Activity-Based Costing and Management
Chapter 7 addresses the following questions:
Q1 How is activity-based costing (ABC) different from traditional costing?
Q2 What are activities, and how are they identified?
Q3 What process is used to assign costs in an ABC system?
Q4 How are cost drivers selected for activities?
Q5 What is activity-based management (ABM)?
Q6 What are the benefits, costs, and limitations of ABC and ABM?
These learning questions (Q1 through Q6) are cross-referenced in the textbook to individual
exercises and problems.
The textbook uses a coding system to identify the complexity of individual requirements in the
exercises and problems.
Questions Having a Single Correct Answer:
No Symbol This question requires students to recall or apply knowledge as shown in the
e This question requires students to extend knowledge beyond the applications
shown in the textbook.
Open-ended questions are coded according to the skills described in Steps for Better Thinking
Step 1 skills (Identifying)
Step 2 skills (Exploring)
Step 3 skills (Prioritizing)
Step 4 skills (Envisioning)
7-2 Cost Management
7.1 If direct labor hours are used for tending machines and equipment, small batches take
fewer direct labor hours and so are allocated less overhead. However, if overhead costs
increase more with setup time than with direct labor costs, the cost to set up for a large
batch is likely similar to the cost of setting up a small batch. The cost per unit is then
probably much lower for the large batch than for the small batch.
7.2 Organization-sustaining activities are activities related to the overall organization and
unaffected by customers served or by quantities of products, batches, or units. Facility-
sustaining activities are activities related to the overall operations of a production facility
and unaffected by customers served or by quantities of products, batches, or units.
Customer-sustaining activities are customer service activities that are independent of
sales volumes and mix. Product-sustaining activities occur to support a product line or a
single product if it is not part of a product line. Batch-level activities increase as the
number of batches increase. These activities include setup and monitoring batches of
product. Unit-level activities increase proportionately with production volumes or sales
7.3 Because ABC uses more cost pools and more cost drivers to reflect cause and effect
relationships, ABC costs usually map the relation between cost and use of resources more
accurately. Hence ABC costs reflect different proportions of the resource costs than do
7.4 No, increasing the number of cost pools and cost drivers can increase measurement error
because small measurement errors for each pool and each driver can distort total cost
once costs are allocated, simply from the increase in calculations that take place. In
addition, if the production process is very simple and products use the same amount of
resources each, increasing the number of cost pools will not increase the accuracy of the
7.5 No, because it is expensive to implement, the costs outweigh the benefits for some firms.
Firms that are already operating efficiently may not benefit from an ABC system,
especially if they have available capacity. Research has shown that ABC is more
successful within organizations that use flexible systems, have integrated information
systems, and produce a variety of products.
7.6 Yes, ABC can be used in service industries. In service organizations, ABC may be
especially helpful if there are capacity limits. Service industries often have a large
proportion of fixed resources, and understanding the relationship between cost and the
use of these resources can improve the efficiency of the organization.
7.7 Measurement error could decrease because ABC can do a better job of allocating costs to
the use of resources. Better allocation reduces problems such as product cross-
subsidization, in which costs are overallocated to some products and underallocated to
others. However, measurement error could increase because increasing the number of
cost pools and cost drivers results in small measurement errors for each pool and each
Chapter 7: Activity-Based Costing and Management 7-3
driver. As the number of calculations increase, these small measurement errors interact
as costs are allocated (rates are developed and used as multipliers), and so the size of
measurement error is likely to increase.
7.8 Several costs that are incurred when implementing an ABC system include the time it
takes employees or consultants to determine appropriate cost pools and cost drivers, the
cost to track and measure the number of activities because these may not be recorded in
the accounting system, and the cost to set up an information system to develop ABC
reports. Several benefits include the ability to identify non-value added activities, and a
better understanding of the use of overhead resources.
7.9 First, meet with accounting employees to learn about all of the different activities they
perform. Identify activities that are homogeneous and can be pooled together. For
example, budget preparation for each department is probably similar, but it may take
different amounts of time according to the complexity of the department. Pool all of the
various budgeting activities. Once a list of activities has been identified, employees’
opinions about appropriate cost drivers can be solicited. Activities that have the same
cost drivers could probably be pooled.
7.10 Yes, research has shown that ABC is more successful within organizations that use
flexible systems, have integrated information systems, and produce a variety of products.
With ABC, a better mapping of the use of resources to each product line allows managers
to choose the optimal product mix. In addition, if the processes are complex, ABC
allows analysis of the activities underlying complex processes so improvements are
easier to identify, as are non-value added activities. In these cases, the costs are likely
less than the benefits achieved.
7.11 Activity-based costing analyzes the activities performed in manufacturing and service
production. Once the activities are identified, costs for each activity are collected into
separate cost pools. Next a cost driver is chosen that reflects changes in the costs of
activities. The cost driver is used to allocate the costs of the activity to products,
services, or some other cost object. There are multiple cost pools and drivers.
Traditional costing uses only a few overhead cost pools and allocates the costs based on
drivers such as direct labor hours, direct labor cost, or machine hours. In a traditional
cost system, the cost pools are very large and so it is impossible to find an allocation base
that reflects resource use. It is merely a logical system of assigning part of overhead
costs to each product or service. ABC, on the other hand, selects cost pools around
activities so that a cost driver can be chosen to better reflect a product or service’s use of
resources. Therefore, ABC systems have more cost pools and drivers. Because an ABC
system is more complex, more time, effort, and money are required to implement ABC
systems than traditional costing systems.
7.12 Activity-based costing is a method of allocating costs to products or other cost objects.
Activity-based management is the process of using ABC information to improve
operations and profitability by analyzing the actual activities and processes to reduce
non-value added activities, and improve the efficiency of activities. In addition,
managers may be able to better understand different products’ uses of fixed resources,
which could be important if there are capacity constraints.
7-4 Cost Management
7.13 There are several reasons for using ABC and ABM to improve an organization’s
environmental performance. Environment-related activities, such as disposing of
hazardous substances and cleaning up spills of these substances, are non-value added. If
those types of activities can be minimized, costs are also likely to be reduced. In
addition, most companies would prefer to avoid the negative reputation effects that are
associated with pollution problems. Once managers become aware of environmental
costs, they may realize that investing in prevention activities will actually reduce costs in
the long run.
7.14 Prevention activities are activities performed to insure defect-free production. These
activities could include
inspecting incoming direct materials
designing and redesigning products and manufacturing processes to reduce defect
identifying areas where defects arise and solving the underlying cause of the
Appraisal activities are activities performed to identify defective units, and include the
Inspection of products
Inspection of manufacturing process
Monitoring of service delivery process
Production activities are activities undertaken in the production or rework of failed units.
Labor tasks and materials to produce spoiled units
Reworking spoiled units
Post-Sales activities are activities undertaken after the product has been sold to remedy
problems caused by defects and failed units. These activities include
Accepting returned products and exchanging them for good products or refunding
Repairing defective units
Preparing for and participating in legal actions that result from defective units
Chapter 7: Activity-Based Costing and Management 7-5
7.15 ABC Cost Hierarchy
A. Receptionist salary is an organization-level cost because the receptionist serves everyone
who comes through the door and thus cannot be identified with one product or unit.
B. Financial forecasting software is an organizational-level cost if it is used to forecast sales
for the entire company. However if it used only by one product line, it is a product-
C. Photocopy machine rental is a facility-level cost when everyone uses the machine, but
could be a product, batch or unit related cost if a password were used to keep track of
copies made for each client or department.
D. Janitorial service is a facility-level cost because the entire facility uses this evenly.
E. Audit manager’s salary is a unit-level cost because the managers is in charge of a number
of different audits and bills his or her time to each audit.
F. Long distance telephone charges are unit-level if the bill includes details of to whom the
calls were made, and could be product-sustaining if the calls are marketing a particular
product. It just depends upon the purpose of the calls. Some companies have Watts lines
and pay a flat fee for all long distance calls. In this case the cost is an organization-level
G. Meal costs for entertaining clients could be a customer-sustaining cost if related only to
that particular customer, or product related if the customer is associated with only one
H. Costs of annual employee golf party is an organization-level because it benefits all
I. Office supplies such as paperclips and tablets of paper are organization-level costs unless
they can be traced to a particular product or batch.
J. Annual subscription for income tax regulations is a product-sustaining cost if it pertains
to one department of the firm. If it pertains to the entire firm, it is a facility-level cost.
7.16 MicroBrew Northwest
Following are the CMA answers to this question. However, one could argue that some of the
unit-level costs could instead be categorized as batch-level.
A. Facility-level costs: Manufacturing facility $1,500,000
7-6 Cost Management
B. Product-sustaining costs: Product development $1,250,000
C. Batch-level costs: Production setup $700,000
D. Unit-level costs:
Materials handling $ 850,000
Production line labor 2,500,000
Power (assuming most power is to cool beer and
run machines, not for overhead) 500,000
Total unit-level costs $3,850,000
7.17 ABC Cost Hierarchy
A. Unit-level activities and costs relate to each unit produced, in this case, each car rented.
The cost of washing each car between rentals is an example of a unit level cost. Costs for
the activities of making the reservation, turning the vehicle over to the renter, and
completing the paperwork at the end of the rental are also unit-level.
B. Batch-level activities and costs relate to the number of batches produced. For a car rental
fleet, cars at a number of outlets are probably sent for oil changes or other routine
maintenance in batches. Car rental companies located off-site near an airport usually
operate a shuttle service from the airport to the rental car location. Multiple passengers
are usually picked up and dropped off on each run of shuttle. Batch-level costs for the
shuttle would include vehicle depreciation, maintenance, and gasoline, plus the driver’s
C. Product-sustaining activities and costs relate to entire product lines. For a car rental
company, the different types of cars for rent could be considered product lines, for
example economy cars, mid-sized cars, and so on. Or the company might see its product
lines more broadly, such as a product line of cars and a separate line for trucks.
Advertising and marketing costs are likely to be product-line related if the company
advertises either trucks or cars, but not both.
D. Customer-sustaining activities and costs relate to the different clients. Sometimes
businesses establish a relationship with car rental agencies if employees need to travel by
car for business. These customers may require special attention, such as car delivery, or
last minute rentals. The costs of these services are customer-sustaining. Rental
companies also have programs such as the Hertz #1 Club, where members receive
preferential treatment. Special costs for these programs include extra personnel to
process the rental and park the vehicle in an easily accessible location.
E. Facility-sustaining costs relate to the facility. For a car rental agency, these could include
depreciation and maintenance of the building and parking lots for each outlet. Facility-
sustaining costs would also include the facility manager’s salary, electricity and janitorial
service, computer terminals, and property taxes.
Chapter 7: Activity-Based Costing and Management 7-7
F. Organization-sustaining costs relate to the entire organization. The CEO’s salary, and
building lease, rent or depreciation costs at the company’s headquarters are all
organization-sustaining costs. Companies such as Hertz also have large organization-
wide costs for computerized reservation and vehicle inventory systems.
7.18 Cost Pools and Cost Drivers
F Machining (As machine hours increase, costs such as maintaining machines
D Purchasing activities (As number of invoices increases, costs such as wages for
employees filling out invoices and supplies used by these employees increase.)
G Inspection (As the number of units produced increases, the number of units
inspected also increases.)
B Assembly (As the number of parts increases, it takes more overhead cost in
material handling, etc. to assemble the product.)
A Payroll (As number of employees increases, more employee time and supplies are
needed to produce paychecks.)
E A special quick freezing process for food (Food is usually frozen in batches. As
the number of batches increases, costs such as electricity and quick-freezing
C Laundry in a hospital (As the number of laundry pounds increases, more labor and
supplies costs are incurred because more batches of clothes are washed.
7.19 Kalder Products
A. Total engineering change cost (6*$300) $1,800
Total allocated cost for AJ40 (1*1,000/(1*1,000 + 1.5*1,000)*(6*300) 720
Remainder is allocated to AJ60 $1,080
B. Total engineering change cost (6*$300) $1,800
Total allocated cost for AJ40 (4*$300) 1,200
Remainder is allocated to AJ60 $ 600
7-8 Cost Management
C. Comparison of costs allocated under the two systems:
AJ40 AJ60 Total
Traditional costing $ 720 $1,080 $1,800
ABC costing 1,200 600 1,800
Product Cross Subsidization
Overcharge (Undercharge) $ (480) $ 480 $ 0
Percent Overcharge (Undercharge) (40)% 80%
Cross subsidization means that one product is allocated more overhead cost relative to its
use of overhead resources and, therefore, other products’ overhead cost is less than their
use of resources.
7.20 Applewood Electronics
1. Manufacturing cost per unit under traditional cost accounting
In the traditional cost accounting system, overhead is allocated to products based on
machine hours. The rate per hour is calculated as follows:
Total estimated overhead $4,800,000
Estimated machine hours:
Monarch (8.0 hours x 22,000 units) 176,000
Regal (4.0 hours x 4,000 units) 16,000
Total estimated machine hours 192,000
Estimated allocation rate per machine hour ($4,800,000/192,000) $25.00
The total manufacturing cost per unit is the sum of per unit direct material, direct
labor, machine usage, and allocated overhead, as follows:
Direct material $208.00 $584.00
Direct labor 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00
Machine usage 8 mach hrs x $18 144.00 4 mach hrs x $18 72.00
Overhead 8 mach hrs x $25 200.00 4 mach hrs x $25 100.00
Total $570.00 $798.00
2. Manufacturing cost per unit under ABC
First, calculate the allocation rate for each of the ABC pools:
Soldering ($942,000/1,570,000 solder joints) $0.60 per solder joint
Shipments ($860,000/20,000 shipments) $43.00 per shipment
Quality control ($1,240,000/77,500 units inspected) $16.00 per inspection
Chapter 7: Activity-Based Costing and Management 7-9
Purchase orders ($950,400/190,080 purchase orders) $5.00 per purchase order
Machine power ($57,600/192,000 machine hours) $0.30 per machine hour
Machine setups ($750,000/30,000 setups) $25.00 per setup
Next, calculate total manufacturing costs allocated to each product under the ABC
system and then calculate the total manufacturing cost per unit:
Soldering 1,185,000 solder jts x $0.60 $ 711,000 385,000 solder jts x $0.60 $ 231,000
Shipments 16,200 shipments x $43 696,600 3,800 shipment x $43 163,400
Quality control 56,200 inspections x $16 899,200 21,300 inspections x $16 340,800
Purchase orders 80,100 POs x $5 400,500 109,980 POs x $5 549,900
Machine power 176,000 mach hrs x $0.30 52,800 16,000 mach hrs x $0.30 4,800
Machine setups 16,000 x $25 400,000 14,000 x $25 350,000
Overhead $3,160,100 $1,639,900
Overhead Per Unit $3,160,100/22,000 units $143.64 $1,639,900/4,000 $ 409.98
Direct material 208.00 584.00
Direct labor 1.5 DL hrs x $12 18.00 3.5 DL hrs x $12 42.00
Machine usage 8 mach hrs x $18 144.00 4 mach hrs x $18 72.00
Cost Per Unit $513.64 $1,107.98
B. The traditional costing system allocates a lump sum of overhead based only on machine
hours, while the ABC system uses six cost pools to allocate the overhead. Allocations
using these cost pools and cost drivers more accurately reflect the flow of resources.
1. Operating profit per unit under traditional cost accounting:
Selling Price $ 900.00 $1,140.00
Manufacturing (570.00) (798.00)
Selling, General, and Administrative (265.00) (244.50)
Traditional costing operating profit $ 65.00 $ 97.50
2. Operating profit per unit under ABC:
Selling Price $900.00 $1,140.00
Manufacturing (513.64) (1,107.98)
Selling, General, and Administrative (265.00) (244.50)
ABC costing operating profit $121.36 $ (212.48)
D. Based on the profit information using ABC, Applewood should concentrate on the
Monarch. Under ABC, it appears that the organization incurs a loss for each unit sold of
Regal. Using this ABC information would definitely affect the recommendation because
one product appears to have a negative profit margin.
7-10 Cost Management
Note: This problem is from an old CMA exam. The calculations shown in this problem
probably include fixed costs. Remember from Chapter 4 that organizations need to
emphasize the product with the highest contribution margin to maximize profits;
however, that product cannot be identified with the information given in this problem.
Applewood would need to separate costs into flexible (those that vary with activity) and
committed (those that do not vary with activity) to determine the ABC contribution
margin for each product. Once this is done, the product with highest contribution margin
can be identified and emphasized.
7.21 Palmer Company
A. Manufacturing cost per unit:
Machine setup 2 setups x $50.00 $ 100
Material handling 19 parts x $0.50 x 100 units 950
Machining 1.25 machine hours x $26.00 x 100 units 3,250
Assembly 1.5 direct labor hours x $22.00 x 100 units 3,300
Inspection 100 units x $12.00 1,200
Direct materials 100 units x $100.00 10,000
Total Costs $18,800
Cost Per Unit $18,800/100 units $188
B. Full cost per unit
Total manufacturing cost per unit $188
Research and marketing costs per unit 140
Other non-manufacturing costs per unit 320
Total full cost per unit $648
C. Cost savings required:
First, calculate the maximum full cost that would allow the company to achieve a profit
of 10% based on full cost:
Selling price = Full Cost + 10% x Full Cost
$650.00 = 100% x Full Cost + 10% x Full Cost
$650.00 = 110% x Full Cost
Full Cost = $650.00/110%
Full Cost = $590.91
Chapter 7: Activity-Based Costing and Management 7-11
Next, calculate the difference between the maximum full cost calculated above and the
current full cost. This is the amount of cost savings required to achieve the desired profit.
Full cost per unit $648.00
Full cost needed to achieve desired profit 590.91
Cost savings required $ 57.09
7.22 Kestral Manufacturing
A. Following are the ABC allocation rates:
Activity Cost Activity level Allocation rate
Machine set-up $ 40,000 400 $100
Material handling 160,000 16,000 $10
Product design 100,000 2,000 $50
Number of inspection 260,000 13,000 $20
For job 42, overhead costs = (2x$100)+(60x$10)+ (40x$20) +(20x$50) = $2,600
B. For job 43, overhead costs = (4x$100)+(20x$10)+(20x$20)+(100x$50) = $6,000
C. Non-value added activities are tasks or functions that are unnecessary and waste
resources because they do not increase the worth of an organization’s goods or services to
customers. At Kestral, non-value-added activities include moving materials from place
to place (such as from receiving dock to warehouse to one work area and then to another
work area). The company could reduce costs by minimizing the handling of materials.
Another non-value-added activity is inspection. With sufficient quality improvements
and continuous inspection by workers during production processes, the need for a
separate inspection process can be reduced or eliminated. Set-up costs are also
considered non-value added and the set-up activity could be analyzed to reduce steps and
materials if possible so that costs are reduced.
7.23 Elite Daycare
[Note about problem complexity: Part A is coded as Extend rather than Step 3 because a more
complex problem involving a similar organization was illustrated as a self-study problem in the
A. There are several cost objects that could be chosen for Elite Daycare, depending on the
planned use of information. The director may want to develop a function for total costs
of the daycare for budget or benchmarking purposes. In that case, the cost object is the
daycare itself. Alternatively, she might choose the type of service (full-time or part-time)
as the cost object. If she wanted to better understand the cost per child, she could choose
7-12 Cost Management
a per-child cost object. This problem focuses on the daycare cost function, so the cost
object is the daycare program.
Next, cost pools need to be developed. For Elite Daycare, there appear to a number of
different activities: greeting and leaving, preparing and serving food, supervising naps,
supervising recreation, and activity time. The greeting and supervising activities can
probably be combined into one cost pool. However, supplies are probably used during
activity time, and the director may want to know an approximate cost per child for
activity time. Therefore, a single pool can be used for greeting, supervising naps, and
recreation; a pool for supervising activities; and another pool can be used for meal-related
activities (preparing and serving food, monitoring behavior).
Next, cost drivers for each pool need to be chosen. Cost drivers for greeting and
supervising activities could be number of children or time spent. Because supervising
naps and recreation activities are similar to greeting, cost driver choices would be similar
for these two pools. A number of different children can be supervised at one time, so
time spent would be probably be easiest to track and provide an appropriate accounting of
costs related to supervising activities. Cost drivers for preparing and serving food could
be either the number of meals served or the number of children served. Tracking meals
served is probably just as easy as tracking number of children, but meals are more closely
related to food preparation, so number of meals served will be used as the cost driver.
Cost drivers for supplies could be number of art activities or number of children, among
others. It would be easiest to track number of children, and it is likely that each child
uses similar amounts of supplies.
B. Annual cost per child
The percentage of time for the greeting and supervising pool is 30% (20%+10%), 20%
for meal-related activities, and 50% for supervising educational activities. These times
can be further categorized into full-time and after-school by considering the percentage of
total hours each program uses. There are 10 hours available per full-time child, and 3
hours per child after school. Therefore, there are 300 (10 hours x 30 children) full-time
child hours available per day and 30 (3 hours x 10children) after-school child hours
available. Of the total 330 hours available, 91% (300/330) of the hours are full-time
child hours, and 9% are after-school child hours.
Now the calculation of the ABC meal related activities cost requires several steps, as
Estimated annual volume of snacks/meals:
(Assume 5 days per week x 50 weeks = 250 days)
Full-time (30 children x 3 snacks & meals x 250 days) 22,500
After-school (10 children x 1 snack x 250 days) 2,500
Number of meals served 25,000
Chapter 7: Activity-Based Costing and Management 7-13
Total food cost $20,000
Time spent on meal preparation (20% x $100,000) 20,000
Total snacks and meals per year $40,000
Estimated cost per snack/meal ($40,000/25,000) $1.60
The total annual ABC cost per child is calculated as follows:
Full-time (3 snacks/meals x 250 days x $1.60) $1,200
After-school (1 snack/meal x 250 days x $1.60) $ 400
Full-time ($10,000/30 children) 333
After-school ($8,000/10 children) 800
Supervising educational activities:
Full-time (50% x 91% x $100,000)/30 1,517
After-school (50% x 9% x $100,000)/10 450
Supervising naps, recreation, and greeting:
Full-time (30% x 91% x $100,000)/30 910
After-school (30% x 9% x $100,000)/10 ______ 270
Total Annual Cost Per Child $3,960 $1,920
C. The employees work with both full-time and after-school children, and there are
uncertainties about how much time they spend with each type of student. If the two
groups of children are combined for some activities, then any allocation of salaries or
wages to each service is arbitrary and unlikely to reflect the two services’ use of
employee time. If the two services are completely separate, the cost of salaries and
wages can be traced directly to the service. However, for activities such as snacks, some
employee time is probably spent preparing snacks for both groups at once, and allocating
this cost would be an uncertain and arbitrary process. It is impossible for employees to
track exact time spent per service for activities undertaken for both services, such as
snacks and possibly meeting parents at the end of the day. There are uncertainties about
whether allocation bases reflect the use of resources because these are fixed resources,
and the cost does not vary proportionately with any type of volume measure. Therefore,
any allocation is arbitrary and will not accurately reflect use of those fixed resources.
[Note about problem complexity: Item C is coded as Step 1 instead of Step 3 because the chapter
explicitly discusses methods for improving customer profitability.]
A. Activity-based management involves the use of ABC cost information to develop a
comparison of the costs and benefits of tasks and procedures undertaken within the
7-14 Cost Management
organization to identify improvements that can be made in quality and efficiency or cost
B. A high-cost customer is one for whom contribution margin is low, relative to other
customers, but who requires costly services such as special customized products, special
shipping procedures, small production and delivery quantities, specialized post-sales
service, or customer services before purchasing, and so on. Low-cost customers would
provide relatively more contribution from their orders with little special treatment. These
customers may order large quantities of regular products and not require any special
delivery or help before or after the sale.
C. There are many possible ways to write this paragraph, and the wording depends on the
assumptions that are made about the particular audience for the paragraph, the customer,
and the nature of the company’s business. Below is a sample paragraph.
Several approaches can be taken to improve profitability for high-cost customers.
Accountants can identify costs for these types of customers, and the company can
negotiate with each customer to either charge for some of the specialized services or
motivate the customers to reduce the amount of costly services required. Ways to reduce
costs include improving the predictability of orders, reducing the amount of engineering
changes or other product changes required, and finding standard products that might
substitute for customized products. Customers requiring large amounts of technical
support following a purchase might be willing to pay for this service.
7.25 New-Rage Cosmetics
1. Quality control cost per order using ABC
Incoming material inspection 12 types of material x $11.50 $ 138.00
In-process inspection 17,500 units x $0.14 2,450.00
Product certification 25 orders x $77.00 1,925.00
Total quality control costs $4,513.00
Quality control cost per order $4,513.00/25 orders $180.52
2. Quality control cost per order using traditional cost accounting
Total quality control costs assigned
= Direct labor costs x 14.5%
= $27,500 x 14.5%
Quality control cost per order = $3,987.50/25 orders = $159.50
Chapter 7: Activity-Based Costing and Management 7-15
B. Under the ABC system, the costs are more related to the resources used to insure quality
control. These costs are primarily product inspection and certification costs, and the
allocated costs change as the types of materials and number of units inspected change.
Under traditional cost accounting, direct labor costs may be related to number of units
inspected if it takes more labor to produce more units, but in automated manufacturing
settings this is not always the case. In addition, direct labor costs are not related to types
of materials. Therefore, using direct labor costs to assign quality costs provides poor
quality information about the variation in quality control costs among different orders.
Accordingly, the ABC system provides more accurate costs for quality control.
7.26 Quality Activities
Please see Exhibit 7.6 for more details about these answers.
_P or A_ 6 (Used to motivate employees to improve quality, also requires appraisal)
7-16 Cost Management
7.27 Steps in ABC
3 Identify and sum the costs into activity-based cost pools
4 Choose a cost driver for each activity
6 For each ABC cost pool, allocate overhead costs to the product or service
1 Identify the relevant cost object
2 Identify the activities necessary for production or service delivery
5 For each ABC cost pool, calculate a cost allocation rate
B. All of these steps include uncertainties.
After a cost object is chosen, uncertainty exists about whether all of the activities
necessary to produce the good or service are identified. Some activities may be
overlooked, or the set of activities may include ones that rarely occur and would be an
immaterial part of the process. In addition, uncertainties exist about the optimal number
of activities for a given cost pool. There is uncertainty about whether the costs for
developing additional cost pools would exceed the benefits. Uncertainties also exist
about whether the system would be more or less accurate when potentially separate
activities are grouped together.
When assigning costs to activities, there is uncertainty about whether all direct costs have
identified and traced to each activity. For example, supplies such as cloths used to wipe
off excess oil during the set-up process may be overlooked. In addition, the assignment
of a common resource cost, such as a supervisor salary, may not reflect the time the
supervisor spends on different activities.
For each cost pool, there is uncertainty about whether all of the potential cost drivers
have been identified and whether the chosen cost driver most accurately reflects the use
of resources within that cost pool. In addition, some activities are interdependent, and the
cost pools and cost drivers may not accurately reflect these interdependencies. Choosing
a cost driver for each activity requires the use of judgment. Some activities may have an
obvious cost driver, while others could have several different drivers. Assembling a box,
for example, may only require direct labor and thus have a clear cost driver. Other
activities could include adding materials, using machine hours, and using direct labor
hours. For these types of activities, several different cost drivers could be chosen. The
accountant implementing ABC must identify the driver that best relates changes in
activities to changes in cost.
Measuring the amount of cost driver used per product is sometimes uncertain. Suppose
time spent cleaning is a cost driver for a housekeeping cost pool. When a new employee
is hired, the actual time may be longer than the normal time for the employee’s first
several months. Therefore, uncertainty exists about whether the allocation base volume
Chapter 7: Activity-Based Costing and Management 7-17
is accurately set, or whether the activity has been correctly measured when allocating the
C. There are many correct choices for this answer. The key is to focus on uncertainties and
to explain why the need for judgment might be greater in one step than in the others.
Below are two sample answers.
The choice of cost drivers might require the greatest use of judgment because of the large
number of uncertainties involved. There are uncertainties about whether all possible cost
driver choices have been identified, and whether the selected cost driver actually reflects
the use of resources of the cost pool more accurately than other choices. In addition,
some high quality cost drivers may not be measured very accurately, there are certainties
about whether a particular cost driver provides the best information.
The choice of activity cost pools might require the greatest use of judgment because it not
only involves a large number of uncertainties (as discussed in Part B above), but it also
affects all of the remaining steps. Choices that are made about the activities influence the
cost and benefits achieved from the entire system.
7.28 ABC Cost Hierarchy
A. A cost hierarchy in ABC divides activities into six levels: unit, batch, product, customer,
facility, and organization. This allows accountants to more carefully identify activities
and their associated costs at all levels within the company.
B. Following are several reasons for uncertainty in classifying costs into the cost hierarchy
categories; students may think of others. As costs are categorized into cost hierarchy
categories, accountants might not completely understand the interdependencies within a
group of activities. For example, costs that appear to be batch-level costs could also be
affected by the number of units or the weight of the batch. Managers cannot be certain
that the chosen cost driver in a specific cost category independently reflects cost changes.
Additionally, costs that appear to be organization-level costs could be driven by changes
in volumes. For example, the costs of billing and interacting with customers regarding
their bills could increase step-wise as a fixed cost. Accountants are uncertain whether
this cost increases as the number of customers increase, or whether it is an organization-
level cost that will not change regardless of volumes.
C. Dividing costs into six levels helps accountants better identify all aspects of costs in a
company. Thinking about a particular level helps accountants focus on activities that
occur at that level. In addition, once activities have been developed for a particular level,
it becomes easier to know how costs change with volumes of activity. For example,
property taxes are a facility-level cost and therefore would not increase based on the
number of batches produced, but only on the value of the building itself. Using these six
levels helps accountants better map resource usage to products and services.
7-18 Cost Management
7.29 Vines Corporation
A. Per unit cost using the old method:
Job Order 410________ Job Order 411________
Direct materials $9,700/10 units $ 970.00 $59,900/200 units $299.50
Direct labor $750/10 units 75.00 $11,250/200 units 56.25
Indirect $115x(25 hrs/10 units) 287.50 $115x(375 hrs/200 units) 215.63
Total $1,332.50 $571.38
B. Cost per unit cost using ABC
Job Order 410_______ Job Order 411________
Material handling 500 parts x $0.40 $ 200.00 2,000 parts x $0.40 $ 800.00
Milling 150 mach hrs x $20 3,000.00 1,050 mach hrs x $20 21,000.00
Grinding 500 parts x $0.80 400.00 2,000 parts x $0.80 1,600.00
Assembly 2 assembly hrs x $5 10.00 30 assembly hrs x $5 150.00
Inspection 10 units x $25 250.00 200 units x $25 5,000.00
Shipping 1 order x $1,500 1,500.00 1 order x $1,500 1,500.00
Direct material 9,700.00 59,900.00
Direct labor 750.00 11,250.00
Total costs for order $15,810.00 $101,200.00
Total cost per unit $15,810.00/10 units $1,581.00 $101,200.00/200 units $506.00
C. In the traditional costing system, the indirect costs were combined into a single cost pool
and then allocated based on direct labor hours used by each order. Direct labor hours may
or may not be related to costs in the overhead pool. It’s unlikely that they are related to a
very large portion of those costs. However, under ABC, the indirect costs are divided
into six cost pools and allocated using cost drivers that are more likely to reflect the use
of resources. Therefore, the cost allocations provide more accurate information about
D. There are many uncertainties about the choice of cost driver for each activity-based cost
pool. There may be several different drivers that could be used, and several of them
could be similar in their ability to relate cost to the activity. For example, if a school has
classrooms that are similar in physical size with similar numbers of students in each
class, number of rooms may be an adequate cost driver. However, if younger students
are messier and cleaning their rooms takes longer, then time spent might be a better cost
driver. Sometimes time spent is not measured. In this case number of rooms could be
used, or square feet if rooms are different sizes. And this is a fairly forthright activity
with easy to identify cost drivers. Other activities can be much more complex, and
finding cost drivers can be more difficult. Identifying the most appropriate cost driver
requires effort, and the best driver may be expensive to measure. If the activity changes
in any way, a new driver might be needed.
E. An ABC system allocates costs using more cost pools and more appropriate cost drivers,
so costs are likely to be less distorted. For example, if direct labor hours were
Chapter 7: Activity-Based Costing and Management 7-19
abnormally high for one job, under the traditional costing system the indirect costs
assigned to that job would be higher even if more costs were not incurred. Under ABC
this possibility for error is minimized because there are more allocation bases than direct
labor hours. The ABC system is more costly to implement because it takes time to
develop and many employees need to be involved. ABC is more useful in analyzing
operations to improve quality and reduce costs. Non-value added activities can be
identified and other activities can be simplified, once they have been identified. This
doesn’t tend to happen with traditional costing.
7.30 Kim Mills
A sample spreadsheet showing the solutions for this problem is available on the Instructor’s web
site for the textbook (available at www.wiley.com/college/eldenburg).
1&2 Following are excerpts from a sample spreadsheet for this problem.
Denim Cotton Cotton Total
Direct materials $8,000 $24,000 $20,000 $52,000
Direct labor cost $660 $1,320 $920 $2,900
Total Overhead $57,996
Units 1,000 4,000 2,000 7,000
Direct labor hours 33 66 46 145
Machine hours 500 1,333 1,500 3,333
Number of set-ups 10 30 20 60
Inspection hours 83.3 333.3 166.6 583.2
7-20 Cost Management
TRADITIONAL PROCESS COSTING
Note: Because there are no beginning or ending inventories, equivalent units are equal to physical units.
Also, there is no need to calculation conversion cost per unit separately for the two departments because
conversion costs are allocated in both departments to the number of bolts produced. With no beginning or
ending inventories, the number of bolts produced is identical in the two departments.
Equivalent Conversion Cost Per Unit
Total Conversion Costs to Account for: Total
Direct labor $2,900
Total Units (Bolts) to Account for 7,000
Equivalent Conversion Cost Per Unit $8.69943
Process Cost Report Denim LW Cotton HW Cotton Total
Number of bolts 1,000 4,000 2,000 7,000
Direct materials $8,000 $24,000 $20,000 $52,000
Conversion costs $8,699 $34,798 $17,399 $60,896
Total Costs Accounted for $16,699 $58,798 $37,399 $112,896
Summary of Cost Per Unit:
Direct materials $8.00 $6.00 $10.00
Conversion costs $8.70 $8.70 $8.70
Total $16.70 $14.70 $18.70
Denim Cotton Cotton
Process Costing $16.70 $14.70 $18.70
Activity-Based Costing 17.49 12.70 22.29
Cost Per Bolt Overstated (Understated
by Traditional Process Costing $ (0.79) $ 2.00 $ (3.59)
Under process costing, the cost per bolt of light-weight cotton was overstated; it absorbed
costs incurred by denim and heavy-weight cotton because costs under process costing are
allocated to the department and then to the product. The production volume of light-
weight cotton (4,000 bolts) is much larger than either denim (1,000 bolts) or heavy
weight cotton (2,000 bolts). When conversion costs are allocated based on number of
units rather than based on the flow of resources used, the product with the most units is
allocated relatively more cost. The production of light-weight cotton requires
proportionately fewer set-ups than the other two products, so it should be allocated less of
the cost for set-up. Light-weight cotton also uses proportionately fewer machine hours,
and so it should also be allocated less of the machine activity costs. In addition, light-
weight cotton uses less direct labor per bolt than the other two products. Under
traditional process costing, direct labor is combined with other conversion costs and is
allocated to units without regard to the actual labor used.
Chapter 7: Activity-Based Costing and Management 7-21
C. Managers may want to investigate machine set-up costs and reduce them, or reduce the
number of set-ups required for all products. In addition, perhaps inspection activities
could be analyzed and costs reduced. The managers might also investigate reasons why
light-weight cotton uses significantly less direct labor than the other two products.
Perhaps direct labor could be used more efficiently, reducing the direct labor cost.
7.31 The Pond Kit Company
A. Total Cost Per Batch:
Material handling 20 parts x $1 per part x 10 kits $ 200.00
Forming 2 molding hours x $40 per hour x 10 kits 800.00
Molding setup 1 batch x $50.00 50.00
Packing and shipping 30 pounds x $1.30 per pound x 10 kits 390.00
Inspection $10 per kit x 10 kits 100.00
Direct labor $20 per kit x 10 kits 200.00
Direct materials $100 per kit x 10 kits 1,000.00
Total costs $2,740.00
B. Total budgeted cost per kit
= Total budgeted cost per batch / Number of kits per batch
= $2,740.00 / 10 kits
= $274.00 per kit
Cost per Kit
Cost Per Batch (10 kits per batch)
Total Cost from Parts A and B $2,740 $274.00
Marketing ($15,000/1,000 batches) 15 1.50
Customer Service ($25,000/1,000 batches) 25 2.50
Total $2,780 $278.00
D. There are other potential activities that could be chosen for this company. Some
activities could be separated further into more pools. For example, packing and shipping
could be separated into a packing activity and a shipping activity. Molding may consist
of several different tasks that could be considered separate activities. Alternatively, some
of these cost pools could possibly be combined, such as molding setup and forming.
There are many different choices that could be made for these activities.
E. The new ABC system can lead to identification of non-value-added costs by focusing
manager attention on the organization’s activities and cost drivers. As activities are
analyzed, some tasks or procedures in these activities might be identified as non-value
added, and then eliminated. For example, if the ponds could be redesigned to require
fewer parts, material-handling costs would likely be reduced. If specific types of defects
cause inspection time to increase, redesigning parts or processes to eliminate the defects
would decrease inspection time and also decrease customer service costs for product
failures. The packing and shipping activities could be analyzed to determine whether
7-22 Cost Management
steps could be combined or some tasks eliminated or outsourced at lower cost. There are
many other non-value activities that students might have identified.
7.32 Data Processors
A. These activities are not the only possible set. Each of these activities could be separated
into a number of other activities. For example, the activity of issuing new credit cards
could be further separated into the following cost pools:
Verifying authorization of new credit cards to be issued
Mailing new credit cards
Validating new credit cards (before first use of the card)
Each cost pool could be disaggregated into more cost pools. Alternatively, some of these
cost pools could be aggregated in some organizations.
Activity Estimated Cost Estimated Activity Rate
Transaction processing $2,000,000 5,000,000 $ 0.40
Statements 1,000,000 250,000 4.00
New credit cards 500,000 100,000 5.00
Billing disputes 90,000 3,000 30.00
C. The volume of activities cannot be predicted with certainty from one month to the next.
For example, although the number of credit cards issued last period is known, economic
changes affect the number of people who will apply, as will advertising campaigns and
competition among financial institutions. Some activities, such as issuing monthly
statements, are easier to estimate than other activities, such as resolving billing disputes.
The number of customers holding credit card accounts probably remains somewhat
constant, although each month some credit card customers are gained and lost. It is more
difficult to predict the number of billing disputes, which fluctuate with the volume of
transactions and also with the degree of problems such as fraudulent credit card use,
retailer errors, and charges for unsatisfactory goods or services.
Costs will be different than expected because it is not possible to perfectly predict future
costs. There may be unanticipated changes in prices, such as electricity rates, telephone
charges, or employee health care costs. If activity volumes are higher than expected, then
employee overtime pay may exceed expectations. Information technology programming
and operating costs may be higher or lower than expected. For example, there could be
fewer problems than expected when making improvements to the transaction processing
system. There are also likely to be random fluctuations in costs such as office supplies.
D. Practical capacity is the maximum capacity under typical operating conditions, taking
into account regularly scheduled holidays and other down time. This company has
several different types of capacity. The discussions below address three types of
capacity; students may think of others.
Chapter 7: Activity-Based Costing and Management 7-23
One type of capacity for Data Processors is the capacity of the computerized technology
to process transactions. Because transactions occur at any time and anywhere in the
world, this capacity must operate 24 hours per day, 365 days per year. The capacity limit
would be measured in terms of the maximum volume of transactions that could be
processed. The practical capacity of the computerized technology for transaction
processing is almost certainly higher than the estimated activity level. The company’s
contracts with its customers probably include guarantees that the system is capable of
processing a higher volume of transactions than expected. In addition, the company
probably has back-up “hot” sites that are fully operational and can take over processing in
the case of system failure due to technological problems, natural disasters, terrorist
Capacity for Data Processors also includes the employee capacity to handle services such
as billing disputes. This type of practical capacity is likely to be higher than estimated
activity levels during slow times, but it could be lower when activities are unexpectedly
high. However, the company probably has contractual commitments to resolve billing
disputes within a maximum number of days. Thus, the company must be capable of
expanding its employee practical capacity, as needed, to meet actual activity levels. The
company may be able to expand this capacity quickly by using employee overtime or
Another type of capacity for Data Processors is the physical capacity for printing and
mailing monthly statements. Once again, the company is probably contractually
committed to performance of this service in a timely manner, so the company must have
sufficient capacity to handle higher than expected volume. Because it may be difficult to
quickly expand this type of physical capacity, the company’s practical capacity is
probably higher than its expected activity level.
7.33 Steps in ABC
A. Government agencies use cost information to evaluate and improve the efficiency of their
services. Most agencies rely on support through a budgeting process, and improving
their efficiency helps them obtain operating funds. In addition, managers may want to
move up in the organization’s ranks, and information about their effectiveness is found
through cost reports and budgets. Governments are also interested in improving their
cost systems because of their stewardship responsibility. They are responsible for
efficiently using public funds and maximizing constituent benefits.
B. Following are the five steps listed in the handbook:
1. Analyze Activities
2. Gather Costs
3. Trace Costs to Activities
4. Establish Output Measures
5. Analyze Costs
7-24 Cost Management
Following are the six steps listed in the textbook:
1. Identify the relevant cost object
2. Identify activities
3. Assign (trace and allocate) costs to activity-based cost pools
4. For each ABC cost pool, choose a cost driver
5. For each ABC cost pool, calculate an allocation rate
* Allocation Rate = Activity Cost/Volume of Cost Driver
6. For each ABC cost pool, allocate activity costs to the cost object
* Allocation = Allocation Rate * Actual Volume of Activity
The handbook does not have a step to identify the relevant cost object. Therefore, step 2
from the textbook is similar to step 1 in the handbook. The textbook has no step to gather
costs; the textbook assumes that costs are gathered. Step 3 from the handbook is similar
to step 3 in the textbook (traces and allocate costs to cost pool). Step 4 is similar in both
methods, although the language used is different. Step 5 in the handbook is very general
while, steps 5 and 6 in the textbook cover the same processes, but in more detail.
7.34 Jefferson County Animal Shelter
A. The staff member identified the following three cost objects. Each cost object represents
one of organization’s three services.
One possibility for cost pools is to create one pool for each cost object. This approach
assumes that all costs can be directly assigned to one of these three services. Based on
the following summary, it appears that some of the costs can be directly traced to the cost
objects. However, some of the costs are indirect. (Note: Judgment is involved in these
classifications; students might have categorized costs differently. For example, students
might have classified veterinarians and technicians as indirect if they assumed that these
employees provide services for the animal shelter in addition to the veterinarian clinic.)
Animal Obedience Veterinarian
Shelter Training Services Indirect Total
Director and staff salaries $ 0 $ 0 $ 0 $ 60,000 $ 60,000
Animal shelter employees’ salaries 100,000 0 0 0 100,000
Veterinarians and technicians 0 0 150,000 0 150,000
Animal trainers* 20,000 20,000 0 0 40,000
Food and supplies** 50,000 0 75,000 0 125,000
Building-related costs 0 0 0 200,000 200,000
Total $170,000 $20,000 $225,000 $260,000 $675,000
* The problem indicates that animal trainers provide training classes and also train
animals housed in the animal shelter. 50% of the animal trainer time is devoted to
obedience classes. The remaining 50% is assumed to relate to training for
animals housed in the animal shelter.
Chapter 7: Activity-Based Costing and Management 7-25
** The problem states that $75,000 of this cost is used by the veterinary clinic. The
remainder ($50,000) is assumed to be used in the animal shelter.
A decision must be made about whether to allocate the two indirect costs to the three
services. “Director and staff salaries” is most likely a facility-level cost for general
administration, which would NOT normally be allocated to individual product lines.
“Building-related costs” is also a facility-level cost. Sometimes this type of cost is
allocated to individual products, and sometimes it is not. The following solution assumes
that the building-related costs are NOT allocated to the shelter’s individual services.
B. There are three cost pools to consider—one for each of the organization’s services. For
the animal shelter, a cost driver could be the number of animal days. On a daily basis,
each animal would require similar time from employees to clean their cages, feed, and
groom, and similar supplies such as food and bedding. Another possible cost driver is the
total number of animals housed. However, this cost driver would not capture differences
in cost caused by lengthy animal stays.
A cost driver for obedience training could be number of classes, number of families
taking classes, or number of weeks in which classes are held. Because each class would
require about the same amount of time regardless of the number of families per class,
number of classes is probably a better cost driver.
A cost driver for veterinary services could be the number of animal-visits. Similar
amounts of time and resources would be used per animal, although this assumes that the
product mix of (e.g., neutering and vaccinations) remains relatively constant.
C. Given the cost pools identified in part A and the cost drivers in part B, the allocation rates
are as follows:
Cost Pool Total Cost Cost Driver Volume Rate
Animal shelter $170,000 Animal days 27,375 $ 6.21
Obedience training 20,000 # of classes 125 160.00
Veterinarian services 225,000 Animal visits 5,000 45.00
The allocation rate for the animal shelter indicates that the average cost of housing a pet
for one day is $6.21. The allocation rate for obedience training indicates that it costs on
average $160 to offer a training class. The allocation rate for veterinarian services
indicates that it costs on average $45 to provide veterinarian care per animal-visit.
1. Quality activities include:
* Prevention activities performed to insure defect-free production
* Appraisal activities performed to identify defective units
* Production activities undertaken in the production or rework of failed units
* Post-sales activities undertaken after the product has been sold to remedy
problems caused by defects and failed units
7-26 Cost Management
The shelter is experiencing a post-sales activity when animals are returned because of
2. No, the current ABC system does not include cost pools related to any of the types of
quality activities listed in Part E.1 above. For example, the system does not track the
cost of training dogs while they are housed in the animal shelter (prevention), the cost
of evaluating dog readiness for adoption (appraisal), the cost of additional training for
dogs with greater than normal behavioral problems (production), or the cost of dogs
returned because of behavior problems (post-sales).
3. There are many possible answers to this question; students may think of other cost
pools or drivers. A possible cost pool could be the cost per animal returned. Costs in
this pool could include costs for further training activities, for admitting the animal to
the facility and working with families to find other animals, and the cost to house the
animals while waiting for a new family. The cost driver for this cost pool would be
the number of animals returned. There are some costs that cannot be measured, such
as the cost of potential adopters who decide not to adopt another animal because of a
7.35 Usefulness of ABC
A. Accountants are likely to believe that ABC information would be useful because ABC
separates overhead costs into more cost pools, and cost drivers are chosen to reflect the
cause and effect relationship for costs, accountants might believe that this information
would be useful for their organizations. In addition, the process of implementing ABC
encourages managers to identify and eliminate non-value-added activities.
B. Managers cannot be certain that new ideas will be implemented correctly in their
organization. In addition, because the ideas are new, managers cannot know for certain
that they work for every organization, or just for some types of organizations. Therefore
they cannot know for certain it will be effective for their organization. Furthermore,
managers cannot know for certain whether employees in their organization will support
the new idea or resist, and additional uncertainty arises about the effectiveness of new
ideas when employees are resistant to these changes. Students may have thought of
C. Managers may adopt a new method if they study the method and believe that the benefits
will exceed the costs for their organization. Managers are accustomed to making
decisions under uncertainty; they do not need absolute “proof” before adopting a
potentially beneficial method. In addition, managers are more apt to adopt a new method
if competitors are adopting it. They may feel that competitors will have an edge because
of this new method and worry that their organization will suffer if the method is not
adopted. Or managers may believe they can move ahead of competitors by employing
the new method. Consultants and others who sell the methods may convince managers
that the method is appropriate for their organization, and so the managers adopt it.
Chapter 7: Activity-Based Costing and Management 7-27
D. Over time, many different types of organizations implement a new idea and for some
organizations it works well and for others it does not work well. Evidence accumulates
that the new method is not a cure-all for organizational problems. New methods are
developed and are advertised widely that may overshadow the older methods. In
addition, over time some new method ideas become common practice. For example, a
focus on quality has become commonplace.
E. In a recession, managers focus less attention on expanding operations and more attention
on improving cost effectiveness, competitiveness, and profitability. ABC information
can help organizations identify non-value added activities, reduce costs, improve quality,
and compete more effectively. These results are more important when business
conditions are less favorable.
7.36 Colombo Frozen Yogurt
Impulse Segment Yogurt Shops Total
Sales Revenue $23,880,000 $5,970,000 $29,850,000
Less: Price Promotions (3,600,000) (900,000) (4,500,000)
Net Sales 20,280,000 5,070,000 25,350,000
Less: COGS – Ingredients, Packaging & Storage1 (11,400,000) (2,850,000) (14,250,000)
Less: COGS – Pick/Pack & Shipping2 (2,625,000) (375,000) (3,000,000)
Gross Margin 6,255,000 1,845,000 8,100,000
Less: Merchandising (1,680,000) (45,000) (1,725,000)
Less: SG&A (3,861,000) (39,000) (3,900,000)
Income $ 714,000 $1,761,000 $ 2,475,000
The case states that the portion of COGS related to ingredients, packaging, and storage
are the same across segments. Therefore, these costs are allocated equally to all cases:
$14,250,000 x (1,200,000 cases/1,500,000 cases) $11,400,000
$14,250,000 x (300,000 cases/1,500,000 cases) 2,850,000
Pick/pack & shipping costs are allocated as follows:
Full pallets @ $75 each:
Cases in full pallets 60,000 240,000
Divided by cases per pallet ÷ 75 ÷ 75
Number of full pallets 800 3,200
Times cost per full pallet x $75 x $75
Total full pallet cost $60,000 $240,000
7-28 Cost Management
Individual orders @ $2.25 per case:
Individual cases 1,140,000 60,000
Times cost per case x $2.25 x $2.25
Total individual case cost $2,565,000 $135,000
Total pick/pack cost $2,625,000 $375,000
B. No, these were not the only possible cost objects. Alternatives included: geographic
regions, individual manufacturing processes, size of customers (in terms of total annual
sales), product flavors, and sales people.
1. The set of ABC activities is different from traditional cost categories because
traditional costing systems tend to aggregate costs that may be driven by different
factors into single cost pools, but ABC activities and cost pools are associated with
cost drivers. This is more easily done when costs are separated into a larger number
of cost pools.
2. There are many possible answers to this question; students may think of reasons not
listed here. Because past cost data were accumulated using these cost categories,
maintaining the old categories would make it easier for the managers to analyze cost
trends. The managers might have believed that the old cost categories were
sufficient—i.e., that they provided the most appropriate breakdowns of costs under
ABC. The managers might have believed that the cost to identify and gather data for
new categories would exceed the benefit. The use of old categories reduced
implementation time and avoided the need for significant employee training.
1. Pick/pack and shipping costs: Shipping costs are likely to vary with the number of
units shipped, where a unit may be defined as a case or a pound of weight. However,
shipping costs might also vary according to the size of a shipment; it costs less to
deliver a large quantity to one location than to deliver smaller quantities to many
locations. Thus, the shipping costs might be considered batch-level. Picking and
packing costs probably vary with the time needed to locate, obtain, and pack a single
shipment. This cost might be a unit-level cost that varies with number of cases.
However, it probably costs less per case to pick/pack a full pallet than a smaller order.
Therefore, the pick/pack costs are likely to be batch-level, where a batch is an
[Note: Students often focus on the unit-level aspect of the pick/pack and shipping
costs and fail to recognize potential classification as batch-level. Student difficulty
with this question might be caused partly by a lack of understanding of operations in
a warehouse setting.]
2. Selling, general, and administrative costs: Selling, general and administrative costs
probably include salaries and other costs for sales, general management, accounting,
human resources, etc. These costs are most likely to be considered facility-level
costs. Overall, they probably do not vary with the individual numbers of units,
Chapter 7: Activity-Based Costing and Management 7-29
batches, products, or customers serviced. Although selling costs might vary with
some level of sales activity, these costs are not likely to be a major part of the overall
selling, general and administrative costs. Alternatively, these costs might be
considered product-level from the perspective of General Mills. Colombo Frozen
Yogurt is one product line within a much larger company.
1. Pick/pack and shipping costs: Colombo has chosen two cost drivers for the pick/pack
and shipping costs. One cost driver is the number of full pallets, and the other driver
is the number of individual cases. As discussed in Part D, some parts of the pick/pack
and shipping costs are likely to vary with number of units such as weight, that could
be represented either by number of cases or number of pallets. Other parts of these
costs are likely to vary with the number of batches. The cost drivers chosen by
Colombo allow for lower total cost per batch when a full pallet is shipped. Therefore,
the choice of cost drivers appears to be reasonable.
2. Selling, general, and administrative costs: As discussed in Part D, the selling,
general, and administrative costs are most likely facility-level costs that are not
usually allocated to individual product lines. Thus, it can argued that the cost driver
chosen—and any other cost driver—would not be appropriate.
However, under the assumption that most of the selling, general, and administrative
costs consist of selling costs, then it would be appropriate to allocate these costs to
product lines. In that case, it would be reasonable to use sales representative time as a
cost driver because greater time is likely to cause higher costs.
[Note: Students have a tendency to discuss whether they agree with Colombo’s
method for estimating the volume of the cost driver rather than to discuss the
reasonableness of the cost driver itself. This misunderstanding can lead to a
meaningful class discussion about the difference between cost measurement and cost
F. There is no one answer to this part. Sample solutions and a discussion of typical student
responses will be included in assessment guidance on the Instructor’s web site for the
textbook (available at www.wiley.com/college/eldenburg).
7-30 Cost Management
BUILD YOUR PROFESSIONAL COMPETENCIES
7.37 Focus on Professional Competency: Research
A. Learning objective Q6 (“What Are the Benefits, Costs, and Limitations of ABC and
ABM?”) specifically addressed the following uncertainties related to ABC calculations:
Choice of activities
Choice of cost drivers
Inability to foresee all possible uses of information
Choice of denominator in allocation rate
Mismeasurement of costs assigned to cost pools
These uncertainties lead to uncertainties about the interpretation of ABC information.
For example, uncertainties about selection of the best cost driver lead to uncertainties
about whether costs are likely to vary with changes in the volume of the cost driver.
Similarly, if managers cannot be certain whether the costs assigned to cost pools are
mismeasured, then they also cannot be certain that ABC costs represent the actual costs
of each activity.
1. Research is needed to identify activities and cost drivers and to establish a plan for
implementation. Research includes discussing operations and costs with individuals
throughout the organization, meeting and holding discussions with members of an
ABC team, investigating the ABC practices used by other companies, reading articles
and cases about ABC, attending courses on ABC implementation, and other activities.
2. An ABC team should consist of individuals from different functional areas within the
organization. Because of their different backgrounds, team members bring different
types of knowledge and perceptions about the company to the team meetings. This
diversity increases creativity and also increases the likelihood that appropriate issues
will be considered as choices are made about activities and cost drivers.
3. Following ABC system implementation, managers and accountants should continue
to evaluate the effectiveness of the system design and consider improvements as
needed. Even a system that is highly appropriate at one point in time can become less
useful as operations evolve over time. This requires research into the usefulness of
the existing system and investigation of potential modifications.
1. Available information about ABC and ABM practices include articles, books,
lectures, courses, and the personal experiences of people.
2. Accountants should always strive to perform their work in a professional manner.
When there are no authoritative rules, accountants need to investigate alternative
sources of information (see part C.1) and determine the best course of action.
Chapter 7: Activity-Based Costing and Management 7-31
3. Articulating assumptions and reasoning provides two major benefits. First, the
process of articulation leads to discovery of flaws in the assumptions and reasoning.
Most people engage in more careful thinking when they articulate it. Second,
presenting assumptions and explaining reasoning to other people often leads to the
discovery of new relevant information. Other people may point out flaws in the
assumptions or recommend better solutions.
4. Conflicting recommendations might exist because of differences in operations,
accounting systems, implementation resources, and goals. Accountants use
professional judgment and elicit advice from experts, when appropriate, as they
choose among conflicting recommendations. Accountants are better able to apply
judgment when they conduct sufficient research to fully understand the ABC methods
and the reasons for conflicting recommendations.
7.38 Integrating Across the Curriculum: Corporate Social Responsibility
The answers in this problem depend on the definitions used for environmental accounting. The
U.S. Environmental Protection Agency (EPA) defines three types of environmental accounting:1
National income accounting: National-level reporting of the consumption of
renewable and nonrenewable natural resources.
Financial accounting: Company-level reporting that focuses primarily on the public
disclosure of material environmental liabilities and costs according to GAAP.
Management accounting: Company-, segment-, product line-, facility-, or system-
level reporting of environmental information to support management decision
making. The information could be used to plan and to direct management attention
towards environmental issues; assist managers in making specific decisions such as
purchasing, outsourcing, capital investments, product pricing, risk management,
process/product design, or compliance strategies; or control and motivate behavior to
improve business results.
Traditionally, companies have not publicly disclosed environmental management accounting
information. However, some governments have begun requiring companies to publicly disclose
this type of information, and the awards described in the problem are designed to encourage
greater voluntary disclosure. The solutions provided below assume that “environmental
accounting” means public disclosure and/or internal use of environmental management
A. Environmental accounting is an ethical problem because of potential conflicts among the
interests of managers, companies, shareholders, vendors, customers, competitors,
governments, society in general, and future generations. Managers, companies, and
shareholders are often interested in maximizing profits, which often conflicts with
management emphasis on environmental considerations or public disclosure of
Office of Pollution Prevention and Toxics, U.S. Environmental Protection Agency, An Introduction to
Environmental Accounting As A Business Management Tool: Key Concepts And Terms, EPA 742-R-95-001, June
1995, accessible at www.epa.gov/opptintr/acctg/resources.htm.
7-32 Cost Management
environmental information. When companies report more environmental information,
they are more likely to be forced by governmental regulation or by public opinion to
reduce negative environmental effects. Competitors and other companies in the supply
chain (vendors and customers) are also affected by a company’s environmental reporting.
Information about environmental issues related to one company is likely to be
informative about environmental issues for other companies in an industry. Consumers
and public interest groups generally prefer more information about environmental issues
to improve their abilities to monitor companies and take actions against companies they
see as degrading the environmental. Governments are often caught in the middle. While
they want to protect public environmental interests, they also want to promote economic
B. The answer to this question depends on the companies that students investigate. Students
often have difficulty distinguishing between “pleasing” presentations and informative
presentations. The answer to this question should include specific reasons about
information on one site being more understandable or easy to find than on another site.
C. Company responsibilities for reporting environmental information are partly a function of
environmental regulation. In countries where greater disclosure is required, companies
have a clear legal responsibility to provide it. Company responsibilities for voluntary
disclosure are less clear. Because of the conflicts of interest mentioned in Part A above,
managers have no clear-cut responsibility. If viewed from the perspective of
shareholders, the company’s responsibility might be to minimize environmental
disclosure. Employees have a stake in the company’s financial well-being and might also
prefer less disclosure; however, employees and their families might be affected by
environmental problems such as air quality degradation or hazardous waste. In this case,
the company’s responsibility might be to provide greater disclosure. Companies
generally do not assume responsibility for competitors. However, greater disclosure by
one company in an industry might stimulate similar disclosures by competitors. The
responsibility to suppliers and customers includes mixed incentives. Less disclosure
might help all related companies achieve higher profits, but greater disclosure could lead
to improved environmental performance across the supply chain. Company managers
often view their responsibility toward government regulators and the general public as
meeting minimum legal requirements. However, this view of responsibility assumes that
companies have no social responsibility for environmental matters. An alternative view
is that companies are responsible for the stewardship of resources they use today and for
the resources available to future generations. Many people would argue that company
responsibilities lie somewhere in between these two extremes—that managers have
responsibilities to generate profits and also to find ways to minimize adverse
environmental effects. From this viewpoint, managers have a responsibility to use
environmental accounting to help them make better environmental decisions.
D. The answer to this question depends on the interpretation of “better reporting” for
environmental behavior, policies, and procedures. In Chapter 1 (Exhibit 1.9, page 12),
higher quality reports were defined as more relevant, understandable, and available.
Given this definition, a better environmental report would provide information that is
more useful to constituents such as shareholders, regulators, customers, and the general
public. It would be easier to understand and would be readily available in a timely
Chapter 7: Activity-Based Costing and Management 7-33
manner. Outsiders who read an environmental report can determine whether the report is
easy to understand and available. However, it is more difficult to determine whether a
report provides the most useful information, particularly when disclosures are voluntary.
When information is provided voluntarily, it may be biased. For example, an
environmental report could provide considerable information about a single
environmentally-friendly project, but be silent about environmental problems. Therefore,
it may not be possible to determine whether one company provides better environmental
reporting than another.
However, suppose it CAN be determined that one company provides better
environmental reporting than another. In that case, better reporting might occur because
the company has better environmental policies and procedures, which in turn could lead
to better environmental behavior. However, the other company could have better
environmental behavior, policies, and procedures but simply fail to provide better
E. Obviously, governmental regulation is a factor affecting the publication of environmental
accounting reports. In the absence of such regulation, companies are likely to be
influenced by the actions of other companies—particularly competitors—and public
opinion. Managers also create and are influenced by the company’s mission and core
competencies. Companies that place high priority on environmental responsibility are
more likely to present a public environmental accounting report.
F. Many factors influence governmental emphasis on matters such as environmental
accounting. Governments in economically stable countries are likely to place a greater
emphasis on the environment. Countries in which citizens are more concerned about the
environment will also place greater emphasis on the environment. Governments are also
influenced by the actions of other governments and by the requirements of international
organizations such as the European Union.
G. Methods similar to the ones described in the chapter for measuring quality costs could be
used to measure environmental costs. The first step would be to identify different types
of environmental activities, costs, and drivers. One example is the list of cost categories
included in the problem, developed by Japan’s Ministry of the Environment.
H. There are two ways that preparing and publishing environmental accounting reports help
companies reduce its environmental costs. First, the process of preparing these reports
necessarily includes investigation of environmental accounting and reports released by
other companies. This investigation can lead to new ideas for reducing environmental
costs. Second, companies that public release environmental information might be
encouraged to more actively engage in continuous environmental improvements.
I. This question is open-ended, so answers will vary. It is important to clarify the trade-offs
made when arriving at conclusions for this type of problem. Some people have a
tendency to adopt a “high road” and fail to recognize the practicalities of governmental
regulation. Other people tend to do the opposite—they dismiss what they perceive as
idealistic solutions and fail to seek creative or new solutions. The best solutions are those
which clarify trade-offs, recognize limitations, and yet still seek to achieve improvement.