ACCG200 SolutionCh 08 PDF

CHAPTER 8
ACTIVITY-BASED COSTING
ANSWERS TO QUESTIONS
8.1 Many businesses are experiencing changes to product structures because, to remain competitive, they
have increased the number of different products they produce.
Many businesses are experiencing changes to costs, many of which do not vary in proportion to
production volume, because:
greater product diversity, resulting from competitive pressures to change product structures referred
to above, increases:
production complexity and the need for manufacturing overhead support, such as production
scheduling, material handling and production setups
costs in non-manufacturing areas such as research and development, product design,
distribution and after-sales service.
growing automation increases manufacturing overhead costs such as depreciation, insurance and
setups compared to direct labour costs
increased customer demands for improved service and quality result in increased manufacturing
overhead and non-manufacturing costs
increased emphasis on customer support and product promotion and advertising, to position
products in the more aggressive market place, results in investment of more resources in
downstream areas such as customer service and marketing.
8.2 A volume-based cost driver is a cost driver that reflects some measure of production volume, either
production output (i.e. units produced) or production input (i.e. direct labour hours or machine hours).
Conventional costing systems assume that manufacturing overhead costs are related to the volume of
production, usually measured by input measures such as direct labour hours. Thus, this approach
assumes that the more direct labour hours worked on a product, the greater its consumption of overhead
resources. Yet, in a modern business environment, many manufacturing overhead costs may not behave
in this way. A significant part of the overhead costs are likely to be driven by factors other than
production volume. For example, some of the overhead costs, like setup costs, are incurred for each
production batch regardless of the number of units in the batch. Others, like factory rent, are incurred
each month regardless of the number of units produced. Still others are incurred because of overall
production complexity. Products that are difficult to make tend to use more overhead resources than
those that are simple to make. Where non-volume based costs are significant, a conventional costing
approach will result in distorted product costs.
8.3 Common indicators of an outdated product costing system and their probable causes are described in
Exhibit 8.2.
8.4 In general terms, where businesses have changed the nature and range of products produced,
manufacturing and information technology used, markets and customers servedbut their management
accounting systems in general, and their product costing systems in particular, have not changed
product costing problems are likely to occur.
More particularly, product costing problems are likely to be more prevalent in businesses where:
overhead costs are a significant proportion of manufacturing costs
the range of products manufactured is diverse
there is diversity in the complexity of products or services
the production volumes of each product vary significantly
indirect or overhead costs are applied to products using a volume-based driver
the proportion of non-manufacturing costs such as research and development, customer support and
so on are increasing relative to manufacturing costs.
Chapter 8 Solutions Manual t/a Management Accounting: Information for Creating and Managing Value 5e
by Langfield-Smith, Thorne and Hilton 1
Many of these conditions also apply to service industries, so the use of the term products can usually
apply equally to services.
8.5 Over time, both upstream and downstream non-manufacturing costs have grown and many of them, such
as product design, development and advertising costs, are related to particular products. Yet, conventional
costing systems usually expense all non-manufacturing costs in the period in which they are incurred.
Ignoring these costs means that management has an incomplete picture of a products costs. This may
make it difficult for managers to decide which products to produce and what prices to set.
8.6 The vertical dimension is the cost-assignment dimension, where the costs of resources are assigned to
activities using resource drivers. Then activity costs are assigned to the products according to their
activity consumption, using activity drivers. The horizontal dimension is the activity-management
dimension which provides information about the work done in the business. This includes the causes (or
root-cause cost drivers) of activities and measures of activity performance.
The costs of the resources are assigned to each activity using resource drivers. The costs of the
resources are recorded already in the existing accounting system, and include items such as wages,
supplies and building occupancy costs. An activity is a unit of work performed within the organisation.
A resource driver is a cost driver that estimates the cost of resources used by an activity. Examples
include floor space, which may be used to assign building costs, or the number of employees, which
may be used to assign wages. Some costs can be traced directly to an activity rather than using resource
drivers. For example, wages can often be traced directly to an activity by identifying the person that
performs the activity.
In the Real Life example of ABC in Australian universities, the costs of resources such as faculties,
academic and administrative support, marketing and so on are assigned to each activitysuch as
preparing and delivering lectures, answering students and liaising with studentsusing resource drivers
established from the payroll system, time surveys, floor space, timetabling systems and financial systems.
8.7 In the Real Life example of ABC in Australian universities, the cost objects are services such as delivery
modes, courses and programs rather than manufactured goods such as the Hensley Tooth.
Exhibit 8.10 represents the bill of activities for the Hensley Tooth which identifies the activities, the cost
per unit of activity driver, the quantity of cost driver consumed and the cost of the activities consumed by
the product. In order to prepare the bill of activities, the costs of activities consumed by the cost object of
the Hensley Tooth have been measured. The costs of various resources used in production were assigned
to activity centres using resource driversa cost driver used to estimate the cost of resources used by an
activity or activity centre. Then the activity centre costs were assigned to activities using relevant
resource drivers. Once activity costs were established, the activity drivers for each activity were identified
to assign the activity costs to the product. An activity driver is a cost driver used to estimate the cost of an
activity consumed by the product. After obtaining estimates of the quantity of activity driver for each
activity relevant for the production of Hensley Tooth for the past year, the cost per unit of activity driver
is calculatedthe total cost of an activity divided by the quantity of its activity driver. The quantity of
activity drivers consumed by the product depends on whether the activity is performed for each unit,
batch or entire product line. Exhibit 8.10 shows the cost of producing the annual volume of 25 000 units
and categorises the activities for Hensley Tooth into different activity levels. The annual cost for each
activity is the cost per unit of activity driver multiplied by the quantity of activity drivers consumed in
producing and selling the Hensley Tooth over the year. The cost per unit of product is the annual cost
divided by the number of units produced over the year.
Similarly in the Real Life example of ABC in Australian universities, once activity costs have been
established (using resource drivers), activity drivers (possibly drivers such as the number of lectures,
number of enrolments and number of students) would be identified for each activity; estimates of the
quantity of activity driver for each activity would be established; the cost per unit of activity driver
would be calculated; and activity costs would then be assigned to the cost objects of courses and
programs and so on according to the quantity of activity drivers consumed by each. Activity-based
costing can help to overcome the problems of inaccurate conventional costing in service organisations
such as universities but compared to manufacturing it may be more difficult to identify individual
activities and service outputs because they may not be repeated in exactly the same way.
8.8 Cost drivers called resource drivers are used to assign costs to activities. Cost drivers called activity
drivers are used to assign activity costs to cost objects. Exhibit 8.5 shows that cost drivers are also used
for activity management to identify the root causes of activity costs. We use different names for these
cost drivers as they each play a different role in activity-based costing.
There are many possible cost drivers and cost objects (such as customers, products and services) for a
banking business. Examples of possible resource and activity cost drivers relating to overhead costs that
cannot be traced directly to product cost objectsfor example, cheque accounts and credit cardsare as
follows:
Resource costs Resource drivers Activity centres

Energy Kilowatts used Computer processing
Issuing statements
Customer enquiries
Computer operator and Directly assigned or according to Computer processing
technician salaries and on time sheet records Issuing statements
costs Customer enquiries
Computer depreciation Directly assigned Computer processing
Issuing statements
Customer enquiries
Computer expendables Orders placed by centres Computer processing
Issuing statements
Customer enquiries
Building costs (rates, Floor area Computer processing
insurance, cleaning) Issuing statements
Customer enquiries
Postage Number of accounts Issuing statements
Wages and on costs of Directly assigned Customer enquiries
general call centre customer
enquiry staff
Telephone costs Directly assigned to centre according Computer processing
to telephone number Issuing statements
Customer enquiries
Activity centre* Activity drivers Cost objects

Computer processing Number of transactions Cheque accounts
Credit cards
Issuing statements Number of statements Cheque accounts
Credit cards
Customer enquiries Telephone minutes Cheque accounts
Credit cards
*
The activities of an activity centre can be analysed further and costed individually if the benefits of doing so for
decision-making and management of performance outweigh the costs. For example, computer processing could be
comprised of activities of set-ups, batch preparation, cross checking tallies, account balancing etc.
Root cause cost drivers: the underlying factors that cause costs to be incurred relate to product and
process design including technology employed and expertise of staff. Providing products such as cheque
accounts and credit card services requires that the products and the processes of providing them are
designed, which involves choices about technology, staff training and other concerns. Particular designs
will cause more or less of particular costs such as labour costs, computer costs and building costs to be
incurred. If any of the costs incurred are non-value added as far as the customer is concerned the product
and/or process are candidates for redesign to reduce or eliminate the non-value added costs and improve
performance.
8.9 Activity-based costing systems can differ over whether they include cost assignment, activity management
or both. They can differ over how costs are measured, budget or actual. The costing systems can differ over
cost objects and the range of costs that are covered. They can also differ over the detail to which costs and
activities are analysed. One other source of difference is whether they are introduced as an ongoing system
or a one-off project. Activity-based costing is usually introduced to tackle problems and the features of the
system depend on the problems that need to be addressed.
8.10 The three approaches described in the chapter were simple activity-based product costing, activity-based
costing for indirect costs, and a comprehensive ABC system for product costing and activity
management. A comparison of the costs and benefits of each of these approaches is set out in
Exhibit 8.6. It shows that the more comprehensive the system, the greater are both the costs and benefits.
The major difference between ABC systems and conventional product costing systems is the allocation of
manufacturing costs to products. Conventional costing systems trace direct materials and direct labour to
products and allocate manufacturing overhead costs using a predetermined overhead rate based on
volume-based cost drivers. Non-manufacturing costs are not allocated at all. ABC systems can assign
different types of costs to products using both volume and non-volume based cost drivers with an
emphasis on the cost of activities that consume resources. The range of costs assigned by the ABC
systems ranges from assigning manufacturing overhead costs to products, manufacturing overhead and
product-related non-manufacturing costs, to including all product-related costs except direct material.
8.11 Some factors or scenarios to consider when deciding whether a business needs to implement an ABC
system are listed below.
An overhead-intensive business with overhead costs being a significant portion of total costs
A large part of manufacturing overhead is not directly related to production volume but is becoming
more non-volume driven; hence, volume-based cost driver may not be appropriate
The business offers a diverse product range where individual products use of support resources
differs from their use of volume-based cost drivers
Production activity involves diverse batch sizes and differing degrees of production complexity
An increase of product-related costs incurred outside of manufacturing relative to manufacturing costs
Sophisticated IT support that allows the business to design, implement and maintain the ABC
system for relatively low cost
The product cost being a key input to strategic decision making; hence the importance of accurate
product costing system.
The most appropriate approach to use depends on the ultimate purpose of the system. Management must
assess the problems that their business is facing and an ABC system is designed to tackle those
problems. When choosing between the simple ABC system, the ABC system for indirect cost and the
comprehensive system it is necessary to consider both benefits and costs of designing, implementing
and maintaining the system. While ABC systems provide more accurate product costs than conventional
costing systems, they are more complex and more expensive to establish and run.
8.12 Direct labour and non-manufacturing costs are analysed, in addition to manufacturing overhead, so that
management can obtain useful information for managing activities right across the business. Also non-
manufacturing costs are often caused by particular products and managers get a better picture of product
costs and product profitability when these costs are assigned to products.
8.13 The assignment of costs to activities can be simplified by using activity centres. Costs are assigned to
activity centres and then to activities. An activity centre consists of a work area where the activities have
a common purpose. It can be a huge task to assign costs directly to activities, particularly where
activities are identified in great detail; it becomes much more manageable when the costs are assigned to
activity centres first. The activities for each centre can then be analysed and costed individually.
8.14 If costs are of a similar nature and are driven by the same resource driver, they can be combined into a
single cost category to simplify their allocation to activities. This approach reduces a relatively large
number of general ledger accounts to fewer cost categories. For example, rent, insurance, council rates
and cleaning costs can be combined as building costs; phone, fax and stationery can be combined as
consumables; part-time, casual and on-cost labour expenses can be combined as wages.
8.15 Unit level activities are performed for each unit produced. Batch level activities are performed for each
batch of product, rather than for each unit of product. A product-level activity is an activity performed to
support the production of each different type of product. It benefits all the units of the product produced.
A facility level activity is an activity required to run the business, but not used by any particular cost
object. Corporate management cost is an example of facility level activity.
Level Car manufacturer (manufacturer) Courier company (service firm)

Unit Weld components Record details of delivery
Batch Schedule production Collate delivery orders for a time period
and area for delivery run
Product Design cars Design appropriate delivery services
according to market demand
Facility Prepare mandatory external financial Maintain delivery vehicles
reports
The activity level classification is relevant to product costing because the quantity of activity drivers
consumed by a product depends on whether the activity is performed for each unit, batch or entire
product line. Conventional product costing includes only manufacturing costs and assumes that they are
volume driven (that is, unit level costs) which may lead to decisions being based on incomplete
information and distortion of manufacturing costs within a range of products.
Batch level costs can vary for different products, although they are assumed under conventional
product costing to be driven by unit volume. Small batch sizes result in relatively high costs per
unit. In the Mason and Cox example, the batch size of the Hensley Tooth was large, which meant
there was a relatively low level of consumption of batch activities per unit, whereas the batch size
of the Custom Tooth was small, which meant there was a relatively high level of consumption of
batch activities per unit.
Product level costs relate to the design, production and sale of an entire product line and so can include
upstream and downstream costs as well as manufacturing or production costs. The same approach of
calculating activity costs and identifying cost drivers for upstream and downstream activities that are
non-production but related to products can be used to provide more comprehensive and relevant
product costs. Upstream research, development and design and downstream marketing, selling,
distribution and customer support of products are product level costs.
Facility level costs relate to activities of providing the overall environment for producing and
selling products. Since facility level activities are not caused by any particular product they can
only be allocated to products in some arbitrary manner, so it can be argued that they should not be
included in the product cost. However manufacturing facility level costs are included under
accounting standards in cost of good sold and inventory values.
The activity level classification highlights the costs that are relevant to decisions about products and
allows for more accurate total product costs and costs per unit than those derived using conventional
absorption costing.
8.16 Facility level activities reflect the costs of providing the overall environment for producing and
selling products and some proponents of ABC recommend that virtually all costs, including facility
costs, be assigned to products. Indeed allocation of facility level costs to products does occur in
practice (Cooper, 1990).
Manufacturing facility level costs are included under accounting standards in cost of good sold and
inventory values. (There may also be some manufacturing facility level which in some cases may be
able to be reasonably allocated to product costs. For instance in the Mason and Cox case, the activity
Manage Plant is a facility level manufacturing cost; and man-hours worked in the production plant on
particular products was considered, in the particular circumstances of Mason and Cox, to be a
reasonable allocation base.)
However, in general, facility level costs should not be included when estimating product costs for
decision making, such as assessing product profitability, because:
facility level activities have no obvious cost drivers, are not caused by any particular product and
may bear no obvious relationship to particular products so that their allocation is arbitrary; the higher
the proportion of allocated facility costs, the greater the arbitrary element of the product costs
average facility level costs per unit can undermine product-related decisions; many product-related
decisions are better based on either unit level costs in the short term or total product costs in the
longer term, rather than looking at the average cost per unit of product; although a business must
cover its facility level costs to make a profit, it is better to deduct them after estimating the product-
related profit margin rather than including them in the product costs.
8.17 The three main types of activity drivers are:

physical volume (e.g. number of kilograms, number of units produced)
the number of transactions of the activity (e.g. number of machine setups, number of production runs)
time duration (e.g. number of machine hours, number of man-hours).
Some examples of each for Australia Post are:
Physical volume Number of transactions of Time duration

activity
Number of letters fed through Number of delivery runs to Number of driver hours
sorting machine sorting centre
Weight of postage items moved Number of delivery runs to post Number of postman hours
offices for deliveries to
addressees
Number of letters rejected by Number of batches of letters with Number of manual sorting hours
sorting machine because of insufficient addresses to be
insufficient address manually sorted
Number of Express Posts Number of Express Post runs to Number of Express Post pick-up
guaranteeing overnight delivery sorting centre and/or delivery hours
Number of Express Post Number of postman hours
deliveries to post offices dedicated to Express Post
delivery
Number of retail sales Number of daily batches of Number of cashier hours
cashier transactions
8.18 The aim of combining activities into larger cost pools is to simplify the costing system. This could not
be achieved unless all the costs in the pool have the same cost driver. The decision to simplify the
costing system will be based on an assessment of the cost and benefit of more detailed information.
When the system is to be used for activity management, much more detailed activities need to be
identified than when used solely for product costing.
8.19 Conventional costing systems tend to understate the cost of low-volume product lines for two reasons.
First, conventional systems assume all manufacturing overhead costs are driven by the volume of
production, that is they are unit level costs. Usually a number of the overhead costs are batch level costs
rather than unit level costs. Small-batch products will consume the same amount of batch costs as large-
batch products and, therefore, have a relatively high consumption of batch activities per unit produced.
Second, low-volume products are often more complex to make and require a large number of overhead
support activities. The level of overhead support is often above the level assumed in the average
plantwide overhead rate used in many conventional systems.
8.20 Benefits from ABC will be greatest when:

overhead is a relatively large and significant proportion of cost
the cost is not driven by volume
significant product diversity occurs
diverse batch sizes and production complexity occur
cost information is important for decision making
the cost of implementing and maintaining an ABC system is low because of well-developed IT
systems and support.
Examples of benefits of ABC in the Real Life scenarios of the text follow.
Parke Davis, ICI and Comalco recognised, by the late 1980s, that outdated costing systems can
adversely affect decisions and competitiveness and that ABC can be of benefit because it allocates
increasing overhead costs more accurately to products. Parke Davis found that the costs of some
products were being understated and others overstated because of increasing overheads and arbitrary
allocation to products. ICI and Comalco were concerned that product costs were inconsistent with
operations managers views of actual costs, and that this was affecting the quality of decision making.
R.M. Williams found that activity-based costing (ABC) enabled the company to identify what drives
costs and to strive for future savings.
Telstra completed, in the early 1990s, a major review of its costing system which showed that managers
were uncertain about product and process costs, overheads were allocated to products by algorithm, and
too many decisions were based on gut feeling rather than on reliable costing information. Telstra, at risk
of making uncompetitive and inappropriate decisions, implemented an ABC system that provided better
information for decision making, including more accurate product and process costs.
Holden Engine Company (HEC), a manufacturer of car components for and subsidiary of General
Motors Holden Australia (GMHA), was struggling to survive by 1990. It produced a diverse range of
products with varying complexity, and production volume, machine cycle time and batch size differed
significantly between products. It allocated manufacturing overhead to products on the basis of direct
labour hours, whilst overheads represented 40 per cent of manufacturing cost and direct labour
represented only 5 per cent. HEC decided to build parts for car makers other than GMHA, but to do this
the company needed more accurate information about product costs and product profitability, as well as
better information for cost management. The solution for HEC was to introduce ABC.
National Roads and Motorists Association (NRMA) in New South Wales identified a number of
deficiencies in its management accounting system, particularly the blanket overhead allocation rates,
which simply spread high administrative costs across all types of services. Activity-based costing was
used to cost NRMAs services more accurately with the result that the relative cost/profit positions of all
services was altered. ABC was also used for activity management, which enabled management to identify
the costs of non-value-added activities and the impact of their total quality management (TQM) program.
Commonwealth Bank of Australia developed activity-based costing, which provided detailed

information about processes, products and customer segments across the entire bank to assist in cost
management.
Police in a number of Australian states and in New Zealand have collected activity data and identified a
total of 126 activities for general policing, including community patrols, police station services,
traffic policing, traffic crash investigation, targeting illegal drug activity and so on. The activity-
based data provides information for cost management, particularly when benchmarked against other
jurisdictions. Activity information can also be used to estimate the costs of major programs such as the
cost of police activities associated with alcohol-related crime in New South Wales.
Department of Education, Training and Youth Affairs (DETYA) commissioned the Development of
an ABC methodology for Australian higher education institutions which can be used to cost library
services, the costs and contribution of different delivery modes (e.g. class room, online and distance
education), courses, programs, departments, faculties and so on.
CardLink Service Ltd regards the benefits of ABC analysis as invaluable but, in weighing up the costs
and benefits, decided to use it on an ad hoc basis. Operating in an environment of rapid technological
change, CardLinks major services include credit card authorisation, credit card transactions processing
and BPay. Although initially established by the major financial institutions with little emphasis on
commercial viability, CardLink, in 2000, decided to offer only services that were profitable. An ABC
project was undertaken to estimate the costs of services and to help set fair prices. It was found that a
number of services were unprofitable, particularly those that involved manual processing. Management
decided to cease some aspects of the business, by either selling them or closing them down. Others were
to be tackled through differential pricing and technology.
Art.com, an e-retailer that sells print art, found that timely and accurate cost information is particularly
important because, like all dot.coms, it faces the problem of predicting demand and, therefore, in
matching resources supplied with resources used. ABC is used to attach a dollar value to used and
unused capacity including unused resources in total, by activity and by product line.
Local councils, in committing to the principles of competitive neutrality and opening business activities
to competitive tendering, needed to ensure that full costs were estimated in submitting in-house tenders
for the provision of goods and services. A number of local councils have moved to activity-based
costing (ABC) systems because of their effectiveness in estimating the full cost of their services. In
addition to providing a detailed allocation system for estimating the costs of goods and services, an
ABC system can, as at Bayside City Council in Victoria, help to establish and monitor responsibility for
activities and service level agreements, set revenue and expenditure budgets and review performance for
each major activity and allow financial outcomes for activities to be aggregated to program level for
internal and external reporting.
8.21 Factors that may impede the introduction of ABC include:

lack of conviction by management that the benefits will exceed the costs
lack of understanding of what ABC is and how it can help an organisation
concerns about the extensive resource requirements to implement ABC
concerns about the resistance to change factors.
8.22 If ABC is based on budgeted costs, then not all the costs will be picked up in ABC product costs as there
may be some committed resources that are not used. The costs of unused capacity, therefore, need to be
added to the ABC costs.
8.23 Activity-based costing involves major changes which may be perceived as threatening and, therefore,
may be resisted. To succeed, the introduction of activity-based costing must be accompanied by a
change management plan that is carefully constructed to take account of factors such as the extent of
change required and the personalities involved. There is some evidence to suggest that this process will
be most effective where a bottom-up rather than a top-down approach is used. Instead of viewing the
activity-based system as a financial system imposed by top management, employees should be
encouraged to consider the activity-based system as a tool which they own, to help them manage their
work. Developing a sense of ownership requires a high degree of participation in the development and
implementation of the new system across all levels of the business. Management must be seen to be
totally committed to the activity-based project, but willing to let employees play a major role in
developing and using the system. Recent research indicates that self-managing work teams can be an
effective change management tool.
8.24 Activity-based costing has some limitations, including the following:

Facility level costs: Some proponents of ABC recommend that virtually all costs, including facility
costs, be assigned to products. However, facility level costs bear no obvious relationship to products.
If facility level costs are assigned to products, the allocation basis must be arbitrary. The higher the
proportion of allocated facility costs, the greater the arbitrary element of the product costs.
Use of average costs: Activity-based estimates of the cost, per unit, of product are average costs.
Unit level costs are incurred for each unit of product, but batch level, product level and any
allocated facility level costs must be divided by the number of units produced to estimate the cost
per unit of product. It is important that managers understand this. Many product related decisions
are better based on the total product costs rather than looking at the cost, per unit, of each product.
Complexity: When activity-based costing is set up as an ongoing costing system, it involves more
detailed recording and analysis than conventional costing systems. If the company is changing
rapidly, the data in the activity-based system must be updated frequently to avoid the production of
outdated, irrelevant information. This can be expensive. The level of complexity increases
dramatically when the system is used for activity management, as well as product costing, because
activity management requires a more extensive and detailed analysis of costs and activities. This
issue is dealt with further in Chapter 16.
8.25 Examples of service organisations using ABC from the Real Life scenarios in the text are:
Telstra completed, in the early 1990s, a major review of its costing system which showed that managers
were uncertain about product and process costs, overheads were allocated to products by algorithm, and
too many decisions were based on gut feeling rather than on reliable costing information. Telstra, at risk
of making uncompetitive and inappropriate decisions, implemented an ABC system that provided better
information for decision making, including more accurate product and process costs.
National Roads and Motorists Association (NRMA) in New South Wales identified a number of
deficiencies in its management accounting system, particularly the blanket overhead allocation rates,
which simply spread high administrative costs across all types of services. Activity-based costing was
used to cost NRMAs services more accurately with the result that the relative cost/profit positions of all
services was altered. ABC was also used for activity management, which enabled management to identify
the costs of non-value-added activities and the impact of their total quality management (TQM) program.
Commonwealth Bank of Australia developed activity-based costing, which provided detailed

information about processes, products and customer segments across the entire bank to assist in cost
management.
Police in a number of Australian states and in New Zealand have collected activity data and identified a
total of 126 activities for general policing, including community patrols, police station services,
traffic policing, traffic crash investigation, targeting illegal drug activity and so on. The activity-
based data provides information for cost management, particularly when benchmarked against other
jurisdictions. Activity information can also be used to estimate the costs of major programs such as the
cost of police activities associated with alcohol-related crime in New South Wales.
Department of Education, Training and Youth Affairs (DETYA) commissioned the Development of
an ABC methodology for Australian higher education institutions which can be used to cost library
services, the costs and contribution of different delivery modes (e.g. class room, online and distance
education), courses, programs, departments, faculties and so on.
CardLink Service Ltd regards the benefits of ABC analysis as invaluable but, in weighing up the costs
and benefits, decided to use it on an ad hoc basis. Operating in an environment of rapid technological
change, CardLinks major services include credit card authorisation, credit card transactions processing
and BPay. Although initially established by the major financial institutions with little emphasis on
commercial viability, CardLink, in 2000, decided to offer only services that were profitable. An ABC
project was undertaken to estimate the costs of services and to help set fair prices. It was found that a
number of services were unprofitable, particularly those that involved manual processing. Management
decided to cease some aspects of the business, by either selling them or closing them down. Others were
to be tackled through differential pricing and technology.
Art.com, an e-retailer that sells print art, found that timely and accurate cost information is particularly
important because, like all dot.coms, it faces the problem of predicting demand and, therefore, in
matching resources supplied with resources used. ABC is used to attach a dollar value to used and
unused capacity including unused resources in total, by activity and by product line.
Local councils, in committing to the principles of competitive neutrality and opening business activities
to competitive tendering, needed to ensure that full costs were estimated in submitting in-house tenders
for the provision of goods and services. A number of local councils have moved to activity-based
costing (ABC) systems because of their effectiveness in estimating the full cost of their services. In
addition to providing a detailed allocation system for estimating the costs of goods and services, an
ABC system can, as at Bayside City Council in Victoria, help to establish and monitor responsibility for
activities and service level agreements, set revenue and expenditure budgets and review performance for
each major activity and allow financial outcomes for activities to be aggregated to program level for
internal and external reporting.
Activity-based costing can be used in service businesses as evidenced by the real life examples in the
text. However, ABC can be more difficult to implement in service organisations than in manufacturing
because:
service businesses often have a higher level of facility costs than do most manufacturers, so fewer
costs may be included in the ABC system
it is often difficult to identify and draw up a list of individual activities and their activity drivers
because activities are non-repetitive. An activity may be repeated, but in a different way for each
client or customer
the non-repetitive production environment and heterogeneous nature of service outputs may also
make it difficult to identify service outputs. If a range of common activities is performed and each
service makes different use of these activities, then it will be possible to draw up a list of activities
and activity drivers, but it will be necessary to produce a separate bill of activities for each service
that is produced.
8.26 A conventional product costing system traces direct material and direct labour costs directly to products.
Manufacturing overhead is allocated using predetermined overhead rate based on volume-based cost
driver. The non-manufacturing costs are not allocated to products. The costs tend to be aggregated to
cost pools and assigned to product based on a plantwide or departmental overhead rates. If the business
uses a plantwide overhead rate, it calculates a single rate for entire production plant. However, the
causes of manufacturing overhead costs may vary from one production department to another. If the
business uses departmental overhead rates, manufacturing overhead rates are calculated for each
production department. However, the number of cost drivers is limited to one per department, and all
cost drivers are measures of production volume. Both types of conventional costing system do not
recognise the wide range of cost drivers and cost behaviours related to various overhead cost items. In a
simple ABC system, manufacturing overhead costs are assigned to cost pools representing overhead
activities rather than departments. Those activities describe the work done in the business and rather
than focusing on the costs of each department, the emphasis is placed on the cost of various activities.
Activity costs are assigned from each activity cost pool to each product in proportion to the products
consumption of the activity using an overhead rate based on the cost per unit of activity driver. This
system allows for identification of a large number of activity cost pools and selection of an appropriate
cost driver (volume and non-volume based) for each activity. Refer further to Exhibit 8.15.
SOLUTIONS TO EXERCISES
EXERCISE 8.27 (20 minutes) Assigning costs to activity centres: manufacturer
1 Costs assigned to Silverwaters Assembly Centre:

Cost assigned to
Total cost Resource driver proportion Assembly Centre
Wages $600 000 20/100 $120 000
Building costs 200 000 1 000/10 000 20 000
Energy 300 000 10 000/250 000 12 000
Other 50 000 20/100 10 000
Total $1 150 000 $162 000
2 Cost categories simplify the cost-assignment process by reducing the number of individual cost
assignments that need to be made into activity centres. Costs that are of a similar nature and driven by the
same resource driver can be combined into a single cost category. Wages will include wage payments and
labour on costs such as payroll tax, workers compensation and employer funded superannuation. Building
costs are likely to include rent, cleaning, insurance and council rates. Energy costs depend on energy
sources. In addition to electricity, they may include gas and solar energy costs. Other is a catch-all and
might include the costs of depreciation, consumables, motor vehicles and so on.
3 A resource driver is a cost driver used to estimate the cost of resources consumed by an activity or
activity centre. For example, the total wages bill can be assigned to activity centres using the number of
people working in the activity centres. A more accurate basis for assigning wage costs is to trace the
wage-related costs of each employee to the actual activity centre where they work. This approach is
often used in practice.
EXERCISE 8.28 (20 minutes) Assigning activity centre costs to activities: manufacturer
1 Cost of activity Load mixer:
Proportion of resource
driver used in Cost of activity:
Cost category Mixing Centre cost Load mixing Load mixer
Wages $100 000 5% $5 000
Energy 80 000 500/10 000 4 000
Depreciation 20 000 100/5 000 400
Other 10 000 5% 500
$210 000 $9 900
2 By definition, direct labour costs can be traced directly to products, so we cannot argue that direct
labour costs have been included in the activity-based product costing system to improve the accuracy of
Acacia Paints product costs. It is more likely that Acacia Paints also uses its activity-based costing
system for cost management. By including direct labour costs as well as overhead costs, Acacia Paints
can obtain useful information for managing activities right across the business. The activity management
view of activity-based costing is dealt with in more detail in Chapter 16.
3 Descriptions of the activities performed and estimates of the amount of resource driver used by each
activity are likely to be obtained from interviews with managers and employees who work in the
Mixing Centre.
EXERCISE 8.29 (20 minutes) Calculating the cost per unit of activity driver:
manufacturer
1&3
Activity Cost per unit of activity driver Activity level
Weigh ingredients $15 per batch Batch
Load mixing machine $23 per batch Batch
Operate mixing machine $16 per machine hour Unit
Unload mixing machine $20 per batch Batch
Press biscuits onto trays $0.04 per biscuit Unit
Move trays to ovens $3.20 per load Batch
2 The cost of each product is estimated by drawing up a bill of activities which lists the activities and
quantity of activity drivers used by the product, the cost per unit of activity driver and the cost of
activities used by the product (activity cost/activity driver quantity of activity driver). Dont forget that
the direct material cost must be added to the bill of activities to obtain an estimate of the product cost
(although some ABC systems also assign material costs to activities).
4 Alternative activity drivers:

Weigh ingredients: number of ingredients, weight of ingredients.
Load mixing machine: weight of ingredients.
Operate mixing machine: number of biscuits.
Unload mixing machine: weight of mixture, type of mixture.
Press biscuits onto trays: labour hours.
Move trays to ovens: number of trays.
EXERCISE 8.30 (25 minutes) Assigning activity costs to products: manufacturer
1
Annual quantity of
activity drivers used
Activity Cost per unit of activity driver by the product Annual cost
Process payables $ 40 per purchase order 400 $16 000
Program production $ 150 per production schedule 100 15 000
Process sales order $ 50 per sales order 300 15 000
Issue materials $ 80 per issue 100 8 000
Set up solder machines $ 105 per set up 100 10 500
Solder circuit boards $ 10 per solder joint 40 000 400 000
Insert motor $ 20 per player 5 000 100 000
Assemble player $ 12 per player 5 000 60 000
Design player $8 000 per model CD standard Assign directly 8 000
Total activity cost (annual) $632 500
$632 500
Total activity cost per unit = = $126.50
5000 units
2 Total cost per unit of product
Activity cost = $126.50
Direct material = 45.00
Total unit cost = $171.50
3 The costs of the activity Design player are product level costs. These are the costs of designing this
particular product and they are assigned directly to the product.
EXERCISE 8.31 (5 minutes) Activity-based costing and inventory valuation:

manufacturer
No. The activity costs include non-manufacturing costs (e.g. process sales order and process payables). Under
Australian accounting standards, non-manufacturing costs must be treated as period costs and expensed in the
period in which they are incurred. They cannot be included in inventory costs.
EXERCISE 8.32 (10 minutes) Classifying activities as unit, batch, product or facility
level costs: manufacturer
Activity Classification
Process payables* Batch
Program production Batch
Process sales order* Batch
Issue materials Batch
Set up solder machines Batch
Solder circuit boards Unit
Insert motor Unit
Assemble player Unit
Design player Product
*
non-manufacturing activity
None of the activities are facility level activities, which are the activities required to run the business but
not used by any product. As facility level activities are not caused by particular products, they should
not be included in product costs.
EXERCISE 8.33 (20 minutes) Classification of activities: winery
The activities of the Seneca Falls Winery may be classified as follows:

U: Unit level
B: Batch level
P: Product-sustaining level
F: Facility level
Activity Classification Activity Classification
(a) P (k) B
(b) P (l) B
(c) P (m) U
(d) P (n) U
(e) P (o) U
(f) P (p) U
(g) P (q) B
(h) B (r) F
(i) B (s) F
(j) B
EXERCISE 8.34 (15 minutes) Comparison of activity-based and conventional product
costs: manufacturer
1 Product A Product B
High-volume product line Yes No
Low-volume product line No Yes
Produced in small batches No Yes
Produced in large batches Yes No
Simple to produce Yes No
Complex to produce No Yes
2 Conventional costing systems tend to overstate the cost of high-volume, relatively simple products, and
understate the cost of low-volume, relatively complex products. In this particular case, both products are
likely to require a number of batch level overhead activities. Product A is likely to be a high-volume
product that is produced in large batches. This will cause relatively low batch costs per unit. Product B
is likely to be a low-volume product produced in small batches. This will cause relatively high batch
costs per unit. The high-volume product, A, is likely to be relatively simple to produce and require
relatively little overhead support. In contrast, the low-volume product, B, is likely to be more complex
to produce and require relatively more overhead support.
These differences are not recognised in the conventional system, which uses a volume-based overhead
cost driver such as direct labour hours or machine hours.
EXERCISE 8.35 (15 minutes) Volume-based cost driver versus ABC: manufacturer
1 Material handling cost per lens:
$50 000
200 = $1 000
[(25)(200) + (25)(200)] *
*The total number of direct labour hours.
An alternative calculation, since both types of product use the same amount of the cost driver, is the
following:
$50 000
= $1 000
50 *
*
The total number of units (of both types) produced.
2 Material handling cost per mirror = $1 000. The analysis is identical to that given for requirement (1).
3 Material handling cost per lens:
$50 000
5
(5 + 15) *
= $500
25
*
The total number of material moves.

The number of material moves for the lens product line.
4 Material handling cost per mirror:
$50 000
15 *
(5 + 15)
= $1 500
25
*
The number of material moves for the mirror product line.
EXERCISE 8.36 (20 minutes) Distortion of product costs: manufacturer
It is likely that Wheelcos product costing system is providing misleading cost information to management. A
common problem in a conventional volume-based costing system is that high-volume products are overcosted
and low-volume products are undercosted. There is evidence of this in the exercise, since Wheelcos
competitors are selling the high volume wheel A22 at a price that is lower than Wheelcos reported
manufacturing cost. In contrast, Wheelco is selling its speciality wheel D52 at a huge margin above the
products reported cost. It is likely that an activity-based costing system would report a lower product cost for
wheel A22 and a substantially higher cost for wheel D52.
The managing directors strategy of pushing the firms speciality products will probably aggravate Wheelcos
problems even further. These products are probably not as profitable as the firms conventional product costing
system makes them appear. Indeed they may be losers rather than winners.
Recommendation: Install an activity-based costing system. If the new reported product costs shift, as suggested
in the preceding comments, then lower the price on the high-volume products such as wheel A22. The prices of
the speciality wheels may need to be raised further. Indeed, it is possible that Wheelco should discontinue low-
volume products.
EXERCISE 8.37 (15 minutes) Key features of activity-based costing: manufacturer
1 Key features of an activity-based costing system:

Two-stage procedure for cost assignment.
Stage one: Identify activities, costs and resource drivers. Calculate costs per activity.
Stage two: Assign the activity costs to the companys product lines in proportion to the amount of
the activity driver used by each product line.
2 As described in the answer to the preceding exercise, the new system will probably reveal distortions in
the firms reported product costs. In all likelihood, the high-volume products have been overcosted and
the low-volume specialty products have been undercosted.
3 Strategic options:
Lower the prices on the firms high-volume products to compete more effectively.
Increase the prices on low-volume specialty products.
Consider eliminating the specialty product lines. This may not be desirable if there is a marketing
need to produce a full product line. Also, the speciality wheels may give Wheelco prestige.
EXERCISE 8.38 (20 minutes) Activity-based costing: service firm
1
2-day, 8-person, 50 km 5-day, 15-person, 100 km
El Questro Gorge Flinders Ranges
Advertising $50 $50
National Park permit 100
Equipment use 320 1 500
Insurance 40 75
Cook meals 400 1 875
Guide walkers 350 700
Total cost per trip $1 160 $4 300
Cost per person $145 $286.67*

Cost per day $580 $860
Cost per person per day $72.50 $57.33*
*
Rounded.
2 The flat rate of $65 per person per day fails to recognise the different resource requirements for the
different trips. For example, the Flinders Ranges trip requires a National Park permit. It also involves
more walking each day and, therefore, has a higher cost for the walking guide per day.
EXERCISE 8.39 (30 minutes) Activity-based costing; identifying activities and activity
drivers: university
There will be a number of possible answers to this question.

1 & 2 Activities in Accounting Department:
Possible activities Activity drivers

Teach lectures Number of lectures
Teach tutorials Number of tutorials
Mark assignments Number of students
Set exams Number of exams
Mark exams Number of exam scripts
Assist students Number of students
Type handouts Number of pages
Print handouts Number of students number of pages
Define syllabus Life expectancy of the subject
Maintain class records Number of students
Order materials Number of inventory items
Maintain departmental accounts Number of staff
Prepare departmental budget Hours to produce
3 Management accounting: Bill of activities

Teach lectures
Teach tutorials
Set exam
Mark exam
Type handouts
Print handouts
Maintain class records
Note: There are a number of activities listed in the above table that will not appear in the bill of activities
for any subject. Some of them, such as maintain departmental accounts and prepare departmental
budget, could be viewed as facility level activities that are not attached to products. Others such as
order materials, are secondary or support activities and their costs would usually be allocated across all
teaching activities. (Support or secondary activities also exist in manufacturing businesses, although we
omitted them from the Mason & Cox case to keep the chapter material simple.)
4 These terms may still apply. For example, unit level activities such as mark exams, mark assignments
and print handouts would be completed for each student. Batch level activities would include those
activities provided for complete classes such as teach lectures and type handouts. Product-level
activities would be those that benefit the entire subject such as define syllabus. Facility level activities
are discussed in 8.35.3.
5 If the materials are easily traceable to the Management Accounting subject, they can be assigned
directly. If they are insignificant, or more easily traced to individual activities, then they can be
included in the activity-based system and assigned to Management Accounting via activities.
EXERCISE 8.40 (20 minutes) Cost drivers and activity cost pools in a simple activity-
based product costing system (appendix): manufacturer
Activity Costs to be assigned Activity driver Level of activity

Move material Depreciation, machinery No. material moves Batch
Set up machine Set-up wages No. setups Batch
Assemble product Depreciation, machinery No. batches produced Batch
Depreciation, plant
Electricity machine
Electricity light
Natural gas heating
Finish product Depreciation, machinery No. batches produced Batch

Depreciation, plant
Electricity machine
Electricity light
Natural gas heating
Inspect product Inspection No. batches produced Batch

No. inspections
Design product Engineering design No. products designed Product-sustaining
Maintain machinery Equipment maintenance, No. units produced Unit
wages No. machine hours worked
Equipment maintenance, parts
Manage plant Insurance, plant No. production units Facility
Custodial wages, plant produced
Property taxes No. direct labour hours
EXERCISE 8.41 (5 minutes) Categorising activity cost pools: manufacturer
See column 4 of the table in solution to Exercise 8.40.
EXERCISE 8.42 (15 minutes) Activity-based costing; quality control costs:
manufacturer
1 (a) Quality control costs assigned to the Satin Sheen line under the traditional system:
Quality control costs = 14.5% direct labour cost
Quality control
costs assigned to
Satin Sheen line = 14.5% $27 500
= $3 988 (rounded)
(b) Quality control costs assigned to the Satin Sheen line under activity-based costing:
Quantity for Assigned

Activity Pool Rate Satin Sheen Cost
Incoming material inspection .................... $11.50 per type 12 types .............. $ 138
In-process inspection ................................. 0.14 per unit 17 500 units........ 2 450
Product certification................................... 77.00 per order 25 orders............. 1 925
Total quality-control costs assigned ....................................................................................... $4 513
2 The traditional product costing system undercosts the Satin Sheen product line, with respect to quality-control
costs, by $525 ($4 513 $3 988). Satin Sheen makes more use of quality control resources than assumed in the
conventional costing system. This may occur because, for example, Satin Sheen uses more orders or material
types than assumed in the average rate used for all products.
EXERCISE 8.43 (15 minutes) Problems with conventional costing systems; activity-
based costing principles: manufacturer
1 Manufacturing overhead is comprised of all indirect manufacturing costs; that is, all manufacturing costs
except direct labour and direct materials. Companies develop overhead rates before production to facilitate
the costing of products as they are completed and shipped, rather than waiting until actual costs are
accumulated for the period of production. Typical overhead costs include:
indirect labour (e.g. a forklift-truck driver, maintenance and inspection labour, engineering labour and
supervisors)
indirect material
other indirect manufacturing costs (e.g. building maintenance, machine and tool maintenance, property
taxes, insurance, depreciation on plant and equipment, rent and utilities).
2 The increase in the overhead rate should not have a negative impact on the company, because the increase in
indirect costs was offset by a decrease in direct labour.
3 An activity-based costing system might benefit this manufacturing company because it assigns costs to
products according to their usage of activities in the production process. More accurate product costs are the
result.
SOLUTIONS TO PROBLEMS
PROBLEM 8.44 (25 minutes) Calculating activity-based product costs; identifying
non-manufacturing costs: manufacturer
1 & 2 Full cost and manufacturing cost, per unit, for Switch 3901:
Activity Full cost Manufacturing cost

Prepare purchase order $2 150
Process payables 1 350
Prepare payroll 3 000
Process sales orders 16 500
Pack and dispatch 8 500
Program solder robots 30 600 30 600
Solder circuits 144 000 144 000
Assemble circuit boards 75 000 75 000
Wire in switch 70 000 70 000
Insert fuse 50 000 50 000
Test switch 20 000 20 000
Design switch 5 000
Total annual cost $426 100 $389 600
Full cost per switch: $85.22 activity cost + $20 direct material = $105.22
Manufacturing cost per switch: $77.92 activity cost + $20 direct material = $97.92
3 The non-manufacturing costs are part of the cost of producing and selling Switch 3901. It is important
the management considers these costs, as well as the manufacturing costs, when assessing the
profitability of Switch 3901 and, therefore, when making decisions such as product mix, outsourcing
and pricing.
PROBLEM 8.45 (30 minutes) Calculating activity costs: winery
1 Cost of the activity centres (in $000s):

Building Machinery Energy Other
Wages costs costs costs costs Total
Filling 1 000 60 400 500 20.0 1 980.0
Corking 500 20 150 200 7.5 877.5
Labelling 200 40 100 100 5.0 445.0
Packing 300 80 250 400 12.5 1 042.5
$2 000 $200 $900 $1 200 $45.0 $4 345.0
2 Cost of activities in Labelling Centre (in $000s):

Building Machinery Energy Other
Wages costs costs costs costs Total
Set up front label machines 25 25.0
Operate front label machines 50 12 70 60 3.5 195.5
Set up back label machines 25 25.0
Operate back label machines 50 8 30 40 1.5 129.5
Inspect labelled bottles 50 20 70.0
Total $200 $40 $100 $100 $5.0 $445.0
3 The company may have high levels of non-volume-driven manufacturing costs which are causing their
existing system to report distorted product costs. Also the company may wish to expand its view of
product costs by assigning non-manufacturing costs to products.
4 The limitations of activity-based costing can include the inappropriate assignment of facility level costs to
products, the ultimate unitisation of batch and product level costs, and the complexity of ABC systems.
PROBLEM 8.46 (30 minutes) Activity-based costing: service
1 Interview salaried client $40 000 / 8 000 $5 per interview

Interview business client 50 000 / 2 000 $25 per interview
Obtain missing data 400 000 / 8 000 $50 per follow-up call
Input data 80 000 / 400 000 $0.20 per data entry
Print return 60 000 / 10 000 $6 per return
Verify return 120 000 / 6 000 $20 per hour
Rectify errors 60 000 / 6 000 $10 per error
Submit return 20 000 / 10 000 $2 per return
(a) Wage and salary return:
Bill of activities Cost

Interview salaried client 1 $5 per interview 5
Interview business client 0 $25 per interview 0
Obtain missing data 0 $50 per follow-up call 0
Input data 20 $0.20 per data entry 4
Print return 1 $6 per return 6
Verify return 22.5 minutes $20 per hour 7.5
Rectify errors 0 $10 per error 0
Submit return 1 $2 per return 2
24.5
(b) Business tax return:
Bill of activities Cost

Interview salaried client 0 $5 per interview 0
Interview business client 1 $25 per interview 25
Obtain missing data 4 $50 per follow-up call 200
Input data 120 0.20 per data entry 24
Print return 1 $6 per return 6
Verify return 1.5 hours $20 per hour 30
Rectify errors 3 $10 per error 30
Submit return 1 $2 per return 2
317
2 The pricing policy is too low for business tax returns as the set price of $200 per return does not even
cover the costs of preparing the return. For business tax returns it may be better to charge time for each
one rather than use an average fee. Also, Rabid may be over-charging for wage and salary returns,
although this will depend on the price charged by competitors. If the business is still attracting wage
and salary returns, then the current pricing could be retained. Before using this information for
decisions, Rabid must make sure that all overheads are picked up in the above figures.
PROBLEM 8.47 (35 minutes) Activity-based costing; analysis of operation: service firm
1 Activity-based costing results in improved costing accuracy for two reasons. First, companies that use
ABC are not limited to a single driver when allocating costs to products and activities. Not all costs
vary with units, and ABC allows users to select a host of non-unit level cost drivers. Second,
consumption ratios often differ greatly among activities. No single cost driver will accurately assign
costs for all activities in this situation.
2 Allocation of administrative cost based on billable hours:

Information systems: 3 100 5 000 = 62%; $342 000 62% = $212 040
E-commerce consulting: 1 900 5 000 = 38%; $342 000 38% = $129 960
Information
e-commerce systems
consulting services
Billings:
1 900 hours $125.. $237 500
3 100 hours $125.. $387 500
Less Professional staff cost:..
1 900 hours $45.. (85 500)
3 100 hours $45.. (139 500)
Administrative cost (129 960) (212 040)
Income $ 22 040 $ 35 960
Income billings. 9.28% 9.28%
3 Activity-based application rates:
Activity Cost Activity driver Application rate
Staff support $180 000 250 clients = $720 per client
In-house computing 136 400 4 400 computer = $31 per CH

hours (CH)
Miscellaneous 25 600 1 000 client = $25.60 per CT

office charges transactions (CT)
Staff support, in-house computing, and miscellaneous office charges of information systems services
and e-commerce consulting:
e-commerce Information
Activity consulting systems services
Staff support:
50 clients $720. $ 36 000
200 clients $720 $144 000
In-house computing:
1 800 CH $31. 55 800
2 600 CH $31. 80 600
Miscellaneous office charges:
600 CT $25.60 15 360
400 CT $25.60 10 240
Total . $107 160 $234 840
Profitability of information systems services and e-commerce consulting:
Information
e-commerce systems
consulting services
Billings:
1 900 hours $125 $237 500
3 100 hours $125... $387 500
Less Professional staff cost:
1 900 hours $45... (85 500)

3 100 hours $45... (139 500)
Administrative cost... (107 160) (234 840)
Income. $ 44 840 $ 13 160
Income billings..... 18.88% 3.40%
4 Yes, his attitude should change. Even though both services are needed and professionals are paid the
same rate, the income percentages show that e-commerce consulting provides a higher return per sales
dollar than information systems services (18.88% vs. 3.40%). Thus, all other things being equal,
professionals should spend more time with e-commerce.
5 Probably not. Although both services produce an attractive return, the firm is experiencing a very tight
labour market and will likely have trouble finding qualified help. In addition, the professional staff is
currently overworked, which would probably limit the services available to new clients.
PROBLEM 8.48 (40 minutes) Estimating activity-based product costs; problems with
conventional costing systems: manufacturer
1 Calculating the cost per unit of activity driver:

Prepare purchase order $25 000 / 2 000 $12.50 per order
Process payables 20 000 / 2 000 $10 per invoice
Prepare payroll 30 000 / 4 000 $7.50 per pay slip
Process sales order 90 000 / 15 000 $6 per sales order
Move finished goods 600 000 / 15 000 $40 per sales order $62 per sales order
Pack and dispatch 240 000 / 15 000 $16 per sales order
Produce basic dies 180 000 / 60 000 $3 per die
Produce optical dies 200 000 / 20 000 $10 per die
Inspect dies 60 000 / 20 000 $3 per die
Clean injection moulders 600 000 / 1 000 $600 per batch
Program injection moulders 360 000 / 1 000 $360 per batch $1760 per batch
Move material 800 000 / 1 000 $800 per batch
Operate injection moulders 2 800 000 / 40 000 $70 per machine hour
Remove dies 96 000 / 4 800 000 $0.02 per lens
Inspect lens 90 000 / 50 000 $1.80 per lens
Design lens 90 000
Calculating product costs:
Coloured plastic UV-absorbing Optical

Prepare purchase order 1 000 12.5 = 12 500 900 12.5 = 11 250 100 12.5 = 1 250
Process payables 1 000 10 = 10 000 900 10 = 9 000 100 10 = 1 000
Prepare payroll 2 000 7.50 = 15 000 1 800 7.5 = 13 500 200 7.5 = 1 500
Sales order costs 6 950 62 = 430 900 8 000 62 = 496 000 50 62 = 3 100
Basic dies 30 000 3 = 90 000 30 000 3 = 90 000
Optical dies 20 000 13 = 260 000
Batch related costs 500 1760 = 880 000 450 1760 = 792 000 50 1760 = 88 000
Injection moulders 20 000 70 = 1 400 000 18 000 70 = 1 260 000 2 000 70 = 140 000
Remove dies 2 500 000 .02 = 50 000 2 250 000 .02 = 45 000 50 000 .02 = 1 000
Inspect lens 50 000 1.80 = 90 000
Design lens 30 000 50 000 10 000
Total 2 918 400 2 766 750 595 850
Coloured plastic = $2 918 400 / 2 500 000 = $1.167 + $2 materials = $3.167
UV-absorbing = $2 766 750 / 2 250 000 = $1.23 + $4 materials = $5.23
Optical = $595 850 / 50 000 = $11.917 + $4 materials = $15.917
2 We would expect the cost of the optical lenses to be higher under ABC as it represents only 1 per cent of
the production but it causes all of the inspect cost, 11 per cent of design cost and 5 per cent of batch
related costs.
PROBLEM 8.49 (30 minutes) Activity-based costing: service organisation
1 (a) Cost per unit of activity driver:

Cook meals $5 per meal
Transport clients (internal) $50 per hour
Transport clients (external) $75 per hour
Clean rooms $5 per room
Bath clients $9 per bath
Dress clients $3 per client
Administer medication $1.60 per dose
Provide occupational therapy $150 per class
Provide physiotherapy $50 per hour
Run sheltered workshop $750 per day
(b) Daily cost of supporting the three types of client:
High-dependency Low-dependency Outpatient client
client client
Meals cooked $15.00 $15.00 $5.00
Internal transport 200.00 0.00 0.00
External transport 225.00 150.00 75.00
Room cleaned 10.00 5.00 0.00
Bath 9.00 0.00 0.00
Dress 3.00 0.00 0.00
Medication 6.40 1.60 1.60
Occupational therapy 15.00 30.00 30.00
Physiotherapy 200.00 100.00 50.00
Sheltered workshop 0 37.50 37.50
Cost per client $683.40 $339.10 $199.10
2 There are many possible answers here. For example, there are no administrative activities, and the
activity run sheltered workshop would be comprised of many other activities such as supervise.
3 The real problem is that each client really has their own specific bill of activities and the type of
averaging involved in identifying only three service types may not provide accurate cost data for each
client. But can you suggest a better alternative?
PROBLEM 8.50 (45 minutes) Activity-based costing; product decisions: manufacturer
PLEASE NOTE: There is an error in the data for this question. The direct material costs should have been
$656 for the Zodiac and $352 for the Novelle. This error will be corrected in the first reprint and the solution
below is based on the correct data.
If you have set this question for your class based on the direct material costs of $584 for the Zodiac and
$208 for the Novelle, an alternative solution is also provided below. However, alert students will note that the
cost of goods sold in this solution is not consistent with the total cost of goods sold shown on page 419.
1 An ABC system is a two-stage process of assigning costs to products. In stage one, activity-cost pools
are established. In stage two an activity driver is identified for each activity-cost pool. Then the costs in
each pool are assigned to each product line in proportion to the amount of the activity driver consumed
by each product line.
2 TEC should not continue with its plans to emphasise the Zodiac model and phase out the Novelle model. As
shown in the following activity-based costing analysis, the Zodiac model has a gross margin of less than 3
per cent, while the Novelle model generates a gross margin of nearly 43 per cent.
Cost per unit of activity driver:
Soldering............................. $ 942 000 1 570 000 = $ 0.60 per solder joint

Shipments ........................... 860 000 20 000 = 43.00 per shipment
Quality control.................... 1 240 000 77 500 = 16.00 per inspection
Purchase orders................... 950 400 190 080 = 5.00 per order
Machine power ................... 57 600 192 000 = 0.30 per hour
Machine setups ................... 750 000 30 000 = 25.00 per setup
Costs per model:
Zodiac Novelle
Direct costs:
Materiala ......................................................................................... $2 624 000 $ 7 744 000
Direct labourb ................................................................................. 168 000 396 000
Total direct costs .................................................................................... $2 792 000 $ 8 140 000
Overhead activity costs:
Profitability analysis:
Zodiac Novelle Total
Sales $4 560 000 $19 800 000 $24 360 000
Less Cost of goods sold .................................... $4 431 900 $11 300 100 12 276 000
Gross margin ...................................................... $ 128 100 $8 499 900 $12 084 000
Units sold............................................................ 4 000 22 000
Per-unit calculations:
Selling price............................................... $1 140.00 $900.00
Less Cost of goods sold............................ 1 107.98 513.64
Gross margin ............................................. $ 32.02 $386.36
Gross margin percentage ................................... 2.8%a 42.9%b
a
$104.02/$1 140.00 = 2.8%
b
$530.36/$900.00 = 42.9%
Solderingc ..................................................................................... $ 231 000 $ 711 000

Shipmentsd ................................................................................... 163 400 696 600
Quality controle ............................................................................ 340 800 899 200
Purchase ordersf ........................................................................... 549 900 400 500
Machine powerg ........................................................................... 4 800 52 800
Machine setupsh ........................................................................... 350 000 400 000
Total overhead activity costs................................................................ $1 639 900 $ 3 160 100
Total cost .............................................................................................. $4 431 900 $11 300 100
Calculations: Zodiac Novelle

4 000 $565 22 000 $352
a
Material .....................................................
4 000 $42 22 000 $18
b
Direct labour .............................................
385 000 $.60 1 185 000 $.60
c
Soldering ...................................................
3 800 $43 16 200 $43
d
Shipments..................................................
21 300 $16 56 200 $16
e
Quality control ..........................................
109 980 $5 80 100 $5
f
Purchase orders .........................................
16 000 $.30 176 000 $.30
g
Machine power .........................................
14 000 $25 16 000 $25
h
Machine setups .........................................
Alternative solution based on direct material costs of $584 for the Zodiac and $208 for the Novelle:
2 TEC should not continue with its plans to emphasise the Zodiac model and phase out the Novelle model. As
shown in the following activity-based costing analysis, the Zodiac model has a gross margin of less than 10
per cent, while the Novelle model generates a gross margin of nearly 60 per cent.
Cost per unit of activity driver:
Soldering............................. $ 942 000 1 570 000 = $ 0.60 per solder joint

Shipments ........................... 860 000 20 000 = 43.00 per shipment
Quality control.................... 1 240 000 77 500 = 16.00 per inspection
Purchase orders................... 950 400 190 080 = 5.00 per order
Machine power ................... 57 600 192 000 = 0.30 per hour
Machine setups ................... 750 000 30 000 = 25.00 per setup
Costs per model:
Zodiac Novelle
Direct costs:
Materiala ......................................................................................... $2 336 000 $4 576 000
Direct labourb ................................................................................. 168 000 396 000
Total direct costs .................................................................................... $2 504 000 $4 972 000
Overhead activity costs:

Solderingc ....................................................................................... $ 231 000 $ 711 000
Shipmentsd ..................................................................................... 163 400 696 600
Quality controle .............................................................................. 340 800 899 200
Purchase ordersf ............................................................................. 549 900 400 500
Machine powerg ............................................................................. 4 800 52 800
Machine setupsh ............................................................................. 350 000 400 000
Total overhead activity costs.................................................................. $1 639 900 $3 160 100
Total cost ................................................................................................ $4 143 900 $8 132 100
Calculations: Zodiac Novelle

4 000 $584 22 000 $208
a
Material .....................................................
4 000 $42 22 000 $18
b
Direct labour .............................................
385 000 $.60 1 185 000 $.60
c
Soldering ...................................................
3 800 $43 16 200 $43
d
Shipments..................................................
21 300 $16 56 200 $16
e
Quality control ..........................................
109 980 $5 80 100 $5
f
Purchase orders .........................................
16 000 $.30 176 000 $.30
g
Machine power .........................................
14 000 $25 16 000 $25
h
Machine setups .........................................
Profitability analysis:
Zodiac Novelle Total
Sales $4 560 000 $19 800 000 $24 360 000
Less Cost of goods sold ..................................... $4 143 900 $8 132 100 12 276 000
Gross margin ....................................................... $ 416 100 $11 667 900 $12 084 000
Units sold............................................................. 4 000 22 000
Per-unit calculations:
Selling price................................................ $1 140.00 $900.00
Less Cost of goods sold............................. 1 035.98 369.64
Gross margin .............................................. $ 104.02 $530.36
Gross margin percentage .................................... 9.1%a 58.9%b
a
$104.02 $1 140.00 = 9.1%
b
$530.36 $900.00 = 58.9%
PROBLEM 8.51 (30 minutes) (appendix) Activity-based costing for overhead versus
conventional costing systems: manufacturer
1 Deluxe manufacturing overhead cost:

16 000 machine hours $80 = $1 280 000
$1 280 000 8 000 units = $160 per unit
Executive manufacturing overhead cost:
22 500 machine hours $80 = $1 800 000
$1 800 000 15 000 units = $120 per unit
Deluxe Executive
Direct material $ 35 $ 60
Direct labour 20 20
Manufacturing overhead 160 120
Unit cost $215 $200
2 Activity-based application rates:

Activity Cost Activity driver Application rate
Manufacturing setups $ 672 000 80 setups (SU) = $8 400 per SU
38 500 machine
Machine processing 1 848 000 hours (MH) = $48 per MH
175 outgoing
Product shipping 560 000 shipments (OS) = $3 200 per OS
Manufacturing setup, machine processing and product shipping costs of a Deluxe unit and an
Executive unit:
Activity Deluxe Executive
Manufacturing setups:
50 SU $8 400. $ 420 000
30 SU $8 400. $ 252 000
Machine processing:
16 000 MH $48 768 000
22 500 MH $48 1 080 000
Product shipping:
100 OS $3 200. 320 000
75 OS $3 200. 240 000
Total .. $1 508 000 $1 572 000

Production volume (units) 8 000 15 000
Cost per unit . $188.50* $104.80**
* $1 508 000 8 000 units = $188.50
** $1 572 000 15 000 units = $104.80
The manufactured cost of a Deluxe cabinet is $243.50 and the manufactured cost of an Executive
cabinet is $184.80. The calculations follow:
Deluxe Executive
Direct material . $ 35.00 $ 60.00
Direct labour. 20.00 20.00
Manufacturing setup, machine
processing, and outgoing shipments 188.50 104.80
Total cost .. $243.50 $184.80
3 The Deluxe storage cabinet is undercosted. The use of machine hours produced a unit cost of $215; in
contrast, the more accurate activity-based-costing approach shows a unit cost of $243.50. The difference
between these two amounts is $28.50.
4 Cost distortion:
The Deluxe cabinet product line is undercosted by $228 000, and the Executive cabinet product line is
overcosted by $228 000. Supporting calculations follow:
Deluxe Executive
$28.50 8 000 = $228 000
*
$(15.20) 15 000 = $(228 000)

*
$243.50 $215.00
$184.80 $200.00
5 No, the discount is not advisable. The regular selling price of $260, when compared against the more
accurate ABC cost figure, shows that each sale provides a profit to the firm of $16.50 ($260.00
$243.50). However, a $30 discount will actually produce a loss of $13.50 ($243.50 $230.00), and the
more units that are sold, the larger the loss. Notice that with the less-accurate, machine-hour-based
figure ($215), the marketing manager will be misled, believing that each discounted unit sold would
boost income by $15 ($230 $215).
PROBLEM 8.52 (60 minutes) (appendix) Activity cost pools; cost drivers:
manufacturer
1 Overhead to be assigned to film development chemical order:

Cost per unit of
Activity cost pool activity driver Level of cost driver Assigned overhead cost
Machine setups $2 000 per setup 4 setups $ 8 000
Material handling $2 per kg 10 000 kg 20 000
Hazardous waste control $5 per kg 2 000 kg 10 000
Quality control $75 per inspection 10 inspections 750
Other overhead costs $10 per machine hour 500 machine hrs 5 000
Total $43 750
$43 750
2 Overhead cost per box of chemicals = = $43.75 per box
1000 boxes
total budgeted overhead cost

3 Predetermined overhead rate =
total budgeted machine hours
$625 000
=
20 000
= $31.25 per machine hour
4 Overhead to be assigned to film development chemical order, given a single predetermined overhead rate:
(a) Overhead assigned = $31.25 per machine hour @ 500 machine hours
= $15 625 in total
$15 625
(b) Overhead cost per box of chemicals = = $15.625 per box
1000 boxes
= $15.625 per box
5 The production of film development chemicals entails a relatively large number of machine setups, a
large amount of hazardous materials and several inspections. Thus, they are quite costly in terms of
driving overhead costs. Use of a single predetermined overhead rate obscures this characteristic of the
production job. Underestimating the overhead cost per box could have adverse consequences for
Halifax. For example, it could lead to poor decisions about product pricing. The simple activity-based
costing system for overhead will serve management much better than the system based on a single,
predetermined overhead rate.
6 Calculation of overhead assigned to photographic plates:

Activity cost pool Pool rate Level of cost driver Assigned overhead cost
Machine setups $2 000 per setup 2 setups $4 000
Material handling $2 per kg 800 kg 1 600
Hazardous waste control $5 per kg 300 kg 1 500
Quality control $75 per inspection 3 inspections 225
Other overhead costs $10 per machine hour 50 machine hours 500
Total $7 825
$7825
Overhead cost per unit =
100 plates
= $78.25
Calculation of unit cost, per plate:
Direct material $120.00
Direct labour 40.00
Manufacturing overhead 78.25
Total cost per plate $238.25
SOLUTIONS TO CASES
CASE 8.53 (60 minutes) Activity-based costing; forecasting; ethics: manufacturer
1 Eloise Smiths predecessor at East Coast Marine Ltd (ECM) would have used a 10 per cent material
handling rate, calculated as follows:
Payroll ....................................................................................................... $180 000

Employee on-costs .................................................................................... 36 000
Telephone .................................................................................................. 38 000
Other utilities............................................................................................. 22 000
Materials and supplies............................................................................... 6 000
Depreciation .............................................................................................. 6 000
Total Material Handling Department costs .............................................. $288 000
total Material - Handling Department costs
Material handling rate =
total direct - material costs
$288 000
=
$2 006 000 + $874 000
= 10%
2 (a) The revised material handling costs to be allocated on a per-purchase-order basis is $1.00,
calculated as follows:
Total Material Handling Department costs............................................................... $288 000

Deduct Direct costs:
Direct government payroll .......................................... $36 000
Employee on-costs (20% $36 000) ......................... 7 200
Direct phone line......................................................... 2 800 46 000
Material handling costs applicable to purchase orders ............................................. $242 000
Total number of purchase orders 242 000
Material handling cost per purchase order $ 1.00
(b) Purchase orders might be a more reliable cost driver than is the dollar amount of direct material,
because resources are consumed in processing a purchase order. The size of the order does not
necessarily have an impact on the consumption of resources.
3 There is a $74 600 reduction in material handling costs allocated to government contracts by ECM as a
result of the new allocation method, calculated as follows:
Previous method:
Government material................................................................................. $2 006 000
Material handling rate............................................................................ 10%
Total (previous method)............................................................................ $ 200 600
New method:
Directly traceable material handling costs
[$36 000 + (20% $36 000) + $2 800] ........................................... $ 46 000
Purchase orders (80 000 $1.00) ............................................................. 80 000
Total (new method)................................................................................... $126 000
Net reduction ............................................................................................. $ 74 600
4 A forecast of the cumulative dollar impact over a three-year period of Eloise Smiths recommended
change for allocating Material Handling Department costs to the Government Contracts Unit is $234
346, calculated as follows:
Coming year Next year Following year
Calculation of forecasted variable material handling costs:
Direct material cost:

Coming year $2 880 000
Next year ($2 880 000 1.025).................................................... $2 952 000
Following year ($2 952 000 1.025)........................................... _________ _________ $ 3 025 800
Material handling rate (10%)........................................................ $ 88 000 $ 295 200 $ 302 580
Deduct Direct traceable costs * .................................................... 46 000 46 000 46 000
Variable material handling costs .................................................. $ 242 000 $ 249 200 $ 256 580
Calculation of forecasted purchase orders:

Coming year
Next year (242 000 1.05)........................................................... 242 000 254 100
Following year (254 100 1.05) .................................................. _________ _________ 266 805
Government purchase orders (33% of total) ................................ 80 000 83 853 88 046 (rounded)
Calculation of material handling costs allocated to government contracts:
Variable material handling costs .................................................. 242 000 $ 249 200 $ 256 580
Purchase orders ............................................................................. 242 000 254 100 266 805
Variable material handling costs per purchase
order (rounded) ..................................................................... $1.00 $ .98 $ .96
Government purchase orders ........................................................ 80 000 83 853 88 046
Projected variable material handling
costs (rounded) ..................................................................... $80 000 $ 82 176 $ 84 524
Fixed material handling costs* ...................................................... 46 000 46 000 46 000
Total material handling costs allocated to
government contracts ........................................................... $ 126 000 $ 128 176 $ 130 524
*
$36 000 + (20% $36 000) + $2 800 = $46 000
Calculation of cumulative dollar impact:
Government material ................................................................... $ 2 006 000 $2 066 400b $2 118 060c

Material handling at 10% (previous method)............................... $200 600 $ 206 640d $ 211 806e
Deduct Material handling costs allocated to
government contracts (new method).................................... 126 000 128 176 130 524
Net reduction in government contract
material handling costs......................................................... $ 74 600 $ 78 464 $ 81 282
a
$2 006 000
b
70% $2 952 000 = $2 066 400
c
70% $3 025 800 = $2 118 060
d
10% $2 066 400 = $206 640
e
10% $2 118 060 = $211 806
In summary, the cumulative dollar impact of the recommended change in allocating Material
Handling Department costs is $234 346, calculated as follows:
Coming year ...................................................... $ 74 600

Next year............................................................ 78 464
Following year ................................................... 81 282
Total ................................................................... $234 346
5 (a) Referring to the standards of ethical conduct for management accountants, Eloise Smith faces
the a number of ethical issues including:
Integrity
Eloise must be straightforward and honest in professional and business relationships. She
must be truthful.
Objectivity
Eloise must not act in a way that compromises her professional or business judgement
because of the undue influence of others.
Independence
Eloise must be free and be seen to be free of any interest which might be regarded as being
incompatible with integrity and objectivity.
Professional behaviour
Eloise must avoid any action that may bring discredit to the profession.
(b) The steps Eloise could take to resolve this ethical conflict are as follows:
Eloise should first follow the established policies at ECM.
If this approach does not resolve the conflict or if such policies do not exist, she should discuss
the problem with her immediate superior, except when it appears that the superior is involved. If
the Government Contracts Unit manager, Paul Jones, is her superior, then she obviously cannot
discuss the problem with him. In this case she should go to the next-higher managerial level and
continue, up to the audit committee of the board of directors, until the conflict is resolved.
She should also discuss the situation with an objective advisor to clarify the issues involved and
obtain an understanding of possible courses of action.
If the ethical conflict still exists after exhausting all levels of internal review, then she may have
no other course of action than to resign from the company and submit an informative
memorandum to an appropriate representative of the company.
CASE 8.54 (30 minutes) Activity-based costing; conventional costing: manufacturer
1 Over the last twenty years Cravings for Cakes is likely to have experienced a decrease in direct labour as
a percentage of total manufacturing costs and an increase in manufacturing overhead, especially fixed
manufacturing overhead. These changes have been caused largely by the increased automation, which
implies an increase in fixed overheads and decreased direct labour, and the increase in product diversity,
which requires an increased level of production support. Non-manufacturing costs are also likely to have
become relatively more important due to the resources required to satisfy increased customer demands,
especially in the areas of quality and delivery.
2 (a) The existing costing system is likely to overcost the high-volume lamington. Generally, high-
volume products require relatively little overhead support per unit produced as they are produced
in large batches and are often relatively simple to produce. Yet under conventional costing, with
volume-based cost drivers, these products attracted a high share of manufacturing overhead.
(b) The existing costing system is likely to undercost the low-volume Danish pastry. Low-volume
products tend to be overhead intensive, yet under conventional costing systems these products
attract a relatively low share of manufacturing overhead.
3 Under activity-based costing, costs would be assigned to products according to their consumption of
overhead (and other) activities, resulting in a more accurate estimate of product costs.
4 U. B. Bright would need to consider the problems facing Cravings for Cakes in deciding which costs to
include within the activity-based system (refer to Exhibit 8.6 for details of the costs and benefits of
these three approaches).
CASE 8.55 (50 minutes) Estimating activity costs; assigning costs to activity centres:
manufacturer
1 Costs per activity centre (in $000s)

Building
Cost centre Wages costs Depn Consbles Energy Other Total
Product development 15 3.2 1.0 1 20.2
Sales and despatch 30 8.0 1.5 2 41.5
Mixing 45 8.0 10 5.0 16 3 87.0
Filling 60 16.0 30 10.0 16 4 146.0
Baking 45 8.0 50 10.0 320 3 436.0
Packing 60 16.0 5 15.0 48 4 148.0
Administration 30 16.0 5 5.0 2 48.0
Corporate management 15 4.8 2.5 1 23.3
Total $300 $80.0 $100 $50.0 $400 $20 $950
2 U. B. Bright used cost categories to simplify the process of assigning costs to activities. There would be
many different accounts in Cravings for Cakes general ledger and it would be very cumbersome to
assign the costs in each individual account to activity centres and then activities.
3 Bright would have looked for costs that were related to a common theme and could be assigned to
activity centres (and activities) using a common resource driver.
Cost category Examples of costs included
Wages Wages, labour on-costs such as workers compensation, payroll tax and
superannuation
Building Costs Rent, council rates, cleaning
Depreciation Depreciation (possibly other machine related costs)
Consumables Oils, greases, gloves, overalls, office supplies
Energy Electricity and gas
Other Any costs not covered by the five categories above. Examples include vehicle costs,
travel, postage, telephone
4 It would be more accurate to trace the wages and labour on costs to the individual employees who work
in each activity centre.
5 It would be more accurate to trace the depreciation costs to the individual machines in each activity
centre.
CASE 8.56 (30 minutes) Estimating activity costs; assigning activity centre costs to
activities: manufacturer
1 Activity costs in Mixing Centre (in $000s):

Building
Cost centre Wages costs Depn Consbles Energy Other Total
Set up scales 9.00 0.4 1.00 $0.6 11.0
Weigh ingredients 4.50 0.4 0.50 0.30 5.70
Load mixers 11.25 0.8 1.25 0.75 14.05
Operate mixers 13.50 4.0 10.0 1.50 16.0 0.90 45.90
Clean mixers 4.50 1.6 0.50 0.30 6.90
Move mixture to filling 2.25 0.8 0.25 0.15 3.45
$45.0 $8.0 $10.0 $5.0 $16.0 $3.0 $87.0
2 Usually this information is collected by an ABC project team conducting interviews with employees
who work in the activity centres.
3 The best way of ensuring the quality of the information is to collect the information using a project team
with a good working knowledge of all facets of the business, a good rapport with their co-workers and
good communication skills.
4 All the activities in the Mixing Centre are batch level.
CASE 8.57 (90 minutes) Assigning activity costs to products; benefits, costs and
limitations of ABC: manufacturer
1 (a) Activity Cost per unit of activity driver

Prepare annual accounts
Process receivables $3.00 per invoice
Process payables $10.00 per purchase order
Program production $28.00 per production schedule
Process sales order $10.00 per sales order
Dispatch sales order $12.00 per dispatch
Develop and test products Assigned directly to products
Load mixers $14.05 per batch
Operate mixers $0.2295 per kg
Clean mixers $6.90 per batch
Move mixture to filling $0.01725 per kg
Clean trays $1.25 per tray
Fill trays $0.02 per cake or pastry
Move to baking $0.50 per tray
Set up ovens $50 per batch
Bake cakes/pastries $130.00 per batch
Move to packing $2.50 per tray
Pack cakes/pastries $0.10 per cake or pastry
Inspect pastries $0.05 per cake or pastry
(b) (i) Lamington: Bill of Activities (Batch size 1000: Annual volume 100 000)
Cost per unit of Annual quantity of

activity driver activity driver Annual cost
Process receivables $3.00 500 $1 500
Process payables 10.00 200 2 000
Program production 28.00 100 2 800
Process sales order 10.00 400 4 000
Load mixers 14.05 100 1 405
Operate mixers 0.2295 30 000 6 885
Clean mixers 6.90 100 690
Move mixture to filling 0.01725 30 000 518
Clean trays 1.25 2 000 2 500
Fill trays 0.02 100 000 2 000
Move to baking 0.50 2 000 1 000
Set up ovens 50.00 100 5 000
Bake cakes/pastries 130.00 100 13 000
Move to packing 2.50 2 000 5 000
Pack cakes/pastries 0.10 100 000 10 000
Dispatch sales order 12.00 500 6000
Develop and test product 600
$64 898
Cost per unit 64.898 cents
(ii) Danish pastry: Bill of activities (Batch size 200: Annual volume 10 000)
Cost per unit of Annual quantity of

activity driver activity driver Annual cost
Process receivables $3.00 150 $450
Process payables 10.00 100 1 000
Program production 28.00 50 1 400
Process sales order 10.00 100 1 000
Load mixers 14.05 50 703
Operate mixers 0.2295 4 000 918
Clean mixers 6.90 50 345
Move mixture to filling 0.01725 4 000 69
Clean trays 1.25 400 500
Fill trays 0.02 10 000 200
Move to baking 0.50 400 200
Set up ovens 50.00 50 2 500
Bake cakes/pastries 130.00 50 6 500
Inspect cakes/pastries 0.05 10 000 500
Move to packing 2.50 400 1 000
Pack cakes/pastries 0.10 10 000 1 000
Dispatch sales order 12.00 150 1 800
Develop and test product 2 400
$22485
Cost per unit $2.2485
2 Direct material costs must be added as the activity costs cover only labour and overhead (manufacturing
and non-manufacturing).
3 The activity cost per danish is much higher because of the high batch costs and relatively small-batch
size. Also the danish requires an additional activity inspection (although this adds only 5 cents per unit).
It is likely that the significant difference between the cost of lamingtons and danishes would not be
reflected in the conventional costing system. Many of the overhead activities such as moving, cleaning
and setup are not caused by the volume production (as assumed in the conventional costing) but by
batch quantities. Small batch sizes (as for danishes) imply relatively high, per unit, costs for these
overhead activities and vice versa for large batch sizes (as for lamingtons). This would not be picked up
in a conventional system that assumes overhead is volume driven. Also conventional product costs do
not include non-manufacturing costs, such as processing of payables and sales orders and many of these
are batch level costs.
4 To: I. M. Craving
From: U. B. Bright
Re: Evaluation of activity-based costing (ABC)
Further to our conversation I present the following evaluation of ABC.
Benefits
ABC will provide more accurate estimates of the costs of our products than we obtain from our existing
product costing system. This will assist the company in assessing product profitability and deciding
which products to produce and promote.
It is highly likely that our existing costing system understates the cost of low-volume product lines and
overstates their profitability. Also the system probably overstates the cost of high volume product lines.
This happens because manufacturing overhead costs are assigned to products using a volume-based cost
driver.* Many years ago, when our costing system was first introduced, this approach made sense.
Manufacturing overheads were relatively insignificant and largely volume driven. However, our
manufacturing processes have changed, causing a change in cost structure and cost behaviour.
Manufacturing overheads are now significant and a substantial part of them is not caused by, or related
to, the volume of production. By using a volume-based cost driver to apply these costs to products, our
costing system over costs the high-volume products and under costs the low-volume products.
Also, we have experienced a significant increase in the level of non-manufacturing costs. Many of these
costs are caused by individual products. We would have a better understanding of product profitability if
these costs were assigned to products. This can be achieved through activity-based product costing.
Costs and limitations
Activity-based product costing systems are more expensive to implement and maintain than
conventional costing systems. They must measure a number of different cost drivers, assign costs to a
number of activities and measure individual products consumption of the range of cost drivers.
Conventional costing systems use one plantwide overhead rate or a few departmental rates.
In addition, activity-based product costing can suffer some important limitations. Some costs, such as
top management costs, are not related to the production of individual products. Some activity-based
systems ignore cost behaviour and assign these costs, called facility level costs, to products. Activity-
based product costing systems should be designed to exclude facility level costs from product costs.
Also, although activity-based costing recognises a range of non-volume-based cost drivers, ultimately the
system unitises batch and product level costs to calculate the cost per unit of product. This implies that
there is a direct relationship between these costs and the volume of production, which is not true. Users of
activity-based information must be aware of this limitation and interpret the cost estimates with care.
Where possible, it is better to base product-line decisions on total product costs rather than unit costs.
Benefits versus costs
Accurate product costs are an essential input to making important strategic decisions about our
productsfor example, which products to produce and in what quantities. Activity-based product
costing is expensive to implement and maintain. It suffers from several limitations, although some of
these can be overcome through careful design of the ABC system and a sensible interpretation of the
ABC information. It appears that the benefits of ABC would outweigh its costs in our company and I
recommend a thorough evaluation of ABC product costing.
CASE 8.58 (90 minutes) (appendix) Conventional versus simple activity-based
costing systems; strategic cost analysis: manufacturer
1 Based on the cost data from Gigabytes conventional, volume-based product costing system, product G
is the firms least profitable product. Its reported actual gross margin is only $66.00, as compared with
$254.25 and $313.50 for products T and W respectively. However, the validity of this conclusion
depends on the accuracy of the product costs reported by Gigabytes product costing system.
2 Again, based on the product costs reported by the firms conventional, volume-based product costing
system, product W appears to be very profitable. As in requirement (1), however, the validity of this
assessment depends on the accuracy of the reported product costs.
3 Gigabytes competitors have moved aggressively into the market for gismos (product G), but they have
abandoned the whatchamacallit (product W) market to Gigabyte.
These competing firms apparently believe they can sell gismos at a much lower price than Gigabytes
management feels is feasible. This evidence suggests that Gigabytes competitors may believe their
product cost for gismos is below Gigabytes reported product cost. In contrast, Gigabytes competitors
apparently believe that they cannot afford to sell whatchamacallits at Gigabytes current price of $600.
Perhaps the competing firms reported production costs for product W are higher than the cost reported
by Gigabytes product costing system.
The danger to Gigabyte is that the company will be forced out of the market for its second largest selling
product. This could be disastrous to Gigabyte Ltd.
4 Percentages for raw-material costs:
Raw material cost Annual raw material Percentage of total raw

Product per unit Annual volume cost material cost*
G $105.00 8 000 $ 840 000 25%
T 157.50 15 000 2 362 500 69%
W 52.50 4 000 210 000 6%
Total $3 412 500 100%
*
Percentages rounded to nearest whole number.
5 Product costs based on an activity-based costing system:
Product G Product T Product W
Direct material .................................................. $105.00 $157.50 $ 52.50
Direct labour..................................................... 48.00 36.00 24.00
Machinerya ........................................................ 110.25 122.50 238.88
Machine setupb ................................................. 0.43 0.32 1.89
Inspectionc ........................................................ 31.50 46.20 157.50
Material handlingd ............................................ 82.03 120.75 39.38
Engineeringe ..................................................... 45.25 6.90 142.21
Total.................................................................. $422.46 $490.17 $656.36
a
Machinery
Product G: ($3 675 000 24%) 8 000 units = $110.25
Product T: ($3 675 000 50%) 15 000 units = $122.50
Product W: ($3 675 000 26%) 4 000 units = $238.88
b
Machine setup
Product G: ($15 750 22%) 8 000 units = $ .43
Product T: ($15 750 30%) 15 000 units = $ .32
Product W: ($15 750 48%) 4 000 units = $ 1.89
c
Inspection
Product G: ($1 575 000 16%) 8 000 units = $ 31.50
Product T: ($1 575 000 44%) 15 000 units = $ 46.20
Product W: ($1 575 000 40%) 4 000 units = $157.50
d
Material handling
Product G: ($2 625 000 25%) 8 000 units = $ 82.03
Product T: ($2 625 000 69%) 15 000 units = $120.75
Product W: ($2 625 000 6%) 4 000 units = $ 39.38
e
Engineering
Product G: ($1 034 250 35%) 8 000 units = $ 45.25
Product T: ($1 034 250 10%) 15 000 units = $ 6.90
Product W: ($1 034 250 55%) 4 000 units = $142.21
6 Comparison of reported product costs, new budgeted prices and actual selling prices:

Reported product costs:
Conventional, volume-based costing system $573.00 $508.50 $286.50
Activity-based costing system 422.46 490.17 656.36
Budgeted price based on new product costs
(150% new product cost) 633.69 735.26 984.54
Current actual selling price 639.00 762.75 600.00
7 Memorandum
Date: Today
To: Managing Director, Gigabyte Ltd
From: I.M. Student
Subject: Gigabytes competitive position
Gigabytes product-costing system has been providing misleading product cost information. Our
conventional, volume-based costing system overcosted gismos and thingamajigs, but it substantially
undercosted whatchamacallits. As a result Gigabyte has been overpricing gismos and thingamajigs and
underpricing whatchamacallits. The company has been losing money on every sale in the product W
market. Our competitors have taken advantage of our mispricing by moving aggressively into the gismo
market and abandoning the whatchamacallit market to Gigabyte. As a result, our profitability has suffered.
I recommend the following courses of action:
1) Implement the new activity-based costing system and revise its database frequently.
2) Lower the target price of gismos to $639, the current actual selling price. This price is slightly over
our usual 50 per cent markup over product cost.
3) Consider lowering the price of thingamajigs to $736 in order to increase demand. The lower price
still yields Gigabyte a 50 per cent markup over product cost.
4) Raise the price of whatchamacallits to $985. If the product does not sell at that price, consider
discontinuing the product line.
8
Conventional, volume-based costing system:

reported product cost ................................... $573.00 $508.50 $ 286.50
Activity-based costing system:
reported product cost ................................... 422.46 490.17 656.36
Amount of cost distortion per unit...................... $150.54 $ 18.33 $(369.86)
Conventional Conventional Conventional

system system system
overcosts overcosts undercosts
product G by product T by product W by
$150.54 $18.33 $369.86
per unit per unit per unit
Product volume ................................................... 8 000 15 000 4000
Total amount of cost distortion for entire product

line ....................................................................... $1 204 320 $ 274 950 $(1 479 440)
The sum of these three amounts is $(170). It would be
zero except for the slight rounding errors in the
calculation of the new product costs to the nearest cent.

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ACCG200 SolutionCh 08 PDF

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CHAPTER 8

Resource costs Resource drivers Activity centres

Activity centre* Activity drivers Cost objects

Level Car manufacturer (manufacturer) Courier company (service firm)

8.17 The three main types of activity drivers are:

Physical volume Number of transactions of Time duration

8.20 Benefits from ABC will be greatest when:

Commonwealth Bank of Australia developed activity-based costing, which provided detailed

8.21 Factors that may impede the introduction of ABC include:

8.24 Activity-based costing has some limitations, including the following:

Commonwealth Bank of Australia developed activity-based costing, which provided detailed

1 Costs assigned to Silverwaters Assembly Centre:

1 Cost of activity Load mixer:

4 Alternative activity drivers:

EXERCISE 8.30 (25 minutes) Assigning activity costs to products: manufacturer

EXERCISE 8.31 (5 minutes) Activity-based costing and inventory valuation:

EXERCISE 8.33 (20 minutes) Classification of activities: winery

The activities of the Seneca Falls Winery may be classified as follows:

1 Material handling cost per lens:

*The total number of direct labour hours.

3 Material handling cost per lens:

4 Material handling cost per mirror:

EXERCISE 8.37 (15 minutes) Key features of activity-based costing: manufacturer

1 Key features of an activity-based costing system:

EXERCISE 8.38 (20 minutes) Activity-based costing: service firm

Cost per person $145 $286.67*

There will be a number of possible answers to this question.

Possible activities Activity drivers

3 Management accounting: Bill of activities

Activity Costs to be assigned Activity driver Level of activity

Finish product Depreciation, machinery No. batches produced Batch

Inspect product Inspection No. batches produced Batch

EXERCISE 8.41 (5 minutes) Categorising activity cost pools: manufacturer

See column 4 of the table in solution to Exercise 8.40.

Quality control costs = 14.5% direct labour cost

Quantity for Assigned

Activity Full cost Manufacturing cost

PROBLEM 8.45 (30 minutes) Calculating activity costs: winery

1 Cost of the activity centres (in $000s):

2 Cost of activities in Labelling Centre (in $000s):

PROBLEM 8.46 (30 minutes) Activity-based costing: service

1 Interview salaried client $40 000 / 8 000 $5 per interview

Bill of activities Cost

Bill of activities Cost

2 Allocation of administrative cost based on billable hours:

Income billings. 9.28% 9.28%

3 Activity-based application rates:

Activity Cost Activity driver Application rate

Staff support $180 000 250 clients = $720 per client

In-house computing 136 400 4 400 computer = $31 per CH

Miscellaneous 25 600 1 000 client = $25.60 per CT

1 900 hours $45... (85 500)

Income billings..... 18.88% 3.40%

1 Calculating the cost per unit of activity driver:

Coloured plastic UV-absorbing Optical

PROBLEM 8.49 (30 minutes) Activity-based costing: service organisation

1 (a) Cost per unit of activity driver:

PROBLEM 8.50 (45 minutes) Activity-based costing; product decisions: manufacturer

Cost per unit of activity driver:

Soldering............................. $ 942 000 1 570 000 = $ 0.60 per solder joint

Solderingc ..................................................................................... $ 231 000 $ 711 000

Calculations: Zodiac Novelle

Cost per unit of activity driver: