Solution manual cost management measuaring monitoring and motivating performance 1st by wolcott ch07

7.3 Because ABC uses more cost pools and more cost drivers to reflect cause and effect relationships, ABC costs usually map the relation between cost and use of resources more accuratel

Chapter 7 Activity-Based Costing and Management

LEARNING OBJECTIVES

Chapter 7 addresses the following questions:

Q1 How is activity-based costing (ABC) different from traditional costing?

Q2 What are activities, and how are they identified?

Q3 What process is used to assign costs in an ABC system?

Q4 How are cost drivers selected for activities?

Q5 What is activity-based management (ABM)?

Q6 What are the benefits, costs, and limitations of ABC and ABM?

These learning questions (Q1 through Q6) are cross-referenced in the textbook to individual exercises and problems

COMPLEXITY SYMBOLS

The textbook uses a coding system to identify the complexity of individual requirements in the exercises and problems

Questions Having a Single Correct Answer:

No Symbol This question requires students to recall or apply knowledge as shown in the

textbook

e This question requires students to extend knowledge beyond the applications

shown in the textbook

Open-ended questions are coded according to the skills described in Steps for Better Thinking (Exhibit 1.10):

 Step 1 skills (Identifying)

 Step 2 skills (Exploring)

 Step 3 skills (Prioritizing)

 Step 4 skills (Envisioning)

7-2 Cost Management

QUESTIONS

7.1 If direct labor hours are used for tending machines and equipment, small batches take

fewer direct labor hours and so are allocated less overhead However, if overhead costs increase more with setup time than with direct labor costs, the cost to set up for a large batch is likely similar to the cost of setting up a small batch The cost per unit is then probably much lower for the large batch than for the small batch

7.2 Organization-sustaining activities are activities related to the overall organization and

unaffected by customers served or by quantities of products, batches, or units sustaining activities are activities related to the overall operations of a production facility and unaffected by customers served or by quantities of products, batches, or units

Facility-Customer-sustaining activities are customer service activities that are independent of sales volumes and mix Product-sustaining activities occur to support a product line or a single product if it is not part of a product line Batch-level activities increase as the number of batches increase These activities include setup and monitoring batches of product Unit-level activities increase proportionately with production volumes or sales volumes

7.3 Because ABC uses more cost pools and more cost drivers to reflect cause and effect

relationships, ABC costs usually map the relation between cost and use of resources more accurately Hence ABC costs reflect different proportions of the resource costs than do traditional costs

7.4 No, increasing the number of cost pools and cost drivers can increase measurement error

because small measurement errors for each pool and each driver can distort total cost once costs are allocated, simply from the increase in calculations that take place In addition, if the production process is very simple and products use the same amount of resources each, increasing the number of cost pools will not increase the accuracy of the allocations

7.5 No, because it is expensive to implement, the costs outweigh the benefits for some firms

Firms that are already operating efficiently may not benefit from an ABC system,

especially if they have available capacity Research has shown that ABC is more

successful within organizations that use flexible systems, have integrated information systems, and produce a variety of products

7.6 Yes, ABC can be used in service industries In service organizations, ABC may be

especially helpful if there are capacity limits Service industries often have a large

proportion of fixed resources, and understanding the relationship between cost and the use of these resources can improve the efficiency of the organization

7.7 Measurement error could decrease because ABC can do a better job of allocating costs to

the use of resources Better allocation reduces problems such as product

cross-subsidization, in which costs are overallocated to some products and underallocated to others However, measurement error could increase because increasing the number of cost pools and cost drivers results in small measurement errors for each pool and each

Chapter 7: Activity-Based Costing and Management 7-3

driver As the number of calculations increase, these small measurement errors interact

as costs are allocated (rates are developed and used as multipliers), and so the size of measurement error is likely to increase

7.8 Several costs that are incurred when implementing an ABC system include the time it

takes employees or consultants to determine appropriate cost pools and cost drivers, the cost to track and measure the number of activities because these may not be recorded in the accounting system, and the cost to set up an information system to develop ABC reports Several benefits include the ability to identify non-value added activities, and a better understanding of the use of overhead resources

7.9 First, meet with accounting employees to learn about all of the different activities they

perform Identify activities that are homogeneous and can be pooled together For example, budget preparation for each department is probably similar, but it may take different amounts of time according to the complexity of the department Pool all of the various budgeting activities Once a list of activities has been identified, employees’ opinions about appropriate cost drivers can be solicited Activities that have the same cost drivers could probably be pooled

7.10 Yes, research has shown that ABC is more successful within organizations that use

flexible systems, have integrated information systems, and produce a variety of products With ABC, a better mapping of the use of resources to each product line allows managers

to choose the optimal product mix In addition, if the processes are complex, ABC allows analysis of the activities underlying complex processes so improvements are easier to identify, as are non-value added activities In these cases, the costs are likely less than the benefits achieved

7.11 Activity-based costing analyzes the activities performed in manufacturing and service

production Once the activities are identified, costs for each activity are collected into separate cost pools Next a cost driver is chosen that reflects changes in the costs of activities The cost driver is used to allocate the costs of the activity to products,

services, or some other cost object There are multiple cost pools and drivers

Traditional costing uses only a few overhead cost pools and allocates the costs based on drivers such as direct labor hours, direct labor cost, or machine hours In a traditional cost system, the cost pools are very large and so it is impossible to find an allocation base that reflects resource use It is merely a logical system of assigning part of overhead costs to each product or service ABC, on the other hand, selects cost pools around activities so that a cost driver can be chosen to better reflect a product or service’s use of resources Therefore, ABC systems have more cost pools and drivers Because an ABC system is more complex, more time, effort, and money are required to implement ABC systems than traditional costing systems

7.12 Activity-based costing is a method of allocating costs to products or other cost objects

Activity-based management is the process of using ABC information to improve

operations and profitability by analyzing the actual activities and processes to reduce non-value added activities, and improve the efficiency of activities In addition,

managers may be able to better understand different products’ uses of fixed resources, which could be important if there are capacity constraints

7-4 Cost Management

7.13 There are several reasons for using ABC and ABM to improve an organization’s

environmental performance Environment-related activities, such as disposing of

hazardous substances and cleaning up spills of these substances, are non-value added If those types of activities can be minimized, costs are also likely to be reduced In

addition, most companies would prefer to avoid the negative reputation effects that are associated with pollution problems Once managers become aware of environmental costs, they may realize that investing in prevention activities will actually reduce costs in the long run

7.14 Prevention activities are activities performed to insure defect-free production These

activities could include

inspecting incoming direct materials

designing and redesigning products and manufacturing processes to reduce defect rates

identifying areas where defects arise and solving the underlying cause of the defects

Appraisal activities are activities performed to identify defective units, and include the

following activities:

Inspection of products

Inspection of manufacturing process

Monitoring of service delivery process

Testing

Production activities are activities undertaken in the production or rework of failed units

These include

Labor tasks and materials to produce spoiled units

Reworking spoiled units

Post-Sales activities are activities undertaken after the product has been sold to remedy

problems caused by defects and failed units These activities include

Accepting returned products and exchanging them for good products or refunding their cost

Repairing defective units

Preparing for and participating in legal actions that result from defective units

Chapter 7: Activity-Based Costing and Management 7-5

EXERCISES 7.15 ABC Cost Hierarchy

A Receptionist salary is an organization-level cost because the receptionist serves everyone who comes through the door and thus cannot be identified with one product or unit

B Financial forecasting software is an organizational-level cost if it is used to forecast sales for the entire company However if it used only by one product line, it is a product-sustaining cost

C Photocopy machine rental is a facility-level cost when everyone uses the machine, but could be a product, batch or unit related cost if a password were used to keep track of copies made for each client or department

D Janitorial service is a facility-level cost because the entire facility uses this evenly

E Audit manager’s salary is a unit-level cost because the managers is in charge of a number

of different audits and bills his or her time to each audit

F Long distance telephone charges are unit-level if the bill includes details of to whom the calls were made, and could be product-sustaining if the calls are marketing a particular product It just depends upon the purpose of the calls Some companies have Watts lines and pay a flat fee for all long distance calls In this case the cost is an organization-level cost

G Meal costs for entertaining clients could be a customer-sustaining cost if related only to that particular customer, or product related if the customer is associated with only one product

H Costs of annual employee golf party is an organization-level because it benefits all

departments

I Office supplies such as paperclips and tablets of paper are organization-level costs unless they can be traced to a particular product or batch

J Annual subscription for income tax regulations is a product-sustaining cost if it pertains

to one department of the firm If it pertains to the entire firm, it is a facility-level cost

7-6 Cost Management

B Product-sustaining costs: Product development $1,250,000

D Unit-level costs:

Power (assuming most power is to cool beer and

7.17 ABC Cost Hierarchy

A Unit-level activities and costs relate to each unit produced, in this case, each car rented The cost of washing each car between rentals is an example of a unit level cost Costs for the activities of making the reservation, turning the vehicle over to the renter, and

completing the paperwork at the end of the rental are also unit-level

B Batch-level activities and costs relate to the number of batches produced For a car rental fleet, cars at a number of outlets are probably sent for oil changes or other routine

maintenance in batches Car rental companies located off-site near an airport usually operate a shuttle service from the airport to the rental car location Multiple passengers are usually picked up and dropped off on each run of shuttle Batch-level costs for the shuttle would include vehicle depreciation, maintenance, and gasoline, plus the driver’s labor costs

C Product-sustaining activities and costs relate to entire product lines For a car rental company, the different types of cars for rent could be considered product lines, for

example economy cars, mid-sized cars, and so on Or the company might see its product lines more broadly, such as a product line of cars and a separate line for trucks

Advertising and marketing costs are likely to be product-line related if the company advertises either trucks or cars, but not both

D Customer-sustaining activities and costs relate to the different clients Sometimes

businesses establish a relationship with car rental agencies if employees need to travel by car for business These customers may require special attention, such as car delivery, or last minute rentals The costs of these services are customer-sustaining Rental

companies also have programs such as the Hertz #1 Club, where members receive

preferential treatment Special costs for these programs include extra personnel to

process the rental and park the vehicle in an easily accessible location

E Facility-sustaining costs relate to the facility For a car rental agency, these could include depreciation and maintenance of the building and parking lots for each outlet Facility-sustaining costs would also include the facility manager’s salary, electricity and janitorial service, computer terminals, and property taxes

Chapter 7: Activity-Based Costing and Management 7-7

F Organization-sustaining costs relate to the entire organization The CEO’s salary, and

building lease, rent or depreciation costs at the company’s headquarters are all

sustaining costs Companies such as Hertz also have large

organization-wide costs for computerized reservation and vehicle inventory systems

7.18 Cost Pools and Cost Drivers

F Machining (As machine hours increase, costs such as maintaining machines

increase)

D Purchasing activities (As number of invoices increases, costs such as wages for

employees filling out invoices and supplies used by these employees increase.)

G Inspection (As the number of units produced increases, the number of units

inspected also increases.)

B Assembly (As the number of parts increases, it takes more overhead cost in

material handling, etc to assemble the product.)

A Payroll (As number of employees increases, more employee time and supplies are

needed to produce paychecks.)

E A special quick freezing process for food (Food is usually frozen in batches As

the number of batches increases, costs such as electricity and quick-freezing supplies increases.)

C Laundry in a hospital (As the number of laundry pounds increases, more labor and

supplies costs are incurred because more batches of clothes are washed

7.19 Kalder Products

Total allocated cost for AJ40 (1*1,000/(1*1,000 + 1.5*1,000)*(6*300) 720

7-8 Cost Management

C Comparison of costs allocated under the two systems:

Product Cross Subsidization Overcharge (Undercharge) $ (480) $ 480 $ 0 Percent Overcharge (Undercharge) (40)% 80%

Cross subsidization means that one product is allocated more overhead cost relative to its

use of overhead resources and, therefore, other products’ overhead cost is less than their

use of resources

7.20 Applewood Electronics

A

1 Manufacturing cost per unit under traditional cost accounting

In the traditional cost accounting system, overhead is allocated to products based on

machine hours The rate per hour is calculated as follows:

Estimated machine hours:

Estimated allocation rate per machine hour ($4,800,000/192,000) $25.00 The total manufacturing cost per unit is the sum of per unit direct material, direct

labor, machine usage, and allocated overhead, as follows:

Direct labor 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00

Machine usage 8 mach hrs x $18 144.00 4 mach hrs x $18 72.00

Overhead 8 mach hrs x $25 200.00 4 mach hrs x $25 100.00

2 Manufacturing cost per unit under ABC

First, calculate the allocation rate for each of the ABC pools:

Soldering ($942,000/1,570,000 solder joints) $0.60 per solder joint Shipments ($860,000/20,000 shipments) $43.00 per shipment Quality control ($1,240,000/77,500 units inspected) $16.00 per inspection

Chapter 7: Activity-Based Costing and Management 7-9

Purchase orders ($950,400/190,080 purchase orders) $5.00 per purchase order Machine power ($57,600/192,000 machine hours) $0.30 per machine hour Machine setups ($750,000/30,000 setups) $25.00 per setup

Next, calculate total manufacturing costs allocated to each product under the ABC

system and then calculate the total manufacturing cost per unit:

Monarch _ Regal

B The traditional costing system allocates a lump sum of overhead based only on machine

hours, while the ABC system uses six cost pools to allocate the overhead Allocations

using these cost pools and cost drivers more accurately reflect the flow of resources

D Based on the profit information using ABC, Applewood should concentrate on the

Monarch Under ABC, it appears that the organization incurs a loss for each unit sold of

Regal Using this ABC information would definitely affect the recommendation because

one product appears to have a negative profit margin

7-10 Cost Management

Note: This problem is from an old CMA exam The calculations shown in this problem

probably include fixed costs Remember from Chapter 4 that organizations need to emphasize the product with the highest contribution margin to maximize profits;

however, that product cannot be identified with the information given in this problem Applewood would need to separate costs into flexible (those that vary with activity) and committed (those that do not vary with activity) to determine the ABC contribution margin for each product Once this is done, the product with highest contribution margin can be identified and emphasized

7.21 Palmer Company

A Manufacturing cost per unit:

Machining 1.25 machine hours x $26.00 x 100 units 3,250 Assembly 1.5 direct labor hours x $22.00 x 100 units 3,300

B Full cost per unit

C Cost savings required:

First, calculate the maximum full cost that would allow the company to achieve a profit

of 10% based on full cost:

Selling price = Full Cost + 10% x Full Cost

$650.00 = 100% x Full Cost + 10% x Full Cost

$650.00 = 110% x Full Cost Full Cost = $650.00/110%

Full Cost = $590.91

Chapter 7: Activity-Based Costing and Management 7-11

Next, calculate the difference between the maximum full cost calculated above and the current full cost This is the amount of cost savings required to achieve the desired profit

Full cost needed to achieve desired profit 590.91

7.22 Kestral Manufacturing

A Following are the ABC allocation rates:

B For job 43, overhead costs = (4x$100)+(20x$10)+(20x$20)+(100x$50) = $6,000

C Non-value added activities are tasks or functions that are unnecessary and waste

resources because they do not increase the worth of an organization’s goods or services to customers At Kestral, non-value-added activities include moving materials from place

to place (such as from receiving dock to warehouse to one work area and then to another work area) The company could reduce costs by minimizing the handling of materials Another non-value-added activity is inspection With sufficient quality improvements and continuous inspection by workers during production processes, the need for a

separate inspection process can be reduced or eliminated Set-up costs are also

considered non-value added and the set-up activity could be analyzed to reduce steps and materials if possible so that costs are reduced

7.23 Elite Daycare

[Note about problem complexity: Part A is coded as Extend rather than Step 3 because a more

complex problem involving a similar organization was illustrated as a self-study problem in the chapter.]

A There are several cost objects that could be chosen for Elite Daycare, depending on the planned use of information The director may want to develop a function for total costs

of the daycare for budget or benchmarking purposes In that case, the cost object is the daycare itself Alternatively, she might choose the type of service (full-time or part-time)

as the cost object If she wanted to better understand the cost per child, she could choose

activity time Therefore, a single pool can be used for greeting, supervising naps, and recreation; a pool for supervising activities; and another pool can be used for meal-related activities (preparing and serving food, monitoring behavior)

Next, cost drivers for each pool need to be chosen Cost drivers for greeting and

supervising activities could be number of children or time spent Because supervising naps and recreation activities are similar to greeting, cost driver choices would be similar for these two pools A number of different children can be supervised at one time, so time spent would be probably be easiest to track and provide an appropriate accounting of costs related to supervising activities Cost drivers for preparing and serving food could

be either the number of meals served or the number of children served Tracking meals served is probably just as easy as tracking number of children, but meals are more closely related to food preparation, so number of meals served will be used as the cost driver Cost drivers for supplies could be number of art activities or number of children, among others It would be easiest to track number of children, and it is likely that each child uses similar amounts of supplies

B Annual cost per child

The percentage of time for the greeting and supervising pool is 30% (20%+10%), 20% for meal-related activities, and 50% for supervising educational activities These times can be further categorized into full-time and after-school by considering the percentage of total hours each program uses There are 10 hours available per full-time child, and 3 hours per child after school Therefore, there are 300 (10 hours x 30 children) full-time child hours available per day and 30 (3 hours x 10children) after-school child hours available Of the total 330 hours available, 91% (300/330) of the hours are full-time child hours, and 9% are after-school child hours

Now the calculation of the ABC meal related activities cost requires several steps, as follows:

Estimated annual volume of snacks/meals:

(Assume 5 days per week x 50 weeks = 250 days)

Full-time (30 children x 3 snacks & meals x 250 days) 22,500

Chapter 7: Activity-Based Costing and Management 7-13

The total annual ABC cost per child is calculated as follows:

Full-Time After-School Snacks/meals:

Full-time (3 snacks/meals x 250 days x $1.60) $1,200

C The employees work with both full-time and after-school children, and there are

uncertainties about how much time they spend with each type of student If the two groups of children are combined for some activities, then any allocation of salaries or wages to each service is arbitrary and unlikely to reflect the two services’ use of

employee time If the two services are completely separate, the cost of salaries and wages can be traced directly to the service However, for activities such as snacks, some employee time is probably spent preparing snacks for both groups at once, and allocating this cost would be an uncertain and arbitrary process It is impossible for employees to track exact time spent per service for activities undertaken for both services, such as snacks and possibly meeting parents at the end of the day There are uncertainties about whether allocation bases reflect the use of resources because these are fixed resources, and the cost does not vary proportionately with any type of volume measure Therefore, any allocation is arbitrary and will not accurately reflect use of those fixed resources

7.24 ABM

[Note about problem complexity: Item C is coded as Step 1 instead of Step 3 because the chapter

explicitly discusses methods for improving customer profitability.]

A Activity-based management involves the use of ABC cost information to develop a

comparison of the costs and benefits of tasks and procedures undertaken within the

7-14 Cost Management

organization to identify improvements that can be made in quality and efficiency or cost reductions

B A high-cost customer is one for whom contribution margin is low, relative to other

customers, but who requires costly services such as special customized products, special shipping procedures, small production and delivery quantities, specialized post-sales service, or customer services before purchasing, and so on Low-cost customers would provide relatively more contribution from their orders with little special treatment These customers may order large quantities of regular products and not require any special delivery or help before or after the sale

C There are many possible ways to write this paragraph, and the wording depends on the assumptions that are made about the particular audience for the paragraph, the customer, and the nature of the company’s business Below is a sample paragraph

Several approaches can be taken to improve profitability for high-cost customers

Accountants can identify costs for these types of customers, and the company can

negotiate with each customer to either charge for some of the specialized services or motivate the customers to reduce the amount of costly services required Ways to reduce costs include improving the predictability of orders, reducing the amount of engineering changes or other product changes required, and finding standard products that might substitute for customized products Customers requiring large amounts of technical support following a purchase might be willing to pay for this service

7.25 New-Rage Cosmetics

A

1 Quality control cost per order using ABC

Incoming material inspection 12 types of material x $11.50 $ 138.00

Quality control cost per order $4,513.00/25 orders $180.52

2 Quality control cost per order using traditional cost accounting

Total quality control costs assigned

= Direct labor costs x 14.5%

= $27,500 x 14.5%

= $3,987.50 Quality control cost per order = $3,987.50/25 orders = $159.50

Chapter 7: Activity-Based Costing and Management 7-15

B Under the ABC system, the costs are more related to the resources used to insure quality control These costs are primarily product inspection and certification costs, and the allocated costs change as the types of materials and number of units inspected change

Under traditional cost accounting, direct labor costs may be related to number of units inspected if it takes more labor to produce more units, but in automated manufacturing settings this is not always the case In addition, direct labor costs are not related to types

of materials Therefore, using direct labor costs to assign quality costs provides poor quality information about the variation in quality control costs among different orders Accordingly, the ABC system provides more accurate costs for quality control

7-16 Cost Management

PROBLEMS 7.27 Steps in ABC

A

3 Identify and sum the costs into activity-based cost pools

4 Choose a cost driver for each activity

6 For each ABC cost pool, allocate overhead costs to the product or service

1 Identify the relevant cost object

2 Identify the activities necessary for production or service delivery

5 For each ABC cost pool, calculate a cost allocation rate

B All of these steps include uncertainties

After a cost object is chosen, uncertainty exists about whether all of the activities

necessary to produce the good or service are identified Some activities may be

overlooked, or the set of activities may include ones that rarely occur and would be an immaterial part of the process In addition, uncertainties exist about the optimal number

of activities for a given cost pool There is uncertainty about whether the costs for

developing additional cost pools would exceed the benefits Uncertainties also exist about whether the system would be more or less accurate when potentially separate activities are grouped together

When assigning costs to activities, there is uncertainty about whether all direct costs have identified and traced to each activity For example, supplies such as cloths used to wipe off excess oil during the set-up process may be overlooked In addition, the assignment

of a common resource cost, such as a supervisor salary, may not reflect the time the supervisor spends on different activities

For each cost pool, there is uncertainty about whether all of the potential cost drivers have been identified and whether the chosen cost driver most accurately reflects the use

of resources within that cost pool In addition, some activities are interdependent, and the cost pools and cost drivers may not accurately reflect these interdependencies Choosing

a cost driver for each activity requires the use of judgment Some activities may have an obvious cost driver, while others could have several different drivers Assembling a box, for example, may only require direct labor and thus have a clear cost driver Other

activities could include adding materials, using machine hours, and using direct labor hours For these types of activities, several different cost drivers could be chosen The accountant implementing ABC must identify the driver that best relates changes in

activities to changes in cost

Measuring the amount of cost driver used per product is sometimes uncertain Suppose time spent cleaning is a cost driver for a housekeeping cost pool When a new employee

is hired, the actual time may be longer than the normal time for the employee’s first several months Therefore, uncertainty exists about whether the allocation base volume