Exam (elaborations)

Garrison (CDN), Managerial Accounting, 12ce CHAPTER 7 Solutions

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Managerial Accounting 12th Edition

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Managerial Accounting 12th Edition

Chapter 7Activity-Based Costing: A Tool to Aid Decision MakingDiscussion Case (20 minutes)Potential benefits of adopting an ABC system that arise from having more accurate product (or service) costs include:• Improved product (or service) pricing decisions• Improved product (or service) mix dec...

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managerial accounting 12th edition

Institution Managerial Accounting 12th Edition
Course Managerial Accounting 12th Edition

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Chapter 7
Activity-Based Costing: A Tool to Aid Decision
Making

Discussion Case (20 minutes)

Potential benefits of adopting an ABC system that arise from having more
accurate product (or service) costs include:
• Improved product (or service) pricing decisions
• Improved product (or service) mix decisions
• Ability to target process improvements in key activities that can
result in cost savings

Quantifying any of these benefits is an inherently subjective exercise but it
can be done. For example, the revised product costs generated by an ABC
system could lead management to change prices on one or more of its
existing products. Estimates would then be required of the change in
demand that would arise from a change in the product prices. The change
in demand would depend on the price elasticity of demand, which depends
on the number of substitute products available to consumers.
Similarly, management could estimate the cost savings that would result
from process improvements made to key activities. One approach to
developing the estimates would be to compare the current level of
performance on a key activity (e.g., the time taken to set-up production
equipment) to benchmark data from leading competitors. An estimate
could then be made of the cost savings that would arise if the set-up time
could be reduced to the benchmark level. This would be computed as the
cost per set-up hour multiplied by the targeted reduction in hours.
One approach to use when dealing with uncertainty is the expected value
approach to calculating the financial impact of various alternatives. For
example, management could estimate the subjective probabilities of
different levels of demand that may arise from a change in prices
suggested by more accurate product costs generated by an ABC system.
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The income effect of each alternative would be calculated as: (price per
unit x estimated volume) – (variable cost per unit × estimated volume) –
fixed expenses. This operating income level would then be multiplied by
the subjective probability of achieving the predicted volume level given the
new price. These steps would be repeated for other possible sales volume
levels and the results summed to come up with the expected profit margin
given the change in sales price. The expected profit margin could then be
compared to the current profit margin to determine if the benefits exceed
the costs of adopting the ABC system.

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Solutions to Questions

7-1 Under activity-based costing, non- 7-4 An activity cost pool is a “bucket” in
manufacturing costs such as selling, shipping and which costs are accumulated relating to a single
distribution costs are assigned to products activity measure in an activity-based costing
wherever possible. This allows managers to system. Activity cost pools can consist of both
calculate the complete cost, manufacturing and manufacturing activities such as quality
non-manufacturing, of a product or service. Recall inspections and non-manufacturing activities such
that under the traditional costing approach only as shipping.
manufacturing costs are assigned to products. All
other costs such as selling and shipping are 7-5 Unit-level activities are performed for
expensed as period costs as incurred. each unit that is produced. Batch-level activities
are performed for each batch regardless of how
7-2 When direct labour is used as an many units are in the batch. Product-level
allocation base for overhead, it is assumed that activities must be carried out to support a product
overhead cost is directly proportional to direct regardless of how many batches are run or units
labour. When cost systems were originally produced. Customer-level activities must be
developed this assumption may have been carried out to support customers regardless of
reasonably accurate. However, direct labour has what products or services they buy. Organization-
declined in importance in some industries while sustaining activities are carried out regardless of
overhead has been increasing. This suggests that the company’s precise product mix or mix of
there is not a direct link between the level of customers.
direct labour and overhead anymore. Indeed,
when a company automates, direct labour is 7-6 Organization-sustaining costs and the
replaced by machines; a decrease in direct labour costs of idle capacity should not be assigned to
is accompanied by an increase in overhead. This products. These costs represent resources that
violates the assumption that overhead cost is are not consumed by the products.
directly proportional to direct labour. Moreover,
while the empirical evidence is not entirely clear, 7-7 A transaction driver is based on a simple
it appears that overhead cost may be driven by count of the number of times an activity occurs.
factors such as product diversity and complexity An example would be the number of inspections
as well as by volume. carried out on raw materials used in production. A
duration driver reflects the amount of time
7-3 When an overhead rate is based on the required to carry out an activity. An example
budgeted level of activity, products are implicitly would be the time spent inspecting raw materials
charged for the costs of the capacity they don’t used in production. Transaction drivers tend to be
use as well as for the costs of capacity that they used more often in practice because they are
do use. This is because all of the costs of capacity easier to record.
—whether utilized or not—are spread across the
budgeted production. Since the costs of capacity 7-8 Since people often work on more than
are largely fixed, this results in higher unit one activity, there has to be some way of esti-
product costs when the level of activity declines. mating how much time they spend on each. The
most practical approach is often to ask them what
If an overhead rate is based on the level of percentage of time they spend on each activity. It
activity at capacity, a product is charged only for is also possible to ask people to keep records of
the costs of capacity that it actually uses. The how they spend their time or observe them as
costs of unused capacity are not charged to they perform their tasks, but both of these
products and are instead charged to the current alternatives are costly and it is not obvious that
period as expenses of the period (see Appendix the data would be any better. People who know
3A). As a result, unit product costs are more they are being observed may change how they
stable and costs do not appear to increase as the behave.
level of budgeted activity decreases.
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7-9 Benchmarking is a systematic approach 7-11 The second stage allocation in activity-
used to compare the performance of some aspect based costing is the process by which activity
of an organization’s operations to that of rates are used to apply costs to products and
outstanding external companies or other divisions customers.
within the same organization. For example,
manufacturing companies could benchmark 7-12 The two chief limitations are: First, the
defect rates against other top companies in the portion of overhead costs that relate to facility-
industry. Benchmarking is often used in level activities are still usually allocated to
conjunction with activity-based management as a products on some arbitrary basis, such as
means of improving key processes or operations machine-hours or direct labour-hours. Critics of
identified as performing below acceptable levels. activity-based costing argue that facility-level
activities account for the bulk of all overhead
7-10 In traditional cost systems, product-level costs in some companies. Second, high
costs are spread across all products measurement costs are involved in operating an
indiscriminately using direct labour-hours or some activity-based costing system. That is, the system
other basis that is tied to volume. As a requires the tracking of large amounts of detail
consequence, high-volume products are assigned and the completion of many separate
the bulk of such costs. If a product is responsible computations in order to determine the cost of a
for 40 percent of the direct labour in a factory, it unit or product.
will be assigned 40 percent of the manufacturing
overhead cost in the factory—including 40 percent 7-13 The activity-based costing approach
of the product-level costs of low-volume products. described in the chapter is probably unacceptable
In an activity-based costing system, batch-level for external financial reports for two reasons.
and product-level costs are assigned more First, activity-based product costs, as described in
appropriately. This results in shifting product-level this chapter, exclude some manufacturing costs
costs back to the products that cause them and and include some nonmanufacturing costs which
away from the high-volume products. (There will is not allowed under GAAP. Second, the first-stage
be a similar effect with batch-level costs if high- allocations are usually based on interviews rather
volume products are produced in larger batches than verifiable, objective data.
than low-volume products.)

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Exam (elaborations)

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