Atkinson, Solutions Manual t/a Management Accounting, 6E
Chapter 5
Activity-Based Cost
Systems
QUESTIONS
5-1 Traditional volume-based cost allocation systems that use only drivers that
vary directly with the volume of products produced—such as direct labor
dollars, direct labor hours, or machine hours—are likely to systematically
distort product costs because they break the link between the cause for the
costs and the basis for assignment of the costs to the individual products. Costs
may vary not only with respect to volume of production, but also, for example,
with batch-related activities (e.g., changeovers, setups, and inspection of the
first item of production run) and the number of products (e.g., scheduling
materials receipts and improving products). Also, cost distortions tend to be
greater with greater differences between relative proportions of indirect
resources used by cost objects because traditional cost assignments based on
volume-related measures do not accurately reflect these differences.
5-2 Volume-based traditional product costing systems that use only drivers that
vary directly with the volume of products produced—such as direct labor
dollars, direct labor hours, or machine hours—are most likely to distort
product costs under the following two conditions: (1) Indirect and support
expenses are high, especially when they exceed the cost of the allocation base
itself (such as direct labor cost); and (2) Product diversity is high: the plant
produces both high-volume and low-volume products, standard and custom
products, and complex and simple products. The combination of these two
conditions will magnify the distortions that arise because volume-based
product costing systems do not accurately reflect differences in non-volume-
related resource usage across products or other cost objects.
Activity-based costing systems provide more accurate costs when these two
conditions hold by creating more accurate links between the causes of indirect
and support costs and the bases for assignment of the costs to cost objects. For
example, costs may vary not only with respect to volume of production, but
also activities such as changeovers, setups, and inspection of the first item of
–138–
,Atkinson, Solutions Manual t/a Management Accounting, 6E
production run, which are not done in proportion to the number of units
produced. Moreover, some costs vary with the number of different products
(e.g., scheduling materials receipts and improving products).
5-3 Yes, traditional costing systems are more likely to overcost high-volume
products because all indirect and support costs are assigned to products in
proportion to the number of production units (through volume-based cost
drivers), and the low-volume products are likely to require higher indirect and
support costs per unit. The high-volume products essentially cross-subsidize
the low-volume products in the sense that indirect and support costs are
assigned uniformly in proportion to volume.
5-4 Companies producing a varied and complex mix of products require many
more resources to support their highly varied mix, and therefore have higher
costs. Examples of the greater resources required include a much larger
production support staff to schedule machine and production runs; perform
changeovers and setups between production runs; inspect items at the
beginning of each production run; move materials; ship and expedite orders;
develop new and improve existing products; negotiate with vendors; schedule
materials receipts; order, receive, and inspect incoming materials and parts;
and update and maintain the much larger computer-based information system.
5-5 A significant change in resource costs triggers an update of the capacity cost
rates. A significant and permanent change in operations, such as the efficiency
with which an activity is performed, triggers an update of the unit time
estimate. If new activities become part of operations, the time to perform the
activity will be estimated and then multiplied by the appropriate capacity cost
rate to determine the cost of the activity.
5-6 The two sets of parameters that must be estimated in time-driven activity-
based costing are 1) the capacity cost rate for each type of indirect resource;
that is, the unit cost of supplying capacity for each department or process,
based on practical capacity, and 2) the consumption of capacity, which is an
estimate of how much of a resource’s capacity (such as time or space) is used
by the activities performed to produce the various products, services, or
customers.
To compute a capacity cost rate, first identify all costs incurred to supply that
resource (such as a machine, an indirect production employee, the computer
system, factory space, a warehouse, or a truck). Then, identify the capacity
supplied by that resource. The capacity would be the hours of work provided
by the machine or production employee, or the space provided by the
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, Chapter 5: Activity-Based Cost Systems
warehouse or truck. For most resources (people, equipment, and machines),
capacity is measured by the time supplied. The resource’s capacity cost rate is
calculated by dividing its cost by the capacity it supplies, usually expressed as
a cost per hour or cost per minute. For warehouses, production space, and
trucks, the capacity cost rate would be measured by cost per square foot (or
square meter) of usable space. For computer memory, the resource capacity
cost rate would be the cost per megabyte or gigabyte.
5-7 Managers use the information on activity costs to identify opportunities for
operational improvements and reductions in operations costs, decisions about
product mix and pricing, and targeted customer segments. An example of an
operational change is requiring minimum order sizes to eliminate short,
unprofitable production runs. Another example is changing the facility layout
to reduce moves of work in progress. Product designs can be changed in order
to manufacture products with fewer parts or common parts to reduce material
handling support costs. Finally, as discussed in more detail in Chapter 6, if
activity-based cost analysis shows that full-pallet shipments are less costly per
unit than partial-pallet shipments, customers can be encouraged to receive full-
pallet shipments. Of course, customers who insist on very small order sizes or
partial-pallet shipments can be charged a price high enough to cover the extra
costs associated with such activities.
5-8 The capacity cost driver rate should reflect the underlying efficiency of the
process—for example, the cost of resources to handle each production order—
and this efficiency is measured better by using the capacity of the resources
supplied (practical capacity) as the denominator when calculating capacity
cost driver rates. The numerator in a capacity cost driver rate calculation
represents the costs of supplying resource capacity to do work. The
denominator should match the numerator by representing the quantity of work
the resources can perform. Unassigned costs represent the cost of unused
capacity and should be used as feedback to managers on their supply and
demand decisions.
5-9 Immediate financial improvement may not follow even after process
improvements reduce the demand for indirect and support resources. This is
because the support costs are often committed. The organization must actively
manage the unused capacity by increasing the volume of business or reducing
the supply of unused resources.
5-10 Service organizations are often ideally suited for activity-based costing
because virtually all of the costs for a service company are indirect and appear
–140–
, Atkinson, Solutions Manual t/a Management Accounting, 6E
to be fixed. The large component of apparently fixed costs in service
companies arises because, unlike manufacturing companies, service
companies have virtually no material costs—the prime source of short-term
variable costs. Service companies must supply virtually all of their resources
in advance to provide the capacity to perform work for customers during each
period. Fluctuations during the period of demand by individual products and
customers for the activities performed by these resources do not influence
short-term spending to supply the resources.
5-11 As mentioned in 5-10, virtually all the costs for a service company are indirect
and appear to be fixed. Service companies have few or no direct materials and
many of their personnel provide indirect, not direct, support to products and
customers. Consequently, service companies do not have direct, traceable
costs to serve as convenient allocation bases.
Unlike physical products, services cannot be inventoried for future sales.
Service companies must supply virtually all their resources in advance to
provide the capacity to perform work for customers during each period, and
demand often fluctuates. For some service industries, the increase in spending
resulting from an incremental transaction or customer is essentially zero.
Therefore, service companies making decisions about products and customers
based on short-term variable costs might provide a full range of all products
and services to customers at prices near zero, leading to little recovery of the
costs of all the committed resources supplied in order to deliver services to
customers.
It can be difficult to identify and measure the outputs for a service
organization. The variation in demand for organizational resources is much
more customer-driven in service organizations than in manufacturing
organizations. A service company can determine and control the efficiency of
its internal activities, but customers determine the quantity of demands for
these operating activities. For example, customers may vary greatly in the
number of transactions and the balances in their checking accounts. Service
companies must focus on customer costs and customer profitability;
measuring revenues and costs at the customer level provides service
companies with far more relevant and useful information than at the product
level. Finally, a customer may have multiple relationships with a service
company. Therefore, the cost system should provide information that supports
determining profitability of the entire relationship with the customer.
Customer costs and customer profitability are discussed in more detail in
Chapter 6.
–141–
Chapter 5
Activity-Based Cost
Systems
QUESTIONS
5-1 Traditional volume-based cost allocation systems that use only drivers that
vary directly with the volume of products produced—such as direct labor
dollars, direct labor hours, or machine hours—are likely to systematically
distort product costs because they break the link between the cause for the
costs and the basis for assignment of the costs to the individual products. Costs
may vary not only with respect to volume of production, but also, for example,
with batch-related activities (e.g., changeovers, setups, and inspection of the
first item of production run) and the number of products (e.g., scheduling
materials receipts and improving products). Also, cost distortions tend to be
greater with greater differences between relative proportions of indirect
resources used by cost objects because traditional cost assignments based on
volume-related measures do not accurately reflect these differences.
5-2 Volume-based traditional product costing systems that use only drivers that
vary directly with the volume of products produced—such as direct labor
dollars, direct labor hours, or machine hours—are most likely to distort
product costs under the following two conditions: (1) Indirect and support
expenses are high, especially when they exceed the cost of the allocation base
itself (such as direct labor cost); and (2) Product diversity is high: the plant
produces both high-volume and low-volume products, standard and custom
products, and complex and simple products. The combination of these two
conditions will magnify the distortions that arise because volume-based
product costing systems do not accurately reflect differences in non-volume-
related resource usage across products or other cost objects.
Activity-based costing systems provide more accurate costs when these two
conditions hold by creating more accurate links between the causes of indirect
and support costs and the bases for assignment of the costs to cost objects. For
example, costs may vary not only with respect to volume of production, but
also activities such as changeovers, setups, and inspection of the first item of
–138–
,Atkinson, Solutions Manual t/a Management Accounting, 6E
production run, which are not done in proportion to the number of units
produced. Moreover, some costs vary with the number of different products
(e.g., scheduling materials receipts and improving products).
5-3 Yes, traditional costing systems are more likely to overcost high-volume
products because all indirect and support costs are assigned to products in
proportion to the number of production units (through volume-based cost
drivers), and the low-volume products are likely to require higher indirect and
support costs per unit. The high-volume products essentially cross-subsidize
the low-volume products in the sense that indirect and support costs are
assigned uniformly in proportion to volume.
5-4 Companies producing a varied and complex mix of products require many
more resources to support their highly varied mix, and therefore have higher
costs. Examples of the greater resources required include a much larger
production support staff to schedule machine and production runs; perform
changeovers and setups between production runs; inspect items at the
beginning of each production run; move materials; ship and expedite orders;
develop new and improve existing products; negotiate with vendors; schedule
materials receipts; order, receive, and inspect incoming materials and parts;
and update and maintain the much larger computer-based information system.
5-5 A significant change in resource costs triggers an update of the capacity cost
rates. A significant and permanent change in operations, such as the efficiency
with which an activity is performed, triggers an update of the unit time
estimate. If new activities become part of operations, the time to perform the
activity will be estimated and then multiplied by the appropriate capacity cost
rate to determine the cost of the activity.
5-6 The two sets of parameters that must be estimated in time-driven activity-
based costing are 1) the capacity cost rate for each type of indirect resource;
that is, the unit cost of supplying capacity for each department or process,
based on practical capacity, and 2) the consumption of capacity, which is an
estimate of how much of a resource’s capacity (such as time or space) is used
by the activities performed to produce the various products, services, or
customers.
To compute a capacity cost rate, first identify all costs incurred to supply that
resource (such as a machine, an indirect production employee, the computer
system, factory space, a warehouse, or a truck). Then, identify the capacity
supplied by that resource. The capacity would be the hours of work provided
by the machine or production employee, or the space provided by the
–139–
, Chapter 5: Activity-Based Cost Systems
warehouse or truck. For most resources (people, equipment, and machines),
capacity is measured by the time supplied. The resource’s capacity cost rate is
calculated by dividing its cost by the capacity it supplies, usually expressed as
a cost per hour or cost per minute. For warehouses, production space, and
trucks, the capacity cost rate would be measured by cost per square foot (or
square meter) of usable space. For computer memory, the resource capacity
cost rate would be the cost per megabyte or gigabyte.
5-7 Managers use the information on activity costs to identify opportunities for
operational improvements and reductions in operations costs, decisions about
product mix and pricing, and targeted customer segments. An example of an
operational change is requiring minimum order sizes to eliminate short,
unprofitable production runs. Another example is changing the facility layout
to reduce moves of work in progress. Product designs can be changed in order
to manufacture products with fewer parts or common parts to reduce material
handling support costs. Finally, as discussed in more detail in Chapter 6, if
activity-based cost analysis shows that full-pallet shipments are less costly per
unit than partial-pallet shipments, customers can be encouraged to receive full-
pallet shipments. Of course, customers who insist on very small order sizes or
partial-pallet shipments can be charged a price high enough to cover the extra
costs associated with such activities.
5-8 The capacity cost driver rate should reflect the underlying efficiency of the
process—for example, the cost of resources to handle each production order—
and this efficiency is measured better by using the capacity of the resources
supplied (practical capacity) as the denominator when calculating capacity
cost driver rates. The numerator in a capacity cost driver rate calculation
represents the costs of supplying resource capacity to do work. The
denominator should match the numerator by representing the quantity of work
the resources can perform. Unassigned costs represent the cost of unused
capacity and should be used as feedback to managers on their supply and
demand decisions.
5-9 Immediate financial improvement may not follow even after process
improvements reduce the demand for indirect and support resources. This is
because the support costs are often committed. The organization must actively
manage the unused capacity by increasing the volume of business or reducing
the supply of unused resources.
5-10 Service organizations are often ideally suited for activity-based costing
because virtually all of the costs for a service company are indirect and appear
–140–
, Atkinson, Solutions Manual t/a Management Accounting, 6E
to be fixed. The large component of apparently fixed costs in service
companies arises because, unlike manufacturing companies, service
companies have virtually no material costs—the prime source of short-term
variable costs. Service companies must supply virtually all of their resources
in advance to provide the capacity to perform work for customers during each
period. Fluctuations during the period of demand by individual products and
customers for the activities performed by these resources do not influence
short-term spending to supply the resources.
5-11 As mentioned in 5-10, virtually all the costs for a service company are indirect
and appear to be fixed. Service companies have few or no direct materials and
many of their personnel provide indirect, not direct, support to products and
customers. Consequently, service companies do not have direct, traceable
costs to serve as convenient allocation bases.
Unlike physical products, services cannot be inventoried for future sales.
Service companies must supply virtually all their resources in advance to
provide the capacity to perform work for customers during each period, and
demand often fluctuates. For some service industries, the increase in spending
resulting from an incremental transaction or customer is essentially zero.
Therefore, service companies making decisions about products and customers
based on short-term variable costs might provide a full range of all products
and services to customers at prices near zero, leading to little recovery of the
costs of all the committed resources supplied in order to deliver services to
customers.
It can be difficult to identify and measure the outputs for a service
organization. The variation in demand for organizational resources is much
more customer-driven in service organizations than in manufacturing
organizations. A service company can determine and control the efficiency of
its internal activities, but customers determine the quantity of demands for
these operating activities. For example, customers may vary greatly in the
number of transactions and the balances in their checking accounts. Service
companies must focus on customer costs and customer profitability;
measuring revenues and costs at the customer level provides service
companies with far more relevant and useful information than at the product
level. Finally, a customer may have multiple relationships with a service
company. Therefore, the cost system should provide information that supports
determining profitability of the entire relationship with the customer.
Customer costs and customer profitability are discussed in more detail in
Chapter 6.
–141–
