34 Cost Management
Activity-Based Costing and Management
Chapter 7 addresses the following questions:
LO1 Differentiate activity-based costing (ABC) from traditional costing.
LO2 Use cost hierarchy to help assign costs to activities.
LO3 Apply an ABC system in assigning costs.
LO4 Describe the characteristics and use of activity-based management (ABM).
LO5 Explain GPK and RCA.
LO6 Describe how ABC, GKP, and RCA affect managers’ incentives and decisions.
These learning questions (LO1 through LO6) are cross-referenced in the textbook to individual
exercises and problems.
© 2012 John Wiley and Sons Canada, Ltd. 35 Cost Management
7.1 If direct labour hours are used for tending machines and equipment, small batches take
fewer direct labour hours and so are allocated less overhead. However, if overhead costs
increase more with setup time than with direct labour 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. Facility-
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.
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
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
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
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
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 36
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
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 labour hours, direct labour 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
© 2012 John Wiley and Sons Canada, Ltd. 37 Cost Management
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.
7.13 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
• identifying areas where defects arise and solving the underlying cause of the
Appraisal activities are activities performed to identify defective units, and include the
• Inspection of products
• Inspection of manufacturing process
• Monitoring of service delivery process
Production activities are activities undertaken in the production or rework of failed units.
• Labour 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
• Repairing defective units
• Preparing for and participating in legal actions that result from defective units
7.15 ABC, GPK, and RCA are costing systems that use multiple cost pools and more
accurately map costs to the use of resources than traditional costing systems.
Implementation for all three methods requires identifying multiple cost pools and
analyzing activities or resources to discover cause-and-effect relationships of cost and
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 38
cost drivers. ABC analyzes activities and uses a specific hierarchy. GPK considers cost
centres that are usually smaller than departments, perform a single repetitive activity and
are under the control of one manager. RCA analyzes cost centres and resource cost pools.
Both GPK and RCA focus on volume of time. GPK uses practical or budgeted capacity
for the denominator level of the cost driver, while RCA uses theoretical capacity. ABC is
best used for cost control, improving efficiency and understanding the relationship
between costs and the use of resources. GPK focuses on marginal costs and so it can be
used for short term decisions, RCA can be used for short-, mid-, and long-term decisions.
© 2012 John Wiley and Sons Canada, Ltd. 39 Cost Management
7.16 Which of the following statements best describes the objective of kaizen costing?
a) To accumulate costs that are associated with a short-term or long-term project
b) To determine all costs related to the quality of a product
c) To reduce costs and improve quality through continuous improvement
d) To simplify cost accounting in a just-in-time environment
7.17 Which of the following statements best describes activity-based management?
a) ABM is an approach developed in response to the competitive pressures of today’sglobal
b) ABM does not use activity-based costing to improve a business.
c) ABM is designed to set the goals and objectives of an organization.
d) ABM focuses on functional areas and products.
7.18 Which of the following statements is correct?
a) Machine-related costs are batch-level activities.
b) Engineering costs are unit-level activities.
c) Inspection and testing costs are organization-sustaining activities.
d) Supervision and scheduling costs are facility-sustaining activities.
7.19 What is the overhead cost per unit using activity-based costing?
a) $42.00 $84.00
b) $67.86 $66.76
c) $77.00 $61.00
d) $84.00 $56.00
Ans: B (VE1 Machine-related: $62,000/(1,000*2 + 1,500*4) * 2 MH = $15.50 )
(VE1 Supervision and scheduling: $48,000/(140+180) * 140/1000 = $21.00)
(VE1 Engineering: $32,000/(240+260) * 240/1000 = $15.36)
(VE1 Inspection and testing: $26,000/(320+200) * 320/1000 = $16.00)
(VE1 $15.50 + $21.00 + $15.36 + $16.00 = $67.86)
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 40
7.20 What is the overhead cost per unit using traditional costing?
a) $42.00 $84.00
b) $67.20 $66.20
c) $73.50 $63.00
d) $80.64 $58.24
Ans:A($168,000/(1,000*2+1,500*4) * 2 = $42.00)
© 2012 John Wiley and Sons Canada, Ltd. 41 Cost Management
7.21 Mapping Costs to the Cost Hierarchy – Fairgood& Hernandez, CA
A. Receptionist salary is an organization-sustaining activity (1) 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-sustaining activity (1) 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 activity (4).
C. Photocopy machine rental is anorganization-sustaining activity (1) 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 anorganization-sustaining activity (1) because the entire facility uses
E. Audit manager’s salary is a unit-level activity (6)because the manager 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 activity (6) if the bill includes details of to
whom the calls were made, and could be product-sustaining activity (4) 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-sustaining activity (1).
G. Meal costs for entertaining clients could be a customer-sustaining activity (3)if related
only to that particular customer, or product sustaining activity(4)if the customer is
associated with only one product.
H. Costs of annual employee golf party is an organization-sustaining activity (1)because it
benefits all departments.
I. Office supplies such as paperclips and tablets of paper are organization-sustaining
activity (1)costs unless they can be traced to a particular product or batch.
J. Annual subscription for income tax regulations is a product-sustaining activity (4)if it
pertains to one department of the firm. If it pertains to the entire firm, it is a facility-
sustaining activity (2).
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 42
7.22 Identifying Costs Using the ABC Cost Hierarchies – Steam Whistle Brewing
Following are the CMA answers to this question. However, one could argue that some of the
unit-level costs could instead be categorized as batch-level.
A. Facility-sustainingcosts: Manufacturing facility $1,500,000
B. Product-sustaining costs: Product development $1,250,000
C. Batch-level costs: Production setup $700,000
D. Unit-level costs:
Materials handling $ 850,000
Production line labour 2,500,000
Power (assuming most power is to cool beer and
run machines, not for overhead) 500,000
Total unit-level costs $3,850,000
7.23 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 the shuttle. Batch-level costs for
the shuttle would include vehicle depreciation, maintenance, and gasoline, plus the
driver’s labour 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
© 2012 John Wiley and Sons Canada, Ltd. 43 Cost Management
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 activities and 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.
F. Organization-sustaining activities and costs relate to the entire organization. The CEO’s
salary, and building lease, rent or depreciation costs at the company’s headquarters are all
organization-sustaining costs. Companies such as Hertz also have large organization-
wide costs for computerized reservation and vehicle inventory systems.
7.24 Cost Pools and Cost Drivers
F Machining (As machine hours increase, costs such as maintaining machines
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
C Laundry in a hospital (As the number of laundry pounds increases, more labour
and supplies costs are incurred because more batches of clothes are washed.
7.25 Traditional Versus ABC Costing - Kalder Products
A. Total engineering change cost 6 change orders *$300 each $1,800
Total machine hours 1 MHr + 1.5 MHr 2.5 MHr
Rate $1,800 / 2.5 MHr $720/MHr
Total allocated cost for AJ40 1 MHr * $720/MHr $ 720
Total allocated cost for AJ60 1.5 MHr * $720/MHr 1,080
Total allocated costs $1,800
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 44
B. Total engineering change cost 6 change orders *$300 each $1,800
Total allocated cost for AJ40 4 change orders *$300 $1,200
Total allocated cost for AJ60 2 change orders * $300 600
Total allocated costs $1,800
C. Comparison of costs allocated under the two systems:
AJ40 AJ60 Total
Traditional costing $ 720 $1,080 $1,800
ABC costing 1,200 600 1,800
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.
7.26 ABC Cost Hierarchy, Traditional Versus ABC Costing – Yonex Company
Testing and Inspections Batch level activities and costs
Machine Setup Batch level activities and costs
Machine Stamping Unit level activities and costs
Plant Maintenance Facility sustaining level activities and costs
B. Total Labour Hours for two products: 1,500 + 2,500 = 4,000 hours
$400,000 / 4,000 hours = $100 per labour hour
MB-R: $100 x 1,500 = $150,000
MB-X: $100 x 2,500 = $250,000
Using the traditional costing method, MB-R is allocated $150,000 of the overhead
costs, while MB-X is allocated $250,000.
© 2012 John Wiley and Sons Canada, Ltd. 45 Cost Management
C. The overhead rate cost per activity is calculated as follows:
Total OH Rate
Activity MB-R MB-X Activity TotalCost Cost/Activity
Testing and Inspections 400 400 800 $120,000 $150
Machine Setup 120 80 200 $80,000 $400
Machine Stamping 25,000 15,000 40,000 $160,000 $4
Plant Maintenance 1,500 2,500 4,000 $40,000 $10
Activity OH Rate MB-R OH MB-X OH
Testing and Inspections $150 400 $60,000 400 $60,000
Machine Setup $400 120 $48,000 80 $32,000
Machine Stamping $4 25,000 $100,000 15,000 $60,000
Plant Maintenance $10 1,500 $15,000 2,500 $25,000
Total Overhead Allocated $223,000 $177,000
D. Using the traditional costing method, MB-X is over costed $250,000 versus $177,000.
This is likely to lead to inaccurate pricing and make the product less competitive in the
market. ABC costing better matches resources usage to the overhead costs, and thus can
help managers make better decisions, especially in resources usage, pricing, product mix,
or performance evaluation.
7.27 Traditional Versus ABC Costing – CompuTrain Learning Centre
A. Overhead rate for each type of activity:
Cost Activity Cost/Activity
Registration $10,000 120 + 280 = 400 students $25 per student
Computer Depreciation $36,000 1,400 + 1,000 = 2400hrs $15 per hour
Rent $26,000 16 + 10 = 26 classrooms classroom
Total Overhead Costs $72,000
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 46
Rate IT Training Office Training
Registration $25 120 $3,000 280 $ 7,000
Computer Depreciation $15 1,400 $21,000 1,000 $ 15,000
Rent $1,000 16 $16,000 10 $ 10,000
Total Overhead Costs $40,000 $ 32,000
B. The average cost per student for each service:
IT Training Office Training
Direct Materials (books & courseware) $9,000 $6,000
Direct Labour (instructors) 15,000 9,000
Registration 3,000 7,000
Computer Depreciation 21,000 15,000
Rent 16,000 10,000
Total Overhead costs 40,000 32,000
Total Costs $64,000 $47,000
# of students 120 280
Cost per student $533.33 $167.86
C. Under the traditional costing method, IT Training was over charged by $5,000 for the
overhead costs, which subsidized Office Training. As a result, IT Training per student
was over costed by $41.67, and Office Training per student was under costed by $17.86.
IT Training was over costed because based on the traditional costing method, IT Training
had higher labour cost, and overhead was proportionally costed more to the IT Training.
Using the ABC method, the overhead was charged based on the resources usage, which
better matched the activities to the costs.
© 2012 John Wiley and Sons Canada, Ltd. 47 Cost Management
7.28 ABC Costing, ABM - Applewood Electronics
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:
Total estimated overhead $4,800,000
Estimated machine hours:
Monarch (8.0 hours x 22,000 units) 176,000
Regal (4.0 hours x 4,000 units) 16,000
Total estimated machine hours 192,000
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
labour, machine usage, and allocated overhead, as follows:
Direct material $208.00 $584.00
Direct labour 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00
Machine usage 8 machhrs x $18 144.00 4 machhrs x $18 72.00
Overhead 8 machhrs x $25 200.00 4 machhrs x $25 100.00
Total $570.00 $798.00
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
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:
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 48
Soldering 1,185,000 solder jts x $0.6$ 711,000 385,000 solder jts x $$ 231,000
Shipments 16,200 shipments x $43 696,600 3,800 shipment x $43 163,400
Quality control 56,200 inspections x $16 899,200 21,300 inspections x $16 340,800
Purchase orders 80,100 POs x $5 400,500 109,980 POs x $5 549,900
Machine power 176,000 machhrs x $0.30 52,800 16,000 machhrs x $0.30 4,800
Machine setups 16,000 x $25 400,000 14,000 x $25 350,000
Total ManufacturingOverhead $3,160,100 $1,639,900
Overhead Per Unit $3,160,100/22,000 units $143.64 $1,639,900/4,000 units$ 409.98
Direct material 208.00 584.00
Direct labour 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00
Machine usage 8 machhrs x $18 144.00 4 machhrs x $18 72.00
Total ManufacturingCost Per Unit $513.64 $1,107.98
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.
1. Operating profit per unit under traditional cost accounting:
Selling Price $ 900.00 $1,140.00
Manufacturing (570.00) (798.00)
Selling, General, and Administrative (265.00) (244.60)
Traditional costing operating profit $ 65.00 $ 97.40
2. Operating profit per unit under ABC:
Selling Price $900.00 $1,140.00
Manufacturing (513.64) (1,107.98)
Selling, General, and Administrative (265.00) (244.60)
ABC costing operating profit $121.36 $ (212.58)
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.
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
© 2012 John Wiley and Sons Canada, Ltd. 49 Cost Management
margin for each product. Once this is done, the product with highest contribution margin
can be identified and emphasized.
7.29 ABC Costing, ABM - Palmer Company
A. Manufacturing cost per unit:
Machine setup 2 setups x $50.00 $ 100
Material handling 100 units x 19 parts x $0.50 950
Machining 100 units x 1.25 machine hours x $26.00 3,250
Assembly 100 units x 1.5 direct labour hours x $22.00 3,300
Inspection 100 units x $12.00 1,200
Direct materials 100 units x $100.00 10,000
Total Costs $18,800
Cost Per Unit $18,800/100 units $188
B. Full cost per unit
Total manufacturing cost per unit $188
Research and marketing costs per unit 140
Other non-manufacturing costs per unit 320
Total full cost per unit $648
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
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 per unit $648.00
Full cost needed to achieve desired profit 590.91
Cost savings required $ 57.09
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 50
7.30 ABC in Job Costing, ABM, Non-Value-Added Activities - Kestral Manufacturing
A. Following are the ABC allocation rates:
Activity Cost / Activity level Allocation rate
Machine set-up $ 40,000 / 400 $100
Material handling 160,000 / 16,000 $10
Product design 100,000 / 2,000 $50
Number of inspection 260,000 /13,000 $20
For job 42, overhead costs = (2x$100)+(60x$10)+ (40x$20) +(20x$50) = $2,600
B. For job 43, overhead costs = (4x$100)+(20x$10)+(20x$20)+(100x$50) = $6,000
For the 100 units completed the cost per unit would be calculated as follows:
Direct Materials 24,000
Direct Labour 4,000
Overhead Allocated 6,000
Total Job cost 34,000
Cost per unit = 34,000 / 100 units = $340
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.
7.31 Design ABC System, Per-Unit ABC Costs, Uncertainties - Elite Daycare
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
a per-child cost object. This problem focuses on the daycare cost function, so the cost
object is the daycare program.
© 2012 John Wiley and Sons Canada, Ltd. 51 Cost Management
Next, cost pools need to be developed. For Elite Daycare, there appear to a number of
different activities: greeting and leaving, preparing and serving food, supervising naps,
supervising recreation, and activity time. The greeting and supervising activities can
probably be combined into one cost pool. However, supplies are probably used during
activity time, and the director may want to know an approximate cost per child for
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
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
After-school (10 children x 1 snack x 250 days) 2,500
Number of meals served 25,000
Total food cost $20,000
Time spent on meal preparation (20% x $100,000) 20,000
Total cost of snacks and meals per year $40,000
Estimated cost per snack/meal ($40,000/25,000) $1.60
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 52
The total annual ABC cost per child is calculated as follows:
Full-time (3 snacks/meals x 250 days x $1.60) $1,200
After-school (1 snack/meal x 250 days x $1.60) $ 400
Full-time ($10,000/30 children) 333
After-school ($8,000/10 children) 800
Supervising educational activities:
Full-time (50% x 91% x $100,000)/30 1,517
After-school (50% x 9% x $100,000)/10 450
Supervising naps, recreation, and greeting:
Full-time (30% x 91% x $100,000)/30 910
After-school (30% x 9% x $100,000)/10 ______ 270
Total Annual Cost Per Child $3,960 $1,920
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.
7.32 ABM, 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
organization to identify improvements that can be made in quality and efficiency or cost
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
© 2012 John Wiley and Sons Canada, Ltd. 53 Cost Management
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.
7.33 Quality Costs Using ABC Versus Traditional Costing - New-Rage Cosmetics
1. Quality control cost per order using ABC
Incoming material inspection 12 types of material x $11.50 $ 138.00
In-process inspection 17,500 units x $0.14 2,450.00
Product certification 25 orders x $77.00 1,925.00
Total quality control costs $4,513.00
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
= Directlabour costs x 14.5%
= $27,500 x 14.5%
Quality control cost per order = $3,987.50/25 orders = $159.50
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 labour costs may be related to number of units
inspected if it takes more labour to produce more units, but in automated manufacturing
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 54
settings this is not always the case. In addition, direct labour costs are not related to types
of materials. Therefore, using direct labour 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.
7.34 Categorizing Quality Activities
Please see Exhibit 7.7 for more details about these answers.
___A___ 1. Inspection of units when they are 100% complete to remove defective
___P___ 2. Design of a process with as few parts as possible to reduce the chance of
___PS__ 3. Warranty costs for defective products returned to the factory for rework.
___PR__ 4. Reworking of spoiled units before they leave the factory.
___PS__ 5. Costs to defend the company against lawsuits for damages caused by
_P or A_ 6. Tracking number of defects for each manufacturing team and posting of
daily defect rates on a plant-wide bulletin board.
(Used to motivate employees to improve quality, also requires appraisal)
___PR__ 7. Redesign of a manufacturing process to reduce the rate of defects.
7.35 GPK Multi-Level Income Statement -- Krishnan Manufacturing
Following is a multilevel income statement for the Krishnan Manufacturing Plant using a
Variable costs 200,000
Contribution margin 1 600,000
Fixed costs, product 150,000
Idle capacity costs 75,000
Contribution margin 2 375,000
Fixed costs, company 200,000
GPK profit $175,000
The problem states that “Krishnan’s accountant aggregates the idle capacity costs.” Thus,
the solution above assumes that the $75,000 idle capacity cost relates only to the Krishnan
plant, not to the entire company.
© 2012 John Wiley and Sons Canada, Ltd. 55 Cost Management
7.36 GPK, RCA, Cost Rates -- Diagnostic Services
A and B. Cost function calculations:
Fixed costs: $3,000 per year
Proportional costs: $2.10 per X-ray hour × 5,000 budgeted X-ray hours = $10,500
Fixed costs: 6,000 kWh × $0.10 per kWh = $600
Proportional costs: 4kWh per hour of X-ray use × 5,000 budgeted X-ray hours ×
$0.10 per kWh = $2,000
Fixed costs: 300 technician hours × $45 per labour hour = $13,500
Proportional costs: 1 technician hour per hour of X-ray use × 5,000 budgeted X-ray
hours × $45 per labour hour = $225,000
Fixed costs: 100 maintenance hours × $20 per hour = $2,000
Proportional costs: 0.0424 maintenance hour per hour of X-ray use × 5,000 budgeted
X-ray hours × $20 per maintenance hour = $4,240
Fixed costs: 1,000 square feet × $25 per square feet = $25,000
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 56
A and B (continued). Cost rates under GPK and RCA:
Cost Centre: X-Ray Resource Cost Pool: X-Ray
Fixed Proportional Fixed Proportional
Output Measure – X-Ray Hours: Output Measure – X-Ray Hours:
Practical capacity 5,600 Theoretical capacity 8,760
Budgeted capacity 5,000 Budgeted capacity 5,000
Primary Costs: Primary Costs:
Depreciation $ 93,100 $ 0 Depreciation $ 93,100 $ 0
Supplies 3,000 10,500 Supplies 3,000 10,500
Electricity 600 2,000 Electricity 600 2,000
Total Primary Costs 96,700 12,500 Total Primary Costs 96,700 12,500
From Other Cost Pools (i.e., From Other Resources (i.e.,
Secondary Costs): Secondary Costs):
Labour (technician) 13,500 225,000 Labour (technician) 13,500 225,000
Maintenance - equipment 2,000 4,240 Maintenance - equipment 2,000 4,240
Maintenance - facilities 25,000 0 Maintenance - facilities 25,000 0
Fully Assigned Resource Costs $137,200 $241,740 Fully Assigned Resource Costs $137,200 $241,740
Fully Assigned Cost Rate Per Hour $24.50 $48.348 Fully Assigned Cost Rate Per Hour $15.662 $48.348
C. Cost for patient requiring 0.5 hour of time:
GPK cost = ($24.50 + $48.348) × 0.5 hour = $36.424
RCA cost = ($15.662 + $48.348) × 0.5 hour = $32.005
D. GPK cost is higher than RCA cost because RCA uses theoretical capacity for fixed costs. Theoretical capacity is larger than
budgeted capacity in the denominator, resulting in a smaller cost rate.
© 2012 John Wiley and Sons Canada, Ltd. 57 Cost Management
E. The technician needs to be on hand for the hours that the diagnostic centre is open. There
are likely certain tasks that need to be done on a daily basis to prepare the machine. Costs
for maintenance are similar; some routine maintenance is done on a regular basis and
does not depend on the number of X-ray hours. Even though these costs are proportional
in the technician and maintenance cost pools, a portion of each cost is fixed with respect
to X-ray equipment usage.
7.37 GPK, RCA Capacity Analysis – Diagnostic Services
Budgeted Practical Theoretical
Capacity Capacity Capacity
Estimated volume – X-ray hours 5,000 5,600 8,760
Fixed cost rate per X-ray hour $27.44 * $24.50 $15.662
Fixed costs allocated to patient services
(5,200 hours × fixed cost rate) $142,688 $127,400 $81,443
Assigned to idle capacity:
Unplanned idle capacity
(5,000 – 5,200) hours × fixed cost rate ($5,488) ($4,900) ($3,132)
Planned idle capacity:
(5,000-5,000) hours × $27.44 0
(5,600-5,000) hours × $24.50 14,700
(8,760-5,000) hours × $15.662 58,889
Total Fixed Costs Assigned $137,200 $137,200 $137,200
* $137,200 fixed costs ÷ 5,000 budgeted capacity = $27.44
© 2012 John Wiley and Sons Canada, Ltd. Chapter 7: Activity-Based Costing and Management 58
7.38 Setting Up an ABC System, Uncertainties
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 exi