managerial account (8)

account

Chapter 8

Activity-Based Costing: A Tool to Aid Decision Making

Solutions to Questions

8-1 Activity-based costing differs from tradi-tional costing systems in a number of ways. In activity-based costing, nonmanufacturing as well as manufacturing costs may be assigned to prod-ucts. And, some manufacturing costs may be ex-cluded from product costs. An activity-based cost-ing system typically includes a number of activity cost pools, each of which has its unique measure of activity. These measures of activity often differ from the allocation bases used in traditional cost-ing systems. Finally, the activity rates differ from typical predetermined overhead rates in that they should be based on activity at capacity rather than on the budgeted level of activity.

8-2 When direct labor is used as an allocation base for overhead, it is implicitly assumed that overhead cost is directly proportional to direct labor. When cost systems were originally devel-oped in the 1800s, this assumption may have been reasonably accurate. However, direct labor has declined in importance over the last hundred years while overhead has been increasing. This suggests that there is no longer a direct link be-tween the level of direct labor and overhead. In-deed, when a company automates, direct labor is replaced by machines; a decrease in direct labor is accompanied by an increase in overhead. This violates the assumption that overhead cost is di-rectly proportional to direct labor. Overhead cost appears to be driven by factors such as product diversity and complexity as well as by volume, for which direct labor has served as a convenient measure.

8-3 When an overhead rate is based on the budgeted level of activity, products are implicitly charged for the costs of the capacity they don’t use as well as for the costs of capacity that they do use. This is because all of the costs of capaci-ty—whether utilized or not—are spread across the budgeted production. Since the costs of capacity are largely fixed, this results in higher unit prod-uct costs when the level of activity declines. If an overhead rate is based on the level of activity at capacity, a product is charged only for the costs of capacity that it actually uses. The costs of unused capacity are not charged to prod-ucts and are instead charged to the current pe-riod as expenses of the period (see Appendix 3A). As a result, unit product costs are more stable and costs do not appear to increase as the level of budgeted activity decreases.

8-4 Activity-based costing may be resisted because it changes the ―rules of the game.‖ It changes some of the key measures such as prod-uct costs used in making decisions and may affect how individuals are evaluated. Without top man-agement support, there may be little interest in making these changes. In addition, if top manag-ers continue to make decisions based on the numbers generated by the traditional costing sys-tem, subordinates will quickly conclude that the activity-based costing system can be ignored. 8-5 Unit-level activities are performed for each unit that is produced. Batch-level activities are performed for each batch regardless of how many units are in the batch. Product-level activi-ties must be carried out to support a product re-gardless of how many batches are run or units produced. Customer-level activities must be car-ried out to support customers regardless of what products or services they buy. Organization-sustaining activities are carried out regardless of the company’s precise product mix or mix of cus-tomers.

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