CHAPTER 4

Activity-Based COSTING

CHAPTER LEARNING OBJECTIVES

1. Discuss the difference between traditional costing and activity-based costing. A traditional costing system assigns overhead to products on the basis of predetermined plantwide or departmentwide rates such as direct labor or machine hours. An ABC system allocates overhead to identified activity cost pools and then assigns costs to products using related cost drivers that measure the activities (resources) consumed.

The development of an activity-based costing system involves the following four steps. (1) Identify and classify the major activities involved in the manufacture of specific products and allocate overhead to cost pools. (2) Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool and total estimated annual cost driver usage. (3) Compute the activity-based overhead rate for each cost pool. (4) Assign overhead costs to products using the overhead rates determined for each cost pool and each product’s use of each cost driver.

2. Apply activity-based costing to a manufacturer. To identify activity cost pools, a company must perform an analysis of each operation or process, documenting and timing every task, action, or transaction. Cost drivers identified for assigning activity cost pools must (a) accurately measure the actual consumption of the activity by the various products and (b) have related data easily available. The overhead allocated to each activity cost pool is divided by the estimated use of cost drivers to determine the activity-based overhead rate for each pool. Overhead is assigned to products by multiplying a particular product’s use of a cost driver by the activity-based overhead rate. This is done for each activity cost pool and then summed.

3. Explain the benefits and limitations of activity-based costing. Features of ABC that make it a more accurate product costing system include (1) the increased number of cost pools used to assign overhead (including use of the activity-level hierarchy), (2) the enhanced control over overhead costs (including identification of non-value-added activities), and (3) the better management decisions it makes possible. The limitations of ABC are (1) the higher analysis and measurement costs that accompany multiple activity centers and cost drivers, and (2) the necessity still to assign some costs arbitrarily.

4. Apply activity-based costing to service industries. The overall objective of using ABC in service industries is no different than for manufacturing industries—that is, improved costing of services performed (by job, service, contract, or customer). The general approach to costing is the same: analyze operations, identify activities, accumulate overhead costs by activity cost pools, and identify and use cost drivers to assign the cost pools to the services.

^a5. Explain just-in-time (JIT) processing. JIT is a processing system dedicated to having on hand the right materials and products just at the time they are needed, thereby reducing the amount of inventory and the time inventory is held. One of the principal accounting effects is that one account, Raw and In-Process Inventory, replaces both the raw materials and work in process inventory accounts.

TRUE-FALSE STATEMENTS

1. Traditional costing systems use multiple predetermined overhead rates.

2. Traditionally, overhead has been assigned based on direct labor cost or direct labor hours.

3. Current trends in manufacturing include less direct labor and more overhead.

4. Activity-based costing allocates overhead to multiple activity cost pools and assigns the cost pools to products using cost drivers.

5. A cost driver does not generally have a direct cause-effect relationship with the resources consumed.

6. The first step in activity-based costing is to assign overhead costs to products using cost drivers.

7. To achieve accurate costing, a high degree of correlation must exist between the cost driver and the actual consumption of the activity cost pool.

8. Low-volume products often require more special handling than high-volume products.

9. When overhead is properly assigned in ABC, it will usually decrease the unit cost of high-volume products.

10. ABC leads to enhanced control over overhead costs.

11. ABC usually results in less appropriate management decisions.

12. ABC is generally costlier to implement than traditional costing.

13. ABC eliminates all arbitrary cost allocations.

14. ABC is particularly useful when product lines differ greatly in volume and manufacturing complexity.

15. ABC is particularly useful when overhead costs are an insignificant portion of total costs.

16. Activity-based management focuses on reducing costs and improving processes.

17. Any activity that increases the cost of producing a product is an value-added activity.

18. Engineering design is an value-added activity.

19. Non-value-added activities increase the cost of a product but not its perceived value.

20. Machining is a non-value-added activity.

21. Not all activities labeled nonessential are totally wasteful nor can they be totally eliminated.

22. Plant management is a batch-level activity.

23. Painting is a product-level activity.

24. The overall objective of using ABC in a service firm is the same that it is in a manufacturer.

25. What sometimes makes implementation of activity-based costing difficult in service industries is that a smaller proportion of overhead costs are company-wide costs.

26. The same general approach to identifying activities, activity cost pools, and cost drivers is used by a service company as by a manufacturing company.

^a27. Just-in-time strives to eliminate inventories by using a pull approach.

^a28. Quality control is less important in just-in-time than in traditional manufacturing philosophies.

^a29. Inventory storage costs are reduced in just-in-time processing.

^a30. Rework costs typically increase in just-in-time processing.

MULTIPLE CHOICE QUESTIONS

31. Which of the following is not typical of traditional costing systems?

a. Use of a single predetermined overhead rate.

b. Use of direct labor hours or direct labor cost to assign overhead.

c. Assumption of correlation between direct labor and incurrence of overhead cost.

d. Use of multiple cost drivers to allocate overhead.

32. In traditional costing systems, overhead is generally applied based on

a. direct labor.

b. machine hours.

c. direct material dollars.

d. units of production.

33. An activity that has a direct cause-effect relationship with the resources consumed is a(n)

a. cost driver.

b. overhead rate.

c. cost pool.

d. product activity.

34. Which best describes the flow of overhead costs in an activity-based costing system?

a. Overhead costs  direct labor cost or hours  products

b. Overhead costs  products

c. Overhead costs  activity cost pools  cost drivers  products

d. Overhead costs  machine hours  products

35. The costs that are easiest to trace directly to products are

a. direct materials and direct labor.

b. direct labor and overhead.

c. direct materials and overhead.

d. none of the above; all three costs are equally easy to trace to the product.

36. Often the most difficult part of computing accurate unit costs is determining the proper amount of _________ to assign to each product, service, or job.

a. direct materials

b. direct labor

c. overhead

d. direct materials and direct labor

37. Predetermined overhead rates in traditional costing are often based on

a. direct labor cost for job order costing and machine hours for process costing.

b. machine hours for job order costing and direct labor cost for process costing.

c. multiple bases for job order costing and direct labor cost for process costing.

d. multiple bases for both job order costing and process costing.

38. Direct labor is sometimes the appropriate basis for assigning overhead cost to products. It is appropriate to use direct labor when which of the following is true?

(1) Direct labor constitutes a significant part of total product cost.

(2) A high correlation exists between direct labor and changes in the amount of overhead costs.

a. (1) only

b. (2) only

c. Either (1) or (2)

d. Both (1) and (2)

39. Advances in computerized systems, technological innovation, global competition, and automation have changed the manufacturing environment drastically by

a. increasing direct labor costs and increasing overhead costs.

b. increasing direct labor costs and decreasing overhead costs.

c. decreasing direct labor costs and decreasing overhead costs.

d. decreasing direct labor costs and increasing overhead costs.

40. Activity-based costing

a. allocates overhead to activity cost pools and then assigns the activity cost pools to products and services by means of cost drivers.

b. accumulates overhead in one cost pool and then assigns the overhead to products and services by means of a cost driver.

c. assigns activity cost pools to products and services and then allocates overhead back to the activity cost pools.

d. allocates overhead directly to products and services based on activity levels.

41. The costs associated with ordering materials, setting up machines, assembling products, and inspecting products are examples of

a. cost drivers.

b. activity pools.

c. direct labor costs.

d. nonmanufacturing activities.

42. Which cost driver would an “Ordering and Receiving Materials” cost pool most likely have?

a. machine hours

b. number of setups

c. number of purchase orders

d. number of inspection tests

43. Hartley Company produces two products, Flower and Planter. Flower is a high-volume item totaling 20,000 units annually. Planter is a low-volume item totaling only 6,000 units per year. Flower requires one hour of direct labor for completion, while each unit of Planter requires 2 hours. Therefore, total annual direct labor hours are 32,000 (20,000 + 12,000). Estimated annual manufacturing overhead costs are $960,000. Hartley uses a traditional costing system and assigns overhead based on direct labor hours. Each unit of Planter would be assigned overhead of

a. $30.00.

b. $36.91.

c. $60.00.

d. need more information to compute.

Ex. 172

Hayward Industries manufactures dining chairs and tables. The following information is available regarding the two products and their estimated use of cost drivers:

Dining Chairs Tables Estimated Cost

Machine setups 200 600 $48,000

Inspections 250 470 $72,000

Labor hours 2,600 2,400

Hayward is considering switching from one overhead rate based on labor hours to ABC.

Instructions

Perform the following analyses for these two components of overhead:

a. Compute total machine setups and inspection costs assigned to each product, using a single overhead rate.

b. Compute total machine setups and inspection costs assigned to each product, using activity-based costing.

c. Comment on your findings.

Ex. 173

Randel Manufacturing has five activity cost pools and two products (a budget tape vacuum and a deluxe tape vacuum). Information is presented below:

Est. Use of Cost Drivers

Activity Cost Pools Cost Driver Est. Overhead Budget Deluxe

Ordering and Receiving Orders $ 130,000 600 400

Machine Setup Setups 297,000 500 400

Machining Machine hours 1,000,000 150,000 100,000

Assembly Parts 1,600,000 1,200,000 800,000

Inspection Inspections 300,000 550 450

Instructions

Ex. 174

Horton, Reiser, and Associates, a law firm, employs ABC. The following Estimated data for each of the activity cost pools is provided for 2022:

Estimated Estimated Use of

Activity Cost Pools Overhead Cost Drivers per Activity

Researching legal issues $ 31,500 900 research hours

Preparing legal documents 480,000 30,000 pages

Meeting with clients 1,760,000 8,800 professional hours

During 2022, the firm worked 660 research hours, 10,000 professional hours, and prepared 25,000 document pages.

Instructions

Compute the total overhead applied during the year 2022.

Ex. 175

Nancy Lake owns a small department store in a metropolitan area. For twenty years, the accountant has assigned overhead to the various departments—Women’s Apparel, Men’s Apparel, Cosmetics, Housewares, Shoes, and Electronics—based on the basis of employee hours worked. Nancy Lake’s daughter, who is an accounting student at a local university, has suggested her mother should consider using activity-based costing (ABC). In an attempt to implement ABC, Nancy Lake and her daughter have identified the following activities.

Instructions

Determine a cost driver for each of the activities listed below.

Cost Pool Cost Driver

a. Placing orders ______________________________

b. Stocking merchandise ______________________________

c. Waiting on customers ______________________________

d. Janitorial and maintenance ______________________________

e. Training employees ______________________________

f. Administrative ______________________________

g. Advertising and Marketing ______________________________

h. Accounting and Legal Services ______________________________

i. Wrapping packages ______________________________

Ex. 176

A list of possible cost drivers is presented below:

Code Code

A Engineering hours D Number of subassemblies

B Setups E Boxes

C Machine hours F Orders

Instructions

For each of the following activity cost pools, select the most appropriate cost driver:

Code Cost Pool

_____ 1. Machine setup

_____ 2. Ordering and receiving

_____ 3. Packaging and shipping

_____ 4. Engineering design

_____ 5. Machining

_____ 6. Assembly

Ex. 177

Identify appropriate cost drivers for the following activity cost pools:

1. Human resources

2. Security

3. Receiving

4. Data processing

Ex. 178

Two of the activity cost pools for Molina Company are (a) machining ($325,000) and (b) inspections ($42,000). Possible cost drivers are direct labor hours (2,550), machine hours (12,500), square footage (2,000), and number of inspections (200).

Instructions

Compute the overhead rate for each activity using the most relevant cost driver.

Ex. 179

Sutton Industries produces two models of televisions, Standard and Luxury. It sells 100,000 Standard televisions and 15,000 Luxury televisions annually. Sutton switched from traditional costing to activity-based costing and discovered that the cost assigned to Luxury televisions increased so dramatically that the Luxury was now only marginally profitable.

Instructions

Give a probable explanation for this shift.

Ex. 180

Compute activity-based cost rates from the following Estimated data for Upton Golf Co.:

Activity Cost Pool Estimated Overhead Estimated Cost Driver

Designing $2,550,000 75,000 designer hours

Machining 525,000 21,000 machine hours

Packing 620,000 31,000 labor hours

EX. 181

We Store It Company rents storage units of various sizes to individuals and companies. The following activities have been identified as activity cost pools for accumulating overhead and assigning it to rental services provided. (a) repairs, (b) customer setups, (c) employee training, (d) supplies ordering, (e) temperature/humidity control, (f) security, and (g) cleaning.

Instructions

For each activity, identify a cost driver that might be used to assign overhead costs.

Ex. 182

American Delights manufactures a wide variety of holiday and seasonal decorative items. American’s activity-based costing overhead rates are:

Purchasing $380 per order

Storing $2 per square foot/days

Machining $100 per machine hour

Supervision $5 per direct labor hour

The Snow Man project involved 3 purchase orders, 4,000 square feet/days, 60 machine hours, and 40 direct labor hours. The cost of direct materials on the job was $19,000 and the direct labor rate is $30 per hour.

Instructions

Determine the total cost of the Snow Man project.

Ex. 183

Label the following costs as value-added (VA) or non-value-added (NVA):

____ 1. Engineering design

____ 2. Machine repair

____ 3. Inventory storage

____ 4. Machining

____ 5. Assembly

____ 6. Painting

____ 7. Inspections

____ 8. Packaging

Ex. 184

The Parton and Sons law firm uses activity-based costing. Classify these activities as value-added or non-value-added:

1. Taking appointments

2. Reception

3. Meeting with clients

4. Bookkeeping

5. Court time

6. Meeting with opposing attorneys

7. Billing

8. Advertising

Ex. 185

Merando Manufacturing Company manufactures small tools. Classify each of the following activity costs of the tool company as either unit-level, batch-level, product-level, or facility-level:

1. Plant management

2. Drilling

3. Painting

4. Machine setups

5. Product design

6. Cutting

7. Inspection

8. Inventory management

Ex. 186

Castleman, Inc. designs, prints, and delivers advertising copy for companies throughout the tri-state area. Sometimes this entails designing and printing a single copy and other times multiple copies of the same advertisement. Listed below are typical activity costs:

1. Printer ink.
2. Paper
3. Depreciation on equipment
4. Machine setup costs
5. Designing
6. Supervisory salaries
7. Ordering materials
8. Delivery
9. Building insurance
10. Printing

Instructions

Classify each of these activities as either unit-level, batch-level, product-level, or facility-level.

Ex. 187

Jayson Woods, PSC is an architectural firm that uses activity-based costing. The three activity cost pools used by Jayson Woods are: Salaries and Wages, Travel Expense, and Plan Reproduction Expense. The firm has provided the following information concerning activity and costs:

Salaries and wages $430,000

Travel expense 100,000

Plan reproduction expense 120,000

Total $650,000

Estimated Use of Cost Driver per Service

Project Business

Assignment Development Other

Salaries and wages 60% 30% 10%

Travel expense 40% 40% 20%

Plan reproduction expense 35% 40% 25%

Instructions

Calculate the total cost to be allocated to the (a) Project Assignment, (b) Business Development, and (c) Other activity cost pools.