managerial accounting fourth cdn. ed. sample chapter

ACCOUNTING TOOLS FOR BUSINESS DECISION-MAKING

WEYGANDT | KIMMEL | KIESO | ALY

FOURTH CANADIAN EDITION

MANAGERIAL

study objectives

5CHAPTE

R Activity-Based Costing

Chapter 5

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Aft er studying this chapter, you should be able to do the following:

1. Recognize the diff erence between traditional costing and activity-based costing (ABC) and understand the nature of ABC.

2. Apply activity-based costing to a manufacturer.

3. Understand the benefi ts and limitations of activity-based costing.

4. Apply activity-based costing to service industries.

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THE “ABCs” OF TRACKING COSTSWhen a company makes engines that can sell for millions of dollars each, getting a handle on costs is crucial. Yet the traditional way of determining manufacturing costs, by allocating a generic portion of overhead to each product, can end up burying the true cost, resulting in more diffi cult decision-making.

Pratt & Whitney Canada Corp. makes more than $600 million worth of aerospace and industrial engines at fi ve plants across the country every year, and receives millions of dollars in contracts to maintain these engines. But the company was struggling under its traditional costing method. “Our manufacturing costs were killing us,” said Claude Lévesque, former manager of costing operations at Pratt & Whitney Canada. “We knew that we had to reduce them, but fi rst we had to determine what they actually were. We needed to develop far more cost wisdom than was enabled by our traditional standard cost system.” Under that system, overhead was allocated to each manufactured part based on time spent in each machine, so a tiny, low-cost washer spending fi ve minutes in an inexpensive machine would be assigned the same amount of overhead as a large, high-cost engine spending fi ve minutes in an expensive machine.

To more accurately determine manufacturing costs, Pratt & Whitney Canada switched to an activity-based costing (ABC) system, which allocates actual overhead costs based on the activities that happen when making a product. To do this, the company’s accounting department worked to determine the cost of each process that an engine part undergoes when

being produced—starting with materials, proceeding through the machining process, and ending with product inspection and documentation. “It’s far more than an accounting exercise,” said Mr. Lévesque. “We had to thoroughly understand each manufacturing process, in order to properly accumulate its actual costs as accurately and rationally as possible.” Using sophisticated soft ware, the accountants entered costs for hundreds of materials and processes.

Under ABC, Pratt & Whitney Canada assigns overhead based on material usage per activity and not just time spent in a machine. For example, the company discovered that in the sandblasting activity, the cost of the grains of sand was greater than the cost of the time spent in the sandblasting machine, so it adjusted its overhead allocation accordingly. It also can more accurately determine research and devel-opment costs and depreciation for each part.

With its previous costing method, Pratt & Whitney Canada determined costs by department, but ABC allows it to know costs per machine. Th is helps managers under-stand which machines are underused, which parts cost more to produce, and which plants have higher costs—all important information for decision-making.

Sources: “Pratt & Whitney Canada Signs $75M, 15-Year Helicopter Engine Maintenance Program,” Canadian Manufacturing, February 27, 2014; “Object Technology Opens New Costing Horizons for Pratt & Whitney Canada,” 3C Soft ware case study, www.3csoft ware.com; Pratt & Whitney Canada corporate website, www.pwc.ca.

Preview of Chapter 5

As indicated in our feature story about Pratt & Whitney Canada Corporation, the traditional costing systems described in earlier chapters are not the best answer for every company. Because Pratt & Whitney suspected that the traditional system was hiding signifi cant diff erences in its real cost structure, it looked for a new method to assign costs. Similar searches by other companies for ways to improve operations and gather more accurate data for decision-making have resulted in the development of powerful new management tools, including activity-based costing (ABC), which this chapter explains and illustrates. Th e chapter is organized as follows:

ACTIVITY-BASED COSTING

Traditional costing systems Need for a new approach Activity-based costing

Traditional Costing

and Activity-Based

Costing

Identify and classify activities and allocate overhead to cost pools (step 1)

Identify cost drivers (step 2) Calculate overhead rates (step 3)

Assign overhead costs to products (step 4)

Unit cost comparison

Applying an Activity-

Based Costing

System

Benefi ts of ABC Limitations of ABC When to use ABC

Benefi ts and Limitations

of Activity-Based

Costing

Traditional costing example Activity-based costing example

Activity-Based Costing

in Service Industries

✓thenavigator

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170 C H A P T E R 5 Activity-Based Costing

Traditional Costing and Activity-Based CostingTRADITIONAL COSTING SYSTEMSIt is probably impossible to determine the exact cost of a product or service, However, for managers to make better decisions, they must have the most accurate cost estimates possible. A product’s cost can be estimated most accurately when this cost can be traced directly to the product produced or the service provided. Direct material and direct labour costs are the easiest to determine, because these can be traced directly to the product by examining material requisition forms and payroll time sheets. Overhead costs, on the other hand, are an indirect or common cost that generally cannot be easily or directly traced to individual products or services. Instead, we use estimates to assign overhead costs to products and services. Oft en the most diffi cult part of calculating accurate unit costs is determining the proper amount of overhead cost to assign to each product, service, or job. In our coverage of job-order costing in Chapter 3 and of process costing in Chapter 4, we used a single or plant-wide overhead rate throughout the year for the entire factory operation. Th is rate was called the predetermined overhead rate. For job-order costing, we assumed that direct labour cost was the relevant activity base for assigning all overhead costs to jobs. For process costing, we assumed that machine hours were the relevant activity base for assigning all overhead costs to the process or department. Using direct labour as the activity base made sense when overhead cost allocation systems were fi rst developed. At that time, direct labour made up a large portion of the total manufac-turing cost. Th erefore, it was widely accepted that there was a high correlation between direct labour and overhead costs. As a result, direct labour became the most popular basis for allocating overhead. Even in today’s increasingly automated environment, direct labour is sometimes the appropriate basis for assigning overhead costs to products. It is appropriate to use direct labour when (a) direct labour is a signifi cant part of the total product cost, and (b) there is a high correlation between direct labour and changes in the amount of overhead costs. Illustration 5-1 shows a simplifi ed (one-stage) traditional costing system that uses direct labour to assign overhead costs.

THE NEED FOR A NEW APPROACHIn recent years manufacturers and service providers have experienced tremendous change. Advances in computerized systems, technological innovation, global competition, and automation have changed the manufacturing environment dramatically. As a result, the amount of direct labour that is used in many industries has greatly decreased, and total overhead costs from depreciation on expensive equipment and machinery and from utilities, repairs, and maintenance have signifi cantly increased. When there is no correlation between direct labour and overhead, it is inappropriate to use plant-wide, predetermined overhead rates that are based on direct labour. When this correlation does not exist, companies that use overhead rates based on direct labour have signifi cant product cost distortions. To avoid these distortions, many companies now use machine hours as the basis for allocating overhead in an automated manufacturing environment. But machine hours can be inadequate as the only plant-wide basis for allocating all overhead. If the manufacturing process is complex, more accurate product cost calculations require multiple allocation bases. In situations like these, manag-ers need to consider an overhead cost-allocation method that uses multiple bases. Th at method is activity-based costing.

ACTIVITY-BASED COSTINGBroadly speaking, activity-based costing (ABC) is an approach for allocating overhead costs. More specifi cally, ABC allocates overhead to multiple activity cost pools, and it then assigns the activity cost pools to products and services by using cost drivers. To understand more clearly what that means, you need to apply new meanings to the rather common-sounding words that make

S T U DY O B J E C T I V E 1

Recognize the difference

between traditional costing and

activity-based costing (ABC) and

understand the nature of ABC.

Illustration 5-1Traditional one-stage costing system

DirectLabour

Hours orDollars

OverheadCosts

Products


Traditional Costing and Activity-Based Costing 171

up the defi nition. In activity-based costing, an activity is any event, action, transaction, or work sequence that incurs a cost when producing a product or providing a service. An activity cost pool is a distinct type of activity (such as ordering materials or setting up machines). A cost driver is any factor or activity that has a direct cause–eff ect relationship with the resources consumed. Th e reasoning behind ABC cost allocation is simple: products consume activities, and activities consume resources. Activity-based costing involves the four steps shown in Illustration 5-2:

Th ese defi nitions will become clearer as we look more closely at how ABC works. ABC allocates overhead in a two-stage process. In the fi rst stage (Step 1), it allocates overhead costs to activity cost pools. (Traditional costing systems, in contrast, allocate these costs to departments or jobs.) Examples of overhead activity cost pools are ordering materials, setting machines, assembling prod-ucts, and inspecting products. In the second stage (Steps 2–4), ABC uses cost drivers to assign the overhead allocated to the activity cost pools to specifi c products using cost drivers. Th e cost drivers measure the number of individual activities that are performed to produce products or provide services. Examples are the number of purchase orders, number of set-ups, labour hours, or number of inspections. Illustration 5-3 shows examples of activities, and the possible cost drivers that measure them, for a company that manufactures two products: axles and steering wheels. In the fi rst step (as shown at the top of the illustration), the company allocates its overhead costs to activity cost pools. In this simplifi ed example, it has identifi ed four activity cost pools: purchasing, storing, machining, and supervising. Aft er allocating the costs to the activity cost pools, the company uses cost drivers to measure the costs to be assigned to the individual prod-ucts (either axles or steering wheels) based on each product’s use of each activity. For example, if axles require more activity by the purchasing department, as measured by the number of required purchase orders, then the company will allocate more of the overhead cost from the purchasing pool to the axles. Not all products or services share equally in these activities. When a product’s manufacturing operation is more complex, it is likely to have more activities and cost drivers. If there is little or no correlation between changes in the cost driver and the consumption of the overhead cost, inaccu-rate product costs will result.

Alternative TerminologyProduct costs are also called inventory costs.

Illustration 5-2The four steps of activity-based costing

1. Identify and classify the activities involved in the manufacture of specific products and assign overhead to cost pools.

2. Identify the cost driver that has a strong correlation to the costs accumulated in each cost pool.

3. Calculate the activity-based overhead rate for each cost pool.

4. Allocate overhead costs to products using the overhead rates determined for each cost pool.



PURCHASING DEPARTMENT

Products

Cost Drivers

Activity Cost Pools

Supervising $ Machining $ Storing $ Purchasing $

Number of Purchase Orders

SquareMetres

Occupied

Number of Machine Hours

Number of Employees

Axles 4,200 Steering Wheels 8,800

Total $ � 4,200 � Cost per Axle Total $ � 8,800 � Cost per Steering Wheel

Overhead Costs

Illustration 5-3Activities and related cost

drivers B E F O R E Y O U G O O N. . .

Do It! Costing Systems

Indicate whether the following statements are true or false.

(a) A traditional costing system allocates overhead by means of multiple overhead rates in each department.

(b) Activity-based costing allocates overhead costs in a two-stage process.

(c) Direct material and direct labour costs are easier to trace to products than overhead.

(d) As manufacturing processes have become more automated, more companies have chosen to allocate overhead on the basis of direct labour costs.

(e) In activity-based costing, an activity is any event, action, transaction, or work sequence that incurs cost by consuming resources when producing a product.

Action Plan

• Understand that a traditional costing system allocates overhead on the basis of a single predetermined overhead rate in each department.

• Understand that an ABC system allocates overhead to identifi ed activity cost pools, and then assigns costs to products using related cost drivers that measure the resources consumed.

Solution

(a) False. (b) True. (c) True. (d) False. (e) True.

Related exercise material: BE5-1, BE5-2, E5-17, and Do It! D5-13.✓thenavigator


Applying an Activity-Based Costing System 173

Applying an Activity-Based Costing SystemYou should understand that ABC generally does not replace an existing job-order or process costing system. ABC simply segregates overhead into various cost pools in an eff ort to provide more accurate cost information. Th us, ABC supplements the traditional cost systems; it does not replace them. We now present a simple case that compares traditional costing and activity-based costing. Assume that Atlas Company produces two automobile antitheft devices: Th e Boot and Th e Club. Th e Boot is a high-volume item totalling 25,000 units annually. Th e Club is a low-volume item totalling only 5,000 units per year. Each product requires one hour of direct labour to complete. Total annual direct labour hours are therefore 30,000 (25,000 1 5,000). Expected annual manufac-turing overhead costs are $900,000. Th us, the predetermined overhead rate under traditional costing, using direct labour hours, is $30 ($900,000 4 30,000) per direct labour hour. Since both products require one direct labourhour per unit, both products are allocated overhead costs of $30 per unit under traditional costing. Let’s now continue the example of Atlas Company to show how ABC eliminates the distortion that can occur in traditional overhead cost allocation. We will calculate unit costs under ABC. Activity-based costing involves the following four steps.

1. Identify and classify the major activities involved in the manufacture of specifi c products, and allocate manufacturing overhead costs to cost pools.

2. Identify the cost driver that has a strong correlation to the costs accumulated in the cost pool.3. Calculate the overhead rate for each cost driver.4. Assign manufacturing overhead costs for each cost pool to products, using the overhead rates

(cost per driver).

Recall that both products manufactured by the Atlas Company are allocated overhead costs of $30 per unit under traditional costing.

IDENTIFY AND CLASSIFY ACTIVITIES AND ALLOCATE OVERHEAD TO COST POOLS (STEP 1)A well-designed activity-based costing system starts with an analysis of the activities performed to manufacture a product or provide a service. Th is analysis should identify all resource-consuming activities. It requires documenting every activity undertaken to accomplish a task. Atlas Company identifi ed three activity-cost pools: setting up machines, machining, and inspecting. Next, the system assigns overhead costs directly to the appropriate activity cost pool. For example, all overhead costs directly associated with Atlas Company’s machine set-ups (such as sal-aries, supplies, and depreciation) would be assigned to the machine set-up cost pool. Illustration 5-4 shows the three cost pools, along with the estimated overhead allocated to each cost pool.


Apply activity-based costing to a

manufacturer.

Illustration 5-4Activity cost pools and estimated overhead

Activity Cost Pools Estimated OverheadSetting up machines $300,000Machining 500,000Inspecting 100,000Total $900,000

IDENTIFY COST DRIVERS (STEP 2)Aft er costs are allocated to the activity cost pools, the company must identify the cost drivers for each cost pool. Th e cost driver must accurately measure the actual consumption of the activity by the various products. To achieve accurate costing, a high degree of correlation must exist between the cost driver and the actual consumption of the overhead costs in the cost pool.



Illustration 5-5 shows the cost drivers identifi ed by Atlas and their total expected use per activity cost pool.

Illustration 5-5Cost drivers and their

expected use

Activity Cost Pools Cost Drivers Expected Use of Cost Drivers per ActivitySetting up machines Number of set-ups 1,500 set-upsMachining Machine hours 50,000 machine hoursInspecting Number of inspections 2,000 inspections

Availability and ease of obtaining data relating to the cost driver is an important factor that must be considered in its selection.

CALCULATE OVERHEAD RATES (STEP 3)Next, the company calculates an activity-based overhead rate per cost driver by dividing the estimated overhead per activity by the number of cost drivers expected to be used per activity. Illustration 5-6 shows the formula for this calculation.

Atlas Company calculates its activity-based overhead rates by using estimated overhead per activity cost pool, shown in Illustration 5-4, and the expected use of cost drivers per activity, shown in Illustration 5-5. Th ese calculations are presented in Illustration 5-7.

Illustration 5-6Formula for calculating activity-based

overhead rate

Estimated Overhead per Activity �

Expected Use of CostDrivers per Activity �

Activity-BasedOverhead Rate

ASSIGN OVERHEAD COSTS TO PRODUCTS (STEP 4)In assigning overhead costs, it is necessary to know the expected use of cost drivers for each prod-uct. Because of its low volume, Th e Club requires more set-ups and inspections than Th e Boot. Illustration 5-8 shows the expected use of cost drivers per product for each of Atlas’s products.

Illustration 5-7Calculation of activity-based

overhead ratesActivity Cost Pools

Estimated Overhead ÷

Expected Use of Cost Drivers per Activity 5

Activity-Based Overhead Rates

Setting up machines $300,000 1,500 set-ups $200 per set-upMachining 500,000 50,000 machine hours $ 10 per machine hourInspecting 100,000 2,000 inspections $ 50 per inspectionTotal $900,000

Illustration 5-8Expected use of cost drivers

per product

Expected Use of Cost Drivers per Product

Activity Cost Pools Cost Drivers Expected Use of Cost Drivers per Activity Th e Boot Th e Club

Setting up machines Number of set-ups 1,500 set-ups 500 1,000Machining Machine hours 50,000 machine hours 30,000 20,000Inspecting Number of inspections 2,000 inspections 500 1,500

To assign overhead costs to each product, Atlas multiplies the activity-based overhead rates per cost driver (Illustration 5-7) by the number of cost drivers expected to be used per product (Illustration 5-8). Illustration 5-9 shows the overhead cost assigned to each product.


Applying an Activity-Based Costing System 175

Under ABC, the overhead cost per unit is $17 for Th e Boot and $95 for Th e Club. When com-pared with the $30 per unit overhead charge under traditional costing, ABC shift s costs from the high-volume product (Th e Boot) to the low-volume product (Th e Club). Th is shift occurs because low-volume products oft en require more special handling, such as machine set-ups and inspections. Th is is true for Atlas Company. Th us, the low-volume product frequently is responsible for more overhead costs per unit than is a high-volume product.1 Assigning overhead using ABC will usually increase the cost per unit for low-volume products as compared with a traditional overhead alloca-tion. Th erefore, traditional cost drivers such as direct labour hours are usually not appropriate for assigning overhead costs to low-volume products.

UNIT COST COMPARISONIllustration 5-10 shows the unit cost for each product under traditional costing.

Illustration 5-9Assignment of activity cost pools to products

Illustration 5-10Calculation of unit costs—traditional costing

ProductsManufacturing Costs Th e Boot Th e ClubDirect materials $40 $30Direct labour 12 12Overhead 30* 30*Total unit cost $82 $72*Predetermined overhead rate 3 Direct labour hours 5 $30 3 1 hr. 5 $30

1Robin Cooper and Robert S. Kaplan, “How Cost Accounting Distorts Product Costs,” Management Accounting 69, No. 10 (April 1988), pp. 20–27.

In Illustration 5-11, a comparison of unit manufacturing costs under traditional costing and ABC shows the following signifi cant diff erences.

Illustration 5-11Comparison of unit product costs

Th e Boot Th e Club

Manufacturing CostsTraditional

Costing ABCTraditional

Costing ABCDirect materials $40 $40 $30 $ 30Direct labour 12 12 12 12Overhead 30 17 30 95Total cost per unit $82 $69 $72 $137

Overstated Understated$13 $65

Th e comparison shows that unit costs under traditional costing are signifi cantly distorted. Th e cost of producing Th e Boot is overstated by $13 per unit ($82 2 $69), and the cost of producing Th e

1

2

3

4

5

6

7

8

9

10

$200,000

200,000

75,000

$475,000

5,000

$95

$200

$10

$50

1,000

20,000

1,500

$100,000

300,000

25,000

$425,000

25,000

$17

$200

$10

$50

500

30,000

500

Setting up machines

Machining

Inspecting

Total costs assigned [(a)]

Units produced [(b)]

Overhead cost per unit [(a) ÷ (b)]

A

fx

C D G H I J K LB E F

Atlas Company.xlsFormulas Data Review ViewPage LayoutInsertHome

ATLAS COMPANY

Activity Cost Pools

The Boot The ClubExpected Use

of Cost Driversper Product

Activity-BasedOverhead

Rates

CostAssigned

CostAssigned

Expected Useof Cost Drivers

per Product

Activity-BasedOverhead

Rates= =× ×



Club is understated by $65 per unit ($137 2 $72). Th ese diff erences are entirely due to how manu-facturing overhead is assigned. A likely consequence of the diff erences in assigning overhead is that Atlas Company has been overpricing Th e Boot and possibly losing market share to competitors. Moreover, it has been sacrifi cing profi tability by underpricing Th e Club.

Have you been on a fl ight where the airline charged to check the fi rst bag? Did you pay the money to check it or did you just bring a carry-on bag? Either way, the airlines are hoping to reduce their costs or increase their revenues. Baggage handling is extremely labour intensive. When airlines fi rst started charging for checked bags in 2008, it was estimated that the cost of all that tagging, sorting, loading on carts, loading in planes, unloading, and sorting again added up to about $9 per bag. Carriers also have equipment costs: sorters, carts, conveyors, tractors, and storage facilities, for about another $4 per bag. Finally, there is additional fuel cost of an 18-kilogram item—about $2 in fuel for a 3-hour fl ight. Costs have gone up since then, and many North American airlines are charging $25 to check the fi rst bag, including Air Canada and Porter Airlines on fl ights to and from the United States. WestJet was also con-sidering implementing baggage fees. Not only does this save the airlines money, it brings in additional passenger fees and increases the amount of space available for hauling cargo. An airline can charge at least $80 for hauling a small parcel for same-day delivery service. The largest U.S. airlines collected a record U.S. $3.5 billion in baggage fees in 2012.

Sources: Tamara Elliott, “WestJet Looks at Adding Baggage Fees,” Global News, February 4, 2014; “Porter Airlines Checked Baggage Fee for U.S. Flights Coming in August,” The Huffi ngton Post Canada, July 4, 2013; Scott Mayerowitz, The Associated Press, “Airlines Collected Record Baggage Fees in 2012,” Global News, May 14, 2013; Vanessa Lu, “Air Canada to Charge for Checked Bags,” Toronto Star, September 2, 2011; Scott McCartney, “What It Costs an Airline to Fly Your Luggage,” Wall Street Journal Online, November 25, 2008.

Why do airlines charge even higher rates for heavier bags, bags that are odd shapes (such as ski bags), and bags with hazardous materials in them?

BUSINESS INSIGHT Handling Baggage Costs

b

B E F O R E Y O U G O O N. . .

Do It! Apply ABC

Using the data on the next page, do the following:

(a) Prepare a schedule that shows the calculations of the activity-based overhead rates per cost driver.

(b) Prepare a schedule for assigning each activity’s overhead cost to the two products.

(c) Calculate the overhead cost per unit for each product.

(d) Comment on the comparative overhead cost per unit.

Lift Jack Company, as shown in Illustration 5-12, has seven activity cost pools and two products. It expects to produce 200,000 units of its automobile scissors jack, and 80,000 units of its truck hydraulic jack. Having identifi ed its activity cost pools and the cost drivers for each cost pool, Lift Jack Company accumulated the following data on the activity cost pools and cost drivers.

Annual Overhead Data

Activity Cost Pools Cost DriversEstimated Overhead

Ordering and receiving Purchase orders $ 200,000Machine set-up Set-ups 600,000Machining Machine hours 2,000,000Assembling Parts 1,800,000Inspecting and testing Tests 700,000

$5,300,000

Expected Use of Cost

Drivers per Product

Expected Use of Cost Drivers per Activity

Scissors Jacks

Hydraulic Jacks

2,500 orders 1,000 1,5001,200 set-ups 500 700

800,000 hours 300,000 500,0003,000,000 parts 1,800,000 1,200,000

35,000 tests 20,000 15,000


Benefi ts and Limitations of Activity-Based Costing 177

Action Plan

• Determine the activity-based overhead rate by dividing the estimated overhead per activity by the expected use of cost drivers per activity.

• Assign the overhead of each activity cost pool to the individual products by multiplying the expected use of the cost drivers per product by the activity-based overhead rate.

• Determine the overhead cost per unit by dividing the overhead assigned to each product by the number of units of that product.

Solution

(a) Calculations of activity-based overhead rates per cost driver:

Activity Cost Pools

Estimated Overhead ÷



Ordering and receiving $ 200,000 2,500 purchase orders $80 per orderMachine set-up 600,000 1,200 set-ups $500 per set-upMachining 2,000,000 800,000 machine hours $2.50 per machine hourAssembling 1,800,000 3,000,000 parts $0.60 per partInspecting and testing 700,000 35,000 tests $20 per testTotal $5,300,000

(b) Assignment of each activity’s overhead cost to products, using ABC:

Scissors Jacks Hydraulic Jacks

Activity Cost Pools

Expected Use of Cost Drivers

per Product 3

Activity-Based Overhead

Rates 5Cost

Assigned


per Product 3

Activity-Based Overhead

Rates 5Cost

AssignedOrdering and receiving 1,000 $80 $ 80,000 1,500 $80 $ 120,000Machine set-up 500 $500 250,000 700 $500 350,000Machining 300,000 $2.50 750,000 500,000 $2.50 1,250,000Assembling 1,800,000 $0.60 1,080,000 1,200,000 $0.60 720,000Inspecting and testing 20,000 $20 400,000 15,000 $20 300,000Total assigned costs $2,560,000 $2,740,000

(c) Calculation of overhead cost per unit:

Total costs Total units Overhead assigned produced cost per unit

Scissors Jack $2,560,000 200,000 $12.80Hydraulic Jack $2,740,000 80,000 $34.25

(d) These data show that the total overhead assigned to 80,000 hydraulic jacks is nearly as great as the over-head assigned to 200,000 scissors jacks. However, the overhead cost per hydraulic jack is $34.25. It is only $12.80 per scissors jack.

Related exercise material: BE5-6, BE5-7, E5-17, E5-19, E5-20, E5-21, E5-23, and Do It! D5-14. ✓thenavigator

Benefi ts and Limitations of Activity-Based CostingBENEFITS OF ABCABC has three primary benefi ts:

1. ABC leads to more cost pools and therefore more accurate product costing.2. ABC leads to enhanced control over overhead costs.3. ABC leads to better management decisions.


Understand the benefi ts and

limitations of activity-based costing.



Th e Advantage of Multiple Cost PoolsTh e main mechanism by which ABC increases product cost accuracy is the use of multiple cost pools. Instead of one plantwide pool (or even several departmental pools) and a single cost driver, companies use numerous activity cost pools with more relevant cost drivers. Th us, costs are allo-cated more directly on the basis of the cost drivers used to produce each product. Note that in the Lift Jack Company example, the manufacturing cost pool refl ected multiple manufacturing activities, including machining, assembling, and painting. Th ese activities were in-cluded in a single pool for simplicity. In many companies, the number of activities—and thus the number of pools—can be substantial. For example, Clark-Hurth (a division of Clark Equipment Company), a manufacturer of axles and transmissions, identifi ed over 170 activities. Compumotor (a division of Parker Hannifi n) identifi ed over 80 activities in just the procurement function of its Material Control Department. Illustration 5-12 shows the design of a more complex activity-based costing system with seven activity cost pools for Lift Jack Company. Lift Jack Company manufac-tures two automotive jacks: an automobile scissors jack and a truck hydraulic jack.Illustration 5-12

ABC system design—Lift Jack Company

Overhead Costs

Activity Cost Pools

Ordering and Receiving Materials Cost Pool

Setting Up Machines Cost Pool

Machining Cost Pool

Assembling Cost Pool

Inspecting and Testing

Cost Pool

Painting Cost Pool

Supervising Cost Pool

Cost DriversNumber of Purchase

Orders

Numberof

Set-ups

Machine Hours

Numberof

Parts

Numberof

Parts

Numberof

Tests

Numberof

Parts

DirectLabourHours

Products

To gain the full advantage of having multiple cost pools, the costs within the pool must be correlated with the driver. To achieve this, a company’s managers oft en characterize activities as belonging to one of the following four activity-level groups when designing an ABC system.

1. Unit-level activities are performed for each unit of production. For example, the assembly of cell phones is a unit-level activity because the amount of assembly the company performs increases with each additional cell phone assembled.

2. Batch-level activities are performed every time a company produces another batch of a product. For example, suppose that to start processing a new batch of ice cream, an ice cream producer needs to set up its machines. Th e amount of time spent setting up machines increases with the number of batches produced, not with the number of units produced.

3. Product-level activities are performed every time a company produces a new type of product. For example, before a pharmaceutical company can produce and sell a new type of medicine, it must undergo very substantial product tests to ensure the product is eff ective and safe. Th e amount of time spent on testing activities increases with the number of products the company produces.

4. Facility-level activities are required to support or sustain an entire production process. Consider, for example, a hospital. Th e hospital building must be insured and heated, and the property taxes must be paid, no matter how many patients the hospital treats. Th ese costs do not vary as a func-tion of the number of units, batches, or products.



Companies may achieve greater accuracy in overhead cost allocation by recognizing these four diff erent levels of activities and, from them, developing specifi c activity cost pools and their related cost drivers. Illustration 5-13 graphically displays this four-level activity hierarchy, along with the types of activities and examples of cost drivers for those activities at each level.

Th e Advantage of Enhanced Cost ControlABC leads to enhanced control over overhead costs. Under ABC, companies can trace many over-head costs directly to activities—allowing some costs previously considered to be indirect costs to be identifi ed as direct costs. In developing an ABC system, managers increase their awareness of the activities performed by the company in its production and supporting processes. Th is awareness helps managers classify activities as value-added or non–valued-added. Value-added activities are those activities of a company’s operations that increase the perceived value of a product or service to customers. Examples of value-added activities in a manu-facturing operation include engineering design, machining, assembly, and painting. Examples of value-added activities in a service company include performing surgery at a hospital, providing legal research at a law fi rm, or delivering packages by a freight company. Non–value-added activities are those activities that, if eliminated, would not reduce the per-ceived value of a company’s product or service. Th ese activities simply add cost to, or increase the time spent on, a product or service without increasing its perceived value. One example is inven-tory storage. If a company eliminated the need to store inventory, it would not reduce the value of its product, but it would decrease its product costs. Other examples include moving materials, work in process, or fi nished goods from one location to another in the plant during the production process; waiting for manufacturing equipment to become available; inspecting goods; and fi xing defective goods under warranty.

Illustration 5-13Hierarchy of activity levels

Types of Activities Examples of Cost DriversFour Levels

Equipment set-upsPurchase orderingInspection

Materials handling

Number of set-ups or set-up timeNumber of purchase ordersNumber of inspections or inspection timeNumber of material moves

Machine-related Drilling, cutting, milling, trimming, pressing

Labour-related Assembling, painting, sanding, sewing

Machine hours

Direct labour hours or cost

Batch-Level Activities

Unit-Level Activities

Facility-Level Activities

Plant management salariesPlant depreciationProperty taxesUtilities

Number of employees managedSquare footageSquare footageSquare footage

Product designEngineering changes

Number of product designsNumber of changes

Product-Level Activities

There.This baby shouldkeep the building

cool. Cutting EdgeApparel Company



Companies oft en use activity fl owcharts to help identify the ABC activities, such as the one shown in Illustration 5-14. Th e top part of this fl owchart identifi es activities as value-added (highlighted in red) or non–value-added. Two rows in the lower part of the fl owchart show the number of days spent on each activity. Th e fi rst row shows the number of days spent on each activity under the current manufacturing process. Th e second row shows the number of days expected to be spent on each activity under management’s proposed reengineered manufacturing process.Illustration 5-14

Flowchart showing value-added and non–value-added activities

HEARTLAND MANUFACTURING COMPANYActivity Flowchart

ActivitiesNVA NVA NVA NVA VA NVA NVA VA NVA NVA NVA VA

Receive and Inspect Materials

Move and Store Materials

Move Materials to Production

and Wait

Set Up Machines

Machining:Inspect

Moveand

WaitAssembly

Inspect and Test

Moveto

Storage

Store Finished Goods

Package and Ship

Drill Lathe

Current

Days 1 12 2.5 1.5 2 1 0.2 6 2 0.3 0.5 14 1

Total Current Average Time 44 days

Proposed

Days 1 4 1.5 1.5 2 1 0.2 2 2 0.3 0.5 10 1

Total Proposed Average Time 27 days

Proposed reduction in non–value-added time 17 days

VA value-added NVA non–value-added

Th e proposed changes would reduce time spent on non–value-added activities by 17 days. Th is 17-day improvement is due entirely to moving inventory more quickly through the non–value-added processes—that is, by reducing inventory time in moving, storage, and waiting. Not all activities labelled non–value-added are totally wasteful, nor can they be totally elimi-nated. For example, although inspection time is a non–value-added activity from a customer’s perspective, few companies would eliminate their quality control functions. Similarly, moving and waiting time is non–value-added, but it would be impossible to completely eliminate. Nevertheless, when managers recognize the non–value-added characteristic of these activities, they are motivated to minimize them as much as possible. Attention to such matters is part of the growing practice of activity-based management, which helps managers concentrate on continuous improvement of operations and activities.

DECISION TOOLKIT

Decision Checkpoints Info Needed for Decision Tools to Use for Decision How to Evaluate Results

How can ABC help managers manage the business?

Activities classifi ed as value-added and non–value-added

The activity analysis fl owchart extended to identify each activity as value-added or non–value-added

The fl owchart should motivate managers to minimize non–value-added activities. Managers should better understand the relationship between activities and the resources they consume.

✓thenavigator



Th e Advantage of Better Management DecisionsSome companies experiencing the benefi ts of activity-based costing have applied it to a broader range of management activities. Activity-based management (ABM) extends the use of ABC from product costing to a comprehensive management tool that focuses on reducing costs and improving processes and decision-making. Managers extend the use of ABC via ABM for both strategic and operational decisions or perspectives. For example, returning to Atlas Company, its managers might use ABC information about Th e Boot and Th e Club to improve the effi ciency of its operations. For example, aft er realizing that both products require a high volume of set-up hours—as well as the costs of these hours—they might want to reduce the hours required to set up production runs. Such information may lead managers to increase the number of units produced with each set-up or to optimize production schedules for the two products. ABC also helps managers evaluate employees, departments, and business units. Atlas, for ex-ample, might use ABC information about salespeople’s activities related to customer visits, number of orders, and post-sales customer service. Such information informs managers about how much eff ort salespeople are exerting, as well as how effi cient they are in dealing with customers. Similarly, Atlas might use ABC information about each department’s use of shared resources, like inventory space. Such information lets managers know which departments are the most effi cient, which in turn leads to sharing best-practices information within the company. ABC information also helps Atlas to establish performance standards within the company, as well as benchmark its perfor-mance against other companies. Th e implications of ABC are not limited to operational decisions. Th e diff erences in profi t-ability between the Th e Boot and Th e Club may suggest a need to change the company’s product mix. Such considerations, in turn, have implications for Atlas’s marketing strategy. ABM may guide managers in considering diff erent target customer markets for the two products. As another, more extreme, example, managers might consider outsourcing production for one of the products or dropping one of the product lines altogether. It is often the case that ABM for one perspective has implications for another perspective. For instance, the strategic decision to drop a product line is usually followed by operational de-cisions regarding what to do with employees’ time or the machinery and equipment originally used to manufacture the dropped product. Similarly, increases in employees’ effi ciency following

Processing customer transactions is a non–value-added activity. Several Canadian companies are trying to reduce transaction costs by charging customers for receiving a paper bill, up to $4 per month, because on-line billing is less costly. These companies are in industries such as banking, telecommu-nications, and public utilities. They argue that on-line billing is better for the environment and is more convenient for customers, and that customers who have moved to on-line billing shouldn’t subsidize the transaction costs of those who receive a paper bill. The move to charge for paper bills is unpopular with consumers, many of whom feel that issuing paper bills is a cost of doing business and that those without Internet access should not be penalized. A survey of members of the Canadian Association of Retired Persons found that two thirds of them said they would move their business to another company that didn’t charge for paper statements. The federal government announced in its fall 2013 Throne Speech that it intended to end the practice for telecommunications companies.

Sources: Ellen Roseman, “$2 Paper Phone Bill Fee in CRTC Crosshairs: Roseman,” Toronto Star, October 27, 2013; Althia Raj, “Charging for Paper Bills: There Oughta Be A Law, Opposition Says,” The Huffi ngton Post Canada, October 1, 2013; Leslie MacKinnon, “Fees for Paper Billing Hurt Most Vulnerable, Says NDP,” CBC News, November 7, 2012.

What are some ethical issues involved when companies pass on transaction costs to consumers?

BUSINESS INSIGHT Paper Billing



from operational decisions often lead to changes in employee hiring and compensation strat-egy. The interrelated nature of the strategic and operational perspectives often means that a decision is not made until the cascading implications of that decision are also identified and considered.

LIMITATIONS OF ABCABC can be very benefi cial, but it is not without its limitations. ABC can be expensive to use. Th e increased cost of identifying multiple activities and applying numerous cost drivers discourages many companies from using ABC. ABC systems are also more complex than traditional systems. So companies must ask, is the cost of implementation greater than the benefi t of greater accuracy? For some companies, there may be no need to consider ABC at all because their existing system is suffi cient. Further, ABC does not offer complete accuracy because some arbitrary allocations re-main. Even though more overhead costs can be assigned directly to products through ABC, some overhead costs still need to be allocated by arbitrary cost drivers, such as labour or ma-chine hours. In light of these limitations, how does a company know when to use ABC? Th e presence of one or more of the following factors would point to possible use:

1. Product lines diff er greatly in volume and manufacturing complexity.2. Product lines are numerous and diverse, requiring various degrees of support services.3. Overhead costs constitute a signifi cant portion of total costs.4. Th e manufacturing process or the number of products has changed signifi cantly; for example,

from labour-intensive to capital-intensive due to automation.5. Production or marketing managers are ignoring data provided by the existing system and are

instead using “bootleg” costing data or other alternative data when pricing or making other product decisions.

Ultimately, it is important to realize that the redesign and installation of a product costing system is a signifi cant decision that requires considerable costs and a major eff ort to accomplish. Th erefore, fi nancial managers need to be cautious and deliberate when initiating changes in costing systems. A key factor in implementing a successful ABC system is the support of top manage-ment, especially given that the benefi ts of ABC are not completely visible until aft er it has been implemented.

IFRS NotesDepending on how the ABC system is designed, it may not conform to IFRS. For instance, in ABC, nonmanufacturing costs may be included in overhead cost pools and allocated to products. However, under external reporting and IFRS, only manufacturing costs are inventoriable costs, and nonmanufacturing costs cannot be allocated to products. As a result, many organizations use ABC as a supplement to, rather than a replacement for, their existing cost system. However, maintaining two cost systems is costlier than maintaining just one system and may cause confusion about which set of numbers to rely on. A modifi ed form of activity-based costing can be used to develop product costs for external fi nancial reports compliant with IFRS. With this approach, ABC:

• Includes all manufacturing costs, such as organization- sustaining costs and unused capacity costs, in product costs.

• Excludes all nonmanu-facturing costs even if they are clearly caused by the products.

DECISION TOOLKIT


When should we use ABC? Knowledge of the products or product lines, the manufacturing process, overhead costs, and managers’ needs for accurate cost information

A detailed and accurate cost accounting system; co-operation between accountants and operating managers

Compare the results under both costing systems. If managers are better able to understand and control their operations using ABC, and the costs are not prohibitive, use of ABC would be benefi cial.

✓thenavigator


Activity-Based Costing in Service Industries 183

Activity-Based Costing in Service IndustriesAlthough initially developed and implemented by manufacturers, activity-based costing is also widely used in service industries. ABC is used by airlines, railroads, hotels, hospitals, banks, insurance companies, telephone companies, and fi nancial services fi rms. Th e overall objective of ABC in service fi rms is no diff erent than it is in a manufacturing company. Th at objective is to identify the key activities that generate costs and to keep track of how many of those activities are completed for each service performed (by job, service, contract, or customer). Th e general approach to identifying activities, activity cost pools, and cost drivers is the same for service companies and for manufacturers. Also, the labelling of activities as value-added and non–value-added, and the attempt to reduce or eliminate non–value-added activities as much as possible, is just as valid in service industries as in manufacturing operations. What sometimes makes implementation of activity-based costing diffi cult in service industries is that, compared with manufacturers, a larger proportion of overhead costs are company-wide costs that cannot be directly traced to specifi c services performed by the company. To illustrate how activity-based costing is used in a service company contrasted to traditional costing, we use a public accounting fi rm. Th is illustration applies to any service fi rm that performs numerous services for a client as part of a job, such as a law fi rm, consulting fi rm, or architect.

TRADITIONAL COSTING EXAMPLEAssume that the public accounting fi rm of Check and Doublecheck prepares the condensed annual budget shown in Illustration 5-15. Th e fi rm engages in a number of services, including audit, tax, and computer consulting. Direct labour is oft en the professional service performed. Under traditional costing, direct labour is the basis for overhead application to each job. As shown in Illustration 5-15, the predeter-mined overhead rate of 50% is calculated by dividing the total estimated overhead cost by the total direct labour cost. To determine the operating income earned on any job, Check and Doublecheck applies overhead at the rate of 50% of actual direct professional labour costs incurred. For exam-ple, assume that Check and Doublecheck records $140,000 of actual direct professional labour cost during its audit of Plano Moulding Company, which was billed an audit fee of $260,000. Under traditional costing, using 50% as the rate for applying overhead to the job, Check and Doublecheck


Do It! Classify Activity Levels

Morgan Toy Company manufactures six primary product lines of toys in its Morganville plant. As a result of an activity analysis, the accounting department has identifi ed eight activity cost pools. Each of the toy products is produced in large batches, with the whole plant devoted to one product at a time. Classify each of the following activities as either unit-level, batch-level, product-level, or facility-level: (a) engineering design, (b) machine set-up, (c) toy design, (d) interviews of prospective employees, (e) inspections after each set-up, (f) polishing parts, (g) assembling parts, and (h) health and safety.

Action Plan

• You should use unit-level activities for each unit of product, batch-level activities for each batch of product, product-level activities for an entire product line, and facility-

level activities for across the entire range of products.

Solution

(a) Product-level. (b) Batch-level. (c) Product-level. (d) Facility-level. (e) Batch-level. (f) Unit-level. (g) Unit-level. (h) Facility-level.

Related exercise material: BE5-10, BE5-11, BE5-12, E5-33, E5-34, and Do It! D5-15. ✓thenavigator


Apply activity-based costing to

service industries.



would calculate applied overhead and operating income related to the Plano Moulding Company audit as shown in Illustration 5-16.

Illustration 5-15Condensed annual budget of a service

fi rm under traditional costingRevenue $4,000,000Direct labour $1,200,000Overhead (expected) 600,000Total costs 1,800,000Operating income $2,200,000

Estimated overhead 5 Predetermined overhead rate

Direct labour cost

$600,000 5 50% $1,200,000

CHECK AND DOUBLECHECK, CPAsAnnual Budget

Illustration 5-16Overhead applied under traditional

costing systemRevenue $260,000Less: Direct professional labour $140,000 Applied overhead (50% 3 $140,000) 70,000 210,000Operating income $ 50,000

CHECK AND DOUBLECHECK, CPAsPlano Moulding Company Audit

Th is example, under traditional costing, uses only one cost driver (direct labour cost) to deter-mine the overhead application rate.

ACTIVITY-BASED COSTING EXAMPLEUnder activity-based costing, Check and Doublecheck distributes its estimated annual overhead costs of $600,000 to three activity cost pools. Th e fi rm calculates activity-based overhead rates per cost driver by dividing each activity overhead cost pool by the expected number of cost drivers used per activity. Illustration 5-17 shows an annual overhead budget using an ABC system.

Th e assignment of the individual overhead activity rates to the actual number of activities used in the performance of the Plano Moulding Company audit results in total overhead assigned of $57,200, as shown in Illustration 5-18.

Illustration 5-17Condensed annual budget of a service

fi rm under activity-based costing

CHECK AND DOUBLECHECK, CPAsAnnual Overhead Budget

Expected Use of Activity-Based Estimated Cost Drivers Overhead Activity Cost Pools Cost Drivers Overhead 4 per Activity 5 Rates

Administration Number of partner-hours $335,000 3,350 $100 per partner-hourCustomer development Revenue billed 160,000 $4,000,000 $0.04 per $1 of revenueRecruiting and training Direct professional hours 105,000 30,000 $3.50 per hour $600,000

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Activity-Based Costing in Service Industries 185

Under activity-based costing, Check and Doublecheck assigns overhead costs of $57,200 to the Plano Moulding Company audit, as compared with $70,000 under traditional costing. Illustration 5-19 compares total costs and operating margins under the two costing systems.

Illustration 5-18Assigning overhead in a service company

1

2

3

4

5

6

7

8

9

10

AP18 fx

C EB D

Check and Doublecheck CPA.xlsCheck and Doublecheck CPA.xlsFormulas Data Review ViewPage LayoutInsertHome

AdministrationCustomer developmentRecruiting and training


Cost DriversActivity Cost Pools

ActualUse ofDrivers

Activity-Based

OverheadRates

CostAssigned

Number of partner-hoursRevenue billedDirect professional hours

335$260,000

3,800

$33,50010,40013,300

$57,200

$100.00$0.04$3.50

Illustration 5-19 shows that the assignment of overhead costs under traditional costing and ABC costing is diff erent. Th e total cost assigned to performing the audit of Plano Moulding Company is greater under traditional costing by $12,800, and the profi t margin is signifi cantly lower. Traditional costing understates the profi tability of the audit.

Illustration 5-19Comparison of traditional costing with ABC in a service company


Traditional Costing ABCRevenue $260,000 $260,000Expenses Direct professional labour $140,000 $140,000 Applied overhead 70,000 57,200 Total expenses 210,000 197,200Operating income $ 50,000 $ 62,800

Profi t margin 19.2% 24.2%


Do It! Apply ABC to Service Company

We Carry It, Inc. is a trucking company. It provides local, short-haul, and long-haul services. The company has developed the following thee cost pools.

Activity Cost Pools

Cost Drivers

Estimated Overhead


Loading and unloading Number of pieces $ 70,000 100,000 piecesTravel Kilometres driven 250,000 500,000 kmLogistics Hours 60,000 2,000 hours

(a) Calculate the activity-based overhead rates for each pool.

(b) Determine the overhead allocated to Job A1027, which has 150 pieces and requires 200 km of driving and 0.75 hours of logistics.

(continued)



Action Plan

• Divide the estimated overhead by the expected use of cost driver per activity to deter-mine activity-based overhead rate.

• Apply the activity-based overhead rate to jobs based on actual use of drivers.

Solution

(a) The activity-based overhead rates are as follows.

Activity Cost Pools

Estimated Overhead 4


Activity-Based Overhead Rate

Loading and unloading $ 70,000 100,000 pieces $0.70 per pieceTravel 250,000 500,000 km $0.50 per kmLogistics 60,000 2,000 hours $30 per hour

(b) The overhead applied to Job A1027 is (150 3 $0.70) 1 (200 3 $0.50) 1 (0.75 3 $30) 5 $227.50

Related exercise material: BE5-9, E5-21, E5-23, and Do It! D5-16.✓thenavigator

A common practice of activity-based management is to try to reduce or eliminate time spent on non–value-added activities. One study found that knowledge workers spend an average of 41% of their time on discretionary activities. How much of your day is spent on activities that do not add value? In 2010, Canadians involved in these leisure activities spent an average of the following amounts per day doing this: 2 hours and 52 minutes watching TV, 1 hour and 23 minutes using a computer, or 2 hours and 20 minutes playing video games.

What Do You Think?If you don’t know where your time is going, try keeping track of everything you do for three to seven days and make notes every hour or so. Note the time; activity; whether it was scheduled, interrupted, or urgent; and the people involved. You may be surprised at how much time is wasted. Would this help you to manage time better?

YES—There are a limited number of hours in a day. You should try to maximize your chances of achieving your goals by eliminating wasted time.NO—Being an effi ciency expert doesn’t guarantee that you will be happy. Schedules and daily planners are too constraining.

Sources: Julian Birkinshaw and Jordan Cohen, “Make Time for the Work that Matters,” Harvard Business Review, September 2013; Statistics Canada, “General Social Survey: Time Use,” The Daily, July 12, 2011; “Time Log Techniques,” www.time-management-guide.com/time-log.html.

ALL ABOUT YOU Where Does the Time Go?

A

USING THE DECISION TOOLKIT

Preece Company manufactures a line of high-end exercise equipment of commercial quality. Assume that the controller has proposed changing from a traditional costing system to an activity-based costing system. Th e vice-president fi nance is not convinced, so she requests that the next large order for equipment be costed under both systems to compare and analyze. Th e company receives an order from Slim-Way Salons, Inc., for 150 low-impact treadmills, which the control-ler identifi es as the order to use for dual costing. Th e following cost data relate to the Slim-Way order.

(continued)

(continued)


187 Using the Decision Toolkit

(continued)

Data relevant to both costing systems:Direct materials $55,500Direct labour hours 820Direct labour rate per hour $18.00

Data relevant to the traditional costing system:Th e predetermined overhead rate is 300% of direct labour cost.

Data relevant to the activity-based costing system:

Activity Cost Pools Cost Drivers Activity-Based Overhead Rate

Expected Use of Cost Drivers for

the OrderEngineering design Engineering hours $30 per hour 330Machine set-up Set-ups $200 per set-up 22Machining Machine hours $25 per hour 732Assembly Number of sub-assemblies $8 per sub-assembly 1,500Packaging and shipping Packaging/shipping hours $15 per hour 152Building occupancy Machine hours $6 per hour 732

InstructionsCalculate the total cost of the Slim-Way Salons, Inc., order under (a) the traditional costing system and (b) the activity-based costing system. (c) As a result of this comparison, which costing system is Preece likely to adopt? Why?

Solution(a) Traditional costing system:

Direct materials $ 55,500Direct labour (820 × $18) 14,760Overhead assigned ($14,760 × 300%) 44,280Total costs assigned to Slim-Way order $114,540Number of low-impact treadmills 150Cost per unit $ 763.60

(b) Activity-based costing system:

Direct materials $ 55,500Direct labour (820 × $18) 14,760Overhead activity costs:

Engineering design (330 hours 3 $30) $ 9,900Machine set-up (22 set-ups 3 $200) 4,400Machining (732 machine hours 3 $25) 18,300Assembly (1,500 sub-assemblies 3 $8) 12,000Packaging and shipping (152 hours 3 $15) 2,280Building occupancy (732 hours 3 $6) 4,392 51,272

Total costs assigned to Slim-Way order $121,532Number of low-impact treadmills 150Cost per unit $ 810.21

(c) Preece Company will likely adopt ABC because of the diff erence in the cost per unit (which ABC found to be higher). More importantly, ABC provides greater insight into the sources and causes of the cost per unit. Managers have a better understanding of which activities to control in order to reduce costs. ABC will provide better product costing and may improve profi tability for the company.

✓thenavigator



Summary of Study Objectives1. Recognize the diff erence between traditional costing and activity-

based costing (ABC) and understand the nature of ABC. A traditional costing system allocates overhead to products based on a predetermined plant-wide or department-wide volume of unit-based output rates, such as direct labour or machine hours. An ABC system allocates overhead to identify activity cost pools, and then assigns costs to products using related cost drivers that measure the activities (resources) consumed.

2. Apply activity-based costing to a manufacturer. Th e develop-ment of an activity-based costing system for a manufacturer involves four steps: (1) Identify and classify the major activitiesthat pertain to the manufacture of specifi c products, and allocate manufacturing overhead costs to the appropriate cost pools. To identify activity cost pools, a company must perform an analysis of each operation or process, documenting and timing every task, action, or transaction. (2) Identify the cost driver that has a strong correlation to the costs accumulated in each activity cost pool. Cost drivers that companies identify for activity cost pools must (a) accurately measure the actual consumption of the activity by the various products, and (b) have data on them that are easily available. (3) Calculate the activity-based overhead rate per cost driver. (4) Use the cost drivers to assign overhead costs for each activity cost pool to products or services.

3. Understand the benefi ts and limitations of activity-based costing. What makes ABC a more accurate product cost-ing system is (1) the increased number of cost pools used

to assign overhead, (2) the enhanced control over overhead costs, and (3) the better management decisions it makes pos-sible. Th e limitations of ABC are (1) the higher analysis and measurement costs that accompany multiple activity centres and cost drivers, and (2) the need to still allocate some costs arbitrarily.

Value-added activities increase the worth of a product or service. Non–value-added activities simply add cost to, or increase the time spent on, a product or service without increasing its market value. Being aware of these classifi ca-tions helps managers reduce or eliminate the time spent on the non–value-added activities.

Activities may be classifi ed as unit-level, batch-level, product-level, and facility-level. A company controls overhead costs at unit, batch, product, and facility levels by modifying unit-, batch-, product-, and facility-level activities, respectively. Failure to recognize this classifi cation of levels can result in distorted product costing.

4. Apply activity-based costing to service industries. Th e overall objective of using ABC in service industries is the same as in manufacturing industries; that is, improved costing of the services provided (by job, service, contract, or customer). Th e general approach to costing is the same: analyze operations, identify activities, accumulate overhead costs by activity cost pools, and identify and use cost drivers to assign the cost pools to the services.

✓thenavigator

DECISION TOOLKIT—A SUMMARY


When should we use ABC? Knowledge of the products or product lines, the manufacturing process, overhead costs, and managers’ needs for accurate cost information

A detailed and accurate cost accounting system; co-operation between accountants and operating managers

Compare the results under both costing systems. If managers are better able to understand and control their operations using ABC, and the costs are not prohibitive, the use of ABC would be benefi cial.

How can ABC help managers manage the business?

Activities classifi ed as value-added or non–value-added

The activity analysis fl owchart extended to identify each activity as value-added or non–value-added

The fl owchart should motivate managers to minimize non–value-added activities. Managers should better understand the relationship between activities and the resources they consume.

✓thenavigator


Comprehensive Do It! 189

Activity Any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service. (p. 171)

Activity-based costing (ABC) An overhead cost allocation system that allocates overhead to multiple activity cost pools and assigns the activity cost pools to products or services by using cost drivers that represent the activities used. (p. 170)

Activity-based management (ABM) An extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision-making. (p. 181)

Activity cost pool Th e overhead cost allocated to a distinct type of activity or related activities. (p. 171)

Batch-level activities Activities performed for each batch of products. (p. 178)

Cost driver Any factor or activity that has a direct cause–eff ect relationship with the resources consumed. In ABC, companies

use cost drivers to assign activity cost pools to products or services. (p. 171)

Facility-level activities Activities required to support or sustain an entire production process that are not dependent on the number of products, batches, or units produced. (p. 178)

Non–value-added activity An activity that adds cost to, or increases the time spent on, a product or service without increas-ing its market value. (p. 179)

Product-level activities Activities performed for and identifi -able with an entire product line. (p. 178)

Unit-level activities Activities performed for each unit of production. (p. 178)

Value-added activity An activity that increases the worth of a product or service. (p. 179)

Glossary

Comprehensive Do It!Spreadwell Paint Company manufactures two high-quality base paints: an oil-based paint and a latex paint. Both paints are house paints and are manufactured in a neutral white colour only. Th e white base paints are sold to franchised retail paint and decorating stores, which add pigments to tint (colour) the paint as desired by the customer. Th e oil-based paint is made from petroleum products, and is thinned and cleaned with organic solvents such as mineral spirits or turpentine. Th e latex paint is made from water, and thinned and cleaned with it; synthetic resin particles that are suspended in the water dry and harden when exposed to the air. Spreadwell uses the same processing equipment to produce both paints in diff erent production runs. Between batches, the vats and other processing equipment must be washed and cleaned. Aft er analyzing the company’s entire operations, Spreadwell’s accountants and production managers have identifi ed activity cost pools and have accumulated annual budgeted overhead costs for each pool as follows:

Activity Cost Pools Estimated OverheadPurchasing $ 240,000Processing (weighing and mixing, grinding, thinning

and drying, straining) 1,400,000Packaging (1-litre and 5-litre containers) 580,000Testing 240,000Storage and inventory control 180,000Washing and cleaning equipment 560,000Total annual budgeted overhead $3,200,000

(continued)



(continued)

With further analysis, the company identifi ed activity cost drivers and scheduled their expected use by product and activity as follows:


Activity Cost Pools Cost Drivers

Expected Use of Cost Drivers per Activity Oil-Based Latex

Purchasing Purchase orders 1,500 orders 800 700Processing Litres processed 1,000,000 litres 400,000 600,000Packaging Containers fi lled 400,000 containers 180,000 220,000Testing Number of tests 4,000 tests 2,100 1,900Storing Average number

of litres on hand 18,000 litres 10,400 7,600Washing Number of

batches 800 batches 350 450

Spreadwell has budgeted 400,000 litres of oil-based paint and 600,000 litres of latex paint for processing during the year.

Instructions(a) Prepare a schedule showing the calculations of the activity-based overhead rates.(b) Prepare a schedule that assigns each activity’s overhead cost pool to each product.(c) Calculate the overhead cost per unit for each product.(d) Classify each activity cost pool as value-added or non–value-added.

Solution to Comprehensive Do It!(a) Calculations of activity-based overhead rates:

Activity Cost Pools

Estimated Overhead



Purchasing $ 240,000 1,500 orders $160 per orderProcessing 1,400,000 1,000,000 litres $1.40 per litrePackaging 580,000 400,000 containers $1.45 per containerTesting 240,000 4,000 tests $60 per testStoring 180,000 18,000 litres $10 per litreWashing 560,000 800 batches $700 per batch

$3,200,000

(b) Assignment of activity cost pools to products: oil-based paint and latex paint

Oil-Based Paint Latex Paint

Activity Cost Pools

Expected Use of

DriversOverhead

RatesCost

Assigned

Expected Use of

DriversOverhead

RatesCost

AssignedPurchasing 800 $160 $ 128,000 700 $160 $ 112,000Processing 400,000 $1.40 560,000 600,000 $1.40 840,000Packaging 180,000 $1.45 261,000 220,000 $1.45 319,000Testing 2,100 $60 126,000 1,900 $60 114,000Storing 10,400 $10 104,000 7,600 $10 76,000Washing 350 $700 245,000 450 $700 315,000Total overhead assigned $1,424,000 $1,776,000

(c) Calculation of overhead cost assigned per unit:

Oil-Based Paint Latex PaintTotal overhead cost assigned $1,424,000 $1,776,000Total litres produced 400,000 600,000Overhead cost per litre $3.56 $2.96

(d) Value-added activities: processing and packaging; Non–value-added activities: purchasing, testing, storing, and washing

✓thenavigator

Action Plan

• Identify the major activities

that pertain to the manu-

facture of specifi c products

and allocate manufacturing

overhead costs to activity

cost pools.

• Identify the cost drivers

that accurately measure

each activity’s contribution

to the fi nished product.

• Calculate the activity-

based overhead rates.

• Assign manufactur-

ing overhead costs for

each activity cost pool

to products, using the

activity-based overhead

rates.


Brief Exercises 191

Self-Test, Brief Exercises, Exercises, Problems—Set A, and many more components are available for practice in WileyPlus.

Self-Study Questions Answers are at the end of the chapter.(SO 1) 1. Activity-based costing (ABC)

(a) can be used only in a process cost system.(b) focuses on units of production.(c) focuses on activities performed to produce a

product.(d) uses only a single basis of allocation.

(SO 1) 2. Activity-based costing(a) is the initial phase of converting to a just-in-

time operating environment.(b) can be used only in a job-order costing system.(c) is a two-stage overhead cost allocation system

that identifi es activity cost pools and cost drivers.(d) uses direct labour as its primary cost driver.

(SO 1, 2) 3. Any activity that causes resources to be consumed is called a(a) just-in-time activity.(b) facility-level activity.(c) cost driver.(d) non–value-added activity.

(SO 2) 4. Th e overhead rate for Machine Set-ups is $100 per set-up. Products A and B have 80 and 60 set-ups, respectively. Th e overhead assigned to each product is(a) Product A $8,000, Product B $8,000.(b) Product A $8,000, Product B $6,000.(c) Product A $6,000, Product B $6,000.(d) Product A $6,000, Product B $8,000.

(SO 2) 5. Donna Crawford Co. has identifi ed an activity cost pool to which it has allocated estimated overhead of $1,920,000. It has determined the expected use of cost drivers for that activity to be 160,000 inspec-tions. Widgets require 40,000 inspections, Gadgets 30,000 inspections, and Targets, 90,000 inspections. Th e overhead assigned to each product is(a) Widgets $40,000, Gadgets $30,000, Targets

$90,000.(b) Widgets $480,000, Gadgets $360,000, Targets

$108,000.

(c) Widgets $360,000, Gadgets $480,000, Targets $1,080,000.

(d) Widgets $480,000, Gadgets $360,000, Targets $1,080,000.

(SO 3) 6. An activity that adds costs to the product but does not increase its market value is a(a) value-added activity.(b) cost driver.(c) cost-benefi t activity.(d) non–value-added activity.

(SO 3) 7. Th e following activity is value-added:(a) Storage of raw materials(b) Moving parts from machine to machine(c) Shaping a piece of metal on a lathe(d) All of the above.

(SO 3) 8. A relevant facility-level cost driver for heating costs is(a) machine hours.(b) direct material.(c) fl oor space.(d) direct labour costs.

(SO 1, 2) 9. An activity that has a direct cause–eff ect relation-ship with the resources consumed is a(n)(a) cost driver.(b) overhead rate.(c) cost pool.(d) product activity.

(SO 1, 2) 10. Th e fi rst step in activity-based costing is to(a) assign manufacturing overhead costs for each

activity cost pool to products.(b) calculate the activity-based overhead rate per

cost driver.(c) identify and classify the major activities in-

volved in the manufacture of specifi c products.(d) identify the cost driver that has a strong correla-

tion to the activity cost pool.

✓thenavigator

Brief ExercisesBE5-1 Infotrac Inc. sells a high-speed retrieval system for information. It provides the following information for the year.

Budgeted ActualOverhead cost $1,000,000 $950,000Machine hours 50,000 45,000Direct labour hours 100,000 92,000

(SO 1)Identify diff erences between costing systems.



Overhead is applied on the basis of machine hours.(a) Calculate the predetermined overhead rate.(b) Determine the amount of overhead applied for the year.(c) Explain how an activity-based costing system might diff er in terms of calculating a predetermined overhead rate.

BE5-2 Sassafras Inc. has conducted an analysis of overhead costs related to one of its product lines using a traditional costing system (volume-based) and an activity-based costing system. Following are its results:

Traditional Costing ABCSales revenues $600,000 $600,000Overhead costs:

Product RX3 $ 34,000 $ 50,000Product Y12 36,000 20,000

$ 70,000 $ 70,000

Explain how a diff erence in the overhead costs between the two systems may have occurred.

BE5-3 Altex Co. identifi es the following activities that pertain to manufacturing overhead: materials handling, machine set-ups, factory machine maintenance, factory supervision, and quality control. For each activity, identify an appropriate cost driver.

BE5-4 Ayala Company manufactures four products in a single production facility. Th e company uses activity-based costing. Th e company has identifi ed the following activities through its activity analysis: (a) inventory control, (b) ma-chine set-ups, (c) employee training, (d) quality inspections, (e) material ordering, (f) drilling operations, and (g) building maintenance. For each activity, name a cost driver that might be used to assign overhead costs to products.

BE5-5 Mordica Company identifi es three activities in its manufacturing process: machine set-ups, machining, and inspections. Estimated annual overhead cost for each activity is $150,000, $325,000, and $87,500, respectively. Th e cost driver for each activity and the expected annual usage are: number of set-ups 2,500, machine hours 25,000, and number of inspections 1,750. Calculate the overhead rate for each activity.

BE5-6 Coats Galore, Inc. uses activity-based costing as the basis for information to set prices for its six lines of seasonal coats. Calculate the activity-based overhead rates using the following budgeted data for each of the activity cost pools.

Activity Cost PoolsEstimated Overhead


Designing $ 450,000 10,000 designer hoursSizing and cutting 4,000,000 160,000 machine hoursStitching and trimming 1,440,000 80,000 labour hoursWrapping and packing 336,000 32,000 fi nished units

BE5-7 Computer Parts, Inc., a manufacturer of computer chips, employs activity-based costing. Th e following budgeted data for each of the activity cost pools are provided below for the year 2016.

Activity Cost PoolsEstimated Overhead


Ordering and receiving $ 90,000 12,000 ordersEtching 480,000 60,000 machine hoursSoldering 1,760,000 440,000 labour hours

For 2016, the company had 11,000 orders and used 50,000 machine hours, and labour hours totalled 500,000. What is the total overhead applied?

BE5-8 Hirani Novelty Company identifi ed the following activities in its production and support operations. Classify each of these activities as either value-added or non–value-added.

(SO 1)Identify diff erences between costing systems.

(SO 2)Identify cost drivers.

(SO 2)Identify cost drivers.

(SO 2)Calculate activity-based overhead activities.

(SO 2)Calculate activity-based overhead rates.

(SO 2)Calculate activity-based overhead rates.

(SO 3)Classify activities as value-added or non–value-added.

(a) Purchasing(b) Receiving(c) Design engineering(d) Storing inventory

(e) Cost accounting(f) Moving work in process(g) Inspecting and testing(h) Painting and packing


Do It! Review 193

BE5-9 Wu and Martin is an architectural fi rm that is contemplating the installation of activity-based costing. Th e following activities are performed daily by staff architects. Classify these activities as value-added or non–value-added: (a) designing and draft ing, 3 hours; (b) staff meetings, 1 hour; (c) on-site supervision, 2 hours; (d) lunch, 1 hour; (e) con-sultation with client on specifi cations, 1.5 hours; (f) entertaining a prospective client for dinner, 2 hours.

BE5-10 Quick Pix is a large digital processing centre that serves 130 outlets in grocery stores, service stations, camera and photo shops, and drug stores in 16 nearby towns. Quick Pix operates 24 hours a day, six days a week. Classify each of the following activity costs of Quick Pix as either unit-level, batch-level, product-level, or facility-level.

(SO 3, 4)Classify service company activities as value-added or non–value-added.

(SO 3, 4)Classify activities according to level.

(a) Colour printing materials(b) Photocopy paper(c) Depreciation of machinery(d) Set-ups for enlargements(e) Supervisor’s salary

(f) Ordering materials(g) Pickup and delivery(h) Commission to dealers(i) Insurance on the building(j) Loading developing machines

BE5-11 Tool Time, Inc. operates 20 injection moulding machines in the production of tool boxes of four diff erent sizes, named the Apprentice, the Handyman, the Journeyman, and the Professional. Classify each of the following costs as unit-level, batch-level, product-level, or facility-level.

(SO 3)Classify activities according to level.

(a) First-shift supervisor’s salary(b) Powdered raw plastic(c) Dies for casting plastic components(d) Depreciation on injection moulding machines

(e) Changing dies on machines(f) Moving components to the assembly department(g) Engineering design(h) Employee health and medical insurance coverage

BE5-12 Spin Cycle Company uses three activity pools to apply overhead to its products. Each activity has a cost driver used to allocate the overhead costs to the product. Th e activities and related overhead costs are as follows: product design $40,000; machining $300,000; and material handling $100,000. Th e cost drivers and expected use are as follows.

Expected Use of Cost Drivers Activities

Cost Drivers per Activity

Product design Number of product changes 10Machining Machine hours 150,000Material handling Number of set-ups 100

(a) Calculate the predetermined overhead rate for each activity.(b) Classify each of these activities as unit-level, batch-level, product-level, or facility-level.

(SO 2, 3)Calculate rates and activity levels.

Do It! ReviewD5-13InstructionsIndicate whether the following statements are true or false.(a) Th e reasoning behind ABC cost allocation is that products consume activities and activities consume resources.(b) Activity-based costing is an approach for allocating direct labour to products.(c) In today’s increasingly automated environment, direct labour is never an appropriate basis for allocating costs to

products.(d) A cost driver is any factor or activity that has a direct cause–eff ect relationship with resources consumed.(e) Activity-based costing segregates overhead into various cost pools in an eff ort to provide more accurate cost information.

D5-14 Weber Industries has three activity cost pools and two products. It expects to produce 3,000 units of Product BC113 and 1,400 of Product AD908. Having identifi ed its activity cost pools and the cost drivers for each pool, Weber ac-cumulated the following data relative to those activity cost pools and cost drivers.

Annual Overhead DataExpected Use of Cost Drivers per Product

Activity Cost Pool Cost DriversEstimated Overhead


Product BC113

Product AD908

Machine set-up Set-ups $ 16,000 40 25 15Machining Machine hours 110,000 5,000 1,000 4,000Packing Orders 30,000 500 150 350

(SO 1)Identify characteristics of traditional and ABC costing systems.

(SO 2)Calculate activity-based overhead rates and assign overhead using ABC.



Instructions(a) Prepare a schedule showing the calculations of the activity-based overhead rates per cost driver.(b) Prepare a schedule assigning each activity’s overhead cost to the two products.(c) Calculate the overhead cost per unit for each product. (Round to nearest cent.)(d) Comment on the comparative overhead cost per product.

D5-15 Good Harvest Company manufactures four lines of garden tools. As a result of an activity analysis, the accounting department has identifi ed eight activity cost pools. Each of the product lines is produced in large batches, with the whole plant devoted to one product at a time.InstructionsClassify each of the following activities or costs as unit-level, batch-level, product-level, or facility-level.

(SO 3)Classify activities according to level.

(a) Machining parts(b) Product design(c) Plant maintenance(d) Machine set-up

(e) Assembling parts(f) Purchasing raw materials(g) Property taxes(h) Painting

D5-16 Ready Ride is a trucking company. It provides local, short-haul, and long-haul services. It has developed the fol-lowing three cost pools.

Activity Cost Pools Cost Drivers Estimated OverheadExpected Use of Cost Driver

per ActivityLoading and unloading Number of pieces $ 90,000 90,000Travel Kilometres driven 450,000 600,000Logistics Hours 75,000 3,000

Instructions(a) Calculate the activity-based overhead rates for each pool.(b) Determine the overhead allocated to Job XZ3275, which has 150 pieces, requires 200 km of driving, and 0.75 hours

of logistics.

(SO 4)Apply ABC to a service company.

ExercisesE5-17 Elle Inc. has two types of handbags: standard and custom. Th e controller has decided to use a plant-wide overhead rate based on direct labour costs. Th e president has heard of activity-based costing and wants to see how the results would diff er if this system were used. Two activity cost pools were developed: machining and machine set-up. Presented below is information related to the company’s operations.

Standard CustomDirect labour costs $50,000 $100,000Machine hours 500 1,000Set-up hours 100 400

Total estimated overhead costs are $277,500. Th e overhead cost allocated to the machining activity cost pool is $177,000, and $100,500 is allocated to the machine set-up activity cost pool.Instructions(a) Calculate the overhead rate using the traditional (plant-wide) approach.(b) Calculate the overhead rate using the activity-based costing approach.(c) Determine the diff erence in allocation between the two approaches.

E5-18 Khan Inc. has conducted the following analysis related to its product lines using a traditional costing system (volume-based) and an activity-based costing system. Both the traditional and the activity-based costing systems include direct materials and direct labour costs.

Total CostsProducts Sales Revenue Traditional ABCProduct 440X $180,000 $55,000 $50,000Product 137Y 160,000 50,000 35,000Product 249S 70,000 15,000 35,000

Instructions(a) For each product line, calculate operating income using the traditional costing system.(b) For each product line, calculate operating income using the activity-based costing system.

(SO 1, 2)Assign overhead using traditional costing and ABC.

(SO 1)Explain the diff erence between traditional and activity-based costing.


Exercises 195

(c) Using the following formula, calculate the percentage diff erence in operating income for each of Khan’s product lines: [Operating Income (ABC) 2 Operating Income (traditional cost)] 4 Operating Income (traditional cost). (Round the percentage to two decimals.)

(d) Provide a rationale for why the costs for Product 440X are approximately the same using either the traditional or activity-based costing system.

E5-19 International Fabrics has budgeted overhead costs of $955,000. It has allocated overhead on a plant-wide basis to its two products (wool and cotton) using direct labour hours, which are estimated to be 477,500 for the current year. Th e company has decided to experiment with activity-based costing and has created two activity cost pools and related activity cost drivers. Th ese two cost pools are cutting (the cost driver is machine hours) and design (the cost driver is the number of set-ups). Overhead allocated to the cutting cost pool is $400,000 and $555,000 is allocated to the design cost pool. Additional information related to these pools is as follows:

Wool Cotton TotalMachine hours 100,000 100,000 200,000Number of set-ups 1,000 500 1,500

Instructions(a) Determine the amount of overhead allocated to the wool product line and the cotton product line using activity-based

costing.(b) What is the diff erence between the allocation of overhead to the wool and cotton product lines using activity-based cost-

ing versus the traditional approach, assuming direct labour hours were incurred evenly between the wool and cotton?

E5-20 Alonzo Inc. manufactures two products: car wheels and truck wheels. To determine the amount of overhead to assign to each product line, the controller, YuYu Ortega, has developed the following information:

Car TruckEstimated wheels produced 40,000 10,000Direct labour hours per wheel 2 6

Total estimated overhead costs for the two product lines are $840,000.Instructions(a) Calculate the overhead cost assigned to the car wheels and truck wheels, assuming that direct labour hours is used to

allocate overhead costs.(b) YuYu is not satisfi ed with the traditional method of allocating overhead because he believes that most of the overhead

costs relate to the truck wheel product line because of its complexity. He therefore develops the following three activity cost pools and related cost drivers to better understand these costs:

Activity Cost Pools Expected Use of Cost Drivers Estimated Overhead CostsSetting up machines 500 set-ups $260,000Assembling 35,000 labour hours 280,000Inspection 600 inspections 300,000

Calculate the activity-based overhead rates for these three cost pools.(c) Calculate the cost that is assigned to the car and truck product lines using an activity-based costing system, given the

following information:

Expected Use of Cost Drivers per ProductCar Truck

Number of set-ups 100 400Direct labour hours 20,000 15,000Number of inspections 50 550

(d) What do you believe YuYu should do?

E5-21 Shady Lady sells window coverings to both commercial and residential customers. Th e following information relates to its budgeted operations for the current year:

Commercial ResidentialRevenues $300,000 $480,000Direct material costs $ 30,000 $ 70,000Direct labour costs 100,000 300,000Overhead costs 55,000 185,000 162,000 532,000Operating income (loss) $115,000 $ (52,000)



(SO 1, 2, 4)Assign overhead using traditional costing and ABC.



Th e controller, Susan Chan, is concerned about the residential product line. She cannot understand why this line is not more profi table given that window coverings are less complex to install for residential customers. In addition, the residential client base resides close to the company offi ce, so travel costs are not as expensive on a per-client visit for resi-dential customers. As a result, she has decided to take a closer look at the overhead costs assigned to the two product lines to determine whether a more accurate product costing model can be developed. Following are the three activity cost pools and related information she developed:

Activity Cost Pools Estimated Overhead Cost DriversScheduling and travel $84,000 Hours of travelSet-up time 77,000 Number of set-upsSupervision 56,000 Direct labour cost


Commercial ResidentialScheduling and travel 1,000 680Set-up time 450 250

Instructions(a) Calculate the activity-based overhead rates for each of the three cost pools, and determine the overhead cost assigned

to each product line.(b) Calculate the operating income for each product line, using the activity-based overhead rates.(c) What do you believe Susan Chan should do?

E5-22 Perdon Corporation manufactures safe—large mobile safes and large walk-in stationary bank safes. As part of its annual budgeting process, Perdon is analyzing the profi tability of its two products. Part of this analysis involves estimating the amount of overhead to be allocated to each product line. Th e information shown below relates to overhead.

Mobile Safes Walk-In SafesUnits planned for production 200 50Material moves per product line 300 200Purchase orders per product line 450 350Direct labour hours per product line 800 1,700

Instructions(a) Th e total estimated manufacturing overhead was $260,000. Under traditional costing (which assigns overhead on the

basis of direct labour hours), what amount of manufacturing overhead costs are assigned to:1. One mobile safe?2. One walk-in safe?

(b) Th e total estimated manufacturing overhead of $260,000 was composed of $160,000 for material handling costs and $100,000 for purchasing activity costs. Under activity-based costing (ABC):1. What amount of material handling costs are assigned to:

a. One mobile safe? b. One walk-in safe?

2. What amount of purchasing activity costs are assigned to: a. One mobile safe? b. One walk-in safe?(c) Compare the amount of overhead allocated to one mobile safe and to one walk-in safe under the traditional costing

approach versus under ABC.

E5-23 Quik Prints Company is a small printing and copying fi rm with three high-speed off set printing presses, fi ve copiers (two colour and three black and white), one collator, one cutting and folding machine, and one fax machine. To improve its pricing practices, owner-manager Damon Whitebone is installing activity-based accounting. Damon employs fi ve employees: two printers/designers, one receptionist/bookkeeper, one salesperson/copy-machine operator, and one janitor/delivery clerk. Damon can operate any of the machines and, in addition to managing the entire operation, performs the training, designing, selling, and marketing functions.InstructionsAs Quik Prints’ independent accountant who prepares tax forms and quarterly fi nancial statements, you have been asked to identify the activities that would be used to accumulate overhead costs for assignment to jobs and customers. Using your knowledge of a small printing and copying fi rm (and some imagination), identify at least 12 activity cost pools as the start of an activity-based costing system for Quik Prints Company.

E5-24 Galavic Corporation manufactures snowmobiles in its Blue Mountain plant. It has budgeted the following costs for the fi rst quarter’s operations.


(SO 2, 4)Identify activity cost pools.

(SO 2)Identify activity cost pools and cost drivers.


Exercises 197

Machine set-up, indirect materials $ 4,000Inspections 16,000Tests 4,000Insurance, plant 110,000Engineering design 140,000Depreciation, machinery 520,000Machine set-up, indirect labour 20,000

Property taxes $ 29,000Oil, heating 19,000Electricity, plant lighting 21,000Engineering prototypes 60,000Depreciation, plant 210,000Electricity, machinery 36,000Custodial (machine maintenance) wages 19,000

InstructionsClassify the above costs of Galavic Corporation into activity cost pools using the following: engineering, machinery, machine set-up, quality control, factory utilities, and maintenance. Th en identify a cost driver that may be used to assign each cost pool to each line of snowmobiles.

E5-25 Peter Catalano’s Verde Vineyards, in the Niagara Peninsula, produces three varieties of wine: merlot, viognier, and pinot noir. His winemaster, Kyle Pohle, has identifi ed the following activities as cost pools for accumulating overhead and assigning it to products.

1. Culling and replanting: Dead or overcrowded vines are culled, and new vines are planted or relocated. (Each variety has a separate vineyard.)

2. Tying: Th e posts and wires are reset, and vines are tied to the wires for the dormant season.3. Trimming: At the end of the harvest, the vines are cut and trimmed back in preparation for the next season.4. Spraying: Th e vines are sprayed with chemicals for protection against insects and fungi.5. Harvesting: Th e grapes are hand-picked, placed in carts, and transported to the crushers.6. Stemming and crushing: Cartfuls of bunches of grapes of each variety are separately loaded into machines, which

remove stems and gently crush the grapes.7. Pressing and fi ltering: Th e crushed grapes are transferred to presses, which mechanically remove the juices and fi lter

out bulk and impurities.8. Fermentation: Th e grape juice, by variety, is fermented in either stainless-steel tanks or oak barrels.9. Aging: Th e wines are aged in either stainless-steel tanks or oak barrels for one to three years, depending on the

variety.10. Bottling and corking: Bottles are machine-fi lled and corked.11. Labelling and boxing: Each bottle is labelled, as is each nine-bottle case, with the name of the vintner, vintage, and

variety.12. Storing: Packaged and boxed bottles are stored awaiting shipment.13. Shipping: Th e wine is shipped to distributors and private retailers.14. Heating and air-conditioning of plant and offi ces.15. Maintenance of buildings and equipment: Printing, repairs, replacements, and general maintenance are performed

in the off -season.InstructionsFor each of Verde’s 15 activity cost pools, identify a probable cost driver that might be used to assign overhead costs to its three wine varieties.

E5-26 Fontillas Instrument, Inc. manufactures two products: missile range instruments and space pressure gauges. During April, it produced 50 range instruments and 300 pressure gauges and incurred estimated overhead costs of $94,500. An analysis of estimated overhead costs reveals the following activities:

Activities Cost Drivers Total Cost1. Materials handling Number of requisitions $40,0002. Machine set-ups Number of set-ups 27,5003. Quality inspections Number of inspections 27,000

$94,500

Th e cost driver volume for each product was as follows:

Cost Drivers Instruments Gauges TotalNumber of requisitions 400 600 1,000Number of set-ups 150 300 450Number of inspections 200 400 600

Instructions(a) Determine the overhead rate for each activity.(b) Assign the manufacturing overhead costs for April to the two products using activity-based costing.(c) Write a memorandum to the president of Fontillas Instrument explaining the benefi ts of activity-based costing.

(SO 2)Identify activity cost drivers.

(SO 2, 3)Calculate overhead rates, assign overhead using ABC, and discuss the advantages of ABC.



E5-27 H&Y Company uses four activity pools to apply overhead to its products. Each activity has a cost driver used to allocate the overhead costs to the product. Th e activities and related overhead costs are as follows:

Activity Total Costs Volume of Cost DriverMaterial handling $ 200,000 100,000 partsPurchase orders 210,000 35 ordersSet-up hours 300,000 150 hoursMachining 480,000 3,000 machine hoursTotal costs $1,190,000

Th e above activities are used by the two diff erent products as follows:

PC-21 WX-34Material handling 75,000 parts 25,000 partsPurchase orders per product 15 20Set-up hours 100 hours 50 hoursNumber of machine hours 2,000 machine hours 1,000 machine hours

Instructions(a) Calculate how much of the material handling cost will be allocated to PC-21.(b) Determine the ABC allocation rate for Purchase orders.(c) Calculate how much of the Set-up costs will be allocated to WX-34.(d) Calculate how much of the total activity costs will be allocated to PC-21.

E5-28 Lim Clothing Company manufactures its own designed and labelled sports attire and sells its products through catalogue sales and retail outlets. While Lim has used activity-based costing in its manufacturing activities for years, it has always used traditional costing in assigning its selling costs to its product lines. Selling costs have traditionally been assigned to Lim’s product lines at a rate of 80% of direct material costs. Its direct material costs for the month of March for Lim’s “high-intensity” line of attire are $400,000. Th e company has decided to extend activity-based costing to its selling costs. Data relating to the high-intensity line of products for the month of March are as follows:

Activity Cost Pools Cost Drivers Overhead Rate

Number of Cost Drivers Used per Activity

Sales commissions Dollar sales $0.06 per dollar sales $950,000Advertising—TV/Radio Minutes $300 per minute 250Advertising—Newspaper Column inches $10 per column inch 2,000Catalogues Catalogues mailed $2.50 per catalogue 6,000Cost of catalogue sales Catalogue orders $1 per catalogue order 9,000Credit and collection Dollar sales $0.04 per dollar sales $950,000

Instructions(a) Calculate the selling costs to be assigned to the high-intensity line of attire for the month of March using

1. the traditional product costing system (direct material cost is the cost driver), and2. activity-based costing.

(b) By what amount does the traditional product costing system under-cost or over-cost the high-intensity product line?(c) Classify each of the activities as value-added or non–value-added.

E5-29 Healthy Products, Inc. uses a traditional product costing system to assign overhead costs uniformly to all prod-ucts. To meet Canadian Food Inspection Agency (CFIA) requirements and to assure its customers of safe, sanitary, and nutritious food, Healthy Products engages in a high level of quality control. It assigns its quality-control overhead costs to all products at a rate of 17% of direct labour costs. Its direct labour cost for the month of June for its low-calorie dessert line is $65,000. In response to repeated requests from its vice-president, fi nance, Healthy’s management agrees to adopt activity-based costing. Data relating to the low-calorie dessert line for the month of June are as follows:

Activity Cost Pools Cost Drivers Rate

Number of Cost Drivers Used per

ActivityInspections of material

receivedNumber of kilograms $0.80 per kilogram 6,000 kilograms

In-process inspections Number of servings $0.33 per serving 10,000 servingsCFIA certifi cation Customer orders $12.00 per order 420 orders

(SO 2, 3)Calculate overhead rates and assign overhead using ABC.

(SO 1, 2, 3)Assign overhead using traditional costing and ABC; classify activities as value-added or non–value-added.

(SO 1, 2, 3)Assign overhead using traditional costing and ABC; classify activi-ties as value-added or non–value-added.


Exercises 199

Instructions(a) Calculate the quality-control overhead cost to be assigned to the low-calorie dessert product line for the month of

June using1. the traditional product costing system (direct labour cost is the cost driver), and2. activity-based costing.

(b) By what amount does the traditional product costing system under-cost or over-cost the low-calorie dessert line?(c) Classify each of the activities as value-added or non–value-added.

E5-30 In an eff ort to expand the usefulness of its activity-based costing system, Peter Catalano’s Verde Vineyards decides to adopt activity-based management techniques (ABM). One of these ABM techniques is classifying its activities as either value-added or non–value-added.InstructionsUsing Verde’s list of 15 activity cost pools in E5-25, classify each of the activities as either value-added or non–value-added.

E5-31 Anna Bellatorre, Inc. is interested in using its activity-based costing system to improve its operating effi ciency and its profi t margins by applying activity-based management techniques. As part of this undertaking, you have been asked to classify its plant activities as value-added or non–value-added.InstructionsUsing the list of activities below, classify each activity as either value-added or non–value-added.



(a) Designing new models(b) Purchasing raw materials and parts(c) Storing and managing inventory(d) Receiving and inspecting raw materials and parts(e) Interviewing and hiring new personnel(f) Machine forming sheet steel into appliance parts

(g) Manually assembling parts into appliances(h) Training all employees of the company(i) Insuring all tangible fi xed assets(j) Supervising production(k) Maintaining and repairing machinery and equipment(l) Painting and packaging fi nished appliances

E5-32 Duplessis and Najarali is a law fi rm that is initiating an activity-based costing system. Réjean Duplessis, the senior partner and a strong supporter of ABC, has prepared the following list of activities performed by a typical lawyer in a day at the fi rm:

Activities HoursWriting contracts and letters 1.0Attending staff meetings 0.5Taking depositions 1.0Doing research 1.0Travelling to/from court 1.0Contemplating legal strategy 1.0Eating lunch 1.0Litigating a case in court 2.5Entertaining a prospective client 2.0

InstructionsClassify each of the activities listed by Réjean Duplessis as value-added or non–value-added and defend your classifi cation. How much time was value-added and how much was non–value-added?

E5-33 Having itemized its costs for the fi rst quarter of next year’s budget, Galavic Corporation wants to install an activity-based costing system. First, it identifi ed the activity cost pools in which to accumulate factory overhead; second, it identifi ed the relevant cost drivers. (Th is was done in E5-24.)InstructionsUsing the activity cost pools identifi ed in E5-24, classify each of those cost pools as either unit-level, batch-level, product-level, or facility-level.

E5-34 Otto Dieff enbach & Sons, Inc. is a small manufacturing company that uses activity-based costing. Dieff enbach & Sons accumulates overhead in the following activity cost pools.

(SO 3, 4)Classify service company activities as value-added or non–value-added.

(SO 3)Classify activities by level.

(SO 3)Classify activities by level.1. Hiring personnel

2. Managing parts inventory3. Purchasing4. Testing prototypes5. Designing products

6. Setting up equipment7. Training employees8. Inspecting machine parts9. Machining

10. Assembling

InstructionsFor each activity cost pool, indicate whether the activity cost pool would be unit-level, batch-level, product-level, or facility-level.



Problems: Set AP5-35A FireOut, Inc. manufactures steel cylinders and nozzles for two models of fi re extinguishers: (1) a home fi re extinguisher and (2) a commercial fi re extinguisher. Th e home model is a high-volume (54,000 units), half-litre cylinder that holds 2.5 kilograms of multi-purpose dry chemical at 480 PSI (pounds per square inch). Th e commercial model is a low-volume (10,200 units), two-litre cylinder that holds 10 kilograms of multi-purpose dry chemical at 390 PSI. Both products require 1.5 hours of direct labour for completion. Th erefore, total annual direct labour hours are 96,300 or [1.5 hrs. 3 (54,000 1 10,200)]. Expected annual manufacturing overhead is $1,502,280. Th us, the predetermined overhead rate is $15.60 or ($1,502,280 4 96,300) per direct labour hour. Th e direct materials cost per unit is $18.50 for the home model and $26.50 for the commercial model. Th e direct labour cost is $19 per unit for both the home and the commercial models.

Th e company’s managers identifi ed six activity cost pools and related cost drivers, and accumulated overhead by cost pool as follows:



Expected Use of Drivers by ProductHome Commercial

Receiving Kilograms $ 70,350 335,000 215,000 120,000Forming Machine hours 150,500 35,000 27,000 8,000Assembling Number of parts 390,600 217,000 165,000 52,000Testing Number of tests 51,000 25,500 15,500 10,000Painting Litres 52,580 5,258 3,680 1,578Packing and shipping Kilograms 787,250 335,000 215,000 120,000

$1,502,280Instructions(a) Under traditional product costing, calculate the total unit cost of each product. Prepare a simple comparative schedule

of the individual costs by product (similar to Illustration 5-4).(b) Under ABC, prepare a schedule showing the calculations of the activity-based overhead rates (per cost driver).(c) Prepare a schedule assigning each activity’s overhead cost pool to each product based on the use of cost drivers.

(Include a calculation of overhead cost per unit, rounding to the nearest cent.)(d) Calculate the total cost per unit for each product under ABC.(e) Classify each of the activities as a value-added activity or a non–value-added activity.(f) Comment on

1. the comparative overhead cost per unit for the two products under ABC, and2. the comparative total costs per unit under traditional costing and ABC.

P5-36A Allen Inc. is a manufacturer of quality shoes. Th e company has always used a plant-wide allocation rate for allocating manufacturing overhead to its products. Th e plant manager believes it is time to change to a better method of cost allocation. Th e accounting department has established the following relationships between production activities and manufacturing overhead costs:

Activities Cost Drivers Allocation RateMaterial handling Number of parts $ 8 per partAssembly Labour hours 80 per hourInspection Time spent by item at inspection station 12 per minute

Th e previous plant-wide allocation rate method was based on direct manufacturing labour hours, and if that method is used, the allocation rate is $800 per labour hour.Instructions(a) Assume that a batch of 1,000 pairs of shoes requires 4,000 parts, 50 direct manufacturing labour hours, and 60 minutes

of inspection time. What are the indirect manufacturing costs per pair of shoes to produce a batch of 1,000 pairs of shoes, assuming the previous plant-wide allocation rate method is used?

(b) What are the indirect manufacturing costs per pair of shoes to produce a batch of 1,000 pairs of shoes, assuming the activity-based method of allocation is used?

(c) Comment on the results. (adapted from CMA Canada)P5-37A Jacobson Electronics manufactures two HD television models: the Royale, which sells for $1,400, and a new model, the Majestic, which sells for $1,100. Th e production costs calculated per unit under traditional costing for each model in 2016 were as follows:

Traditional Costing Royale MajesticDirect materials $600 $320Direct labour ($20 per hour) 100 80Manufacturing overhead ($35 per direct labour hour) 175 140Total per unit cost $875 $540

(SO 1, 2, 3)Assign overhead using traditional costing and ABC; calculate unit costs; classify activities as value-added or non–value-added.

(a) Unit cost—Home model $60.90

(c) Cost assigned—Home model $1,031,300

(d) Cost/unit—Home model $56.60

(SO 1, 2)Assign overhead costs using traditional costing and ABC; compare results.

(a) $40 per pair

(b) $36.72 per pair

(SO 2)Assign overhead to products using ABC and evaluate the decision.


Problems: Set A 201

In 2016, Jacobson manufactured 20,000 units of the Royale and 10,000 units of the Majestic. Th e overhead rate of $35 per direct labour hour was determined by dividing total expected manufacturing overhead of $4.9 million by the total direct labour hours (140,000) for the two models. Under traditional costing, the gross profi t on the models was $525 for the Royale or ($1,400 2 $875), and $560 for the Majestic or ($1,100 2 $540). Because of this diff erence, management is considering phasing out the Royale model and increasing the production of the Majestic model. Before finalizing its decision, management asks Jacobson’s controller to prepare an analysis using activity-based costing (ABC). Th e controller accumulates the following information about overhead for the year ended December 31, 2016:




Purchasing Number of orders $ 750,000 25,000 $30 per orderMachine set-ups Number of set-ups 600,000 20,000 30 per set-upMachining Machine hours 3,100,000 100,000 31 per hourQuality control Number of inspections 450,000 5,000 90 per inspection

Th e cost drivers used for each product were as follows:

Cost Drivers Royale Majestic TotalPurchase orders 11,250 13,750 25,000Machine set-ups 10,000 10,000 20,000Machine hours 40,000 60,000 100,000Inspections 2,250 2,750 5,000

Instructions(a) Assign the total 2016 manufacturing overhead costs to the two products using activity-based costing (ABC).(b) What was the cost per unit and gross profi t of each model using ABC costing?(c) Are management’s future plans for the two models sound? Explain.

P5-38A Kiddy Company manufactures bicycles. It recently received a request to manufacture 10 units of a mountain bike at a price lower than it normally accepts. Bruce, the sales manager, indicated that if the order were accepted at that price, the company could expect additional orders from the same client. Bruce believes that if Kiddy could off er this price in the market generally, sales of this bike would increase by 30%. Melany, president of Kiddy, is skeptical about accepting the order. Th e company has a policy of not accepting any order that does not provide a markup of 20% on full manufactur-ing costs. Th e price off ered is $575 per bike. Th e controller, Sanjay, has recently researched the possibility of using activity-based multiple overhead rates instead of the single rate currently in use. He has promised more accurate estimated overhead product costing, and Melany is curious about how this approach would aff ect product costing and pricing of the mountain bike. Th e plant-wide overhead rate is based on an expected volume of 10,000 direct labour hours and the following bud-geted overhead:

Machine operating costs $ 75,000Rework labour 45,000Inspection 25,000Scrap costs 35,000General factory overhead 120,000Total $300,000

Expected activities for selected cost drivers for 2016:

Machine hours 25,000Units reworked 600Inspection hours 500Units scrapped 140Direct labour hours 12,000

Estimated data for the production of one mountain bike:

Direct materials $ 160Direct labour (7.5 hours/unit) $ 180Number of machine hours 6Number of units reworked 0.25Number of inspection hours 0.10Number of units scrapped 0.05

(a) Royale $2,080,000(b) Cost/unit—Royale

$804




Instructions(a) Using the single-rate method to assign overhead on a plant-wide basis, determine whether or not Kiddy should accept

the order for the 10 mountain bikes. Explain your decision.(b) Using activity-based costing to assign overhead, determine whether or not Kiddy should accept the order for the 10

mountain bikes. Explain your decision.

(adapted from CGA-Canada)

P5-39A Stellar Stairs Co. designs and builds factory-made premium wooden stairs for homes. Th e manufactured stair components (spindles, risers, hangers, hand rails) permit installation of stairs of varying lengths and widths. All are made of white oak wood. Th e company’s budgeted manufacturing overhead costs for 2016 are as follows:

Overhead Cost Pools AmountPurchasing $ 69,000Handling materials 82,000Production (cutting, milling, fi nishing) 210,000Setting up machines 95,000Inspecting 90,000Inventory control (raw materials and fi nished goods) 126,000Utilities 180,000Total budget overhead costs $852,000

For the last four years, Stellar Stairs Co. has been charging overhead to products on the basis of machine hours. For 2016, it has budgeted 100,000 machine hours. Heather Fujar, owner-manager of Stellar Stairs Co., recently directed her accountant, Kiko Nishikawa, to imple-ment the activity-based costing system that she has repeatedly proposed. At Heather Fujar’s request, Kiko and the production foreperson identify the following cost drivers and their usage for the previously budgeted overhead cost pools.

Activity Cost Pools Cost DriversExpected Use of

Cost DriversPurchasing Number of orders 600Handling materials Number of moves 8,000Production

(cutting, milling, fi nishing) Direct labour hours 100,000Setting up machines Number of set-ups 1,250Inspecting Number of inspections 6,000Inventory control

(raw materials and fi nished goods) Number of components 168,000Utilities Square metres occupied 9,000

Jason Dion, sales manager, has received an order for 280 stairs from Community Builders, Inc., a large housing devel-opment contractor. At Jason’s request, Kiko prepares cost estimates for producing components for 280 stairways so Jason can submit a contract price per stair to Community Builders. She accumulates the following data for the production of 280 stairways:

Direct materials $103,600Direct labour 112,000Machine hours 14,500Direct labour hours 5,000Number of purchase orders 60Number of material moves 800Number of machine set-ups 100Number of inspections 450Number of components 16,000Number of square metres occupied 800

Instructions(a) Calculate the predetermined overhead rate using traditional costing with machine hours as the basis.(b) What is the manufacturing cost per stairway under traditional costing? (Round to the nearest cent.)(c) What is the manufacturing cost per stairway under the proposed activity-based costing? (Round to the nearest cent.

Prepare all of the necessary schedules.)(d) Which of the two costing systems is preferable in pricing decisions and why?

(a) Price of bicycle: $678

(b) Price using ABC: $563.10

(SO 1, 2)Assign overhead costs using traditional costing and ABC; compare results

(b) Cost/stairway $1,356.56

(c) Cost/stairway $1,134.20


Problems: Set A 203

P5-40A International Steel Company has budgeted manufacturing overhead costs of $1,930,000. It has allocated over-head on a plant-wide basis to its two products (soft steel and hard steel) using machine hours, which are estimated to be 90,000 for the current year. Th e company has decided to experiment with activity-based costing and has created fi ve activity cost pools and related activity cost drivers as follows:

Activity Centre Cost Driver Estimated Overhead Expected ActivityMaterial handling Number of moves $280,000 40,000 movesPurchase orders Number of orders $100,000 1,200 ordersProduct testing Number of tests $420,000 3,500 testsMachine set-up Number of set-ups $320,000 5,000 set-upsMachining Machine hours $810,000 90,000 machine hours

Each unit of the products requires the following:

Soft Steel Hard SteelDirect materials costs $300 $200Direct labour costs $120 $60Purchase orders 2 3Machine set-up 5 10Product testing 3 4Machining 50 50Material handling 4 6

Instructions(a) Under traditional product costing using machine hours, calculate the total manufacturing cost per unit of both products.(b) Under ABC, prepare a schedule showing the calculation of the activity-based overhead rates (per cost driver).(c) Calculate the total manufacturing cost per unit for both products under ABC.(d) Write a memo to the president of the company discussing the implications of your analysis for the

company’s plans. In this memo, provide a brief description of ABC, as well as an explanation of how the traditional approach can result in distortions.

P5-41A Hy and van Lamsweerde is a public accounting fi rm that off ers two primary services, auditing and tax return preparation. A controversy has developed between the partners of the two service lines regarding who is contributing the greater amount to the bottom line. Th e area of contention is the assignment of overhead. Th e tax partners argue for assign-ing overhead on the basis of 40% of direct labour dollars, while the audit partners argue for implementing activity-based costing. Th e partners agree to use next year’s budgeted data for analysis and comparison. Th e following overhead data are collected:

Expected Use of Cost Drivers per Service


Expected Use of Cost Drivers Audit Tax

Employee training Direct labour dollars $216,000 $1,800,000 $1,050,000 $750,000Typing and secretarial Number of reports and forms 76,200 2,500 800 1,700Computing Number of minutes 204,000 60,000 25,000 35,000Facility rental Number of employees 142,500 40 22 18Travel Per expense reports 81,300 Direct 56,000 25,300

$720,000

Instructions(a) Using traditional product costing as proposed by the tax partners, calculate the total overhead cost assigned to both

services (audit and tax) of Hy and van Lamsweerde.(b) 1. Using activity-based costing, prepare a schedule showing the calculations of the activity-based overhead rates (per

cost driver).2. Prepare a schedule assigning each activity’s overhead cost pool to each service based on the use of the cost drivers.

(c) Classify each of the activities as a value-added activity or a non–value-added activity.(d) Comment on the comparative overhead cost for the two services under both traditional costing and ABC.

P5-42A GoGo Ltd. manufactures three models of children’s swing sets: Standard, Deluxe, and Super. Th e Standard set is made of steel, the Deluxe set is made of aluminum, and the Super set is made of a titanium-aluminum alloy. Because of the diff erent materials used, production requirements diff er signifi cantly across models in terms of machine types and time requirements. However, once the parts are produced, assembly time per set is similar for the three models. For this reason, GoGo has adopted the practice of allocating overhead costs on the basis of machine hours. Last year, the company


(a) Hard Steel: $1,332(b) Soft Steel: $1,325(c) Hard Steel: $2,122

(SO 1, 2, 3, 4)Assign overhead costs to services using traditional costing and ABC; calculate overhead rates and unit costs; compare results.

(b) (2) Cost assigned—Tax $350,241

(c) Diff erence—Audit $50,241

(SO 1, 2)Assign overhead costs using traditional cost-ing and ABC; compare results.



produced 5,000 Standard sets, 500 Deluxe sets, and 2,000 Super sets. Th e company had the following revenues and expenses for the year:

GOGO LTD.Income Statement

Year Ended December 31, 2016Standard Deluxe Super Total

Sales $475,000 $380,000 $560,000 $1,415,000Direct costs:

Direct materials 200,000 150,000 240,000 590,000Direct labour 54,000 14,000 24,000 92,000

Variable overhead costs:Machine set-ups ? ? ? 25,000Order processing ? ? ? 60,000Warehouse ? ? ? 90,000Shipping ? ? ? 35,000

Contribution margin ? ? ? 523,000Fixed overhead costs:

Plant administration 88,000Other 182,000

Gross profi t $ 253,000

Th e chief fi nancial offi cer of GoGo has hired a consultant to recommend cost allocation bases. Th e consultant has recommended the following:

Activity LevelActivities Cost Drivers Standard Deluxe Super TotalMachine set-ups No. of production runs 22 11 17 50Sales order processing No. of sales orders received 300 200 300 800Warehouse costs No. of units held in inventory 200 100 100 400Shipping No. of units shipped 5,000 500 2,000 7,500

Th e consultant found no basis for allocating the plant administration and other fi xed overhead costs, and recommended that they not be applied to products.Instructions(a) Complete the income statement using the bases recommended by the consultant. Do not allocate any fi xed overhead costs.(b) Explain how activity-based costing might result in better decisions by GoGo’s management.


(a) CM for Super: $233,166

Problems: Set BP5-43B VidPlayers, Inc. manufactures two types of DVD players, a deluxe model and a standard model. Th e deluxe model is a multi-format progressive-scan DVD player with networking capability, Dolby digital, and DTS decoder. Th e standard model’s primary feature is progressive-scan. Annual production is 20,000 units for the deluxe and 50,000 units for the standard. Both products require two hours of direct labour for completion. Th erefore, total annual direct labour hours are 140,000 or 2 hrs. 3 (20,000 1 50,000). Expected annual manufacturing overhead is $980,000. Th us, the predetermined overhead rate is $7 or ($980,000 4 140,000) per direct labour hour. Th e direct materials cost per unit is $11 for the deluxe model and $42 for the standard model. Th e direct labour cost is $18 per unit for both the deluxe and the standard models. Th e company’s managers identifi ed six activity cost pools and related cost drivers and accumulated overhead by cost pool as follows.

Activity Cost Pool Cost DriverEstimated Overhead


Expected Use of Drivers by Product

Deluxe StandardPurchasing Orders $130,000 500 150 350Receiving Kilograms 30,000 20,000 4,000 16,000Assembling Number of parts 370,000 74,000 20,000 54,000Testing Number of tests 115,000 23,000 10,000 13,000Finishing Units 140,000 70,000 20,000 50,000Packing and shipping Kilograms 195,000 78,000 17,000 61,000

$980,000

(SO 1, 2, 3)Assign overhead using traditional costing and ABC; calculate unit costs; classify activities as value-added or non–value-added.


Problems: Set B 205

Instructions(a) Under traditional product costing, calculate the total unit cost of both products. Prepare a simple comparative schedule

of the individual costs by product.(b) Under ABC, prepare a schedule showing the calculations of the activity-based overhead rates (per cost driver).(c) Prepare a schedule assigning each activity’s overhead cost pool to each product based on the use of cost drivers.

(Include a calculation of overhead cost per unit, rounding to the nearest cent.)(d) Calculate the total cost per unit for each product under ABC.(e) Classify each of the activities as a value-added activity or a non–value-added activity.(f) Comment on

1. the comparative overhead cost per unit for the two products under ABC, and2. the comparative total costs per unit under traditional costing and ABC.

P5-44B Tough Th ermos, Inc. manufactures two plastic thermos containers at its plastic moulding facility in Lethbridge, Alberta. Its large container, called the Ice House, has a volume of fi ve litres, side carrying handles, a snap-down lid, and a side drain and plug. Its smaller container, called the Cool Chest, has a volume of two litres, an over-the-top carrying handle, which is part of a tilting lid, and a removable shelf. Both containers and their parts are made entirely of hard-moulded plastic. Th e Ice House sells for $35 and the Cool Chest sells for $24. Th e production costs calculated per unit under traditional costing for each model in 2016 were as follows:

Traditional Costing Ice House Cool ChestDirect materials $ 9.50 $ 6.00Direct labour ($10 per hour) 8.00 5.00Manufacturing overhead ($17.08 per direct labour hour) 13.66 8.54Total per unit cost $31.16 $19.54

In 2016, Tough Th ermos manufactured 50,000 units of the Ice House and 20,000 units of the Cool Chest. Th e over-head rate of $17.08 per direct labour hour was determined by dividing total expected manufacturing overhead of $854,000 by the total direct labour hours (50,000) for the two models. Under traditional costing, the gross profi t on the two containers was $3.84 for the Ice House or $35 2 $31.16, and $4.46 for the Cool Chest or $24 2 $19.54. Th e gross margin rates on cost are 12% for the Ice House or $3.84 4 $31.16, and 23% for the Cool Chest or $4.46 4 $19.54. Because Tough Th ermos can earn a gross margin rate on the Cool Chest that is nearly twice as great as that earned on the Ice House, with less investment in inventory and labour costs, its management is urging its sales staff to put its eff orts into selling the Cool Chest over the Ice House. Before fi nalizing its decision, management asks the controller Sven Meza to prepare a product costing analysis using activity-based costing (ABC). Meza accumulates the following information about overhead for the year ended December 31, 2016:

Activities Cost DriversEstimated Overhead



Purchasing Number of orders $179,000 4,475 $40 per orderMachine set-ups Number of set-ups 195,000 780 $250 per set-upExtruding Machine hours 320,000 80,000 $4 per machine hourQuality control Tests and inspections 160,000 8,000 $20 per test

Th e cost drivers used for each product were the following:

Cost Drivers Ice House Cool Chest TotalPurchase orders 2,500 1,975 4,475Machine set-ups 480 300 780Machine hours 60,000 20,000 80,000Tests and inspections 5,000 3,000 8,000

Instructions(a) Assign the total 2016 manufacturing overhead costs to the two products using activity-based costing (ABC).(b) What was the cost per unit and gross profi t of each model using ABC costing?(c) Are management’s future plans for the two models sound?

P5-45B Mars Company has four categories of overhead: purchasing and receiving materials, machine operating costs, materials handling, and shipping. Th e costs expected for these categories for the coming year are as follows:

Purchasing and receiving materials $ 300,000Machine operating costs 900,000Materials handling 160,000Shipping 140,000Total $1,500,000

(a) Unit cost—Deluxe $43

(c) Cost assigned—Deluxe $277,500

(d) Cost/unit—Deluxe $42.88

(SO 2)Assign overhead to products using ABC and evaluate decision.

(a) Ice House $560,000(b) Ice House cost/unit:

$28.70




Th e plant currently applies overhead using machine hours and expected annual capacity. Expected capacity is 300,000 machine hours. Pragya Jahangir, the fi nancial controller, has been asked to submit a bid on job #287, on which she has assembled the following data:

Direct materials per unit $1.35Direct labour per unit $1.85Applied overhead $ ?Number of units produced 6,000Number of purchases and receipts 3Number of machine hours 3,000Number of material moves 300Number of kilometres to ship to the customer 2,300

Pragya has been told that Arrow Company, a major competitor, is using activity-based costing and will bid on job #287 with a price of $6.75 per unit. Before submitting her bid, Pragya wants to assess the eff ects of this alternative costing approach. She estimates that 850,000 units will be produced next year, 3,000 purchases and receipts will be made, 400,000 moves will be performed plant-wide, and the delivery of fi nished goods will require 280,000 kilometres. Th e bid price policy is full manufacturing cost plus 25%.

Instructions(a) Calculate the bid price per unit of job #287 using machine hours to assign overhead.(b) Using an activity-based approach, determine whether Mars or Arrow will produce the most competitive bid and

obtain the contract. Show all your calculations.


P5-46B Prime Furniture designs and builds factory-made, premium, wood armoires for homes. All are made of white oak. Its budgeted manufacturing overhead costs for the year 2016 are as follows.

Overhead Cost Pools AmountPurchasing $ 45,000Handling materials 50,000Production (cutting, milling, fi nishing) 130,000Setting up machines 85,000Inspecting 60,000Inventory control (raw materials and fi nished goods) 80,000Utilities 100,000Total budget overhead costs $550,000

For the last four years, Prime Furniture has been charging overhead to products on the basis of materials cost. For the year 2016, materials cost of $500,000 were budgeted. Wei Huang, owner-manager of Prime Furniture, recently directed her accountant, Tom Turkel, to implement the activity-based costing system that he has repeatedly proposed. At Wei Huang’s request, Tom and the production manager identify the following cost drivers and their usage for the previously budgeted overhead cost pools.

Overhead Cost Pools Activity Cost DriversExpected Use of

Cost DriversPurchasing Number of orders 500Handling materials Number of moves 5,000Production (cutting, milling, fi nishing) Direct labour hours 65,000Setting up machines Number of set-ups 1,000Inspecting Number of inspections 4,000Inventory control (raw materials and fi nished goods) Number of components 40,000Utilities Square metres occupied 5,000

Maria Carvalho, sales manager, has received an order for 10 luxury armoires from Cohn’s Interior Design. At Maria’s request, Tom prepares cost estimates for producing components for 10 armoires so Maria can submit a contract price per armoire to Cohn’s. He accumulates the following data for the production of 10 armoires.

(a) Markup: $1.425(b) Overhead cost per

unit: $1.762



Problems: Set B 207

Direct materials $5,200Direct labour $3,500Direct labour hours 200Number of purchase orders 3Number of material moves 32Number of machine set-ups 4Number of inspections 20Number of components 640Number of square metres occupied 32

Instructions(a) Calculate the predetermined overhead rate using traditional costing with materials cost as the basis.(b) What is the manufacturing cost per armoire under traditional costing?(c) What is the manufacturing cost per armoire under the proposed activity-based costing? (Prepare all of the necessary

schedules.)(d) Determine which of the two costing systems is preferable in pricing decisions and why.P5-47B Quality Paints Inc. uses a traditional cost accounting system to apply quality-control costs uniformly to all its products at a rate of 30% of the direct labour cost. Th e monthly direct labour cost for the varnish paint line is $100,000. Th e company is considering activity-based costing to apply quality-control costs. Th e monthly data for the varnish paint line have been gathered as follows:

Activity Cost Pools Cost Drivers Unit RatesUse of Drivers

for Varnish PaintIncoming material inspection Type of material $ 25.00 per type 50 typesIn-process inspection Number of units 0.30 per unit 30,000 unitsProduct certifi cation Per order 150.00 per order 80 orders

Instructions(a) Calculate the monthly quality-control cost to be assigned to the varnish paint line using a traditional costing system

that allocates overhead based on the direct labour cost.(b) Calculate the monthly quality-control cost to be assigned to the varnish paint line using an activity-based costing system.(c) Comment on the results. (adapted from CMA Canada)P5-48B International Steel Company has budgeted manufacturing overhead costs of $2.5 million. It has allocated over-head on a plant-wide basis to its two products (Standard Steel and Deluxe Steel) using machine hours, which are estimated to be 100,000 for the current year. Th e company has decided to experiment with activity-based costing and has created fi ve activity cost pools and related activity cost drivers as follows:

Activity Centre Cost Driver Estimated Overhead Expected ActivityMaterial handling Number of moves $250,000 50,000 movesPurchase orders Number of orders $200,000 4,000 ordersProduct testing Number of tests $450,000 9,000 testsMachine set-up Number of set-ups $600,000 6,000 set-upsMachining Machine hours $1,000,000 100,000 machine hours

Each unit of the products requires the following:Standard Steel Deluxe Steel

Direct materials costs $200 $250Direct labour costs $100 $120Purchase orders 2 3Machine set-up 5 10Product testing 3 4Machining 50 50Materials handling 5 10

Instructions(a) Under traditional product costing using machine hours, calculate the total manufacturing cost per unit of both products.(b) Under ABC, prepare a schedule showing the calculation of the activity-based overhead rates (per cost driver).(c) Calculate the total manufacturing cost per unit for both products under ABC.(d) Write a memo to the president of the company discussing the implications of your analysis for the company’s

plans. In this memo, provide a brief description of ABC, as well as an explanation of how the traditional approach can result in distortions.

(b) Cost/armoire $1,201.67

(c) Cost/armoire $1,020.83


(b) Total cost $22,250


(a) Deluxe Steel: $1,620(b) Standard Steel: $1,275(c) Deluxe Steel: $2,270



P5-49B Scalar Manufacturing produces automobile parts in batches in one continuous manufacturing process. Th e company uses direct labour hours to assign overhead to each part. Magda Malakova, the fi nancial controller, is wondering what the reasons are for the low profi ts in 2016 and why the gear product line did not attain Scalar’s 20% net profi t margin target (net profi t per unit on sale price). She has calculated the 2016 net profi t per unit as follows:

Brake Disk GearSales price per unit $35.00 $43.00Manufacturing costs per unit:

Direct materials 10.00 7.50Direct labour(0.1 hour 3 $12/hour) 1.20(0.5 hour 3 $12/hour) 6.00Overhead(0.1 hour 3 $50/hour) 5.00(0.5 hour 3 $50/hour) 25.00

Total manufacturing cost per unit $16.20 $38.50Net profi t per unit $18.80 $ 4.50Net profi t margin percentage 53.7% 10.5%

Magda intends to implement activity-based costing at Scalar. Each part requires engineering design activity. Once the design is completed, the equipment can be set up for batch production. Once the batch is completed, a sample is taken and inspected to see if the parts are within the tolerances allowed. Th e manufacturing process has fi ve activities: engineering, set-ups, machining, inspection, and processing. Overhead has been assigned to each activity using direct attribution and resource drivers:

Engineering $ 80,000Set-ups 45,000Machining 120,000Inspection 60,000Processing 35,000Total overhead $340,000

Magda has identifi ed activity drivers for each activity and listed their practical capacities:

Engineering Hours

Number of Set-ups

Machine Hours

Number of Inspections

Direct Labour Hours

4,000 250 20,000 1,500 7,000

Following are the production data in 2016 for brake disks and gears:

Brake Disk GearNumber of units produced 5,000 3,000Engineering hours per unit 0.05 0.15Number of set-ups 25 9Machine hours per unit 2.5 1Number of inspections 250 125

Instructions(a) Using the activity-based approach, calculate the activity rates, the net profi t per unit, and the net profi t margin percent-

age for both the brake disk and the gear.(b) Explain why the new profi t margin percentages for the brake disk and the gear are diff erent from what they were

originally.


P5-50B McDonald and O’Toole is a law fi rm that serves both individuals and corporations. A controversy has developed between the partners of the two service lines as to who is contributing the greater amount to the bottom line. Th e area of contention is the assignment of overhead. Th e individual partners argue for assigning overhead on the basis of 28.125% of direct labour dollars, while the corporate partners argue for implementing activity-based costing. Th e partners agree to use next year’s budgeted data for purposes of analysis and comparison. Th e following overhead data are collected to develop the comparison.


(a) Percentage of profi t margin: brake disk, 12.57%

(SO 1, 2, 3, 4)Assign overhead costs to services using tradi-tional costing and ABC; calculate overhead rates; compare results.


Cases 209

Activity Cost Pool Cost DriverEstimated Overhead


Expected Use of Cost Drivers per Service

Corporate IndividualEmployee training Direct labour dollars $120,000 $1,600,000 $900,000 $700,000Clerical Number of reports and forms 60,000 2,000 500 1,500Computing Number of minutes 100,000 40,000 17,000 23,000Facility rental Number of employees 100,000 25 14 11Travel Per expense reports 70,000 Direct 48,000 22,000

$450,000

Instructions(a) Using traditional product costing as proposed by the tax partners, calculate the total overhead cost assigned to both

services (individual and corporate) of McDonald and O’Toole.(b) 1. Using activity-based costing, prepare a schedule showing the calculations of the activity-based overhead rates (per

cost driver). 2. Prepare a schedule assigning each activity’s overhead cost pool to each service based on the use of the cost

drivers.(c) Classify each of the activities as a value-added activity or a non–value-added activity.(d) Comment on the comparative overhead cost service line under both traditional costing and ABC.

P5-51B ProDriver Inc. (PDI) recently started operations to obtain a share of the growing market for golf equipment. PDI manufactures two models of specialty drivers: the Th underbolt model and the Earthquake model. Two professional engineers and a professional golfer, none of whom had any accounting background, formed the company as a partnership. Th e business has been very successful, and to cope with the increased level of activity, the partners have hired a CPA as their controller. One of the fi rst improvements that the controller wants to make is to update the costing system by chang-ing from a single overhead application rate using direct labour hours to activity-based costing. Th e controller has identifi ed the following three activities as cost drivers, along with the related cost pools:

ModelNumber of Material

RequisitionsNumber of Product

InspectionsNumber of

Orders ShippedTh underbolt 46 23 167Earthquake 62 31 129Costs per pool $54,000 $8,200 $103,000

Instructions(a) Using activity-based costing, prepare a schedule that shows the allocation of the costs of each cost pool to each model.

Show your calculations.(b) Identify three conditions that should be present in PDI in order for the implementation of activity-based costing to

be successful.


(b) (2) Cost assigned—Individual $221,000

(d) Diff erence—Traditional method $24,125

(SO 2, 3)Assign overhead costs using ABC.

(a) Overhead assigned: Th underbolt, $84,604

CasesC5-52 For the past fi ve years, Collins Ltd. has been running a con-sulting practice in which it provides two major services: general management consulting and executive training seminars. Th e CFO is not quite sure that he is charging accurate fees for the diff erent services

he provides. He has recently read an article about activity-based costing that convinced him he could use ABC to improve the accuracy of his costing. He has gathered the following selected information concerning the consulting practice during the previous year:

Overhead Activities Cost Pools Activities Cost DriversPlanning and review $ 900,000 120,000 hours Billable hoursResearch 150,000 400 journals Journals purchasedGeneral administration 1,800,000 600 clients Number of clientsBuilding and equipment 360,000 2,400 square metres Square metres occupiedClerical 306,000 34 professionals Professional staff

$3,516,000



In addition, the CFO gathered the following statistics for each of the two types of services provided to clients during the year:

Management Consulting Executive TrainingDirect labour costs $1,800,000 $900,000Billable hours 90,000 30,000Research—journals purchased 280 120Number of clients 240 360Square metres 1,600 800Professional staff 20 14

Instructions(a) In the past, the CFO took the total overhead costs and divided

them by the total billable hours to determine an average rate. To this amount he would then add the direct labour costs per hour and double this total amount to establish his average hourly charge-out rate. What was the CFO’s average hourly charge-out rate using this method?

(b) Using ABC, what would the CFO’s charge-out rate be? Note that he will continue to add the overhead to the direct labour costs per hour on a service basis and then double this amount to set an average hourly charge-out rate.

(c) Identify and discuss three ways in which ABC leads to more accurate product costs.

(d) Identify and discuss two limitations of ABC.(e) Aft er reviewing the ABC methodology described in part (b), iden-

tify one signifi cant fl aw in how the overhead costs will be allocated by the CFO in the ABC system. Discuss how this fl aw would aff ect the average hourly charge-out rates (that is, increase or decrease the rates) for management consulting and executive training. You do not have to calculate the new rates to answer this part of the question.


C5-53 Aerotech International Inc. of Montreal has supported a re-search and development (R&D) department that for many years has been the sole contributor to the company’s new products. Th e R&D activity is an overhead cost centre that provides services only to in-house manufacturing departments (four diff erent product lines), all of which produce aerospace-related products. Th e department has never sold its services outside, but because of its long history of success, larger manufacturers of aerospace prod-ucts have approached Aerotech to hire its R&D department for special projects. Because the costs of operating the R&D department have been spiralling uncontrollably, Aerotech’s management is considering taking on these outside contracts to absorb the increasing costs. However, managers don’t have any cost basis for charging R&D services to outsiders, and they need to gain control of their R&D costs. Management decide to implement an activity-based costing system in order to determine the charges for both outsiders and the in-house users of the department’s services. R&D activities fall into four pools with the following annual costs:

Market analysis $1,050,000 Product development 3,600,000Product design 2,350,000 Prototype testing 1,400,000

Analysis determines that the appropriate cost drivers and their usage for the four activities are as follows:

Activities Cost Drivers Total Estimated DriversMarket analysis Hours of analysis 15,000 hoursProduct design Number of designs 2,500 designsProduct development Number of products 90 productsPrototype testing Number of tests 500 tests

Instructions(a) Calculate the activity-based overhead rate for each activity cost pool.(b) How much cost would be charged to an in-house manufacturing

department that consumed 1,800 hours of market analysis time, was provided with 280 designs relating to 10 products, and requested 92 engineering tests?

(c) How much cost would serve as the basis for pricing an R&D bid with an outside company on a contract that would consume 800 hours of analysis time, require 178 designs relating to three products, and result in 70 engineering tests?

(d) What is the benefi t to Aerotech International Inc. of applying activity-based costing to its R&D activity to charge for both in-house and outside services?

B & B ELECTRONICS COMPANYIncome Statement

Year Ended December 31, 2016Flat Deluxe Total

Sales $5,040,000 $19,800,000 $24,840,000Cost of goods sold 3,680,000 14,960,000 18,640,000Gross margin 1,360,000 4,840,000 6,200,000Selling and administrative expenses 780,000 2,640,000 3,420,000Net profi t $ 580,000 $ 2,200,000 $ 2,780,000Units produced and sold 4,000 22,000Net profi t per unit sold $145.00 $100.00

C5-54 B & B Electronics Company manufactures two large-screen television models: the Deluxe, which has been produced for many years and sells for $900, and the Flat, a new model, which sells for $1,260.

Based on the following income statement for 2016, the CFO at B & B has decided to concentrate the marketing resources on the Flat model and to begin to phase out the Deluxe model.


Cases 211

C5-55 Wet Ride Inc. manufactures and distributes three types of water skis: beginner, intermediate, and advanced. Production is highly automated for the beginner model, whereas the intermediate and advanced models require increasing degrees of labour, depending on the shaping and fi nishing processes. Wet Ride applies all indirect costs to production using a single predetermined overhead (OH) rate based on direct labour hours (DLH). Management estimates that 30,000 direct labour hours will be used in the upcoming year, at a rate of $14 per hour. Assume that the following activity took place in the fi rst month of the new year:

Instructions(a) Calculate the production costs for each product in the fi rst month

of the upcoming year, using direct labour hours as the allocation base. (Round calculations to the nearest cent.)

(b) Calculate the production costs for each product in the fi rst month of the upcoming year, using activity-based costing. (Round calcula-tions to the nearest cent.)

Beginner Intermediate AdvancedNumber of units produced 20,000 8,000 3,000Direct material costs $20,800 $13,000 $8,000Direct labour hours 500 1,000 2,000Number of orders 6 4 3Number of production runs 2 2 3Kilograms of material used 8,000 3,200 1,500Machine hours 1,200 300 200Number of inspections 3 3 3Number of units shipped 18,000 7,500 2,500

(c) Compare your answers in parts (a) and (b). Is the overhead charged to each product the same under each method? Explain.


Th e standard unit costs for the Flat and Deluxe models are as follows:

Flat DeluxeDirect materials $650 $250Direct labour:

Flat (3.5 hrs. 3 $20/hr.) 70Deluxe (1.5 hrs. 3 $20/hr.) 30

Machine usage:Flat (4 hrs. 3 $25/hr.) 100Deluxe (8 hrs. 3 $25/hr.) 200

Manufacturing overhead 100 200Standard cost $920 $680

Manufacturing overhead was applied on the basis of machine hours at a predetermined rate of $25 per hour. B & B Electronics Company’s CFO is in favour of the use of an activity-based costing system and has

gathered the following information about the company’s manufacturing overhead costs for 2016:

Units of the Cost DriverActivity Centres and Cost Drivers Activity Costs Flat Deluxe TotalSoldering (number of solder joints) $ 900,000 300,000 1,200,000 1,500,000Shipments (number of shipments) 800,000 4,800 15,200 20,000Quality control (number of inspections) 1,200,000 21,000 59,000 80,000Purchase orders (number of orders) 800,000 110,000 50,000 160,000Machine power (machine hours) 100,000 16,000 176,000 192,000Machine set-ups (number of set-ups) 1,000,000 4,000 6,000 10,000Total traceable costs $4,800,000

InstructionsUsing activity-based costing, determine whether B & B Electronics should continue to emphasize the Flat model and phase out the Deluxe model. (adapted from CMA Canada)

A consultant recently suggested that Wet Ride switch to an activity-based costing system, and assembled the following information:

Activities Recommended Cost Drivers Estimated OH Cost Cost DriversOrder processing Number of orders $ 60,000 100 ordersMaterials handling Kilograms of materials used 600,000 120,000 kilogramsMachine depreciation

and maintenance Machine hours 420,000 20,000 hoursQuality control Number of inspections 120,000 40 inspections

$1,200,000



Instructions(a) Evaluate Walker Ltd.’s current product costing system of charging

manufacturing overhead on the basis of direct labour dollars using a plant-wide rate.

(b) Comment on the chief engineer’s statement that the manufacturing overhead cost in the assembly department would be reduced to zero if the automation proposal were implemented.

(c) How might Walker Ltd. fi nd the ABC information useful in applying manufacturing overhead and revising its product-costing system to accommodate automation in the assembly department?

(adapted from CMA Canada)

Historical Plant-Wide Data

YearAverage Annual

Direct Labour CostAverage Annual

Manufacturing Overhead CostAverage Manufacturing

Overhead Application Rate2012 $ 500,000 $ 1,000,000 200%2013 600,000 3,000,000 500%2014 1,000,000 7,000,000 700%2015 1,500,000 12,000,000 800%2016 2,000,000 20,000,000 1,000%

Annual Averages during a Recent YearMoulding

DepartmentComponent Department

Assembly Department

Direct labour costs $ 1,000,000 $ 875,000 $ 125,000Manufacturing overhead costs 11,000,000 7,000,000 2,000,000

C5-56 The CEO of Walker Ltd. is currently investigating ways to modernize the company’s manufacturing process. At the first staff meeting, the chief engineer presented a proposal for automating the assembly department, and recommended that the company pur-chase two robots that would be able to replace the eight direct labour employees in the department. The cost savings outlined in the chief engineer’s proposal include the elimination of the direct labour cost in the assembly department and a reduction of the manufacturing overhead cost in the department to zero, since the company charges manufacturing overhead on the basis of direct labour dollars using a plant-wide rate. The CEO of Walker Ltd. is puzzled by the chief engineer’s explanation: “This just doesn’t make any sense. How can a

department’s overhead rate drop to zero by adding expensive, high-tech manufacturing equipment? If anything, it seems like the rate ought to go up.” Th e chief engineer responds by saying, “I’m an engineer, not an accountant. But if we’re charging overhead on the basis of direct labour, and we eliminate the labour, then we eliminate the overhead.” Th e CFO explains that as fi rms become more automated, they should rethink their product costing systems. Th e CEO asks the CFO to look into the matter and prepare a report for the next staff meeting. Th e CFO gathers the following data on the manufacturing overhead rates experienced by Walker Ltd. over the last fi ve years. Th e CFO also estimates the following annual averages for each manufacturing department over the past several years:

C5-57 The Canadian Motorcycle Company (CMC) produces two models of motorcycles: Faster and Slower. The company has five categories of overhead costs: purchasing, receiving, machine oper-ating costs, handling, and shipping. Each category represents the following percentages of total overhead costs, which amount to $4 million:

Purchasing 25.0% Handling 10.0%Receiving 12.5% Shipping 15.0%Machine operating 37.5%

Current capacity is 200,000 machine hours, and the current pro-duction uses 100% of the available hours. Th e sales mix is 45% Faster and 55% Slower. Th e overhead costs are applied to each model based on machine hours. Th e production costs for each model of motorcycle and other rel-evant information are as follows:

Faster SlowerDirect materials per unit $8,000 $6,500Direct labour per unit $1,750 $1,850Applied overhead ? ?Number of units produced 400 500Number of purchases 5 4Number of shipments received 3 3Percentage of machine hours consumed by each product

50% 50%

Number of moves in handling 75 100Number of kilometres to ship to customers 4,000 4,250

Instructions(a) CMC determines its prices by adding 40% to the cost of direct

materials and direct labour. Determine if this pricing policy is appropriate. Show all calculations to support your answer.

(b) Use an activity-based approach to determine whether CMC can make a profi t if it sells the Faster model for $15,000. Show all supporting calculations. (Round all answers to the nearest dollar.)



“All About You” Activity 213

“All About You” ActivityC5-60 Look on the Internet for time management resources that are designed specifi cally for students. If you cannot fi nd one, look at the University of Guelph library web page.

InstructionsUse the resources to answer the following questions.

(a) Why is it important to set time management goals?(b) How can a task list, a master plan, and a calendar help you with time

management?(c) Procrastination is a very common problem for students. What are

some tips for dealing with it?

Ctho

C5-58 Java Inc. is a distributor and processor of a variety of diff erent blends of coffee. The company buys coffee beans from around the world and roasts, blends, and packages them for resale. Java Inc. currently offers 10 different coffees in 500-gram bags to gourmet shops. The major cost is raw materials; however, there is a substan-tial amount of manufacturing overhead in the mostly automated roasting and packing process. Th e company uses relatively little direct labour. Some of the coff ees are very popular and sell in large volumes, while a few of the newer blends have very low volumes. Java Inc. prices its coff ee at total product costs, including allocated overhead, plus a markup of 25%. If prices for certain coff ees are signifi cantly higher than market, the prices are adjusted lower. Data for the 2016 budget include manufacturing overhead of $3.5 million, which has been allocated in the existing costing system based on each product’s budgeted direct labour cost. Th e budgeted direct labour cost for 2016 totals $700,000. Purchases and use of materials (mostly coff ee beans) are budgeted to total $6 million.

Th e budgeted prime costs for 500-gram bags of two of the company’s products are as follows:

Mocha VanillaDirect materials $3.20 $2.80Direct labour $0.25 $0.25

Data for the 2016 production of Mocha and Vanilla coff ee are as follows. Th ere will be no beginning or ending materials inventory for either of these coff ees.

Mocha VanillaExpected sales 50,000 kilograms 1,000 kilogramsBatch size 50,000 kilograms 250 kilogramsSet-ups 3 per batch 3 per batchPurchase order size 12,500 kilograms 250 kilogramsRoasting time 1 hour/50 kg 1 hour/50 kgBlending time 0.5 hour/50 kg 0.5 hour/50 kgPackaging time 0.1 hour/50 kg 0.1 hour/50 kg

Java’s controller believes the traditional costing system may be providing misleading cost information. He has developed an activity-based analysis of the 2016 budgeted manufacturing overhead costs shown in the following table:

Instructions(a) Calculate the company’s 2016 budgeted manufacturing overhead

rate using direct labour costs as the single rate and the 2016 bud-geted costs and selling prices of 500 grams of Mocha coff ee and 500 grams of Vanilla coff ee.

(b) Use the controller’s activity-based approach to estimate the 2016 budgeted cost for one kilogram of Mocha coff ee and one kilogram of Vanilla coff ee.

(c) Comment on the results. (adapted from CMA Canada)

C5-59 Marcus Lim, the cost accountant for Hi-Power Mower Company, recently installed activity-based costing at the company’s western lawn tractor (riding mower) plant, where three models are manufactured: the 8-horsepower Bladerunner, the 12-horsepower Quickcut, and the 18-horsepower Supercut. Marcus’s new product costs for these three models show that the company’s traditional costing system had been signifi cantly undercosting the 18-horsepower Supercut, due primarily to the lower sales volume of the Supercut compared with the Bladerunner and the Quickcut. Before completing his analysis and reporting these results to management, Marcus is approached by his friend Ray Pon, who is the production manager for the 18-horsepower Supercut model. Ray has heard from one of Marcus’s staff about the new product costs and is upset and worried for his job because the new costs show the Supercut to be losing, rather than making, money.

At fi rst Ray condemns the new cost system, so Marcus explains the practice of activity-based costing and why it is more accurate than the company’s present system. Even more worried now, Ray begs Marcus, “Massage the fi gures just enough to save the line from being discontin-ued. You don’t want me to lose my job, do you? Anyway, nobody will know.” Marcus holds fi rm but agrees to review all his calculations for accuracy before submitting his costs to management.

InstructionsAnswer the following questions:(a) Who are the stakeholders in this situation?(b) What, if any, are the ethical considerations in this situation?(c) What are Marcus’s ethical obligations to the company? To his friend?

Activity Pools Cost Drivers Budgeted Units Budgeted CostPurchasing Purchase orders 1,150 $ 575,000Materials handling Set-ups 1,750 612,500Quality control Batches 500 150,000Roasting Roasting hours 100,000 950,000Blending Blending hours 23,125 462,500Packaging Packaging hours 30,000 750,000Total manufacturing overhead cost $3,500,000



Waterways Continuing Problem(Th is is a continuation of the Waterways Problem from Chapters 1 through 4.)

WCP-5 Spirits were high at the monthly meeting of the top manage-ment of Waterways. Installation was proceeding nicely on the 10 jobs for the city, and the company had just received confi rmation that the local school board had accepted its bid to install irrigation systems in 25 school playgrounds. Unfortunately, not everyone was celebrating. Lee Williams, the vice-president of the installation and training divi-sion, was troubled. He has been supervising the city jobs and he believes the current system of assigning overhead costs to the jobs does not refl ect accurately the actual cost of overhead. “Several major things have changed since we set our overhead rate at 120% of direct labour cost,” Lee explained. “I’ve noticed that the new sys-tems are requiring a lot of the more expensive glue and they were designed to accommodate only titanium fasteners. We are using special packaging to transport the systems to the sites, not to mention the new heavy equip-ment we had to purchase to prepare the ground for the install.”

Madison Tremblay, vice-president of sales and marketing, was quick to respond. “I can’t believe that you’re suggesting there’s some-thing wrong with our bids,” he retorted. He was visibly annoyed. “Th is is the fi rst time in several years that our sales group has been successful in increasing our market share,” he continued, “and now you want to mess with the pricing! I want you to explain that to the salespeople who have just received their fi rst bonus commission cheques in a very long time.” Ben Clark, who designed the new system, agreed with Madison, suggesting that maybe the problem was not with the cost, but was more likely cost control. Th eir accountant, Jordan Leigh, did not like confl ict. “I have an idea,” he said. “We have been investigating using a new costing system in our manufacturing plant called activity-based costing, or ABC. ABC is sup-posed to lead to more accurate overhead costing and it provides a better way to control overhead costs. With a little work I think we could adapt it to our installation services.” When he off ered to do an analysis and bring his recommendations back to the next management meeting, the rest of the group agreed to wait for the results before making any changes.

DM5-1 As you learned in the previous chapters, Current Designs has two main product lines—composite kayaks, which are handmade and very labour-intensive, and rotomoulded kayaks, which require less labour but employ more expensive equipment. Current Designs’ controller, Diane Buswell, is now evaluating several diff erent methods of assigning overhead to these products. It is important to ensure that costs are appropriately assigned to the company’s products. At the same time, the system that is used must not be so complex that its costs are greater than its benefi ts. Diane has decided to use the following activities and costs to evaluate the methods of assigning overhead.

Activity CostDesigning new models $121,100Creating and testing prototypes 152,000Creating moulds for kayaks 188,500Operating oven for the rotomoulded kayaks 40,000Operating the vacuum line for the composite kayaks 28,000Supervising production employees 180,000Curing (the time that is needed for the chemical processes to fi nish before the next step in the produc-

tion process; many of these costs are related to the space required in the building) 190,400

Total $900,000

As Diane examines the data, she decides that the cost of operat-ing the oven for the rotomoulded kayaks and the cost of operating the vacuum line for the composite kayaks can be directly assigned to each of these product lines and do not need to be allocated with the other costs.

InstructionsFor purposes of this analysis, assume that Current Designs uses $234,000 in direct labour costs to produce 1,000 composite kayaks and $286,000 in direct labour costs to produce 4,000 rotomoulded kayaks each year.(a) One method of allocating overhead would allocate the common costs

to each product line by using an allocation basis such as the number of employees working on each type of kayak or the amount of factory space used for the production of each type of kayak. Diane knows that about 50% of the area of the plant and 50% of the employees work on

the composite kayaks, and the remaining space and other employees work on the rotomoulded kayaks. Using this information, and re-membering that the cost of operating the oven and vacuum line have been directly assigned, determine the total amount to be assigned to the composite kayak line and the rotomoulded kayak line, and the amount to be assigned to each of the units in each line.

(b) Another method of allocating overhead is to use direct labour dol-lars as an allocation basis. Remembering that the costs of the oven and the vacuum line have been assigned directly to the product lines, allocate the remaining costs using direct labour dollars as the alloca-tion basis. Th en, determine the amount of overhead that should be assigned to each unit of each product line using this method.

(c) Activity-based costing requires a cost driver for each cost pool. Use the following information to assign the costs to the product lines using the activity-based costing approach.

Activity Cost Driver

Driver Amount for Composite Kayaks

Driver Amount for Rotomoulded Kayaks

Designing new models

Number of models 3 1

Creating and testing

prototypes

Number of prototypes

6 2Creating moulds for kayaks

Number of moulds 12 1

Supervising production

employees

Number of employees

12 12Curing Number of days

of curing time 15,000 2,000

What amount of overhead should be assigned to each composite kayak using this method? What amount of overhead should be assigned to each rotomoulded kayak using this method?(d) Which of the three methods do you think Current Designs should

use? Why?

Decision-Making at Current Designs


Answers to Self-Study Questions 215

Jordan’s fi rst action was to identify and classify all the activities that consume resources during this specifi c type of installation into a num-ber of cost pools, and then determine the overhead costs that should be

assigned to each cost pool. At the same time he determined a cost driver for each pool. Th e following table shows these cost pools along with the estimated overhead allocation to each one.

Activity Cost Pools Cost Drivers Estimated Overhead Expected Use per ActivitySupervision, security, maintenance Number of workdays $ 450,000 1,500Liability insurance Number of employees 100,000 800Equipment costs Hours of operation 90,000 12,000Indirect supplies and delivery Length in metres 250,000 250,000Employee benefi ts Direct labour cost 150,000 600,000

$1,040,000

Th en, based on the information used to prepare the bids, Jordan determined that each of the 25 projects for the school board would require the following overhead activities.

Th e material costs for each project were expected to be $13,000.

Instructions(a) Calculate the expected cost of this type of installation using both

the traditional method and activity-based costing.

(b) Given the information calculated in part (a), make a recommendation to the management of Waterways as to what action they should take.

(c) Explain why you think Waterways’ current bidding process would lead to increased market share.

Answers to Self-Study Questions1. c 2. c 3. c 4. b 5. d 6. d 7. c 8. c 9. a 10. c

Activity Cost Pools Cost Drivers Expected Use per JobSupervision, security, maintenance Number of workdays 30 Liability insurance Number of employees 4 Equipment costs Hours of operation 240 Indirect supplies and delivery Length in metres 3,000 Employee benefi ts Direct labour cost $12,000


managerial accounting fourth cdn. ed. sample chapter

Documents

manufacturing costs

costing abc system

actual overhead costs

actual costs

traditional costing

limitations of activity

manufacturing process

manager of costing operations