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CHAPTER 4

ACTIVITY-BASED PRODUCT COSTING


QUESTIONS FOR WRITING AND DISCUSSION
1. Unit costs provide essential information represent a significant proportion of total
needed for inventory valuation and prepara- overhead costs.
tion of income statements. Knowing unit
8. Low-volume products may consume non-unit-
costs is also critical for many decisions such
level overhead activities in much greater
as bidding decisions and accept-or-reject
proportions than indicated by a unit-level cost
special order decisions.
driver and vice versa for high-volume
2. Cost measurement is determining the dollar products. If so, then the low-volume prod-ucts
amounts associated with resources used in will receive too little overhead and the high-
production. Cost assignment is associating volume products too much.
the dollar amounts, once measured, with 9. If some products are undercosted and oth-ers
units produced. are overcosted, a firm can make a num-ber of
3. An actual overhead rate is rarely used be- competitively bad decisions. For ex-ample,
cause of problems with accuracy and timeli- the firm might select the wrong product mix or
ness. Waiting until the end of the year to en- submit distorted bids.
sure accuracy is rejected because of the 10. Nonunit-level overhead activities are those
need to have timely information. Timeliness overhead activities that are not highly corre-
of information based on actual overhead
lated with production volume measures. Ex-
costs runs into difficulty (accuracy problems)
amples include setups, material handling,
because overhead is incurred nonuniformly
and because production also may be non- and inspection. Nonunit-level cost drivers are
uniform. causal factors—factors that explain the
consumption of nonunit-level overhead. Ex-
4. For plantwide rates, overhead is first col- amples include setup hours, number of
lected in a plantwide pool, using direct trac- moves, and hours of inspection.
ing. Next, an overhead rate is computed and
used to assign overhead to products. 11. Product diversity is present whenever prod-
ucts have different consumption ratios for
5. First stage: Overhead is assigned to produc- different overhead activities.
tion department pools using direct tracing,
driver tracing, and allocation. Second stage: 12. An overhead consumption ratio measures the
Individual departmental rates are used to proportion of an overhead activity con-sumed
assign overhead to products as they pass by a product.
through the departments. 13. Departmental rates typically use unit-level
6. Departmental rates would be chosen over cost drivers. If products consume nonunit-
plantwide rates whenever some depart- level overhead activities in different propor-
ments are more overhead intensive than tions than those of unit-level measures, then
others and if certain products spend more it is possible for departmental rates to move
time in some departments than they do in even further away from the true consump-tion
others. ratios, since the departmental unit-level ratios
7. Plantwide overhead rates assign overhead to usually differ from the one used at the plant
products in proportion to the amount of the level.
unit-level cost driver used. If the prod-ucts 14. Agree. Prime costs can be assigned using
consume some overhead activities in direct tracing and so do not cause cost dis-
different proportions than those assigned by tortions. Overhead costs, however, are not
the unit-level cost driver, then cost dis- directly attributable and can cause distor-
tortions can occur (the product diversity tions. For example, using unit-level activity
factor). These distortions can be significant if drivers to trace nonunit-level overhead costs
the nonunit-level overhead costs would cause distortions.
75
15. Activity-based product costing is an over- ties are those that are performed each time a
head costing approach that first assigns batch of products is produced. Product-level
costs to activities and then to products. The or sustaining activities are those that are
assignment is made possible through the performed as needed to support the various
identification of activities, their costs, and the products produced by a company. Facility-
use of cost drivers. level activities are those that sustain a facto-
16. An activity dictionary is a list of activities ry’s general manufacturing process
accompanied by information that describes 20. Rates can be reduced by building a system
each activity (called attributes) that approximates the cost assignments of a
fully specified ABC system. One way to do
17. A primary activity is consumed by the final
this is by using only the most expensive ac-
cost objects such as products and custom-
tivities to assign costs. If the most expensive
ers, whereas secondary activities are con-
activities represent a large percentage of the
sumed by other activities (ultimately con-
total costs, then most of the costs are as-
sumed by primary activities). signed using a cause-and-effect relation-ship,
18. Costs are assigned using direct tracing and thus creating a good level of accuracy while
resource drivers. reducing the complexity of the ABC system.
19. Unit-level activities are those that occur each
time a product is produced. Batch-level activi-
76
EXERCISES

4–1

1.
Quarter 1 Quarter 2 Quarter 3 Quarter 4 Total
Units produced 400,000 160,000 80,000 560,000 1,200,000
Prime costs $8,000,000 $3,200,000 $1,600,000 $11,200,000 $24,000,000
Overhead costs $3,200,000 $2,400,000 $3,600,000 $2,800,000 $12,000,000
Unit cost:
Prime $20 $20 $20 $20 $20
Overhead 8 15 45 5 10
Total $28 $35 $65 $25 $30

2. Actual costing can produce wide swings in the overhead cost per unit. The
cause appears to be nonuniform incurrence of overhead and nonuniform
production (seasonal production is a possibility).

3. First, calculate a predetermined rate:


OH rate = $11,640,000/1,200,000
= $9.70 per unit
This rate is used to assign overhead to the product throughout the year. Since
the driver is units produced, $9.70 would be assigned to each unit. Add-ing this
to the actual prime costs produces a unit cost under normal costing:
Unit cost = $9.70 + $20.00 = $29.70
This cost is close to the actual annual cost of $30.00.
77
4–2

1. $27,000,000/90,000 = $300 per direct labor hour (DLH)

2. $300 × 91,000 = $27,300,000

3. Applied overhead $ 27,300,000


Actual overhead 27,200,000
Overrapplied overhead $ 100,000

4. Predetermined rates allow the calculation of unit costs and avoid the prob-
lems of nonuniform overhead incurrence and nonuniform production asso-
ciated with actual overhead rates. Unit cost information is needed throughout
the year for a variety of managerial purposes.

4–3

1. Predetermined overhead rate = $4,500,000/600,000 = $7.50 per DLH

2. Applied overhead = $7.50 × 585,000 = $4,387,500

3. Applied overhead $ 4,387,500


Actual overhead 4,466,250
Underapplied overhead $ (78,750 )

4. Unit cost:
Prime costs $ 6,750,000
Overhead costs 4,387,500
Total $ 11,137,500
Units ÷ 750,000
Unit cost $ 14.85
78
4–4

1. Predetermined overhead rate = $4,500,000/187,500 = $24 per machine hour


(MHr)

2. Applied overhead = $24 × 187,875 = $4,509,000

3. Applied overhead $ 4,509,000


Actual overhead 4,466,250
Overapplied overhead $ 42,750

4. Unit cost:
Prime costs $ 6,750,000
Overhead costs 4,509,000
Total $ 11,259,000
Units ÷ 750,000
Unit cost $ 15.01*
*Rounded

5. Gandars needs to determine what causes its overhead. Is it primarily labor


driven (e.g., composed predominantly of fringe benefits, indirect labor, and
personnel costs), or is it machine oriented (e.g., composed of depreciation on
machinery, utilities, and maintenance)? It is impossible for a decision to be
made on the basis of the information given in this exercise.
79
4–5

1. Predetermined rates:
Drilling Department: Rate = $600,000/280,000 = $2.14* per MHr
Assembly Department: Rate = $392,000/200,000
= $1.96 per DLH
*Rounded

2. Applied overhead:
Drilling Department: $2.14 × 288,000 = $616,320 Assembly
Department: $1.96 × 196,000 = $384,160 Overhead variances:
Drilling Assembly Total
Actual overhead $602,000 $ 412,000 $ 1,014,000
Applied overhead 616,320 384,160 1,000,480
Overhead variance $ (14,320) over $ 27,840 under $13,520 under

3. Unit overhead cost = [($2.14 × 4,000) + ($1.96 × 1,600)]/8,000


= $11,696/8,000
= $1.46*
*Rounded
80
4–6

1. Activity rates:
Machining = $632,000/300,000
= $2.11* per MHr
Inspection = $360,000/12,000
= $30 per inspection hour
*Rounded

2. Unit overhead cost = [($2.11 × 4,000) + ($30 × 800)]/8,000


= $32,440/8,000
= $4.055

4–7

1.
Scented Cards Regular Cards
a a
Inspection hours 0.20 0.80
b b
Setup hours 0.50 0.50
c c
Machine hours 0.25 0.75
d d
Number of moves 0.75 0.25
a. Total inspection hours = 200 (40+160); 40/200 for Scented and 160/200 for Regular
b. Total Setup hours = 100 (50+50); 50/100 for Scented and 50/100 for Regular
c. Total Machine hours = 800 (200+600); 200/800 for Scented and 600/800 for Regular
d. Total Number of moves = 300 (225+75); 225/300 for Scented and 75/300 for Regular

2. The consumption ratios vary significantly from driver to driver. Using, for ex-
ample, only machine hours to assign the overhead may create accuracy prob-
lems. Both setup hours and number of moves have markedly different consump-
tion ratios.

4–8

1. Rates:

Inspecting products: $2,000/200 = $10 per inspection hour


Setting up equipment: $2,500/100 = $25 per setup hour
Machining: $4,000/800 = $5 per machine hour
Moving materials: $900/300 = $3.00 per move

Note: The denominator is the total driver amount (sum of the demand of the two
products).
81
2.

Rate = Cost/hours
Inspection hours = Cost/Rate = $2,000/$20 = 100 inspection hours

4–9

1.
Normal Intensive
Treating patients:
$4.00 × 5,000 $ 20,000
$4.00 × 20,000 $ 80,000
Providing hygienic care:
$5.00 × 5,000 25,000
$5.00 × 11,000 55,000
Responding to requests:
$2.00 × 30,000 60,000
$2.00 × 50,000 100,000
Monitoring patients:
$0.75 × 20,000 15,000
$0.75 × 180,000 135,000
Cost Assigned $ 120,000 $370,000

2. Nursing cost per patient day:

Normal Intensive
$120,000/10,000 $12.00
$370,000/8,000 $46.25

4–10

1. Yes. Because direct materials and direct labor are directly traceable to
each product, their cost assignment should be accurate.
2. The consumption ratios for each (using machine hours and setup hours
as the activity drivers) are as follows:
Elegant Fina
Machining 0.10 0.90 (500/5,000 and 4,500/5,000)
Setups 0.50 0.50 (100/200 and 100/200)

3. Elegant: (1.75 × $9,000)/3,000 = $5.25 per briefcase


82
Fina: (1.75 × $3,000)/3,000 = $1.75 per briefcase

Note: Overhead rate = $21,000/$12,000 = $1.75 per direct labor dollar (or
175 percent of direct labor cost).

There are more machine and setup costs assigned to Elegant than Fina.
This is clearly a distortion because the production of Fina is automated
and uses the machine resources much more than the handcrafted Ele-
gant. In fact, the consumption ratio for machining is 0.10 and 0.90 (us-
ing machine hours as the measure of usage). Thus, Fina uses 9 times
the machining resources as Elegant. Setup costs are similarly dis-
torted. The products use an equal number of setup hours. Yet if direct
labor dollars are used, then the Elegant briefcase receives three times
more machining costs than the Fina briefcase.

4. Products tend to make different demands on overhead activities and


this should be reflected in overhead cost assignments. Usually this
means the use of both unit and nonunit-level activity drivers. In this ex-
ample, there is a unit-level activity (machining) and a nonunit-level
activity (setting up equipment).

Machine rate: $18,000/5,000 = $3.60 per machine hour


Setup rate: $3,000/200 = $15 per setup hour

Costs assigned to each product:


Machining: Elegant Fina
$3.60 × 500 $ 1,800
$3.60 × 4,500 $16,200
Setups:
$15 × 100 1,500 1,500
Total $ 3,300 $17,700
Units ÷ 3,000 ÷ 3,000
Unit overhead cost $ 1.10 $ 5.90
83
4-11

1.
Resource Unloading Counting Inspecting
Equipment $12,000 $ 800
Fuel 2,400
Operating 1,000 500
Labor* 48,000 30,000 42,000
Total $63,400 $30,000 $43,300

*(0.40 × $120,000; 0.25 × $120,000; 0.35 × $120,000)

2. Direct tracing and driver tracing are used. When the resource is used only by
one activity, then direct tracing is possible. When the activities are shared, as in
the case of labor, then resource drivers must be used.

4–12

Activity dictionary:

Activity Activity Primary/ Activity


Name Description Secondary Driver
Providing nursing Satisfying patient Primary Nursing hours
care needs

Supervising Coordinating Secondary Number of nurses


nurses nursing activities

Feeding patients Providing meals Primary Number of meals


to patients

Laundering Cleaning and Primary Pounds of laundry


bedding and delivering clothes
clothes and bedding

Providing Therapy treatments Primary Hours of therapy


physical directed by
therapy physician

Monitoring Using equipment to Primary Monitoring hours


patients monitor patient
conditions
84
4–13

1. Cost of labor (0.40 × $50,000) $20,000


Forklift (direct tracing) 10,000
Total cost of receiving $30,000

2.
Activity rates:
Receiving: $30,000/60,000 = $0.50 per part
Setup: $60,000/300 = $200 per setup
Grinding: $90,000/18,000 = $5 per MHr
Inspecting: $20,000/2,000 = $10 per inspection

Subassembly A Subassembly B
Overhead:
Setup:
$200 × 150 $ 30,000
$200 × 150 $ 30,000
Inspecting:
$10 × 1,500 15,000
$10 × 500 5,000
Grinding:
$5 × 7,200 36,000
$5 × 10,800 54,000
Receiving:
$0.50 × 20,000 10,000
$0.50 × 40,000 20,000
Total costs assigned $ 91,000 $109,000

3. Setup pool: $60,000 + [($60,000/$150,000) × $50,000] = $80,000


Grinding pool: $90,000 + [($90,000/$150,000) × $50,000] = $120,000

Pool rates:
Setup = $80,000/300 =
$266.67/setup

Grinding = $120,000/18,000
= $6.67/ Mhr
85
Approximating assignment:

Subassembly A Subassembly B
Setup:
$266.67 × 150 $40,000
$266.67 × 150 $ 40,000
Grinding:
$6.67 × 7,200 48,024
$6.67 × 10,800 72,036
Total costs assigned $ 88,024 $112,036

4. Error (Subassembly A) = ($91,000 - $88,024)/$91,000 = 0.033 Error


(Subassembly B) = ($109,000 - $112,036)/$109,000 = - 0.028

The error is small and so the approach may be desirable as it reduces the
complexity and size of the system, making it more likely to be accepted by
management.

4–14

1. Unit-level activities: Machining


Batch-level activities: Setups and packing
Product-level activities: Receiving
Facility-level activities: None

2. Activity rates:
(1) Machining: $80,000/40,000 = $2 per MHr
(2) Setups: $32,000/400 = $80 per setup
(3) Receiving: $18,000/600 = $30 per receiving order
(4) Packing: $48,000/3,200 = $15 per packing order

Overhead assignment:
Infantry
Activity 1: $2 × 20,000 = $ 40,000
Activity 2: $80 × 300 = 24,000
Activity 3: $30 × 200 = 6,000
Activity 4: $15 × 2,400 = 36,000
Total $ 106,000
86
Special forces
Activity 1: $2 × 20,000 = $ 40,000
Activity 2: $80 × 100 = 8,000
Activity 3: $30 × 400 = 12,000
Activity 4: $15 × 800 = 12,000
Total $ 72,000

Combining Activities 2 and 4 produces a new pooled rate:

($32,000 +$48,000)/400 = $ 200 per setup

Overhead assignment:
Infantry
Activity 1: $2 × 20,000 = $ 40,000
Activity 2*: $200 × 300 = 60,000
Activity 3: $30 × 200 = 6,000
Total $106,000
*Combined activities 2 and 4

Special forces
Activity 1: $2 × 20,000 = $ 40,000
Activity 2: $200× 100 = 20,000
Activity 3: $30 × 400 = 12,000
Total $ 72,000

The assignments are the same and this happens because the consump-
tion ratios of activities 2 and 4 are identical. Thus, rate reduction can
occur by combining all activities with identical rates.
3. The two most expensive activities are the first and the combined 2 and 4
activities. Each has $80,000 of cost. Thus if the cost of activity 3 is allo-
cated in proportion to the cost, each of the expensive activities would
receive 50% of the $18,000 or $9,000. This yields the following pool rates:

Activity (pool 1) 1: ($80,000 + $9,000)/40,000 = $2.225 per machine hour

Activities 2 and 4 (pool 2): ($80,000 + $9,000)/400 = $222.50 per setup


87
Overhead assignment:
Infantry
Pool 1: $2.225 × 20,000 = $ 44,500
Pool 2: $222.50 × 300 = 66,750
Total $111,250

Special forces
Pool 1: $2.225 × 20,000 = $ 44,500
Pool 2: $222.5 × 100 = 22,250
Total $ 66,750

4. Infantry: ($111,250 - $106,000)/$106,000 = .05 (rounded)

Special forces = ($66,750 - $72,000)/$72,000 = -.07 (rounded)

The error is less than 10% for both products. Using machine hours
would have produce a rate of $ 178,000/40,000 = $4.45 per Mhr and an
assignment of $89,000 to each product ($4.45 × 20,000). The error for
the plantwide rate would be
Infantry: ($89,000 - $106,000)/106,000 = 0.16 (rounded)

Special forces = ($89,000 - $72,000)/$72,000 = 0.24 (rounded)

Thus, the plantwide rate produces product costing errors that are more
than three times the magnitude of the approximately relevant ABC as-
signments. Clearly, the approximation produces a more reasonable and
useful outcome and is less complex than the full ABC system.

4–15

1. Unit-level: Testing products, inserting dies

2. Batch-level: Setting up batches, handling wafer lots, purchasing


materials, receiving materials

3. Product-level: Developing test programs, making probe cards,


engineering design, paying suppliers

4. Facility-level: Providing utilities, providing space


88
PROBLEMS

4–16

1. Cost before addition of duffel bags:

$60,000/100,000 = $0.60 per unit

The assignment is accurate because all costs belong to one product.

2. Activity-based cost assignment:

Stage 1:

Activity rate = $120,000/80,000 = $1.50 per transaction

Stage 2:

Overhead applied:
Backpacks: $1.50 × 40,000* = $60,000
Duffel bags: $1.50 × 40,000 = $60,000
*80,000 transactions/2 = 40,000 (number of transactions had
doubled)

Unit cost:
Backpacks: $60,000/100,000 = $0.60 per unit
Duffel bags: $60,000/25,000 = $2.40 per unit

3. Product cost assignment:


Overhead rates:
Patterns: $48,000/10,000 = $4.80 per direct labor hour
Finishing: $72,000/20,000 = $3.60 per direct labor hour
89
Unit cost computation:
Backpacks Duffel Bags
Patterns:
$4.80 × 0.1 $0.48
$4.80 × 0.4 $1.92
Finishing:
$3.60 × 0.2 0.72
$3.60 × 0.8 2.88
Total per unit $1.20 $4.80

4. This problem allows us to see what the accounting cost per unit should
be by providing the ability to calculate the cost with and without the
duffel bags. With this perspective, it becomes easy to see the benefits of
the activity-based approach over those of the functional-based ap-
proach. The activity-based approach provides the same cost per unit as
the single-product setting. The functional-based approach used trans-
actions to allocate accounting costs to each producing department, and
this allocation probably reflects quite well the consumption of ac-
counting costs by each producing department. The problem is the
second-stage allocation. Direct labor hours do not capture the con-
sumption pattern of the individual products as they pass through the
departments. The distortion occurs, not in using transactions to assign
accounting costs to departments, but in using direct labor hours to as-
sign these costs to the two products.

In a single-product environment, ABC offers no improvement in prod-


uct-costing accuracy. However, even in a single-product environment, it
may be possible to increase the accuracy of cost assignments to oth-er
cost objects such as customers.

4–17

1. Plantwide rate = $1,320,000/440,000 = $3.00 per DLH

Overhead cost per unit:


Model A: $3.00 × 140,000/30,000 = $14.00
Model B: $3.00 × 300,000/300,000 = $3.00
90
2. Calculation of activity rates:

Activity Driver Activity Rate


Setup Prod. runs $360,000/100 = $3,600 per run
Inspection Insp. hours $280,000/2,000 = $140 per hour
Machining Mach. Hours $320,000/220,000 = $1.454 per hr
Maintenance Maint. hours $360,000/100,000 =$3.60 per hr

Overhead assignment:
Model A Model B
Setups
$3,600 × 40 $ 144,000
$3,600 × 60 $216,000
Inspections
$140 × 800 112,000
$140 × 1,200 168,000
Machining
$1.454 × 20,000 29,080
$1.454 × 200,000 290,800
Maintenance
$3.60 × 10,000 36,000
$3.60 × 90,000 ----- 324,000
Total overhead $321,080 $998,800
Units produced ÷ 30,000 ÷300,000
Overhead per unit $ 10.70 $ 3.33

3. Departmental rates:

Overhead cost per unit:


Model A: [($4.66 × 10,000) + ($1.20 × 130,000)]/30,000 = $6.76
Model B: [($4.66 × 170,000) + ($1.20 × 270,000)]/300,000 = $3.72
4.
A common justification is that of using machine hours for machine-
intensive departments and labor hours for labor-intensive departments.
Using activity-based costs as the standard, we can say that departmen-
tal rates decreased the accuracy of the overhead cost assignment (over
91
the plantwide rate) for both products. Looking at Department 1, this de-
partment’s costs are assigned at a 17:1 ratio which overcosts B and
undercosts A in a big way. This raises some doubt about the conven-
tional wisdom regarding departmental rates.

4–18

1. Labor and gasoline are driver tracing.


Labor (0.75 × $180,000) $ 135,000 Time = Resource driver
Gasoline ($4.50 × 6,000 moves) 27,000 Moves = Resource driver
Depreciation 18,000 Direct tracing
Total cost $180,000
2. Plantwide rate = $660,000/20,000
= $33 per DLH
Unit cost:
Basic Deluxe
Prime costs $160.00 $320.00
Overhead:
$33 × 10,000/40,000 8.25
$33 × 10,000/20,000 16.50
$168.25 $336.50
3. Activity rates:
Maintenance $114,000/4,000 = $28.50 per maint. hour
Engineering $120,000/6,000 = $20 per eng. hour
Material handling $180,000/6,000 = $30 per move
Setting up $ 96,000/80 = $1,200 per move
Purchasing $ 60,000/300 = $200 per requisition
Receiving $ 40,000/750 = $53.33 per order
Paying suppliers $ 30,000/750 = $40 per invoice
Providing space $ 20,000/10,000 = $2.00 per machine hour
92
4-18 (continued)

Unit cost:
Basic Deluxe
Prime costs $6,400,000 $6,400,000
Overhead:
Maintenance
$28.50 × 1,000 28,500
$28.50 × 3,000 85,500
Engineering
$20 × 1,500 30,000
$20 × 4,500 90,000
Material Handling
$30 × 1,200 36,000
$30 × 4,800 144,000
Setting up
$1,200 × 16 19,200
$1,200 × 64 76,800
Purchasing
$200 × 100 20,000
$200 × 200 40,000
Receiving
$53.33 × 250 13,333
$53.33 × 500 26,665
Paying Suppliers
$40 × 250 10,000
$40 × 500 20,000
Providing space
$2 × 5,000 10,000
$2 × 5,000 10,000
Total $6,567,033 $6,892,965
Units produced ÷ 40,000 ÷ 20,000
Unit cost (ABC) $ 164.18 $ 344.65
Unit cost (traditional) $ 168.25 $ 336.50

The ABC costs are more accurate (better tracing—closer representa-tion


of actual resource consumption). This shows that the basic model was
overcosted and the deluxe model undercosted when the plantwide
overhead rate was used.
93
4-18 (continued)
4. Consumption ratios:
Maint. Eng. Mat. H. Setups Purch. Receiving Pay. Sup Space
Basic 0.25 0.25 0.20 0.20 0.33 0.33 0.33 0.50
Delux 0.75 0.75 0.80 0.80 0.67 0.67 0.67 0.50

5. When products consume activities in the same proportion, the activi-ties


with the same proportions can be combined into one pool. This is so
because the pooled costs will be assigned in the same proportion as the
individual activity costs. Using these consumption ratios as a guide, we
create four pools, reducing the number of rates from 8 to 4.
Pool 1:
Maintenance $114,000
Engineering 120,000
Total $234,000
Maintenance hours ÷ 4,000
Pool rate $ 58.50
Note: Engineering hours could also be used as a driver. The activities
are grouped together because they have the same consumption ratios:
(0.25, 0.75).

Pool 2: Material handling $180,000


Setting up 96,000
Total $276,000
Number of moves ÷ 6,000
Pool rate $ 46

Note: Material handling and setups have the same consumption ratios:
(0.20, 0.80). The number of setups could also be used as the pool driv-er.
94
4-18 (concluded)

Pool 4: Purchasing $ 60,000


Receiving 40,000
Paying suppliers 30,000
Total $130,000
Orders processed ÷ 750
Pool rate $ 173.33

Note: The three activities are all product-level activities and have the
same consumption ratios: (0.33, 0.67)

Pool 5: Providing space $ 20,000


Machine hours ÷ 10,000
Pool rate $ 2

Note: This is the only facility-level activity.

4–19

1. Unit-level costs ($120 × 20,000) $ 2,400,000


Batch-level costs ($80,000 × 20) 1,600,000
Product-level costs ($80,000 × 10) 800,000
Facility-level ($20 × 20,000) 400,000
Total cost $ 5,200,000

2. Unit-level costs ($120 × 30,000) $ 3,600,000


Batch-level costs ($80,000 × 20) 1,600,000
Product-level costs ($80,000 × 10) 800,000
Facility-level costs 400,000
Total cost $ 6,400,000
The unit-based costs increase because these costs vary with the number of
units produced. Because the batches and engineering orders did not change,
the batch-level costs and product-level costs remain the same, behaving as
fixed costs with respect to the unit-based driver. The facility-level costs are
fixed costs and do not vary with any driver.

3. Unit-level costs ($120 × 30,000) $ 3,600,000


Batch-level costs ($80,000 × 30) 2,400,000
Product-level costs ($80,000 × 12) 960,000
Facility-level costs 400,000
Total cost $ 7,360,000
95
Batch-level costs increase as the number of batches changes, and the costs of
engineering support change as the number of orders change. Thus, batches
and orders increased, increasing the total cost of the model.

4. Classifying costs by category allows their behavior to be better understood.


This, in turn, creates the ability to better manage costs and make decisions.

4–20

1. The total cost of care is $1,950,000 plus a $50,000 share of the cost of super-
vision [(25/150) × $300,000]. The cost of supervision is computed as follows:
Salary of supervisor (direct) $ 70,000
Salary of secretary (direct) 22,000
Capital costs (direct) 100,000
Assistants (3 × 0.75 × $48,000) 108,000
Total $ 300,000
Thus, the cost per patient day is computed as follows:
$2,000,000/10,000 = $200 per patient day

(The total cost of care divided by patient days.) Notice that every maternity
patient—regardless of type—would pay the daily rate of $200.

2. First, the cost of the secondary activity (supervision) must be assigned to the
primary activities (various nursing care activities) that consume it (the driver is
the number of nurses):

Maternity nursing care assignment:

(25/150) × $300,000 = $50,000

Thus, the total cost of nursing care is $950,000 + $50,000 = $1,000,000.

Next, calculate the activity rates for the two primary activities:
Occupancy and feeding: $1,000,000/10,000 = $100 per patient day
Nursing care: $1,000,000/50,000 = $20 per nursing hour
96
4–20 Concluded

Finally, the cost per patient day type can be computed:


Patient Daily Rate*
Normal $150
Cesarean 225
Complications 500
*($100 × 7,000) + ($20 × 17,500)/7,000
($100 × 2,000) + ($20 × 12,500)/2,000
($100 × 1,000) + ($20 × 20,000)/1,000

This example illustrates that activity-based costing can produce significant


product costing improvements in service organizations that experience prod-
uct diversity.

3. The Laundry Department cost would increase the total cost of the Maternity
Department by $100,000 [(200,000/1,000,000) × $500,000]. This would increase
the cost per patient day by $10 ($100,000/10,000). The activity approach would
need more detailed information—specifically, the amount of pounds of laun-
dry caused by each patient type. The activity approach will increase the accu-
racy of the cost assignment if patient types produce a disproportionate share
of laundry. For example, if patients with complications produce 40 percent of
the pounds with only 10 percent of the patient days, then the $10 charge per
day is not a fair assignment.
97
4–21

1. Activity classification:
Unit-level: Machining
Batch-level: Material handling, setups, inspection, and receiving
Product-level: Maintenance and engineering
Facility-level: None

2. Pool 1, consumption ratios: (0.5, 0.5):


Machining $ 90,000
Activity driver ÷ 100,000 MHr
Pool rate $ 0.90 per MHr

Pool 2, consumption ratios: (0.75, 0.25):


Setups $ 96,000
Inspection 60,000
Total $ 156,000
Activity driver ÷ 80 setups*
Pool rate $ 1,950 per setup
*Inspection hours could also be used.

Pool 3, consumption ratios: (0.33, 0.67):


Material handling $ 120,000
Receiving 30,000
Total $ 150,000
Activity driver ÷ 6,000 material moves
Pool rate $ 25 per move

Pool 4, consumption ratios: (0.67, 0.33):


Engineering $ 100,000
Maintenance 80,000
Total $ 180,000
Activity driver ÷ 6,000 maintenance hours*
Pool rate $ 30 per maintenance hour
*Number of engineering hours could also be used.
98
4–21 Concluded

3. Computation of unit overhead costs:


Small Clock Large Clock
Unit-level activities:
Pool 1:
$0.90 × 50,000 $ 45,000
$0.90 × 50,000 $ 45,000

Batch-level activities:
Pool 2:
$1,950 × 60 117,000
$1,950 × 20 39,000
Pool 3:
$25 × 2,000 50,000
$25 × 4,000 100,000

Product-level activities:
Pool 4:
$30 × 4,000 120,000
$30 × 2,000 60,000
Total overhead costs $ 332,000 $ 244,000
Units produced ÷ 100,000 ÷ 200,000
Overhead cost per unit $ 3.32 $ 1.22
99
4–22

1. Overhead rate = $6,990,000/272,500 = $25.65 per DLH*


Overhead assignment:
X-12: $25.65 × 250,000/1,000,000 = $6.41*
S-15: $25.65 × 22,500/200,000 = $2.89*
*Rounded numbers used throughout

Unit gross margin:


X-12 S-15
Price $ 15.93 $ 12.00
Cost 10.68* 6.02**
Gross margin $ 5.25 $ 5.98
*Prime costs + Overhead = ($4.27 + $6.41)
**Prime costs + Overhead = ($3.13 + $2.89)

2. Pools Driver Pool Rate


Setup Runs $240,000/300 = $800 per run
Machine Machine hrs. $1,750,000/185,000 = $9.46/per MHr
Receiving Orders $2,100,000/1,400 = $1,500/per order
Engineering Engineering hrs. $2,000,000/10,000 = $200/per eng. hour
Material handling Moves $900,000/900 = $1,000/per move
100
4–22 Continued

Overhead assignment:
X-12 S-15
Setup costs:
$800 × 100 $ 80,000
$800 × 200 $ 160,000
Machine costs:
$9.46 × 125,000 1,182,500
$9.46 × 60,000 567,600
Receiving costs:
$1,500 × 400 600,000
$1,500 × 1,000 1,500,000
Engineering costs:
$200 × 5,000 1,000,000
$200 × 5,000 1,000,000
Material-handling costs:
$1,000 × 500 500,000
$1,000 × 400 400,000
Total overhead costs $ 3,362,500 $ 3,627,600
Units produced ÷ 1,000,000 ÷ 200,000
Overhead cost per kg $ 3.36 $ 18.14
Prime cost per kg 4.27 3.13
Unit cost $ 7.63 $ 21.27
Selling price $ 15.93 $ 12.00
Less unit cost 7.63 21.27
Unit gross margin $ 8.30 $ (9.27)
101
4–22 Concluded

3. No. The cost of making X-12 is $7.63, much less than the amount indicated by
functional-based costing. The company can compete by lowering its price on
the high-volume product. The $10 price offered by competitors is not out of
line. The concern about selling below cost is unfounded.

4. The $12 price of compound S-15 is well below its cost of production. This ex-
plains why Pearson has no competition and why customers are willing to pay
$15, a price that is probably still way below competitors’ quotes.

5. The price of X-12 should be lowered to a competitive level and the price of S-15
increased so that a reasonable return is being earned.

4–23

1. Activity rates:

Testing products = $252,000/300 = $840 per setup


Purchasing materials = $36,000/1,800 = $20 per order
Machining = $252,000/21,000 = $12 per machine hour
Receiving = $60,000/2,500 = $24 per receiving hour

Overhead cost assignment:

Model A Model B
Testing products:
$840 × 200 $168,000
$840 × 100 $ 84,000
Purchasing materials:
$20 × 600 12,000
$20 × 1,200 24,000
Machining:
$12 × 12,000 144,000
$12 × 9,000 108,000
Receiving:
$24 × 750 18,000
$24 × 1,750 42,000
Total OH assigned $ 342,000 $258,000
102
2. New cost pools:

Testing products: $252,000 + [($252,000/$504,000) × $96,000] = $300,000


Machining: $252,000 + [($252,000/$504,000) × $96,000] = $300,000

New activity rates:

Testing products: $300,000/300 = $1,000 per setup


Machining: $300,000/21,000 = $14.29 per hour

Model A Model B
Testing products:
$1,000 × 200 $200,000
$1,000 × 100 $100,000
Machining:
$14.29 × 12,000 171,480
$14.29 × 9,000 128,610
Total OH assigned $371,480 $228,610

3. Percentage error:

Model A: ($371,480 – $342,000)/$342,000 = 0.086 (8.6%)


Model B: ($228,610 – $258,000)/$258,000 = –0.114 (11.4%)

The error is not bad and is certainly not in the range that is often seen when
comparing a plantwide rate assignment with the ABC costs. For example, if Model
A is expected to use 30% of the direct labor hours, then it would receive a plant-
wide assignment of $180,000, producing an error of more than 47%—an error al-
most six times greater than the approximately relevant assignment. In this type of
situation, it may be better to go with two drivers to gain acceptance and get rea-
sonably close to the more accurate ABC cost. It also avoids the data collection
costs of the bigger system.
103
4–24

1.

Welding $2,000,000
Machining 1,000,000
Setups 400,000
Total $3,400,000

Percentage of total activity costs = $3,400,000/$4,000,000= 85%.

2.

Allocation:

($2,000,000/$3,400,000) × $600,000 = $352,941


($1,000,000/$3,400,000) × $600,000 = $176,471
($400,000/$3,400,000) × $600,000 = $70,588

Cost pools:

Welding = $2,000,000 + $352,941 = $2,352,941


Machining = $1,000,000 + $176,471 = $1,176,471
Setups = $400,000 + $70,588 = $470,588

Activity rates:

Rate 1: Welding = $2,352,941/4,000 = $588 per welding hour Rate


2: Machining = $1,176,471/10,000 = $118 per machine hour Rate
3: Setups = $470,588/100 = $4,706 per batch

Overhead assignment:
Subassembly A Subassembly B
Rate 1:
$588 × 1,600 welding hours $ 940,800
$588 × 2,400 welding hours $1,411,200
Rate 2:
$118 × 3,000 machine hours 354,000
$118 × 7,000 machine hours 826,000
Rate 3:
104
$4,706 × 45 batches 211,770
$4,706 × 55 batches 258,830
Total overhead costs $1,506,570 $2,496,030
Units produced ÷ 1,500 ÷ 3,000
Overhead per unit $ 1,004 $ 832

3. Percentage error:

Error (Subassembly A) = ($1,004 – $1,108)/$1,108 = –0.094 (–9.4%)


Error (Subassembly B) = ($832 – $779)/$779 = 0.068 (6.8%)

The error is at most 10%. The simplification is simple and easy to implement.
Most of the costs (85%) are assigned accurately. Only three rates are used to as-
sign the costs, representing a significant reduction in complexity.
105
MANAGERIAL DECISION CASES

4–25

1. Shipping and warehousing costs are currently assigned using tons of paper
produced, a unit-based measure. Many of these costs, however, are not dri-ven
by quantity produced. Many products have special handling and shipping
requirements involving extra costs. These costs should not be assigned to
those products that are shipped directly to customers.

2. The new method proposes assigning the costs of shipping and warehousing
separately for the low-volume products. To do so requires three cost assign-
ments: receiving, shipping, and carrying. The cost drivers for each cost are
tons processed, items shipped, and tons sold.
Pool rate, receiving costs:
Receiving cost/Tons processed = $1,100,000/56,000 tons
= $19.64 per ton processed*
Pool rate, shipping costs:
Shipping cost per shipping item = $2,300,000/190,000
= $12.11 per shipping item*
Pool rate, carrying cost (an opportunity cost):
Carrying cost per year (LLHC) = 25 × $1,665 × 0.16 =
$6,660
Carrying cost per ton sold = $6,660/10 = $666
Shipping and warehousing cost per ton sold:
Receiving $ 19.64
Shipping ($12.11 × 7) 84.77
Carrying 666.00
Total $770.41
*Rounded
106
4–25 Continued

3. Profit analysis:
Revised profit per ton (LLHC):
Selling price $ 2,400.00
Less manufacturing cost 1,665.00
Gross profit $ 735.00
Less shipping and warehousing 770.41
Loss $ (35.41 )
Original profit per ton:
Selling price $ 2,400.00
Less manufacturing costs 1,665.00
Gross profit $ 735.00
Less shipping and warehousing 30.00
Profit $ 705.00
The revised profit, reflecting a more accurate assignment of shipping and wa-
rehousing costs, presents a much different picture of LLHC. The product is, in
reality, losing money for the company. Its earlier apparent profitability was
attributable to a subsidy being received from the high-volume products (by
spreading the special shipping and handling costs over all products, using
tons produced as the cost driver). The same effect is also true for the other
low-volume products. Essentially, the system is understating the handling
costs for low-volume products and overstating the cost for high-volume
products.

4. The decision to drop some high-volume products and emphasize low-volume


products could clearly be erroneous. As LLHC has demonstrated, its appar-ent
profitability is attributable to distorted cost assignments. A significant change
in the image of LLHC was achieved by simply improving the accuracy of
shipping and handling costs. Further improvements in accuracy in the
overhead assignments may cause the view of LLHC to deteriorate even more.
Conversely, the profitability of high-volume products may improve signifi-
cantly with increased costing accuracy. This example underscores the impor-
tance of having accurate and reliable accounting information. The accounting
system must bear the responsibility of providing reliable information.
107
4–25 Concluded

5. Ryan’s strategy changed because his information concerning the individual


products changed. Apparently, the accounting system was undercosting the
low-volume products and overcosting the high-volume products. Once better
information was available, Ryan was able to respond better to competitive
conditions.

4–26

1. Disagree. Chuck is expressing an uninformed opinion. He has not spent the


effort to find out exactly what activity-based management and costing are at-
tempting to do; therefore, he has no real ability to offer any constructive criti-
cism of the possible benefits of these two approaches.

2. and 3.
At first glance, it may seem strange to even ask if Chuck’s behavior is unethi-
cal. After all, what is unethical about expressing an opinion, albeit unin-
formed? While offering uninformed opinions or recommendations may be of
little consequence in many settings, a serious issue arises when a person’s
expertise is relied upon by others to make decisions or take actions that could
be wrong or harmful to themselves or their organizations. This very well may
be the case for Chuck’s setting, and his behavior may be labeled
professionally unethical.
Chuck’s lack of knowledge about activity-based systems is a signal of his
failure to maintain his professional competence. Standard I-1 of the IMA
Statement of Ethical Professional Practice indicates that management ac-
countants have a responsibility to continually develop their knowledge and
skills. Failure to do so is unethical.

RESEARCH ASSIGNMENT

4–27

Answers will vary.


108