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Chapter 5

Activity-based Costing and Activity-based


Management

Assignment Material
5-1  Broad averaging (or ‘peanut-butter costing’) describes a costing approach that uses broad averages for
assigning (or spreading, as in spreading peanut butter) the cost of resources uniformly to cost objects when the
individual products or services, in fact, use those resources in non-uniform ways.
Broad averaging, by ignoring the variation in the consumption of resources by different cost objects, can
lead to inaccurate and misleading cost data, which in turn can negatively impact the marketing and operating
decisions made based on that information.

5-2  Overcosting may result in competitors entering a market and taking market share for products that a
company erroneously believes are low-margin or even unprofitable.
Undercosting may result in companies selling products on which they are in fact losing money, when they
erroneously believe them to be profitable.

5-3  Costing system refinement means making changes to a simple costing system that reduces the use of
broad averages for assigning the cost of resources to cost objects and provides better measurement of the costs
of overhead resources used by different cost objects.
Three guidelines for refinement are:
1. Classify as many of the total costs as direct costs as is economically feasible.
2. Expand the number of indirect cost pools until each of these pools is more homogenous.
3. Use the cause-and-effect criterion, when possible, to identify the cost-allocation base for each indirect-
cost pool.

5-4  An activity-based approach refines a costing system by focusing on individual activities as the fundamental
cost objects. It uses the cost of these activities as the basis for assigning costs to other cost objects such as
products or services.

5-5  Four levels of a cost hierarchy are:


(i) Output unit-level costs: costs of activities performed on each individual unit of a product or service.
(ii) Batch-level costs: costs of activities related to a group of units of products or services rather than to
each individual unit of product or service.
(iii) Product-sustaining costs or service-sustaining costs: costs of activities undertaken to support
individual products or services regardless of the number of units or batches in which the units are
produced.
(iv) Facility-sustaining costs: costs of activities that cannot be traced to individual products or services but
support the organization as a whole.

5-6  It is important to classify costs into a cost hierarchy because costs in different cost pools relate to different
cost-allocation bases and not all cost-allocation bases are unit-level. For example, an allocation base like setup
hours is a batch-level allocation base, and design hours is a product-sustaining base, both insensitive to the
number of units in a batch or the number of units of product produced. If costs were not classified into a cost
hierarchy, the alternative would be to consider all costs as unit-level costs, leading to misallocation of those
costs that are not unit-level costs.

5-7  An ABC approach focuses on activities as the fundamental cost objects. The costs of these activities are
built up to compute the costs of products, and services, and so on. Simple costing systems have one or a few
indirect cost pools, irrespective of the heterogeneity in the facility while ABC systems have multiple indirect
cost pools. An ABC approach attempts to use cost drivers as the allocation base for indirect costs, whereas a
simple costing system generally does not. The ABC approach classifies as many indirect costs as direct costs
as possible. A simple costing system has more indirect costs.

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5-8  Four decisions for which ABC information is useful are:
1. pricing and product mix decisions,
2. cost reduction and process improvement decisions,
3. product design decisions, and
4. decisions for planning and managing activities.

5-9  No. Department indirect-cost rates are similar to activity-cost rates if (1) a single activity accounts for a
sizable fraction of the department’s costs, or (2) significant costs are incurred on different activities within a
department but each activity has the same cost-allocation base, or (3) significant costs are incurred on different
activities with different cost-allocation bases within a department but different products use resources from the
different activity areas in the same proportions.

5-10  ‘Tell-tale’ signs that indicate when ABC systems are likely to provide the most benefits are as follows:
1. Significant amounts of indirect costs are allocated using only one or two cost pools.
2. All or most indirect costs are identified as output-unit-level costs (i.e., few indirect costs are described
as batch-level, product-sustaining, or facility-sustaining costs).
3. Products make diverse demands on resources because of differences in volume, process steps,
batch size, or complexity.
4. Products that a company is well suited to make and sell show small profits, whereas products that a
company is less suited to produce and sell show large profits.
5. Operations staff has significant disagreements with the accounting staff about the costs of
manufacturing and marketing products and services.

5-11  The main costs and limitations of ABC are the measurements necessary to implement the systems. Even
basic ABC systems require many calculations to determine costs of products and services. Activity-cost rates
often need to be updated regularly. Very detailed ABC systems are costly to operate and difficult to understand.
Sometimes the allocations necessary to calculate activity costs often result in activity-cost pools and quantities of
cost-allocation bases being measured with error. When measurement errors are large, activity-cost information
can be misleading.

5-12  No, ABC systems apply equally well to service companies such as banks, railroads, hospitals, and
accounting firms, as well merchandising companies such as retailers and distributors.

5-13  No. An activity-based approach should be adopted only if its expected benefits exceed its expected costs.
It is not always a wise investment. If the jobs, products or services are alike in the way they consume indirect
costs of a company, then a simple costing system will suffice.

5-14  Increasing the number of indirect-cost pools does NOT guarantee increased accuracy of product or
service costs. If the existing cost pool is already homogeneous, increasing the number of cost pools will not
increase accuracy. If the existing cost pool is not homogeneous, accuracy will increase only if the increased cost
pools themselves increase in homogeneity vis-a-vis the single cost pool.

5-15  The controller faces a difficult challenge. The benefits of a better accounting system show up in improved
decisions by managers. It is important that the controller have the support of these managers when seeking
increased investments in accounting systems. Statements by these managers showing how their decisions will
be improved by a better accounting system are the controller’s best arguments when seeking increased funding.
For example, the new system will result in more accurate product costs which will influence pricing and product
mix decisions. The new system can also be used to reduce product costs which will lower selling prices. As a
result, the customer will benefit from the new system.

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Solution for Exercises
5-33
1. Cost smoothing or peanut-butter costing is a costing approach that uniformly assigns the cost of resources
to customers when the individual customers use those resources in a non-uniform way. The reunion dinner
averages the costs across all five people. These five people differ sizably in what they consume.
2.
Diner Entree Dessert Drinks Total
Aashish `270 `80 `240 `590
Amit 240 30 0 270
Nitin 210 60 130 400
Ankur 310 60 120 490
Aakash  150  40  60  250
Average 236 54 110 400
The average-cost pricing will result in each person paying `400.
Amount over or (undercosted)
Aashish, `400 – `590 = `(190) Under costed
Amit, `400 – `270 = `130 Over costed
Nitin, `400 – `400 = 0 Accurately costed
Ankur, `400 – `490 = `(90) Under costed
Aakash, `400 – `250 = `150 Over costed
Yes, Aakash’s complaint is justified. He is ‘overcharged’ by `150. He could point out likely negative
behaviors with this approach to costing. These include:
(a) It can lead some people to order the most expensive items because others will ‘subsidize’ their
extravagance.
(b) It can lead to friction when those who dine economically are forced to subsidize those who dine
extravagantly. At the limit, some people may decide not to attend the reunion dinners.
Likely benefits of this approach are:
(a) It is simple, and
(b) It (purportedly) promotes a group atmosphere at the dinner.
3. Each one of the costs in the data is directly traceable to an individual diner. This makes it straightforward to
compute the individual cost per diner. Examples where this is not possible include:
❖❖ A plate of hors d’oeuvres is shared by two or more diners.
❖❖ A loaf of garlic bread is shared by two or more diners.
❖❖ A bottle of mineral water or wine is shared by two or more diners.
Each of these items cannot be directly traced to only one diner.
Some possible behaviors if each person pays for his or her own bill are:
(a) Some people may reduce their ordering of more expensive items because they will not be subsidized
by other diners.
(b) May encourage some potential diners to attend who otherwise would have stayed away.
(c) May encourage a person ‘trying to impress others with his or her success’ to order the most expensive
items.

5-34
1. (a) Product-sustaining costs are costs of activities undertaken to support individual products regardless
of the number of units or batches in which the product is produced. Costs of designing processes,
drawing process charts, and making engineering changes for individual products, `8,00,000, are
product-sustaining costs.
(b) Batch-level costs are costs of activities that are related to a group of units of a product rather than each
individual unit of a product. Purchase order-related costs (including costs of receiving materials and
paying suppliers) of `5,00,000 are batch-level costs.

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(c) Output unit-level costs are costs of activities performed on each individual unit of a product. Direct
materials costs of `60,00,000 are output unit-level costs.
(d) Setup costs of `6,00,000 are batch-level costs.
(e) Direct manufacturing labor costs of `10,00,000 are output unit-level costs.
(f) Machine-related overhead costs (depreciation and maintenance) of `11,00,000 are output unit-level
costs.
(g) Facility-sustaining costs are costs of activities that cannot be traced to individual products or services
but support the organization as a whole. Plant management, plant rent, and insurance costs of
`9,00,000 are facility-sustaining costs.
2. The complex boom box made in many batches will use significantly more batch-level overhead resources
compared to the simple boom box that is made in a few batches. In addition, the complex boom box will
use more product-sustaining overhead resources because it is complex. Because each boom box requires
the same amount of machine-hours, both the simple and the complex boom box will be allocated the same
amount of overhead costs per boom box if Telecom uses only machine-hours to allocate overhead costs
to boom boxes. As a result, the complex boom box will be undercosted (it consumes a relatively high level
of resources but is reported to have a relatively low cost) and the simple boom box will be overcosted
(it consumes a relatively low level of resources but is reported to have a relatively high cost).
3. Using the cost hierarchy to calculate activity-based costs can help Telecom to identify both the costs of
individual activities and the cost of activities demanded by individual products.
Telecom can use this information to manage its business in several ways.
1. Pricing and product mix decisions. Knowing the resources needed to manufacture and sell different types
of boom boxes can help Telecom to price the different boom boxes and also identify which boom boxes are
more profitable. It can then emphasize its more profitable products.
2. Telecom can use information about the costs of different activities to improve processes and reduce costs of
the different activities. Telecom could have a target of reducing costs of activities (setups, order processing,
etc.) by, say, 3% and constantly seek to eliminate activities and costs (such as engineering changes) that
its customers perceive as not adding value.
3. Telecom management can identify and evaluate new designs to improve performance by analyzing how
product and process designs affect activities and costs.
4. Telecom can use its ABC systems and cost hierarchy information to plan and manage activities. What
activities should be performed in the period and at what cost?  3,60,000

5-35
Plantwide indirect-cost rates.
Actual variable MOH
1. Actual plantwidevariable MOH rate =
Actural machine-hours
= `6,17,200/8,000
= `77.15 per machine-hour
2. United Motors Holden Motors Leland Vehicle
Plantwide MOH `77.15 × 240;
`77.15 × 5,600; `77.15 × 2,160 `18,516 `4,32,040 `1,66,644
3. The conditions that would enable machine-hours to provide an accurate estimate of variable manufacturing
overhead cost incurred on each individual contract are:
(a) Machine-hours is the sole cost driver, and there is a linear relation between variable manufacturing
overhead cost and machine-hours.
(b) Machine-hours used per contract can be accurately measured.
(c) Each automobile assembly company under contract is alike in the way they consume variable
manufacturing overhead.

5-36
Department indirect-cost rates as activity rates (continuation of previous question)
1. Variable MOH Costs Total Driver Units Rate
Design-CAD `78,000 780 `100 per design-hour
Engineering 59,200 740 80 per engineer-hour
Production 4,80,000 8,000 60 per machine-hour

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2. Tata Motors Maruti Udyog Hyundai Motors
Design `100 × 220; `100 × 400; `100 × 160 `22,000 `40,000 `16,000
Engineering `80 × 140; `80 × 120; `80 × 480 11,200 9,600 38,400
Production `60 × 240; `60 × 5,600; `60 × 2,160 14,400 3,36,000 1,29,600
Total 47,600 3,85,600 1,84,000
3. Tata Motors Maruti Udyog Hyundai Motors
(a) Department rate `47,600 `3,85,600 `1,84,000
(b) Plantwide rate 18,516 4,32,040 1,66,644
(figures from previous question)
Ratio of (a) ÷ (b) 2.57 0.89 1.10

The three contracts differ sizably in the way they use the resources of the three departments. The
percentage of total driver units in each department used by the contract companies is:
Department Tata Motors Marti Udyog Hyundai Motors
Design 28% 51% 21%
Engineering 19 16 65
Production 3 70 27

The Tata Motors contract uses only 3% of total machines-hours in current year, yet uses 28% of CAD
design-hours and 19% of engineering hours. The result is that the plantwide rate, based on machine-hours,
will greatly underestimate the cost of resources used on the Tata Motors contract. Hence, the 257% increase in
indirect costs assigned to the Tata Motors contract when department rates are used.
In contrast, the Marti Udyog contract uses less of design (51%) and engineering (16%) than of machine-
hours (70%). Hence, the use of department rates will report lower indirect costs for Marti Udyog than does a
plantwide rate.

5-37
1. Direct costs
  Direct materials `1,50,000
Indirect costs
  Product support 9,83,000
Total costs 11,33,000
Cost per pound of potato cuts = `11,33,000/10,00,000 `1.133
2. Cost Pool Costs in Pool Number of Driver Units Costs per Driver Unit
Cleaning `1,20,000 12,00,000 raw kgs `0.10
Cutting 2,31,000 3,850 hours* `60
Packaging 4,44,000 37,000 hours** `12
*(900,000 ÷ 250) + (100,000 ÷ 400) = 3,600 + 250 = 3,850
**(900,000 ÷ 25) + (100,000 ÷ 100) = 36,000 + 1,000 = 37,000
3. Retail Potato Cuts Institutional Potato Cuts
Direct costs
Direct materials `1,35,000 `15,000
Packaging 1,80,000 `3,15,000 8,000 `23,000
Indirect costs
Cleaning
  `0.10 × 90% × `12,00,000 1,08,000 12,000
  `0.10 × 10% × `12,00,000
Cutting
  `60 × 3,600 hours 2,16,000 15,000
  `60 × 250 hours

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Packaging
  `12 × 36,000 4,32,000 7,56,000 12,000 39,000
  `12 × 1,000
Total costs 10,71,000 62,000
Kgs produced 9,00,000 1,00,000
Costs per kg 1.19 0.62
The total costs of `11,33,000 (`10,71,000 + `62,000) are the same as those in Requirement 1.
4. There is much evidence of product-cost cross-subsidization.
Cost per kg Retail Institutional
Current system `1.133 `1.133
ABC system 1.190 0.620

Assuming the ABC numbers are more accurate, potato cuts sold to the retail market are undercosted while
potato cuts sold to the institutional market are overcosted.
The current system assumes each product uses all the activity areas in a homogeneous way. This is
not the case. Institutional sales use sizably less resources in the cutting area and the packaging area. The
percentage of total costs for each cost category are:
Retail Institutional Total
Direct costs
Direct materials 90.0% 10.0% 100.0%
Packaging 95.7 4.3 100.0
Indirect costs
Cleaning 90.0 10.0 100.0
Cutting 93.5 6.5 100.0
Packaging 97.3 2.7 100.0
Units produced 90.0% 10.0% 100.0%

Lays can use the revised cost information for a variety of purposes:
1. Pricing/product emphasis decisions. The sizable drop in the reported cost of potatoes sold in the
institutional market makes it possible that Lays was overpricing potato products in this market. It lost the
bid for a large institutional contract with a bid 30% above the winning bid. With its revised product cost
dropping from `1.133 to `0.620, Lays could have bid much lower and still made a profit. An increased
emphasis on the institutional market appears warranted.
2. Product design decisions. ABC provides a road map as to how to reduce the costs of individual products.
The relative components of costs are:
Particulars Retail Institutional
Direct costs
Direct materials 12.6% 24.20%
Packaging 16.8 12.90
Indirect costs
Cleaning 10.1 19.35
Cutting 20.2 24.20
Packaging 40.3 19.35
Total costs 100.0% 100.00%
  Packaging-related costs constitute 57.1% (16.8% + 40.3%) of total costs of the retail product line. Design
efforts that reduce packaging costs can have a big impact on reducing total unit costs for retail.
3. Process improvements. Each activity area is now highlighted as a separate cost. The three indirect cost
areas comprise over 60% of total costs for each product, indicating the upside from improvements in the
efficiency of processes in these activity areas.

5-38
1. Pricing decisions at Ramesh Associates are heavily influenced by reported cost numbers. Suppose
Ramesh is bidding against another firm for a client with a job similar to that of Coal India. If the costing
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system overstates the costs of these jobs, Ramesh may bid too high and fail to lend the client. If the costing
system understates the costs of these jobs, Ramesh may bid low, lend the client, and then lose money in
handling the case.
2. Coal India Ansahi Glass Total
Direct professional labor, `700 × 104; `700 × 96 `72,800 `67,200 `1,40,000
Indirect cost allocated `1,050 × 104; `1,050 × 96 1,09,200 1,00,800 2,10,000
Total costs to be billed 1,82,000 1,68,000 3,50,000

5-39
1. Indirect costs = `70,000
Total professional labor-hours = 200 hours (104 hours on Coal India + 96 hours on Asahi Glass)
Indirect cost allocated per professional labor-hour = `70,000 ÷ 200 = `350 per hour
2. Coal India Asahi Glass Total
Direct costs:
Direct professional labor, `700 × 104; `700 × 96 `72,800 `67,200 `1,40,000
Research support labor 16,000 34,000 50,000
Computer time 5,000 13,000 18,000
Travel and allowances 6,000 44,000 50,000
Telephones/faxes 2,000 10,000 12,000
Photocopying 2,500 7,500 10,000
Total direct costs 1,04,300 1,75,700 2,80,000
Indirect costs allocated, `350 × 104; `350 × 96 36,400 33,600 70,000
Total costs to be billed 1,40,700 2,09,300 3,50,00
3. Coal India Asahi Glass Total
Previous question `1,82,000 `1,68,000 `3,50,000
This question 1,40,700 2,09,300 3,50,000

This problem approach directly traces to the individual jobs `1,40,000 that is allocated in the previous
problem approach on the basis of direct professional labor-hours. The averaging assumption implicit in the
previous problem approach appears incorrect—for example, the Asahi Glass job has travel costs over seven
times higher than the Coal India case despite having lower direct professional labor-hours.

5-40
1. Particulars Coal India Asahi Glass Total
Direct costs
Partner professional labor, `1,000 × 24; `1,000 × 56 `24,000 `56,000 `80,000
Associate professional labor, `500 × 80; `500 × 40 40,000 20,000 60,000
Research support labor 16,000 34,000 50,000
Computer time 5,000 13,000 18,000
Travel and allowances 6,000 44,000 50,000
Telephones/faxes 2,000 10,000 12,000
Photocopying 2,500 7,500 10,000
Total direct costs 95,500 1,84,500 2,80,000
Indirect costs allocated
Indirect costs for partners, `575 × 24; `575 × 56 13,800 32,200 46,000
Indirect costs for associates, `200 × 80; `200 × 40 16,000 8,000 24,000
Total indirect costs 29,800 40,200 70,000
Total costs to be billed 1,25,300 2,24,700 3,50,000
Comparison Coal India Asahi Glass Total
Single direct cost/Single indirect cost pool `1,82,000 `1,68,000 `3,50,000
Multiple direct costs/Multiple indirect cost pools 1,25,300 2,24,700 3,50,000

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  The higher the percentage of costs directly traced to each case, the more accurate the product cost of
each individual case.
  The Coal India and Asahi Glass cases differ in how they use ‘resource areas’ of Ramesh Associates:
Particulars Coal India Asahi Glass
Partner professional labor 30% 70%
Associate professional labor 66.7 33.3
Research support labor 32 68
Computer time 27.8 72.2
Travel and allowances 12 88
Telephones/faxes 16.7 83.3
Photocopying 25 75

  The Coal India case makes relatively low use of the higher-cost partners but relatively higher use of the
lower-cost associates than does Asahi’s Glass. The Coal India case also makes relatively lower use of
the support labor, computer time, travel, phones/faxes, and photocopying resource areas than does the
Asahi’s Glass case.
2. The specific areas where the multiple direct/multiple indirect (MD/MI) approach can provide better
information for decisions at Ramesh Associates include:
  Pricing and product (case) emphasis decisions. In a bidding situation using single direct/single
indirect (SD/SI) data, Ramesh may win bids for legal cases on which it will subsequently lose money. It may
also not win bids on which it would make money with a lower-priced bid.
  From a strategic viewpoint, SD/SI exposes Ramesh Associates to cherry-picking by competitors. Other
law firms may focus exclusively on Coal India-type cases and take sizable amounts of ‘profitable’ business
from Ramesh Associates. MD/MI reduces the likelihood of Ramesh Associates losing cases on which it
would have made money.
  Client relationships. MD/MI provides a better ‘road map’ for clients to understand how costs are
accumulated at Ramesh Associates. Ramesh can use this road map when meeting with clients to plan
the work to be done on a case before it commences. Clients can negotiate ways to get a lower-cost case
from Ramesh, given the information in MD/MI—for example, (a) use a higher proportion of associate labor
time and a lower proportion of a partner time, and (b) use fax machines more and air travel less. If clients
are informed in advance how costs will be accumulated, there is less likelihood of disputes about bills
submitted to them after the work is done.
  Cost control. The MD/MI approach better highlights the individual cost areas at Ramesh Associates
than does the SD/SI approach:
MD/MI SD/SI
Number of direct cost categories 7 1
Number of indirect cost categories 2 1
Total 9 2
  MD/MI is more likely to promote better cost-control practices than SD/SI (as the nine cost categories in
MD/MI may differ in terms of how to effectively manage costs in each cost category).

5-41
1. Calculation of plantwide overhead rate:
Amounts (in thousands)
Particulars Molding Component Assembly Total
Manufacturing department overhead `42,000 `32,400 `45,200 `1,19,600
Service departments:
  Power 36,800
  Maintenance 8,000
Total budgeted plantwide overhead 1,64,400
Budgeted direct manufacturing labor-hours (DMLH):
  Molding 500
  Component 2,000
  Assembly 1,500
    Total budgeted DMLH 4,000

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Budgeted platwide overhead
Plantwide overhead rate =
Budgeted DMLH
= `1,64,400/4,000 = `41.10 per DMLH
2. (a) The department overhead cost rates are shown
Departments (in thousands)
Particulars Service Manufacturing
Departmental overhead costs Power Maintenance Component Molding Assembly
Allocation of maintenance costs `36,800 `8,000 `42,000 `32,400 `45,200
(direct method)
`8,000 × 90/125, 25/125, 10/125 (8000) 5,760 1,600 640
Allocation of power costs
`36,800 × 360/800, 320/800,
120/800 (36,800) – 16,560 14,720 5,520
Total budgeted overhead of
manufacturing departments 0 0 64,320 48,720 51,360
(b) Allocation Base 875MH 20,000 MLH 1,500 DMLH
Budgeted Rate (Budgeted
overhead ÷ Allocation base) 73.50/MH 24.36/DMLH 34.24/DMLH

3. Samsonite Ltd. should use department rates to allocate plant overhead because: (1) the cost drivers of
resources used in each department differ and (2) the departments do not use resources from the support
departments in the same proportion. Hence, department rates better capture cause-and-effect relationships
at Samsonite than does a plantwide rate.
4. Samsonite should further subdivide the department cost pools into activity-cost pools if (a) significant
costs are incurred on different activities within the department, (b) the different activities have different cost
drivers, and (c) different products use different activities in different proportions.

5-42
1. Budgeted MOH rate in year 3 = `42,16,000/2,00,000 units = `21.08 per kg unit of cake
Raisin Cake Layered Carrot Cake
Direct manufacturing cost per unit
Direct materials `120 `180
Direct manufacturing labor 28 `148 40 `220
Indirect manufacturing cost per unit
Manufacturing overhead (`21.08 × 1; `21.08 × 1) 21.08 21.08 21.08 21.08
Total manufacturing cost per unit 169.08 241.08
2. ABC costs for 120,000 one-pound units of raisin cake and 80,000 one-kg units of layered carrot
cake in year 3:
Raisin Cake Layered Carrot Cake
Total Costs Per Unit Cost Total Costs Per Unit Cost
(1) (2) = (1) ÷ 120,000 (3) (4) = (3) ÷ 80,000
Direct costs
Direct materials `1,44,00,000 `120 `1,44,00,000 `180
Direct manufacturing labor 33,60,000 28 32,00,000 40
   Total direct costs 1,77,60,000 148 1,76,00,000 220
Indirect costs Mixing
 Mixing
  `0.80 × 6,00,000 4,80,000 4.00
  `0.80 × 6,40,000 5,12,000 6.40
  Cooking
  2.8 × 2,40,000 6,72,000 5.60
  2.8 × 2,40,000 6,72,000 8.40

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 Cooling
  0.4 × 3,60,000 1,44,000 1.20
  0.4 × 4,00,000 1,60,000 2.00
  Creaming/Icing
  5.0 × 0 0 0
  5.0 × 2,40,000 12,00,000 15.00
  Packaging
  1.6 × 3,60,000 5,76,000 4.80
  1.6 × 5,60,000 8,96,000 11.20
   Total indirect costs 18,72,000 15.60 34,40,000 43.00
Total costs 1,96,32,000 163.60 2,10,40,000 263

  Note that the significant shift in product mix will cause absorbed costs (based on budgeted rates and
actual quantities of the cost-allocation base) to be different from the budgeted manufacturing overhead
costs.
3. The unit product costs in requirements 1 and 2 differ only in the assignment of indirect costs to individual
products.
  The ABC system recognizes that indirect resources used per kg of layered carrot cake is 2.76
(`43 ÷ `15.60) times the indirect resources used per kg of raisin cake. The existing costing system
erroneously assumes equal usage of activity areas by a kg of raisin cake and a kg of layered carrot cake.
4. Uses of activity-based cost numbers include:
(a) Pricing decisions. EB can use the ABC data to decide preliminary prices for negotiating with its customers.
Raisin cake is currently overcosted, while layered carrot cake is undercosted. Actual production of
layered carrot cake is 100% more than budgeted. One explanation could be the underpricing of the
layered carrot cake.
(b) Product emphasis. EB has more accurate information about the profitability of the products with ABC.
EB can use this information for deciding which products to push (especially if there are production
constraints).
(c) Product design. ABC provides a road map on how a change in product design can reduce costs. The
percentage breakdown of total indirect costs for each product is:
Raisin Cake Layered Carrot Cake
 Mixing 25.6% (`4.00/`15.60) 14.9% (`6.40/`43)
 Cooking 35.9 19.5
 Cooling 7.7 4.7
 Creaming/Icing 0.0 34.9
 Packaging 30.8 26.0
100.0% 100.0%
  EB can reduce the cost of either cake by reducing its usage of each activity area. For example, EB
can reduce raisin cake’s cost by sizably reducing its cooking time or packaging time. Similarly, a sizable
reduction in creaming/icing will have a marked reduction in the costs of the layered carrot cake. Of
course, EB must seek efficiency improvements without compromising quality.
(d) Process improvements. Improvements in how activity areas are configured will cause a reduction in the
costs of products that use those activity areas.
(e) Cost planning and flexible budgeting. ABC provides a more refined model to forecast costs of EB and
to explain why actual costs differ from budgeted costs.

5-43
Medical supplies costs
  1. (a) Medical supplies rate =
Total number of patient-year
= `6,00,000/150 = `4,000/patient-year
Rent and clinic maint. costs
Rent and clinic maintenance rate =
Total amount of square feet of space
= `3,60,000/30,000 = `12 per square foot

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Admin. cost rate for patient-charts food and laundry
Administrative costs to manage partient charts, food, laund
dry
=
Total number of patient-year

= `12,00,000/150 = `8,000/patient-year
Laboratory services costs
Laboratory services rate =
Total number of laboratory tests

= `2,00,000/2,500 = `80 per test
  These cost drivers are chosen as the ones that best match the descriptions of why the costs arise.
Other answers are acceptable, provided clear explanations are given.
(b) Activity-based costs for each program and cost per patient-year of the alcohol and drug program

follow:
Alcohol Drug After-care
Direct labor
  Physicians at `6,00,000 × 0; 4; 0 `24,00,000
  Psychologists at `3,00,000 × 6; 4; 8 `18,00,000 12,00,000 `24,00,000
  Nurses at `1,20,000 × 4; 6; 10 4,80,000 7,20,000 12,00,000
   Direct labor costs 22,80,000 43,20,000 36,00,000
Medical supplies1 `4,000 × 40; 50; 60 1,60,000 2,00,000 2,40,000
Rent and clinic maintenance2 `12 × 9,000;
9,000; 12,000 1,08,000 1,08,000 1,44,000
Administrative costs to manage patient charts,
food, and laundry3 `8,000 × 40; 50; 60 3,20,000 4,00,000 4,80,000
Laboratory services4 `80 × 400; 1,400; 700 32,000 1,12,000 56,000
Total costs 29,00,000 51,40,000 45,20,000
Cost per patient-year = `29,00,000/40 = `72,500 (Alcohol) = 51,40,000/50 = `1,02,800 (Drug)
1
Allocated using patient-years
2
Allocated using square feet of space
3
Allocated using patient-years
4
Allocated using number of laboratory tests
(c) The ABC system more accurately allocates costs because it identifies better cost drivers. The ABC
system chooses cost drivers for overhead costs that have a cause-and-effect relationship between the
cost drivers and the costs. Of course, Amitabh should continue to evaluate if better cost drivers can be
found than the ones they have identified so far.
  By implementing the ABC system, Amitabh can gain a more detailed understanding of costs and
cost drivers. This is valuable information from a cost management perspective. The system can yield
insight into the efficiencies with which various activities are performed. Amitabh can then examine
if redundant activities can be eliminated. Amitabh can study trends and work toward improving the
efficiency of the activities.
  In addition, the ABC system will help Amitabh determine which programs are the most costly to
operate. This will be useful in making long-run decisions as to which programs to offer or emphasize.
The ABC system will also assist Amitabh in setting prices for the programs that more accurately reflect
the costs of each program.
2. The concern with using costs per patient-year as the rule to allocate resources among its programs is that
it emphasizes ‘input’ to the exclusion of ‘outputs’ or effectiveness of the programs. After-all, Amitabh’s goal
is to cure patients while controlling costs, not minimize costs per-patient year. The problem, of course, is
measuring outputs.
Unlike many manufacturing companies, where the outputs are obvious because they are tangible and
measurable, the outputs of service organizations are more difficult to measure. Examples are ‘cured’ patients
as distinguished from ‘processed’ or ‘discharged’ patients, ‘educated’ as distinguished from ‘partially educated’
students, and so on.

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5-44
1. (a) Budgeted manufacturing overhead rate
Budgeted manufacturing overhead
=
Budgeted direct labor cost
= `30,00,000/`6,00,000 = `5 for each rupee of direct labor
(b)

Particulars Indian Malaysian
Direct costs
Direct materials `42 `32
Direct labor 3 3
Indirect costs 45 35
Manufacturing overhead (3 × 5) 15 15
Total costs 60 50
Budgeted selling prices per pound:
  Indian (`60 × 1.30)   = `78
  Malaysian (`50 × 1.30) = 65
2. The total budgeted unit costs per kg are:
Indian Coffee Malaysian Coffee
Direct costs per unit Direct costs per unit
Direct materials `42 Direct materials `32
Direct labor 3 `45 Direct labor 3 `35
Indirect costs per unit Indirect costs per unit
Purchase orders 0.20 Purchase orders 10
(4 orders × `5,000/1,00,000 kgs) (4 orders × `5,000/2,000 kgs)
Material handling 1.2 Material handling 24
(30 setups × `4,000/1,00,000 kgs) (12 setups × `4,000/2,000 kgs)
Quality control 0.20 Quality control 4.8
(10 batches × `2,400/1,00,000 kgs) (4 batches × `2,400/2,000 kgs)
Roasting 1 Roasting 1
(1,000 hours × `100/1,00,000 kgs) (20 hours × `100/2,000 kgs)
Blending 0.50 Blending 0.50
(500 hours × `100/1,00,000 kgs) (10 hours × `100/2,000 kgs)
Packaging 0.10 Packaging 0.10
(100 hours × `100/1,00,000 kgs) (2 hours × `100/2,000 kgs)
Total cost per unit 48.20 Total cost per unit 75.40
  The comparative cost numbers are
Indian Malaysian
Requirement 1 `60 `50
Requirement 2 48.20 75.40
  The ABC system in requirement 2 reports a decreased cost for the high-volume Mauna Loa and an
increased cost for the low-volume Malaysian.
3. The traditional costing approach leads to cross-subsidization between the two products.
  With the traditional approach, the high-volume Indian is overcosted, while the low-volume Malaysian is
undercosted. The ABC system indicates that Indian is profitable and should be emphasized.
  Pricing of Indian can be reduced to make it more competitive. In contrast, Malaysian should be priced
at a much higher level if the strategy is to cover the current period’s cost. Barista Coffee may wish to have
lower margins with its low-volume products in an attempt to build up volume.

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