Activity-Based Costing: Answers To Review Questions

CHAPTER 8
ACTIVITY-BASED COSTING
ANSWERS TO REVIEW QUESTIONS
8.1 A traditional volume-based costing system refers to a system for applying overhead to products on the
basis of data that varies with the volume of production. The overhead rates are therefore often based on
direct labour hours, amount of direct material, direct labour cost, machine hours or number of units
produced.
8.2 In modern manufacturing environments problems have increased in the last few decades due to
increased automation, the increase in the proportion of total cost that is classified as overhead, and the
increase in the costs themselves. The misallocation of overhead due to using traditional volume-based
data becomes a greater problem when the amount of overhead being misallocated grows in size.
However, increasingly large amounts of overhead are now not dependent on output volumes. For
example, large volumes of output can come from a few large batches and a product with low total
production may need to be produced in small batches. The costs associated with reconfiguring
processing equipment and other setup costs that are incurred for a batch do not change in amount
according to production-volume-based variables, such as direct labour hours or machine hours. These
volume-based data do not, therefore, ‘drive’ the costs. In fact they can result in the over-allocation of
setup costs to large-batch products and under-allocation to small-batch products, with one subsidising
the other.
8.3 Production managers wanting to drop products they believe are too costly to make is an indicator that the
product costing system is not being used correctly, is out of date or has been set up incorrectly to capture
costing information. Other common indicators that the costing system is no longer appropriate for the
current operating environment of the firm include when profit margins are difficult to explain; complex
products appear to have high profit margins; production and marketing managers develop supplementary
costing systems upon which they place greater credence; frequent requests for special costing studies;
some products do not have any competition in the market whereas others appear to have a market price
below or marginally above the cost of production; price increases do not affect demand; bids for complex
products are easily won but bids for simple products are not competitive.
8.4 The vertical dimension is the cost assignment dimension, where the costs of resources are assigned to
activities using resource drivers. Then activity costs are assigned to the products according to their
activity consumption, using activity drivers. The horizontal dimension is the activity management
dimension, which provides information about the work done in the business. This includes the causes
(or root cause cost drivers) of activities and measures of activity performance.
The costs of the resources are assigned to each activity using resource drivers. The costs of the
resources are recorded already in the existing accounting system and include items such as wages,
supplies and building occupancy costs. An activity is a unit of work performed within the organisation.
A resource driver is a cost driver that estimates the cost of resources used by an activity. Examples
include floor space, which may be used to assign building costs, or the number of employees, which
may be used to assign wages. Some costs can be traced directly to an activity rather than using resource
drivers. For example, wages can often be traced directly to an activity by identifying the person that
performs the activity.
8.5 The two dimensional activity-based costing model provides a costing focus and an activity management
focus. Since costs are incurred in the performance of activities, better management of activities provides
better cost management. However, activity management through the use of activity analysis also
facilitates improvement in the effectiveness and efficiency of individual activities, promotes the use of
non-financial performance measures, which are often more relevant and readily actionable than financial
measures, and provides a basis for the better design of processes. A simple activity-based costing system
provides very limited data for the purpose of activity management.
8.6 The first step would be to consider whether the business is currently experiencing any problems with its
existing costing system and whether ABC might help address these problems. For example, the benefits of
ABC will be greatest when the existing costing system is seriously distorting the estimated costs of
products. This is most likely to happen when overhead costs are a significant portion of total costs and a
large part of overhead is not directly related to production volume, the business has a diverse product
range and individual products’ use of support resources differs from their use of volume-based cost
drivers, production activity involves diverse batch sizes and product complexity, and the proportion of
Copyright © 2017 McGraw-Hill Education (Australia) Pty Ltd

IRM Langfield-Smith, Smith, Andon, Hilton, Thorne Management Accounting 8e
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product-related costs incurred outside of manufacturing is increasing relative to manufacturing costs. In
addition it is necessary to consider to what extent management actually relies on information about
product costs in making key strategic decisions. There are likely to be high ‘costs’ associated with
making inappropriate decisions based on inaccurate product costs in a highly competitive environment
where product cost is a key input to strategic decision making and where competitors have accurate
product cost information. It is also important to consider the cost of designing, implementing and
maintaining the ABC system, which is likely to be influenced by the extent of IT support within the
firm.
Having identified the issues with the existing costing system, it is necessary to consider what sort of
ABC system is required (a simple activity-based system that only includes manufacturing costs, a more
detailed system that includes non-manufacturing costs, or a comprehensive system that includes all costs
except direct material), as this will influence both the benefits that can be obtained from the ABC system
and the resources required to implement and maintain the system.
8.7 Activity-based costing systems can differ over whether they include cost assignment, activity management
or both. They can differ over how costs are measured, budget or actual. The costing systems can differ
over cost objects and the range of costs that are covered. They can also differ over the detail to which costs
and activities are analysed. One other source of difference is whether they are introduced as an ongoing
system or a one-off project. Activity-based costing is usually introduced to tackle problems and the
features of the system depend on the problems that need to be addressed.
8.8 Facility level activities reflect the costs of providing the overall environment for producing and
selling products and some proponents of ABC recommend that virtually all costs, including facility
costs, be assigned to products. Indeed allocation of facility level costs to products does occur in
practice (Cooper, 1990).
Manufacturing facility level costs are included under accounting standards in cost of goods sold and
inventory values. (There may also be some manufacturing facility level costs which in some cases may
be able to be reasonably allocated to product costs. For instance in the Mason & Cox case, the activity
Manage Plant is a facility level manufacturing cost; and man-hours worked in the production plant on
particular products was considered, in the particular circumstances of Mason & Cox, to be a reasonable
allocation base.)
However, in general, facility level costs should not be included when estimating product costs for
decision making, such as assessing product profitability, because:
 facility level activities have no obvious cost drivers, are not caused by any particular product and
may bear no obvious relationship to particular products so that their allocation is arbitrary; the higher
the proportion of allocated facility costs, the greater the arbitrary element of the product costs
 average facility level costs per unit can undermine product-related decisions; many product-related
decisions are better based on either unit level costs in the short term or total product costs in the
longer term, rather than looking at the average cost per unit of product; although a business must
cover its facility level costs to make a profit, it is better to deduct them after estimating the product-
related profit margin rather than including them in the product costs.
8.9 An activity driver is a cost driver used to estimate the cost of an activity consumed by the cost object
(for example, a product).
 An activity driver should reflect a cause of the cost of the activity. (They will then also be useful in
cost management and activity management as they will give actionable indicators of cost causation.)
In a bank the activity ‘refilling of the ATMs with banknotes’ may be thought to relate to the number
of customer transactions and the frequency of transactions, but the data needs to be closely
examined as the amount withdrawn in an average transaction can be significantly higher in one
location than another, and the more that is withdrawn each time, the more frequently it needs to be
replenished. Appropriate measures that can forecast staff requirements are used in banks, insurance
companies and other service organisations to plan staffing levels using sessional and short contract
staff as needed to ‘top up’ the regular staff base.
 An activity driver should vary proportionately with the activity costs. Hence, the activity driver
should have a behaviour pattern similar to that of the activity costs.
In a bank an example would be the use of numbers of cheques processed as the cost driver for
cheque processing costs. We might expect the cost of cheque processing to double when the number
of cheques processed doubles, or to halve when the number of cheques processed halves.

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 An activity driver should not be too expensive to measure. Preferably it would already be in use for
some other purpose. Where the most appropriate activity driver (in terms of cost causation) is not
easy to measure, it may be necessary to use a surrogate measure.
In a bank the collection of data pertaining to the number of cheques processed and the number of
loan applications processed would be easy to obtain, as this information would be collected for other
purposes. and would be useful as cost drivers for those processing activities. Alternatively, the
number of loans approved may be a better activity driver for the costs of processing property loan
applications, as approved clients may need to have the proposed purchase property valued by the
bank valuer. An even better activity driver may be the time spent on each valuation but this
information may be difficult to obtain and too expensive to collate.
8.10 Traditional costing systems tend to overstate the cost of high-volume product lines for two reasons.
First, conventional systems assume the volume of production drives all manufacturing overhead costs,
that is, it assumes that they are all unit level costs. However, usually a number of the overhead costs are
batch level costs rather than unit level costs. Small-batch products will consume the same amount of
batch costs as large-batch products and, therefore, have a relatively high consumption of batch activities
per unit produced. Second, low-volume products are often more complex to make and require a large
number of overhead support activities. The level of overhead support is often above the level assumed in
the average plantwide overhead rate used in many conventional systems.
8.11 Benefits from ABC will be greatest when:
 overhead is a relatively large and significant proportion of cost
 the cost is not driven by volume
 significant product diversity occurs
 diverse batch sizes and production complexity occur
 cost information is important for decision making
 the cost of implementing and maintaining an ABC system is low because of well-developed IT
systems and support.
The ‘Real life’ entitled Activity-based costing in the NSW public sector describes how the principles of
activity-based product costing can be applied in the public sector to produce more accurate estimates of
the costs of services produced. For example, it describes how an ABC system can better identify the
costs of corporate services, which are provided from a central unit, to support the provision of different
public services. Although public services are not sold, information about their costs can help to ensure
that resources are used efficiently.
While the ‘Real life’ referred to does not address the question directly, we would expect there to be
improvements such as:
 the ability to more easily cost programs and plan initiatives
 more accurate costing of services which can lead to focusing cost containment effort on the correct
causes
 the provision of information for cost management, particularly when benchmarking between
departments and against other providers
 depending on how comprehensive the costing system is, ABC can also provide a strong foundation
for activity management, such as identifying the costs of non-value-added activities and improved
processes through the use of activity analysis
ABC is very effective in budgeting in the public sector, reducing waste and clearly identifying actions
required and responsibilities for those actions.
8.12 Factors that may impede the introduction of ABC include:
 lack of conviction by management that the benefits will exceed the costs (note that research has
shown that non-financial benefits are often high)
 lack of understanding of what ABC is and how it can help an organisation
 concerns about the extensive resource requirements to implement ABC
 concerns about the resistance to change factors.

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8.13 An ongoing ABC system may not be required to satisfy the needs of the organisation. Sometimes the
requirement is for more accurate information to inform strategic decisions, or periodic checks on
performance. In these cases the ABC exercise will be directed to the use for which it is undertaken. If
there is lack of diversity between cost objects (e.g. products or customers) or overheads form a small
part of total costs, there is little to be gained from operating an expensive sophisticated costing system
on an ongoing basis.
8.14 Traditional costing methods use a range of approaches that become progressively more sophisticated
and accurate. We have seen that the choice between approaches depends on a cost-benefit exercise
evaluating the benefits of greater detail and accuracy versus the extra costs involved in establishing and
maintaining the costing system. An example is the need to choose between the complex reciprocal
method of allocating service department costs and the simpler but less accurate step-down method of
service cost allocation.
Similarly, the ABC approach adopted can be simple, less costly but less accurate, or progressively more
complex, costly and accurate, simply by increasing the number of cost drivers used by the costing
system. When ABC was first adopted by airline companies it was reported that one had a costing system
with 40 000 cost drivers! The most complex system will identify what is believed to truly drive the cost
of each activity. However there are often acceptable alternatives that are common to many activities,
which can reduce the number of cost drivers.
Selection of the cost drivers is determined by cost and benefit considerations and can be evaluated by
reference to certain criteria.
Three factors that should influence the selection and evaluation of cost drivers are:
 The cost of measurement
o Is the data easy to obtain? Is it being collected for some other purpose? If not, would it
be useful for some other purpose if it is collected?
 The accuracy of representation
o How closely does the depicted pattern of consumption resemble the actual pattern of
consumption?
 The influence on behaviour
o Since people respond to what is measured, will recording this data modify behaviour? If
so, how? Is it a desirable outcome?
8.15 If ABC is based on budgeted costs, then not all the costs may be picked up in ABC product costs as
there may be some committed resources that are not used. The costs of unused capacity, therefore, need
to be added to the ABC costs.
8.16 Activity-based costing involves major changes which may be perceived as threatening and, therefore,
may be resisted. To succeed, the introduction of activity-based costing must be accompanied by a
change management plan that is carefully constructed to take account of factors such as the extent of
change required and the personalities involved. There is some evidence to suggest that this process will
be most effective where a ‘bottom-up’ rather than a ‘top-down’ approach is used. Instead of viewing the
activity-based system as a financial system imposed by top management, employees should be
encouraged to consider the activity-based system as a tool which they own, to help them manage their
work. Developing a sense of ownership requires a high degree of participation in the development and
implementation of the new system across all levels of the business. Management must be seen to be
totally committed to the activity-based project, but willing to let employees play a major role in
developing and using the system. Recent research indicates that self-managing work teams can be an
effective change management tool.

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8.17 Activity-based costing has some limitations that may be impacting its adoption in Australia and New
Zealand, including the following:
 Facility level costs: Some proponents of ABC recommend that virtually all costs, including facility
costs, be assigned to products. However, facility level costs bear no obvious relationship to products.
If facility level costs are assigned to products, the allocation basis must be arbitrary. The higher the
proportion of allocated facility costs, the greater the arbitrary element of the product costs.
 Use of average costs: Activity-based estimates of the cost per unit of product are average costs.
Unit level costs are incurred for each unit of product, but batch level, product level and any
allocated facility level costs must be divided by the number of units produced to estimate the cost
per unit of product. It is important that managers understand this. The average costs per unit are
only valid at that level of activity. Many product-related decisions are better based on the total
product costs rather than looking at the cost, per unit, of each product.
 Complexity: When activity-based costing is set up as an ongoing costing system, it involves more
detailed recording and analysis than conventional costing systems. If the company is changing
rapidly, the data in the activity-based system must be updated frequently to avoid the production of
outdated, irrelevant information. This can be expensive. The level of complexity increases
dramatically when the system is used for activity management, as well as product costing, because
activity management requires a more extensive and detailed analysis of costs and activities. This
issue is dealt with further in Chapter 16.
8.18 Problems that may have been experienced in this case include:
 the difficulty of collecting activity data—how frequently do staff record their data and how many
leave it until the end of the day or the end of the week and provide inaccurate data?
 the difficulty of identifying activities as opposed to processes and tasks. Decisions need to be made
with regard to how activities are defined (we can define activities at a micro level and a macro
level, for example). People filling out these activity data sheets also often have difficulty classifying
what they are doing as one activity or another due to a close relationship between them
 it is often difficult to identify and draw up a list of individual activities and their activity drivers
because activities are non-repetitive. An activity may be repeated, but in a different way each time
 the terminology used in data collection can be familiar to some people but foreign to others who are
used to a different term for the activity. There can be differences in terminology between
departments, for example. Some organisations have a dictionary of terms so that terminology in one
part of the organisation can be translated to the terminology used in another part of it
 the nature of an activity and the demands on a staff member, can differ significantly between rural,
urban and remote environments
 guidance to costing activities is often found in the use to which the information is to be put, but a
‘non-repetitive production environment’ and the heterogeneous nature of service outputs may make
it difficult to identify service outputs. If a range of common activities is performed and each service
makes different use of these activities, then it will be possible to draw up a list of activities and
activity drivers, but it will be necessary to produce a separate bill of activities for each service that is
produced. Again, they may differ between locations. There may also need to be an extensive list of
activities.

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8.19 Service organisations can often benefit from the use of activity-based costing because typically they
experience the classic environment for costing errors from a conventional costing approach:
 diverse outputs
 diverse customers and clients
 very high overheads as a percentage of total costs.
In addition, these organisations are often free from a problem encountered by manufacturing firms using
ABC: usually they do not carry inventories so the product costs provided by the ABC system are not
confined to those required for external reporting. (There are also benefits to be found in the use of the
activity analysis for management purposes.)
Drawbacks to the use of ABC in service organisations include:
 the difficulty of identifying the individual outputs to be costed. For example, what is the output in a
hospital? How many products should a railway line have on each line (one for each combination of
stations where you can join and leave the train, for example)?
 the extreme customisation of outputs in some organisations
 the frequent difficulty of identifying cost drivers
 the high amount of facility sustaining costs
 difficulty finding a suitable hierarchy of costs (often this difficulty results in an even higher
percentage of costs being treated as facility level costs—it is linked to the issue about not identifying
cost drivers)
8.20 A comparison of the two different ABC systems is provided in the text. It is important for students to
recognise the need to choose the system that best suits the organisation. It is not a case of one approach
is always best. The comprehensive ABC system includes all costs in the organisation. It brings in non-
manufacturing costs in addition to manufacturing costs. This can be particularly important if there is
diversity in customers, differences in the marketing of different products, differences in sales support
required by different products and so on. The more comprehensive system also provides substantial data
that can assist in activity management techniques (covered in Chapter 16).
If Mason & Cox just wanted more accurate product costing they may have satisfied their needs with the
simple ABC approach. However, it seems that they wished to have access to activity management data
and benefited from an examination of product-related non-manufacturing costs. Hence the
comprehensive system better met their needs.

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SOLUTIONS TO EXERCISES
EXERCISE 8.21 (20 minutes) Distortion of product costs: manufacturer

1 It is likely that Spinning Wheels’ product costing system is providing misleading cost information to
management. A common problem in a conventional volume-based costing system is that high-volume
products are overcosted and low-volume products are undercosted. There is evidence of this in the
exercise, since Spinning Wheels’ competitors are selling a product similar to the X25 at a price that is
lower than Spinning Wheels’ reported manufacturing cost.
In contrast, Spinning Wheels is selling its speciality wheel Z50 at a huge margin above the product’s
reported cost. It is likely that an activity-based costing system would report a lower product cost for
wheel X25 and a substantially higher cost for wheel Z50.
2 The managing director’s strategy of pushing the firm’s speciality products will probably aggravate
Spinning Wheels’ problems even further. These products are probably not as profitable as the firm’s
conventional product costing system makes them appear. Indeed they may be losers rather than winners.
3 Recommendation: Install an activity-based costing system. If the new reported product costs shift, as
suggested in the preceding comments, then lower the price on the high-volume products such as wheel
X25. The prices of the speciality wheels may need to be raised further. Indeed, it is possible that
Spinning Wheels should discontinue low-volume products.
EXERCISE 8.22 (15 minutes) Key features of activity-based costing: manufacturer

1 Key features of an activity-based costing system:
 Two-stage procedure for cost assignment.
 Stage one: Identify activities, costs and resource drivers. Calculate costs per activity.
 Stage two: Assign the activity costs to the company’s product lines in proportion to the amount of
the activity driver used by each product line.
2 As described in the answer to the preceding exercise, the new system will probably reveal distortions in
the firm’s reported product costs. In all likelihood, the high-volume products have been overcosted and
the low-volume speciality products have been undercosted.
3 Strategic options:
 Lower the prices on the firm’s high-volume products to compete more effectively.
 Increase the prices on low-volume speciality products.
 Consider eliminating the speciality product lines. This may not be desirable if there is a
marketing need to produce a full product line. Also, the speciality wheels may give Spinning
Wheels prestige.

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EXERCISE 8.23 (20 minutes) Activity-based costing: service firm
1
2-day, 8-person, 50 km 5-day, 15-person, 100 km
El Questro Gorge Flinders Ranges
Advertising $75 $75
National Park permit – 150
Equipment use 480 2250
Insurance 60 112.5
Cook meals 600 2812.5
Guide walkers 525 1050
Total cost per trip $1740 $6450
Cost per person $217.5 $430

Cost per day $870 $1290
Cost per person per day $108.75 $86
2 The flat rate of $97.50 per person per day fails to recognise the different resource requirements for the
different trips. For example, the Flinders Ranges trip requires a National Park permit. It also involves
more walking each day and, therefore, has a higher cost for the walking guide per day. On the other
hand some costs are a flat charge regardless of the number of days. Hence the Flinders Range tour is
cheaper per person per day. The flat rate of $97.50 does not cover the costs of the El Questro Gorge trip
which is being subsidised by the walkers going to the Flinders Ranges.
EXERCISE 8.24 (20 minutes) Classification of activities: winery

The activities of the Wallaby Gully Winery may be classified as follows:
U: Unit level
B: Batch level
P: Product-sustaining level
F: Facility level
Activity Classification Activity Classification
1 P 11 B
2 P 12 B
3 P 13 U
4 P 14 U
5 P 15 B
6 P 16 B
7 P 17 B
8 B 18 F
9 B 19 F
10 B
A useful discussion could cover the need to define a unit (a bottle of wine or a case of wine?) and whether
activities 15 and 16 should be batch level or unit level activities.

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EXERCISE 8.25 (20 minutes) Activity costs and activity drivers: manufacturer
There is no single correct answer to this exercise. There are many reasonable solutions.
Cost pool 1:Material- related activity

Raw materials and components $4 425 000
Inspection of finished goods 45 000
Total 4 470 000
Activity driver: raw-material cost or raw material volume

Cost pool 2:Machinery-related activity
Depreciation, machinery $2 100 000
Electricity, machinery 180 000
Equipment maintenance, wages 225 000
Equipment maintenance, parts 45 000
Total $2 550 000
Activity driver: number of units produced or machine hours

Cost pool 3:Setup
Setup wages $60 000
Total $60 000
Cost pool 4:Inspection

Inspection of finished goods $45 000
Total $45 000
Cost driver: number of inspections or length of time spent on inspections

Cost pool 4:Engineering
Engineering design $915 000
Total $915 000
Cost driver: number of parts in a product

Cost pool 5:Facility sustaining activity
Depreciation, plant $ 1 050 000
Insurance, plant 900 000
Electricity, light 90 000
Security wages, plant 60 000
Property taxes 180 000
Natural gas, heating 45 000
Total $2 325 000
Cost driver: for costs allocated to support departments, square footage; for costs assigned to products,

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number of units produced.
EXERCISE 8.26 (5 minutes) Activity costs and activity drivers: manufacturer

Material-related activity: unit level
Machinery-related activity: unit level
Setup: batch level
Inspection: batch level if each batch inspected or unit level if each unit of product is inspected
Engineering: product sustaining
Facility sustaining activity: facility sustaining
EXERCISE 8.27 (25 minutes) Assigning activity costs to products: manufacturer

1
Annual quantity of
activity drivers
used by the
Activity Cost per unit of activity driver product Annual cost
Process payables $90 per purchase order 400 $36 000
Program production $337.50 per production schedule 100 33 750
Process sales order $112.50 per sales order 300 33 750
Issue materials $180 per issue 100 18 000
Set up solder machines $237 per setup 100 23 700
Solder circuit boards $22.50 per solder joint 40 000 900 000
Insert motor $45 per player 5000 225 000
Assemble player $27 per player 5000 135 000
Design player $18 000 per model CD standard Assign directly 18 000
Total activity cost (annual) $1 423 200
$1 423 200
Total activity cost per unit = 5000 units = $284.64
2 Total cost per unit of product

Activity cost $284.64
Direct material 67.50
Total unit cost $352.14
3 The costs of the activity ‘Design player’ are product level costs. These are the costs of designing this
particular product and they are assigned directly to the product.

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EXERCISE 8.28 (15 minutes) Activity-based costing; quality control costs:
manufacturer
1 (a) Quality control costs assigned to the Satin Sheet line under the traditional system:
Quality control costs = 16%  direct labour cost
Quality control
costs assigned to
Satin Sheet line = 16%  $147 000
= $23 520
(b) Quality control costs assigned to the Satin Sheet line under activity-based costing:
Activity Cost per unit of activity Quantity for Assigned
driver Satin Sheet cost
Incoming material inspection $34.50 per type 24 types $ 828
In-process inspection 0.42 per unit 35 000 units 14 700
Product certification $216.00 per order 50 orders 10 800
Total quality-control costs assigned $26 328
2 The traditional product costing system undercosts the Satin Sheet product line, with respect to quality control
costs, by $2808 ($26 328 – $23 520). Satin Sheet makes more use of quality control resources than assumed in
the traditional costing system. This may occur because, for example, Satin Sheet uses more orders or material
types than assumed in the average rate used for all products.
EXERCISE 8.29 (15 minutes) Problems with conventional costing systems; activity-
based costing principles: manufacturer
1 Manufacturing overhead is comprised of all indirect manufacturing costs; that is, all manufacturing costs
except direct costs, which usually comprise direct labour and direct materials. Typical overhead costs
include:
 indirect labour (e.g. a forklift-truck driver, maintenance and inspection labour, engineering labour and
supervisors)
 indirect materials
 other indirect manufacturing costs (e.g. building maintenance, machine and tool maintenance, property
taxes, insurance, depreciation on plant and equipment, rent and utilities).
2 The increase in the overhead rate should not have a negative impact on the company because the increase in
indirect costs was more than offset by a decrease in direct labour (an increase in indirect costs of $400 000
with a decrease in direct labour of $600 000). Someone should explain to the managing director the
reclassification of costs and the impact on the overhead rate of increasing the numerator at the same time as
decreasing the denominator.
3 An activity-based costing system might benefit this manufacturing company because it assigns costs to
products according to their usage of activities in the production process. More accurate product costs are the
result.

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EXERCISE 8.30 (15 minutes) Comparison of activity-based and traditional product
costs: manufacturer
1 Sweater Overcoat
High-volume product line Yes No
Low-volume product line No Yes
Produced in small batches No Yes
Produced in large batches Yes No
Simple to produce Yes No
Complex to produce No Yes
2 Traditional costing systems tend to overstate the cost of high-volume, relatively simple products, and
understate the cost of low-volume, relatively complex products.
In this particular case, both products are likely to require a number of batch level overhead activities.
The sweater is likely to be a high-volume product that is produced in large batches. This will cause
relatively low batch costs per unit. The overcoat is likely to be a low-volume product produced in small
batches. This will cause relatively high batch costs per unit. The high-volume product, the sweater, is
likely to be relatively simple to produce and require relatively little overhead support. In contrast, the
low-volume product, the overcoat, is likely to be more complex to produce and require relatively more
overhead support.
These differences are not recognised in the traditional system, which uses a volume-based overhead cost
driver such as direct labour hours or machine hours.
EXERCISE 8.31 (20 minutes) (appendix) Assigning activity centre costs to activities:
manufacturer
1 Cost of activity ‘Load mixer’:
Amount of
Cost of activity:
resource driver
Cost category Mixing centre cost used to load mixer ‘Load mixer’
Wages $220 000 5% $11 000
Energy 176 000 500/10 000 8 800
Depreciation 44 000 100/5000 880
Other 22 000 5% 1 100
$462 000 $21 780
2 By definition, direct labour costs can be traced directly to products, so we cannot argue that direct
labour costs have been included in the activity-based product costing system to improve the accuracy of
Bottle Brush Paints’ product costs. It is more likely that Bottle Brush Paints also uses its activity-based
costing system for cost management. By including direct labour costs as well as overhead costs, Bottle
Brush Paints can obtain useful information for managing activities right across the business.
3 Descriptions of the activities performed and estimates of the amount of resource driver used by each
activity are likely to be obtained from interviews with managers and employees who work in the
Mixing Centre.

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EXERCISE 8.32 (20 minutes) (appendix) Assigning costs to activity centres:
manufacturer
1 Costs assigned to Top Tech’s Assembly Centre:

Cost assigned to
Total cost Resource driver proportion Assembly Centre
Wages $720 000 20/100 $144 000
Building costs 240 000 1 000/10 000 24 000
Energy 360 000 10 000/250 000 14 400
Other 60 000 20/100 12 000
Total $1 380 000 $194 400
2 Cost categories simplify the cost assignment process by reducing the number of individual cost
assignments that need to be made into activity centres. Costs that are of a similar nature and driven by the
same resource driver can be combined into a single cost category. Wages will include wage payments and
labour on-costs such as payroll tax, workers compensation and employer-funded superannuation. Building
costs are likely to include rent, cleaning, insurance and council rates. Energy costs depend on energy
sources. In addition to electricity, they may include gas and solar energy costs. ‘Other’ is a catch-all and
might include the costs of depreciation, consumables, motor vehicles and so on.
3 A resource driver is a cost driver used to estimate the cost of resources consumed by an activity or
activity centre. For example, the total wages bill can be assigned to activity centres using the number of
people working in the activity centres. A more accurate basis for assigning wage costs is to trace the
wage-related costs of each employee to the actual activity centre where they work. This approach is
often used in practice.

13
SOLUTIONS TO PROBLEMS
PROBLEM 8.33 (60 minutes) Conventional and activity-based product costing:
manufacturer
1 Overhead to be assigned to film development chemical order:

Cost per unit of
Activity activity driver Level of activity driver Assigned overhead cost
Machine setups $3000 per setup 4 setups $ 12 000
Material handling $3 per kg 10 000 kg 30 000
Hazardous waste control $7.50 per kg 2000 kg 15 000
Quality control $112.50 per inspection 10 inspections 1 125
Other overhead costs $15 per machine hour 500 machine hrs 7 500
Total $65 625
$65 625
=$65 .625 per box
2 Overhead cost per box of chemicals= 1000 boxes
total budgeted overhead cost

3 Predetermined overhead rate= total budgeted machine hours
$937 500
= 20 000 = $46.875 per machine hour
4 Overhead to be assigned to film development chemical order, given a single predetermined overhead rate:
(a) Overhead assigned=$46.875 per machine hour @ 500 machine hours
=$23 437.50 in total
$23 437.50
= $23.44 per box (rounded )
(b) Overhead cost per box of chemicals= 1000 boxes
5 The production of film development chemicals entails a relatively large number of machine setups, a
large amount of hazardous materials and several inspections. Thus, they are quite costly in terms of
driving overhead costs. Use of a single predetermined overhead rate obscures this characteristic of the
production job. Underestimating the overhead cost per box could have adverse consequences for
Snappy. For example, it could lead to poor decisions about product pricing. The simple activity-based
costing system for overhead will serve management much better than the system based on a single,
predetermined overhead rate.

14
6 Calculation of overhead assigned to photographic plates:
Activity Cost per unit of Level of Assigned overhead cost

Machine setups activity
$3000 perdriver
setup activitydriver
2 setups $ 6 000.00
Material handling $3 per kg 800 kg 2 400.00
Hazardous waste control $7.50 per kg 300 kg 2 250.00
Quality control $112.50 per 3 inspections 337.50
Other overhead costs inspection
$15 per machine hour 50 machine hours 750.00
Total $11 737.50
$11 737 .50

Overhead cost per unit = 100 plates
=$117.38 per unit
Calculation of unit cost, per plate: Direct material $180.00

Direct labour 60.00
Manufacturing overhead 117.38
Total cost per plate $357.38
PROBLEM 8.34 (30 minutes) Traditional and activity-based product costing:

manufacturer
1 Predetermined overhead rate = budgeted overhead ÷ budgeted direct labour hours
= $960 000 ÷ 25 000* = $38.4 per direct labour hour
*25,000 budgeted direct labour hours = (3000 units of Basic)(3 hrs/unit) +
(4000 units of Superior)(4 hrs/unit)
Basic Superior
Direct material. $ 25 $ 40
Direct labour:
3 hours × $12 36
4 hours × $12 48
Manufacturing overhead:
3 hours × $38.4 115.20
4 hours × $38.4 153.60
Total cost $176.20 $241.60

15
2 Activity-based overhead application rates:
Activity driver Cost per unit

of activity
Activity Cost
driver
Order $180 000 ÷ 550 orders = $327 per OP
processing processed (OP)
Machine 672 000 ÷ 44 000 machine = $15.27 per MH
processing
hrs (MH)
Product 108 000 ÷ 11 000 inspection = $9.82 per IH
inspection hrs (IH)
Order processing, machine processing and product inspection costs of a Basic unit and a Superior
unit:
Activity Basic Superior

Order processing:
330 OP × $327 $ 107 910
220 OP × $327 $ 71 940
Machine processing:
19 800 MH × $15.27 302 346
24 200 MH × $15.27 369 534
Product inspection:
2 200 IH × $9.82 21 604
8 800 IH × $9.82 86 416
Total $431 949 $527 949
Production volume (units) 3000 4000
Cost per unit $143.98* $131.98**
* $431 949 ÷ 3000 units = $143.98
** $527 949 ÷ 4000 units = $131.98
The manufactured cost of a Basic unit is $204.98, and the manufactured cost of an Superior unit is
$219.98:
Basic Superior
Direct material $ 25 $ 40
Direct labour:
3 hours × $12 36
4 hours × $12 48
Order processing, machine processing, and
product inspection.
143.98 131.98
Total cost $204.98 $219.98

16
3 (a) The Superior product is overcosted by the traditional product costing system. The labour-
hour application base resulted in a $241.60 unit cost; in contrast, the more accurate ABC
approach yielded a lower unit cost of $219.98. The opposite situation occurs with the Basic
product, which is undercosted by the traditional approach ($176.20 vs $204.98 under ABC).
(b) Yes, especially since the company’s selling prices are based heavily on cost. An overcosted
product will result in an inflated selling price, which could prove detrimental in a highly
competitive marketplace. Customers will be turned off and will go elsewhere, which hurts
profitability. With undercosted products, selling prices may be too low to adequately cover a
product’s more accurate (higher) cost. This situation is also troublesome and will result in a
lower income being reported for the company.
4 The Excel spreadsheet for requirements 1, 2 and 3 (a) will be as shown above, although the cells
should include formulae to calculate the necessary values.
Budgeted overhead is now $(300 000 + 672 000 + 270 000)
Predetermined overhead rate = budgeted overhead ÷ budgeted direct labour hours
= $1 242 000 ÷ 25 000* = $49.68 per direct labour hour
*25 000 budgeted direct labour hours = (3000 units of Basic)(3 hrs/unit) +
(4000 units of Superior)(4 hrs/unit)
Basic Superior
Direct material. $ 25 $ 40
Direct labour:
3 hours × $12 36
4 hours × $12 48
Manufacturing overhead:
3 hours × $49.68 149.04
4 hours × $49.68 198.72
Total cost $210.04 $286.72
Activity-based overhead application rates:
Cost per unit of

activity driver
Activity Cost Activity driver
Order $300 000 ÷ 550 orders = $545.45 per OP

Processing processed (OP)
Machine 672 000 ÷ 44 000 machine = $15.27 per MH

processing
hrs (MH)
Product 270 000 ÷ 11 000 inspection = $24.5 per IH

Inspection hrs (IH)

17
Order processing, machine processing and product inspection costs of a Basic unit and an Superior
unit:
Activity Basic Superior
Order processing:
330 OP × $600 $ 198 000
220 OP × $600 $ 132 000
Machine processing:
19 800 MH × $15.27 302 346
24 200 MH × $15.27 369 534
Product inspection:
2200 IH × $24.5 53 900
8800 IH × $24.5 215 600
Total $554 246 $717 134
Production volume (units) 3000 4000
Cost per unit $184 $179
The manufactured cost of a Basic unit is $245, and the manufactured cost of a Superior unit is $267:
Basic Superior
Direct material $ 25 $ 40
Direct labour:
3 hours × $12 36
4 hours × $12 48
Order processing, machine processing, and
product inspection.
184 179
Total cost $245 $267
The Superior product is overcosted by the traditional product costing system. The labour-hour
application base resulted in a $286.72 unit cost; in contrast, the more accurate ABC approach yielded
a lower unit cost of $267.00. The opposite situation occurs with the Basic product, which is
undercosted by the traditional approach ($210.04 vs $245.00 under ABC).

18
PROBLEM 8.35 (30 minutes) Traditional and activity-based product costing:
manufacturer
1 Deluxe manufacturing overhead cost:

16 000 machine hours  $120 = $1 920 000
$1 920 000 ÷ 8 000 units = $240 per unit
Executive manufacturing overhead cost:
22 500 machine hours  $120 = $2 700 000
$2 700 000 ÷ 15 000 units = $180 per unit
Deluxe Executive
Direct material $ 52.50 $ 90
Direct labour 30.00 30
Manufacturing overhead 240.00 180
Unit cost $322.50 $300
2 Activity-based application rates:

Activity Cost Activity driver Application rate
Manufacturing setups $ 1 008 000 ÷ 80 setups (SU) = $12 600 per SU
38 500 machine
Machine processing 2 772 000 ÷ hours (MH) = $72 per MH
175 outgoing
Product shipping 840 000 ÷ shipments (OS) = $4800 per OS
Manufacturing setup, machine processing and product shipping costs of a Deluxe unit and an Executive
unit:
Activity Deluxe Executive

Manufacturing setups:
50 SU  $12 600 $ 630 000
30 SU  $12 600 $ 378 000
Machine processing:
16 000 MH  $72 1 152 000
22 500 MH  $72 1 620 000
Product shipping:
100 OS  $4 800 480 000
75 OS  $4 800 360 000
Total $2 262 000 $2 358 000
Production volume (units) 8000 15 000
Cost per unit $282.75 $157.20

19
The manufactured cost of a Deluxe cabinet is $243.50 and the manufactured cost of an Executive
cabinet is $184.80. The calculations follow:
Deluxe Executive
Direct material $ 52.50 $ 90.00
Direct labour 30.00 30.00
Manufacturing setup, machine
processing, and outgoing shipments 282.75 157.20
Total cost $365.25 $277.20
3 The cost of the Deluxe storage cabinet is understated. The use of machine hours produced a unit cost of
$322.50; in contrast, the more accurate activity-based costing approach shows a unit cost of $365.25.
The difference between these two amounts is $42.75. Cost distortion: The Deluxe cabinet product line is
undercosted by $228 000, and the Executive cabinet product line is overcosted by $342 000. Supporting
calculations follow:
Deluxe Executive
$42.75  8000 = $342 000 $(22.80)†  15 000 = $(342 000)
†
$277.20  $300
4 No, the discount is not advisable. The regular selling price of $390, when compared against the more
accurate ABC cost figure, shows that each sale provides a profit to the firm of $24.75 ($390.00 –
$365.25). However, a $45 discount will actually produce a loss of $20.25 ($345 – $365.25), and the
more units that are sold, the larger the loss. Notice that with the less accurate, machine-hour-based
figure ($322.50), the marketing manager will be misled, believing that each discounted unit sold would
boost income by $22.50 ($345 – $322.50).

20
PROBLEM 8.36 (30 minutes) Traditional and activity-based product costing, cost
distortions: manufacturer
1 The predetermined overhead rate is calculated as follows:

Predetermined overhead rate = Budgeted manufacturing overhead/budgeted direct labour hours
= $1 224000/102 000* = $12 per hour
*Direct labour, budgeted hours:
REG: 5000 units  9 hours...................................................................................45 000 hours
ADV: 4000 units  11 hours................................................................................44 000 hours
GMT: 1000 units  13 hours................................................................................13 000 hours
Total direct-labour hours......................................................................................102 000 hours
2 Activity-based costing analysis:
Activity Activity Activity cost Activity Activity Cost per unit of

level driver quantity activity driver
driver
Unit Machine $310 500 Machine 115 000 $ 2.70
related hours
Batch Material hand. 52 500 Production run 100 525.00
Batch Purchasing 75 000 Purchase 300 250.00
orders
Batch Setup 85 000 Production 100 850.00
runs
Batch Inspection 27 500 Inspection 1100 25.00
hours
Batch Shipping 66 000 Shipments 1100 60.00
Product Engineering 32 500 Engineering 650 50.00
hours
Facility Facility 575 000 Machine 115 000 5.00
hours
Total $1 224 000

21
3 Calculation of new product costs under ABC:
REG ADV GMT

Direct material $129.00 $151.00 $203.00
Direct labour (not including
setup time)
171.00 (9 hr. @ $19) 209.00 (11 hr. @ $19) 247.00 (13 hr. @ $19)
Total direct costs per unit $300.00 $360.00 $450.00
Manufacturing overhead (based on ABC)*:
Machine-related $ 27.00 $ 32.40 $ 45.90
Setup 4.20 5.25 10.50
Purchasing 5.00 6.00 26.00
Material handling 6.80 8.50 17.00
Quality assurance 2.00 2.50 7.50
Packing/shipping 6.00 6.00 12.00
Engineering design 2.50 2.50 10.00
Facility 50.00 60.00 85.00
Total ABC overhead $103.50 $123.15 $213.90
cost per unit
Total product cost per unit $403.50 $483.15 $663.90
* calculation of overhead costs per product

22
Activity Pool rate Produc Activity driver Activity cost Product line Activity
t line quantity for for product cost per
product Prod. unit of
volume product
Machine $ 2.70 REG 50 000 $135 000 5000 $27.00

Related ADV 48 000 129 600 4000 32.40
GMT 17 000 45 900 1000 45.90
Total 115 000 $310 500
Material 525.00 REG 40 $ 21 000 5000 4.20
Hand. ADV 40 21 000 4000 5.25
GMT 20 10 500 1000 10.50
Total 100 $ 52 500
Purch. 250.00 REG 100 $ 25 000 5000 5.00
ADV 96 24 000 4000 6.00
GMT 104 26 000 1000 26.00
Total 300 $ 75 000
Setup 850.00 REG 40 $ 34 000 5000 6.80
ADV 40 34 000 4000 8.50
GMT 20 17 000 1000 17.00
Total 100 $ 85 000
Inspect. 25.00 REG 400 $ 10 000 5000 2.00
ADV 400 10 000 4000 2.50
GMT 300 7 500 1000 7.50
Total 1100 $ 27 500
Ship. 60.00 REG 500 $ 30 000 5000 6.00
ADV 400 24 000 4000 6.00
GMT 200 12 000 1000 12.00
Total 1100 $ 66 000
Eng. 50.00 REG 250 $ 12 500 5000 2.50
ADV 200 10 000 4000 2.50
GMT 200 10 000 1000 10.00
Total 650 $ 32 500
Fac. 5.00 REG 50 000 $250 000 5000 50.00
ADV 48 000 240 000 4000 60.00
GMT 17 000 85 000 1000 85.00
Total 115 000 $575 000
Grand $1 224 000
total

23
4 Comparison of costs under two alternative costing systems:
REG ADV GMT
Conventional product cost
Direct material 129.00 151.00 203.00
Direct labour 171.00 209.00 247.00
Manufacturing overhead 108.00 132.00 156.00
408.00 492.00 606.00
ABC product cost
Direct material 129.00 151.00 203.00
Direct labour 171.00 209.00 247.00
Manufacturing overhead 103.50 123.15 213.90
403.50 483.15 663.90
Difference (4.50) (8.85) 57.90
5 The REG and ADV products were overcosted by the traditional system and the GMT product was
undercosted by the traditional system:
Reported unit product cost:

Traditional, volume-based costing system $408.00 $492.00 $606.00
Activity-based costing system 403.50 483.15 663.90
Cost distortion:
REG and ADV overcosted by traditional system $ 4.50 $ 8.85
GMT undercosted by traditional system ($ 57.90)

24
6 The following spreadsheet shows the changes in the overhead costs for the products. The direct costs
will be unchanged. The changes are highlighted. As the total machine related costs and the facility
costs have doubled, we expect, and find, that their cost per unit has also doubled.
Activity Activity Activity Activity Cost Product Driver Cost for Line Cost per
cost driver driver per line quantity product productio unit of
quantit unit of for line n volume product
y activity product
driver line
Machine $621 000 Machine 115 000 $5.40 REG 50 000 $270 000 5000 $54.00
Related Hours ADV 48 000 259 200 4000 64.80
GMT 17 000 91 800 1000 91.80
Total 115 000 $621 000 -
Material 52 500 Production 100 525.00 REG 40 $21 000 5000 4.20
Handling Runs ADV 40 21 000 4000 5.25
GMT 20 10 500 1000 10.50
Total 100 $52 500 -
Purchasing 75 000 Purchase 300 250.00 REG 100 $25 000 5000 5.00
Orders ADV 96 24 000 4000 6.00
GMT 104 26 000 1000 26.00
Total 300 $75 000 -
Setup 85 000 Production 100 850.00 REG 40 $34 000 5000 6.80
Runs ADV 40 34 000 4000 8.50
GMT 20 17 000 1000 17.00
Total 100 $85 000 -
Inspection 27 500 Inspection 1100 25.00 REG 400 $10 000 5000 2.00
Hours ADV 400 10 000 4000 2.50
GMT 300 7500 1000 7.50
Total 1100 $27 500 -
Shipping 66 000 Shipments 1100 60.00 REG 500 $30 000 5000 6.00
ADV 400 24 000 4000 6.00
GMT 200 12 000 1000 12.00
Total 1100 $66 000 -
Engineerin 32 500 Engineerin 650 50.00 REG 250 $12 500 5000 2.50
g g
Hours ADV 200 10 000 4000 2.50
GMT 200 10 000 1000 10.00
Total 650 $32 500 -
Facility 1 150 000 Machine 115 000 10.00 REG 50 000 $500 000 5000 100.00
Hours ADV 48 000 480 000 4000 120.00
GMT 17 000 170 000 1000 170.00
Total 115 000 $1 150 000

Grand Total $2 109 50 Grand $2 109 500
0 Total

25
Product costs and profitability:
REG ADV GMT
Direct material $129.00 $151.00 $203.00
Direct labour (not including
setup time)
171.00 209.00 247.00
Total direct costs per unit $300.00 $360.00 $450.00
Manufacturing overhead (based on ABC)*:

Machine-related $ 54.00 $ 64.80 $ 91.80
Setup 4.20 5.25 10.50
Purchasing 5.00 6.00 26.00
Material handling 6.80 8.50 17.00
Quality assurance 2.00 2.50 7.50
Packing/shipping 6.00 6.00 12.00
Engineering design 2.50 2.50 10.00
Facility 100.00 120.00 170.00
Total ABC overhead
cost per unit
$180.50 $215.55 $344.80
Total product cost per unit $480.50 $575.55 $794.80
Compare with conventional costing $408.00 $492.00 $606.00

* calculation of overhead costs per product

26
PROBLEM 8.37 (30 minutes) Activity-based costing: service firm
1 Interview salaried client $60 000/8000 $7.50 per interview
Interview business client 75 000/2000 $37.50 per interview
Obtain missing data 600 000/8000 $75 per follow-up call
Input data 120 000/400 000 $0.30 per data entry
Print return 90 000/10 000 $9 per return
Verify return 180 000/6000 $30 per hour
Rectify errors 90 000/6000 $15 per error
Submit return 30 000/10 000 $3 per return
(a) Wage and salary return:

Bill of activities Cost
Interview salaried client 1 $7.50 per interview 7.50
Input data 20 $0.30 per data entry 6.00
Print return 1 $9 per return 9.00
Verify return 22.5 minutes $30 per hour 11.25
Submit return 1 $3 per return ___3.00
36.75
(b) Business tax return:
Bill of activities Cost
Interview business client 1 $37.50 per interview 37.50
Obtain missing data 4 $75 per follow-up call 300.00
Input data 120 0.30 per data entry 36.00
Print return 1 $9 per return 9.00
Verify return 1.5 hours $30 per hour 45.00
Rectify errors 3 $15 per error 45.00
Submit return 1 $3 per return __3.00
475.50
2 The pricing policy is too low for business tax returns as the set price of $300 per return does not even
cover the costs of preparing the return. For business tax returns it may be better to charge time for each
one rather than use an average fee. Also, Mel may be overcharging for wage and salary returns,
although this will depend on the price charged by competitors. If the business is still attracting wage
and salary returns, then the current pricing could be retained. Before using this information for
decisions, Mel must make sure that all overheads are picked up in the above figures.

27
PROBLEM 8.38 (35 minutes) Activity-based costing; analysis of operation: service firm
1 Activity-based costing results in improved costing accuracy for two reasons. First, companies that use
ABC are not limited to a single driver when allocating costs to products and activities. Not all costs vary
with units and ABC allows users to select a host of non-unit level cost drivers. Second, consumption
ratios often differ greatly among activities. No single cost driver will accurately assign costs for all
activities in this situation.
2 Allocation of administrative cost based on billable hours:

Information systems: 3100 ÷ 5000 = 62%; $513 000 × 62% = $318 060
E-commerce consulting: 1900 ÷ 5000 = 38%; $513 000 × 38% = $194 940
e-commerce Information Systems

consulting services
Billings:
1900 hours × $187.50 $356 250
3100 hours × $187.50 $581 250
Less Professional staff cost:
1900 hours × $67.50 (128 250)
3100 hours × $67.50 (209 250)
Administrative cost (194 940) (318 060)
Income $ 33 060 $ 53 940
Income ÷ billings 9.28% 9.28%

28
3 Activity-based costing:
Activity Cost Activity driver Application rate
Staff support $270 000 ÷ 250 clients = $1080 per client
In-house computing 204 600 ÷ 4400 computer = $46.50 per CH

hours (CH)
Miscellaneous 38 400 ÷ 1000 client = $38.40 per CT

office charges transactions (CT)
Staff support, in-house computing, miscellaneous office charges of information systems services and e-
commerce consulting:
e-commerce Information
consulting systems services
Activity
Staff support:
50 clients × $1080 $ 54 000
200 clients × $1080 $216 000
In-house computing:
1800 CH × $46.50 83 700
2600 CH × $46.50 120 900
Miscellaneous office charges:
600 CT × $38.40 23 040
400 CT × $38.40 15 360
Total $160 740 $352 260
Profitability of information systems services and e-commerce consulting:
e-commerce Information
consulting systems services
Billings:
1900 hours × $187.50 $356 250
3100 hours × $187.50 $581 250
Less Professional staff cost:
1900 hours × $67.50 (128 250)
3100 hours × $67.50 (209 250)
Administrative cost (160 740) (352 260)

Income $ 67 260 $ 19 740
Income ÷ billings 18.88% 3.40%

29
4 Yes, his attitude should change. Even though both services are needed and professionals are paid the
same rate, the income percentages show that e-commerce consulting provides a higher return per sales
dollar than information systems services (18.88% vs 3.40%). Thus, all other things being equal,
professionals should spend more time with e-commerce.
5 Probably not. Although both services produce an attractive return, the firm is experiencing a very tight
labour market and will likely have trouble finding qualified help. In addition, the professional staff are
currently overworked, which would probably limit the services available to new clients.

30
PROBLEM 8.39 (45 minutes) Activity-based costing; product decisions: manufacturer
1 An activity-based costing system is a two-stage process of assigning costs to products. In stage one,
activity costs are established. In stage two an activity driver is identified for each activity. Then the
activity costs are assigned to each product line in proportion to the amount of the activity driver
consumed by each product line.
2 Territory Electronics should not continue with its plans to emphasise the Zodiac model and phase out the
Novelle model. As shown in the following activity-based costing analysis, the Zodiac model has a gross
margin of less than 1 per cent, while the Novelle model generates a gross margin of nearly 42 per cent.
Cost per unit of activity driver:
Soldering $880 000 ÷ 1 600 000 = $0.55 per solder joint
Shipments 836 000 ÷ 19 000 = 44.00 per shipment
Quality control 1 170 000 ÷ 78 000 = 15.00 per inspection
Purchase orders 1 110 000 ÷ 185 000 = 6.00 per order
Machine power 47 500 ÷ 190 000 = 0.25 per hour
Machine setups 948 500 ÷ 9485 = 100.00 per setup
Costs per model:

Zodiac Novelle
Direct costs:
Materiala $2 620 000 $7 986 000
Direct labourb 196 000 462 000
Total direct costs $2 816 000 $8 448 000
Assigned costs:
Solderingc $220 000 $660 000
d
Shipments 167 200 668 800
Quality controle 315 900 854 100
f
Purchase orders 632 700 477 300
Machine powerg 3 800 43 700
h
Machine setups 450 000 498 500
Total assigned costs $1 789 600 $3 202 400
Total cost $4 605 600 $11 650 400
Calculations:
Zodiac Novelle
a
Material 4000  $655 22 000  $363
b
Direct labour 4000  $49 22 000  $21
c
Soldering 400 000 $0.55 1 200 000  $0.55
d
Shipments 3800  $44 15 200  $44
e
Quality control 21 060  $15 56 940  $15
f
Purchase orders 105 450  $6 79 550  $6
g
Machine power 15 200  $0.25 174 800  $0.25
h
Machine setups 4500  $100 4985  $100
31
Profitability analysis:
Zodiac Novelle Total
Sales $4 640 000 $20 020 000 $24 660 000
Less: Cost of goods sold 4 605 600 11 650 400 16 256 000
Gross margin $34 400 $8 369 600 $8 404 000
Units sold 4000 22 000
Per unit calculations:

Selling price $1 160.00 $910.00
Less: Cost of goods sold 1 151.40 529.56
Gross margin $8.60 $380.44
a
Gross margin percentage 0.7% 41.8%b
a
$8.60/$1 160.00 = 0.7%
b
$380.44/$910.00 = 41.8%
PROBLEM 8.40 (30 minutes) Overhead application; activity-based costing:

manufacturer
1 Valdosta Vinyl Company (VVC) is currently using a plantwide overhead rate that is applied on the basis of
direct labour dollars. In general, a plantwide manufacturing overhead rate is acceptable only if a similar
relationship between overhead and direct labour exists in all departments or the company manufactures
products that receive the same proportional services from each department.
In most cases departmental overhead rates are preferable to plantwide overhead rates because plantwide
overhead rates do not provide the following:
 A framework for reviewing overhead costs on a departmental basis, identifying departmental cost
overruns or taking corrective action to improve departmental cost control
 Sufficient information about product profitability, thus increasing the difficulties associated with
management decision making.
2 Because the company uses a plantwide overhead rate applied on the basis of direct labour dollars, the
elimination of direct labour in the Moulding Department through the introduction of robots may appear to
reduce the overhead cost of the Moulding Department to zero. However, this change will not reduce fixed
manufacturing costs such as depreciation and plant supervision. In reality, the use of robots is likely to
increase fixed costs because of increased depreciation. Under the current method of allocating overhead costs,
these costs merely will be absorbed by the remaining departments.
3 (a) In order to improve the allocation of overhead costs in the Cutting and Finishing departments,
management should move toward an activity-based costing system. The firm should:
 Establish activity costs for each significant activity
 Select a cost driver for each activity that best reflects the relationship of the activity to the overhead
costs incurred.

32
(b) In order to accommodate the automation of the Moulding Department in its overhead accounting
system, the company should:
 Establish a separate activity and cost per unit of activity driver, such as robot or machine hours, for
the Moulding Department.
 Apply overhead costs to the Moulding Department on the basis of robot or machine hours.
PROBLEM 8.41 (45 minutes) Overhead application; activity-based costing:

manufacturer
1 a. WGCC's predetermined overhead rate, using direct-labour cost as the single cost driver, is $5 per direct
labour dollar, calculated as follows:
Overhead rate = total manufacturing-overhead cost
budgeted direct-labor cost
= $3 000 000/$600 000
= $5 per direct-labour dollar
b. The full product costs and selling prices of one kilogram of Kona and one kilogram of Malaysian coffee
are calculated as follows:
Kona Malaysian
Direct material..................................................... $3.20 $4.20

Direct labour........................................................ .30 .30
Overhead (0.30 × $5)........................................... 1.50 1.50
Full product cost.................................................. $5.00 $6.00
Markup (30%)...................................................... 1.50 1.80
Selling price......................................................... $6.50 $7.80

33
2 A new product cost, under an activity-based costing approach, is $7.46 per kg of Kona and $4.82 per kg of
Malaysian coffee, calculated as follows:
Budgeted Budgeted
Activity Cost Driver Activity Cost Unit Cost
Purchasing Purchase orders 1 158 $579 000 $500
Material handling Setups 1 800 720 000 400
Quality control Batches 720 144 000 200
Roasting Roasting hours 96 100 961 000 10
Blending Blending hours 33 600 336 000 10
Packaging Packaging hours 26 000 260 000 10
Kona Coffee
Standard cost per kilogram:
Direct material.............................................................................................................. $3.20
Direct labour................................................................................................................. .30
Purchasing (4 orders  $500/2000 kg)......................................................................... 1.00
Material handling (12 setups  $400/2000 kg)............................................................. 2.40
Quality control (4 batches  $200/2000 kg)................................................................. .40
Roasting (20 hours  $10/2000 kg).............................................................................. .10
Blending (10 hours  $10/2000 kg).............................................................................. .05
Packaging (2 hours  $10/2000 kg).............................................................................. .01
Total cost...................................................................................................................... $7.46
Malaysian Coffee
Standard cost per kilogram:

Direct material.............................................................................................................. $4.20
Direct labour................................................................................................................. .30
Purchasing (4* orders  $500/100 000 kg).................................................................. .02
Material handling (30 setups  $400/100 000 kg)........................................................ .12
Quality control (10 batches  $200/100 000 kg).......................................................... .02
Roasting (1,000 hours  $10/100 000 kg).................................................................... .10
Blending (500 hours  $10/100 000 kg)....................................................................... .05
Packaging (100 hours  $10/100 000 kg)..................................................................... .01
Total cost...................................................................................................................... $4.82
*Budgeted sales ÷ purchase order size

100 000 kg ÷ 25 000 kg. = 4 orders

34
3 a. The ABC analysis indicates that several activities other than direct labour drive overhead. The cost
computations show that the current system significantly undercosted Kona coffee, the low-volume
product, and overcosted the high-volume product, Malaysian coffee.
b. The implication of the ABC analysis is that the low-volume products are using resources but are not
covering their share of the cost of those resources. The Kona blend is currently priced at $6.50 [see
requirement 1(b)], which is significantly below its activity-based cost of $7.46. The company should set
long-run prices above cost. If there is excess capacity and many of the costs are fixed, it may be
acceptable to price some products below full activity-based cost temporarily in order to build demand
for the product. Otherwise, the high-volume, high-margin products are subsidising the low-volume,
low-margin products.
PROBLEM 8.42 (30 minutes) Activity-based costing: service organisation

1 (a) Cost per unit of activity driver:
Cook meals $5 per meal
Transport clients (internal) $50 per hour
Transport clients (external) $75 per hour
Clean rooms $5 per room
Bath clients $9 per bath
Dress clients $3 per client
Administer medication $1.60 per dose
Provide occupational therapy $150 per class
Provide physiotherapy $50 per hour
Run workshop $750 per day
(b) Daily cost of supporting the three types of client:

High- Low- Outpatient
dependency dependency client
client client
Meals cooked $15.00 $15.00 $5.00
Internal transport 200.00 0.00 0.00
External 225.00 150.00 75.00
transport
Room cleaned 10.00 5.00 0.00
Bath 9.00 0.00 0.00
Dress 3.00 0.00 0.00
Medication 6.40 1.60 1.60
Occupational 15.00 30.00 30.00
therapy
Physiotherapy 200.00 100.00 50.00
Workshop 0 37.50 37.50
Cost per client $683.40 $339.10 $199.10
2 There are many possible answers here. For example, there are no administrative activities, and the
activity ‘run workshop’ would be comprised of many other activities such as ‘supervise’.

35
3 The real problem is that each client really has their own specific bill of activities and the type of
averaging involved in identifying only three service types may not provide accurate cost data for each
client. But can you suggest a better alternative?
PROBLEM 8.43(30 minutes) (appendix) Calculating activity costs: winery

1 Cost of the activity centres (in $’000s):
Building Machinery Energy Other
costs costs
Wages costs costs Total
Filling 1000 60 400 500 20.0 1980.0
Corking 500 20 150 200 7.5 877.5
Labelling 200 40 100 100 5.0 445.0
Packing 300 80 250 400 12.5 1042.5
$2000 $200 $900 $1200 $45.0 $4345.0
2 Cost of activities in Labelling Centre (in $’000s):

Building Machinery Energy Other
costs costs costs
Wages costs Total
Set up front label machines 25 – – – – 25.0
Operate front label machines 50 12 70 60 3.5 195.5
Set up back label machines 25 – – – – 25.0
Operate back label machines 50 8 30 40 1.5 129.5
Inspect labelled bottles 50 20 – – – 70.0
Total $200 $40 $100 $100 $5.0 $445.0
3 The company may have high levels of non-volume-driven manufacturing costs which are causing their
existing system to report distorted product costs. Also the company may wish to expand its view of
product costs by assigning non-manufacturing costs to products.
4 The limitations of activity-based costing can include the inappropriate assignment of facility level costs to
products, the ultimate unitisation of batch and product level costs and the complexity of ABC systems.

36
SOLUTIONS TO CASES
CASE 8.44 (90 minutes) Traditional versus simple activity-based costing product;
strategic cost analysis: manufacturer
1 Based on the cost data from Gigabyte’s conventional volume-based product costing system, product G
is the firm’s least profitable product. Its reported actual gross margin is only $22.00, as compared with
$84.75 and $104.50 for products T and W respectively. However, the validity of this conclusion
depends on the accuracy of the product costs reported by Gigabyte’s product costing system.
2 Again, based on the product costs reported by the firm’s traditional volume-based product costing
system, product W appears to be very profitable. As in requirement 1, however, the validity of this
assessment depends on the accuracy of the reported product costs.
3 Gigabyte’s competitors have moved aggressively into the market for gismos (product G), but they have
abandoned the whatchamacallit (product W) market to Gigabyte.
These competing firms apparently believe they can sell gismos at a much lower price than Gigabyte’s
management feels is feasible. This evidence suggests that Gigabyte’s competitors may believe their
product cost for gismos is below Gigabyte’s reported product cost. In contrast, Gigabyte’s competitors
apparently believe that they cannot afford to sell whatchamacallits at Gigabyte’s current price of $200.
Perhaps the competing firms’ reported production costs for product W are higher than the cost reported
by Gigabyte’s product costing system.
The danger to Gigabyte is that the company will be forced out of the market for its second largest selling
product. This could be disastrous to Gigabyte Ltd.
4 Percentages for raw material costs:
Raw material Annual raw Percentage of total

Product cost per unit Annual volume material cost raw material cost*
G $35.00 8000 $ 280 000 25%
T 52.50 15 000 787 500 69%
W 17.50 4000 70 000 6%
Total $1 137 500 100%
*
Percentages rounded to nearest whole number.

37
5 Product costs based on an activity-based costing system:
Product G Product T Product W
Direct material $35.00 $52.50 $17.50
Direct labour 16.00 12.00 8.00
a
Machinery 38.28 40.83 76.56
Machine setupb 0.13 0.11 0.66
c
Inspection 9.84 15.75 52.50
Material handlingd 27.34 40.25 13.13
e
Engineering 15.08 2.30 47.40
Total $141.67 $163.74 $215.75
a
Machinery
Product G: ($1 225 000  25%)  8000 units = $38.28
Product T: ($1 225 000  50%)  15 000 units = $40.83
Product W: ($1 225 000  25%)  4000 units = $76.56
b
Machine setup
Product G: ($5250  20%)  8000 units = $0.13
Product T: ($5250  30%)  15 000 units = $0.11
Product W: ($5250  50%)  4000 units = $0.66
c
Inspection
Product G: ($525 000  15%)  8000 units = $9.84
Product T: ($525 000  45%)  15 000 units = $15.75
Product W: ($525 000  40%)  000 units = $52.50
d
Material handling
Product G: ($875 000  25%)  8000 units = $27.34
Product T: ($875 000  69%)  15 000 units = $40.25
Product W: ($875 000  6%)  000 units = $13.13
e
Engineering
Product G: ($344 750  35%)  8 000 units = $15.08
Product T: ($344 750  10%)  15 000 units = $2.30
Product W: ($344 750  55%)  4 000 units = $47.40

38
6 Comparison of reported product costs, new budgeted prices and actual selling prices:
Product G Product T Product

W
Reported product costs:
Conventional volume-based costing system $191.00 $169.50 $95.50
Activity-based costing system 141.67 163.74 215.75
Budgeted price based on new product costs
(150% × new product cost) 212.51 245.61 323.63
Current actual selling price 213.00 254.25 200.00

39
7 Memorandum
Date: Today
To: Managing Director, Gigabyte Ltd
From: IM Student
Subject: Gigabyte’s competitive position
Gigabyte’s product-costing system has been providing misleading product cost information. Our
conventional volume-based costing system overcosted gismos and thingamajigs, but it substantially
undercosted whatchamacallits. As a result Gigabyte has been overpricing gismos and thingamajigs and
underpricing whatchamacallits. The company has been losing money on every sale in the product W
market. Our competitors have taken advantage of our mispricing by moving aggressively into the gismo
market and abandoning the whatchamacallit market to Gigabyte. As a result, our profitability has suffered.
I recommend the following courses of action:
(1) Implement the new activity-based costing system and revise its database frequently.
(2) Lower the target price of gismos to $213, the current actual selling price. This price is slightly over
our usual 50 per cent markup over product cost.
(3) Consider lowering the price of thingamajigs to $246 in order to increase demand. The lower price
still yields Gigabyte a 50 per cent markup over product cost.
(4) Raise the price of whatchamacallits to $324. If the product does not sell at that price, consider
discontinuing the product line.
8
Product G Product T Product W
Conventional volume-based costing system:

reported product cost $191.00 $169.50 $95.50
Activity-based costing system:
reported product cost 141.67 163.74 215.75
Amount of cost distortion per unit 49.33 $ 5.76 $(120.25)
Conventional Conventional Conventional

system system system
overcosts overcosts undercosts
product G by product T by product W by
$49.33 $5.76 $120.25
per unit per unit per unit
Product volume  8000  15 000  4000
Total amount of cost distortion for entire

product line $394 640 $ 86 400 $(481 000)
The sum of these three amounts is $(40). It would be
zero except for the slight rounding errors in the
calculation of the new product costs to the nearest cent.

40
CASE 8.45 Conventional versus simply activity-based costing; strategic cost
analysis: manufacturer
1
Standard Deluxe Heavy-duty
model model model
Product costs based on traditional, volume-
based costing system $105.00 $215.00 $232.00
× 110%  110%  110%  110%
Target price $115.50 $236.50 $255.20
2 Product costs based on activity-based costing system:

Standard Deluxe model Heavy-duty
model
model
Direct material $10.00 $25.00 $42.00
Direct labour 10.00 20.00 20.00
Machinery depreciation and maintenancea 32.00 208.00 75.20
Engineering, inspection and
repair of defectsb 17.04 43.50 34.08
Purchasing, receiving, shipping and
material handlingc 15.28 52.00 29.25
Factory depreciation, taxes, insurance
and miscellaneous overhead costsd 12.50 89.25 25.59
Total $96.82 $437.75 $226.12
a
Pool I:
Depreciation, machinery $1 480 000
Maintenance, machinery 120 000
Total $1 600 000
Standard: ($1 600 000 × 40%)  20 000 = $32.00
Deluxe: ($1 600 000 × 13%)  1000 = $208.00
Heavy-duty: ($1 600 000 × 47%)  10 000 = $75.20
b
Pool II:
Engineering $350 000
Inspection and repair of defects 375 000
Total $725 000
Standard: ($725 000  47%)  20 000 = $17.04
Deluxe: ($725 000  6%)  1000 = $43.50
Heavy-duty: ($725 000  47%)  10 000 = $34.08

41
c
Pool III:
Purchasing, receiving, and shipping $250 000
Material handling 400 000
Total $650 000
Standard: ($650 000  47%)  20 000 = $15.28
Deluxe: ($650 000  8%)  1000 = $52.00
Heavy-duty: ($650 000  45%)  10 000 = $29.25
d
Pool IV:
Depreciation, taxes, and insurance for factory $300 000
Miscellaneous manufacturing overhead 295 000
Total $595 000
Standard: ($595 000  42%)  20 000 = $12.50
Deluxe: ($595 000  15%)  1000 = $89.25
Heavy-duty: ($595 000  43%)  10 000 = $25.59
3
Standard Deluxe Heavy Duty
Model Model Model
Product costs based on activity-based
costing system $96.82 $437.75 $226.12
× 110%  110%  110%  110%
New target price $106.50 $481.53 $248.73
The new target price of the standard model, $106.50, is lower than the current actual selling price, $110.
4 MEMORANDUM
Date: Today
To: President, Morelli Electric Motor Corporation
From: IM Student
Subject: Product costing
Based on the cost data from our conventional volume-based product costing system, our standard model is
not very profitable. Its reported actual profit margin is only $5 ($110 – $105). However, the validity of this
conclusion depends on the accuracy of the product costs reported by our product costing system. Our
competitors are selling motors like our standard model for $106. This price suggests that their product cost is
substantially below our previously reported cost of $105.
Our new activity-based costing system reveals serious product cost distortions stemming from our old
costing system. The new costing system shows that the standard model costs only $96.82, which implies a
target price of $106.50. This price is lower than our current actual selling price and is consistent with the
price our competitors are charging.
In contrast, our new product costing system reveals that the deluxe model's product cost is $437.75 instead of
the previously reported cost of $215. The new product cost suggests a target price of $481.53 for the deluxe
model, rather than $236.50, which was our previous target price for the deluxe model.

42
5 The company should adopt and maintain the activity-based costing system. The price of the standard model
should be lowered to $106. Lowering the price should enable the firm to regain its competitive position in
the market for the standard model. Further price cuts should be considered if marketing studies indicate such
a move will increase demand.
The price of the deluxe model should be set near the target price of $481.53. If the deluxe model does not
sell at this price, management should consider discontinuing the product line. Input from the marketing staff
should be sought before such an action is taken. An important consideration is the extent to which sales in
the standard model and heavy-duty model markets depend on the firm's offering a complete product line.
A slight price reduction should be considered for the heavy-duty model (from $255.20 down to $248.73).
However, the product cost distortion from the old costing system did not affect this model as seriously as it
did the other two.
6
Standard Deluxe model Heavy-duty
model model
Traditional volume-based costing system:
reported product cost $105.00 $215.00 $232.00
Activity-based costing system:
reported product cost 96.82 437.75 226.12
Amount of cost distortion per unit $ 8.18 $(222.75) $ 5.88
Traditional Traditonal Traditional

system system system
overcosts undercosts overcosts
standard deluxe heavy-duty
model by model by model by
$8.18 $222.75 $5.88
per unit per unit per unit
Product volume  20 000  1000  10 000

Total amount of cost distortion for entire
product line $163 600 $(222 750) $58 800
Sum of these three

amounts is $(350). It
would be zero except for
the slight rounding errors
in the calculation of the
new product costs to the
nearest cent.

43
CASE 8.46 (30 minutes) Activity-based costing; traditional costing: manufacturer
1 Over the last 20 years Cravings for Cakes is likely to have experienced a decrease in direct labour as a
percentage of total manufacturing costs and an increase in manufacturing overhead, especially fixed
manufacturing overhead. These changes have been caused largely by the increased automation, which
implies an increase in fixed overheads and decreased direct labour, and the increase in product diversity,
which requires an increased level of production support. Non-manufacturing costs are also likely to have
become relatively more important due to the resources required to satisfy increased customer demands,
especially in the areas of quality and delivery.
2 (a) The existing costing system is likely to overcost the high-volume lamington. Generally, high-
volume products require relatively little overhead support per unit produced as they are produced
in large batches and are often relatively simple to produce. Yet under conventional costing, with
volume-based cost drivers, these products attracted a high share of manufacturing overhead.
(b) The existing costing system is likely to undercost the low-volume Danish pastry. Low-volume
products tend to be overhead intensive, yet under conventional costing systems these products
attract a relatively low share of manufacturing overhead.
3 Under activity-based costing, costs would be assigned to products according to their consumption of
overhead (and other) activities, resulting in a more accurate estimate of product costs.
4 U. B. Bright would need to consider the problems facing Cravings for Cakes in deciding which costs to
include within the activity-based system.

44
CASE 8.47 (50 minutes) Estimating activity costs; assigning costs to activity centres:
manufacturer
1 Costs per activity centre (in $’000s)

Building
Cost centre Wages costs Depn Cons’bles Energy Other Total
Product development 15 3.2 – 1.0 – 1 20.2

Sales and dispatch 30 8.0 – 1.5 – 2 41.5
Mixing 45 8.0 10 5.0 16 3 87.0
Filling 60 16.0 30 10.0 16 4 146.0
Baking 45 8.0 50 10.0 320 3 436.0
Packing 60 16.0 5 15.0 48 4 148.0
Administration 30 16.0 5 5.0 – 2 48.0
Corporate management 15 4.8 – 2.5 – 1 23.3
Total $300 $80.0 $100 $50.0 $400 $20 $950
2 U. B. Bright used cost categories to simplify the process of assigning costs to activities. There would be
many different accounts in Cravings for Cakes’ general ledger and it would be very cumbersome to
assign the costs in each individual account to activity centres and then activities.
3 Bright would have looked for costs that were related to a common theme and could be assigned to
activity centres (and activities) using a common resource driver.
Cost category Examples of costs included

Wages Wages, labour on-costs such as workers compensation, payroll tax and
superannuation
Building costs Rent, council rates, cleaning
Depreciation Depreciation (possibly other machine related costs)
Consumables Oils, greases, gloves, overalls, office supplies
Energy Electricity and gas
Other Any costs not covered by the five categories above. Examples include vehicle costs,
travel, postage, telephone
4 It would be more accurate to trace the wages and labour on-costs to the individual employees who work
in each activity centre.
5 It would be more accurate to trace the depreciation costs to the individual machines in each activity
centre.

45
CASE 8.48 (30 minutes) Estimating activity costs; assigning activity centre costs to
activities: manufacturer
1 Activity costs in Mixing Centre (in $’000s):

Building
Activity Wages costs Depn Cons’bles Energy Other Total
Set up scales 9.00 0.4 – 1.00 – $0.6 11.0
Weigh ingredients 4.50 0.4 – 0.50 – 0.30 5.70
Load mixers 11.25 0.8 – 1.25 – 0.75 14.05
Operate mixers 13.50 4.0 10.0 1.50 16.0 0.90 45.90
Clean mixers 4.50 1.6 – 0.50 – 0.30 6.90
Move mixture to filling 2.25 0.8 – 0.25 – 0.15 3.45
$45.0 $8.0 $10.0 $5.0 $16.0 $3.0 $87.0
2 Usually this information is collected by an ABC project team conducting interviews with employees
who work in the activity centres.
3 The best way of ensuring the quality of the information is to collect the information using a project team
with a good working knowledge of all facets of the business, a good rapport with their co-workers and
good communication skills.
4 All the activities in the Mixing Centre are batch level.

46
CASE 8.49 (90 minutes) (appendix) Assigning activity costs to products; benefits,
costs and limitations of ABC: manufacturer
1 (a) Activity Cost per unit of activity driver

Prepare annual accounts –
Process receivables $3.00 per invoice
Process payables $10.00 per purchase order
Program production $28.00 per production schedule
Process sales order $10.00 per sales order
Dispatch sales order $12.00 per dispatch
Develop and test products Assigned directly to products
Load mixers $14.05 per batch
Operate mixers $0.2295 per kg
Clean mixers $6.90 per batch
Move mixture to filling $0.01725 per kg
Clean trays $1.25 per tray
Fill trays $0.02 per cake or pastry
Move to baking $0.50 per tray
Set up ovens $50 per batch
Bake cakes/pastries $130.00 per batch
Move to packing $2.50 per tray
Pack cakes/pastries $0.10 per cake or pastry
Inspect pastries $0.05 per cake or pastry

47
(b) (i) Lamington: Bill of activities (Batch size 1000: Annual volume 100 000)
Cost per unit of Annual quantity of

activity driver activity driver Annual cost
Process receivables $3.00 500 $1500
Process payables 10.00 200 2000
Program production 28.00 100 2800
Process sales order 10.00 400 4000
Load mixers 14.05 100 1405
Operate mixers 0.2295 30 000 6885
Clean mixers 6.90 100 690
Move mixture to filling 0.01725 30 000 518
Clean trays 1.25 2000 2500
Fill trays 0.02 100 000 2000
Move to baking 0.50 2 000 1000
Set up ovens 50.00 100 5000
Bake cakes/pastries 130.00 100 13 000
Move to packing 2.50 2000 5000
Pack cakes/pastries 0.10 100 000 10 000
Dispatch sales order 12.00 500 6000
Develop and test product 600
$64 898
Cost per unit 64.898 cents

48
(ii) Danish pastry: Bill of activities (Batch size 200: Annual volume 10 000)
Cost per unit of Annual quantity of

activity driver
activity driver Annual cost
Process receivables $3.00 150 $450
Process payables 10.00 100 1000
Program production 28.00 50 1400
Process sales order 10.00 100 1000
Load mixers 14.05 50 703
Operate mixers 0.2295 4000 918
Clean mixers 6.90 50 345
Move mixture to filling 0.01725 4000 69
Clean trays 1.25 400 500
Fill trays 0.02 10 000 200
Move to baking 0.50 400 200
Set up ovens 50.00 50 2500
Bake cakes/pastries 130.00 50 6500
Inspect cakes/pastries 0.05 10 000 500
Move to packing 2.50 400 1000
Pack cakes/pastries 0.10 10 000 1000
Dispatch sales order 12.00 150 1800
Develop and test product 2400
$22485
Cost per unit $2.2485
2 Direct material costs must be added as the activity costs cover only labour and overhead
(manufacturing and non-manufacturing).
3 The activity cost per Danish is much higher because of the high batch costs and relatively small-batch
size. Also the Danish requires an additional activity inspection (although this adds only 5 cents per unit).
It is likely that the significant difference between the cost of lamingtons and Danishes would not be
reflected in the conventional costing system. Many of the overhead activities such as moving, cleaning
and setup are not caused by the volume production (as assumed in the conventional costing) but by
batch quantities. Small batch sizes (as for Danishes) imply relatively high per unit costs for these
overhead activities and vice versa for large batch sizes (as for lamingtons). This would not be picked up
in a conventional system that assumes overhead is volume driven. Also conventional product costs do
not include non-manufacturing costs, such as processing of payables and sales orders and many of these
are batch level costs.

49
4 To: I. M. Craving
From: U. B. Bright
Re: Evaluation of activity-based costing (ABC)
Further to our conversation I present the following evaluation of ABC.
Benefits
ABC will provide more accurate estimates of the costs of our products than we obtain from our existing
product costing system. This will assist the company in assessing product profitability and deciding
which products to produce and promote.
It is highly likely that our existing costing system understates the cost of low-volume product lines and
overstates their profitability. Also the system probably overstates the cost of high-volume product lines.
This happens because manufacturing overhead costs are assigned to products using a volume-based cost
driver. Many years ago, when our costing system was first introduced, this approach made sense.
Manufacturing overheads were relatively insignificant and largely volume driven. However, our
manufacturing processes have changed, causing a change in cost structure and cost behaviour.
Manufacturing overheads are now significant and a substantial part of them is not caused by, or related
to, the volume of production. By using a volume-based cost driver to apply these costs to products, our
costing system overcosts the high-volume products and undercosts the low-volume products.
Also, we have experienced a significant increase in the level of non-manufacturing costs. Many of these
costs are caused by individual products. We would have a better understanding of product profitability if
these costs were assigned to products. This can be achieved through activity-based product costing.
Costs and limitations

Activity-based product costing systems are more expensive to implement and maintain than
conventional costing systems. They must measure a number of different cost drivers, assign costs to a
number of activities and measure individual products’ consumption of the range of cost drivers.
Conventional costing systems use one plantwide overhead rate or a few departmental rates.
In addition, activity-based product costing can suffer some important limitations. Some costs, such as
top management costs, are not related to the production of individual products. Some activity-based
systems ignore cost behaviour and assign these costs, called facility level costs, to products. Activity-
based product costing systems should be designed to exclude facility level costs from product costs.
Also, although activity-based costing recognises a range of non-volume-based cost drivers, ultimately the
system unitises batch and product level costs to calculate the cost per unit of product. This implies that
there is a direct relationship between these costs and the volume of production, which is not true. Users of
activity-based information must be aware of this limitation and interpret the cost estimates with care.
Where possible, it is better to base product-line decisions on total product costs rather than unit costs.
Benefits versus costs

Accurate product costs are an essential input to making important strategic decisions about our products
—for example, which products to produce and in what quantities. Activity-based product costing is
expensive to implement and maintain. It suffers from several limitations, although some of these can be
overcome through careful design of the ABC system and a sensible interpretation of the ABC
information. It appears that the benefits of ABC would outweigh its costs in our company and I
recommend a thorough evaluation of ABC product costing.

50

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CHAPTER 8

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EXERCISE 8.21 (20 minutes) Distortion of product costs: manufacturer

EXERCISE 8.22 (15 minutes) Key features of activity-based costing: manufacturer

Copyright © 2017 McGraw-Hill Education (Australia) Pty Ltd

Cost per person $217.5 $430

EXERCISE 8.24 (20 minutes) Classification of activities: winery

Copyright © 2017 McGraw-Hill Education (Australia) Pty Ltd

Cost pool 1:Material- related activity

Activity driver: raw-material cost or raw material volume

Activity driver: number of units produced or machine hours

Cost pool 4:Inspection

Cost driver: number of inspections or length of time spent on inspections

Cost driver: number of parts in a product

Copyright © 2017 McGraw-Hill Education (Australia) Pty Ltd

EXERCISE 8.26 (5 minutes) Activity costs and activity drivers: manufacturer

EXERCISE 8.27 (25 minutes) Assigning activity costs to products: manufacturer

2 Total cost per unit of product

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Copyright © 2017 McGraw-Hill Education (Australia) Pty Ltd

1 Costs assigned to Top Tech’s Assembly Centre:

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1 Overhead to be assigned to film development chemical order:

total budgeted overhead cost

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Activity Cost per unit of Level of Assigned overhead cost

$11 737 .50

Calculation of unit cost, per plate: Direct material $180.00

PROBLEM 8.34 (30 minutes) Traditional and activity-based product costing:

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Activity driver Cost per unit

Activity Basic Superior

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Cost per unit of

Order $300 000 ÷ 550 orders = $545.45 per OP

Machine 672 000 ÷ 44 000 machine = $15.27 per MH

Product 270 000 ÷ 11 000 inspection = $24.5 per IH

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Activity Basic Superior

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1 Deluxe manufacturing overhead cost:

2 Activity-based application rates:

Activity Deluxe Executive

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1 The predetermined overhead rate is calculated as follows:

2 Activity-based costing analysis:

Activity Activity Activity cost Activity Activity Cost per unit of

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REG ADV GMT

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Machine $ 2.70 REG 50 000 $135 000 5000 $27.00

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Reported unit product cost:

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Manufacturing overhead (based on ABC)*: