Chapter 5: Activity-Based Costing

Question 1

Plantwide Overhead Rate

Answer 1

• Simplest method
• Uses a single allocation base and rate
• Cost accounting information captures only total overhead costs (accumulated in a single pool) and then volume of the allocation base (such as total direct labour-hours)

Question 2

The use of plantwide rate assumes the following:

Answer 2

1) All overhead costs in the organization are driven (or caused) by the single allocation base used
2) Cost objects (eg products) consume overhear resources in the same proportion in which they consume the allocation base

Both assumptions are weak, meaning a single plantwide overhead rate has serious limitations

Question 3

Departmental Overhead ate

Answer 3

• Using multiple cost pools
• Using multiple overhead rates along departmental lines
• Each cost pool captures the overhead costs incurred by a specific department

Ex: 3 departments in a manufacturing plant: Machining, assembly, and maintenance = 3 overhead cost pools (one for each)

Not as great as other systems, can still lead to distortions

Question 4

In departmental Overhead Rate the rates are usually tied to an aspect of the job

Answer 4

Machining could use machine-hours used
Assembly could use labour-hours
Maintenance could use maintenance-hours

Question 5

A serious limitation in the case of both plantwide and departmental overhead allocation is the failure by both methods to recognize two facts:

Answer 5

1) The total overhead cost pool in an organization is an accumulation of the costs of numerous resources that are consumer by the organization its serve its customer
2) The individual overhead costs may be driven by different factors

Lastly, they fail to recognize that different cost objects (i.e products, services, and customers0 may consume the different overhead resources in varying proportion

Question 6

Conventional costing systems that use plantwide or departmental overhead rates suffer from an important limitation:

Answer 6

They tend to assign too much overhead to high-volume products and too little overhead to low-volume products

Question 7

Activity-based Costing (ABC)

Answer 7

A two-stage costing method in which overhead costs are assigned to products on the basis of the activities they consume.

Far better than using a plantwide or department wide manufacturing overhead

Question 8

Super simple way to look at ABC

Answer 8

A customer order for a product or service triggers a number of activities; a number of different types of resources are required to carry out these activities; and resources cost money

Question 9

Cost drivers

Answer 9

Activities that drive costs, that is, cause costs to go up or down.

Question 10

Each allocation base in an ABC system represents a major _________ that causes overhead costs

Answer 10

Activity

Question 11

Activity

Answer 11

A task (or a series of tasks) carried out to fulfill the organization’s purpose.

Question 12

Examples of activities:

Answer 12

1) customer service cost pool
- Receiving customer orders
- Handling customer complaints
- Billing Customers

2) Manufacturing Costs
- Machining
- Assembly
- Production scheduling
- Product testing

3) Accounting cost pool
- Processing payroll
- Processing a credit application
- Repairing performance reports
- Processing accounts payable or accounts receivable

Question 13

Each major activity has its own _________ (aka activity cost pool), its own ____________, and its own predetermined ________________( also known as activity rate)

Answer 13

Overhead cost pool
Activity Measure
Overhead rate

Question 14

Activity cost pool

Answer 14

A “bucket” in which costs that relate to a single activity in the activity-based costing system are accumulated.

Question 15

Activity Measure

Answer 15

An allocation base in an activity-based costing system; ideally, a measure of whatever causes the costs in an activity cost pool.

Question 16

Activity rate

Answer 16

A predetermined overhead rate in activity-based costing. Each activity cost pool has its own activity rate that is used to apply overhead to products and services.

Question 17

Predetermined activity rate =
(equation)
POHR

Answer 17

Estimated activity costs / Estimated activity volume

Estimated $50,000 for sewing and there is estimated 200 hours worth of sewing, activity rate = $250 / hour

Question 18

Designing an Activity-based costing system includes at least the following 7 steps:

Steps 3-6 = 1st part / first stage of ABC
Step 7 = second stage / 2nd part of ABC

Answer 18

1) Identify activities and create an activity dictionary
2) Create activity cost pools
3) Identify the resources consumed by individual activity cost pools
4) Identify the activity measure for each activity cost pool
5) Estimate the total activity volume for each measure
6) Compute a predetermined activity rate for each activity cost pool
7) Allocate activity costs to desired cost objects

Question 19

Step 1) Identify activities and create an activity dictionary

Answer 19

• Hundred or even thousands of activities cause overhead costs (Such as taking phone call orders, filling out an invoice, training new employees)
• To figure out most important activities to consider, they interview a broad range of managers to identify the activities they think are important and consume the most resources
• List is then refined and goes past top management
• Results in a activity dictionary that defines the activities to be included in the system and specifies how each will be measured

Question 20

Step 2) Create activity cost pools

Answer 20

In a manufacturing firm, not every organization has to perform every activity listed in the activity dictionary each time an additional unit is manufactured

Generally a manufacturing organization can classify its activities into four types

Question 21

Generally a manufacturing organization can classify its activities into four types:

Answer 21

1) Unit level
2) Batch level
3) Product level
4) Facility level

Question 22

1) Unit level activities

Answer 22

Activities that arise as a result of the total volume of goods and services produced, and that are performed every time a unit is produced.

Example: The assembly of a Runner Dog Watch would be a unit level activity since every unit has to be assembled

Question 23

2) Batch level activities

Answer 23

Activities performed every time a batch of goods is handled or processed, regardless of how many units are in a batch. The amount of resources consumed depends on the number of batches run, rather than on the number of units in the batch.

They depend on the number of batches processed (the number of schedules, number of setups, number of material receipts)

Question 24

Examples of processing objectives include:

Answer 24

Scheduling production orders, setting up equipment (ie getting equipment ready for producing the next batch of products)

Question 25

3) Product level activities (product-sustaining activities)

Answer 25

Activities that relate to specific products and that must be carried out regardless of how many units are produced and sold or batches run.

Example: Maintaining information regrading the parts for a product (known as product administration), issuing engineering change notices to modify a product to meet a customer’s specifications, and developing special test routines when a product is first placed into production

Question 26

4) Facility level activities (organization-sustaining activities)

Answer 26

Activities that relate to overall production and therefore cannot be traced to specific products. Costs associated with these activities pertain to a plant’s general manufacturing process.

Carried out regardless of which products are produced, how many batches are run, or how many units are made

Not caused by particular products

Question 27

Facility level costs

Answer 27

Include such items as factory management salaries, insurance, property taxes, and building depreciation

Usually combined into a single cost pool and allocated to products using an arbitrary basis such as direct labour-hours

Question 28

Facility-level costs must be allocated to meet

Answer 28

external reporting requirements as well as to hold managers accountable for the costs of resources which, unless allocated, would be considered by them to be free

Question 29

Step 3) Identify the resources consumed by individual activity cost pools

Answer 29

As an example: Product Testing
-Include tome supplied by testers, depreciation of testing equipment, and the testing supplies that can be directly traced to the cost pool

Such resources must be assigned to the individual cost pools and the cost determined

Question 30

Step 4) Identify the activity measure for each activity cost pool

Answer 30

For example: When the amount of the cost assigned to the product testing activity cost pool is known, the next step is to identify an activity measure that will be used to assign the cost of this activity cost pool to final cost objects

Ideally the activity measure should be the cost driver for this activity cost pool

It may not always be possible to identify the cost driver

Question 31

Step 5) Estimate the total activity volume for each measure

Answer 31

Remaining step are about the mechanics of allocating the pool cost to the cost objects

Since product testing is a batch-level activity, the volume of the activity measure will depend on the estimated number of batches to be produced as well the testing policy

Question 32

Step 6) Compute a predetermined activity rate for each activity cost pool

Answer 32

Next you compute the activity rate using the formula Estimated activity costs / Estimated activity volume

Question 33

Step 7) Allocate activity costs to desired cost objects

Answer 33

Second stage of the cost allocation process

in this stage, costs from the different pools are allocated to the desired cost objects using the activity rate and the volume of activity measure consumed by that cost object

Usually you take the number from step 6 and multiply it by how many tests / objects will be conducted

Question 34

Activity-based costing in nonmanufacturing function and organizations

Answer 34

• Can be used to assign selling and admin expenses
• Allows manager in organizations to enhance their understanding of costs as well as asses the performance of the cost objects

Can be found in marketing and administrative sections, also used in banks, hospitals, cities, and data service companies

Question 35

Using activity-based costing in service companies

Answer 35

Can be used to prepare a channel profitability report

Question 36

Benefits of Activity-based Costing

Answer 36

1) Accurate costing
2) Cost estimation
3) Activity-based management

Question 37

1) Accurate costing

Answer 37

• Improve the accuracy of costs assigned to cost objects
• Improves product costs by accumulating overhead costs into multiple activity cost pools that represent the major activities, instead of just one or two pools
• The activity cost pools are more homogeneous than departmental cost pools
• ABC does not rely on volume-based allocation bases (such as direct labour-hours or machine-hours), instead managers use a combination of volume-based and non-volume based activity measures to assign overhead costs to cost objects

Question 38

Non-volume based activity measures

Answer 38

Include batch-level and product-level activity measures

Question 39

2) Cost estimation

Answer 39

Increased accuracy means better estimation of costs

-can help estimate costs related to quality

Question 40

3) Activity-based management

Answer 40

Allows manager to identify activities that could be improved, resulting in greater efficiency and lower cost

Question 41

Activity-based management (ABM)

Answer 41

A management approach that focuses on managing activities as a way of eliminating waste and reducing delays and defects.

ABM is a tool that can supplement management practices such as total quality management and process reengineering

Question 42

Benchmarking

Answer 42

A study of organizations that are among the best in the world at performing a particular task.

Comparing yourself against the best

Question 43

Limitations of activity-based costing

Answer 43

1) The cost of implementing and maintaining an ABC system may outweigh the benefits
2) It would be naïve to assume that all the costs comprising the product cost-even when provided by an activity-based costing system-are all relevant when making decisions

Question 44

1) The cost of implementing and maintaining an ABC system may outweigh the benefits

Answer 44

• Involves a great deal of effort
• must be designed by a cross-functional team
• data must be collected and verified

Question 45

When are the benefits of activity-based costing most likely to be worth the cost?

Answer 45

1) Products differ substantially in volume, in lot size, and the activities they require
2) Conditions have changed substantially since the existing cost system was established
3) Overhead costs are high and increasing, and no one knows why
4) Management does not trust the existing cost system and ignores data from the system when making decisions

Question 46

Limitations of the ABC model

Answer 46

-Relies on a number of critical assumptions such as the cost in each activity pool is strictly proportional to its activity measure

Question 47

Downfalls to having a single allocation base in assinging overhead costs to prodcts

Answer 47

In this situation, the allocation is driven by the relative volume of production - the high volume consumes more of the allocation base and is burdened with more of the overhead cost

Question 48

ABC differs from traditional costing in two ways

Answer 48

1) ABS uses multiple allocation bases that each represent an activity cost pool
2) The activity cost pools are diverse, and both volume-based and non volume based activity measures are used to assign the overhead costs

Question 49

When overhead is applied to a product, Work in Process is debited, and Manufacturing Overhead is credited.

Answer 49

True

Question 50

The journal entry to record actual manufacturing overhead costs involves:

Answer 50

a debit to manufacturing overhead

Question 51

Prevention costs are:

Answer 51

costs associated with activities aimed at preventing future defects/errors

Question 52

Appraisal costs are:

Answer 52

costs associated with quality inspection activities

Question 53

Ordinarily, the unit product costs of high-volume products increase and the unit product costs of low-volume products decrease when activity-based costing replaces a traditional overhead costing system based on direct labour-hours.

Answer 53

False

Question 54

Low-volume product

Answer 54

When a company implements activity-based costing, allocation of MOH often shifts from high-volume to low-volume products with a higher unit product cost resulting for the low-volume products.

Question 55

Appendix 5A

Answer 55

Everything below this until stated elsewise

Question 56

Four Categories of Quality Costs:

Answer 56

1) Prevention Costs:
2) Appraisal costs
3) Internal failure costs
4) External failure costs

Question 57

1) Prevention Costs:

Answer 57

Costs associated with activities aimed at preventing future defects/errors

Question 58

2) Appraisal costs

Answer 58

Costs associated with quality inspection activities

Question 59

3) Internal failure costs

Answer 59

Costs associated with activities carried out when the defect is discovered before the product is delivered to the customer

Question 60

4) External failure costs

Answer 60

Costs associated with activities undertaken after the defect/error is discovered by the customer.

Question 61

Cost of Quality Report:

Answer 61

shows the details of quality costs under the four categories mentioned above.