ACW 2220 Management Accounting 1

Semester 2 2023
Tutorial Solution
Topic 7: Activity-based Costing (Chapter 5)

5-1 What is broad averaging, and what consequences can it have on costs?

Broad averaging (or “peanut-butter costing”) describes a costing approach that uses broad
averages for assigning (or spreading, as in spreading peanut butter) the cost of resources uniformly
to cost objects when the individual products or services, in fact, use those resources in non-
uniform ways.

Broad averaging, by ignoring the variation in the consumption of resources by different cost
objects, can lead to inaccurate and misleading cost data, which in turn can negatively impact the
marketing and operating decisions made based on that information.

5-2 Inaccurate costing can result in two deviations. Name the two deviations and explain how
they can impact a business.

These two deviations are overcosting and undercosting. Undercosting will cause underpricing
which can lead to sales that actually result in losses, because the sales may bring in less revenue
than the cost of resources, though the company is under the assumption that it is making a profit.
Overcosting will lead to overpricing, causing a loss in market share to competitors producing
similar products.

5-3 What is costing system refinement? Describe three guidelines for refinement.

Costing system refinement means making changes to a simple costing system that reduces the use
of broad averages for assigning the cost of resources to cost objects and provides better
measurement of the costs of overhead resources used by different cost objects.

Three guidelines for refinement are

1. Classify as many of the total costs as direct costs as is economically feasible.
2. Expand the number of indirect cost pools until each of these pools is more homogenous.
3. Use the cause-and-effect criterion, when possible, to identify the cost-allocation base for
each indirect-cost pool.

5-12 Explain why ABC is equally important for both manufacturing and service companies.

ABC systems can be used equally for product costing and service costing as well as for strategic
decisions in manufacturing and service companies. ABC systems are more suited to service
companies because a vast majority of their cost structure is composed of indirect costs.

5-13 “Activity-based costing is providing more accurate and detailed information and should
replace simple costing.” Do you agree? Explain.

No. The additional costs and resources needed may not exceed the benefits gained by having more
accurate and detailed information provided by the ABC system. Thus, cost benefit analysis is
always needed to make sure that expected benefits exceed expected costs to replace simple costing.

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5-22 Plant-wide, department, and activity-cost rates.

1.
Trophies Plaques Total
Direct materials
Forming $26,000 $22,500
Assembly 5,200 18,750
Total 31,200 41,250
Direct manufacturing labor
Forming 31,200 18,000
Assembly 15,600 21,000
Total 46,800 39,000
Total direct costs $78,000 $80,250 $158,250

($24, 000 + $20, 772 + $46, 000 + $21,920) $112, 692

Budgeted =
overhead rate = $158, 250 $158, 250
$0.712114
= per dollar of direct cost

Trophies Plaques Total

Direct materials $ 31,200 $ 41,250 $ 72,450
Direct labor 46,800 39,000 85,800
Total direct cost 78,000 80,250 158,250
Allocated overhead* 55,544 57,148 112,692
Total costs $133,544 $137,398 $270,942

*Allocated overhead = Total direct cost  Budgeted overhead rate (0.712114).

Budgeted
overhead rate — Budgeted Forming Department overhead costs
2. Forming Dept. = Budgeted Forming Department direct manufacturing labor costs
$24, 000 + $20, 772
= $31, 200 + $18, 000
$44, 772
=
= $49, 200 $0.91 per Forming Department direct manuf.-labor dollar
Budgeted
overhead rate — Budgeted Assembly Department overhead costs
Assembly Dept. = Budgeted Assembly Department direct costs
$46, 000 + $21,920
= ($5, 200 + $18, 750 + $15, 600 + $21, 000)

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 $67,920
=
= $60,550 $1.121718 per Assembly Department direct cost dollar

Trophies Plaques Total

Direct materials $ 31,200 $ 41,250 $ 72,450
Direct labor 46,800 39,000 85,800
Total direct cost 78,000 80,250 158,250
Allocated overhead
Forming Dept.a 28,392 16,380 44,772
Assembly Dept.b 23,332 44,588 67,920
Total costs $129,724 $141,218 $270,942

Trophies Plaques Total

a
Forming Dept.
Direct manufacturing labor costs $31,200 $18,000 $49,200
Allocated overhead
(0.91 × $31,200; $18,000) $28,392 $16,380 $44,772
b
Assembly Dept.
Total direct costs
($5,200 + $15,600; $18,750 + $21,000) $20,800 $39,750 $60,550
Allocated overhead
(1.121718  $20,800; $39,750) $23,332 $44,588 $67,920

3.

Forming Department

$24, 000
Budgeted setup rate = 156 batches = $153.84615 per batch

$20, 772
Budgeted supervision rate = $49, 200 = $0.422195 per direct-labor dollar

Assembly Department

$46, 000
Budgeted set up rate = 146 batches = $315.06849 per batch

$21,920
Budgeted supervision rate = $36, 600 = $0.598907 per direct manuf.-labor dollar

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 Trophies Plaques Total

Direct material costs $ 31,200 $ 41,250 $ 72,450

Direct labor costs 46,800 39,000 85,800
Total direct costs 78,000 80,250 158,250

Forming Dept. overhead

Set up
$153.84615  40; 116 6,154 17,846 24,000
Supervision
0.422195 × $31,200; $18,000 13,172 7,600 20,772

Assembly Department overhead

Set up
$315.06849 × 43; 103 13,548 32,452 46,000
Supervision
0.598907 × $15,600; $21,000 9,343 12,577 21,920

Total costs $120,217 $150,725 $270,942

4. As Triumph uses more refined cost pools, the costs of trophies decreases, and costs of
plaques increases. This is because plaques use a higher proportion of cost drivers (batches of set
ups and direct manufacturing labor costs) than trophies, whereas the direct costs (the allocation
base used in the simple costing system) are slightly smaller for plaques compared to trophies. This
results in plaques being undercosted and trophies overcosted in the simple costing system.

Department costing systems increase the costs of plaques relative to trophies because the forming
department costs are allocated based on direct manufacturing labor costs in the forming
department and plaques use more direct manufacturing labor in this department compared to
trophies.

Disaggregated information can improve decisions by allowing managers to see the details that help
them understand how different aspects of cost influence total cost per unit. Managers can also
understand the drivers of different cost categories and use this information for pricing and
product-mix decisions, cost reduction and process-improvement decisions, design decisions, and
to plan and manage activities. However, too much detail can overload managers who don’t
understand the data or what it means. Also, managers looking at per-unit data may be misled when
considering costs that aren’t unit-level costs.

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 5-26 Activity-based costing, manufacturing.

1. Simple costing system:

Total indirect costs = $95,000 + $45,000 + $25,000 + $60,000 + $8,000 + 3%[($125  3,200) +
($200  1,800)]
= $255,800
Total machine-hours = 5,500 + 4,500 = 10,000
Indirect cost rate per machine-hour = $255,800  10,000
= $25.58 per machine-hour

Simple Costing System Interior Exterior

Direct materialsa $ 96,000 $ 81,000
Direct manufacturing laborb 76,800 64,800
Indirect cost allocated to each job
($25.58 × 5,500; 4,500 machine hours) 140,690 115,110

Total costs $313,490 $260,910

Total cost per unit

($313,490  3,200; $260,910  1,800) $ 97.97 $ 144.95
a
$30 × 3,200 units; $45  1,800 units
b
$16 × 1.5 × 3,200 units; $16  2.25  1,800 units

2. Activity-based costing system

Total Cost
Cost of Driver
Activity Activity Cost Driver Quantity Allocation Rate
(1) (2) (3) (4) (5) = (2)  (4)
Product per production
scheduling $95,000 Production runs 125c $760.00 run
Material handling $45,000 Material moves per material
240d $187.50 move
Machine setup $25,000
Machine setups 200e $125.00 per setup
Assembly $60,000
Machine hours 10,000 $ 6.00 per machine hour
Inspection $ 8,000
Inspections 400f $ 20.00 per inspection
Marketing Percentage of $ 0.03 per dollar of sales
revenues
c
40 + 85 = 125; d 72 + 168 = 240; e 45 + 155 = 200; f
250 + 150 = 400

ABC System Interior Exterior

Direct materials $ 96,000 $ 81,000
Direct manufacturing labor 76,800 64,800
Indirect costs allocated:
Production scheduling ($760 per run  40; 85) 30,400 64,600
Material handling ($187.50 per move  72; 168) 13,500 31,500
Machine setup ($125 per setup  45; 155) 5,625 19,375

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 Assembly ($6 per MH × 5,500; 4,500) 33,000 27,000
Inspection ($20 per inspection × 250; 150) 5,000 3,000
Marketing (0.03  $125  3,200; 0.03  $200  1,800) 12,000 10,800
Total costs $272,325 $302,075

Total cost per unit

($272,325 ÷ 3,200 units; $302,075 ÷ 1,800 units) $ 85.10 $ 167.82

3.
Cost per unit Interior Exterior
Simple Costing System $97.97 $144.95
Activity-based Costing System $85.10 $167.82
Difference (Simple – ABC) $12.87 $ (22.87)

Relative to the ABC system, the simple costing system overcosts interior doors and undercosts
exterior doors. Interior doors require 1.72 machine-hours per unit (5,500 hours ÷ 3,200 units)
while exterior doors require 2.5 machine-hours per unit (4,500 hours ÷ 1,800 units). In the simple-
costing system, overhead costs are allocated to the interior and exterior doors on the basis of the
machine-hours used by each type of door. The ABC study reveals that the ratio of the cost of
production runs, material moves, and setups for each exterior door versus each interior door is
even higher than the ratio of 2.5 to 1.72 machine-hours for each exterior relative to each interior
door. This higher ratio results in higher indirect costs allocated to exterior doors relative to interior
doors in the ABC system.

4. Decorative Doors, Inc. can use the information revealed by the ABC system to change its
pricing based on the ABC costs. Under the simple system, Decorative Doors was making an
operating margin of 21.6% on each interior door ([$125 – $97.97]  $125) and 27.5% on each
exterior door ([$200 – $144.95]  $200). But, the ABC system reveals that it is actually making an
operating margin of about 32% ([$125 – $85.10]  $125) on each interior door and about 16%
([$200 – $167.82]  $200) on each exterior door. Decorative Doors, Inc., should consider
decreasing the price of its interior doors to be more competitive. Decorative Doors should also
consider increasing the price of its exterior doors, depending on the competition it faces in this
market.

Decorative Doors can also use the ABC information to improve its own operations. It could
examine each of the indirect cost categories and analyze whether it would be possible to deliver
the same level of service, but consume fewer indirect resources, or find a way to reduce the per-
unit-cost-driver cost of some of those indirect resources. Making these operational improvements
can help Decorative Doors to reduce costs, become more competitive, and reduce prices to gain
further market share while increasing its profits.

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5-31 Job costing with single direct-cost category, single indirect-cost pool, law firm.

1. Pricing decisions at Bradley Associates are heavily influenced by reported cost numbers.
Suppose Bradley is bidding against another firm for a client with a job similar to that of
Campa Coal. If the costing system overstates the costs of these jobs, Bradley may bid too
high and fail to land the client. If the costing system understates the costs of these jobs,
Bradley may bid low, land the client, and then lose money in handling the case.
2.
Campa Coal St. Edith’s Glass Total
Direct professional labor
$80  150; $80  100 $12,000 $8,000 $20,000
Indirect costs allocated
$100  150; $100  100 15,000 10,000 25,000
$27,000 $18,000 $45,000

5-32 Job costing with multiple direct-cost categories, single indirect-cost pool, law firm
(continuation of 5-31).

1.
Indirect costs = $10,000
Total professional labor-hours = 250 hours (150 hours on Campa Coal + 100 hours on St.
Edith’s Glass)
Indirect cost allocated per professional labor-hour (revised) = $10,000 ÷ 250 = $40 per
hour

2.
Campa Coal St. Edith’s Total
Glass
Direct costs:
Direct professional labor
$80150; $80100 $12,000 $8,000 $20,000
Research support labor 1,800 3,850 5,650
Computer time 400 1,600 2,000
Travel and allowances 700 4,200 4,900
Telephones/faxes 250 1,200 1,450
Photocopying 300 700 1,000
Total direct costs 15,450 19,550 35,000
Indirect costs allocated
$40150; $40100 6,000 4,000 10,000
Total costs to be billed $21,450 $23,550 $45,000

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3.
Campa Coal St. Edith’s Glass Total
Problem 5-31 $27,000 $18,000 $45,000
Problem 5-32 21,450 23,550 45,000

The Problem 5-32 approach directly traces $15,000 of general support costs to the individual jobs.
In Problem 5-31, these costs are allocated on the basis of direct professional labor-hours. The
averaging assumption implicit in the Problem 5-31 approach appears incorrect—for example, the
St. Edith’s Glass job has travel costs six times higher than the Campa Coal case despite having
lower direct professional labor-hours.