Chapter 7 Activity-Based Costing and Managements3.amazonaws.com/prealliance_oneclass_sample/lz68wDM5GG.pdf34 Cost Management Chapter 7 Activity-Based Costing and Management LEARNING

34 Cost Management

Chapter 7Activity-Based Costing and Management

LEARNING OBJECTIVES

Chapter 7 addresses the following questions:

LO1 Differentiate activity-based costing (ABC) from traditional costing.LO2 Use cost hierarchy to help assign costs to activities.LO3 Apply an ABC system in assigning costs.LO4 Describe the characteristics and use of activity-based management (ABM).LO5 Explain GPK and RCA.LO6 Describe how ABC, GKP, and RCA affect managers’ incentives and decisions.

These learning questions (LO1 through LO6) are cross-referenced in the textbook to individual exercises and problems.

© 2012 John Wiley and Sons Canada, Ltd.

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QUESTIONS

7.1 If direct labour hours are used for tending machines and equipment, small batches take fewer direct labour hours and so are allocated less overhead. However, if overhead costs increase more with setup time than with direct labour costs, the cost to set up for a large batch is likely similar to the cost of setting up a small batch. The cost per unit is then probably much lower for the large batch than for the small batch.

7.2 Organization-sustaining activities are activities related to the overall organization and unaffected by customers served or by quantities of products, batches, or units. Facility-sustaining activities are activities related to the overall operations of a production facility and unaffected by customers served or by quantities of products, batches, or units. Customer-sustaining activities are customer service activities that are independent of sales volumes and mix. Product-sustaining activities occur to support a product line or a single product if it is not part of a product line. Batch-level activities increase as the number of batches increase. These activities include setup and monitoring batches of product. Unit-level activities increase proportionately with production volumes or sales volumes.

7.3 Because ABC uses more cost pools and more cost drivers to reflect cause and effect relationships, ABC costs usually map the relation between cost and use of resources more accurately. Hence ABC costs reflect different proportions of the resource costs than do traditional costs.

7.4 No, increasing the number of cost pools and cost drivers can increase measurement error because small measurement errors for each pool and each driver can distort total cost once costs are allocated, simply from the increase in calculations that take place. In addition, if the production process is very simple and products use the same amount of resources each, increasing the number of cost pools will not increase the accuracy of the allocations.

7.5 No, because it is expensive to implement, the costs outweigh the benefits for some firms. Firms that are already operating efficiently may not benefit from an ABC system, especially if they have available capacity. Research has shown that ABC is more successful within organizations that use flexible systems, have integrated information systems, and produce a variety of products.

7.6 Yes, ABC can be used in service industries. In service organizations, ABC may be especially helpful if there are capacity limits. Service industries often have a large proportion of fixed resources, and understanding the relationship between cost and the use of these resources can improve the efficiency of the organization.

7.7 Measurement error could decrease because ABC can do a better job of allocating costs to the use of resources. Better allocation reduces problems such as product cross-subsidization, in which costs are overallocated to some products and underallocated to


Chapter 7: Activity-Based Costing and Management 36

others. However, measurement error could increase because increasing the number of cost pools and cost drivers results in small measurement errors for each pool and each driver. As the number of calculations increase, these small measurement errors interact as costs are allocated (rates are developed and used as multipliers), and so the size of measurement error is likely to increase.

7.8 Several costs that are incurred when implementing an ABC system include the time it takes employees or consultants to determine appropriate cost pools and cost drivers, the cost to track and measure the number of activities because these may not be recorded in the accounting system, and the cost to set up an information system to develop ABC reports. Several benefits include the ability to identify non-value added activities, and a better understanding of the use of overhead resources.

7.9 First, meet with accounting employees to learn about all of the different activities they perform. Identify activities that are homogeneous and can be pooled together. For example, budget preparation for each department is probably similar, but it may take different amounts of time according to the complexity of the department. Pool all of the various budgeting activities. Once a list of activities has been identified, employees’ opinions about appropriate cost drivers can be solicited. Activities that have the same cost drivers could probably be pooled.

7.10 Yes, research has shown that ABC is more successful within organizations that use flexible systems, have integrated information systems, and produce a variety of products. With ABC, a better mapping of the use of resources to each product line allows managers to choose the optimal product mix. In addition, if the processes are complex, ABC allows analysis of the activities underlying complex processes so improvements are easier to identify, as are non-value added activities. In these cases, the costs are likely less than the benefits achieved.

7.11 Activity-based costing analyzes the activities performed in manufacturing and service production. Once the activities are identified, costs for each activity are collected into separate cost pools. Next a cost driver is chosen that reflects changes in the costs of activities. The cost driver is used to allocate the costs of the activity to products, services, or some other cost object. There are multiple cost pools and drivers. Traditional costing uses only a few overhead cost pools and allocates the costs based on drivers such as direct labour hours, direct labour cost, or machine hours. In a traditional cost system, the cost pools are very large and so it is impossible to find an allocation base that reflects resource use. It is merely a logical system of assigning part of overhead costs to each product or service. ABC, on the other hand, selects cost pools around activities so that a cost driver can be chosen to better reflect a product or service’s use of resources. Therefore, ABC systems have more cost pools and drivers. Because an ABC system is more complex, more time, effort, and money are required to implement ABC systems than traditional costing systems.

7.12 Activity-based costing is a method of allocating costs to products or other cost objects. Activity-based management is the process of using ABC information to improve


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operations and profitability by analyzing the actual activities and processes to reduce non-value added activities, and improve the efficiency of activities. In addition, managers may be able to better understand different products’ uses of fixed resources, which could be important if there are capacity constraints.

7.13 There are several reasons for using ABC and ABM to improve an organization’s environmental performance. Environment-related activities, such as disposing of hazardous substances and cleaning up spills of these substances, are non-value added. If those types of activities can be minimized, costs are also likely to be reduced. In addition, most companies would prefer to avoid the negative reputation effects that are associated with pollution problems. Once managers become aware of environmental costs, they may realize that investing in prevention activities will actually reduce costs in the long run.

7.14 Prevention activities are activities performed to insure defect-free production. These activities could include

• inspecting incoming direct materials• designing and redesigning products and manufacturing processes to reduce defect

rates• identifying areas where defects arise and solving the underlying cause of the

defects

Appraisal activities are activities performed to identify defective units, and include the following activities:

• Inspection of products• Inspection of manufacturing process• Monitoring of service delivery process• Testing

Production activities are activities undertaken in the production or rework of failed units. These include

• Labour tasks and materials to produce spoiled units• Reworking spoiled units

Post-Sales activities are activities undertaken after the product has been sold to remedy problems caused by defects and failed units. These activities include

• Accepting returned products and exchanging them for good products or refunding their cost

• Repairing defective units• Preparing for and participating in legal actions that result from defective units

7.15 ABC, GPK, and RCA are costing systems that use multiple cost pools and more accurately map costs to the use of resources than traditional costing systems. Implementation for all three methods requires identifying multiple cost pools and analyzing activities or resources to discover cause-and-effect relationships of cost and



cost drivers. ABC analyzes activities and uses a specific hierarchy. GPK considers cost centres that are usually smaller than departments, perform a single repetitive activity and are under the control of one manager. RCA analyzes cost centres and resource cost pools. Both GPK and RCA focus on volume of time. GPK uses practical or budgeted capacity for the denominator level of the cost driver, while RCA uses theoretical capacity. ABC is best used for cost control, improving efficiency and understanding the relationship between costs and the use of resources. GPK focuses on marginal costs and so it can be used for short term decisions, RCA can be used for short-, mid-, and long-term decisions.


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MULTIPLE-CHOICE QUESTIONS

7.16 Which of the following statements best describes the objective of kaizen costing?a) To accumulate costs that are associated with a short-term or long-term projectb) To determine all costs related to the quality of a productc) To reduce costs and improve quality through continuous improvementd) To simplify cost accounting in a just-in-time environment

Ans: C

7.17 Which of the following statements best describes activity-based management?a) ABM is an approach developed in response to the competitive pressures of today’sglobal market.b) ABM does not use activity-based costing to improve a business.c) ABM is designed to set the goals and objectives of an organization.d) ABM focuses on functional areas and products.

Ans: D

7.18 Which of the following statements is correct?a) Machine-related costs are batch-level activities.b) Engineering costs are unit-level activities.c) Inspection and testing costs are organization-sustaining activities.d) Supervision and scheduling costs are facility-sustaining activities.

Ans: A

7.19 What is the overhead cost per unit using activity-based costing?VE1 VE2

a) $42.00 $84.00b) $67.86 $66.76c) $77.00 $61.00d) $84.00 $56.00

Ans: B (VE1 Machine-related: $62,000/(1,000*2 + 1,500*4) * 2 MH = $15.50 )(VE1 Supervision and scheduling: $48,000/(140+180) * 140/1000 = $21.00)(VE1 Engineering: $32,000/(240+260) * 240/1000 = $15.36)(VE1 Inspection and testing: $26,000/(320+200) * 320/1000 = $16.00)(VE1 $15.50 + $21.00 + $15.36 + $16.00 = $67.86)



7.20 What is the overhead cost per unit using traditional costing?VE1 VE2

a) $42.00 $84.00b) $67.20 $66.20c) $73.50 $63.00

d) $80.64 $58.24

Ans: A ($168,000/(1,000*2+1,500*4) * 2 = $42.00)


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EXERCISES

7.21 Mapping Costs to the Cost Hierarchy – Fairgood& Hernandez, CA

A. Receptionist salary is an organization-sustaining activity (1) because the receptionist serves everyone who comes through the door and thus cannot be identified with one product or unit.

B. Financial forecasting software is an organizational-sustaining activity (1) if it is used to forecast sales for the entire company. However if it used only by one product line, it is a product-sustaining activity (4).

C. Photocopy machine rental is anorganization-sustaining activity (1) when everyone uses the machine, but could be a product, batch or unit related cost if a password were used to keep track of copies made for each client or department.

D. Janitorial service is anorganization-sustaining activity (1) because the entire facility uses this evenly.

E. Audit manager’s salary is a unit-level activity (6)because the manager is in charge of a number of different audits and bills his or her time to each audit.

F. Long distance telephone charges are unit-level activity (6) if the bill includes details of to whom the calls were made, and could be product-sustaining activity (4) if the calls are marketing a particular product. It just depends upon the purpose of the calls. Some companies have Watts lines and pay a flat fee for all long distance calls. In this case the cost is an organization-sustaining activity (1).

G. Meal costs for entertaining clients could be a customer-sustaining activity (3)if related only to that particular customer, or product sustaining activity(4)if the customer is associated with only one product.

H. Costs of annual employee golf party is an organization-sustaining activity (1)because it benefits all departments.

I. Office supplies such as paperclips and tablets of paper are organization-sustaining activity (1)costs unless they can be traced to a particular product or batch.

J. Annual subscription for income tax regulations is a product-sustaining activity (4)if it pertains to one department of the firm. If it pertains to the entire firm, it is a facility-sustaining activity (2).



7.22 Identifying Costs Using the ABC Cost Hierarchies – Steam Whistle Brewing

Following are the CMA answers to this question. However, one could argue that some of the unit-level costs could instead be categorized as batch-level.

A. Facility-sustainingcosts: Manufacturing facility $1,500,000

B. Product-sustaining costs: Product development $1,250,000

C. Batch-level costs: Production setup $700,000

D. Unit-level costs:Materials handling $ 850,000Production line labour 2,500,000Power (assuming most power is to cool beer and

run machines, not for overhead) 500,000Total unit-level costs $3,850,000

7.23 ABC Cost Hierarchy

A. Unit-level activities and costs relate to each unit produced, in this case, each car rented. The cost of washing each car between rentals is an example of a unit level cost. Costs for the activities of making the reservation, turning the vehicle over to the renter, and completing the paperwork at the end of the rental are also unit-level.

B. Batch-level activities and costs relate to the number of batches produced. For a car rental fleet, cars at a number of outlets are probably sent for oil changes or other routine maintenance in batches. Car rental companies located off-site near an airport usually operate a shuttle service from the airport to the rental car location. Multiple passengers are usually picked up and dropped off on each run of the shuttle. Batch-level costs for the shuttle would include vehicle depreciation, maintenance, and gasoline, plus the driver’s labour costs.

C. Product-sustaining activities and costs relate to entire product lines. For a car rental company, the different types of cars for rent could be considered product lines, for example economy cars, mid-sized cars, and so on. Or the company might see its product lines more broadly, such as a product line of cars and a separate line for trucks. Advertising and marketing costs are likely to be product-line related if the company advertises either trucks or cars, but not both.

D. Customer-sustaining activities and costs relate to the different clients. Sometimes businesses establish a relationship with car rental agencies if employees need to travel by car for business. These customers may require special attention, such as car delivery, or last minute rentals. The costs of these services are customer-sustaining. Rental companies also have programs such as the Hertz #1 Club, where members receive


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preferential treatment. Special costs for these programs include extra personnel to process the rental and park the vehicle in an easily accessible location.

E. Facility-sustaining activities and costs relate to the facility. For a car rental agency, these could include depreciation and maintenance of the building and parking lots for each outlet. Facility-sustaining costs would also include the facility manager’s salary, electricity and janitorial service, computer terminals, and property taxes.

F. Organization-sustaining activities and costs relate to the entire organization. The CEO’s salary, and building lease, rent or depreciation costs at the company’s headquarters are all organization-sustaining costs. Companies such as Hertz also have large organization-wide costs for computerized reservation and vehicle inventory systems.

7.24 Cost Pools and Cost Drivers

F Machining (As machine hours increase, costs such as maintaining machines increase)

D Purchasing activities (As number of invoices increases, costs such as wages for employees filling out invoices and supplies used by these employees increase.)

G Inspection (As the number of units produced increases, the number of units inspected also increases.)

B Assembly (As the number of parts increases, it takes more overhead cost in material handling, etc. to assemble the product.)

A Payroll (As number of employees increases, more employee time and supplies are needed to produce paychecks.)

E A special quick freezing process for food (Food is usually frozen in batches. As the number of batches increases, costs such as electricity and quick-freezing supplies increases.)

C Laundry in a hospital (As the number of laundry pounds increases, more labour and supplies costs are incurred because more batches of clothes are washed.

7.25 Traditional Versus ABC Costing - Kalder Products

A. Total engineering change cost 6 change orders *$300 each $1,800Total machine hours 1 MHr + 1.5 MHr 2.5 MHrRate $1,800 / 2.5 MHr $720/MHr

Total allocated cost for AJ40 1 MHr * $720/MHr $ 720Total allocated cost for AJ60 1.5 MHr * $720/MHr 1,080Total allocated costs $1,800



B. Total engineering change cost 6 change orders *$300 each $1,800

Total allocated cost for AJ40 4 change orders *$300 $1,200Total allocated cost for AJ60 2 change orders * $300 600Total allocated costs $1,800

C. Comparison of costs allocated under the two systems:

AJ40 AJ60 TotalTraditional costing $ 720 $1,080 $1,800ABC costing 1,200 600 1,800

Product Cross SubsidizationOvercharge (Undercharge) $ (480) $ 480 $ 0

Percent Overcharge (Undercharge) (40)% 80%

Cross-subsidization means that one product is allocated more overhead cost relative to its use of overhead resources and, therefore, other products’ overhead cost is less than their use of resources.

7.26 ABC Cost Hierarchy, Traditional Versus ABC Costing – Yonex Company

A.

Activity ClassificationTesting and Inspections Batch level activities and costsMachine Setup Batch level activities and costsMachine Stamping Unit level activities and costsPlant Maintenance Facility sustaining level activities and costs

B. Total Labour Hours for two products: 1,500 + 2,500 = 4,000 hours$400,000 / 4,000 hours = $100 per labour hourMB-R: $100 x 1,500 = $150,000MB-X: $100 x 2,500 = $250,000

Using the traditional costing method, MB-R is allocated $150,000 of the overhead costs, while MB-X is allocated $250,000.


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C. The overhead rate cost per activity is calculated as follows:

Activity MB-R MB-XTotal

Activity TotalCostOH Rate

Cost/ActivityTesting and Inspections 400 400 800 $120,000 $150Machine Setup 120 80 200 $80,000 $400Machine Stamping 25,000 15,000 40,000 $160,000 $4Plant Maintenance 1,500 2,500 4,000 $40,000 $10

Activity OH Rate MB-RMB-R

OH MB-XMB-X

OHTesting and Inspections $150 400 $60,000 400 $60,000Machine Setup $400 120 $48,000 80 $32,000Machine Stamping $4 25,000 $100,000 15,000 $60,000Plant Maintenance $10 1,500 $15,000 2,500 $25,000

Total Overhead Allocated $223,000 $177,000

D. Using the traditional costing method, MB-X is over costed $250,000 versus $177,000. This is likely to lead to inaccurate pricing and make the product less competitive in the market. ABC costing better matches resources usage to the overhead costs, and thus can help managers make better decisions, especially in resources usage, pricing, product mix, or performance evaluation.

7.27 Traditional Versus ABC Costing – CompuTrain Learning Centre

A. Overhead rate for each type of activity:

Cost ActivityOverhead RateCost/Activity

Registration $10,000 120 + 280 = 400 students $25 per studentComputer Depreciation $36,000 1,400 + 1,000 = 2400hrs $15 per hour

Rent $26,000 16 + 10 = 26 classrooms$1,000 per classroom

Total Overhead Costs $72,000



Overhead Rate IT Training Office Training

Registration $25 120 $3,000 280 $ 7,000 Computer Depreciation $15 1,400 $21,000 1,000 $ 15,000 Rent $1,000 16 $16,000 10 $ 10,000 Total Overhead Costs $40,000 $ 32,000

B. The average cost per student for each service:

IT Training Office TrainingDirect Materials (books & courseware) $9,000 $6,000Direct Labour (instructors) 15,000 9,000

Overhead:Registration 3,000 7,000Computer Depreciation 21,000 15,000

Rent 16,000 10,000Total Overhead costs 40,000 32,000Total Costs $64,000 $47,000# of students 120 280Cost per student $533.33 $167.86

C. Under the traditional costing method, IT Training was over charged by $5,000 for the overhead costs, which subsidized Office Training. As a result, IT Training per student was over costed by $41.67, and Office Training per student was under costed by $17.86. IT Training was over costed because based on the traditional costing method, IT Training had higher labour cost, and overhead was proportionally costed more to the IT Training. Using the ABC method, the overhead was charged based on the resources usage, which better matched the activities to the costs.


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7.28 ABC Costing, ABM - Applewood Electronics

A.1. Manufacturing cost per unit under traditional cost accounting

In the traditional cost accounting system, overhead is allocated to products based on machine hours. The rate per hour is calculated as follows:

Total estimated overhead $4,800,000

Estimated machine hours:Monarch (8.0 hours x 22,000 units) 176,000Regal (4.0 hours x 4,000 units) 16,000

Total estimated machine hours 192,000

Estimated allocation rate per machine hour ($4,800,000/192,000) $25 .00

The total manufacturing cost per unit is the sum of per unit direct material, direct labour, machine usage, and allocated overhead, as follows:

Monarch RegalDirect material $208.00 $584.00Direct labour 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00Machine usage 8 machhrs x $18 144.00 4 machhrs x $18 72.00Overhead 8 machhrs x $25 200 .00 4 machhrs x $25 100 .00

Total $570 .00 $798 .00

2. Manufacturing cost per unit under ABC

First, calculate the allocation rate for each of the ABC pools:

Soldering ($942,000/1,570,000 solder joints) $0.60 per solder jointShipments ($860,000/20,000 shipments) $43.00 per shipmentQuality control ($1,240,000/77,500 units inspected) $16.00 per inspectionPurchase orders ($950,400/190,080 purchase orders) $5.00 per purchase orderMachine power ($57,600/192,000 machine hours) $0.30 per machine hourMachine setups ($750,000/30,000 setups) $25.00 per setup

Next, calculate total manufacturing costs allocated to each product under the ABC system and then calculate the total manufacturing cost per unit:



Monarch___________ Regal__________Soldering 1,185,000 solder jts x $0.60 $ 711,000 385,000 solder jts x $0.60 $ 231,000Shipments 16,200 shipments x $43 696,600 3,800 shipment x $43 163,400Quality control 56,200 inspections x $16 899,200 21,300 inspections x $16 340,800Purchase orders 80,100 POs x $5 400,500 109,980 POs x $5 549,900Machine power 176,000 machhrs x $0.30 52,800 16,000 machhrs x $0.30 4,800Machine setups 16,000 x $25 400,000 14,000 x $25 350,000

Total ManufacturingOverhead $3,160,100 $1,639,900

Total Manufacturing Overhead Per Unit $3,160,100/22,000 units $143.64 $1,639,900/4,000 units $ 409.98

Direct material 208.00 584.00Direct labour 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00Machine usage 8 machhrs x $18 144 .00 4 machhrs x $18 72 .00

Total ManufacturingCost Per Unit $513 .64 $1,107 .98

B. The traditional costing system allocates a lump sum of overhead based only on machine hours, while the ABC system uses six cost pools to allocate the overhead. Allocations using these cost pools and cost drivers more accurately reflect the flow of resources.

C.1. Operating profit per unit under traditional cost accounting:

Monarch RegalSelling Price $ 900.00 $1,140.00Manufacturing (570.00) (798.00)Selling, General, and Administrative (265 .00 ) (244 .60 )

Traditional costing operating profit $ 65 .00 $ 97 .40

2. Operating profit per unit under ABC:Monarch Regal

Selling Price $900.00 $1,140.00Manufacturing (513.64) (1,107.98)Selling, General, and Administrative (265 .00 ) (244 .60 )

ABC costing operating profit $121 .36 $ (212 .58 )

D. Based on the profit information using ABC, Applewood should concentrate on the Monarch. Under ABC, it appears that the organization incurs a loss for each unit sold of Regal. Using this ABC information would definitely affect the recommendation because one product appears to have a negative profit margin.

Note: This problem is from an old CMA exam. The calculations shown in this problem probably include fixed costs. Remember from Chapter 4 that organizations need to emphasize the product with the highest contribution margin to maximize profits; however, that product cannot be identified with the information given in this problem. Applewood would need to separate costs into flexible (those that vary with activity) and committed (those that do not vary with activity) to determine the ABC contribution


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margin for each product. Once this is done, the product with highest contribution margin can be identified and emphasized.

7.29 ABC Costing, ABM - Palmer Company

A. Manufacturing cost per unit:

Machine setup 2 setups x $50.00 $ 100Material handling 100 units x 19 parts x $0.50 950Machining 100 units x 1.25 machine hours x $26.00 3,250Assembly 100 units x 1.5 direct labour hours x $22.00 3,300Inspection 100 units x $12.00 1,200Direct materials 100 units x $100.00 10,000

Total Costs $18,800

Cost Per Unit $18,800/100 units $188

B. Full cost per unit

Total manufacturing cost per unit $188Research and marketing costs per unit 140Other non-manufacturing costs per unit 320

Total full cost per unit $648

C. Cost savings required:

First, calculate the maximum full cost that would allow the company to achieve a profit of 10% based on full cost:

Selling price = Full Cost + 10% x Full Cost$650.00 = 100% x Full Cost + 10% x Full Cost$650.00 = 110% x Full CostFull Cost = $650.00/110%Full Cost = $590.91

Next, calculate the difference between the maximum full cost calculated above and the current full cost. This is the amount of cost savings required to achieve the desired profit.

Full cost per unit $648.00Full cost needed to achieve desired profit 590 .91

Cost savings required $ 57 .09



7.30 ABC in Job Costing, ABM, Non-Value-Added Activities - Kestral Manufacturing

A. Following are the ABC allocation rates:

Activity Cost / Activity level Allocation rateMachine set-up $ 40,000 / 400 $100Material handling 160,000 / 16,000 $10Product design 100,000 / 2,000 $50Number of inspection 260,000 /13,000 $20

$560,000

For job 42, overhead costs = (2x$100)+(60x$10)+ (40x$20) +(20x$50) = $2,600

B. For job 43, overhead costs = (4x$100)+(20x$10)+(20x$20)+(100x$50) = $6,000For the 100 units completed the cost per unit would be calculated as follows:

Direct Materials 24,000Direct Labour 4,000Overhead Allocated 6,000Total Job cost 34,000

Cost per unit = 34,000 / 100 units = $340

C. Non-value added activities are tasks or functions that are unnecessary and waste resources because they do not increase the worth of an organization’s goods or services to customers. At Kestral, non-value-added activities include moving materials from place to place (such as from receiving dock to warehouse to one work area and then to another work area). The company could reduce costs by minimizing the handling of materials. Another non-value-added activity is inspection. With sufficient quality improvements and continuous inspection by workers during production processes, the need for a separate inspection process can be reduced or eliminated. Set-up costs are also considered non-value added and the set-up activity could be analyzed to reduce steps and materials if possible so that costs are reduced.

7.31 Design ABC System, Per-Unit ABC Costs, Uncertainties - Elite Daycare

A. There are several cost objects that could be chosen for Elite Daycare, depending on the planned use of information. The director may want to develop a function for total costs of the daycare for budget or benchmarking purposes. In that case, the cost object is the daycare itself. Alternatively, she might choose the type of service (full-time or part-time) as the cost object. If she wanted to better understand the cost per child, she could choose a per-child cost object. This problem focuses on the daycare cost function, so the cost object is the daycare program.


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Next, cost pools need to be developed. For Elite Daycare, there appear to a number of different activities: greeting and leaving, preparing and serving food, supervising naps, supervising recreation, and activity time. The greeting and supervising activities can probably be combined into one cost pool. However, supplies are probably used during activity time, and the director may want to know an approximate cost per child for activity time. Therefore, a single pool can be used for greeting, supervising naps, and recreation; a pool for supervising activities; and another pool can be used for meal-related activities (preparing and serving food, monitoring behavior).

Next, cost drivers for each pool need to be chosen. Cost drivers for greeting and supervising activities could be number of children or time spent. Because supervising naps and recreation activities are similar to greeting, cost driver choices would be similar for these two pools. A number of different children can be supervised at one time, so time spent would be probably be easiest to track and provide an appropriate accounting of costs related to supervising activities. Cost drivers for preparing and serving food could be either the number of meals served or the number of children served. Tracking meals served is probably just as easy as tracking number of children, but meals are more closely related to food preparation, so number of meals served will be used as the cost driver. Cost drivers for supplies could be number of art activities or number of children, among others. It would be easiest to track number of children, and it is likely that each child uses similar amounts of supplies.

B. Annual cost per childThe percentage of time for the greeting and supervising pool is 30% (20%+10%), 20% for meal-related activities, and 50% for supervising educational activities. These times can be further categorized into full-time and after-school by considering the percentage of total hours each program uses. There are 10 hours available per full-time child, and 3 hours per child after school. Therefore, there are 300 (10 hours x 30 children) full-time child hours available per day and 30 (3 hours x 10children) after-school child hours available. Of the total 330 hours available, 91% (300/330) of the hours are full-time child hours, and 9% are after-school child hours.

Now the calculation of the ABC meal related activities cost requires several steps, as follows:

Estimated annual volume of snacks/meals:(Assume 5 days per week x 50 weeks = 250 days)

Full-time (30 children x 3 snacks & meals x 250 days) 22,500After-school (10 children x 1 snack x 250 days) 2,500

Number of meals served 25,000

Total food cost $20,000Time spent on meal preparation (20% x $100,000) 20,000

Total cost of snacks and meals per year $40,000

Estimated cost per snack/meal ($40,000/25,000) $1 .60



The total annual ABC cost per child is calculated as follows:Full-Time After-School

Snacks/meals:Full-time (3 snacks/meals x 250 days x $1.60) $1,200After-school (1 snack/meal x 250 days x $1.60) $ 400

Supplies:Full-time ($10,000/30 children) 333After-school ($8,000/10 children) 800

Supervising educational activities:Full-time (50% x 91% x $100,000)/30 1,517After-school (50% x 9% x $100,000)/10 450

Supervising naps, recreation, and greeting:Full-time (30% x 91% x $100,000)/30 910After-school (30% x 9% x $100,000)/10 ______ 270

Total Annual Cost Per Child $3,960 $1,920

C. The employees work with both full-time and after-school children, and there are uncertainties about how much time they spend with each type of student. If the two groups of children are combined for some activities, then any allocation of salaries or wages to each service is arbitrary and unlikely to reflect the two services’ use of employee time. If the two services are completely separate, the cost of salaries and wages can be traced directly to the service. However, for activities such as snacks, some employee time is probably spent preparing snacks for both groups at once, and allocating this cost would be an uncertain and arbitrary process. It is impossible for employees to track exact time spent per service for activities undertaken for both services, such as snacks and possibly meeting parents at the end of the day. There are uncertainties about whether allocation bases reflect the use of resources because these are fixed resources, and the cost does not vary proportionately with any type of volume measure. Therefore, any allocation is arbitrary and will not accurately reflect use of those fixed resources.

7.32 ABM, Customer Profitability

A. Activity-based management involves the use of ABC cost information to develop a comparison of the costs and benefits of tasks and procedures undertaken within the organization to identify improvements that can be made in quality and efficiency or cost reductions.

B. A high-cost customer is one for whom contribution margin is low, relative to other customers, but who requires costly services such as special customized products, special shipping procedures, small production and delivery quantities, specialized post-sales


53 Cost Management

service, or customer services before purchasing, and so on. Low-cost customers would provide relatively more contribution from their orders with little special treatment. These customers may order large quantities of regular products and not require any special delivery or help before or after the sale.

C. There are many possible ways to write this paragraph, and the wording depends on the assumptions that are made about the particular audience for the paragraph, the customer, and the nature of the company’s business. Below is a sample paragraph.

Several approaches can be taken to improve profitability for high-cost customers. Accountants can identify costs for these types of customers, and the company can negotiate with each customer to either charge for some of the specialized services or motivate the customers to reduce the amount of costly services required. Ways to reduce costs include improving the predictability of orders, reducing the amount of engineering changes or other product changes required, and finding standard products that might substitute for customized products. Customers requiring large amounts of technical support following a purchase might be willing to pay for this service.

7.33 Quality Costs Using ABC Versus Traditional Costing - New-Rage Cosmetics

A.1. Quality control cost per order using ABC

Incoming material inspection 12 types of material x $11.50 $ 138.00In-process inspection 17,500 units x $0.14 2,450.00Product certification 25 orders x $77.00 1,925 .00

Total quality control costs $4,513 .00

Quality control cost per order $4,513.00/25 orders $180 .52

2. Quality control cost per order using traditional cost accounting

Total quality control costs assigned= Directlabour costs x 14.5%= $27,500 x 14.5%= $3,987.50

Quality control cost per order = $3,987.50/25 orders = $159.50

B. Under the ABC system, the costs are more related to the resources used to insure quality control. These costs are primarily product inspection and certification costs, and the allocated costs change as the types of materials and number of units inspected change.

Under traditional cost accounting, direct labour costs may be related to number of units inspected if it takes more labour to produce more units, but in automated manufacturing



settings this is not always the case. In addition, direct labour costs are not related to types of materials. Therefore, using direct labour costs to assign quality costs provides poor quality information about the variation in quality control costs among different orders. Accordingly, the ABC system provides more accurate costs for quality control.

7.34 Categorizing Quality Activities

Please see Exhibit 7.7 for more details about these answers. ___A___ 1. Inspection of units when they are 100% complete to remove defective

units.___P___ 2. Design of a process with as few parts as possible to reduce the chance of

defects.___PS__ 3. Warranty costs for defective products returned to the factory for rework.___PR__ 4. Reworking of spoiled units before they leave the factory.___PS__ 5. Costs to defend the company against lawsuits for damages caused by

defective products._P or A_ 6. Tracking number of defects for each manufacturing team and posting of

daily defect rates on a plant-wide bulletin board.(Used to motivate employees to improve quality, also requires appraisal)

___PR__ 7. Redesign of a manufacturing process to reduce the rate of defects.

7.35 GPK Multi-Level Income Statement -- Krishnan Manufacturing

Following is a multilevel income statement for the Krishnan Manufacturing Plant using a GPK approach.

Revenues $800,000Variable costs 200,000

Contribution margin 1 600,000Fixed costs, product 150,000Idle capacity costs 75,000

Contribution margin 2 375,000Fixed costs, company 200,000

GPK profit $175,000

The problem states that “Krishnan’s accountant aggregates the idle capacity costs.” Thus, the solution above assumes that the $75,000 idle capacity cost relates only to the Krishnan plant, not to the entire company.


55 Cost Management

7.36 GPK, RCA, Cost Rates -- Diagnostic Services

A and B. Cost function calculations:

X-ray suppliesFixed costs: $3,000 per yearProportional costs: $2.10 per X-ray hour × 5,000 budgeted X-ray hours = $10,500

ElectricityFixed costs: 6,000 kWh × $0.10 per kWh = $600Proportional costs: 4kWh per hour of X-ray use × 5,000 budgeted X-ray hours ×

$0.10 per kWh = $2,000

X-ray technicianFixed costs: 300 technician hours × $45 per labour hour = $13,500Proportional costs: 1 technician hour per hour of X-ray use × 5,000 budgeted X-ray

hours × $45 per labour hour = $225,000

MaintenanceFixed costs: 100 maintenance hours × $20 per hour = $2,000Proportional costs: 0.0424 maintenance hour per hour of X-ray use × 5,000 budgeted

X-ray hours × $20 per maintenance hour = $4,240

FacilitiesFixed costs: 1,000 square feet × $25 per square feet = $25,000



A and B (continued). Cost rates under GPK and RCA:

GPK RCACost Centre: X-Ray Resource Cost Pool: X-Ray

Fixed Proportional Fixed ProportionalOutput Measure – X-Ray Hours:

Practical capacityBudgeted capacity

5,6005,000

Output Measure – X-Ray Hours:Theoretical capacityBudgeted capacity

8,7605,000

Primary Costs:DepreciationSuppliesElectricity

$ 93,1003,000

600

$ 010,5002,000


$ 93,1003,000

600

$ 010,5002,000

Total Primary Costs 96,700 12,500 Total Primary Costs 96,700 12,500From Other Cost Pools (i.e., Secondary Costs):

Labour (technician)Maintenance - equipmentMaintenance - facilities

13,5002,000

25,000

225,0004,240

0

From Other Resources (i.e., Secondary Costs):

Labour (technician)Maintenance - equipmentMaintenance - facilities

13,5002,000

25,000

225,0004,240

0Fully Assigned Resource Costs $137,200 $241,740 Fully Assigned Resource Costs $137,200 $241,740Fully Assigned Cost Rate Per Hour $24.50 $48.348 Fully Assigned Cost Rate Per Hour $15.662 $48.348

C. Cost for patient requiring 0.5 hour of time:

GPK cost = ($24.50 + $48.348) × 0.5 hour = $36.424RCA cost = ($15.662 + $48.348) × 0.5 hour = $32.005

D. GPK cost is higher than RCA cost because RCA uses theoretical capacity for fixed costs. Theoretical capacity is larger than budgeted capacity in the denominator, resulting in a smaller cost rate.


57 Cost Management

E. The technician needs to be on hand for the hours that the diagnostic centre is open. There are likely certain tasks that need to be done on a daily basis to prepare the machine. Costs for maintenance are similar; some routine maintenance is done on a regular basis and does not depend on the number of X-ray hours. Even though these costs are proportional in the technician and maintenance cost pools, a portion of each cost is fixed with respect to X-ray equipment usage.

7.37 GPK, RCA Capacity Analysis – Diagnostic Services

Budgeted Practical TheoreticalCapacity Capacity Capacity

Estimated volume – X-ray hours 5,000 5,600 8,760Fixed cost rate per X-ray hour $27.44 * $24.50 $15.662

Fixed costs allocated to patient services (5,200 hours × fixed cost rate) $142,688 $127,400 $81,443

Assigned to idle capacity:

Unplanned idle capacity(5,000 – 5,200) hours × fixed cost rate ($5,488) ($4,900) ($3,132)

Planned idle capacity:(5,000-5,000) hours × $27.44 0(5,600-5,000) hours × $24.50 14,700(8,760-5,000) hours × $15.662 58,889

Total Fixed Costs Assigned $137,200 $137,200 $137,200

* $137,200 fixed costs ÷ 5,000 budgeted capacity = $27.44



PROBLEMS

7.38 Setting Up an ABC System, Uncertainties

A. 3 Identify and sum the costs into activity-based cost pools 4 Choose a cost driver for each activity 6 For each ABC cost pool, allocate overhead costs to the product or service 1 Identify the relevant cost object 2 Identify the activities necessary for production or service delivery 5 For each ABC cost pool, calculate a cost allocation rate

B. All of these steps include uncertainties.

After a cost object is chosen, uncertainty exists about whether all of the activities necessary to produce the good or service are identified. Some activities may be overlooked, or the set of activities may include ones that rarely occur and would be an immaterial part of the process. In addition, uncertainties exist about the optimal number of activities for a given cost pool. There is uncertainty about whether the costs for developing additional cost pools would exceed the benefits. Uncertainties also exist about whether the system would be more or less accurate when potentially separate activities are grouped together.

When assigning costs to activities, there is uncertainty about whether all direct costs have identified and traced to each activity. For example, supplies such as cloths used to wipe off excess oil during the set-up process may be overlooked. In addition, the assignment of a common resource cost, such as a supervisor salary, may not reflect the time the supervisor spends on different activities.

For each cost pool, there is uncertainty about whether all of the potential cost drivers have been identified and whether the chosen cost driver most accurately reflects the use of resources within that cost pool. In addition, some activities are interdependent, and the cost pools and cost drivers may not accurately reflect these interdependencies. Choosing a cost driver for each activity requires the use of judgment. Some activities may have an obvious cost driver, while others could have several different drivers. Assembling a box, for example, may only require direct labour and thus have a clear cost driver. Other activities could include adding materials, using machine hours, and using direct labour hours. For these types of activities, several different cost drivers could be chosen. The accountant implementing ABC must identify the driver that best relates changes in activities to changes in cost.

Measuring the amount of cost driver used per product is sometimes uncertain. Suppose time spent cleaning is a cost driver for a housekeeping cost pool. When a new employee is hired, the actual time may be longer than the normal time for the employee’s first several months. Therefore, uncertainty exists about whether the allocation base volumeis


59 Cost Management

accurately set, or whether the activity has been correctly measured when allocating the cost.

C. There are many correct choices for this answer. The key is to focus on uncertainties and to explain why the need for judgment might be greater in one step than in the others. Below are two sample answers.

The choice of cost drivers might require the greatest use of judgment because of the large number of uncertainties involved. There are uncertainties about whether all possible cost driver choices have been identified, and whether the selected cost driver actually reflects the use of resources of the cost pool more accurately than other choices. In addition, some high quality cost drivers may not be measured very accurately, there are certainties about whether a particular cost driver provides the best information.

The choice of activity cost pools might require the greatest use of judgment because it not only involves a large number of uncertainties (as discussed in Part B above), but it also affects all of the remaining steps. Choices that are made about the activities influence the cost and benefits achieved from the entire system.

7.39 ABC Cost Hierarchy, Uncertainties

A. A cost hierarchy in ABC divides activities into six levels: unit, batch, product, customer, facility, and organization. This allows accountants to more carefully identify activities and their associated costs at all levels within the company.

B. Following are several reasons for uncertainty in classifying costs into the cost hierarchy categories; students may think of others. As costs are categorized into cost hierarchy categories, accountants might not completely understand the interdependencies within a group of activities. For example, costs that appear to be batch-level costs could also be affected by the number of units or the weight of the batch. Managers cannot be certain that the chosen cost driver in a specific cost category independently reflects cost changes.

Additionally, costs that appear to be organization-level costs could be driven by changes in volumes. For example, the costs of billing and interacting with customers regarding their bills could increase step-wise as a fixed cost. Accountants are uncertain whether this cost increases as the number of customers increase, or whether it is an organization-level cost that will not change regardless of volumes.

C. Dividing costs into six levels helps accountants better identify all aspects of costs in a company. Thinking about a particular level helps accountants focus on activities that occur at that level. In addition, once activities have been developed for a particular level, it becomes easier to know how costs change with volumes of activity. For example, property taxes are a facility-level cost and therefore would not increase based on the number of batches produced, but only on the value of the building itself. Using these six levels helps accountants better map resource usage to products and services.



7.40 Cumulative Problem (Chapter 5): ABC Versus Traditional Job Costing, Cost Driver Uncertainties, Advantages and Disadvantages - Vines Corporation

A. Per unit cost using the old method:

Job Order 410________ Job Order 411________Direct materials $9,700/10 units $ 970.00 $59,900/200 units $299.50Direct labour $750/10 units 75.00 $11,250/200 units 56.25Indirect $115x25 hrs/10 units 287 .50 $115x375 hrs/200 units 215 .63

Total $1,332 .50 $571 .38

B. Cost per unit cost using ABC

Job Order 410_______ Job Order 411________Material handling 500 parts x $0.40 $ 200.00 2,000 parts x $0.40 $ 800.00Milling 150 machhrs x $20 3,000.00 1,050 machhrs x $20 21,000.00Grinding 500 parts x $0.80 400.00 2,000 parts x $0.80 1,600.00Assembly 2 assembly hrs x $5 10.00 30 assembly hrs x $5 150.00Inspection 10 units x $25 250.00 200 units x $25 5,000.00Shipping 1 order x $1,500 1,500.00 1 order x $1,500 1,500.00Direct material 9,700.00 59,900.00Direct labour 750 .00 11,250 .00 Total costs for order $15,810 .00 $101,200 .00

Total costper unit $15,810.00/10 units $1,581 .00 $101,200.00/200 units $506 .00

C. In the traditional costing system, the indirect costs were combined into a single cost pool and then allocated based on direct labour hours used by each order. Direct labour hours may or may not be related to costs in the overhead pool. It’s unlikely that they are related to a very large portion of those costs. However, under ABC, the indirect costs are divided into six cost pools and allocated using cost drivers that are more likely to reflect the use of resources. Therefore, the cost allocations provide more accurate information about costs.

D. There are many uncertainties about the choice of cost driver for each activity-based cost pool. There may be several different drivers that could be used, and several of them could be similar in their ability to relate cost to the activity. For example, if a school has classrooms that are similar in physical size with similar numbers of students in each class, number of rooms may be an adequate cost driver. However, if younger students are messier and cleaning their rooms takes longer, then time spent might be a better cost driver. Sometimes time spent is not measured. In this case number of rooms could be used, or square feet if rooms are different sizes. And this is a fairly forthright activity with easy to identify cost drivers. Other activities can be much more complex, and finding cost drivers can be more difficult. Identifying the most appropriate cost driver requires effort, and the best driver may be expensive to measure. If the activity changes in any way, a new driver might be needed.


61 Cost Management

E. An ABC system allocates costs using more cost pools and more appropriate cost drivers, so costs are likely to be less distorted. For example, if direct labour hours were abnormally high for one job, under the traditional costing system the indirect costs assigned to that job would be higher even if more costs were not incurred. Under ABC this possibility for error is minimized because there are more allocation bases than direct labour hours. The ABC system is more costly to implement because it takes time to develop and many employees need to be involved. ABC is more useful in analyzing operations to improve quality and reduce costs. Non-value added activities can be identified and other activities can be simplified, once they have been identified. This doesn’t tend to happen with traditional costing.

7.41 Cumulative Problem (Chapter 6): ABC Versus Traditional Process Costing, ABM -- Kim Mills

A sample spreadsheet showing the solutions for this problem is available on the Instructor’s web site for the textbook (available at www.wiley.com/canada/eldenburg).

A.1&2 Following are excerpts from a sample spreadsheet for this problem.

Input Area

DenimLight-Weight

CottonHeavy-Weight

Cotton TotalDirect Costs: Direct materials $8,000 $24,000 $20,000 $52,000 Direct labour cost $660 $1,320 $920 $2,900

Overhead Costs: Machine $40,000 Setup $11,000 Inspection $6,996 Total Overhead $57,996

Volumes: Units 1,000 4,000 2,000 7,000 Direct labour hours 33 66 46 145 Machine hours 500 1,333 1,500 3,333 Number of set-ups 10 30 20 60 Inspection hours 83.3 333.3 166.6 583.2



TRADITIONAL PROCESS COSTINGNote: Because there are no beginning or ending inventories, equivalent units are equal to physical units.Also, there is no need to calculate conversion cost per unit separately for the two departments becauseconversion costs are allocated in both departments to the number of bolts produced. With no beginning or ending inventories, the number of bolts produced is identical in the two departments.

Equivalent Conversion Cost Per UnitTotal Conversion Costs to Account for: Total Direct labour $2,900 Overhead $57,996 Total $60,896

Total Units (Bolts) to Account for 7,000

Equivalent Conversion Cost Per Unit $8.69943

Process Cost Report Denim LW Cotton HW Cotton Total

Number of bolts 1,000 4,000 2,000 7,000

Direct materials $8,000 $24,000 $20,000 $52,000Conversion costs $8,699 $34,798 $17,399 $60,896 Total Costs Accounted for $16,699 $58,798 $37,399 $112,896

Summary of Cost Per Unit: Direct materials $8.00 $6.00 $10.00 Conversion costs $8.70 $8.70 $8.70 Total $16.70 $14.70 $18.70

ACTIVITY-BASED COSTING

Calculation of Activity Allocation Rates Volume of AllocationCost Driver Total Cost Cost Driver Rate

Machine Machine hours $40,000 3,333 $12.00012 Setup Number of setups $11,000 60 $183.33333 Inspection Inspection hours $6,996 583 $11.99588

ABC Cost Report Denim LW Cotton HW Cotton TotalActivity volumes: Number of bolts 1,000 4,000 2,000 7,000 Machine hours 500 1,333 1,500 3,333 Number of setups 10 30 20 60 Inspection hours 83.3 333.3 166.6 583.2

Costs Assigned: Direct materials $8,000 $24,000 $20,000 $52,000 Direct labour $660 $1,320 $920 $2,900 Machine $6,000 $16,000 $18,000 $40,000 Setup $1,833 $5,500 $3,667 $11,000 Inspection $999 $3,998 $1,999 $6,996 Total $17,493 $50,818 $44,585 $112,896

Cost Per Unit:© 2012 John Wiley and Sons Canada, Ltd.

63 Cost Management

Direct materials $8.00 $6.00 $10.00 Direct labour $0.66 $0.33 $0.46 Machine $6.00 $4.00 $9.00 Setup $1.83 $1.38 $1.83 Inspection $1.00 $1.00 $1.00 Total $17.49 $12.70 $22.29

B.Light-Weight Heavy-Weight

Denim Cotton CottonProcess Costing $16.70 $14.70 $18.70Activity-Based Costing 17 .49 12 .70 22 .29

Cost Per Bolt Overstated (Understatedby Traditional Process Costing $ (0 .79 ) $ 2 .00 $ (3 .59 )

Under process costing, the cost per bolt of light-weight cotton was overstated; it absorbed costs incurred by denim and heavy-weight cotton because costs under process costing are allocated to the department and then to the product. The production volume of light-weight cotton (4,000 bolts) is much larger than either denim (1,000 bolts) or heavy weight cotton (2,000 bolts). When conversion costs are allocated based on number of units rather than based on the flow of resources used, the product with the most units is allocated relatively more cost. The production of light-weight cotton requires proportionately fewer set-ups than the other two products, so it should be allocated less of the cost for set-up. Light-weight cotton also uses proportionately fewer machine hours, and so it should also be allocated less of the machine activity costs. In addition, light-weight cotton uses less direct labour per bolt than the other two products. Under traditional process costing, direct labour is combined with other conversion costs and is allocated to units without regard to the actual labour used.

C. Managers may want to investigate machine set-up costs and reduce them, or reduce the number of set-ups required for all products. In addition, perhaps inspection activities could be analyzed and costs reduced. The managers might also investigate reasons why light-weight cotton uses significantly less direct labour than the other two products. Perhaps direct labour could be used more efficiently, reducing the direct labour cost.



7.42 ABC Costs, Uncertainties, ABM, Non-Value-Added Activities - The Pond Kit Company

A. Total Cost Per Batch:

Material handling 20 parts x $1 per part x 10 kits $ 200.00Forming 2 moulding hours x $40 per hour x 10 kits 800.00Moulding setup 1 batch x $50.00 50.00Packing and shipping 30 kgx $1.30 per kgx 10 kits 390.00Inspection $10 per kit x 10 kits 100.00Direct labour $20 per kit x 10 kits 200.00Direct materials $100 per kit x 10 kits 1,000 .00

Total costs $2,740 .00

B. Total budgeted cost per kit= Total budgeted cost per batch / Number of kits per batch= $2,740.00 / 10 kits= $274.00 per kit

C.Cost per Kit

Cost Per Batch (10 kits per batch)Total Cost from Parts A and B $2,740 $274.00Marketing ($15,000/1,000 batches) 15 1.50Customer Service ($25,000/1,000 batches) 25 2 .50

Total $2,780 $278 .00

D. There are other potential activities that could be chosen for this company. Some activities could be separated further into more pools. For example, packing and shipping could be separated into a packing activity and a shipping activity. Moulding may consist of several different tasks that could be considered separate activities. Alternatively, some of these cost pools could possibly be combined, such as molding setup and forming. There are many different choices that could be made for these activities.

E. The new ABC system can lead to identification of non-value-added costs by focusing manager attention on the organization’s activities and cost drivers. As activities are analyzed, some tasks or procedures in these activities might be identified as non-value added, and then eliminated. For example, if the ponds could be redesigned to require fewer parts, material-handling costs would likely be reduced. If specific types of defects cause inspection time to increase, redesigning parts or processes to eliminate the defects would decrease inspection time and also decrease customer service costs for product failures. The packing and shipping activities could be analyzed to determine whether steps could be combined or some tasks eliminated or outsourced at lower cost. There are many other non-value activities that students might have identified.


65 Cost Management

7.43 Uncertainties, Actual Versus Estimated Costs, Practical Capacity - Data Processors

A. These activities are not the only possible set. Each of these activities could be separated into a number of other activities. For example, the activity of issuing new credit cards could be further separated into the following cost pools:

• Verifying authorization of new credit cards to be issued• Mailing new credit cards• Validating new credit cards (before first use of the card)

Each cost pool could be disaggregated into more cost pools. Alternatively, some of these cost pools could be aggregated in some organizations.

B.Activity Estimated Cost Estimated Activity RateTransaction processing $2,000,000 5,000,000 $ 0.40Statements 1,000,000 250,000 4.00New credit cards 500,000 100,000 5.00Billing disputes 90,000 3,000 30.00

C. The volume of activities cannot be predicted with certainty from one month to the next. For example, although the number of credit cards issued last period is known, economic changes affect the number of people who will apply, as will advertising campaigns and competition among financial institutions. Some activities, such as issuing monthly statements, are easier to estimate than other activities, such as resolving billing disputes. The number of customers holding credit card accounts probably remains somewhat constant, although each month some credit card customers are gained and lost. It is more difficult to predict the number of billing disputes, which fluctuate with the volume of transactions and also with the degree of problems such as fraudulent credit card use, retailer errors, and charges for unsatisfactory goods or services.

Costs will be different than expected because it is not possible to perfectly predict future costs. There may be unanticipated changes in prices, such as electricity rates, telephone charges, or employee health care costs. If activity volumes are higher than expected, then employee overtime pay may exceed expectations. Information technology programming and operating costs may be higher or lower than expected. For example, there could be fewer problems than expected when making improvements to the transaction processing system. There are also likely to be random fluctuations in costs such as office supplies.

D. Practical capacity is the maximum capacity under typical operating conditions, taking into account regularly scheduled holidays and other down time. This company has several different types of capacity. The discussions below address three types of capacity; students may think of others.

One type of capacity for Data Processors is the capacity of the computerized technology to process transactions. Because transactions occur at anytime and anywhere in the world, this capacity must operate 24 hours per day, 365 days per year. The capacity limit



would be measured in terms of the maximum volume of transactions that could be processed. The practical capacity of the computerized technology for transaction processing is almost certainly higher than the estimated activity level. The company’s contracts with its customers probably include guarantees that the system is capable of processing a higher volume of transactions than expected. In addition, the company probably has back-up “hot” sites that are fully operational and can take over processing in the case of system failure due to technological problems, natural disasters, terrorist attacks, etc.

Capacity for Data Processors also includes the employee capacity to handle services such as billing disputes. This type of practical capacity is likely to be higher than estimated activity levels during slow times, but it could be lower when activities are unexpectedly high. However, the company probably has contractual commitments to resolve billing disputes within a maximum number of days. Thus, the company must be capable of expanding its employee practical capacity, as needed, to meet actual activity levels. The company may be able to expand this capacity quickly by using employee overtime or temporary labour.

Another type of capacity for Data Processors is the physical capacity for printing and mailing monthly statements. Once again, the company is probably contractually committed to performance of this service in a timely manner, so the company must have sufficient capacity to handle higher than expected volume. Because it may be difficult to quickly expand this type of physical capacity, the company’s practical capacity is probably higher than its expected activity level.

7.44 Cumulative Problem (Chapter 4): ABC, ABM, Customer Profitability, Keep or Drop -- Flying Carpets

[Note: This problem requires application of knowledge from Chapter 4.]

A. Profitability per customer:

Boutique Store Discount RetailerRevenues $135,000 $850,000

Direct costs (DM and DL) 80,000 400,000Sales representatives 1,800 720Production line supervisor 2,430 972Delivery costs 20,000 8,000

Customer contribution $ 30,770 $440,308

Calculation of sales representative costs:60 hours × $20 × 150% $1,80024 hours × $20 × 150% $720

Calculation of production line supervisor costs:© 2012 John Wiley and Sons Canada, Ltd.

67 Cost Management

90 hours × $18 × 150% $2,43036 hours × $18 × 150% $972

B. Flying Carpet could ask that the Boutique Store pay for the extra costs such as sales representative time, production line supervisor time, and delivery costs. Flying Carpet could also raise its Boutique Store prices to ensure that direct costs as a percent of revenues are no higher than for the discount retailer.

C. If the other customer has a higher contribution than the Boutique Store, it’s possible that it should be replaced. However, managers at Flying Carpets do not know whether sales at the discount retailer are affected by the featured homes in the local lifestyle magazine. Without data about potential losses in sales, it may be risky to stop serving the Boutique Store.

7.45 Cumulative Problem (Chapter 4): ABC, RCA, Cost Rates, Capacity Analysis, Special Order -- Flightways

[Note: This problem requires application of knowledge from Chapter 4.]

A. ABC cost rate

Simulator supplies:Fixed $ 1,000Proportional ($4.50 per simulator hour × 3,400

simulator hours) 15,300Electricity:

Fixed (6,000 kWh × $0.10 per kWh) 600Proportional (165 kWh per simulator hour × 3,400

simulator hours × $0.10 per kWh) 56,100Simulator depreciation:

Fixed 1,505,160Maintenance:

Fixed (50 maintenance hours × $70 per maintenance hour) 3,500Proportional (0.06 maintenance hours per similar hour

× 3,400 simulator hours × $70 per maintenance hour) 14,280Facilities:

Fixed (2,000 square feet × $15 per square foot) 30,000Total costs $1,625,940

Divided by budgeted simulator hours ÷ 3,400ABC rate per simulator hour $478 .22

B. Based on the calculations in Part A, the sales manager probably should not accept the special order because the special order price of $400 is less than the ABC cost of $478.22 per similar hour. This answer assumes that all of the ABC costs are relevant (both fixed



and proportional costs). It also assumes that budgeted simulator hours is an appropriate volume for the allocation base.

C.RCA

Resource Cost Pool: Flight SimulatorFixed Proportional

Cost Driver – Number of hours:Theoretical capacity – fixed costsBudgeted capacity - variable costs

8,7603,400


$1,505,1601,000

600

$ 015,30056,100

Total Primary Costs 1,506,760 71,400From Other Resources (i.e., Secondary Costs):

Maintenance - equipmentMaintenance - facilities

3,50030,000

14,2800

Fully Assigned Resource Costs $1,540,260 $85,680Fully Assigned Cost Rate Per Hour $175.8288 $25.20

D. Under the RCA cost allocation method, the proportional cost is $25.20 per hour, and the special order price of $400 per hour would easily cover the proportional costs. Therefore, the RCA calculations suggest that the sales manager should accept the offer.

E. RCA provides more accurate cost information for short-term decisions because it more accurately separates the fixed and proportional costs.

F. There are several qualitative factors that affect special order decisions. If other customers find out that one customer gets a special rate, they may also demand a lower rate. If using a lower rate attracts a customer who will later pay a higher rate, it is more likely to be a worthwhile contract.


69 Cost Management

G. Capacity analysis:Offer Offer Not

Accepted AcceptedTheoretical capacity – Number of simulator hours 8,760 8,760Fixed cost rate per hour $175.8288 $175.8288

Fixed costs allocated to simulator hours:3,300 hours × $175.8288 $ 580,235(3,300 + 250) hours × $175.8288 $ 624,192

Allocated to idle capacity:

Unplanned idle capacity(3,400 – 3,300) hours× $175.8288 17,583(3,400 – 3,300 – 250) hours× $175.8288 (26,374)

Planned idle capacity(8,760-3,400) hours × $175.8288 942,442 942,442

Total Fixed Costs Allocated $1,540,260 $1,540,260

7.46 Government Use of ABC, Steps for Performing ABC – US Federal Aviation Administration

A. Government agencies use cost information to evaluate and improve the efficiency of their services. Most agencies rely on support through a budgeting process, and improving their efficiency helps them obtain operating funds. In addition, managers may want to move up in the organization’s ranks, and information about their effectiveness is found through cost reports and budgets. Governments are also interested in improving their cost systems because of their stewardship responsibility. They are responsible for efficiently using public funds and maximizing constituent benefits.

B. Following are the five steps listed in the handbook:1. Analyze activities2. Gather costs3. Trace costs to activities4. Establish output measures5. Analyze costs



Following are the six steps listed in the textbook:1. Identify the relevant cost object2. Identify activities3. Assign costs to activity-based cost pools4. For each ABC cost pool, choose a cost driver5. For each ABC cost pool, calculate an allocation rate6. For each ABC cost pool, allocate activity costs to the cost object

The handbook does not have a step to identify the relevant cost object. Therefore, step 2 from the textbook is similar to step 1 in the handbook. The textbook has no step to gather costs; the textbook assumes that costs are gathered. Step 3 from the handbook is similar to step 3 in the textbook (Assign costs to activity-based cost pools). Step 4 is similar in both methods, although the language used is different. Step 5 in the handbook is very general while, steps 5 and 6 in the textbook cover the same processes, but in more detail.

MINI-CASES

7.47 Design ABC Cost System, Usefulness of ABM – Town of Jefferson Animal Shelter

A. The staff member identified the following three cost objects. Each cost object represents one of the organization’s three services.

• Animal shelter• Obedience training• Veterinarian services

One possibility for cost pools is to create one pool for each cost object. This approach assumes that all costs can be directly assigned to one of these three services. Based on the following summary, it appears that some of the costs can be directly traced to the cost objects. However, some of the costs are indirect. (Note: Judgment is involved in these classifications; students might have categorized costs differently. For example, students might have classified veterinarians and technicians as indirect if they assumed that these employees provide services for the animal shelter in addition to the veterinarian clinic.)

Direct Costs___________Animal Obedience VeterinarianShelter Training Services Indirect Total

Director and staff salaries $ 0 $ 0 $ 0 $ 60,000 $ 60,000Animal shelter employees’ salaries 100,000 0 0 0 100,000Veterinarians and technicians 0 0 150,000 0 150,000Animal trainers* 20,000 20,000 0 0 40,000Food and supplies** 50,000 0 75,000 0 125,000Building-related costs 0 0 0 200,000 200,000

Total $170,000 $20,000 $225,000 $260,000 $675,000

* The problem indicates that animal trainers provide training classes and also train animals housed in the animal shelter. 50% of the animal trainer time is devoted to


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obedience classes. The remaining 50% is assumed to relate to training for animals housed in the animal shelter.

** The problem states that $75,000 of this cost is used by the veterinary clinic. The remainder ($50,000) is assumed to be used in the animal shelter.

A decision must be made about whether to allocate the two indirect costs to the three services. “Director and staff salaries” is most likely a facility-level cost for general administration, which would NOT normally be allocated to individual product lines. “Building-related costs” is also a facility-level cost. Sometimes this type of cost is allocated to individual products, and sometimes it is not. The following solutionassumes that the building-related costs are NOT allocated to the shelter’s individual services.

B. There are three cost pools to consider—one for each of the organization’s services. For the animal shelter, a cost driver could be the number of animal days. On a daily basis, each animal would require similar time from employees to clean their cages, feed, and groom, and similar supplies such as food and bedding. Another possible cost driver is the total number of animals housed. However, this cost driver would not capture differences in cost caused by lengthy animal stays.

A cost driver for obedience training could be number of classes, number of families taking classes, or number of weeks in which classes are held. Because each class would require about the same amount of time regardless of the number of families per class, number of classes is probably a better cost driver.

A cost driver for veterinary services could be the number of animal-visits. Similar amounts of time and resources would be used per animal, although this assumes that the product mix of (e.g., neutering and vaccinations) remains relatively constant.

C. Given the cost pools identified in part A and the cost drivers in part B, the allocation rates are as follows:

AllocationCost Pool Total Cost Cost Driver Volume RateAnimal shelter $170,000 Animal days 27,375 $ 6.21Obedience training 20,000 # of classes 125 160.00Veterinarian services 225,000 Animal visits 5,000 45.00

The allocation rate for the animal shelter indicates that the average cost of housing a pet for one day is $6.21. The allocation rate for obedience training indicates that it costs on average $160 to offer a training class. The allocation rate for veterinarian services indicates that it costs on average $45 to provide veterinarian care per animal-visit.



D.1. Quality activities include:

* Prevention activities performed to insure defect-free production* Appraisal activities performed to identify defective units* Production activities undertaken in the production or rework of failed units* Post-sales activities undertaken after the product has been sold to remedy

problems caused by defects and failed units

The shelter is experiencing a post-sales activity when animals are returned because of behavior problems.

2. No, the current ABC system does not include cost pools related to any of the types of quality activities listed in Part E.1 above. For example, the system does not track the cost of training dogs while they are housed in the animal shelter (prevention), the cost of evaluating dog readiness for adoption (appraisal), the cost of additional training for dogs with greater than normal behavioral problems (production), or the cost of dogs returned because of behavior problems (post-sales).

3. There are many possible answers to this question; students may think of other cost pools or drivers. A possible cost pool could be the cost per animal returned. Costs in this pool could include costs for further training activities, for admitting the animal to the facility and working with families to find other animals, and the cost to house the animals while waiting for a new family. The cost driver for this cost pool would be the number of animals returned. There are some costs that cannot be measured, such as the cost of potential adopters who decide not to adopt another animal because of a bad experience.

7.48 ABC Costs, Benefits, and Popularity – CFO.com

A. Accountants are likely to believe that ABC information would be useful because ABC separates overhead costs into more cost pools, and cost drivers are chosen to reflect the cause and effect relationship for costs, accountants might believe that this information would be useful for their organizations. In addition, the process of implementing ABC encourages managers to identify and eliminate non-value-added activities.

B. Managers cannot be certain that new ideas will be implemented correctly in their organization. In addition, because the ideas are new, managers cannot know for certain that they work for every organization, or just for some types of organizations. Therefore they cannot know for certain it will be effective for their organization. Furthermore, managers cannot know for certain whether employees in their organization will support the new idea or resist, and additional uncertainty arises about the effectiveness of new ideas when employees are resistant to these changes. Students may have thought of additional uncertainties.

C. Managers may adopt a new method if they study the method and believe that the benefits will exceed the costs for their organization. Managers are accustomed to making


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decisions under uncertainty; they do not need absolute “proof” before adopting a potentially beneficial method. In addition, managers are more apt to adopt a new method if competitors are adopting it. They may feel that competitors will have an edge because of this new method and worry that their organization will suffer if the method is not adopted. Or managers may believe they can move ahead of competitors by employing the new method. Consultants and others who sell the methods may convince managers that the method is appropriate for their organization, and so the managers adopt it.

D. Over time, many different types of organizations implement a new idea and for some organizations it works well and for others it does not work well. Evidence accumulates that the new method is not a cure-all for organizational problems. New methods are developed and are advertised widely that may overshadow the older methods. In addition, over time some new method ideas become common practice. For example, a focus on quality has become commonplace.

E. In a recession, managers focus less attention on expanding operations and more attention on improving cost effectiveness, competitiveness, and profitability. ABC information can help organizations identify non-value added activities, reduce costs, improve quality, and compete more effectively. These results are more important when business conditions are less favourable.

7.49 Integrating Across the Curriculum: Corporate Social Responsibility, Environmental accounting reports, ABC and ABM for environmental costs

The answers in this problem depend on the definitions used for environmental accounting.

In the United States, the U.S. Environmental Protection Agency (EPA)defines three types of environmental accounting:1

• National income accounting: National-level reporting of the consumption of renewable and non-renewable natural resources.

• Financial accounting: Company-level reporting that focuses primarily on the public disclosure of material environmental liabilities and costs according to GAAP.

• Management accounting: Company-, segment-, product line-, facility-, or system-level reporting of environmental information to support management decision making. The information could be used to plan and to direct management attention towards environmental issues; assist managers in making specific decisions such as purchasing, outsourcing, capital investments, product pricing, risk management, process/product design, or compliance strategies; or control and motivate behavior to improve business results.

In Canada, Environment Canada defines Environmental Management Accounting (EMA) as the identification, collection, estimation, analysis, internal reporting, and use of

1 Office of Pollution Prevention and Toxics, U.S. Environmental Protection Agency, An Introduction to Environmental Accounting As A Business Management Tool: Key Concepts And Terms, EPA 742-R-95-001, June 1995, accessible at www.epa.gov/opptintr/acctg/resources.htm.© 2012 John Wiley and Sons Canada, Ltd.


materials and energy flow information, environmental cost information, and other cost information for both conventional and environmental decision-making within an organization. EMA provides essential information for companies that aim to save money and reduce environmental impacts.2

Traditionally, companies have not publicly disclosed environmental management accounting information. However, some governments have begun requiring companies to publicly disclose this type of information, and the awards described in the problem are designed to encourage greater voluntary disclosure. The solutions provided below assume that “environmental accounting” means public disclosure and/or internal use of environmental management accounting.

A. Environmental accounting is an ethical problem because of potential conflicts among the interests of managers, companies, shareholders, vendors, customers, competitors, governments, society in general, and future generations. Managers, companies, and shareholders are often interested in maximizing profits, which often conflicts with management emphasis on environmental considerations or public disclosure of environmental information. When companies report more environmental information, they are more likely to be forced by governmental regulation or by public opinion to reduce negative environmental effects. Competitors and other companies in the supply chain (vendors and customers) are also affected by a company’s environmental reporting. Information about environmental issues related to one company is likely to be informative about environmental issues for other companies in an industry. Consumers and public interest groups generally prefer more information about environmental issues to improve their abilities to monitor companies and take actions against companies they see as degrading the environmental. Governments are often caught in the middle. While they want to protect public environmental interests, they also want to promote economic growth.

B. The answer to this question depends on the companies that students investigate. Students often have difficulty distinguishing between “pleasing” presentations and informative presentations. The answer to this question should include specific reasons about information on one site being more understandable or easy to find than on another site.

C. Company responsibilities for reporting environmental information are partly a function of environmental regulation. In countries where greater disclosure is required, companies have a clear legal responsibility to provide it. Company responsibilities for voluntary disclosure are less clear. Because of the conflicts of interest mentioned in Part A above, managers have no clear-cut responsibility. If viewed from the perspective of shareholders, the company’s responsibility might be to minimize environmental disclosure. Employees have a stake in the company’s financial well-being and might also prefer less disclosure; however, employees and their families might be affected by environmental problems such as air quality degradation or hazardous waste. In this case, the company’s responsibility might be to provide greater disclosure. Companies generally do not assume responsibility for competitors. However, greater disclosure by

2Environment Canada Website http://www.ec.gc.ca/p2/default.asp?lang=En&n=892EE8D7-1 (Retrieved February 24, 2012).© 2012 John Wiley and Sons Canada, Ltd.

http://www.ec.gc.ca/p2/default.asp?lang=En&n=892EE8D7-1

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one company in an industry might stimulate similar disclosures by competitors. The responsibility to suppliers and customers includes mixed incentives. Less disclosure might help all related companies achieve higher profits, but greater disclosure could lead to improved environmental performance across the supply chain. Company managers often view their responsibility toward government regulators and the general public as meeting minimum legal requirements. However, this view of responsibility assumes that companies have no social responsibility for environmental matters. An alternative view is that companies are responsible for the stewardship of resources they use today and for the resources available to future generations. Many people would argue that company responsibilities lie somewhere in between these two extremes—that managers have responsibilities to generate profits and also to find ways to minimize adverse environmental effects. From this viewpoint, managers have a responsibility to use environmental accounting to help them make better environmental decisions.

D. The answer to this question depends on the interpretation of “better reporting” for environmental behavior, policies, and procedures. In Chapter 1 (Exhibit 1.13, page 20),higher quality reports were defined as more relevant, understandable, and available. Given this definition, a better environmental report would provide information that is more useful to constituents such as shareholders, regulators, customers, and the general public. It would be easier to understand and would be readily available in a timely manner. Outsiders who read an environmental report can determine whether the report is easy to understand and available. However, it is more difficult to determine whether a report provides the most useful information, particularly when disclosures are voluntary. When information is provided voluntarily, it may be biased. For example, an environmental report could provide considerable information about a single environmentally-friendly project, but be silent about environmental problems. Therefore, it may not be possible to determine whether one company provides better environmental reporting than another.

However, suppose itcan be determined that one company provides better environmental reporting than another. In that case, better reporting might occur because the company has better environmental policies and procedures, which in turn could lead to better environmental behavior. However, the other company could have better environmental behavior, policies, and procedures but simply fail to provide better reporting.

E. Obviously, governmental regulation is a factor affecting the publication of environmental accounting reports. In the absence of such regulation, companies are likely to be influenced by the actions of other companies—particularly competitors—and public opinion. Managers also create and are influenced by the company’s mission and core competencies. Companies that place high priority on environmental responsibility are more likely to present a public environmental accounting report.

F. Many factors influence governmental emphasis on matters such as environmental accounting. Governments in economically stable countries are likely to place a greater emphasis on the environment. Countries in which citizens are more concerned about the environment will also place greater emphasis on the environment. Governments are also



influenced by the actions of other governments and by the requirements of international organizations such as the European Union.

G. Methods similar to the ones described in the chapter for measuring quality costs could be used to measure environmental costs. The first step would be to identify different types of environmental activities, costs, and drivers. One example is the list of cost categories included in the problem, developed by Japan’s Ministry of the Environment.

H. There are two ways that preparing and publishing environmental accounting reports help companies reduce its environmental costs. First, the process of preparing these reports necessarily includes investigation of environmental accounting and reports released by other companies. This investigation can lead to new ideas for reducing environmental costs. Second, companies that publicly release environmental information might be encouraged to more actively engage in continuous environmental improvements.

I. This question is open-ended, so answers will vary. It is important to clarify the trade-offs made when arriving at conclusions for this type of problem. Some people have a tendency to adopt a “high road” and fail to recognize the practicalities of governmental regulation. Other people tend to do the opposite—they dismiss what they perceive as idealistic solutions and fail to seek creative or new solutions. The best solutions are those which clarify trade-offs, recognize limitations, and yet still seek to achieve improvement.


Chapter 7 Activity-Based Costing and Managements3.amazonaws.com/prealliance_oneclass_sample/lz68wDM5GG.pdf34 Cost Management Chapter 7 Activity-Based Costing and Management LEARNING

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