Module 18

Activity-Based Costing,
Customer Profitability, and
Activity-Based Management

Learning Objectives – coverage by question

True/False Multiple Choice Exercises Problems Essays

LO1 – Explain the changes in

the modern production
1, 2
environment that have affected
cost structures.

LO2 –Understand the concept

of activity based costing (ABC) 3-5 1-13 1, 2 1-3 1
and how it is applied.

LO3 – Explain the difference

between traditional plantwide
6 14-16 3-7 3 2, 3
and departmental overhead
methods and ABC.

LO4 – Describe the

implementation of an activity- 7, 8 17-22 4
based costing system.

LO5 – Explain customer

profitability analysis based on 9, 10 5
ABC.

LO6 – Explain the difference

between ABC and activity- 11 23-25
based management.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-1
Module 18: Activity-Based Costing, Customer Profitability, and
Activity-Based Management

True/False

Topic: Changing Cost Environment

LO: 1
1. The twentieth century saw an accelerating shift from traditional manufacturing activities to production
procedures requiring large investments in raw materials and labor.

Answer: False
Rationale: The shift was from traditional labor-based techniques to large investments in automated
equipment.

Topic: Changing Cost Environment

LO: 1
2. Over the past century, overhead costs have increased as a percentage of total product cost.

Answer: True
Rationale: Production employees spend significantly less time on actual production and more time on
scheduling, setting up, maintaining, and moving materials. In combination with increased automation,
the result is an increase in manufacturing overhead costs.

Topic: Activity-Based Costing

LO: 2
3. Activity-based costing determines the cost of activities and traces their costs to cost objects on the
basis of the cost object’s utilization of units of activity.

Answer: True
Rationale: Activity-based costing is a system of analysis that identifies and measures the cost of key
activities, and then traces these activity costs to products or other cost objects based on the quantity
of activity consumed by the cost object.

Topic: Purchasing Department Cost Allocation

LO: 2
4. The number of purchase orders is a reasonable basis for allocating to jobs the purchasing
department costs.

Answer: True
Rationale: This is a reasonable basis for allocating purchasing department costs. The dollar value of
purchase orders is also a reasonable basis.

©Cambridge Business Publishers, 2015

18-2 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Activity-Based Costing
LO: 2
5. Activity-Based Costing (ABC) is a two-stage method of cost assignment that assigns overhead costs
to key activities, and then assigns those costs to products or services based on their use of those
activities.

Answer: True
Rationale: ABC determines the major activities (such as machine setups or materials moves) that
drive overhead costs, and it measures the cost for each unit of activity. Production is then charged
for the use of those activities at the ABC rate.

Topic: Plantwide Allocation Rate

LO: 3
6. The plantwide rate approach is the simplest to apply, but it is also the most costly to implement,
compared to a departmental or activity-based cost allocation system.

Answer: False
Rationale: The plantwide rate approach is the simplest, and least costly, to apply, but it provides the
least precise measurement of product costs.

Topic: ABC Implementation

LO: 4
7. ABC is generally more costly to implement than traditional costing.

Answer: True
Rationale: Often companies maintain traditional costing for external purposes and ABC for pricing
and other internal decision-making purposes. In addition, ABC systems must be built facility by facility
rather than being embedded in a software system that can be used by all facilities within the
company.

Topic: ABC Implementation

LO: 4
8. ABC is particularly useful when product lines differ greatly in volume and in manufacturing complexity.

Answer: True
Rationale: Traditional systems tend to over cost high-volume, low-complexity products and they tend
to under cost low-volume, high-complexity products.

Topic: Customer Profitability

LO: 5
9. ABC is useful for product costing, but traditional costing is superior for customer profitability.

Answer: False
Rationale: One of the most beneficial applications of ABC is in the analysis of the profitability of
customers.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-3
Topic: Customer Profitability
LO: 5
10. If products are being sold to customers A and B above costs and the company is earning a profit,
then customers A and B must both be profitable.

Answer: False
Rationale: Profitability of individual customers depends on whether the gross profit from sales to
those customers exceeds the customer-specific costs of serving those customers. Some customers
are simply more costly than other customers and some may be even unprofitable.

Topic: Activity-Based Management

LO: 6
11. Activity-based management (ABM) focuses on reducing costs and maximizing value to consumers.

Answer: True
Rationale: ABM is defined as the identification and selection of activities to maximize the value of
activities and processes while minimizing their cost from the perspective of the final consumer.

©Cambridge Business Publishers, 2015

18-4 Financial & Managerial Accounting for MBAs, 4th Edition
Multiple Choice

Topic: Activities and Cost Drivers

LO: 2
1. The most appropriate cost driver for the activity of cleaning (bussing) tables in a restaurant is:
A) The number of cooks in the kitchen
B) The number of tables cleaned
C) The number of employees assigned to the job of cleaning tables
D) The amount of money deposited to the bank each day

Answer: B
Rationale: On the basis of logical analysis the number of tables cleaned is the most appropriate cost
driver.

Topic: Activity-Based Costing

LO: 2
2. Which of the following statements about activity based costing is true?
A) The most widely used approach to activity-based costing involves the use of a two-stage model.
B) Activity-based costing involves tracing the cost of activities used by the various cost objects.
C) Activity-based costing involves determining the cost of activities.
D) All of the above

Answer: D
Rationale: Activity based costing is a system of analysis that identifies and measures the cost of key
activities and then traces these activity costs to products or other cost objects based on the quantity
of activity consumed by cost objects. ABC is used widely through the two stage costing model.

Topic: Cost Object

LO: 2
3. An object to which costs are assigned is called:
A) A value chain
B) A cost object
C) A cost pool
D) Overhead

Answer: B
Rationale: A cost object is an object to which costs are assigned. Examples include departments,
products, and services.

Topic: Activity-Based Costing

LO: 2
4. Which of the following procedures best describes activity-based costing?
A) All overhead costs are recorded as expenses as incurred.
B) Overhead costs are assigned directly to products.
C) Overhead costs are assigned to activities; then costs are assigned to products.
D) Overhead costs are assigned to departments; then costs are assigned to products.

Answer: C
Rationale: In activity based costing, indirect costs including overhead are assigned to activities; then
activity costs are assigned to products or other cost objects.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-5
Topic: Two-Stage Activity-Based Costing Model
LO: 2
5. Which of the following tasks is not required when using a two-stage activity-based costing model?
A) Identifying activities
B) Assigning costs to activities
C) Determining how much direct labor each cost object consumes
D) Determining the cost per unit of activity

Answer: C
Rationale: Direct labor and direct materials are direct product costs that are directly assigned to
products and excluded from activity cost pools in a two stage ABC model.

Topic: Two-Stage Activity-Based Costing

LO: 2
6. In a two-stage activity-based costing model, stage one involves:
A) Assigning activity costs to cost objects
B) Measuring the various indirect resource costs and determining resource drivers
C) Assigning indirect resource costs to activity pools
D) Assigning direct costs to cost objects

Answer: C
Rationale: In Stage one, indirect resource costs are assigned to activity pools. In Stage two, activity
costs are reassigned to cost objects using activity drivers. Direct costs such as direct materials and
labor are assigned directly to cost objects.

Topic: Activity-Based Costing

LO: 2
7. In an activity-based costing model, total costs assigned to cost objects may include:
A) Only direct costs
B) Both direct costs and resource costs
C) Both activity costs and resource costs
D) Both direct costs and activity costs

Answer: D
Rationale: Total costs assigned to cost objects may include the direct costs of material and labor plus
indirect costs assigned via activity cost pools.

©Cambridge Business Publishers, 2015

18-6 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Job Costing with Activity-Based Costing
LO: 2
8. Chattanooga, Inc. has two categories of overhead: maintenance and inspection. Costs expected for
these categories for the coming year are as follows:

Maintenance $800,000
Inspection 400,000

The following data have been assembled for use in developing a bid for a proposed job:

Direct materials $6,000

Direct labor $16,000
Machine-hours 400
Number of inspections 4
Direct labor-hours 800

The practical capacity of machine-hours for all jobs during the year is 25,000, and for inspections is
800. These are the cost drivers for maintenance and inspection costs, respectively.

Using the appropriate cost drivers, the total cost of the potential job is:
A) $22,000
B) $14,400
C) $33,600
D) $36,800

Answer: D
Rationale: The activity rate for maintenance is $800,000 / 25,000 machine hours or $32 per machine
hour. The rate for inspections is $400,000 / 800 inspections or $500 per inspection. Overhead for
the job is $32 x 400 machine hours = $12,800 + $500 x 4 inspections = $2,000. Total overhead of
$14,800 + Direct materials $6,000 + Direct labor $16,000 = $36,800 total job cost.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-7
Topic: Product Costing with Activity-Based Costing
LO: 2
9. Thomas, Inc. uses activity-based costing. The company produces two products, 001 and 002.
Information relating to the two products is as follows:

001 002
Units produced 38,000 50,000
Machine-hours 15,000 17,000
Direct labor-hours 16,000 24,000
Materials handling (number of moves) 8,000 12,000
Setups 10,000 14,000

The following costs are reported:

Materials handling $320,000

Labor-related overhead 960,000
Setups 600,000

Setup costs assigned to 002 are:

A) $350,000
B) $224,000
C) $280,000
D) $288,000

Answer: A
Rationale: Total setup costs of $600,000 / 24,000 total setups = $25 per set up. Product 002 setups
of 14,000 x $25 = $350,000.

©Cambridge Business Publishers, 2015

18-8 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Product Costing with Activity-Based Costing
LO: 2
10. Chinchilla, Inc. uses activity-based costing. The company produces X and Y. Information relating to
the two products is as follows:

X Y
Units produced 38,000 50,000
Machine-hours 15,000 17,000
Direct labor-hours 16,000 24,000
Materials handling (number of moves) 8,000 12,000
Setups 10,000 14,000

The following costs are reported:

Materials handling $320,000

Labor-related overhead 560,000
Setups 480,000

Labor-related overhead costs assigned to product X are:

A) $384,000
B) $464,000
C) $576,000
D) $224,000

Answer: D
Rationale: Labor-related overhead of $560,000 / 40,000 total direct labor hours = $14 per labor hour.
Product X labor hours of 16,000 x $14 = $224,000.

Topic: Activity-Based Costing

LO: 2
11. Which of the following is a true characteristic of activity-based costing?
A) Activity-based costing uses a smaller number of cost pools than does organizational-based
costing.
B) Relative to traditional costing methods, activity-based costing is more concerned with identifying
processes and less concerned with causal factors of overhead costs.
C) Activity-based costing removes the use of judgment from the allocation process.
D) Activity-based costing cannot be used to assign costs unless the activity cost drivers of those
costs are identified.

Answer: D
Rationale: Activity-based costing uses cost drivers to assign activity-cost pools to cost objects;
therefore, it is necessary to identify the cost drivers for each activity-cost pool.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-9
Topic: Two-Stage Activity-Based Costing Model
LO: 2
12. The second stage of an activity-based costing two-stage product costing model includes:
A) Assignment of cost pools to products
B) Assignment of cost pools to cost centers
C) Assignment of resource costs to cost pools
D) All of the above

Answer: A
Rationale: The first stage of an ABC product costing system is to determine the resource costs that
should be assigned to each cost pool, and the second stage is to assign the activity cost pools to the
products.

Topic: Stage Two Activity-Based Costing

LO: 2
13. Assume that total costs assigned to the setup activity cost pool in March are $120,000 and 100
setups were completed in March. Further, assume that during March machines were setup 20 times
to make product X5. The total setup cost that would be assigned to product X5 would be:
A) $1,600
B) $16,000
C) Cannot be determined
D) $24,000

Answer: D
Rationale: Cost per setup is $120,000 /100, or $1,200, and the setup cost assigned to product X5 is
$1,200 x 20 = $24,000

Topic: Practical Capacity

LO: 3
14. The practical capacity for a particular production facility is best described as:
A) The highest level of activity possible allowing for normal repairs and maintenance
B) The highest level of activity possible under any circumstance
C) The highest level of activity at which average costs are minimized
D) The level of activity that makes the most practical sense within the framework of a given situation

Answer: A
Rationale: Practical capacity is the maximum volume of activity, while allowing for normal downtime
for repairs and maintenance. Practical capacity is generally regarded as better than actual capacity
because it does not hide the cost of idle capacity.

©Cambridge Business Publishers, 2015

18-10 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Calculating a Plantwide Rate
LO: 3
15. The following information is available pertaining to Iris Division that uses a plantwide overhead rate
based on machine hours:

Mixing Dept. Finishing Dept. Total

Overhead $60,000 $150,000 $210,000
Direct labor-hours 7,500 2,500 10,000
Machine-hours 2,500 7,500 10,000

Production information pertaining to Job 101:

Mixing Dept. Finishing Dept. Total

Prime costs $10,000 $0 $10,000
Direct Labor-hours 250 0 250
Machine-hours 10 10 20
Units produced 500 0 500

What are the total overhead costs assigned to Job 101?

A) $240
B) $420
C) $360
D) $180

Answer: B
Rationale: The plantwide rate for Iris is $210,000 of overhead / 10,000 machine hours = $21 per
machine hour. The number of machine hours used to produce Job 101 was 20 hours x $21 per
machine hour of overhead = $420 of overhead assigned to Job 101.

Activity-Based Costing
LO: 3
16. Which of the following product costing methods produces the most precise product costing
information?
A) Activity-based costing
B) Departmental overhead rate methods
C) Organization-based costing
D) Plantwide overhead rates

Answer: A
Rationale: Activity-based costing provides the most precise product costing information because
unlike the other methods, it produces information about the activities, the quantities of activities, and
the cost of activities that go into producing a product.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-11
Applications of Activity-Based Costing
LO: 4
17. Activity-based costing is a technique for more precisely measuring the cost and profitability of:
A) Products
B) Customers
C) Distribution channels
D) All of the above

Answer: D
Rationale: In addition to using ABC for product costing and profitability purposes, other important
uses for ABC have also been found such as evaluating costs and profitability of customers and
distribution channels. Any process, function, or activity with indirect costs performed in an
organization is a candidate for ABC analysis.

Topic: Implementation of Activity-Based Costing

LO: 4
18. Which of the following aspects of manufacturing must be understood in order to implement activity
based costing in a production setting?
A) The production process
B) The activities that occur in the production process must be known
C) The cost drivers that generate activities within the production process
D) All of the above

Answer: D
Rationale: To implement an ABC system in a production setting an understanding of items A through
C are all essential.

Topic: Activity-Based Costing Implementation

LO: 4
19. Which of the following statements describes the typical effect of creating a large number of refined
activity cost pools for a given costing application?
A) A complex ABC system with numerous cost pools provides substantial cost improvement over a
smaller system with only seven to ten cost pools.
B) A system containing a large number of cost pools will not tend to exhibit substantial cost accuracy
over a system containing seven to ten cost pools.
C) With the aid of a computer, every public company should strive to develop as many cost pools as
possible because there is virtually no disadvantage of so doing.
D) Employees normally develop a deep appreciation for the complexity of a large, tedious ABC
system.

Answer: B
Rationale: Research on ABC systems has shown that refining the cost measurements by increasing
the number of cost pools beyond a reasonable point does not result in significant increase in cost
accuracy.

©Cambridge Business Publishers, 2015

18-12 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Activity-Based Costing Implementation
LO: 4
20. Activity-based costing systems tend to _____________________ high-volume, low-complexity
products.
A) Undercost
B) Overcost
C) Accurately cost
D) None of the above

Answer: C
Rationale: ABC systems tend to more accurately cost high-volume, low-complexity products as well
as low volume, high-complexity products. Traditional cost systems tend to overcost high-volume,
low-complexity products and undercost low volume, high-complexity products.

Topic: Activity-Based Costing Implementation

LO: 4
21. Although adding more activity cost pools to an activity-based costing system may improve the
precision of product costing, this increase in precision must be judged against:
A) The cost of the product
B) The price of the product
C) The cost of developing and maintaining the additional cost pools
D) All of the above

Answer: C
Rationale: When developing cost systems, the cost-benefit of more precision should always be
considered. At some point increasing precision may come at a cost that exceeds its benefits.

Topic: Benefits of ABC

LO: 4
22. Activity-based costing’s primary benefit is that it provides:
A) Absolutely accurate product costing information
B) Data for external financial reporting purposes
C) More precise cost data for internal decision-making purposes
D) All of the above

Answer: C
Rationale: The primary benefit of ABC is that is improves cost precision which is useful for a variety of
internal decision purposes such as pricing and for evaluating internal processes.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-13
Topic: Activity-Based Management
LO: 6
23. Which of the following statements concerning activity-based management is true?
A) Activity-based management is concerned with maximizing the value of activities.
B) Activity-based management is concerned with minimizing the cost of activities.
C) Activity-based management is concerned with improving processes.
D) All of the above statements are true.

Answer: D
Rationale: Activity based management is a process that analyzes and evaluates the cost and the
individual elements of an activity to manage the activity by redesigning the process, lowering the cost,
and adding value.

Topic: Activity-Based Management

LO: 6
24. _____________________ is defined as the identification and selection of activities to maximize the
value of the activities while minimizing their cost from the perspective of the final consumer.
A) Activity-based costing
B) Activity-based management
C) Strategic cost management
D) None of the above

Answer: B
Rationale: Definition

Topic: Activity-Based Management

LO: 6
25. Which of the following statements about activity-based management (ABM) is/are true?
A) ABM is concerned with how to effectively and efficiently manage activities and processes to
provide value to the final consumer.
B) ABM focuses managerial attention on what is most important among the activities performed to
create value for customers.
C) Defining processes and identifying key activities helps management better understand the
business and to evaluate whether activities performed add value to the customer.
D) All of the above are true.

Answer: D
Rationale: ABM is concerned with helping managers understand the business and to evaluate which
activities are the most important in managing the activities and processes to provide value to the final
consumer.

©Cambridge Business Publishers, 2015

18-14 Financial & Managerial Accounting for MBAs, 4th Edition
Exercises

Topic: Unit Activity Costs and ABC

LO: 2
1. Brian Company manufactures two products: X and Y. The overhead costs have been divided into
four activity pools that use the following cost drivers:

Number of Number of Hours of Number of

Materials Machine Machine Product
Product Requisitions Setups Operation Inspections
Product X 24 70 6,000 50
Product Y 16 230 3,000 110

Cost per
$20,000 $180,000 $270,000 $41,600
Pool

Required:
a. Compute the unit activity costs for each of the cost drivers listed.
b. Assign the overhead costs to products X and Y using activity-based costing.

Answer:
a. Unit activity cost calculations:
Unit cost per Materials Requisition = $20,000 / 40 requisitions = $500 per requisition
Unit cost per Machine Setup = $180,000 / 300 setups = $600 per setup
Unit cost per Hour of Machine Operation = $270,000 / 9,000 hours = $30 per hour
Unit cost per Product Inspection = $41,600 / 160 inspections = $260 per inspection

b. Assignment of overhead based on calculations in part a:

Product X
Materials Requisitions = (24 requisitions)($500 per requisition) = $12,000
Machine Setups = (70 setups)($600 per setup) = $42,000
Machine Operation = (6,000 hours)($30 per hour) = $180,000
Product Inspection = (50 inspections)($260 per inspection) = $13,000
Total cost of Product X = $247,000

Product Y
Materials Requisitions = (16 setups)($500 per setup) = $8,000
Machine Setups = (230 runs)($600 per run) = $138,000
Machine Operation = (3,000 hours)($30 per hour) = $90,000
Product Inspection = (110 orders)($260 per order) = $28,600
Total cost of Product Y = $264,600

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-15
Topic: Unit Activity Costs and ABC
LO: 2
2. Narrow Corporation manufactures two products: A and B. The total indirect manufacturing overhead
resource costs of $200,700 have been assigned to four activity cost pools that use the following cost
drivers:

Number of
Product Machine Runs Packing Hours Orders
Setups
Product A 40 70 2,000 150
Product B 20 140 3,000 250

Cost per
$16,200 $10,500 $130,000 $44,000
Pool

Required:
a. Compute the unit activity costs for each of the cost drivers listed.
b. Assign the overhead costs to products A and B using activity-based costing.

Answer:
a. Unit activity cost calculations:

Unit cost per Setup = $16,200 / 60 = $270.00 per setup

Unit cost per Machine Run = $10,500 / 210 = $50 per run
Unit cost per hour of Packing = $130,000 / 5,000 = $26 per hour
Unit cost per Order = $44,000 / 400 = $110 per order

b. Assignment of overhead based on calculations in part a:

Product A
Setups = (40 setups)($270 per setup) = $10,800
Machine Runs = (70 runs)($50 per run) = $3,500
Packing = (2,000 hours)($26 per hour) = $52,000
Orders = (150 orders)($110 per order) = $16,500
Total cost of Product A = $82,800

Product B
Setups = (20 setups)($270 per setup) = $5,400
Machine Runs = (140 runs)($50 per run) = $7,000
Packing = (3,000 hours)($26 per hour) = $78,000
Orders = (250 orders)($110 per order) = $27,500
Total cost of Product B = $117,900

©Cambridge Business Publishers, 2015

18-16 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Departmental Overhead Rates
LO: 3
3. Gold Coast Company manufactures two products, A and B, and incurs overhead costs in two
production departments, Mixing and Filling. The annual overhead costs in each production
department are as follows:

 Mixing Dept. overhead = $400,000 + $25 per machine-hour

 Filling Dept. overhead = $400,000 + $60 per machine-hour
 Each unit of product A requires 2 machine-hours in the Mixing Department and 3 hours in the
Filling Department.
 Each unit of product B requires 7.5 hours in the Mixing Department and 1.25 hours in the
Filling Department.

During 2014, 30,000 units of A and 25,000 units of B were produced.

Calculate the total overhead costs assigned to a unit of product B, assuming departmental overhead
rates based on machine-hours are used. (Round to two decimal places, when necessary.)

Answer:
Each unit of Product A used 2 hours of Mixing × 30,000 units produced = 60,000 hours, and 3 hours
of Filling × 30,000 units produced = 90,000 hours. Each unit of product B used 7.5 hours of Mixing ×
25,000 units produced = 187,500 hours, and 1.25 hours of Filling × 25,000 units produced = 31,250
hours.

The total hours of Mixing was 60,000 hours for Product A plus 187,500 hours for product B = 247,500
total hours of Mixing. The total hours of Filling was 90,000 hours for Product A and 31,250 hours for
Product B = 121,250 total hours of Filling. The cost per hour of Mixing was $400,000 / 247,500
hours + $25 = $26.62, and the cost per hour of Filling was $400,000 / 121,250 hours + $60 = $63.30.

Product B uses 7.5 hours of Mixing × $26.62 per hour = $199.65, and 1.25 hours of Filling × $63.30 =
$79.13, for a total overhead cost of $199.65 + $79.13 = $278.78.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-17
Topic: Plantwide Overhead Cost Calculations
LO: 3
4. Omaha Corp. produces three products: Clips, Staples, and Pens. Omaha uses a plantwide overhead
rate based on machine hours. The following information is available for the next period:

Product: Clips Staplers Pens

Units Produced 3,000 2,000 5,000
Machine Hours (Assembly) 1 3 2
Machine Hours (Packing) 1 1 1
Direct Labor hours (per unit) 2 2 2
Direct Materials cost (per unit) $10.00 $90.00 $30.00

Note that the direct labor wage rate is a flat $45 per hour with no overtime incurred. Also, total
overhead costs are $860,000 for the Assembly Department and $500,000 for the Packing
Department. Calculate the total product cost per unit of Pens. (Round to two decimal places, when
necessary.)

Answer:
The total overhead cost is $860,000 (Assembly) + $500,000 (Packing) = $1,360,000 / Total machine
hours of (3,000 × 2) for clips + (2,000 × 4) for staplers + (5,000 × 3) for pens = 29,000 total machine
hours. The plantwide overhead rate per machine hour = $1,360,000 / 29,000 = $46.90 per hour. The
unit cost of pens is $30 (materials) + (2 × $45) (labor) + (3 × $46.90) (overhead) = $260.70 total cost
per pen.

Topic: Department Overhead Calculations

LO: 3
5. Omaha Corp. produces three products: Clips, Staples, and Pens. Omaha uses department overhead
rates for Assembly and Packing, both of which are based on machine hours. The following
information is available for the next period:

Product: Clips Staplers Pens

Units Produced 3,000 2,000 5,000
Machine Hours (Assembly) 1 3 2
Machine Hours (Packing) 1 1 1
Direct Labor hours (per unit) 2 2 2
Direct Materials cost (per unit) $10.00 $90.00 $30.00

Note that the direct labor wage rate is a flat $45 per hour with no overtime incurred. Also, total
overhead costs are $860,000 for the Assembly Department and $500,000 for the Packing
Department. Calculate the total product cost per unit of Pens. (Round to two decimal places, when
necessary.)

Answer:
The overhead rate for Assembly is $860,000 / [(3,000 × 1) + (2,000 × 3) + (5,000 × 2)] = $45.26 per
machine hour. The overhead rate for Packing is $500,000 / [(3,000 × 1) + (2,000 × 1) + (5,000 ×
1)] = $50 per machine hour. The unit cost of pens is $30 (materials) + (2 × $45) (labor) + (2 × $45.26)
(Assembly overhead) + (1 × $50) (Packing overhead) = $260.52 total unit cost of pens.

©Cambridge Business Publishers, 2015

18-18 Financial & Managerial Accounting for MBAs, 4th Edition
Topic: Plantwide versus Departmental Overhead Rates
LO: 3
6. Omaha Corp. produces three products: Clips, Staples, and Pens. Omaha is considering the use of
either a single plantwide overhead rate or separate department overhead rates for Assembly and
Packing. In either case, overhead would be applied on the basis of machine hours. The following
information is available for the next period:

Product: Clips Staplers Pens

Units Produced 3,000 2,000 5,000
Machine Hours (Assembly) 1 3 2
Machine Hours (Packing) 1 1 1
Direct Labor hours (per unit) 2 2 2
Direct Materials cost (per unit) $10.00 $90.00 $30.00

Note that the direct labor wage rate is a flat $45 per hour with no overtime incurred. Also, total
overhead costs are $860,000 for the Assembly Department and $500,000 for the Packing
Department. Calculate the effect of using a plantwide rate as opposed to departmental overhead
rates on the three products. (Round to two decimal places, when necessary.)

Answer:
First, calculate the overhead cost of the three products using departmental overhead rates. The
overhead rate for Assembly is $860,000 / [(3,000 × 1) + (2,000 × 3) + (5,000 × 2)] = $45.26 per
machine hour. The overhead rate for Packing is $500,000 / [(3,000 × 1) + (2,000 × 1) + (5,000 × 1)] =
$50 per machine hour. The unit overhead cost of clips is (1 × $45.26) (Assembly overhead) + (1 ×
$50) (Packing overhead) = $95.26 total unit overhead cost of clips. The unit overhead cost of
staplers is (3 × $45.26) (Assembly overhead) + (1 × $50) (Packing overhead) = $185.78 total unit
overhead cost of staplers. The unit overhead cost of pens is (2 × $45.26) (Assembly overhead) + (1
× $50) (Packing overhead) = $140.52 total unit overhead cost of pens.

Second, calculate the overhead cost of the three products using a plantwide overhead rate. The total
overhead cost is $860,000 (Assembly) + $500,000 (Packing) = $1,360,000 / Total machine hours of
(3,000 × 2) for clips + (2,000 × 4) for staplers + (5,000 × 3) for pens = 29,000 total machine hours.
The plantwide overhead rate per machine hour = $1,360,000 / 29,000 = $46.90 per hour. The unit
overhead cost is 2 × $46.90 = $93.80 for clips, 4 × $46.90 = $187.60 for staplers, and 3 × $46.90 =
$140.70 for pens. In this case, the unit overhead cost is more using departmental overhead rates
than it is with using plantwide overhead rates for clips and less using departmental overhead rates
than it is with using plantwide overhead rates for staples and pens; therefore, there is no cross-
subsidization.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-19
Topic: Plantwide Overhead Rates
LO: 3
7. Gold Coast Company manufactures two products, A and B, and incurs overhead costs in two
production departments, Mixing and Filling. The equation for annual overhead costs in each
production department is as follows:

 Mixing Dept. overhead = $400,000 + $25 per machine-hour

 Filling Dept. overhead = $400,000 + $60 per machine-hour
 Each unit of product A requires 2 machine-hours in the Mixing Department and 3 hours in the
Filling Department.
 Each unit of product B requires 7.5 hours in the Mixing Department and 1.25 hours in the
Filling Department.

During 2014, 30,000 units of A and 25,000 units of B were produced.

Calculate the total overhead costs assigned to a unit of product A, assuming plantwide overhead
rates based on machine-hours are used. (Round to two decimal places, when necessary.)

Answer:
Each unit of Product A used 2 hours of Mixing × 30,000 units produced = 60,000 hours, and 3 hours
of Filling × 30,000 units produced = 90,000 hours. Each unit of product B used 7.5 hours of Mixing ×
25,000 units produced = 187,500 hours, and 1.25 hours of Filling × 25,000 units produced = 31,250
hours. The total hours of Mixing was 60,000 hours for Product A plus 187,500 hours for product B =
247,500 total hours of Mixing. The total hours of Filling was 90,000 hours for Product A and 31,250
hours for Product B = 121,250 total hours of Filling.

The total cost incurred in Mixing was $400,000 + (247,500 hours × $25) = $6,587,500, and the total
cost incurred in Filling was $400,000 + (121,250 hours × $60) = $7,675,000. The total overhead
incurred in both Mixing and Filling was $6,587,500 + $7,675,000 = $14,262,500. Total Mixing and
Filling machine hours was 150,000 + 218,750 = 368,750 hours. The plantwide overhead rate per
hour was $14,262,500 / 368,750 hours = $38.68 per hour. Each unit of Product A used 2 machine
hours in Mixing and 3 machine hours in Filling for a total of 5 machine hours. At $38.68 per hour, the
total overhead cost assigned to a unit of Product A was $193.40.

©Cambridge Business Publishers, 2015

18-20 Financial & Managerial Accounting for MBAs, 4th Edition
Problems

Total: Activity-Based Costing

LO: 2
1. Lion Company has identified the following overhead costs and cost drivers for next year:

Overhead Item Expected Costs Cost Driver Maximum Quantity

Setup costs $1,166,400 Number of setups 4,800
Ordering costs 540,000 Number of orders 40,000
Maintenance 1,856,000 Machine-hours 64,000
Power 180,000 Kilowatt-hours 400,000

The following are two of the jobs completed during the year:

Job 201 Job 202

Direct materials $18,000 $20,000
Direct labor $24,000 15,000
Units completed 750 600
Direct labor-hours 180 220
Number of setups 12 15
Number of orders 16 30
Machine-hours 360 300
Kilowatt-hours 180 240

Determine the unit cost for each job using the four cost drivers. (Round amounts to 2 decimal places.)

Answer:
Unit cost for Job 201: $74.20
Unit cost for Job 202: $79.76
Setup: $1,166,400 / 4,800 = $243/setup
Ordering: $540,000 / 40,000 = $13.50/order
Maintenance: $1,856,000 / 64,000 = $29/hour
Power: $180,000 / 400,000 = $0.45/kilowatt-hour

Job 201 Job 202

Direct materials $18,000 Direct materials $20,000
Direct labor 24,000 Direct labor 15,000
Overhead assigned: Overhead assigned:
$243 per setup x 12 setups 2,916 $243 per setup x 15 setups 3,645
$13.50 per order times 16 $13.50 per order times 30
216 405
orders orders
$29 per hour times 360 hours 10,440 $29 per hour times 300 hours 8,700
$0.45 per kwh times 180 kwh 81 $0.45 per kwh times 240 kwh 108
Total cost $55,653 Total cost $47,858

Unit cost $74.20 Unit cost $79.76

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-21
Total: Activity-Based Costing
LO: 2
2. Demon Manufacturing Company has developed the following activity cost information for its
manufacturing activities:

Assembly $30 per hour

Drilling $8 per hole
Inspection $4 per inspection
Machine setup $400 per batch
Movement $30 per batch plus $0.20 per lb.
Shaping $50 per hour
Welding $10 per inch

Filling a batch order for 90 units with a combined weight of 400 pounds required:

 Three sets of inspections per unit

 Drilling four holes in each unit
 Completing 20 inches of welds on each unit
 0.6 hour of shaping for each unit
 One hour of assembly per unit

Calculate the total cost to produce a batch of 90 units.

Answer:
Assembly ($30 x 90) $ 2,700
Drilling ($8 x 4 x 90) 2,880
Inspection ($4 x 3 x 90) 1,080
Machine setup ($400 x 1) 400
Movement [$30 + ($0.20 x 400)] 110
Shaping ($50 x 0.6 x 90) 2,700
Welding ($10 x 20 x 90) 18,000
Total $27,870

©Cambridge Business Publishers, 2015

18-22 Financial & Managerial Accounting for MBAs, 4th Edition
Total: Traditional and Activity-Based Costing
LO: 2, 3
3. Bailey Corporation has four categories of overhead. The expected overhead costs for each category
for next year are as follows:

Maintenance $420,000
Materials handling 180,000
Setups 150,000
Inspection 300,000

The company has been asked to submit a bid for a proposed job. The plant manager believes that
obtaining this job would result in new business in future years. Bids are usually based upon full
manufacturing cost plus 30 percent. Estimates for the proposed job are as follows:

Direct materials $10,000

Direct labor (750 hours) $15,000
Number of material moves 8
Number of inspections 5
Number of setups 3
Number of machine-hours 300

Expected activity for the four activity-based cost drivers that would be used is:

Machine-hours 20,000
Material moves 4,000
Setups 200
Quality inspections 8,000

Required:
a. Determine the amount of overhead that would be allocated to the proposed job if 40,000 direct
labor-hours are used as the volume-based cost driver. Determine the total costs of the proposed
job. Determine the company's bid if the bid is based upon full manufacturing cost plus 30
percent. (Round amounts to 2 decimal places.)

b. Determine the amount of overhead that would be applied to the proposed project if activity-based
costing is used. Determine the total costs of the proposed job if activity-based costing is used.
Determine the company's bid if activity-based costing is used and the bid is based upon full
manufacturing cost plus 30 percent. (Round amounts to 2 decimal places.)

c. Which product costing method produces the more competitive bid?

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-23
 Answer:
a. Amount of overhead allocation: ($420,000 + $180,000 + $150,000 + $300,000) / 40,000
= $26.25 / DLH $26.25  750 DLH = $19,687.50

Total cost of job: ($10,000 + $15,000 + $19,687.50) = $44,687.50

Company bid: ($44,687.50 x 130%) = $58,093.75

b. Amount of overhead allocation:

Maintenance: $420,000 / 20,000 = $21/MH
Materials handling: $180,000 / 4,000 = $45/move
Setups: $150,000 / 200 = $750/setup
Inspection: $300,000 / 8,000 = $37.50/inspection

Overhead assigned:
$21/MH times 300 MH $6,300.00
$45 per move times 8 moves 360.00
$750 per setup times 3 setups 2,250.00
$37.50 per inspection times 5 inspections 187.50
$9,097.50

Total cost of job: $10,000 + $15,000 + $9,097.50 = $34,097.50

Company bid: $34,097.50  130% = $44,326.75

c. Presumably, activity-based costing produces more precise cost information because it tracks the
actual drivers of cost and provides more detailed information. To the extent this presumption is
true, the activity-based costing produces a more competitive bid.

©Cambridge Business Publishers, 2015

18-24 Financial & Managerial Accounting for MBAs, 4th Edition
Essay Questions

Topic: Activity-Based Costing Concepts

LO: 2
1. The most critical step in activity-based costing is identifying cost drivers. Explain this statement.

Answer:
The activity cost driver for a particular cost (or cost pool) is the characteristic selected for measuring
the quantity of the activity for a particular period of time. It is critical that the activity measure used
has a logical causal relationship to the costs in the pool. Statistical methods such as regression
analysis and correlation analysis can be very useful in selecting activity cost drivers; however,
analysis of processes and activities that make up those processes (including interviews with people
involved in those processes) often provides more useful insight into what is the most appropriate cost
driver for a given activity cost pool.

Topic: Cross-Subsidization
LO: 3
2. What is cross-subsidization and when is it most likely to occur?

Answer:
Cross-subsidization is essentially the assignment of indirect, or overhead, costs to the wrong product.
This occurs when one product is assigned too much cost as a result of another being assigned too
little. The product receiving too much cost assignment subsidizes the product that should have
received the cost assignment. Cross-subsidization is most likely to occur when multiple products are
produced using a variety of production procedures.

Topic: Importance of Accurate Cost Measurements

LO: 3
3. Why is it important to have a product costing system that produces reasonably accurate and precise
cost measurements?

Answer:
It is important to have a costing system that provides external users of financial statements with
reliable information about earnings and net worth and to provide internal managers with the
information they need for decision making. For financial reporting purposes, highly generalized costs
systems are often used which are accurately applied, but they are generally inadequate for evaluating
the profitability of individual products, or making decisions about the future of those products in the
product line, because these generalized cost systems do not provide a high level of precision in
measuring actual costs.

©Cambridge Business Publishers, 2015

Test Bank, Module 18 18-25
Topic: Traditional Costing Distortions
LO: 4
4. Comment on cost distortions commonly observed in traditional costing systems.

Answer:
Studies have shown that distortions occur regularly in traditional costing systems in which a
significant variation exists in the volume and complexity of products and services produced.
Traditional systems tend to overcost high-volume, low-complexity products, and they tend to
undercost low-volume, high-complexity products. In companies with a large number of different
products, traditional costing can show that most products are profitable, but after changing to activity-
based costing (ABC), these companies might find that they are actually losing money on products
they previously thought were profitable, and that they are making money on products they previously
thought were losers. Adopting ABC often leads to increased profits merely by changing the product
mix to minimize the number of unprofitable products.

Topic: Customer Profitability

LO: 5
5. How can ABC used to improve customer profitability analysis?

Answer:
Customers make varying demands on companies with some customers requiring little support and
others requiring substantial amounts. Using ABC, companies can determine the amount of its
various customer support activities, and their related costs, that are incurred for the benefit of each
customer. Customer profitability can be determined by deducting customer-specific support costs
from customer generated gross profit. Some customers may be revealed as unprofitable and other
customers may be more or less profitable than others.

ABC should reveal how much of various support costs are used by less profitable customers.
Management should investigate these data and perhaps discuss the usage with the customer.

©Cambridge Business Publishers, 2015

18-26 Financial & Managerial Accounting for MBAs, 4th Edition