Chapter 11 - Answer

MANAGEMENT ACCOUNTING- Solutions Manual

CHAPTER 11

SYSTEMS DESIGN: ACTIVITY-BASED COSTING AND MANAGEMENT

I. Questions

1. The three levels available are: Level 1, in which a company uses a plantwide overhead rate; Level 2, in which a company uses departmental overhead rates; and Level 3, in which a company uses activity-based costing.

2. New approaches to costing are needed because events of the last few decades have made drastic changes in many organizations. Automation has greatly decreased the amount of direct labor required to manufacture products; product diversity has increased in that companies are manufacturing a wider range of products and these products differ substantially in volume, lot size, and complexity of design; and total overhead cost has increased to the point in some companies that a correlation no longer exists between it and direct labor.

3. The departmental approach to assigning overhead cost to products relies solely on volume as an assignment base. Where diversity exists between products (that is, where products differ in terms of number of units produced, lot size, or complexity of production), volume alone is not adequate for overhead costing. Overhead costing based on volume will systematically overcost high-volume products and undercost low-volume products.

4. Process value analysis (PVA) is a systematic approach to gaining an understanding of the steps associated with a product or service. It identifies all resource-consuming activities involved in the production process and labels these activities as being either value-added or non-value-added. Thus, it is the beginning point in designing an activity-based costing system since management must know what activities are involved with each product before activity centers can be designated and cost drivers established. Also, PVA helps management to eliminate any non-value-added activities and thereby streamline operations and minimize costs.

5. The four general levels of activities are:

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Chapter 11 Systems Design: Activity-Based Costing and Management

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

2. Batch-level activities, which are performed each time a batch of goods is handled or processed.

3. Product-level activities, which are performed as needed to support specific products.

4. Facility-level activities, which simply sustain a facility’s general manufacturing process.

6. First, activity-based costing increases the number of cost pools used to accumulate overhead costs. Second, it changes the base used to assign overhead costs to products. And third, it changes a manager’s perception of many overhead costs in that costs that were formerly thought to be indirect (such as depreciation or machine setup) are identified with specific activities and thereby are recognized as being traceable to individual products.

7. The two chief limitations are: First, the portion of overhead costs that relate to facility-level activities are still usually allocated to products on some arbitrary basis, such as machine-hours or direct labor-hours. Critics of activity-based costing argue that facility-level activities account for the bulk of all overhead costs in some companies. Second, high measurement costs are involved in operating an activity-based costing system. That is, the system requires the tracking of large amounts of detail and the completion of many separate computations in order to determine the cost of a unit or product.

8. Yes, activity-based costing can be used in service organizations. It has been successfully implemented, for example, in railroads, hospitals, banks and data service companies.

9. A resource driver is a measure of the quality of resources consumed by an activity.

10. An activity driver is a measure of frequency and intensity of demands placed on activities by cost objects.

11. Two-stage allocation is a procedure that first assigns a firm’s resource costs, namely factory overhead cost, to cost pools, and then to cost objects.

12. Two major advantages of ABM are:

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Systems Design: Activity-Based Costing and Management Chapter 11

a. ABM measures the effectiveness of the key business processes and activities, and identifies how they can be improved to reduce costs and improve the customer value.

b. ABM improves the management focus by allocating resources to key value-added activities, key customers, key products, and continuous improvement methods to maintain the firm’s competitive advantage.

13. When direct labor is used as an allocation base for overhead, it is implicitly assumed that overhead cost is directly proportional to direct labor. When cost systems were originally developed in the 1800s, this assumption may have been reasonably accurate. However, direct labor has declined in importance over the years while overhead has been increasing. This suggests that there is no longer a direct link between the level of direct labor and overhead. Indeed, when a company automates, direct labor is replaced by machines; a decrease in direct labor is accompanied by an increase in overhead. This violates the assumption that overhead cost is directly proportional to direct labor. Overhead cost appears to be driven by factors such as product diversity and complexity as well as by volume, for which direct labor has served as a convenient measure.

14. Employees may resist activity-based costing because it changes the “rules of the game.” ABC changes some of the key measures, such as product costs, used in making decisions and may affect how individuals are evaluated. Without top management support, employees may have little interest in making these changes. In addition, if top managers continue to make decisions based on the numbers generated by the traditional costing system, subordinates will quickly conclude that the activity-based costing system can be ignored.

15. Unit-level activities are performed for each unit that is produced. Batch-level activities are performed for each batch regardless of how many units are in the batch. Product-level activities must be carried out to support a product regardless of how many batches are run or units produced. Customer-level activities must be carried out to support customers regardless of what products or services they buy. Organization-sustaining activities are carried out regardless of the company’s precise product mix or mix of customers.

16. Organization-sustaining costs, customer-level costs, and the costs of idle capacity should not be assigned to products. These costs represent resources that are not consumed by the products.

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II. True or False

1. True 3. False 5. False 7. True 2. True 4. True 6. False 8. True

III. Exercises

Exercise 1

ActivityActivity

Classification

Examples of Traceable

Costs

Examples of Cost

Drivers

a. Materials are moved from the receiving dock to product flow lines by a material-handling crew

Batch-level Labor cost; depreciation

of equipment; space cost

Number of receipts; pounds handled

b. Direct labor workers assemble various products

Unit-level Direct labor cost; indirect labor cost; labor benefits

Direct labor-hours

c. Ongoing training is provided to all employees in the company

Facility-level* Space cost; training costs; administration costs

Hours of training time; number trained

d. A product is designed by a specialized design team

Product-level Space cost; supplies used; depreciation of design equipment

Hours of design time; number of engineering change orders

e. Equipment setups are performed on a regular basis

Batch-level Labor cost; supplies used; depreciation of equipment

Number of setups; hours or setup time

f. Numerical control (NC) machines are used to cut and shape materials

Unit-level Power; supplies used; maintenance; depreciation

Machine-hours; number of units

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* Personnel administration and training costs might be traceable in part to the facility-level and in part to other activity centers at the unit-level, product-level, and batch-level.

Exercise 2

1. plantwide overhead rate 6. Batch-level2. volume 7. Product-level3. two stage, stage, stage 8. Facility-level4. Process value analysis 9. high-volume, low-volume, low-volume5. Unit-level 10. activity centers

Exercise 3

a. Various individuals manage the parts inventories. Product-level

b. A clerk in the factory issues purchase orders for a job. Batch-level

c. The personnel department trains new production workers.

Organization-sustaining

d. The factory’s general manager meets with other department heads such as marketing to coordinate plans.


e. Direct labor workers assemble products. Unit-levelf. Engineers design new products. Product-levelg. The materials storekeeper issues raw materials to

be used in jobs. Batch-levelh. The maintenance department performs periodic

preventative maintenance on general-use equipment.


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

Exercise 4

Sales (P1,650 per standard model glider × 10 standard model gliders + P2,300 per custom designed glider × 2 custom designed gliders)..............................................................................P21,100

Costs:

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Direct materials (P462 per standard model glider × 10 standard model gliders + P576 per custom designed glider × 2 custom designed gliders)..............................................P5,772

Direct labor (P19 per direct labor-hour × 28.5 direct labor-hours per standard model glider × 10 standard model gliders + P19 per direct labor-hour × 32 direct labor-hours per custom designed glider × 2 custom designed gliders).......................................................................6,631

Supporting manufacturing (P18 per direct labor-hour × 28.5 direct labor-hours per standard model glider × 10 standard model gliders + P18 per direct labor-hour × 32 direct labor-hours per custom designed glider × 2 custom designed gliders).......................................................................................................6,282

Order processing (P192 per order × 3 orders)..................................................576Custom designing (P261 per custom design × 2

custom designs)..........................................................................................522Customer service (P426 per customer ×

1 customer)................................................................................................. 426 20,209 Customer margin................................................................................................P 891

Exercise 5

Requirement 1

The predetermined overhead rate is computed as follows:

The unit product costs under the company’s traditional costing system are computed as follows:

Special RegularDirect materials.........................................................................................................P60.00 P45.00Direct labor...............................................................................................................9.60 7.20Manufacturing overhead (0.8 DLH × P5.80 per DLH;

0.6 DLH × P5.80 per DLH)................................................................................... 4.64 3.48 Unit product cost.......................................................................................................P74.24 P55.68

Requirement 2

The activity rates are computed as follows:

(a)Estimated (b)

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Predeterminedoverhead rate = P290,000

50,000 DLHs = P5.80 per DLH


Overhead Total (a) ÷ (b)Activities Cost Expected Activity Activity Rate

Supporting direct labor.............................P150,000 50,000 DLHs P3 per DLHBatch setups.............................................P60,000 250 setup

sP24

0per setup

Safety testing............................................P80,000 100 tests P800

per test

Manufacturing overhead is assigned to the two products as follows:

Special Product:Activity Cost Pool

(a)Activity Rate

(b)Activity

(a) × (b)ABC Cost

Supporting direct labor...........................................................P3 per DLH 8,000 DLHs P24,000Batch setups.............................................................................P240 per setup 200 setups 48,000Safety testing............................................................................P800 per test 80 tests 64,000 Total P136,000

Regular Product:Activity Cost Pool

(a)Activity Rate

(b)Activity

(a) × (b)ABC Cost

Supporting direct labor...........................................................P3 per DLH 42,000 DLHs P126,000Batch setups.............................................................................P240 per setup 50 setups 12,000Safety testing............................................................................P800 per test 20 tests 16,000 Total P154,000

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

Special RegularDirect materials.............................................................................................P60.00 P45.00Direct labor...................................................................................................9.60 7.20Manufacturing overhead (P136,000 ÷ 10,000 units; P154,000

÷ 70,000 units).......................................................................................... 13.60 2.20 Unit product cost...........................................................................................P83.20 P54.40

IV. Problems

Problem 1

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Cost Systems

Pool Rate

Cost Driver Consumption

Cost Assignment

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

P24,020Problem 2

Requirement 1

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

= P452,000

Overhead rate = P452,000 / 50,000 direct labor hours = P9.04 per direct labor hour

Overhead assigned to proposed job = P9.04 x 1,000 direct labor hours = P9,040

(b) Total cost of proposed job:

Direct materials P 6,000Direct labor10,000Overhead applied 9,040

Total cost P25,040

(c) Company’s bid = Full manufacturing cost x 120% = P25,040 x 120% = P30,048

Requirement 2

(a) Maintenance : P200,000 / 20,000 = P10 per machine hourMaterials handling: P32,000 / 1,600 = P20 per moveSetups: P100,000 / 2,500 = P40 per setup

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

Overhead assigned to proposed job:

Maintenance (P10 x 500) P5,000Material handling (P20 x 12) 240Setups (P40 x 2) 80Inspection (P30 x 10) 300

Total overhead assigned to job P5,620

(b) Total cost of proposed project:

Direct materials P 6,000Direct labor10,000Overhead applied 5,620

Total cost P21,620

(c) Company’s bid = Full manufacturing cost x 120% = P21,620 x 120% = P25,944

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

Direct materials P6,000Direct labor 10,000Overhead assigned:

Maintenance (P10 x 500) P5,000Material handling (P20 x 12) 240Setups (P40 x 2) 80Inspections (P30 x 10) 300

Total overhead assigned to job 5,620Total cost P21,620Markup 120%Bid price P25,944

Problem 3 (Activity-Based Costing)

Requirement 1

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

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Activity Cost PoolsAssemblin

g UnitsProcessing

OrdersSupporting Customers Other Total

Manufacturing overhead P250,000 P175,000 P25,000 P50,000 P500,000

Selling and administrative overhead 30,000 135,000 75,000 60,000 300,000

Total cost P280,000 P310,000 P100,000 P110,000 P800,000

Requirement 2

The activity rates for the cost pools are:

(a)Total Cost

(b)Total Activity

(a) (b)Activity Rate

Assembling units P280,000 1,000 units P280 per unitProcessing orders P310,000 250 orders P1,240 per orderSupporting customers

P100,000 100 customersP1,000 per

customer

Requirement 3

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

Activity Cost Pools(a)

Activity Rate(b)

Activity (a) x (b)

ABC CostAssembling units P280 per unit 80 units P22,400Processing orders P1,240 per order 4 orders P4,960Supporting customers P1,000 per customer 1 customer P1,000

Requirement 4

The customer margin can be computed as follows:

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

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

Customer margin P 840

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

Requirement 1

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

b. ModelHY5 AS2

Direct materials...................................................................P35.00 P25.00Direct labor:

P20 per hour × 0.2 DLH, 0.4 DLH...................................4.00 8.00Manufacturing overhead:

P74 per hour × 0.2 DLH, 0.4 DLH................................... 14.80 29.60 Total unit product cost.........................................................P53.80 P62.60

Requirement 2

a. Predetermined overhead rates for the activity cost pools:

Activity Cost Pool (a) (b) (a) ÷ (b)

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Predeterminedoverhead rate

= P1,480,00020,000 DLHs = P74 per DLH

= Manufacturing overhead costDirect labor hours


EstimatedTotal Cost

EstimatedTotal Activity Activity Rate

Machine setups................P180,000 250 setups P720 per setupSpecial milling................P300,000 1,000 MHs P300 per MHGeneral factory................P1,000,000 20,000 DLHs P50 per DLH

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

Model HY5

Activity Cost Pool

(a)Predetermined Overhead Rate

(b)Activity

(a) × (b)Overhead Applied

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

Model AS2

Activity Cost Pool

(a)Predetermined Overhead Rate

(b)Activity

(a) × (b)Overhead Applied

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

b. The unit product cost of each model under activity-based costing would be computed as follows:

ModelHY5 AS2

Direct materials....................................................................................................P35.00 P25.00

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

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

Requirement 3

It is especially important to note that, even under activity-based costing, 68% of the company’s overhead costs continue to be applied to products on the basis of direct labor-hours:

Machine setups (number of setups)...........................P 180,000 12%Special milling (machine-hours)............................... 300,000 20General factory (direct labor-hours).......................... 1,000,000 68 Total overhead cost..................................................P1,480,000 100%

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

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

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

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batches. The smaller the batch, the higher the cost per unit of the batch activity. In the case at hand, the data can be analyzed as shown below.

Model HY5:Cost to complete one setup [see 2(a)]...................................... P720 (a)Number of units processed per setup

(20,000 units ÷ 150 setups).................................................133.33 (b)Setup cost per unit (a) ÷ (b)..................................................... P5.40

Model AS2:Cost to complete one setup (above)......................................... P720 (a)Number of units processed per setup

(40,000 units ÷ 100 setups)................................................. 400 (b)Setup cost per unit (a) ÷ (b)..................................................... P1.80

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

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

V. Multiple Choice Questions

1. A 11. B 21. D2. D 12. D 21. A3. C 13. C 22. B4. B 14. A 23. A5. A 15. C 24. B

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6. D 16. D 25. D7. A 17. D 26. B8. B 18. C 27. C9. D 19. B 28. A10. C 20. A 29. C

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Chapter 11 - Answer