MANAGEMENT ACCOUNTING- Solutions Manual

CHAPTER 9

SYSTEMS DESIGN: ACTIVITY-BASED COSTING

AND MANAGEMENT

I. Questions
1. The three levels available are: Level 1, in which a company uses a
plantwide overhead rate; Level 2, in which a company uses departmental
overhead rates; and Level 3, in which a company uses activity-based
costing.
2. New approaches to costing are needed because events of the last few
decades have made drastic changes in many organizations. Automation
has greatly decreased the amount of direct labor required to manufacture
products; product diversity has increased in that companies are
manufacturing a wider range of products and these products differ
substantially in volume, lot size, and complexity of design; and total
overhead cost has increased to the point in some companies that a
correlation no longer exists between it and direct labor.
3. The departmental approach to assigning overhead cost to products relies
solely on volume as an assignment base. Where diversity exists between
products (that is, where products differ in terms of number of units
produced, lot size, or complexity of production), volume alone is not
adequate for overhead costing. Overhead costing based on volume will
systematically overcost high-volume products and undercost low-volume
products.
4. Process value analysis (PVA) is a systematic approach to gaining an
understanding of the steps associated with a product or service. It
identifies all resource-consuming activities involved in the production
process and labels these activities as being either value-added or non-
value-added. Thus, it is the beginning point in designing an activity-
based costing system since management must know what activities are
involved with each product before activity centers can be designated and
cost drivers established. Also, PVA helps management to eliminate any
non-value-added activities and thereby streamline operations and
minimize costs.
5. The four general levels of activities are:

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1. Unit-level activities, which are performed each time a unit is

produced.
2. Batch-level activities, which are performed each time a batch of
goods is handled or processed.
3. Product-level activities, which are performed as needed to support
specific products.
4. Facility-level activities, which simply sustain a facility’s general
manufacturing process.
6. First, activity-based costing increases the number of cost pools used to
accumulate overhead costs. Second, it changes the base used to assign
overhead costs to products. And third, it changes a manager’s
perception of many overhead costs in that costs that were formerly
thought to be indirect (such as depreciation or machine setup) are
identified with specific activities and thereby are recognized as being
traceable to individual products.
7. The two chief limitations are: First, the portion of overhead costs that
relate to facility-level activities are still usually allocated to products on
some arbitrary basis, such as machine-hours or direct labor-hours.
Critics of activity-based costing argue that facility-level activities
account for the bulk of all overhead costs in some companies. Second,
high measurement costs are involved in operating an activity-based
costing system. That is, the system requires the tracking of large
amounts of detail and the completion of many separate computations in
order to determine the cost of a unit or product.
8. Yes, activity-based costing can be used in service organizations. It has
been successfully implemented, for example, in railroads, hospitals,
banks and data service companies.
9. A resource driver is a measure of the quality of resources consumed by
an activity.
10. An activity driver is a measure of frequency and intensity of demands
placed on activities by cost objects.
11. Two-stage allocation is a procedure that first assigns a firm’s resource
costs, namely factory overhead cost, to cost pools, and then to cost
objects.

12. Two major advantages of ABM are:

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a. ABM measures the effectiveness of the key business processes and

activities, and identifies how they can be improved to reduce costs
and improve the customer value.
b. ABM improves the management focus by allocating resources to key
value-added activities, key customers, key products, and continuous
improvement methods to maintain the firm’s competitive advantage.
13. When direct labor is used as an allocation base for overhead, it is
implicitly assumed that overhead cost is directly proportional to direct
labor. When cost systems were originally developed in the 1800s, this
assumption may have been reasonably accurate. However, direct labor
has declined in importance over the years while overhead has been
increasing. This suggests that there is no longer a direct link between the
level of direct labor and overhead. Indeed, when a company automates,
direct labor is replaced by machines; a decrease in direct labor is
accompanied by an increase in overhead. This violates the assumption
that overhead cost is directly proportional to direct labor. Overhead cost
appears to be driven by factors such as product diversity and complexity
as well as by volume, for which direct labor has served as a convenient
measure.
14. Employees may resist activity-based costing because it changes the
“rules of the game.” ABC changes some of the key measures, such as
product costs, used in making decisions and may affect how individuals
are evaluated. Without top management support, employees may have
little interest in making these changes. In addition, if top managers
continue to make decisions based on the numbers generated by the
traditional costing system, subordinates will quickly conclude that the
activity-based costing system can be ignored.
15. Unit-level activities are performed for each unit that is produced. Batch-
level activities are performed for each batch regardless of how many
units are in the batch. Product-level activities must be carried out to
support a product regardless of how many batches are run or units
produced. Customer-level activities must be carried out to support
customers regardless of what products or services they buy.
Organization-sustaining activities are carried out regardless of the
company’s precise product mix or mix of customers.
16. Organization-sustaining costs, customer-level costs, and the costs of idle
capacity should not be assigned to products. These costs represent
resources that are not consumed by the products.

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II. True or False

1. True 3. False 5. False 7. True

2. True 4. True 6. False 8. True

III. Exercises

Exercise 1
Examples of Examples of
Activity Traceable Cost
Activity Classification Costs Drivers
a. Materials are Batch-level Labor cost; Number of
moved from the depreciation receipts;
receiving dock to pounds
of equipment;
product flow lines handled
space cost
by a material-
handling crew
b. Direct labor Unit-level Direct labor Direct labor-
workers assemble cost; indirect hours
various products labor cost;
labor benefits
c. Ongoing training is Facility-level* Space cost; Hours of
provided to all training costs; training time;
employees in the administration number
company costs trained
d. A product is Product-level Space cost; Hours of
designed by a supplies used; design time;
specialized design depreciation of number of
team design engineering
equipment change orders
e. Equipment setups Batch-level Labor cost; Number of
are performed on a supplies used; setups; hours
regular basis depreciation of or setup time
equipment
f. Numerical control Unit-level Power; Machine-
(NC) machines are supplies used; hours; number
used to cut and maintenance; of units
shape materials depreciation

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* Personnel administration and training costs might be traceable in part to the

facility-level and in part to other activity centers at the unit-level, product-
level, and batch-level.

Exercise 2

1. plantwide overhead rate 6. Batch-level

2. volume 7. Product-level
3. two stage, stage, stage 8. Facility-level
4. Process value analysis 9. high-volume, low-volume, low-volume
5. Unit-level 10. activity centers

Exercise 3

a. Various individuals manage the parts

inventories. Product-level
b. A clerk in the factory issues purchase orders for
a job. Batch-level
c. The personnel department trains new production Organization-
workers. sustaining
d. The factory’s general manager meets with other
department heads such as marketing to Organization-
coordinate plans. sustaining
e. Direct labor workers assemble products. Unit-level
f. Engineers design new products. Product-level
g. The materials storekeeper issues raw materials to
be used in jobs. Batch-level
h. The maintenance department performs periodic
preventative maintenance on general-use Organization-
equipment. sustaining

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

Exercise 4

Sales (P1,650 per standard model glider × 10 standard

model gliders + P2,300 per custom designed glider ×
2 custom designed gliders)...................................................................................
P21,100
Costs:

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Direct materials (P462 per standard model glider ×

10 standard model gliders + P576 per custom
designed glider × 2 custom designed gliders).................................................
P5,772
Direct labor (P19 per direct labor-hour × 28.5 direct
labor-hours per standard model glider × 10
standard model gliders + P19 per direct labor-hour
× 32 direct labor-hours per custom designed glider
× 2 custom designed gliders)...........................................................................
6,631
Supporting manufacturing (P18 per direct labor-hour
× 28.5 direct labor-hours per standard model
glider × 10 standard model gliders + P18 per
direct labor-hour × 32 direct labor-hours per
custom designed glider × 2 custom designed
gliders)..............................................................................................................
6,282
Order processing (P192 per order × 3 orders).....................................................
576
Custom designing (P261 per custom design × 2
custom designs)................................................................................................
522
Customer service (P426 per customer ×
1 customer).......................................................................................................
   426  20,209
Customer margin......................................................................................................
P    891

Exercise 5

Requirement 1

The predetermined overhead rate is computed as follows:

Predetermined P290,000
= = P5.80 per DLH
overhead rate 50,000 DLHs

The unit product costs under the company’s traditional costing system are
computed as follows:
Special Regular
Direct materials................................................................................................................
P60.00 P45.00
Direct labor......................................................................................................................
9.60 7.20
Manufacturing overhead (0.8 DLH × P5.80 per DLH;
0.6 DLH × P5.80 per DLH)........................................................................................
   4.64    3.48
Unit product cost..............................................................................................................
P74.24 P55.68
Requirement 2

The activity rates are computed as follows:

(a)
Estimate (b)

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d
Overhead Total (a) ÷ (b)
Activities Cost Expected Activity Activity Rate
Supporting direct labor..............................
P150,000 50,000 DLHs P3 per DLH
Batch setups...............................................
P60,000 250 setup P24 per setup
s 0
Safety testing..............................................
P80,000 100 tests P80 per test
0

Manufacturing overhead is assigned to the two products as follows:

Special Product:
(a) (b) (a) × (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labor........................................................ P3 per DLH 8,000 DLHs P24,000
Batch setups.........................................................................
P240 per setup 200 setups 48,000
Safety testing........................................................................
P800 per test 80 tests    64,000
Total P136,000

Regular Product:
(a) (b) (a) × (b)
Activity Cost Pool Activity Rate Activity ABC Cost
Supporting direct labor........................................................ P3 per DLH 42,000 DLHs P126,000
Batch setups.........................................................................
P240 per setup 50 setups 12,000
Safety testing........................................................................
P800 per test 20 tests    16,000
Total P154,000

Activity-based costing unit product costs are computed as follows:

Special Regular
Direct materials...................................................................................................
P60.00 P45.00
Direct labor.........................................................................................................
9.60 7.20
Manufacturing overhead (P136,000 ÷ 10,000 units; P154,000
÷ 70,000 units)...............................................................................................
 13.60    2.20
Unit product cost.................................................................................................
P83.20 P54.40

IV. Problems

Problem 1

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Cost Pool Cost Driver Cost

Systems Rate Consumption Assignment
Traditional cost system 350% P10,000 P35,000
ABC system
Labor 10% P10,000 P 1,000
Machining P25/hour 800 hours 20,000
Setup P10/hour 100 hours 1,000
Production order P100/order 12 orders 1,200
Material handling P20/requisition 5 requisitions 100
Parts administration P40/part 18 parts 720
P24,020
Problem 2

Requirement 1

(a)
Total overhead = P200,000 + P32,000 + P100,000 + P120,000
= P452,000

Overhead rate = P452,000 / 50,000 direct labor hours

= P9.04 per direct labor hour

Overhead assigned to proposed job = P9.04 x 1,000 direct labor hours

= P9,040

(b) Total cost of proposed job:

Direct materials P 6,000
Direct labor 10,000
Overhead applied 9,040
Total cost P25,040

(c) Company’s bid = Full manufacturing cost x 120% = P25,040 x 120%

= P30,048

Requirement 2

(a) Maintenance : P200,000 / 20,000 = P10 per machine hour

Materials handling: P32,000 / 1,600 = P20 per move

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Setups: P100,000 / 2,500 = P40 per setup

Inspection: P120,000 / 4,000 = P30 per inspection

Overhead assigned to proposed job:

Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspection (P30 x 10) 300
Total overhead assigned to job P5,620

(b) Total cost of proposed project:

Direct materials P 6,000
Direct labor 10,000
Overhead applied 5,620
Total cost P21,620

(c) Company’s bid = Full manufacturing cost x 120% = P21,620 x 120%

= P25,944

The bid price of P25,944 was determined as follows:

Direct materials P6,000
Direct labor 10,000
Overhead assigned:
Maintenance (P10 x 500) P5,000
Material handling (P20 x 12) 240
Setups (P40 x 2) 80
Inspections (P30 x 10) 300
Total overhead assigned to job 5,620
Total cost P21,620
Markup 120%
Bid price P25,944

Problem 3 (Activity-Based Costing)

Requirement 1

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

Activity Cost Pools

Assemblin Processing Supporting
g Units Orders Customers Other Total
Manufacturing
overhead P250,000 P175,000 P25,000 P50,000 P500,000
Selling and
administrative
overhead 30,000 135,000 75,000 60,000 300,000
Total cost P280,000 P310,000 P100,000 P110,000 P800,000

Requirement 2

The activity rates for the cost pools are:

(a) (b) (a)  (b)

Total Cost Total Activity Activity Rate
Assembling units P280,000 1,000 units P280 per unit
Processing orders P310,000 250 orders P1,240 per order
Supporting customers P1,000 per
P100,000 100 customers customer

Requirement 3

The overhead cost attributable to Lucky Sale would be computed as follows:

(a) (b) (a) x (b)

Activity Cost Pools Activity Rate Activity ABC Cost
Assembling units P280 per unit 80 units P22,400
Processing orders P1,240 per order 4 orders P4,960
Supporting customers P1,000 per customer 1 customer P1,000

Requirement 4

The customer margin can be computed as follows:

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Sales (P595 per unit x 80 units) P47,600

Costs:
Direct materials (P180 per unit x 80 units) P14,400
Direct labor (P50 per unit x 80 units) 4,000
Unit-related overhead (above) 22,400
Order-related overhead (above) 4,960
Customer-related overhead (above) 1,000 46,760
Customer margin P 840

Problem 4 (Activity-Based Costing as an Alternative to Traditional

Product Costing)

Requirement 1

a. When direct labor-hours are used to apply overhead cost to products, the
company’s predetermined overhead rate would be:
Predetermined Manufacturing overhead cost
=
overhead rate Direct labor hours

P1,480,000
= = P74 per DLH
20,000 DLHs

b. Model
HY5 AS2
Direct materials......................................................................
P35.00 P25.00
Direct labor:
P20 per hour × 0.2 DLH, 0.4 DLH.................................... 4.00 8.00
Manufacturing overhead:
P74 per hour × 0.2 DLH, 0.4 DLH....................................  14.80  29.60
Total unit product cost...........................................................
P53.80 P62.60

Requirement 2

a. Predetermined overhead rates for the activity cost pools:

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(a) (b)
Estimated Estimated (a) ÷ (b)
Activity Cost Pool Total Cost Total Activity Activity Rate
Machine setups................P180,000 250 setups P720 per setup
Special milling.................P300,000 1,000 MHs P300 per MH
General factory................
P1,000,000 20,000 DLHs P50 per DLH

The overhead applied to each product can be determined as follows:

Model HY5
(a) (a) × (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups....................................................................................
P720 per setup 150 setups P108,000
Special milling....................................................................................
P300 per MH 1,000 MHs 300,000
General factory....................................................................................
P50 per DLH 4,000 DLHs  200,000
Total manufacturing overhead cost (a)............................................... P608,000
Number of units produced (b)............................................................. 20,000
Overhead cost per unit (a) ÷ (b).......................................................... P30.40

Model AS2
(a) (a) × (b)
Predetermined (b) Overhead
Activity Cost Pool Overhead Rate Activity Applied
Machine setups....................................................................................
P720 per setup 100 setups P 72,000
Special milling....................................................................................
P300 per MH 0 MHs 0
General factory....................................................................................
P50 per DLH 16,000 DLHs  800,000
Total manufacturing overhead cost (a)............................................... P872,000
Number of units produced (b)............................................................. 40,000
Overhead cost per unit (a) ÷ (b).......................................................... P21.80

b. The unit product cost of each model under activity-

based costing would be computed as follows:
Model
HY5 AS2
Direct materials........................................................................................................
P35.00 P25.00

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Direct labor (P20 per DLH × 0.2 DLH; P20 per DLH × 04.DLH).......................... 4.00 8.00
Manufacturing overhead (above).............................................................................
 30.40  21.80
Total unit product cost..............................................................................................
P69.40 P54.80

Comparing these unit cost figures with the unit costs in Part 1(b), we
find that the unit product cost for Model HY5 has increased from P53.80
to P69.40, and the unit product cost for Model AS2 has decreased from
P62.60 to P54.80.

Requirement 3

It is especially important to note that, even under activity-based costing, 68%

of the company’s overhead costs continue to be applied to products on the
basis of direct labor-hours:
Machine setups (number of setups)............................P  180,000 12%
Special milling (machine-hours)................................ 300,000 20
General factory (direct labor-hours)........................... 1,000,000  68
Total overhead cost....................................................P1,480,000 100%

Thus, the shift in overhead cost from the high-volume product (Model AS2)
to the low-volume product (Model HY5) occurred as a result of reassigning
only 32% of the company’s overhead costs.

The increase in unit product cost for Model HY5 can be explained as
follows: First, where possible, overhead costs have been traced to the
products rather than being lumped together and spread uniformly over
production. Therefore, the special milling costs, which are traceable to
Model HY5, have all been assigned to Model HY5 and none assigned to
Model AS2 under the activity-based costing approach. It is common in
industry to have some products that require special handling or special
milling of some type. This is especially true in modern factories that produce
a variety of products. Activity-based costing provides a vehicle for assigning
these costs to the appropriate products.

Second, the costs associated with the batch-level activity (machine setups)
have also been assigned to the specific products to which they relate. These
costs have been assigned according to the number of setups completed for
each product. However, since a batch-level activity is involved, another
factor affecting unit costs comes into play. That factor is batch size. Some
products are produced in large batches and some are produced in small

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batches. The smaller the batch, the higher the cost per unit of the batch
activity. In the case at hand, the data can be analyzed as shown below.
Model HY5:
Cost to complete one setup [see 2(a)]....................................... P720 (a)
Number of units processed per setup
(20,000 units ÷ 150 setups)...................................................133.33 (b)
Setup cost per unit (a) ÷ (b)...................................................... P5.40
Model AS2:
Cost to complete one setup (above).......................................... P720 (a)
Number of units processed per setup
(40,000 units ÷ 100 setups)................................................... 400 (b)
Setup cost per unit (a) ÷ (b)...................................................... P1.80

Thus, the cost per unit for setups is three times as great for Model HY5, the
low-volume product, as it is for Model AS2, the high-volume product.
Such differences in cost are obscured when direct labor-hours (or any other
volume measure) is used as the basis for applying overhead cost to
products.

In sum, overhead cost has shifted from the high-volume product to the low-
volume product as a result of more appropriately assigning some costs to
the products on the basis of the activities involved, rather than on the basis
of direct labor-hours.

V. Multiple Choice Questions

1. A 11. B 21. D
2. D 12. D 21. A
3. C 13. C 22. B
4. B 14. A 23. A
5. A 15. C 24. B

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6. D 16. D 25. D
7. A 17. D 26. B
8. B 18. C 27. C
9. D 19. B 28. A
10. C 20. A 29. C

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