Solutions Manual - Chapter 22: Activity-Based Costing

Multiple Choice Questions - Solutions

1. Activity-based costing allocates overhead based on:

   • Answer: c) ABC allocates based on activities that drive costs.

2. A cost driver is:

   • Answer: b) Cost driver is a factor that causes activity cost.

3. Traditional costing may:

   • Answer: b) Traditional costing may overcost high-volume products.

4. Activity-based costing is most beneficial when:

   • Answer: c) ABC is most beneficial when overhead is significant and products are diverse.

5. A cost pool is:

   • Answer: b) Cost pool is a grouping of costs by activity.

6. Activity rate is calculated as:

   • Answer: b) Activity rate = Activity cost ÷ Cost driver volume.

7. ABC provides:

   • Answer: b) ABC provides more accurate costs.

8. Traditional costing uses:

   • Answer: b) Traditional costing uses a single overhead rate.

9. Cost drivers should be:

   • Answer: b) Cost drivers should be causal, measurable, and cost-effective.

10. ABC is most appropriate when:

• Answer: c) ABC is most appropriate when products consume resources differently.

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Questions - Solutions

Question 1: Definition and Differences

Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. ABC recognizes that it is activities that cause costs, not products.

Differences from traditional costing:

• Traditional: Uses single overhead rate based on one allocation base (e.g., direct labor hours)
• ABC: Uses multiple cost pools and cost drivers to allocate overhead
• Traditional: May distort costs, especially when products consume resources differently
• ABC: Provides more accurate costs by linking costs to activities that drive them
• Traditional: Simpler but less accurate
• ABC: More complex but more accurate

Question 2: Why Traditional Costing May Be Inaccurate

Traditional costing may provide inaccurate product costs because:

• Single allocation base: May not reflect actual cost drivers
• Volume bias: High-volume products may subsidize low-volume products
• Overcosting: Some products assigned too much overhead
• Undercosting: Some products assigned too little overhead
• Ignores complexity: Complex products may consume more resources but get same overhead rate
• Ignores diversity: Products that consume resources differently are treated the same

Example: A simple, high-volume product and a complex, low-volume product may both use direct labor hours, but the complex product uses more setup time, more inspections, and more engineering support. Traditional costing doesn't capture this.

Question 3: Steps in Implementing ABC

1. Identify activities: List all activities that consume resources
2. Assign costs to activities: Group costs into cost pools by activity
3. Identify cost drivers: Determine what causes each activity cost
4. Calculate activity rates: Divide activity cost by cost driver volume
5. Allocate costs to products: Multiply activity rate by product's use of cost driver
6. Calculate product costs: Add direct costs and allocated activity costs

Question 4: Cost Drivers

A cost driver is a factor that causes or drives the cost of an activity. It's the measure of activity consumption.

Identifying appropriate cost drivers:

• Causal relationship: Must cause the activity cost
• Measurable: Must be quantifiable
• Cost-effective: Cost of tracking must be less than benefit
• Practical: Must be feasible to measure

Examples:

• Setup activity → Number of setups
• Material handling → Number of material moves
• Quality inspection → Number of inspections
• Machine processing → Machine hours

Question 5: Cost Pools

A cost pool is a grouping of individual costs that are allocated using a single cost driver.

How created:

• Identify activities that consume resources
• Group related costs together
• Assign all costs for an activity to one cost pool
• Each cost pool has one cost driver

Example: All setup-related costs (setup labor, setup materials, setup equipment) are grouped into a "Setup" cost pool, allocated using "number of setups" as the cost driver.

Question 6: Calculating ABC Product Costs

1. Direct costs: Direct materials + Direct labor (same as traditional)
2. Activity costs: For each activity:
   • Calculate activity rate = Activity cost ÷ Cost driver volume
   • Allocate to product = Activity rate × Product's use of cost driver
3. Total product cost: Direct costs + Sum of all activity costs

Example:

• Direct materials: €50
• Direct labor: €30
• Setup (€50/setup × 1 setup): €50
• Processing (€10/hour × 2 hours): €20
• Inspection (€20/inspection × 1 inspection): €20
• Total: €170

Question 7: Advantages and Disadvantages

Advantages of ABC:

• More accurate product costs
• Better decision-making information
• Identifies truly profitable/unprofitable products
• Helps manage activities that drive costs
• Supports better pricing decisions
• Identifies cost reduction opportunities

Disadvantages of ABC:

• More complex and costly to implement
• Requires more data collection
• May be overkill for simple operations
• Cost of implementation may exceed benefits
• Requires ongoing maintenance

Traditional Costing:

• Advantages: Simple, low cost, sufficient for simple operations
• Disadvantages: May distort costs, less accurate, poor for diverse products

Question 8: When to Use ABC

Use ABC when:

• Overhead costs are significant
• Products/services are diverse
• Products consume resources differently
• Traditional costing shows cost distortions
• Need accurate cost information for decisions
• Benefits exceed implementation costs

Traditional costing sufficient when:

• Overhead is small relative to direct costs
• Products are very similar
• Simple operations
• Cost of ABC exceeds benefits
• Single overhead rate is reasonably accurate

Question 9: ABC and Decision-Making

ABC helps with decision-making by:

• Accurate costs: Provides true product/service costs
• Profitability analysis: Identifies which products are truly profitable
• Pricing: Supports accurate pricing decisions
• Product mix: Helps decide which products to emphasize
• Cost management: Identifies activities to manage or reduce
• Resource allocation: Shows where resources are consumed
• Performance evaluation: Helps evaluate product/process performance

Question 10: Luxembourg SME Implementation

Luxembourg SMEs can implement ABC effectively by:

• Start simple: Begin with most significant activities
• Focus on high-impact areas: Identify activities with largest costs
• Use available data: Leverage existing systems where possible
• Gradual implementation: Phase in ABC over time
• Cost-benefit analysis: Ensure benefits justify costs
• Software support: Use accounting software that supports ABC
• Training: Train staff on ABC concepts and data collection
• Regular review: Update activity rates and cost drivers regularly

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Problems Set A - Solutions

Problem A-1: Identify Activities

Five activities for a manufacturing business:

1. Material Handling

   • Cost driver: Number of material moves
   • Example: Moving materials from warehouse to production

2. Machine Setup

   • Cost driver: Number of setups
   • Example: Setting up machines for different products

3. Quality Inspection

   • Cost driver: Number of inspections
   • Example: Inspecting finished products

4. Production Processing

   • Cost driver: Machine hours
   • Example: Running machines to produce products

5. Order Processing

   • Cost driver: Number of orders
   • Example: Processing customer orders

Problem A-2: Calculate Activity Rate

• Activity cost: €8,000
• Cost driver volume: 400 units
• Activity rate = €8,000 ÷ 400 = €20 per unit

Problem A-3: Allocate Activity Costs

• Activity rate: €20 per setup
• Product requires: 3 setups
• Activity cost allocated = €20 × 3 = €60

Problem A-4: ABC Product Cost

• Direct materials: €50
• Direct labor: €30
• Activity costs:
  • Setup: €60
  • Processing: €40
  • Inspection: €20
• Total product cost = €50 + €30 + €60 + €40 + €20 = €200

Problem A-5: Compare Traditional vs. ABC

Traditional costing:

• Overhead rate: €15 per hour
• Product uses 2 hours
• Traditional overhead = €30

ABC:

• Setup: €50 (1 setup)
• Processing: €20 (2 hours × €10)
• Inspection: €15 (1 inspection)
• ABC overhead = €85

Difference:

• ABC overhead (€85) is €55 higher than traditional (€30)
• This suggests the product is more complex than traditional costing indicates
• Product requires setup and inspection activities that traditional costing doesn't capture
• ABC provides more accurate cost allocation
• Product may be undercosted under traditional method

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Problems Set B - Solutions

Problem B-1: Complete ABC Implementation

a) Activity Rates:

• Setup: €10,000 ÷ 200 = €50 per setup
• Processing: €20,000 ÷ 4,000 = €5 per machine hour
• Inspection: €6,000 ÷ 300 = €20 per inspection
• Ordering: €4,000 ÷ 100 = €40 per order

b) Activity Costs for Product X:

• Setup: €50 × 2 = €100
• Processing: €5 × 10 = €50
• Inspection: €20 × 1 = €20
• Ordering: €40 × 1 = €40
• Total activity costs: €210

c) Total Overhead for Product X:

• €210 (same as activity costs since all overhead is allocated)

Problem B-2: Traditional vs. ABC Comparison

Traditional Costing:

• Product A: 2 hours × €10 = €20 overhead
• Product B: 3 hours × €10 = €30 overhead

ABC:

• Product A:

  • Setup: €50 × 1 = €50
  • Processing: €5 × 2 = €10
  • Inspection: €20 × 1 = €20
  • Total: €80

• Product B:

  • Setup: €50 × 3 = €150
  • Processing: €5 × 3 = €15
  • Inspection: €20 × 2 = €40
  • Total: €205

Comparison:

• Product A: Traditional €20 vs. ABC €80 (undercosted by €60 under traditional)
• Product B: Traditional €30 vs. ABC €205 (undercosted by €175 under traditional)
• Both products are significantly undercosted under traditional method
• Product B is much more complex (more setups and inspections) than traditional costing shows
• ABC reveals true cost structure

Problem B-3: Multi-Activity ABC

Activity Rates:

• Client acquisition: €12,000 ÷ 30 = €400 per client
• Project setup: €8,000 ÷ 40 = €200 per project
• Service delivery: €20,000 ÷ 1,000 = €20 per hour
• Administration: €5,000 ÷ 500 = €10 per transaction

Service A:

• Direct costs: €500
• Client acquisition: €400 × 1 = €400
• Project setup: €200 × 1 = €200
• Service delivery: €20 × 20 = €400
• Administration: €10 × 10 = €100
• Total cost: €1,600

Service B:

• Direct costs: €400
• Client acquisition: €0 (existing client)
• Project setup: €200 × 1 = €200
• Service delivery: €20 × 15 = €300
• Administration: €10 × 8 = €80
• Total cost: €980

Problem B-4: ABC Profitability Analysis

ABC Analysis:

• Product A: Cost €100, Price €120, Profit €20 (16.7% margin)
• Product B: Cost €80, Price €100, Profit €20 (20% margin)
• Both products are profitable under ABC

Traditional Analysis:

• Product A: Cost €90, Price €120, Profit €30 (25% margin) - Appears very profitable
• Product B: Cost €110, Price €100, Loss €10 (-10%) - Appears unprofitable

Difference and Implications:

• Traditional costing overcosts Product B and undercosts Product A
• Under traditional, management might discontinue Product B (shows loss) and focus on Product A (shows high profit)
• Under ABC, both products are profitable, with Product B actually having higher margin
• ABC reveals that Product A is less profitable than traditional shows
• Decision: Keep both products, but ABC suggests Product B is actually better
• Traditional costing could lead to wrong decisions (discontinuing profitable Product B)

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Comprehensive Problem 22 - Solutions

1. Calculate Activity Rates

a) Material Handling Rate:

• Activity cost: €8,000
• Cost driver volume: 400 moves
• Rate = €8,000 ÷ 400 = €20 per move

b) Machine Setup Rate:

• Activity cost: €12,000
• Cost driver volume: 300 setups
• Rate = €12,000 ÷ 300 = €40 per setup

c) Quality Inspection Rate:

• Activity cost: €6,000
• Cost driver volume: 600 inspections
• Rate = €6,000 ÷ 600 = €10 per inspection

d) Production Processing Rate:

• Activity cost: €14,000
• Cost driver volume: 3,500 machine hours
• Rate = €14,000 ÷ 3,500 = €4 per machine hour

e) Packaging Rate:

• Activity cost: €4,000
• Cost driver volume: 2,000 packages
• Rate = €4,000 ÷ 2,000 = €2 per package

f) Engineering/Design Rate:

• Activity cost: €6,000
• Cost driver volume: 200 hours
• Rate = €6,000 ÷ 200 = €30 per engineering hour

2. Calculate Product Costs Using ABC

Product X (High Volume, Simple):

• Direct materials: €50 × 1,000 = €50,000
• Direct labor: €30 × 1,000 = €30,000
• Material handling: €20 × 50 = €1,000
• Machine setup: €40 × 20 = €800
• Quality inspection: €10 × 100 = €1,000
• Production processing: €4 × 1,000 = €4,000
• Packaging: €2 × 1,000 = €2,000
• Engineering/design: €30 × 10 = €300
• Total cost: €89,100
• Cost per unit: €89,100 ÷ 1,000 = €89.10

Product Y (Medium Volume, Moderate):

• Direct materials: €80 × 500 = €40,000
• Direct labor: €50 × 500 = €25,000
• Material handling: €20 × 150 = €3,000
• Machine setup: €40 × 100 = €4,000
• Quality inspection: €10 × 200 = €2,000
• Production processing: €4 × 1,500 = €6,000
• Packaging: €2 × 500 = €1,000
• Engineering/design: €30 × 80 = €2,400
• Total cost: €83,400
• Cost per unit: €83,400 ÷ 500 = €166.80

Product Z (Low Volume, Complex):

• Direct materials: €120 × 200 = €24,000
• Direct labor: €80 × 200 = €16,000
• Material handling: €20 × 200 = €4,000
• Machine setup: €40 × 180 = €7,200
• Quality inspection: €10 × 300 = €3,000
• Production processing: €4 × 1,000 = €4,000
• Packaging: €2 × 500 = €1,000
• Engineering/design: €30 × 110 = €3,300
• Total cost: €62,500
• Cost per unit: €62,500 ÷ 200 = €312.50

3. Compare to Traditional Costing

Traditional Costing:

• Overhead rate: 78.125% of direct labor cost

Product X:

• Direct materials: €50
• Direct labor: €30
• Overhead: €30 × 78.125% = €23.44
• Total cost per unit: €103.44

Product Y:

• Direct materials: €80
• Direct labor: €50
• Overhead: €50 × 78.125% = €39.06
• Total cost per unit: €169.06

Product Z:

• Direct materials: €120
• Direct labor: €80
• Overhead: €80 × 78.125% = €62.50
• Total cost per unit: €262.50

Comparison:

Product	ABC Cost	Traditional Cost	Difference	Status
X	€89.10	€103.44	-€14.34	Overcosted (traditional)
Y	€166.80	€169.06	-€2.26	Slightly overcosted
Z	€312.50	€262.50	+€50.00	Undercosted (traditional)

Analysis:

• Product X is overcosted by €14.34 under traditional (simple, high-volume product)
• Product Y is slightly overcosted by €2.26 (moderate complexity)
• Product Z is significantly undercosted by €50.00 under traditional (complex, low-volume product)
• Traditional costing subsidizes complex Product Z with overhead from simple Product X

4. Profitability Analysis

ABC Profitability:

• Product X: Price €150 - Cost €89.10 = €60.90 profit (40.6% margin)
• Product Y: Price €200 - Cost €166.80 = €33.20 profit (16.6% margin)
• Product Z: Price €350 - Cost €312.50 = €37.50 profit (10.7% margin)

Traditional Profitability:

• Product X: Price €150 - Cost €103.44 = €46.56 profit (31.0% margin)
• Product Y: Price €200 - Cost €169.06 = €30.94 profit (15.5% margin)
• Product Z: Price €350 - Cost €262.50 = €87.50 profit (25.0% margin)

Analysis:

• ABC shows: Product X is most profitable (40.6%), followed by Product Z (10.7%), then Product Y (16.6%)
• Traditional shows: Product Z appears most profitable (25.0%), followed by Product X (31.0%), then Product Y (15.5%)
• Key difference: Traditional makes Product Z look very profitable (25% margin), but ABC shows it's only 10.7% margin
• Most profitable: Product X under both methods, but ABC shows it's even more profitable than traditional indicates
• Least profitable: Product Z under ABC (10.7%), but traditional shows it as second most profitable

5. Decision-Making

a) Focus Product:

• Based on ABC, Product X should be the focus (highest margin at 40.6%)
• Product X is simple, high-volume, and most profitable
• Consider increasing production of Product X

b) Pricing Adjustments:

• Product Z: Consider price increase (only 10.7% margin under ABC)
• Current price €350 may be too low for complexity
• Need to cover high setup, inspection, and engineering costs
• Product Y: Margin is acceptable (16.6%), pricing seems reasonable
• Product X: Pricing is good (40.6% margin), could even reduce price to increase volume

c) Cost Management Actions:

• Product Z: Focus on reducing setup costs, inspection costs, or engineering costs
• Consider process improvements to reduce complexity
• Evaluate if all inspections are necessary
• Look for ways to reduce setup time
• Product X: Already efficient, maintain current processes
• Product Y: Moderate efficiency, look for incremental improvements

d) Discontinue Products:

• Do not discontinue any products - all are profitable under ABC
• Product Z has lowest margin but still profitable
• Consider if Product Z serves strategic purpose (e.g., customer relationships, market positioning)
• If Product Z cannot be improved, consider discontinuing only if resources can be better used elsewhere

6. Implementation Considerations

a) Benefits:

• More accurate product costs
• Better pricing decisions
• Identifies truly profitable products
• Helps manage activities that drive costs
• Supports better resource allocation
• Reveals cost distortions

b) Challenges:

• Implementation cost and complexity
• Data collection requirements
• Need to identify activities and cost drivers
• Ongoing maintenance and updates
• Training staff
• May require system changes

c) Implementation Steps:

1. Identify key activities
2. Assign costs to activities
3. Identify cost drivers
4. Calculate activity rates
5. Allocate costs to products
6. Compare to traditional costing
7. Use ABC information for decisions
8. Regular review and updates

d) Is ABC Worth the Cost?

• Yes, for this company:
  • Significant overhead (€50,000)
  • Diverse products with different complexity
  • Cost distortions identified (Product Z undercosted by €50)
  • Better decisions will improve profitability
  • Benefits likely exceed implementation costs

7. Luxembourg Considerations

a) Compliance Benefits:

• More accurate inventory valuation (PCN requirements)
• Better cost allocation for tax purposes
• Supports proper cost accounting standards
• Helps with transfer pricing if applicable
• Better documentation of costs

b) PCN Accounts:

• Direct materials: PCN 31xx (Inventories)
• Direct labor: PCN 64xx (Personnel Expenses)
• Material handling: PCN 62xx (Operating Expenses)
• Machine setup: PCN 62xx (Operating Expenses)
• Quality inspection: PCN 62xx (Operating Expenses)
• Production processing: PCN 62xx (Operating Expenses)
• Packaging: PCN 62xx (Operating Expenses)
• Engineering/design: PCN 62xx (Operating Expenses)
• Cost of Goods Sold: PCN 60xx (Cost of Sales)

c) VAT Impact:

• VAT on materials: Recorded as VAT Recoverable (PCN 4451)
• VAT on sales: Recorded as VAT Payable (PCN 4457)
• Internal cost analysis excludes VAT
• ABC costs are before VAT (for internal analysis)
• VAT collected on sales is a liability, not revenue

d) Luxembourg-Specific Benefits:

• Better cost information for competitive pricing in Luxembourg market
• Helps with cost management given high operating costs
• Supports profitability in competitive environment
• Better decision-making for Luxembourg SMEs
• Helps identify cost reduction opportunities
• Supports business planning and financing

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Case Solutions

Case 22-1: Implementing ABC

1. Should Implement ABC?

• Yes, if:
  • Overhead is significant
  • Products/services are diverse
  • Current costing may be inaccurate
  • Benefits exceed costs
  • Management needs better cost information

2. Key Activities:

• Material handling
• Machine setup
• Quality inspection
• Production processing
• Order processing
• Customer service
• Administration
• (Varies by business type)

3. Appropriate Cost Drivers:

• Material handling → Number of moves
• Machine setup → Number of setups
• Quality inspection → Number of inspections
• Production processing → Machine hours or labor hours
• Order processing → Number of orders
• Customer service → Number of service calls
• Administration → Number of transactions

4. Simple Implementation:

• Start with 3-5 most significant activities
• Use existing data where possible
• Focus on high-impact areas
• Phase in gradually
• Use simple cost drivers
• Don't overcomplicate

5. Expected Benefits:

• More accurate product costs
• Better pricing decisions
• Identify profitable/unprofitable products
• Better cost management
• Improved profitability
• Better resource allocation

6. Justifying Cost:

• Calculate cost of implementation
• Estimate benefits (improved pricing, better decisions)
• Compare cost to benefits
• Show cost distortions under current system
• Demonstrate potential profit improvements
• Consider long-term benefits

Case 22-2: Cost Distortion Problem

1. Why Traditional Showed Product A as Profitable:

• Traditional costing uses single overhead rate
• Product A may be high-volume, simple product
• Overhead allocated based on volume or labor
• Product A may not consume many overhead resources
• Traditional method doesn't capture complexity

2. Why ABC Shows Unprofitable:

• ABC allocates overhead based on activities consumed
• Product A may consume many activities (setups, inspections, etc.)
• Activity costs allocated to Product A exceed traditional allocation
• True cost is higher than traditional shows
• Product A may be complex despite appearing simple

3. Activities Product A Consumes:

• Multiple setups (frequent changeovers)
• Many inspections (quality issues)
• Material handling (complex materials)
• Engineering support (design changes)
• Special processing requirements
• (Specific activities depend on situation)

4. Discontinue or Reprice:

• Reprice first: Increase price to cover true costs
• If market won't accept higher price, consider discontinuing
• Evaluate strategic value (customer relationships, market position)
• Consider process improvements to reduce costs
• Make decision based on ABC information

5. Other Products with Similar Issues:

• Low-volume, complex products likely undercosted
• Products requiring many setups
• Products with high inspection requirements
• Custom or specialized products
• Products with engineering support needs

6. Company Response:

• Implement ABC for all products
• Review all product costs using ABC
• Adjust pricing based on ABC costs
• Identify and manage cost drivers
• Consider discontinuing unprofitable products
• Focus on truly profitable products
• Improve processes to reduce costs

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End of Chapter 22 Solutions