7755

CHAPTER 4 ACTIVITY-BASED PRODUCT COSTING

QUESTIONS FOR WRITING AND DISCUSSION

1. Unit costs provide essential information needed for inventory valuation and prepara-tion of income statements. Knowing unit costs is also critical for many decisions such as bidding decisions and accept-or-reject special order decisions.

2. Cost measurement is determining the dollar amounts associated with resources used in production. Cost assignment is associating the dollar amounts, once measured, with units produced.

3. An actual overhead rate is rarely used be-cause of problems with accuracy and timeli-ness. Waiting until the end of the year to en-sure accuracy is rejected because of the need to have timely information. Timeliness of information based on actual overhead costs runs into difficulty (accuracy problems) because overhead is incurred nonuniformly and because production also may be non-uniform.

4. For plantwide rates, overhead is first col-lected in a plantwide pool, using direct trac-ing. Next, an overhead rate is computed and used to assign overhead to products.

5. First stage: Overhead is assigned to produc-tion department pools using direct tracing, driver tracing, and allocation. Second stage: Individual departmental rates are used to assign overhead to products as they pass through the departments.

6. Departmental rates would be chosen over plantwide rates whenever some depart-ments are more overhead intensive than others and if certain products spend more time in some departments than they do in others.

7. Plantwide overhead rates assign overhead to products in proportion to the amount of the unit-level cost driver used. If the prod-ucts consume some overhead activities in different proportions than those assigned by the unit-level cost driver, then cost dis-tortions can occur (the product diversity factor). These distortions can be significant if the nonunit-level overhead costs

represent a significant proportion of total overhead costs.

8. Low-volume products may consume non-unit-level overhead activities in much greater proportions than indicated by a unit-level cost driver and vice versa for high-volume products. If so, then the low-volume prod-ucts will receive too little overhead and the high-volume products too much.

9. If some products are undercosted and oth-ers are overcosted, a firm can make a num-ber of competitively bad decisions. For ex-ample, the firm might select the wrong product mix or submit distorted bids.

10. Nonunit-level overhead activities are those overhead activities that are not highly corre-lated with production volume measures. Ex-amples include setups, material handling, and inspection. Nonunit-level cost drivers are causal factors—factors that explain the consumption of nonunit-level overhead. Ex-amples include setup hours, number of moves, and hours of inspection.

11. Product diversity is present whenever prod-ucts have different consumption ratios for different overhead activities.

12. An overhead consumption ratio measures the proportion of an overhead activity con-sumed by a product.

13. Departmental rates typically use unit-level cost drivers. If products consume nonunit-level overhead activities in different propor-tions than those of unit-level measures, then it is possible for departmental rates to move even further away from the true consump-tion ratios, since the departmental unit-level ratios usually differ from the one used at the plant level.

14. Agree. Prime costs can be assigned using direct tracing and so do not cause cost dis-tortions. Overhead costs, however, are not directly attributable and can cause distor-tions. For example, using unit-level activity drivers to trace nonunit-level overhead costs would cause distortions.

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15. Activity-based product costing is an over-head costing approach that first assigns costs to activities and then to products. The assignment is made possible through the identification of activities, their costs, and the use of cost drivers.

16. An activity dictionary is a list of activities accompanied by information that describes each activity (called attributes)

17. A primary activity is consumed by the final cost objects such as products and custom-ers, whereas secondary activities are con-sumed by other activities (ultimately con-sumed by primary activities).

18. Costs are assigned using direct tracing and resource drivers.

19. Unit-level activities are those that occur each time a product is produced. Batch-level activi-

ties are those that are performed each time a batch of products is produced. Product-level or sustaining activities are those that are performed as needed to support the various products produced by a company. Facility-level activities are those that sustain a facto-ry’s general manufacturing process

20. Rates can be reduced by building a system that approximates the cost assignments of a fully specified ABC system. One way to do this is by using only the most expensive ac-tivities to assign costs. If the most expensive activities represent a large percentage of the total costs, then most of the costs are as-signed using a cause-and-effect relation-ship, thus creating a good level of accuracy while reducing the complexity of the ABC system.

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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.

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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

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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.

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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

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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 Inspection hours 0.20a 0.80a Setup hours 0.50b 0.50b Machine hours 0.25c 0.75c Number of moves 0.75d 0.25d 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).

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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

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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.

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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.

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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

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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

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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.

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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.

9999

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

110000

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

110011

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)

110022

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

110033

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.

110044

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:

110055

$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.

110066

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

110077

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.

110088

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.