MANAGEMENT ACCOUNTING- Solutions Manual

CHAPTER 9
SYSTEMS DESIGN: ACTIVITY-BASED COSTING
AND MANAGEMENT
I.

Questions
1. The three levels available are: Level 1, in which a company uses a
plantwide overhead rate; Level 2, in which a company uses departmental
overhead rates; and Level 3, in which a company uses activity-based
costing.
2. New approaches to costing are needed because events of the last few
decades have made drastic changes in many organizations. Automation
has greatly decreased the amount of direct labor required to manufacture
products; product diversity has increased in that companies are
manufacturing a wider range of products and these products differ
substantially in volume, lot size, and complexity of design; and total
overhead cost has increased to the point in some companies that a
correlation no longer exists between it and direct labor.
3. The departmental approach to assigning overhead cost to products relies
solely on volume as an assignment base. Where diversity exists between
products (that is, where products differ in terms of number of units
produced, lot size, or complexity of production), volume alone is not
adequate for overhead costing. Overhead costing based on volume will
systematically overcost high-volume products and undercost low-volume
products.
4. Process value analysis (PVA) is a systematic approach to gaining an
understanding of the steps associated with a product or service. It
identifies all resource-consuming activities involved in the production
process and labels these activities as being either value-added or nonvalue-added. Thus, it is the beginning point in designing an activity-based
costing system since management must know what activities are involved
with each product before activity centers can be designated and cost
drivers established. Also, PVA helps management to eliminate any nonvalue-added activities and thereby streamline operations and minimize
costs.
5. The four general levels of activities are:

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Chapter 11 Systems Design: Activity-Based Costing and Management

1. Unit-level activities, which are performed each time a unit is

produced.
2. Batch-level activities, which are performed each time a batch of goods
is handled or processed.
3. Product-level activities, which are performed as needed to support
specific products.
4. Facility-level activities, which simply sustain a facilitys general
manufacturing process.
6. First, activity-based costing increases the number of cost pools used to
accumulate overhead costs. Second, it changes the base used to assign
overhead costs to products. And third, it changes a managers perception
of many overhead costs in that costs that were formerly thought to be
indirect (such as depreciation or machine setup) are identified with
specific activities and thereby are recognized as being traceable to
individual products.
7. The two chief limitations are: First, the portion of overhead costs that
relate to facility-level activities are still usually allocated to products on
some arbitrary basis, such as machine-hours or direct labor-hours. Critics
of activity-based costing argue that facility-level activities account for the
bulk of all overhead costs in some companies. Second, high measurement
costs are involved in operating an activity-based costing system. That is,
the system requires the tracking of large amounts of detail and the
completion of many separate computations in order to determine the cost
of a unit or product.
8. Yes, activity-based costing can be used in service organizations. It has
been successfully implemented, for example, in railroads, hospitals, banks
and data service companies.
9. A resource driver is a measure of the quality of resources consumed by an
activity.
10. An activity driver is a measure of frequency and intensity of demands
placed on activities by cost objects.
11. Two-stage allocation is a procedure that first assigns a firms resource
costs, namely factory overhead cost, to cost pools, and then to cost
objects.
12. Two major advantages of ABM are:

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a. ABM measures the effectiveness of the key business processes and

activities, and identifies how they can be improved to reduce costs and
improve the customer value.
b. ABM improves the management focus by allocating resources to key
value-added activities, key customers, key products, and continuous
improvement methods to maintain the firms competitive advantage.
13. 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 developed in the 1800s, this
assumption may have been reasonably accurate. However, direct labor has
declined in importance over the years while overhead has been increasing.
This suggests that there is no longer a direct link between the level of
direct labor and overhead. Indeed, 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 directly 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.
14. Employees may resist activity-based costing because it changes the rules
of the game. ABC changes some of the key measures, such as product
costs, used in making decisions and may affect how individuals are
evaluated. Without top management support, employees may have little
interest in making these changes. In addition, if top managers continue to
make decisions based on the numbers generated by the traditional costing
system, subordinates will quickly conclude that the activity-based costing
system can be ignored.
15. Unit-level activities are performed for each unit that is produced. Batchlevel activities are performed for each batch regardless of how many units
are in the batch. Product-level activities must be carried out to support a
product regardless of how many batches are run or units produced.
Customer-level activities must be carried out to support customers
regardless of what products or services they buy. Organization-sustaining
activities are carried out regardless of the companys precise product mix
or mix of customers.
16. Organization-sustaining costs, customer-level costs, and the costs of idle
capacity should not be assigned to products. These costs represent
resources that are not consumed by the products.
II. True or False

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Chapter 11 Systems Design: Activity-Based Costing and Management

1. True
2. True

3. False
4. True

5. False
6. False

7. True
8. True

III. Exercises
Exercise 1
Activity

Activity
Classification

Examples of
Traceable
Costs
Labor cost;
depreciation

Examples of
Cost
Drivers

a. Materials are moved

from the receiving
dock to product flow
lines by a materialhandling crew

Batch-level

b. Direct labor workers

assemble various
products

Unit-level

Direct labor
cost; indirect
labor cost;
labor benefits

Direct laborhours

c. Ongoing training is

Facility-level*

Space cost;
training costs;
administration
costs

Hours of
training time;
number trained

d. A product is
designed by a
specialized design
team

Product-level

Space cost;
supplies used;
depreciation of
design
equipment

Hours of
design time;
number of
engineering
change orders

e. Equipment setups
are performed on a
regular basis

Batch-level

Labor cost;
supplies used;
depreciation of
equipment

Number of
setups; hours
or setup time

f. Numerical control
(NC) machines are
used to cut and
shape materials

Unit-level

Power;
supplies used;
maintenance;
depreciation

Machinehours; number
of units

of equipment;
space cost

provided to all
employees in the
company

Number of
receipts;
pounds handled

* Personnel administration and training costs might be traceable in part to the

facility-level and in part to other activity centers at the unit-level, productlevel, and batch-level.

Exercise 2
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Systems Design: Activity-Based Costing and Management Chapter 11

1.
2.
3.
4.
5.

plantwide overhead rate

volume
two stage, stage, stage
Process value analysis
Unit-level

6.
7.
8.
9.
10.

Batch-level
Product-level
Facility-level
high-volume, low-volume, low-volume
activity centers

Exercise 3
a.
b.
c.
d.
e.
f.
g.
h.

Various individuals manage the parts inventories.

A clerk in the factory issues purchase orders for a
job.
The personnel department trains new production
workers.
The factorys general manager meets with other
department heads such as marketing to
coordinate plans.
Direct labor workers assemble products.
Engineers design new products.
The materials storekeeper issues raw materials to
be used in jobs.
The maintenance department performs periodic
preventative maintenance on general-use
equipment.

Product-level
Batch-level
Organizationsustaining
Organizationsustaining
Unit-level
Product-level
Batch-level
Organizationsustaining

Note: Some of these classifications are debatable and may depend on the
specific circumstances found in particular companies.
Exercise 4
Sales (P1,650 per standard model glider 10 standard
model gliders + P2,300 per custom designed glider 2
custom designed gliders)......................................................................................
P21,100
Costs:
Direct materials (P462 per standard model glider 10
standard model gliders + P576 per custom
designed glider 2 custom designed gliders).................................................
P5,772
Direct labor (P19 per direct labor-hour 28.5 direct
labor-hours per standard model glider 10 standard
model gliders + P19 per direct labor-hour 32 direct
labor-hours per custom designed glider 2 custom
designed gliders)..............................................................................................
6,631
Supporting manufacturing (P18 per direct labor-hour
6,282
28.5 direct labor-hours per standard model glider
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Chapter 11 Systems Design: Activity-Based Costing and Management

10 standard model gliders + P18 per direct laborhour 32 direct labor-hours per custom designed
glider 2 custom designed gliders).................................................................
Order processing (P192 per order 3 orders).....................................................
576
Custom designing (P261 per custom design 2 custom
designs)............................................................................................................
522
Customer service (P426 per customer
1 customer).......................................................................................................
426
20,209
Customer margin......................................................................................................
P 891

Exercise 5
Requirement 1
The predetermined overhead rate is computed as follows:
Predetermined
overhead rate

P290,000
50,000 DLHs

P5.80 per DLH

The unit product costs under the companys traditional costing system are
computed as follows:
Special
Regular
Direct materials................................................................................................................
P60.00
P45.00
Direct labor......................................................................................................................
9.60
7.20
Manufacturing overhead (0.8 DLH P5.80 per DLH;
0.6 DLH P5.80 per DLH)........................................................................................
4.64
3.48
Unit product cost..............................................................................................................
P74.24
P55.68

Requirement 2
The activity rates are computed as follows:
(a)
Estimated
Overhead
Activities
Cost
Supporting direct labor...............................
P150,000
Batch setups...............................................
P60,000
Safety testing..............................................
P80,000

(b)
Total
Expected Activity
50,000 DLHs
250 setups
100 tests

(a) (b)
Activity Rate
P3 per DLH
P240 per setup
P800 per test

Manufacturing overhead is assigned to the two products as follows:

Special Product:
(a)
Activity Cost Pool
Activity Rate
Supporting direct labor..........................................................
P3 per DLH
Batch setups..........................................................................
P240 per setup
Safety testing.........................................................................
P800 per test

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(b)
Activity
8,000 DLHs
200 setups
80 tests

(a) (b)
ABC Cost
P24,000
48,000
64,000

Systems Design: Activity-Based Costing and Management Chapter 11

Total

P136,000

Regular Product:
(a)
Activity Cost Pool
Activity Rate
Supporting direct labor..........................................................
P3 per DLH
Batch setups..........................................................................
P240 per setup
Safety testing.........................................................................
P800 per test
Total

(b)
Activity
42,000 DLHs
50 setups
20 tests

(a) (b)
ABC Cost
P126,000
12,000
16,000
P154,000

Activity-based costing unit product costs are computed as follows:

Special
Direct materials...................................................................................................
P60.00
Direct labor.........................................................................................................
9.60
Manufacturing overhead (P136,000 10,000 units; P154,000
70,000 units)..................................................................................................
13.60
Unit product cost.................................................................................................
P83.20

Regular
P45.00
7.20
2.20
P54.40

IV. Problems
Problem 1
Cost
Systems
Traditional cost system
ABC system
Labor
Machining
Setup
Production order
Material handling
Parts administration

Pool
Rate
350%

Cost Driver
Consumption
P10,000

Cost
Assignment
P35,000

10%
P25/hour
P10/hour
P100/order
P20/requisition
P40/part

P10,000
800 hours
100 hours
12 orders
5 requisitions
18 parts

P 1,000
20,000
1,000
1,200
100
720
P24,020

Problem 2
Requirement 1
(a)
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Chapter 11 Systems Design: Activity-Based Costing and Management

Total overhead

= P200,000 + P32,000 + P100,000 + P120,000

= P452,000

Overhead rate

= P452,000 / 50,000 direct labor hours

= P9.04 per direct labor hour

Overhead assigned to proposed job = P9.04 x 1,000 direct labor hours

= P9,040

(b) Total cost of proposed job:

Direct materials
Direct labor 10,000
Overhead applied
Total cost

P 6,000
9,040
P25,040

(c) Companys bid = Full manufacturing cost x 120% = P25,040 x 120%

= P30,048

Requirement 2
(a) Maintenance :
P200,000 / 20,000
Materials handling: P32,000 / 1,600
=
Setups:
P100,000 / 2,500 =
Inspection:
P120,000 / 4,000 =

= P10 per machine hour

P20 per move
P40 per setup
P30 per inspection

Overhead assigned to proposed job:

Maintenance (P10 x 500)
Material handling (P20 x 12)
Setups (P40 x 2)
Inspection (P30 x 10)
Total overhead assigned to job

P5,000
240
80
300
P5,620

(b) Total cost of proposed project:

Direct materials
Direct labor 10,000
Overhead applied
Total cost

P 6,000
5,620
P21,620

(c) Companys bid = Full manufacturing cost x 120% = P21,620 x 120%

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Systems Design: Activity-Based Costing and Management Chapter 11

= P25,944
The bid price of P25,944 was determined as follows:
Direct materials
Direct labor
Overhead assigned:
Maintenance (P10 x 500)
Material handling (P20 x 12)
Setups (P40 x 2)
Inspections (P30 x 10)
Total overhead assigned to job
Total cost
Markup
Bid price

P6,000
10,000
P5,000
240
80
300
5,620
P21,620
120%
P25,944

Problem 3 (Activity-Based Costing)

Requirement 1
The first-stage allocation of costs to the activity cost pools appears below:
Activity Cost Pools
Processing Supporting
Orders
Customers
Other

Assemblin
g Units
Manufacturing
overhead
Selling and
administrative
overhead
Total cost

Total

P250,000

P175,000

P25,000

P50,000

P500,000

30,000
P280,000

135,000
P310,000

75,000
P100,000

60,000
P110,000

300,000
P800,000

Requirement 2
The activity rates for the cost pools are:

Assembling units
Processing orders
Supporting customers

(a)
Total Cost
P280,000
P310,000
P100,000

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(b)
Total Activity
1,000 units
250 orders
100 customers

(a) (b)
Activity Rate
P280 per unit
P1,240 per order
P1,000 per customer

Chapter 11 Systems Design: Activity-Based Costing and Management

Requirement 3
The overhead cost attributable to Lucky Sale would be computed as follows:
(a)
Activity Rate
P280 per unit
P1,240 per order
P1,000 per customer

Activity Cost Pools

Assembling units
Processing orders
Supporting customers

(b)
Activity
80 units
4 orders
1 customer

(a) x (b)
ABC Cost
P22,400
P4,960
P1,000

Requirement 4
The customer margin can be computed as follows:
Sales (P595 per unit x 80 units)
Costs:
Direct materials (P180 per unit x 80 units)
Direct labor (P50 per unit x 80 units)
Unit-related overhead (above)
Order-related overhead (above)
Customer-related overhead (above)
Customer margin

P47,600
P14,400
4,000
22,400
4,960
1,000
P

46,760
840

Problem 4 (Activity-Based Costing as an Alternative to Traditional

Product Costing)
Requirement 1
a. When direct labor-hours are used to apply overhead cost to products, the
companys predetermined overhead rate would be:
Predetermined
overhead rate

=
=

Manufacturing overhead cost

Direct labor hours
P1,480,000
20,000 DLHs
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P74 per DLH

Systems Design: Activity-Based Costing and Management Chapter 11

b.

Model
HY5
Direct materials......................................................................
P35.00
Direct labor:
P20 per hour 0.2 DLH, 0.4 DLH....................................
4.00
Manufacturing overhead:
P74 per hour 0.2 DLH, 0.4 DLH....................................
14.80
Total unit product cost............................................................
P53.80

AS2
P25.00
8.00
29.60
P62.60

Requirement 2
a. Predetermined overhead rates for the activity cost pools:
(a)
Estimated
Activity Cost Pool
Total Cost
Machine setups.................P180,000
Special milling..................P300,000
General factory.................
P1,000,000

(b)
Estimated
Total Activity
250 setups
1,000 MHs
20,000 DLHs

(a) (b)
Activity Rate
P720 per setup
P300 per MH
P50 per DLH

The overhead applied to each product can be determined as follows:

Model HY5
(a)
Predetermined
Activity Cost Pool
Overhead Rate
Machine setups....................................................................................
P720 per setup
Special milling.....................................................................................
P300 per MH
General factory....................................................................................
P50 per DLH
Total manufacturing overhead cost (a).................................................
Number of units produced (b).............................................................
Overhead cost per unit (a) (b)..........................................................

(b)
Activity
150 setups
1,000 MHs
4,000 DLHs

(a) (b)
Overhead
Applied
P108,000
300,000
200,000
P608,000
20,000
P30.40

Model AS2
Activity Cost Pool

(a)
Predetermined
Overhead Rate

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(b)
Activity

(a) (b)
Overhead
Applied

Chapter 11 Systems Design: Activity-Based Costing and Management

Machine setups....................................................................................
P720 per setup
100 setups
Special milling.....................................................................................
P300 per MH
0 MHs
General factory....................................................................................
P50 per DLH
16,000 DLHs
Total manufacturing overhead cost (a).................................................
Number of units produced (b).............................................................
Overhead cost per unit (a) (b)..........................................................

P 72,000
0
800,000
P872,000
40,000
P21.80

b. The unit product cost of each model under activity-based costing would be
computed as follows:
Model
HY5
AS2
Direct materials........................................................................................................
P35.00
P25.00
Direct labor (P20 per DLH 0.2 DLH; P20 per DLH 04.DLH)...........................
4.00
8.00
Manufacturing overhead (above)..............................................................................
30.40
21.80
Total unit product cost...............................................................................................
P69.40
P54.80

Comparing these unit cost figures with the unit costs in Part 1(b), we find
that the unit product cost for Model HY5 has increased from P53.80 to
P69.40, and the unit product cost for Model AS2 has decreased from
P62.60 to P54.80.
Requirement 3
It is especially important to note that, even under activity-based costing, 68%
of the companys overhead costs continue to be applied to products on the
basis of direct labor-hours:
Machine setups (number of setups)............................P 180,000
Special milling (machine-hours)................................. 300,000
General factory (direct labor-hours)........................... 1,000,000
Total overhead cost.....................................................P1,480,000

12%
20
68
100%

Thus, the shift in overhead cost from the high-volume product (Model AS2) to
the low-volume product (Model HY5) occurred as a result of reassigning only
32% of the companys overhead costs.
The increase in unit product cost for Model HY5 can be explained as follows:
First, where possible, overhead costs have been traced to the products rather
than being lumped together and spread uniformly over production. Therefore,
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Systems Design: Activity-Based Costing and Management Chapter 11

the special milling costs, which are traceable to Model HY5, have all been
assigned to Model HY5 and none assigned to Model AS2 under the activitybased costing approach. It is common in industry to have some products that
require special handling or special milling of some type. This is especially true
in modern factories that produce a variety of products. Activity-based costing
provides a vehicle for assigning these costs to the appropriate products.
Second, the costs associated with the batch-level activity (machine setups)
have also been assigned to the specific products to which they relate. These
costs have been assigned according to the number of setups completed for
each product. However, since a batch-level activity is involved, another factor
affecting unit costs comes into play. That factor is batch size. Some products
are produced in large batches and some are produced in small batches. The
smaller the batch, the higher the cost per unit of the batch activity. In the
case at hand, the data can be analyzed as shown below.
Model HY5:
Cost to complete one setup [see 2(a)]......................................... P720
Number of units processed per setup
(20,000 units 150 setups)...................................................133.33
Setup cost per unit (a) (b)....................................................... P5.40
Model AS2:
Cost to complete one setup (above)............................................ P720
Number of units processed per setup
(40,000 units 100 setups)................................................... 400
Setup cost per unit (a) (b)....................................................... P1.80

(a)
(b)

(a)
(b)

Thus, the cost per unit for setups is three times as great for Model HY5, the
low-volume product, as it is for Model AS2, the high-volume product. Such
differences in cost are obscured when direct labor-hours (or any other volume
measure) is used as the basis for applying overhead cost to products.
In sum, overhead cost has shifted from the high-volume product to the lowvolume product as a result of more appropriately assigning some costs to the
products on the basis of the activities involved, rather than on the basis of
direct labor-hours.

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Chapter 11 Systems Design: Activity-Based Costing and Management

V. Multiple Choice Questions

1.
2.
3.
4.
5.
6.
7.
8.
9.
10.

A
D
C
B
A
D
A
B
D
C

11.
12.
13.
14.
15.
16.
17.
18.
19.
20.

B
D
C
A
C
D
D
C
B
A

21.
21.
22.
23.
24.
25.
26.
27.
28.
29.

D
A
B
A
B
D
B
C
A
C

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