Chapter 5: Activity-Based Costing [ABC] and Activity-Based Management

[ABM]

The problems of broad averaging:

Historically, firms (such as television and automobile manufacturers) manufactured a limited

variety of products. Accordingly, indirect (or overhead) costs were a relatively small
percentage of total costs. Using simple (traditional) costing systems to allocate costs broadly
was easy, inexpensive, and reasonably accurate. However, due to current days product
complexity and diversity, using of advanced technologies, quality requirements and high
channels of distribution, indirect costs have increased. Therefore, broad averaging has
resulted in greater inaccuracy of product costs. For example, the use of a single, plant-wide
manufacturing overhead rate to allocate indirect costs to products often produces unreliable
cost data. The term peanut-butter costing describes a particular costing approach that uses
broad averages for assigning (or spreading, as in spreading peanut butter) the cost of resources
uniformly to cost objects (such as products or services) when the individual products or
services, may in fact, actually use those resources in nonuniform ways.

The results of broad averaging are the subsequent over costing and under costing among
products (or services).
Product under costing: a product consumes a high level of resources but is reported to have
a low cost per unit.
Product over costing: a product consumes a low level of resources but is reported to have a
high cost per unit.

The consequences will be:

Under costed products (or services) will be underpriced and may even lead to sales that
actually result in losses, i.e., sales bring in less revenue than the cost of resources they use.
Over costed products lead to overpricing, causing these products to lose market share to
competitors producing similar products.

Product-Cost Cross-Subsidization – what it is?

Product-cost cross-subsidization means that if a firm under costs one of its products (or
services), it will over cost at least one of its other products. Similarly, if a firm over costs one
of its products, it will under cost at least one of its other products. Product-cost cross-
subsidization is very common in situations in which a cost is uniformly spread, i.e., implying
it is broadly averaged across multiple products without recognizing the amount of resources
consumed by each product.

Simple (Traditional) Costing System Using a Single Indirect-Cost Pool:

Step 1: Identify the products (or services) that are the chosen cost objects.
Step 2: Identify the direct costs of the products.
Step 3: Select the cost-allocation bases to be used for allocating the indirect (or overhead) costs
to the products.
Step 4: Identify the indirect costs associated with each cost-allocation base.
Step 5: Compute the rate per unit of each cost-allocation base.

Step 6: Compute the indirect costs allocated to the products.

Step 7: Compute the total cost of the products by adding all direct and indirect costs
assigned to the products.

Refining a Costing System:

A refined costing system reduces the use of broad averages for assigning the indirect costs of
resources to cost objects (such as jobs, products, and services) and provides better measurement
of the costs of indirect resources used by different cost objects, no matter how differently
various cost objects use indirect resources.

Reasons for Refining a Costing System:

There are three principal reasons that have accelerated the demand for such refinements.
1. Increase in product diversity: The growing demand for customized products has led firms
to increase the variety of products and services they offer. For example, banks, such as the
HDFC Bank, SBI, etc. in India, offer many different types of accounts and services – savings
and current accounts, ATMs, credit cards, and electronic banking. These products differ in the
demands they place on the resources needed to produce them, because of differences in volume,
process, and complexity. The use of broad averages is likely to lead to distorted and inaccurate
cost information.
2. Increase in indirect costs: The use of product and process technology such as computer-
integrated manufacturing (CIM) and flexible manufacturing systems (FMS), has led to an
increase in indirect costs and a decrease in direct costs, particularly direct manufacturing labor
costs. Managing more complex technology and producing very diverse products also requires
committing an increasing amount of resources for various support functions, such as production
scheduling, product and process design, and engineering. Because direct manufacturing labor
is not a cost driver of these costs, allocating indirect costs on the basis of direct manufacturing
labor (which was the common practice) does not accurately measure how resources are being
used by different products.
3. Competition in product markets: As markets have become more competitive, firm-
managers have felt the need to obtain more accurate cost information to help them make
important strategic decisions, such as how to price products and which products to sell. Making
correct pricing and product mix decisions is critical in competitive markets because
competitors quickly capitalize on a firm’s mistakes.

Guidelines for Refining a Costing System:

There are three main guidelines for refining a costing system.
1. Direct-cost tracing. Identify as many direct costs as is economically feasible. This guideline
aims to reduce the amount of costs classified as indirect, thereby minimizing the extent to which
costs have to be allocated, rather than traced.
2. Indirect-cost pools. Expand the number of indirect-cost pools until each pool is more
homogeneous. All costs in a homogeneous cost pool have the same or a similar cause and effect
(or benefits-received) relationship with a single cost driver that is used as the cost-allocation
base.
For example, a single indirect-cost pool containing both indirect machining costs and indirect
distribution costs that are allocated to products using machine-hours. This pool is not
homogeneous because machine-hours are a cost driver of machining costs but not of
distribution costs, which has a different cost driver, number of shipments. If, instead,
machining costs and distribution costs are separated into two indirect-cost pools (with machine-
hours as the cost-allocation base for the machining cost pool and number of shipments as the
cost-allocation base for the distribution cost pool), each indirect-cost pool would become
homogeneous.
3. Cost-allocation bases. Whenever possible, use the cost driver (the cause of indirect costs)
as the cost-allocation base for each homogenous indirect-cost pool (the effect).
 Chapter 5 Multiple Choice Questions
1) Which of the following statements is true of a peanut-butter costing system?
A) A peanut-butter costing system typically has more-homogeneous indirect cost pools.
B) A peanut-butter costing system broadly averages or spreads the cost of resources uniformly
to cost objects.
C) A peanut-butter costing system assumes that all costs are variable.
D) In a peanut-butter costing system, costs of activities are used to assign costs to other cost
objects such as products or services based on the activities the products or services consume.
Answer: B
2) Demand for refinements to the costing system has accelerated due to ________.
A) increase in direct costs
B) decrease in product diversity
C) decrease in indirect costs
D) competition in product markets
Answer: D
3) Collin Inc. produces hospital equipment and the setup requirements vary from product to
product. Collin produces its products based on customer orders and uses ABC costing. In one
of its indirect cost pools, setup costs and distribution costs are pooled together. Costs in this
pool are allocated using number of customer orders for the easiness of costing operations.
Based on the information provided, which of the following arguments is valid?
A) Collin has clearly failed to identify as many direct costs as is economically feasible.
B) All costs in a homogeneous cost pool have the same or a similar cause-and-effect
relationship with the single cost driver that is used as the cost-allocation base for Collin.
C) Collin has unnecessarily wasted resources by classifying setup and distribution costs as they
could have been considered as direct costs.
D) Collin has failed to use the correct cost driver as the cost-allocation base for setup costs.
Answer: D
4) Activity based costing system differs from traditional costing systems in the treatment of
________.
A) direct labour costs
B) direct material costs
C) prime costs
D) indirect costs
Answer: D
5) Product lines that produce different variations (models, styles, or colours) often require
specialized manufacturing activities that translate into ________.
A) fewer indirect costs for each product line
B) decisions to drop product variations
C) a greater number of direct manufacturing labor cost allocation rates
D) greater overhead costs for each product line
Answer: D
Question numbers 6-11 should be answered based on following information:
Premium Company provides the following ABC costing information:
Activities Total Costs Activity-cost drivers
Account inquiry $200,000 10,000 hours
Account billing $140,000 4,000,000 lines
Account verification accounts $75,000 40,000 accounts
Correspondence letters $ 25,000 4,000 letters
Total costs $440,000
The above activities are used by Departments A and B as follows:

Department A Department B
Account inquiry hours 2,500 hours 4,000 hours
Account billing lines 400,000 lines 250,000 lines
Account verification accounts 10,000 accounts 8,000 accounts
Correspondence letters 1,200 letters 1,600 letters
6) How much of the account inquiry cost will be assigned to Department A?
A) $50,000
B) $200,000
C) $60,000
D) $80,000
Answer: A
Explanation: A) Account inquiry costs - Department A = ($200,000 ÷ 10,000) × 2,500=
$50,000
7) How much of the account billing cost will be assigned to Department B?
A) $8,500
B) $8,250
C) $8,750
D) $8,540
Answer: C
Explanation: C) Billing costs - Department B = ($140,000 ÷ 4,000,000) × 250,000 = $8,750
8) How much of account verification costs will be assigned to Department A?
A) $15,000
B) $18,750
C) $75,000
D) $5,000
Answer: B
Explanation: B) Account verification costs - Department A = ($75,000 / 40,000) × 10,000 =
$18,750
9) How much of correspondence costs will be assigned to Department A?
A) $4,000
B) $6,250
C) $7,500
D) $10,000
Answer: C
Explanation: C) Correspondence costs - Department A = ($25,000 ÷ 4,000) × 1,200 = $7,500
10) How much of the total costs will be assigned to Department A?
A) $90,250
B) $90,650
C) $90,350
D) $90,750
Answer: A
Explanation: A) Account inquiry costs = ($200,000 ÷ 10,000) × 2,500 =
$50,000
Billing costs = ($140,000 ÷ 4,000,000) × 400,000 = $14,000
Account verification costs = ($75,000 ÷ 40,000) × 10,000 = $18,750
Correspondence costs = ($25,000 ÷ 4,000) × 1,200 = $7,500
$90,250
11) How much of the total costs will be assigned to Department B?
A) $117,350
B) $113,250
C) $113,750
D) $112,350
Answer: C
Explanation: C)
Account inquiry costs = ($200,000 ÷ 10,000) × 4,000 = $80,000
Billing costs = ($140,000 ÷ 4,000,000) × 250,000 = $ 8,750
Account verification costs = ($75,000 ÷ 40,000) × 8,000 = $15,000
Correspondence costs = ($25,000 ÷ 4,000) × 1,600 = $10,000
$113,750
12) ________ is an example of an output unit-level cost in the cost hierarchy.
A) Factory rent expense
B) Building security costs
C) Top management compensation costs
D) Machine depreciation
Answer: D
13) ________ are the costs of activities undertaken to support individual products or services
regardless of the number of units or batches in which the units are produced.
A) Unit-level costs
B) Batch-level costs
C) Product-sustaining costs
D) Facility-sustaining costs
Answer: C
14) Put the following ABC implementation steps in order ________.
A Compute the allocation rates.
B Compute the total cost of the products.
C Identify the products that are the cost objects.
D Select the cost allocation bases.
A) DACB
B) DBCA
C) BADC
D) CDAB
Answer: D
15) Which of the following cost and cost allocation base have a strong cause and effect
relationship?
A) administration costs and cubic feet
B) setup costs and square feet
C) machine depreciation and output units
D) machine maintenance and setup hours
Answer: C
Answer questions 16-19 by using the information below:
Comfort Corporation manufactures two models of office chairs, a standard and a deluxe model.
The following activity and cost information has been compiled:
Number of Number of Number of
Product Setups Components Direct Labour Hours
Standard 12 8 255
Deluxe 28 12 245

Overhead costs $52,000 $78,000

16) Assume a traditional costing system applies the overhead costs based on direct labour
hours. What is the total amount of overhead costs assigned to the standard model?
A) $65,700
B) $63,600
C) $66,300
D) $66,700
Answer: C
Explanation: C) Total amount of overhead costs = [($52,000 + $78,000) ÷ (255 + 245)] × 255
= $66,300
17) Assume a traditional costing system applies the overhead costs based on direct labour
hours. What is the total amount of overhead costs assigned to the deluxe model?
A) $64,300
B) $63,700
C) $63,300
D) $63,600
Answer: B
Explanation: B) The total amount of overhead costs = [($52,000 + $78,000) ÷ (255 + 245)] ×
245 = $63,700
18) Number of setups and number of components are identified as activity-cost drivers for
overhead. Assuming an activity-based costing system is used, what is the total amount of
overhead costs assigned to the standard model?
A) $49,200
B) $45,600
C) $46,800
D) $47,400
Answer: C
Explanation: C) Setups: $52,000 ÷ (12 + 28) = $1,300
Components: $78,000 ÷ (8 + 12) = $3,900
Total amount of overhead costs = ($1,300 × 12) + ($3,900 × 8) = $46,800
19) Number of setups and number of components are identified as activity-cost drivers for
overhead. Assuming an activity-based costing system is used, what is the total amount of
overhead costs assigned to the deluxe model?
A) $84,400
B) $83,200
C) $82,600
D) $80,800
Answer: B
Explanation: B) Setups: $52,000 ÷ (12 + 28) = $1,300
Components: $78,000 ÷ (8 + 12) = $3,900
Total amount of overhead costs = ($1,300 × 28) + ($3,900 × 12) = $83,200
Answer questions 20-25 by using the information below:
Luzent Corporation has two departments, Small and Large. Central costs could be allocated to
the two departments in various ways.
Small Department Large Department
Square footage 6,750 17,250
Number of employees 1,120 480
Sales $350,000 $1,750,000
20) If advertising expense of $483,000 is allocated on the basis of sales, the cost per cost driver
rate would be ________.
A) $0.22 per dollar of sales
B) $0.23 per dollar of sales
C) $0.25 per dollar of sales
D) $0.24 per dollar of sales
Answer: B
Explanation: B) Cost per cost driver rate = $483,000 ÷ ($350,000 + $1,750,000) = $0.23
21) If total advertising expense of $483,000 is allocated on the basis of sales, the amount
allocated to the Large Department would be ________.
A) $407,500
B) $405,000
C) $402,500
D) $405,250
Answer: C
Explanation: C) Amount allocated to the Large Department
= $483,000 × ($1,750,000/$21,000,000) = $402,500
22) If total payroll processing costs of $64,000 are allocated on the basis of number of
employees, the amount allocated to the Small Department would be ________.
A) $44,800
B) $48,400
C) $46,200
D) $45,600
Answer: A
Explanation: A) Amount allocated to the Small Department = $64,000 × (1,120 ÷ (1,120 +
480)) = $44,800
23) If total payroll processing costs of $64,000 are allocated on the basis of number of
employees, the amount allocated to the Large Department would be ________.
A) $18,400
B) $19,200
C) $17,800
D) $19,400
Answer: B
Explanation: B) Amount allocated to the Large Department = $64,000 × (480 ÷ (1,120 + 480))
= $19,200
24) If total rent expense of $180,000 is allocated on the basis of square footage, the amount
allocated to the Small Department would be ________.
A) $50,525
B) $50,625
C) $50,725
D) $50,825
Answer: B
Explanation: B) Amount allocated to the Small Department
= $180,000 × (6,750 ÷ (6,750 + 17,250)) = $50,625
25) If total rent expense of $180,000 is allocated on the basis of square footage, the amount
allocated to the Large Department would be ________.
A) $129,175
B) $129,475
C) $129,275
D) $129,375
Answer: D
Explanation: D) Amount allocated to the Large Department
= 180,000 × (17,250 ÷ (6,750 + 17,250)) = $129,375

-×-
 Chapter 11: Decision Making and Relevant Information

Information and the Decision Process

Firm managers usually follow a decision model for choosing among different courses of action.
A decision model is a formal method of making a choice that often involves both quantitative
and qualitative analyses. Management accountants analyze and present relevant data to guide
firm managers’ decisions.

The Concept of Relevance:

Relevant Costs and Relevant Revenues – what they are?
Relevant costs are expected future costs, and relevant revenues are expected future
revenues that differ among the alternative courses of action being considered. Revenues and
costs that are not relevant are said to be irrelevant.
Therefore, it is important to recognize that to be relevant costs and relevant revenues they must:
➢ Occur in the future, every decision deal with selecting a course of action based on its
expected future results.
➢ Differ among the alternative courses of action, costs and revenues that do not differ
will not matter and, hence, will have no bearing on the decision being made.

Qualitative and Quantitative Relevant Information – what they are:

Firm managers divide the decision outcomes into two broad categories - quantitative and
qualitative.
Quantitative factors are outcomes that are measured in numerical terms. Some quantitative
factors are financial; they can be expressed in monetary terms, such as, the cost of direct
materials, direct manufacturing labour, and marketing costs. Other quantitative factors are
nonfinancial; they can be measured numerically, but they are not expressed in monetary terms.
Reduction in new product-development time and the percentage of on-time flight arrivals are
examples of quantitative nonfinancial factors.
Qualitative factors are outcomes that are difficult to measure accurately in numerical terms,
e.g., employee morale.
Relevant-cost analysis generally emphasizes quantitative factors that can be expressed in
financial terms. But just because qualitative factors and quantitative nonfinancial factors can’t
be measured easily in financial terms does not make them unimportant.

An Illustration of Relevance: Choosing Output Levels

One-Time-Only Special Orders:

One type of decision that affects output levels is accepting or rejecting special orders when
there is idle production capacity and the special orders have no long-run implications.

Potential Problems in Relevant-Cost Analysis:

Firm managers should avoid two potential problems in relevant-cost analysis.
First, they must watch for incorrect general assumptions, such as all variable costs are relevant
and all fixed costs are irrelevant.
Second, unit-cost data can potentially mislead decision makers in two ways - when irrelevant
costs are included; and when the same unit costs are used at different output levels.
Solutions of potential problems:
The best way for firm managers to avoid above two potential problems is to keep focusing on
(1) total revenues and total costs (rather than unit revenue and unit cost); and
(2) the relevance concepts.
Firm managers should always require all items included in an analysis to be expected total
future revenues and expected total future costs that differ among the alternatives.

Insourcing-vs.-Outsourcing or Make-vs.-Buy Decisions:

Outsourcing is purchasing goods and services from outside vendors rather than producing the
same goods or providing the same services within the firm, which is insourcing.
Decisions about whether a producer of goods or services will insource or outsource are also
called make-or-buy decisions. Surveys of firms indicate that managers consider quality,
dependability of suppliers, and costs as the most important factors in the make-or-buy decision.
Sometimes, however, qualitative factors dominate management’s make-or-buy decision.

A common term in decision making is incremental cost. An incremental cost is the additional
total cost incurred for an activity. Note that incremental cost and differential cost are sometimes
used interchangeably in practice.
On the other hand, incremental revenue is the additional total revenue from an activity.
Differential revenue is the difference in total revenue between two alternatives.

Strategic and Qualitative Factors:

Strategic and qualitative factors affect outsourcing decisions.
Outsourcing is not without risks. As a firm’s dependence on its suppliers increases, suppliers
could increase prices and let quality and delivery performance slip. To minimize these risks,
firms generally enter into long-run contracts specifying costs, quality, and delivery schedules
with their suppliers. Intelligent firm managers build close partnerships or alliances with a few
key suppliers.
Outsourcing decisions invariably have a long-run horizon in which the financial costs and
benefits of outsourcing become more uncertain. Almost always, strategic and qualitative
factors such as the ones described here become important determinants of the outsourcing
decision. Weighing all these factors requires the exercise of considerable management
judgment and care.

Opportunity Costs and Outsourcing:

Often, in practical world, the released capacity can be used for other, profitable purposes.
Therefore, firm managers need to consider capacity constraints in their decision making.
Deciding to use a resource in a particular way causes a firm manager to forgo the opportunity
to use the resource in alternative ways. This lost opportunity is a cost that the manager must
consider when making a decision. Opportunity cost is the contribution to operating income
that is forgone by not using a limited resource in its next-best alternative use.

Besides quantitative considerations, the make-or-buy decisions should also consider strategic
and qualitative factors. If a firm decides to buy products from an outside supplier, it should
also consider factors such as the supplier’s reputation for quality and timely delivery, etc.

Product-Mix Decisions with Capacity Constraints:

The importance of the concept of relevance also applies to product-mix decisions, i.e., the
decisions made by a firm about which products to sell and in what quantities. These decisions
usually have only a short-run focus, because they typically arise in the context of capacity
constraints that can be relaxed in the long-run.
To determine product mix, a firm maximizes operating income, subject to constraints such as
capacity and demand. Throughout our discussions, we will assume that as short-run changes in
product mix occur, the only costs that change are costs that are variable with respect to the
number of units produced (and sold). Under this assumption, the analysis of individual
product contribution margins provides insight into the product mix that maximizes
operating income.
Therefore, firm managers should choose the product with the highest contribution margin per
unit of the constraining resource (factor). That’s the resource that restricts or limits the
production or sale of products. In addition, regardless of the specific constraining resource,
managers should always focus on maximizing total contribution margin by choosing products
that give the highest contribution margin per unit of the constraining resource.

In many cases, a manufacturer or retailer has the challenge of trying to maximize total operating
income for a variety of products, each with more than one constraining resource. Some
constraints may require a manufacturer or retailer to stock minimum quantities of products
even if these products are not very profitable. For example, supermarkets must stock less-
profitable products because customers will be willing to shop at a supermarket only if it carries
a wide range of products that customers desire. To determine the most profitable production
schedule and the most profitable product mix, the manufacturer or retailer needs to determine
the maximum total contribution margin in the face of many constraints. Optimization
techniques, such as linear programming help solve these more-complex problems.

Finally, there is the question of managing the bottleneck constraint to increase output and,
therefore, contribution margin. For example, can the available machine-hours for assembling
products be increased beyond the capacity, for example, by reducing idle time? Can the time
needed to assemble each product (say X machine-hours) be reduced, for example, by reducing
setup time and processing time of assembly? Can quality be improved so that constrained
capacity is used to produce only good units rather than some good and some defective units?
Can some of the assembly operations be outsourced to allow more products to be built? etc.

In addition, one can refer “Theory of Constraints and Throughput Contribution

Analysis”.
 Chapter 11 Multiple Choice Questions
1) For decision making, a listing of the relevant costs ________.
A) will help the decision maker concentrate on the pertinent data
B) will only include historical costs
C) will only include costs that that are same among alternatives
D) will include both sunk costs and opportunity costs
Answer: A
2) Sunk costs ________.
A) are relevant
B) are differential
C) have future implications
D) are ignored when evaluating alternatives
Answer: D
3) Which of the following costs always differ among future alternatives?
A) fixed costs
B) historical costs
C) relevant costs
D) variable costs
Answer: C
4) A relevant cost is a cost that is a(n) ________.
A) future cost
B) past cost
C) sunk cost
D) non-cash expense
Answer: A
5) One-time-only special orders should only be accepted if ________.
A) incremental revenues exceed incremental costs
B) differential revenues exceed variable costs
C) incremental revenues exceed fixed costs
D) total revenues exceed total costs
Answer: A
6) When there is an excess capacity, it makes sense to accept a one-time-only special order for
less than the current selling price if ________.
A) incremental revenues exceed incremental costs
B) additional fixed costs is incurred to accommodate the order
C) the company placing the order is in the same market segment as your current customers
D) incremental revenue equals incremental operating income
Answer: A