CH 5 Study cards

Question 1

Product Over/Under Costing (General)

Answer 1

Simple costing systems assign costs using averages, which can lead to inaccuracies.
This is especially problematic when indirect costs are high or products/services are diverse.
Poor decision-making can occur because the true cost of producing a product or service is not accurately reflected.

Question 2

Under Costing (definition and effect)

Answer 2

When a product consumes a high level of resources but is assigned a low cost per unit.
The product appears to be less expensive to produce than it actually is, leading to poor pricing decisions.

Question 3

Over Costing
Definition and Effect

Answer 3

When a product consumes a low level of resources but is assigned a high cost per unit.
The product seems more expensive than it actually is, which can lead to overpricing and lost sales.

Question 4

Product Cost Cross-Subsidization
Definition and Effect

Answer 4

Occurs when indirect costs are spread uniformly across products, without recognizing the actual resources consumed by each product.
Overcosted Products: These products absorb more costs than they should, making them seem less profitable.
Undercosted Products: These products absorb too little cost, making them appear more profitable than they are.

Question 5

Impact of Over Costing and Under Costing

Answer 5

Overcosted Products:
Absorb too much indirect cost.
Appear less profitable than they really are.

Undercosted Products:
Absorb too little indirect cost.
Appear more profitable than they really are.
This leads to cross-subsidization, where overcosted products end up subsidizing undercosted ones.

Question 6

Simplified Cost Systems:

Answer 6

Use averages to allocate indirect costs.
Problem: Doesn’t account for the actual consumption of resources by different products.

Question 7

Complex Product Mix:

Answer 7

When products/services are diverse, a simple costing method can mask significant cost differences.

Question 8

High Indirect Costs

Answer 8

In environments with high indirect costs (e.g., manufacturing overhead), averaging can lead to significant distortions in product cost allocation.

Question 9

Consequences of Under Costing

Answer 9

Products Appear More Profitable:
Under costing a product makes it seem less expensive to produce, which could lead to lower prices or more aggressive sales tactics.
Result: Loss of profitability and potentially inaccurate pricing strategies.

Distorted Profitability Reporting:
Managers may misjudge the financial health of under costed products, making poor strategic decisions (e.g., underpricing or not investing in the product).

Question 10

Consequences of Over Costing

Answer 10

Products Appear Less Profitable:
Over costing a product makes it seem more expensive to produce, possibly leading to higher prices or reduced sales.
Result: Loss of competitive edge, potential decrease in market share.

Inaccurate Cost Control:
Managers may believe a product is not cost-effective when it actually is, possibly leading to resource allocation decisions that harm profitability.

Question 11

Cross-Subsidization defintion and effect

Answer 11

When overcosted products subsidize the costs of undercosted products.

Effect: This misallocation distorts profit margins and can lead to poor decision-making, as resources are misdirected.

example:
Overcosted Product (A): Appears less profitable than it is, absorbing more overhead costs than necessary.
Undercosted Product (B): Appears more profitable than it is, absorbing fewer overhead costs.

Question 12

Impacts on Pricing Decisions

Answer 12

Undercosted Products:
May be priced too low due to inaccurate cost data, leading to lost profit opportunities.

Overcosted Products:
May be priced too high, resulting in lost sales and reduced competitiveness in the market.

Question 13

Solutions to Product Over/Under Costing

Answer 13

Activity-Based Costing (ABC):
Allocates indirect costs more accurately by identifying activities and assigning costs based on actual consumption.
Benefit: Reduces over/under costing by linking costs to specific activities that drive resource usage.

Use Multiple Cost Pools:
Instead of averaging costs, create separate cost pools for different types of indirect costs (e.g., machine costs, labor costs) to improve allocation accuracy.

Question 14

Correcting Cross-Subsidization

Answer 14

Step 1: Review the current cost allocation system.
Step 2: Identify the resources consumed by each product and adjust the cost allocation base.
Step 3: Implement more precise costing methods like activity-based costing to ensure fairer cost distribution.
Result: Products are more accurately priced, and management can make better decisions regarding product profitability.

Question 15

Long-Term Impact of Inaccurate Costing

Answer 15

Strategic Decisions:
Inaccurate product costing can lead to incorrect decisions about which products to prioritize, discontinue, or invest in.

Financial Performance:
Misallocated costs distort financial statements, leading to inaccurate profit reporting and potential mismanagement of resources.

Question 16

Monitoring Product Costing Accuracy

Answer 16

Periodic Reviews:
Regularly assess costing systems to ensure they reflect the true resource consumption of products.

Adjust for Changes in Production:
When new products are introduced or production methods change, revisit cost allocation methods to keep them aligned with actual resource use.

Question 17

Simple Costing (definition and problem)

Answer 17

Allocates total overhead using a single allocation rate (often called the “peanut butter” approach).

This method may not accurately reflect the actual consumption of overhead by different products.

Uses overhead allocation rate formula

Question 18

Overhead allocation rate formula

Answer 18

Overhead Rate = Budgeted Total Indirect Costs/Budgeted Total Amount of Cost-Allocation Base (e.g., Direct Labor Hours).

Question 19

Guidelines for Refining a Costing System

Answer 19

1. Identify Direct Costs (DC) as Economically Feasible:
   Direct costs should be traced accurately to the product whenever possible.
2. Expand the Number of Indirect Cost Pools:
   Create more cost pools to separate indirect costs that behave differently, making them more homogenous.
3. Select the Right Cost Driver:
   Choose the most appropriate cost driver that has the strongest effect on the cost pool (e.g., machine hours, labor hours).

Question 20

Activity-Based Costing (ABC)

Answer 20

A method used to refine costing systems by identifying individual activities that contribute to product/service costs.

Activities: Events, tasks, or units of work that are directly related to producing a product or service.

ABC Approach: Assigns costs to products/services based on the specific mix of activities required to produce them.

Question 21

Cost Hierarchy in ABC (Definition)

Answer 21

A system used to separate indirect cost pools according to the level at which activities contribute to producing output.

Question 22

Cost Hierarchy in ABC

Answer 22

Unit level
Batch level
Product sustaining level
Facility sustaining level

Question 23

Unit level

Answer 23

Costs from producing individual units of output (e.g., material costs).

Question 24

Batch Level

Answer 24

Costs associated with groups of units (e.g., setup charges).

Question 25

Product Sustaining Level

Answer 25

Costs related to supporting the product (e.g., design costs).

Question 26

Facility Sustaining Level

Answer 26

Costs from operating the organization as a whole (e.g., facility rent, administrative overhead).

Question 27

Output Unit Level Cost (definition and example)

Answer 27

Definition: Costs that arise from producing individual units of output.
Example: Material costs directly tied to each unit produced.

Question 28

Batch Level Costs

Answer 28

Definition: Costs incurred when producing a batch of units rather than a single unit.
Example: Set-up costs, machine calibration costs for a batch of products.

Question 29

Product Sustaining Costs

Answer 29

Definition: Costs related to supporting a product, not directly tied to units or batches.
Example: Design, engineering, or research costs associated with a specific product.

Question 30

Facility Sustaining Costs

Answer 30

Definition: Costs incurred to sustain the overall facility, regardless of the specific products or batches being produced.
Example: Facility maintenance, general administration, security, or utilities.

Question 31

Traditional Costing (Chapter 4) vs. ABC (Chapter 4)

Answer 31

Mathematically Correct: Both methods are accurate.
Acceptable: Both are acceptable methods for cost allocation.
Different Cost Figures: They yield different cost figures, leading to different gross margins.
Only Overhead (OH) Involved: Only overhead costs are allocated, and the total cost for the firm remains the same—just distributed differently across cost objects.
Selection of Method/Driver: The method and cost driver selection should be based on:
Experience
Industry practices
Cost-benefit analysis of each option.

Question 32

Considerations in Implementing ABC

Answer 32

There is a significant amount of indirect costs allocated to multiple cost pools.
Most or all indirect costs are at the unit level.
The product demands diverse resources.
Profitable products show small profits and vice versa.
Operating staff disagrees with the reported cost of manufacturing or marketing products/services.

Question 33

Activity-Based Management (ABM)

Answer 33

Using ABC for Decision-Making:
Distinguish Value-Added from Non-Value-Added Activities: Use ABC information to focus on reducing costs or improving processes.
Improve Pricing/Product Mix Decisions: ABC helps in deciding which processes or products to prioritize.
Assist in Design Decisions: ABC can guide decisions about product design for cost efficiency.
Support Planned Growth: Use ABC to help manage costs during business expansion.

Question 34

ABC in Service and Merchandising Firms

Answer 34

ABC Implementation Outside Manufacturing:
ABC is widely used beyond just manufacturing, including in industries such as:
Healthcare (HC)
Banking
Telecommunications
Retail
Transportation

Question 35

What is the primary issue with simple costing systems?

Answer 35

Simple systems use averages to allocate costs, leading to inaccuracy, especially when indirect costs are high or products/services are diverse.

Question 36

What does “over costed” mean in product costing?

Answer 36

A product is over-costed when it consumes a low level of resources but is allocated a high cost per unit.

Question 37

What is the main goal of Activity-Based Costing (ABC)?

Answer 37

The goal of ABC is to refine costing systems by identifying individual activities and assigning costs based on the mix of activities needed to produce a product or service.

Question 38

What is a “cost allocation base”?

Answer 38

A cost allocation base is a systematic way to link an indirect cost or group of indirect costs to cost objects.

Question 39

What is “product cost cross-subsidization”?

Answer 39

Product cost cross-subsidization occurs when indirect costs are spread uniformly across products without recognizing the actual resources consumed by each product. This leads to over-costed products subsidizing under-costed ones.

Question 40

What is the “peanut butter” approach in costing?

Answer 40

The “peanut butter” approach is a simple costing system that allocates total overhead using a single allocation rate, spreading the costs evenly across all products.

Question 41

What factors should be considered when selecting a method for allocating overhead costs?

Answer 41

Selection should be based on:

Experience
Industry practice
Cost-benefit analysis

Question 42

What is the difference between “under-costed” and “over-costed” products in terms of resource allocation?

Answer 42

Under-costed products consume a high level of resources but are allocated low costs per unit, making them seem more profitable than they are.
Over-costed products consume fewer resources but are allocated high costs per unit, making them seem less profitable than they are.

Question 43

Why might a company benefit from using ABC over traditional costing systems?

Answer 43

ABC is beneficial when:

A significant amount of indirect costs are allocated across multiple cost pools.
Products make diverse demands on resources.
Operating staff disagrees with reported cost of manufacturing or marketing products/services.
Profitable products are showing small profits and vice versa.

Question 44

How does the “Activity-Based Management” (ABM) process help in decision-making?

Answer 44

ABM uses ABC information to:

Distinguish value-added activities from non-value-added activities.
Reduce costs and improve processes.
Improve decisions regarding pricing and product mix.
Assist in design decisions and planning for growth.

Question 45

In the context of ABC, what is a “cost driver”?

Answer 45

A cost driver is a factor or activity that causes a change in the cost of a cost pool, such as machine hours or labor hours.

Question 46

Explain how Activity-Based Costing (ABC) is implemented differently from traditional costing systems, and why ABC might be more suitable for certain firms.

Answer 46

Traditional Costing: Uses a single overhead rate applied across all products, regardless of their actual resource consumption, which can lead to inaccurate cost allocation.
ABC: Identifies individual activities as cost objects and allocates costs based on the resources each activity consumes. This leads to more accurate cost allocation and helps in better pricing, resource management, and profitability analysis.
ABC is more suitable for firms with:
A significant amount of indirect costs allocated across multiple cost pools.
Products/services that have diverse demands on resources.
Operating staff who disagree with reported costs.

Question 47

Traditional Costing:

Answer 47

Uses a single overhead rate applied across all products, regardless of their actual resource consumption, which can lead to inaccurate cost allocation.