Brief Exercise 6-1 (30 minutes) - UiO

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Chapter 3
Systems Design: Activity-Based Costing
Solutions to Questions
3-1 The most common methods of assigning overhead costs to products are
plantwide overhead rates, departmental overhead rates, and activity-based
costing. 3-2 The last few decades have witnessed dramatic changes that have made
conventional costing systems obsolete in many organizations. Automation has
decreased the amount of direct labor, overhead costs have increased, and
companies now handle many more products that differ substantially in
volume, lot size, and complexity. The assumption, implicit in conventional
costing systems, that overhead cost is proportional to direct labor, is
being increasingly questioned. Activity-based costing is an attempt to more
accurately assign overhead costs to products based on the activities
required to make products and the resources consumed by those activities. 3-3 The departmental approach to assigning overhead cost to products
usually relies on some measure of volume as an assignment base. This
approach assumes that overhead costs are proportional to volume. However,
overhead costs are often driven by other factors, including the number of
batches run and product complexity, that are only loosely related, if at
all, to volume. Activity-based costing attempts to more accurately assign
overhead costs to products based on the activities that they cause rather
than just on the number of units produced or direct labor-hours required. 3-4 The hierarchical levels are:
1. Unit-level activities, which are performed each time a unit is
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 sustain an organization's
general capabilities. 3-5 Activity-based costing involves two stages of overhead cost
assignments. In the first stage, costs are assigned to activity cost pools.
In the second stage, costs are allocated from the activity cost pools to
products. 3-6 In a conventional costing system, overhead costs are allocated to
products using some measure of volume such as direct labor-hours or machine-
hours. Consequently, the high-volume products, which have the largest
amount of direct labor-hours or machine-hours, are allocated most of the
overhead cost. In activity-based costing, some of the overhead costs are
typically allocated using batch-level or product-level allocation bases.
For example, if each product is allocated a total of $10,000 in product-
level cost irrespective of its volume, then a high-volume product will be
allocated exactly the same total overhead as a low-volume product. In
contrast, if a measure of volume like direct labor-hours or machine-hours
were used to allocate this cost, the high-volume product would be allocated
a larger total sum than the low-volume product. 3-7 Activity-based costing improves the accuracy of product costs in
three ways. First, activity-based costing increases the number of cost
pools used to accumulate overhead costs. Rather than accumulating all
overhead costs in a single, plantwide pool, or accumulating them in
departmental pools, costs are accumulated for each major activity. Second,
the activity cost pools are more homogeneous than departmental cost pools.
In principle, all of the costs in an activity cost pool pertain to a single
activity. In contrast, departmental cost pools contain the costs of many
different activities carried out in the department. Third, activity-based
costing changes the bases used to assign overhead costs to products. Rather
than assigning costs on the basis of direct labor or some other measure of
volume, costs are assigned on the basis of activity measures that gauge how
much of the overhead resource has been consumed by a particular activity. 3-8 While the product costs computed using activity-based costing are
almost certainly more accurate than those computed using more conventional
costing methods, activity-based costing nevertheless rests on some
questionable assumptions about cost behavior. In particular, activity-based
costing assumes that costs are proportional to activity. In reality, costs
appear to increase less than in proportion to increases in activity. This
implies that activity-based product costs will be overstated for purposes
of making decisions. (The same criticism can be leveled at conventional
product costs.) Second, the costs of implementing and maintaining an
activity-based costing system can be high and the benefits may not justify
this cost.
Brief Exercise 3-1 (10 minutes) |a. |Various individuals manage the parts inventories. |Product-level |
|b. |A clerk in the factory issues purchase orders for a |Batch-level |
| |job. | |
|c. |The personnel department trains new production |Facility-level|
| |workers. | |
|d. |The factory's general manager uses her office in the|Facility-level|
| |factory building. | |
|e. |Direct labor workers assemble products. |Unit-level |
|f. |Engineers design new products. |Product-level |
|g. |The materials storekeeper issues raw materials to be|Batch-level |
| |used in jobs. | |
|h. |The maintenance department performs periodic |Facility-level|
| |preventative maintenance on general-use equipment. | | Some of these classifications are debatable and depend on the
specific circumstances found in particular companies.
Brief Exercise 3-2 (15 minutes) 1. The activity rates are computed as follows: |Activity Cost Pool |(a) |(b) |(a) ÷ (b) |
| |Estimated |Expected |Activity |
| |Overhead |Activity |Rate |
| |Cost | | |
|Labor related |$ 52,000 |8,000 |DLHs |$ 6.50 |per DLH |
|Machine related |15,000 |20,000 |MHs |0.75 |per MH |
|Machine setups |42,000 |1,000 |setups |42.00 |per setup |
|Production orders |18,000 |500 |orders |36.00 |per order |
|Product testing |48,000 |2,000 |tests |24.00 |per test |
|Packaging |75,000 |5,000 |packages |15.00 |per package |
|General factory | 108,800 |8,000 |DLHs |13.60 |per DLH |
|Total |$358,800 | | | | | 2. The predetermined overhead rate based entirely on direct labor-
hours would be computed as follows: |Total estimated overhead cost (a) |$358,800 | |
|Total expected direct labor-hours (b) | 8,000 |DLHs |
|Predetermined overhead rate (a) ÷ (b) |$ 44.85 |per DLH |
Brief Exercise 3-3 (30 minutes) The unit product costs for the products are a combination of direct
materials, direct labor, and overhead costs. The overhead costs assigned to
each product would be computed as follows: | |J78 | |B52 |
| | Expected |Amount | |Expected | |
| |Activity | | | | |
| | | | |Activity |Amount |
|Labor related, at $7.00 per direct labor-hour | 1,000 |$ 7,000 | | 40 |$ 280 |
|Machine related, at $3.00 per machine-hour | 3,200 | 9,600 | | 30 | 90 |
|Machine setups, at $40.00 per setup | 5 | 200 | | 1 | 40 |
|Production orders, at $160.00 per order | 5 | 800 | | 1 | 160 |
|Shipments, at $120.00 per shipment | 10 | 1,200 | | 1 | 120 |
|General factory, at $4.00 per direct labor-hour | 1,000 | 4,000 | | 40 | 160 |
|Total overhead cost assigned (a) | | $22,800 | | |$ 850 |
|Number of units produced (b) | | 4,000 | | | 100 |
|Overhead cost per unit (a) ÷ (b) | |$ 5.70 | | |$8.50 | The unit product costs combine direct materials, direct labor, and overhead
costs as follows: | |J78 |B52 |
|Direct materials |$ 6.50 |$31.00 |
|Direct labor |3.75 |6.00 |
|Manufacturing overhead (see above) | 5.70 | 8.50 |
|Unit product cost |$15.95 |$45.50 |
Brief Exercise 3-4 (30 minutes) 1. Using the company's conventional costing system, the overhead
costs applied to the products would be computed as follows: | | Product H | Product L |Total |
|Number of units produced (a) |40,000 |8,000 | |
|Direct labor-hours per unit (b) | 0.40 | 0.40 | |
|Total direct labor-hours (a) × (b) |16,000 |3,200 |19,200 | |Total manufacturing overhead (a) |$1,632,000 | |
|Total direct labor-hours (b) | 19,200 |DLHs |
|Predetermined overhead rate (a) ÷ (b) |$ 85.00 |per DLH | | | Product H | Product L |Total |
|Manufacturing overhead applied per