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Activity-Based Costing: a tool to Aid Decision Making


Chapter 8

Activity-Based Costing: A Tool to Aid
Decision Making

Solutions to Questions

8-1 Activity-based costing differs from traditional costing systems in a number of ways. In activity-based costing, nonmanufacturing as well as manufacturing costs may be assigned to products. And, some manufacturing costs may be excluded from product costs. An activity-based costing system typically includes a number of activity cost pools, each of which has its unique measure of activity. These measures of activity often differ from the allocation bases used in traditional costing systems. Finally, the activity rates differ from typical predetermined overhead rates in that they should be based on activity at capacity rather than on the budgeted level of activity.

8-2 When direct labor is used as an allocation base for overhead, it is implicitly assumed that overhead cost is directly proportional to direct labor. When cost systems were originally developed in the 1800s, this assumption may have been reasonably accurate. However, direct labor has declined in importance over the last hundred years while overhead has been increasing. This suggests that there is no longer a direct link between the level of direct labor and overhead. Indeed, when a company automates, direct labor is replaced by machines; a decrease in direct labor is accompanied by an increase in overhead. This violates the assumption that overhead cost is directly proportional to direct labor. Overhead cost appears to be driven by factors such as product diversity and complexity as well as by volume, for which direct labor has served as a convenient measure.

8-3 When an overhead rate is based on the budgeted level of activity, products are implicitly charged for the costs of the capacity they don’t use as well as for the costs of capacity that they do use. This is because all of the costs of capacity—whether utilized or not—are spread across the budgeted production. Since the costs of capacity are largely fixed, this results in higher unit product costs when the level of activity declines.

If an overhead rate is based on the level of activity at capacity, a product is charged only for the costs of capacity that it actually uses. The costs of unused capacity are not charged to products and are instead charged to the current period as expenses of the period (see Appendix 3A). As a result, unit product costs are more stable and costs do not appear to increase as the level of budgeted activity decreases.

8-4 Activity-based costing may be resisted because it changes the “rules of the game.” It changes some of the key measures such as product costs used in making decisions and may affect how individuals are evaluated. Without top management support, there may be little interest in making these changes. In addition, if top managers continue to make decisions based on the numbers generated by the traditional costing system, subordinates will quickly conclude that the activity-based costing system can be ignored.

8-5 Unit-level activities are performed for each unit that is produced. Batch-level activities are performed for each batch regardless of how many units are in the batch. Product-level activities must be carried out to support a product regardless of how many batches are run or units produced. Customer-level activities must be carried out to support customers regardless of what products or services they buy. Organization-sustaining activities are carried out regardless of the company’s precise product mix or mix of customers.

8-6 Organization-sustaining costs and the costs of idle capacity should not be assigned to products. These costs represent resources that are not consumed by the products.

8-7 In activity-based costing, costs must first be allocated to activity cost pools and then are allocated from the activity cost pools to products, customers, and other cost objects.

8-8 Since people are often involved in more than one activity, some way must be found to estimate how much time they spend on each. The most practical approach is often to ask employees what percentage of time they spend on each activity. It is also possible to ask people to keep records of how they spend their time or observe them as they perform their tasks, but both of these alternatives are costly and it is not obvious that the data would be any better. People who know they are being observed may change how they behave.

8-9 In traditional cost systems, product-level costs are indiscriminately spread across all products using direct labor-hours or some other allocation base that is tied to volume. As a consequence, high-volume products are assigned the bulk of such costs. If a product is responsible for 40% of the direct labor in a factory, it will be assigned 40% of the manufacturing overhead cost in the factory—including 40% of the product-level costs of low-volume products. In an activity-based costing system, batch-level and product-level costs are assigned more appropriately. This results in shifting product-level costs back to the products that cause them and away from the high-volume products. (A similar effect will be observed with batch-level costs if high-volume products are produced in larger batches than low-volume products.)

8-10 Activity rates tell managers the average cost of resources consumed in carrying out a particular activity such as processing purchase orders. An activity whose average cost is high may be a good candidate for process improvements. Benchmarking can be used to identify which activities have unusually large costs. If some other organization is able to carry out the activity at a significantly lower cost, it is reasonable to suppose that improvement may be possible.

8-11 The activity-based costing approach described in the chapter is probably unacceptable for external financial reports for two reasons. First, activity-based product costs, as described in this chapter, exclude some manufacturing costs and include some nonmanufacturing costs. Second, the first-stage allocations are based on interviews rather than verifiable, objective data.

8-12 While an activity analysis such as in Exhibit 8-9 can yield insights, it should not be used for decision making. The conventional activity analysis contains no indication of what costs can actually be adjusted nor is there any indication of who would be responsible for adjusting the costs after a decision has been made. It would be dangerous, for example, to drop a product based solely on the activity analysis. Most of the costs do not automatically disappear if a product is dropped; managers must take explicit actions to eliminate resources or to transfer resources to other uses. Managers may be reluctant to take these actions—particularly if it involves firing or transferring people. The action analysis has the advantage of making it clearer where savings have to come from and hence which managers will have to take action.

Exercise 8-1 (10 minutes)

a. Receive raw materials from suppliers: Batch-level

b. Manage parts inventories: Product-level

c. Do rough milling work on products: Unit-level

d. Interview and process new employees in the personnel department: Organization-sustaining

e. Design new products: Product-level

f. Perform periodic preventative maintenance on general-use equipment: Organization-sustaining

g. Use the general factory building: Organization-sustaining

h. Issue purchase orders for a job: Batch-level

Some of these classifications are debatable and depend on the specific circumstances found in particular companies.

Exercise 8-2 (15 minutes)

Travel

Pickup and
Delivery

Customer
Service

Other

Totals

Driver and guard wages

$360,000

$252,000

$ 72,000

$ 36,000

$  720,000

Vehicle operating expense

196,000

14,000

0

70,000

280,000

Vehicle depreciation

72,000

18,000

0

30,000

120,000

Customer representative salaries and expenses

0

0

144,000

16,000

160,000

Office expenses

0

6,000

9,000

15,000

30,000

Administrative expenses

           0

   16,000

 192,000

 112,000

    320,000

Total cost

$628,000

$306,000

$417,000

$279,000

$1,630,000

Each entry in the table is derived by multiplying the total cost for the cost category by the percentage taken from the table below that shows the distribution of resource consumption:

Travel

Pickup and
Delivery

Customer
Service

Other

Totals

Driver and guard wages

50%

35%

10%

5%

100%

Vehicle operating expense

70%

5%

0%

25%

100%

Vehicle depreciation

60%

15%

0%

25%

100%

Customer representative salaries and expenses

0%

0%

90%

10%

100%

Office expenses

0%

20%

30%

50%

100%

Administrative expenses

0%

5%

60%

35%

100%

Exercise 8-3 (10 minutes)

Activity Cost Pool

Estimated Overhead Cost

Expected Activity

Activity Rate

Caring for lawn

$72,000

150,000

square feet of lawn

$0.48

per square foot of lawn

Caring for garden beds–
low maintenance

$26,400

20,000

square feet of low maintenance beds

$1.32

per square foot of low maintenance beds

Caring for garden beds–high maintenance

$41,400

15,000

square feet of high maintenance beds

$2.76

per square foot of high maintenance beds

Travel to jobs

$3,250

12,500

miles

$0.26

per mile

Customer billing and service

$8,750

25

customers

$350

per customer

The activity rate for each activity cost pool is computed by dividing its estimated overhead cost by its expected activity.

Exercise 8-4 (10 minutes)

K425

Activity Cost Pool

Activity Rate

Activity

ABC Cost

Labor related

$6

per direct labor-hour

80

direct labor-hours

$  480

Machine related

$4

per machine-hour

100

machine-hours

400

Machine setups

$50

per setup

1

setups

50

Production orders

$90

per order

1

order

90

Shipments

$14

per shipment

1

shipment

14

Product sustaining

$840

per product

1

product

    840

Total

$1,874

M67

Activity Cost Pool

Activity Rate

Activity

ABC Cost

Labor related

$6

per direct labor-hour

500

direct labor-hours

$ 3,000

Machine related

$4

per machine-hour

1,500

machine-hours

6,000

Machine setups

$50

per setup

4

setups

200

Production orders

$90

per order

4

orders

360

Shipments

$14

per shipment

10

shipments

140

Product sustaining

$840

per product

1

product

      840

Total

$10,540

K425

M67

Total cost (a)

$1,874

$10,540

Number of units produced (b)

200

2,000

Average cost per unit (a) ÷ (b)

$9.37

$5.27

Exercise 8-5 (30 minutes)