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Activity-Based Costing: a tool to Aid Decision Making

According to the activity-based costing system, the cost of serving each of the parties can be computed as follows:

a. Party of 4 persons who order a total of 3 drinks:

Activity Cost Pool

(a)
Activity Rate

(b)
Activity

(a) × (b)
ABC Cost

Serving parties

$5.50

per party

1

party

$  5.50

Serving diners

$9.20

per diner

4

diners

36.80

Serving drinks

$2.40

per drink

3

drinks

   7.20

Total

$49.50

b. Party of 2 persons who order no drinks:

Activity Cost Pool

(a)
Activity Rate

(b)
Activity

(a) × (b)
ABC Cost

Serving parties

$5.50

per party

1

party

$  5.50

Serving diners

$9.20

per diner

2

diners

18.40

Serving drinks

$2.40

per drink

0

drinks

        0

Total

$23.90

c. Party of 1 person who orders 2 drinks:

Activity Cost Pool

(a)
Activity Rate

(b)
Activity

(a) × (b)
ABC Cost

Serving parties

$5.50

per party

1

party

$  5.50

Serving diners

$9.20

per diner

1

diner

9.20

Serving drinks

$2.40

per drink

2

drinks

   4.80

Total

$19.50

Exercise 8-21 (continued)

2. The average cost per diner for each party can be computed by dividing the total cost of the party by the number of diners in the party as follows:

a. $49.50 ÷ 4 diners = $12.375 per diner

b. $23.90 ÷ 2 diners = $11.95 per diner

c. $19.50 ÷ 1 diner = $19.50 per diner

3. The average cost per diner differs from party to party under the activity-based costing system for two reasons. First, the cost of serving a party ($5.50) does not depend on the number of diners in the party. Therefore, the average cost per diner of this activity decreases as the number of diners in the party increases. With only one diner, the cost is $5.50. With two diners, the average cost per diner is cut in half to $2.75. With five diners, the average cost per diner would be only $1.10. And so on. Second, the average cost per diner differs also because of the differences in the number of drinks ordered by the diners. If a party does not order any drinks, as was the case with the party of two, no costs of serving drinks are assigned to the party.

The average cost per diner differs from the overall average cost of $16 per diner for several reasons. First, the average cost of $16 per diner includes organization-sustaining costs that are excluded from the computations in the activity-based costing system. Second, the $16 per diner figure does not recognize differences in the diners’ demands on resources. It does not recognize that some diners order more drinks than others nor does it recognize the economies of scale in serving larger parties. (The batch-level costs of serving a party can be spread over more diners if the party is larger.)

We should note that the activity-based costing system itself does not recognize all of the differences in diners’ demands on resources. For example, there are undoubtedly differences in the costs of preparing the various meals on the menu. It may or may not be worth the effort to build a more detailed activity-based costing system that would take such nuances into account.

Problem 8-22 (45 minutes)

1. The first-stage allocation of costs to activity cost pools appears below:

Distribution of Resource Consumption Across Activity Cost Pools

Cleaning Carpets

Travel to Jobs

Job Support

Other

Total

Wages

70%

20%

0%

10%

100%

Cleaning supplies

100%

0%

0%

0%

100%

Cleaning equipment depreciation

80%

0%

0%

20%

100%

Vehicle expenses

0%

60%

0%

40%

100%

Office expenses

0%

0%

45%

55%

100%

President’s compensation

0%

0%

40%

60%

100%

Cleaning Carpets

Travel
to Jobs

Job
Support

Other

Total

Wages

$105,000

$30,000

$        0

$ 15,000

$150,000

Cleaning supplies

40,000

0

0

0

40,000

Cleaning equipment depreciation

16,000

0

0

4,000

20,000

Vehicle expenses

0

48,000

0

32,000

80,000

Office expenses

0

0

27,000

33,000

60,000

President’s compensation

           0

         0

 32,000

   48,000

   80,000

Total cost

$161,000

$78,000

$59,000

$132,000

$430,000

Example: 70% of $150,000 = $105,000

Other entries in the table are determined in a similar manner.

Problem 8-22 (continued)

2. The activity rates are computed as follows:

Activity Cost Pool

(a)
Total Cost

(b)
Total Activity

(a) ÷ (b)
Activity Rate

Cleaning carpets

$161,000

20,000

hundred square feet

$8.05

per hundred square feet

Travel to jobs

$78,000

60,000

miles

$1.30

per mile

Job support

$59,000

2,000

jobs

$29.50

per job