CHAPTER 10

ACTIVITY-BASED COSTING AND MANAGEMENT

TRUE/FALSE
1. Profit margin equals a products gross margin less the cost of capacity resources
needed to support its production.
LO1 False
Profit margin equals a products contribution margin less the
cost of capacity resources needed to support its production.
2. Profit margin is the appropriate measure for evaluating long-term profitability.
LO1 True
3. When allocating capacity costs to products, controllable and non-controllable
cost pools need to be allocated to cost objects.
LO1 False
Controllable costs need to be allocated,
4. Activity-based costing (ABC) is an approach to determining product costs.
LO1 True
5. For a bank, maintaining the ATM computer network would be a product-level
activity.
LO1 True
6. Because ABC is an allocation, it involves the two steps involved in any allocation
compute the allocation rate and multiply the rate by the number of cost driver
units in a cost object.
LO2 True
7. To obtain the activity rate for each cost pool, divide the total cost in each pool by
the unallocated cost.
LO2 False
To obtain the activity rate for each cost pool, divide the total
cost in each pool by the practical capacity of its associated driver.
8. Changing the allocation method never affects the reported profit margins for
each product line.
LO2 False
Changing the allocation method may affect the reported profit
margins for each of the product lines.
9. Implementing a full-fledged activity-based costing system is often a costly, timeconsuming, and tedious exercise.
LO2 True
10.A survey by the Institute of Management Accountants found that only 8% of
responding firms in the U.S. use activity-based costing.
LO2 False
A survey by the Institute of Management Accountants shows
that only 54% of responding firms in the U.S. use activity-based costing.

10-1

11.ABC provides useful information for product planning by providing accurate

estimates of profit margins.
LO3 True

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Activity-Based Costing and Management

12.An ABC system may be used to measure the profitability or profit potential of a
market segment, but not an individual customer.
LO3 False
An ABC system may be used to measure the profitability or
profit potential of an individual customer or a market segment.
13.A curve that plots customer profitability, after ranking customers in order of their
profitability is know as a whale curve.
LO3 True.
14.Activity-based costing helps resource planning by isolating the cost of excess
demand from particular customers.
LO3 False
Activity-based costing helps resource planning by isolating the
cost of excess capacity from the productive use of capacity, so that firms can
find profitable ways of dealing with excess capacity.
15.Non-value adding activities cost money but do not provide commensurate
benefits.
LO3 True
16.How a firm should deal with the cost of unused capacity depends on the reason
for the idle capacity.
Appendix True
17.If a firm has unused capacity with no gainful purpose whatsoever, it should avoid
the cost by ridding itself of the excess capacity.
Appendix True
18.Allocation rates based on actual capacity decrease when a firm has unused
capacity due to low demand because fixed costs do not change proportionally
with activity level.
Appendix False
Allocation rates based on actual capacity increase when a
firm has unused capacity due to low demand because fixed costs do not change
proportionally with activity level.
19.The use of practical capacity for computing allocation rates is an acceptable
method for GAAP.
Appendix False
At present, GAAP does not recognize the use of practical
capacity for computing allocation rates.
20.Under GAAP, the cost of unused capacity would appear as under-applied
overhead.
Appendix True

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Balakrishnan/Managerial Accounting, 2e
MULTIPLE CHOICE
21.Which of the following is not a step in designing a product costing system?
A. Determine how to form cost pools.
B. Identify which cost pools to allocate.
C. Identify the cost driver to use for allocating each cost pool.
D. Determine the appropriate denominator volume of each cost driver to
calculate allocation rates.
E. All of the above are steps in designing a product costing system.
LO1 E
22.The costs associated with a companys security department would be considered
what type of activity?
A. Unit level
B. Batch level
C. Customer level
D. Facility level
LO1-Self test-D
23.Which of the following would be considered a product-level activity?
A.
The accounting departments development of a new payroll system
B.
Human resource managements development of new company policies
C.
Design work necessary to create a new product
D.
Adjusting a piece of machinery to run a new batch
LO1-Self test-C
24.Paulson Company has two products: Y and Z. The company uses activity-based
costing. Estimated costs for the activity cost polls are as follows:
Cost Pool
Estimated
Expected Activity
Cost
Y
Z
Activity 1
$12,000
100
150
Activity 2
$24,800
200
125
Activity 3
$42,000
300
125
The estimated cost for activity 3 per unit is closest to:
A. $98.82
B. $185.41
C. $78.80
D. $166.74
LO1-Self test-A

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Activity-Based Costing and Management

25.Paulson Company has two products: Y and Z. The company uses activity-based
costing. Estimated costs for the activity cost polls are as follows:
Cost Pool
Estimated
Expected Activity
Cost
Y
Z
Activity 1
$12,000
100
150
Activity 2
$24,800
200
125
Activity 3
$42,000
300
125
The estimated cost for activity 1 per unit is closest to:
A.
$120.00
B.
$48.00
C.
$315.20
D.
$80.00
LO1-Self test-B
26.Which of the following would be an inappropriate cost driver in an activitybased costing system?
A.
Number of customer orders
B.
Number of units produced
C.
Machine hours
D.
Any of these are acceptable as long as they are reasonable given the
specific cost pool
LO1-self test-D
27.Vector Company manufactures a number of different products. In its traditional
costing system, overhead costs are allocated based on a predetermined rate.
The company recently switched to an activity-based costing system using
different cost drivers for each of their two activities. Information is as follows:
Estimated
Predetermined
Activity
Overhead Rate
Labor hours
100,000
$12 per labor hour
Number of designs 6,000
$32 per design
Job #16 required 22 labor hours and 3 designs. By how much would this job
have been over or undercosted under the traditional costing system?
A.
Undercosted by $96
B.
Undercosted by $71.09
C.
Overcosted by $96
D.
Undercosted by $53.76
LO1-Self test-D

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Balakrishnan/Managerial Accounting, 2e
28.Research Associates Corporation uses activity-based costing. They have two
activity cost pools and three office locations. Administrative costs are allocated
based on the percent of time used by the various locations. Research costs are
allocated based on computer time used. Information is as follows:
Cost Pool
Estimated Overhead Costs
Administrative
$160,000
Research
$210,000
Estimated department data is as follows:
Administrative
Computer
Percent
Time
Dayton
15%
62,000 minutes
Pikesville
45%
40,000 minutes
Parkersburg
40%
18,000 minutes
The administrative and research costs that the Pikesville office should expect to
receive total:
A. $142,000
B. $132,500
C. $166,500
D. $95,500
LO1-Self test-A
29.Research Associates Corporation uses activity-based costing. They have two
activity cost pools and three office locations. Administrative costs are allocated
based on the percent of time used by the various locations. Research costs are
allocated based on computer time used. Information is as follows:
Cost Pool
Estimated Overhead Costs
Administrative
$160,000
Research
$210,000
Estimated department data is as follows:
Administrative
Computer
Percent
Time
Dayton
15%
62,000 minutes
Pikesville
45%
40,000 minutes
Parkersburg
40%
18,000 minutes
The administrative and research costs that the Dayton office should expect to
receive total:
A. $166,500
B. $132,500
C. $55,500
D. $114,167
LO1-Self test-B

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Activity-Based Costing and Management

30.Pizzeria Gallery specializes in pizza making and delivery. The company uses
activity-based costing for all overhead costs using the following data:
Overhead costs:
Wages
$48,000
Administrative
$62,000
Total
$110,000
Resources are consumed as follows:
Pizza Making
Wages & Salaries
65%
Administrative 20%

Activity Cost Pools

Delivery
Other
20%
15%
30%
50%

Activity for the year is:

Activity Cost Pool
Activity
Pizza Making
19,000 orders
Delivery
17,000 deliveries
The total overhead cost per pizza made according to the activity-based costing
system would be closest to:
A. $5.79
B. $1.64
C. $4.63
D. $2.29
LO1-Self test-D
31.Pizzeria Gallery specializes in pizza making and delivery. The company uses
activity-based costing for all overhead costs using the following data:
Overhead costs:
Wages
$48,000
Administrative
$62,000
Total
$110,000
Resources are consumed as follows:
Pizza Making
Wages & Salaries
65%
Administrative 20%

Activity Cost Pools

Delivery
Other
20%
15%
30%
50%

Activity for the year is:

Activity Cost Pool
Activity
Pizza Making
19,000 orders
Delivery
17,000 deliveries

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Balakrishnan/Managerial Accounting, 2e
The total overhead cost per delivery according to the activity-based costing
system would be closest to?
A.
$6.47
B.
$.56
C.
$1.66
D.
$3.24
LO1-self test-C
32.One member of the maintenance crew who earns a salary of $22,000 per year
tells you that he spends 70% of his time in the plant, 20% in the administrative
offices, and his remaining 10% he cant specify. Another member of the crew
who earns a salary of $19,000 per year tells you that she spends 20% of her
time in the plant, 60% in the administrative offices and her remaining 20% cant
be specified. How much of these workers salary expense will be charged to the
administrative cost pool?
A.
$15,800
B.
$32,800
C.
$17,000
D.
$21,800
LO1-self test-A
33.Which of the following would probably be the most accurate cost driver to use
for allocating the costs associated with a companys engineering department?
A.
Number of customers
B.
Number of designs developed
C.
Machine hours
D.
Direct labor dollars
LO1-Self test-B
34.Fargo Corporation uses an activity-based costing system with three activity cost
pools. The company has provided the following data concerning its costs:
Wages and salaries....
$260,000
Depreciation...............
120,000
Utilities.......................
80,000
Total...........................
$460,000
The distribution of resource consumption across the three activity cost pools is
given below:

Wages and salaries

Depreciation
Utilities

Assembly
35%
40%
30%

10-8

Activity Cost Pools

Fabrication
Other
45%
20%
25%
35%
40%
30%

Activity-Based Costing and Management

If the company chooses machine hours as its cost driver for the fabrication cost
pool, and there were 22,000 machine hours in the year, the cost per machine
hour for fabrication is closest to?
A. $7.41
B. $7.32
C. $8.14
D. $7.53
LO1-Self test-C
35.Rosenbrook Corporation has provided the following data from its activity-based
costing system:
Activity Cost Pool
Total Cost
Assembly................. $477,900
Packaging................ $35,400
Shipping.................. $45,778

Total Activity
29,500 machine-hours
1,200 orders
748 shipments

Data concerning one of the companys products appear below:

Selling price per unit.......................
Direct materials cost per unit.........
Direct labor cost per unit................
Annual unit production and sales. . .
Annual machine-hours....................
Annual orders.................................
Annual shipments...........................

$189.50
$41.59
$38.21
280
405
62
7

According to the activity-based costing system, the annual product margin for
this product is:
A. $21,898
B. $30,716
C. $30,609
D. $24,155
LO1 A
36.Which of the steps in designing a product costing system is not common to all
cost allocations?
A. Determine how to form cost pools.
B. Identify which cost pools to allocate.
C. Identify the cost driver to use for allocating each cost pool.
D. Determine the appropriate denominator volume of each cost driver to
calculate allocation rates.
LO1-Pretest-B
37. Which of the following cost would most likely be selected as a cost driver to
allocate a cost pool of purchasing department costs?
A. Number of employees in the company
B. Total costs incurred in the purchasing department
C. Total labor costs in the purchasing department
D. Number of purchase orders issued by the purchasing department

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Balakrishnan/Managerial Accounting, 2e
LO1-Pretest-D
38.Which of the following lists best describes activities which would likely be
considered to be facility-level cost for a McDonalds restaurant?
A. Ordering inventory before the products are depleted
B. Activities related to cooking a basket of fries
C. Activities pertaining to filling an order for a customer
D. Activities pertaining to television advertising of a new product
LO1-Pretest-A
39.A product manager is calculating the customer order cost for the candy bar
product line. He has the following information:
Customer order cost pool: $50,000
Total volume of all orders: 4,000 customer orders
Number of customer orders for candy bars: 150
What is the allocated cost to the candy bar product line?
A. $333.33
B. $1,875
C. $12.00
D. $26.66
LO1-Pretest-B
40.The CFO of Ward Enterprises is setting up a new activity-based costing system.
He has currently finished identifying the cost pools and has determined which
cost pools should be allocated. What is the next step for him to take in the
process?
A.
B.
C.
D.

Add the cost pools together.

Identify the cost driver for allocating each cost pool
Divide each cost pool by the number of units produced.
Determine the appropriate denominator volume of each cost driver to
calculate allocation rates.
LO1-Post test-B
41.What is an activity-based costing system?
A. An approach to determining product costs
B. An approach that eliminates all non-value-adding costs
C. An approach that allocates all costs that can be directly traced to products or
services
D. An approach that improves the efficiency of organizational processes
LO1-Post test-A
42.Which of the following lists best describes activities considered to be productlevel activities for Coca-Cola?
A. Activities performed by grounds maintenance people
B. Inspecting each liter of Coca-Cola
C. Setup and inspection of bottling machines
D. Activities performed for production support of Diet Coke
LO1-Post test-D

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Activity-Based Costing and Management

43.What information is needed to determine the customer order cost to be allocated
to a product line?
A. Rate per customer order and number of customer orders
B. Costs in customer order pool and number of customer orders
C. Costs in customer order pool and number of customers
D. Number of customer orders and a cost driver
LO1-Post test-A
44.The Technology department at Watkins Transit has a budgeted annual cost of
$65,000. The department has a capacity to handle 250 work stations per year.
Currently, purchasing, shipping, and administrative departments have 20, 45,
and 135 work stations, respectively. If actual capacity is used to allocate costs,
how much cost is allocated to shipping?
A. $14,625
B. $11,700
C. $6,500
D. $17,550
LO1-Post test-A
45.Which of the following is not one of the defining elements that are common to
all cost allocations?
A. Contribution margin.
B. Cost pools.
C. Cost drivers.
D. Denominator volume.
E. All of the above are defining elements that are common to all cost
allocations.
LO1 A
46.Which of the following is not a major decision when allocating capacity costs to
products?
A. How to form cost pools?
B. Which costs (pools) to allocate?
C. What drivers to use?
D. How to measure denominator volume?
E. All of the above are major decisions when allocating capacity costs to
products.
LO1 E
47.Which of the following is an example of a product- or customer-level activity
A. Activities performed by security personnel.
B. Setting up a machine for production.
C. First-part inspections.
D. The work of a product engineer.
E. Work of production employees.
LO1 D

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Balakrishnan/Managerial Accounting, 2e
48.An
A.
B.
C.

advantage of using a practical capacity-based allocation rate is:

It does not change across products.
It spreads all capacity costs over budgeted, rather than actual, volume.
When there is idle capacity, capacity costs are spread over a smaller
production volume.
D. It does not change across periods.
E. All of the above are advantages of using a practical capacity-based allocation
rate.
LO1 D
49.Which of the following are steps involved in ABC allocations?
A. Compute the allocations rate.
B. Multiply the rate by the number of cost driver units in a cost object.
C. Compute contribution margin.
D. A and B only.
E. A, B, and C.
LO2 D
50.The greatest advantage associated with activity-based costing is that:
A. It is easy to design and implement
B. It allocates all overhead costs based on the same cost driver
C. It allows for multiple cost pools and multiple cost drivers
D. It allows for multiple cost pools but only a single cost driver
LO2-Self test-C
51.When implementing activity-based costing, by how much will profit before taxes
differ compared to other cost allocation systems?
A. The difference depends on which other system is used.
B. ABC systems will report higher profit than other systems.
C. ABC systems will report lower profit than other systems.
D. No difference will occur in the amount of profit between ABC and other
systems.
LO2-Pretest-D
52.When customers are ranked by decreasing order of profitability on the X-axis of a
graph and the percentage of total profit on the Y-axis, what is the typical
corresponding curve shape?
A. Whale, increasing and then decreasing
B. Exponential, then decreasing
C. A tangent to the x-axis increasing
D. Linear and increasing
LO2-Pretest-A

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Activity-Based Costing and Management

53.The CFO for Tangent Shipping would like to improve its efficiency of processing
customer orders. Which of the following is not part of the 3 steps for improving
efficiency?
A. Develop a process map for each activity/process chosen.
B. Identify value and non-value-adding activities.
C. Eliminate all non-value-adding activities.
D. Seek ways to improve value-adding activities.
LO2-Pretest-C
54.Atlantic Bank examined the profitability of individual customers and market
segments, and took appropriate actions to improve profitability. What did Atlantic
Bank perform?
A. Product planning
B. Resource planning
C. Customer planning
D. Market planning
LO2-Post test-C
55.The CFO for Tangent Transit would like to improve its efficiency of customer
inquiries on orders. He created an online customer inquiry utility that allows
customers to access and track their orders. Under which of the efficiency
improvement steps will this fall?
A. Develop a process map for each activity/process chosen.
B. Identify value and non-value-adding activities.
C. Create ways to eliminate all non-value-adding activities.
D. Seek ways to improve value-adding-activities
LO2-Post test-D
56.Perry Manufacturing Company produces two products: Standard and Deluxe.
Perry uses the activity-based costing method. The estimated cost and activity
for these products are as follows:
Estimated
Expected Activity
Cost
Standa Deluxe Tota
rd
l
Activity
$25,000
200
300
500
1
Activity
$32,000
400
200
600
2
Activity
$20,000
300
400
700
3
Total
$77,000
900
900
1,80
0
What is the activity rate for activity 2?
A. $42.78
B. $17.78
C. $80.00
D. $160.00
E. $53.33
LO2 E

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Balakrishnan/Managerial Accounting, 2e

57.Which of the following is not a disadvantage of a full-fledged activity-based

costing system?
A. Implementing a full-fledged ABC system is often very costly.
B. Implementing a full-fledged ABC system is time consuming.
C. The assignment of controllable costs of capacity resources is not as reliable
using ABC as with traditional systems.
D. None of the above is a disadvantage of ABC.
E. All of the above are disadvantages of ABC.
LO2 C
58.Tabby Totes, a manufacturer of travel carriers for felines, uses an ABC system.
Tabby produces two carriers, Comfort Carrier and Luxury Carrier. Production and
sales for Comfort Carrier is 800 units and Luxury Carrier is 600 units. Tabby uses
thee activity cost pools. Estimated costs and expected activities is as follows:
Activity
Estimat
Cost Pool
ed Cost
Expected Activity
Comf Luxur
ort
y
Carrie Carrie Tot
r
r
al
Activity 1
$12,000
200
100
300
Activity 2
$18,000
400
200
600
Activity 3
$10,000
400
400
800
The cost per unit of the Comfort Carrier is:
a. $40.00
b. $23.53
c. $42.00
d. $31.25
e. $28.57
LO2 D
59.Kemper Consulting Company is headquartered in Little Rock with offices in
Memphis and Tulsa. All administrative duties are centralized in the Little Rock
office. Canterburys administrative costs are assigned to two activity cost pools,
Accounting and Computer, with the costs allocated to the three offices.
Estimated data for year are as follows:
Activity Cost
Pool
Accounting
Computer

Little Rock
Memphis
Tulsa

Activity Measure
Time spent for
office (%)
Time used by office
(hrs)

Time spent
(%)
35%
40%
25%

10-14

Time used
(hrs)
624
1,560
936

Estimated
Costs
$70,000
$25,000

Activity-Based Costing and Management

How much of the administrative costs will be allocated to the Memphis office?
a. $40,500
b. $47,500
c. $38,000
d. $95,000
e. $70,000
LO2 A
60.Managers use Information from ABC systems to improve profitability by
managing:
a. Products.
b. Resources.
c. Customers.
d. A and B only.
e. A, B and C.
LO3 E
61.As to customer-level profit analysis, batch-level costs relate to:
a. Customers order volume.
b. Tailoring a product to customers desires.
c. Customers frequency of ordering or order size.
d. Warehousing of customers desires.
e. All of the above are batch-level costs.
LO3 C
62.Which of the following is not a characteristic of low-profit customers?
a. Small order size.
b. Demand immediate deliveries.
c. Predictable ordering patterns.
d. Frequent sales force contact.
e. All of the above are characteristics of low-profit customers.
LO3 C
63.Which of the following is not a way in which activity-based costing helps
resource planning?
a. It pinpoints activities and business processes that are costly.
b. It isolates the cost of excess capacity from the productive use of capacity.
c. It allows firms to target specific areas for improving efficiencies.
d. It provides information that helps firms find profitable ways to deal with
excess capacity.
e. All of the above are ways activity-based costing helps resource planning.
LO3 E
64.Which of the following is the correct sequence of steps to improve efficiency
once a process is selected?
a. Identify value- and non-value adding activities; Develop a process map for
each activity/process chosen; Seek ways to improve value-adding activities.
b. Develop a process map for each activity/process chosen; Identify value- and
non-value adding activities; Seek ways to improve value-adding activities.

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Balakrishnan/Managerial Accounting, 2e
c. Identify value- and non-value adding activities; Seek ways to improve valueadding activities; Develop a process map for each activity/process.
d. Seek ways to improve value-adding activities; Identify value- and non-value
adding activities; Develop a process map for each activity/process chosen.
e. Develop a process map for each activity/process chosen; Seek ways to
improve value-adding activities; Identify value- and non-value adding
activities.
LO3 B
65.Which of the following is not a correct way to deal with excess capacity?
a. If the unused capacity is attributed to a temporary lull in demand, the firm
should rid itself of the excess capacity.
b. If the unused capacity has no gainful purpose, the firm should rid itself of the
excess capacity.
c. If the unused capacity results from a temporary lull in demand, the cost of
having to carry excess capacity during lean months is attributed to
production in peak months.
d. If the excess capacity serves a strategic role, the cost of unused capacity is
attributed to management strategy.
e. All of the above are correct ways to deal with excess capacity.
Appendix A
66.By isolating the cost of unused capacity, ABC helps management :
a. Investigate the underlying reason for the unused capacity.
b. Charge the cost of the unused capacity to its cause.
c. Find ways to dispose of the unused capacity.
d. Both A and B.
e. A, B, and C.
Appendix D
67.If a firm responds to higher reported costs by raising prices:
a. It will reduce fixed costs accordingly.
b. It risks setting off a dangerous trend by lowering demand.
c. It will lower allocation rates in response to the report.
d. Both A and B.
e. A, B, and C.
Appendix B
68.Under GAAP, the cost of unused capacity:
a. Is moved to the Balance Sheet as a prepaid asset.
b. Is moved to the Balance Sheet as unearned revenue.
c. Would appear as under-applied overhead.
d. Would appear as over-applied overhead.
e. None of the above.
Appendix C

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Activity-Based Costing and Management

Problems
1. It is important to understand the elements of an activity-based costing (ABC)
system.
Required:
Enter the identifying letters in the blanks below to indicate the term that best
matches each description.
A
B
C
D
E

Activity
Activity-based costing
Activity-based
management
Batch-level activities
Business process

F
G
H

Facility-level activities
Practical capacity
Product-/customer-level activities

I
J

Product planning
Profit margin

a.____
_
b.____
_

Activities that are required to sustain the business.

c.____
_
d.____
_
e.____
_
f._____

Converts a set of organizational inputs into a measurable output.

g.____
_
h.____
_
i._____

Activities that pertain to a group of units.

J_____

Contribution margin less the controllable cost of capacity resources.

Using information from ABC systems to improve profitability by

managing products, customers, and resources.

The set of decisions about which products to offer and their prices.
The basic element of any business process.
A realistic estimate of the maximum possible activity level.

Activities that relate to a specific product or a specific customer.

An allocation methodology used to estimate the controllable cost of
capacity resources.

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Balakrishnan/Managerial Accounting, 2e
2. Modern Accessories has two products: Economy and Super. Production and
sales for the current year is 8,000 Economy and 2,000 Super. There are three
activity cost pools with the following estimated total cost and expected activity:
Estimated
Cost
Activity 1
Activity 2
Activity 3

$36,000
$12,000
$16,000

Expected Activity
Econom
Super
Total
y
2,000
1,000
3,000
750
250
1,000
400
100
500

Required:
a. What is the activity rate under the ABC system for Activity 1?
b. What is the cost per unit of Super under ABC costing (round to the nearest
dollar)?

3. The following table lists characteristics of low- and high-profit customers.

Required:
Indicate by placing an X in the appropriate column whether each of the
following items describes a low-profit customer or high-profit customer.
LowProfit

High-Profit

Characteristic

a. _____

_____

Rigid requirements.

b._____

_____

Frequent sales force contact.

c._____

_____

Predictable ordering patterns.

d._____

_____

Planned deliveries.

e_____

_____

Less pre-sales support.

F_____

_____

Demand delivery at site.

g._____

_____

Has well organized purchase procedures.

h_____

_____

Require more customization.

I_____

_____

Minimal order change requests.

J____

_____

Small order sizes.

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Activity-Based Costing and Management

Solutions to Problems
1. Terms (LO1)
a. F

Activities that are required to sustain the business.

b. C

Using information from ABC systems to improve profitability by

managing products, customers, and resources.

c. E
d. I

Converts a set of organization inputs into a measurable output.

The set of decisions about which products to offer and their prices.

e. A

The basic element of any business process.

f. G

A realistic estimate of the maximum possible activity level.

g. D

Activities that pertain to a group of units.

h. H

Activities that relate to a specific product or a specific customer.

i. B

An allocation methodology used to estimate the controllable cost of

capacity resources.

J. J

Contribution margin less the controllable cost of capacity resources.

2. Activity rate and cost per unit (LO2)

a. Activity rate = $12.
$36,000 3,000 = $12
b. Cost per unit of Super = $13.48.
Activity
1
Activity
2
Activity
3
Total

($36,000 3,000) x
1,000
($12,000 1,000) x
250
($16,000 500) x 100

Cost per unit = $9.10 ($18,200 2,000)

10-19

$12,00
0
$3,000
$
3,200
$18,20
0

Balakrishnan/Managerial Accounting, 2e
3. Activity-based management (LO3)
LowProfit

High-Profit

Characteristic

a.

Rigid requirements.

b.

Frequent sales force contact.

c.

Predictable ordering patterns.

d.

Planned deliveries.

e.

Less pre-sales support.

f.

g.
h.

X
X

I
J.

Demand delivery at site

Require more customization.

X

Has well organized purchase procedures

Minimal order change requests.

Small order sizes.

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Activity-Based Costing and Management

End of Chapter Content
Short Answer
1. What is the definition of unit profit margin?
2. What are the four key steps in designing a product costing system?
3. What is a business process? How are activities and business processes related?
4. What is the basis that ABC systems use to form cost pools?
5. What is the primary criterion that we should use when choosing a driver to
allocate costs from an activity pool to products?
6. What is practical capacity? How does it differ from budgeted capacity? How does
it differ from actual capacity?
7. Why does allocating costs using an ABC system not change the total reported
income for the organization as a whole?
8. What is cross-subsidization?
9. List three ways in which a company can improve profitability using ABC data.
10.What are the two key customer-planning decisions that companies face?
11.What are the differences between product-level profit analysis and customerlevel profit analysis?
12.List five characteristics of customers that are high cost-to-serve customers.
List five characteristics of customers that are low cost-to-serve customers.
13.What is a whale curve?
14.What is the key objective of resource-planning decisions?
15.What is a non-value-adding activity?

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Balakrishnan/Managerial Accounting, 2e
Solutions to Short Answer
1. (LO1)
Unit profit margin equals a products unit contribution margin less the
controllable cost of capacity resources.
2. (LO1)
(1) Determine how to form cost pools, (2) identify which cost pools to
allocate, (3) identify the cost driver to use for allocating each cost pool, and (4)
determine the appropriate denominator volume of each cost driver to calculate
allocation rates.
3. (LO1)
A business process converts organizational inputs into a measurable
output. Each business process is a collection of activities.
4. (LO1)
process.

In ABC, we form cost pools by the activities that make up a business

5. (LO1)
An appropriate cost driver is one that has the strongest causal relation
with the costs in the cost pool.
6. (LO2)
Practical capacity is an estimate of the maximum possible activity
level. The advantage of a practical-capacity based allocation rate is that it does
not change across periods. Practical capacity is higher than both actual- and
budgeted capacity, which reflect realized and planned activity usage.
7. (LO2)
Because, ultimately, ABC is just another allocation system. Changing
the method for allocating costs does not change total cost.
8. (LO2)
Allocating lower amounts to some products and higher amounts to
other products. In such instances, products receiving higher allocations are said
to cross-subsidize products receiving lower allocations.
9. (LO2)

By better managing products, customers, and resources.

10.(LO3)
Decisions related to individual customers and market segments,
including decisions regarding who to sell to and the prices to charge.
11.(LO3)
Product-level profit analysis groups revenues, variable costs, and
capacity costs by product whereas customer-level profit analysis does so by
customer.
12.(LO3)
High cost to serve customers (1) place small order sizes, (2) have
rigid requirements, (2) dont pay on time, (4) require more customization, and
(5) make frequent order change requests. Low cost to serve customers (1)
have larger order sizes, (2) pay on time, (3) have minimal order change
requests, (4) require less pre-sales support, and (5) require less after-sales
support. Please see exhibit 10.13 for 11 characteristics of each type of customer.

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Activity-Based Costing and Management

13.(LO3)
A whale curve plots customer profitability, after ranking customers in
order of their profitability. It has the appearance of a whale because for many
firms, the top 20% of customers account for the bulk of the profit, whereas the
remaining customers actually are unprofitable.
14.(LO3)
To improve the efficiency and effectiveness of organizational
processes.
15.(LO3)
Non-value adding activities are those that cost money but do not
provide commensurate benefits. Firms can identify non-value adding activities by
asking, If we eliminate this activity, would the customer notice?

10-23

Balakrishnan/Managerial Accounting, 2e
Short Essay
1. Some might argue that the costs of developing a product are sunk at the time
the product goes into production. Thus, these costs are not controllable for any
decisions. Should we allocate these costs to products to determine their profit
margin?
2. Suppose we are choosing between two drivers to allocate the costs in the
perform setup cost pool: the number of setups or the number of setup hours.
When will the choice not matter (i.e., will result in the same amount costs being
allocated to the various products from this pool?) What factors do we need to
consider when making this choice?
3. What are some of the problems that we are likely to encounter in measuring
practical capacity? For concreteness, consider measuring the practical capacity
of a purchasing department that has five persons, and whose primary activity is
issuing purchase orders.
4. Surveys show that over 40% of all firms do not employ ABC systems. What might
be the underlying reasons for this finding?
5. Suppose your firm is currently employing a traditional volume-based product
costing system. Further, suppose that you begin to improve this system by
incrementally modifying one cost pool at a time by refining its drivers and so on.
Would such actions always increase the accuracy of reported product costs?
Justify your response.
6. Is the activity inspect incoming materials for requisite quality a value-adding
activity? Justify.
7. Suppose a firm increased the efficiency of all of its processes. The firm needs
fewer resources to produce the same volume and mix of goods and services.
However, the firm does not cut spending on the resources freed up as a result.
What is the effect of these actions on the firms reported profit? What is the key
additional step required to translate efficiency improvements into profit gains?
8. Iguana Insurance allows its customers to pay their premiums in full, in four
quarterly payments, or as twelve monthly payments. Iguana adds a surcharge of
$3 per payment if the customers choose a mode other than annual payment. It
offers a rebate of $1 per payment if the customers set up an automatic
withdrawal plan with their bank. How might Iguana justify these surcharges and
discounts?
9. Airlines have sought to reduce long lines by introducing self-service kiosks and
on-line services for passenger check in. What might be the reasoning that
underlies the introduction of such initiatives?

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Activity-Based Costing and Management

Solutions to Short Essay
1. (LO1)
No. The costs of developing a product are sunk at the time the product
goes into production. These costs are not controllable. Proponents of activity
based costing express the view that these costs should not be viewed as product
level costs and therefore should not be assigned to products. Once incurred,
these costs are not relevant for short-term decisions about pricing. Of course,
prudent managers will estimate these costs prior to incurring them. That is, they
will evaluate profitability including these costs, using long-term prices to
estimate revenues and quantities. The key challenge facing managers is to
ensure that both the short- and the long-run views are given appropriate weight
when they make decisions.
2. (LO1)
This choice will matter whenever setting up different products for
production does not take the same amount of time. An implicit assumption in
using number of setups as the driver is that each setup is like every other setup.
Every setup consumes the same amount of organizational resources. If this is in
fact the case, it does not matter whether we use number of setups or number of
setup hours as the driver (as these two drivers will be perfectly correlated). On
the other hand, if some setups are more time consuming than others, then the
number of setup hours is likely the better driver of resource consumption.
3. (LO2)
Measuring practical capacity is difficult for most resources because it is
hard to determine the maximal utilization level possible for each resource. In the
case of the purchase department with five people, think about trying to
determine how many purchase orders each individual can maximally handle.
First, there will be individual differences arising from differences in efficiencies,
abilities, experience and so on. Second, we know that when human efficiencies
are involved, some days are better than others. That is, individual efficiencies
can vary from day to day. We can only assess practical capacity by analyzing the
collective output of the department over a period of time and determining the
normal volume of work that the department is capable of handling. In addition, it
might be difficult to measure output uniformly. For instance, some orders might
be easier to process than others. We simply cannot compare one order for 100
different items with an order for 5 different items, or with 10 separate orders for
10 items each. Modern views of ABC seek to circumvent this problem by
measuring all resources in terms of base units (e.g., time or space available) and
using these units as cost drivers. See articles on Time-driven Activity Based
Costing for more detail.
4. (LO2)
As we have discussed in the text, there are many reasons why ABC
systems are difficult to implement and maintain in practice. First, ABC systems
are information intensive. Numerous measurements are necessary. Second, they
require a stable operational environment. As firms change over time, cost
structures change and cost drivers and cost rates have to be routinely updated.
Therefore, maintaining the decision usefulness of ABC systems in changing
environments is onerous, time consuming and costly. Indeed, a popular estimate
is maintaining an ABC system for a medium sized facility requires a 0.5 FTE
person or about $75,000 per year.

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Balakrishnan/Managerial Accounting, 2e

5. (LO2)
Intuition would suggest that as we improve the cost system one cost
pool at a time, accuracy should also improve incrementally. But this is not always
the case because errors that traditional volume-based systems cause in
allocating costs from multiple cost pools can often be offsetting. As we improve
the cost system by modifying one cost pool at a time, errors from allocations of
other cost pools surface because of the removal of the offsetting nature of the
errors. Consequently, in such settings, all errors must be removed before we can
be confident about the accuracy of product costs.
6. (LO3)
Many embrace the concept of total quality control and argue that
inspection is a non-value adding activity because the supplier of materials
should provide complete quality assurance. In practice, however, it is
unreasonable to expect that suppliers would be able to give such quality
assurance. Often there are inherent process variations that are impossible or
prohibitively costly to get rid of, and therefore quality issues cannot be
completely overcome. Consequently, some amount of inspection is value adding
in such environments.
7. (LO3)
If the firm does not cut spending on the resources freed up, and
revenues stay the same, then the reported profits will not change because the
company is not translating improved efficiencies into cash flow savings. The key
additional step required is to either cut spending on freed up resources or
gainfully utilize freed up resources by producing and selling more goods and
services
8. (LO3)
These charges essentially reflect the opportunity cost of capital for
Iguana insurance. If the customer makes one full annual payment, the company
has to raise less money to finance its working capital and therefore save on
interest. By adding a surcharge for quarterly or monthly payments, the company
is essentially recovering the cost of raising working capital. In addition, the firm
has to process only one receiving transaction rather than four. Similarly,
automatic withdrawals reduce the transactions costs for the company by
facilitating timely withdrawals -- saving of these costs is justification for the
discount
9. (LO3)
Simply put, self-service kiosks and on-line services are less costly,
more efficient ways of dealing with check-ins. Moreover, even passengers are
happier because they do not have to patiently wait in long lines, and plan their
arrival at airports better. All in all, this is one area in which technology has
resulted in a convenient and cost effective way of organizing an important airline
activity!

10-26

Activity-Based Costing and Management

Exercises
1. The University Credit Union (UCU) has engaged your services to determine the
cost of its various activities. The following data are available for a representative
branch.

Tellers
Assistant
Manager
Managers
The average branch
transactions
each year.

Process
Deposits

Process
Checks

Balance
Inquirie
s

Other
Activiti
es

Total Cost

30%
10%

40%
10%

10%
5%

20%
75%

$150,000
$75,000

X
X
X
X

2%
3%
5%
90%
$90,000
processes 600,000 deposits and 1,250,000 check

Required:
Compute the cost per deposit and the cost to process a check.
2. The QwikFill Corporation recently hired David Oxley to figure out ways to
improve profit. David notes that, like virtually all gas stations, QwikFills stations
also had an air pump that customers could use to fill air in their tires. As per
Davids detailed cost report, an air pumps fully allocated cost is around $1,200
per year. Variable costs are negligible. David offers two solutions. One is to
eliminate the pump and save $1,200 each year. The second is to charge a
quarter (25 cents) for each minute of operation. Currently, about 20 customers
use the pump each day in any given gas station. The average customer takes
about 3 minutes to check and inflate all tires.
Required:
a. At the current volume of operations, identify the increase in profit if
Davids first proposal were to be implemented at all 243 of
QwikFills stations. What is the profit with the second proposal?
b. Do you recommend following either of Davids proposals? Why or
why not?

10-27

Balakrishnan/Managerial Accounting, 2e
Solutions to Exercises
1. (LO2)
We first calculate the total cost of each activity by allocating the cost
of individual accounts to the various activities (stage 1). We do this by employing
the percentage allocations provided.

Tellers
Assistant
manager
Managers
Total

Process
deposits

Process
checks

$45,000*
7,500
1,800
$54,300

Cost

$60,00
0
7,500

Balance Other
enquiri activitie
es
s
$15,00 $30,00
0
0
3,750 56,250

2,700
$70,20
0

4,500
$23,25
0

90,000
$315,00
0

81,000
$167,2
50

$150,00
0
75,000

30% $150,000. Similar computations apply for the other cells.

The next step is to divide the total cost in the cost pool by the denominator
volume to get the overhead rate per unit driver. We have:
Cost per deposit = $54,300/ 600,000 deposits = $0.0905 per deposit
Cost per check = $70,200 / 1,250,000 checks= $0.05616 per check

2. (LO3)
A. The first proposal to eliminate the air pump. That will save QwikFill $1,200
annually per gas station. The total saving for all 243 gas stations will be
$291,600. Of course, we are assuming that there will be no loss in
customer volume if the air pumps are eliminated.
B. Under the second proposal, each gas station will make an additional
amount of $5,475 ($0.25 per minute 3 minutes 20 customers per day
365 days). Thus, for each gas station, QwikFill makes a profit of $4,275
(=$5,475 less the annual cost $1,200 to operate the pump), for a total of
$1,038,825.

10-28