60 per setup)208,000
Waste disposal ($3 per pound)
3,900
Quality contr. ($3.50 per insp.) 227,500
General sup. ($0.60 per board) 39,000
Manufacturing:
Mach. Ins. ($0.40 per part)
624,000
Manual Ins. ($4 per part)
260,000
Wave solder. ($1.20 per board) 78,000
Total costs
$7,192,900
560,000
3,200,000
48,000
$10,406,000
Sales
Total costs
Contribution
$12,000,000
(10,406,000)
$ 1,594,000
$9,750,000
(7,192,900)
$2,557,100
$ 5,600,000
220,000
80,000
160,000
192,000
42,000
280,000
24,000
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d. Based on the calculations made in part (a), the PC boards appear to be more
profitable (in total dollars of gross profit) than the TV boards. Under the
activity-based cost allocations, the TV boards appear to generate a greater
dollar contribution toward profits than the PC boards; additionally the rate of
return for TV boards (26.2%) is much higher than that for PC boards (13.3%).
The difference is attributable to the fact that the standard cost system does
not account for the cost of the complexities associated with the production
of the PC board. These effects are most evident with the costs of manual
insertions required for the PC boards.
(CMA adapted)
36. a. Assignment of overhead costs:
Sky
General administration
$153,839.79
Project costing
21,654.14
A/P/Receiving
62,458.15
A/R
24,500.00
Payroll
10,298.51
Personnel recruiting
16,000.00
Employee insurance processing4,805.98
Proposals
54,509.80
Sales meetings
97,104.36
Shipping
9,391.30
Ordering
19,938.46
Duplicating costs
20,000.00
Blueprinting
34,837.59
Total
$529,338.08
Direct overhead
180,000.00
Total overhead
$709,338.08
Ruene
$127,559.59
13,714.29
52,048.46
18,500.00
11,641.79
8,000.00
5,432.83
68,137.25
74,493.53
11,762.85
16,246.15
18,000.00
27,870.07
$453,406.81
270,000.00
$723,406.81
Wayne
$127,600.62
12,631.58
24,493.39
4,000.00
8,059.70
14,000.00
3,761.19
16,352.94
30,402.11
2,845.85
11,815.38
8,000.00
14,292.34
$278,255.10
177,000.00
$455,255.10
b.
Sky
Sales
$1,500,000
Direct labor
(382,000)
Direct material
(281,000)
Net Contribution $ 837,000
Ruene
$1,419,000
(317,000)
(421,000)
$ 681,000
Wayne
$1,067,000
(317,000)
(185,000)
$ 565,000
c.
Sky
Net contribution $ 837,000.00
Overhead
(709,338.08)
Contribution
$ 127,661.92
Ruene
$ 681,000.00
(723,406.81)
$ (42,406.81)
Wayne
$ 565,000.00
(455,255.10)
$ 109,744.90
d. It is apparent that there are weaknesses in the traditional product costing
system that are having a profound effect on profitability measures. Relative
to profit measures based on the traditional costing measures, the ABC
allocations make it apparent that the Cincinnati office is much less profitable
and the Dayton office is much more profitable.
(IMA adapted)
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37. a. Send/receive goods: $12,000 ÷ 500,000 = $0.024 per lb.
Store goods: $8,000 ÷ 80,000 = $.10 per cubic foot
Move goods: $10,000 ÷ 5,000 = $2.00 per square foot
Identify goods: $4,000 ÷ 500 = $8.00 per package
Jones: (40,000 × $0.024) + (3,000 × $0.10) + (300 × $2) + (5 × $8) = $1,900
Hansen: (40,000 × $0.024) + (2,000 × $0.10) + (200 × $2) + (20 × $8) = $1,720
Assad: (40,000 × $0.024) + (1,000 × $0.10) + (1,000 × $2) + (80 × $8) = $3,700
b. Jones: 40,000 × $0.08 = $3,200
Hansen: 40,000 × $0.08 = $3,200
Assad: 40,000 × $0.08 = $3,200
c. Jones: $1,900 × 1.4 = $2,660
Hansen: $1,720 × 1.4 = $2,408
Assad: $3,700 × 1.4 = $5,180
The current pricing plan captures only one dimension of cost causality,
send/receive goods. Accordingly, the prices charged for warehousing
services are almost independent of the causes of the costs. As indicated in
a comparison of the answers to parts (b) and (c), the existing pricing plan
generates the same price for the three customers whereas an ABC-based
price results in very different prices to be charged to the three customers.
[Adapted from Harold P. Roth and Linda T. Sims, "Costing for Warehousing
and Distribution," Management Accounting, (August 1991) pp. 42-45.
Published by Institute of Management Accountants, Montvale, NJ.]
38. a. In particular, the other initiatives would include management methods to
improve quality. For example, an adoption of the TQM philosophy would be
one of the initiatives; others could include adoption of ABC, employee
empowerment, formation of quality circles, JIT inventory management,
decentralization of decision making, and use of kaizen costing techniques.
b. These tools help orient the firm to managing based on a customer’s
perspective of value. World class competition is based on satisfying the
customer. If a firm concentrates on accentuating those activities that are
highly valued by customers and diminishing those activities that are not
perceived as value-adding by customers, it should be successful in both
managing costs and maintaining market share.
c. Yes. Activity-based costing is most useful if managers are willing to act
based on the information provided by the ABC system. For example,
activity-based costing could lead to changes in product mix and product
pricing. Top management must support the ABC prescriptions for the
costing system to lead to operational improvements.
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d. Preferably, both would be adopted. Without adopting ABC, the ABM
prescriptions may not be understood by managers. But, without ABM, there
may be reduced opportunity to identify and eliminate NVA activities. ABC
would require a separate information system to generate activity-based
information. This would not necessarily be the system that managers would
attend to; rather, they would continue to use the firm’s traditional and formal
information systems. The two sources of information would inevitably give
some conflicting signals and confuse managers. By using both an ABC
system and ABM, actions taken by managers will be consistent with the
information provided by the firms’ formal information systems.
39. a. This problem indicates that ABC and ABM can cause conflict among the
various stakeholders in a business. The equipment installation would likely
be viewed with favor by the stockholders. Analysis indicating that the
equipment would be value-adding obviously underlies the decision to make
the installation. Employees would be strongly against any move that would
result in displacement of 60 percent of the workforce. Such an action would
demoralize both those workers who were fired and those who remained. The
customers would likely have both short-term and long-term concerns.
Short-term customers would be very concerned about the impact on quality
of laying off 60 percent of the workers. However, customers may have a
favorable long-term view of the move because of the potential to improve the
quality and reduce the costs of products.
b. No matter how articulate the explanation given, it is difficult to visualize
acceptance of the explanation by workers who may have dedicated much of
their lives to learning skills required for their current positions. One
approach, however, would be to discuss what customers value in the
products currently produced by the business; then, explain how each
internal area in the business contributes (or fails to contribute) to customer
value. This explanation would need to clearly show that the function
performed by the displaced workers is no longer value-adding in the eyes of
the customer. Also, it would be important to explain to the employees that
this conclusion holds no matter how well the employees perform the
functions.
c. Cycle time is reduced/eliminated largely by reducing non-value-added
activities. When non-value-added activities are reduced, work is no longer
required of the employees who performed those activities. Only if the
employees can be redeployed to other operational areas that are valueadding can employee layoffs be totally avoided. However, to the extent
possible, the company could aggressively implement training programs to
qualify displaced workers for other positions. Secondly, the company could
seek market opportunities to expand the business so that growth would
create an internal demand for those workers’ services in other areas of the
business. Third, the company could provide employee counseling services
to workers and help retrain them for work in other businesses.