Management Accounting Fundamentals [MA1]

Module 5: Activity-based costing and service

department costing
Required readings

Chapter 8, pages 324-347

Appendix A, pages 739-752

Overview

The purpose of this module is to explain the merits and application of activity-based costing and service
department costing. The activity-based costing system is covered in depth, beginning with the initial design
of the system, followed by an illustration of its application. The allocation of overhead costs incurred by
service departments is also explained.

Computer illustrations 5-1 and 5-2 demonstrate the use of spreadsheet program worksheets to (1) allocate
overhead costs using activity-based costing and (2) calculate allocation of service department costs by two
different methods.

Learning objectives

5.1 Explain activity-based costing and how it differs from a traditional costing system. (Level 1)

5.2 Assign overhead costs using activity-based costing. (Level 1)

5.3 List the benefits and limitations of activity-based costing. (Level 2)

5.4 Design a worksheet to assist in comparing the effects of allocating manufacturing overhead based on
direct labour-hours and on activities performed.(Level 1)

5.5 Allocate both fixed and variable service department costs to other departments using the direct
method, the step method, and the reciprocal method. (Level 1)

5.6 Construct worksheets to calculate and compare the allocation of costs using the step method and the
direct method, explaining the differences between the two methods. (Level 1)

5.1 Overhead costing in the new manufacturing environment

LEVEL 1

In Module 2, you observed the application of a predetermined overhead rate in determining the cost of a
product under a job-order costing system. Usually, a single rate was used for all overhead costs, based on
either direct labour-hours or machine-hours.

With the increasing level of automation in many industries today, total overhead costs have increased
substantially to the point where they often represent more than 50% of total product costs. This increase has

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created a need to take a closer look at the accuracy of the allocation of overhead cost to product cost. If
overhead is allocated inaccurately, product prices or contract bids will be calculated based on incorrect cost.
In some cases, this could result in a company selling or bidding too low. The increase in business that this
could cause is good in the short run, but in the long run, owners want stable or increasing profit percentages.
If pricing is incorrect, costs are not recovered in proportion to amounts incurred and in some instances this
can result in unexpected losses.

Overhead rates

The objective of overhead allocation is to approximate what actual overhead charges would be if they were
traced more precisely, that is, traced as a direct cost. The allocation should be fair and equitable to the
recipient based on the benefits received by the recipient. For example, if the costs of the personnel
department are to be charged to jobs or processes, they should be allocated on the basis of who used the
services of the department. But on what basis should the costs be allocated? Prorata based on payroll costs in
the recipient department? Prorata based on the number of employees in the recipient department? Prorata
based on the number of new employees hired?

To achieve a fair and equitable allocation, it is necessary to determine what drives the cost of the providing
department, that is, what causes the cost of the personnel department to increase or decrease from one period
to the next, and then allocate the cost based on the consumption of the activity that drives the cost. Different
rates could be applied for different activities. More than one rate may be used in each department.

If operations are the same in every department, a plantwide overhead rate may be used. The company has
only one overhead rate for every type of product and process in the operation.

Often there will be differences between departments. For example, one department may be very labour
intensive and another department may be completely automated. If the company uses a plantwide rate based
on direct labour-hours, the second department will not be charged any overhead. Departmental overhead
rates charge overhead based on the specific functions of the department. For example, in the second
department, machine-hours may be a more accurate basis for the amount of overhead that the department
should be charged.

A third method of charging overhead is to define a company’s functions or activities instead of its
departments. This method is called activity-based costing (ABC).

5.2 Design of an activity-based costing system

LEVEL 1

The objective of the ABC system is to assign overhead costs based on the amount of overhead each product
consumes or causes. Some overhead costs are related to the volume of units produced. Other overhead costs
are related to factors such as machine setups, change orders, inspections, and so on. Therefore, to accurately
allocate overhead costs, it is necessary to first understand the activities involved in the process and then
allocate costs based on consumption of the activities.

In the first step of the design of an activity-based costing system, the company identifies all activities
involved in producing a product or providing a service. Then it tries to eliminate activities that do not add
value to the final product or service.

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In the second step, the remaining activities are grouped into manageable segments called activity centres.
The number of centres should be sufficient to explain all variations in overhead costs. Some overhead costs
vary by volume of units produced; other costs vary by the number of batches produced, the number of
different products, and so on. Thus, the activity centres need to be segregated on the basis of four different
activity levels — unit level, batch level, product level, and facility level. These different levels are explained
on pages 331-332. Exhibit 8-7 contains examples of activity centres found at each of the levels.

Step 3 is to assign costs of the activities to these activity centres (commonly referred to as cost pools).

In Step 4, activity rates are calculated, and in Step 5 the cost drivers are used to allocate the overhead costs
from the cost pools to the specific products or services. There should be a high degree of correlation between
the cost driver and the actual consumption of overhead in order to obtain an accurate allocation of the
overhead costs. Step 6 involves the preparation of management reports.

5.3 Comparison of traditional and ABC product costs

LEVEL 2

While there are many benefits to using an ABC system, there are some limitations as well. These benefits
and limitations are summarized in the text on pages 339-347. Whether ABC should be adopted by a
particular organization depends on the situation.

There are two fundamental requirements that must be met before an ABC system can be considered for
adoption:

The consumption ratios of unit-based and nonunit-based activities must differ.

The nonunit-based costs should be a significant percentage of total overhead costs.

The benefits of the ABC system must exceed the costs of setting up the system. Cost considerations should
include both the cost of measurement (costs associated with the measurements required by the system) and
the cost of errors (costs associated with making poor decisions based on inaccurate product costs).

Implementing an ABC system is usually advisable when measurement costs are low, competition is fierce,
and product diversity is high.

Online chapter summary

This topic marks the end of the textbook coverage of activity-based costing. To ensure you understand this
material and the corresponding terminology, read the summary on pages 347-348, work through the review
problem on pages 348-349, and go to the Online Learning Centre, click Contents, choose Chapter 8, select
Chapter Summary and review the material thoroughly. If you are unclear on how to access or use this site,
refer to the Online Learning Centre (OLC) Guide in the course navigation pane.

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5.4 Computer illustration 5-1: Activity-based costing

LEVEL 1

Material provided

A partially completed worksheet M5P1, which you will complete.

A completed solution worksheet M5P1S, to which you can compare your work.

Required

Using the worksheet M5P1, complete Requirements 1 and 3b of Problem 8-17 on pages 367-368 of the
textbook by entering the appropriate formulas in rows 24 to 29.

Procedure

Perform the following steps:

1. Open the file MA1M5P1.

2. Move the cell pointer to row 7. The range A5 to F20 comprises the data table. The relevant data from
the problem have been reproduced here to minimize data input.

3. Move the cell pointer to row 21. You will be required to complete the template contained in the range
A21 to F31 in order to answer Requirements 1 and 3b. Requirement 2 has been calculated for you, and
the result appears in cells F15 to F18.

Requirement 1

1. Using the information from the data table, enter in cell B24 the formula that will allow you to calculate
the predetermined overhead rate using direct labour-hours as a base.

2. Complete the schedule in the range B27 to C29 by entering the required formulas. Note that row 30
already contains the required formulas.

Requirement 3b

1. Using the information contained in the data table, enter the required formulas in the range E27 to F29
to calculate the cost of production under the activity-based method.

2. Save a copy of your worksheet.

3. Print a copy of your worksheet.

4. Click the sheet tab M5P1S for the solution. Compare your printout with the solution. If you do not
have the same results, print a copy of the formulas of your worksheet and compare them with the
formulas of the solution worksheet. Correct any errors.

Conclusion

Unit costs appear to be distorted as a result of using direct labour-hours as a base in assigning overhead cost
to products. Although the deluxe model requires twice as much labour time as the regular model, it is still not
being assigned enough overhead cost.

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When the company’s overhead costs are analyzed on a transaction basis, it becomes obvious that the deluxe
model is very expensive to manufacture compared to the regular model. The deluxe model accounts for 40%
of the machine-related costs, even though it accounts for only 11% of the company’s total production. Also,
it accounts for 55% of the scrap/rework orders, which are very costly to the company, and 40% of the
product testing.

When activity-based accounting is used and the company’s transactions are analyzed by product, the
overhead cost jumps from $80 per unit for the deluxe model to $165.60 per unit. This fact suggests that
insufficient overhead cost is being assigned to the deluxe model. If these costs are being used as a basis for
pricing, the selling price for the deluxe model is too low. This may be the reason why profits have been
steadily declining over the last several years. It may also be the reason why sales of the deluxe model have
been increasing rapidly.

5.5 Guidelines for service department cost allocation

LEVEL 1

The CICA Handbook, section 3030 (related to inventory valuation), requires that overhead be allocated to
products to arrive at cost for reporting purposes. Producing and operating department costs are allocated to
products that pass through them. Service department costs are also part of overhead and should be included
in the cost of the product. Since no products pass through service departments, their costs must first be
allocated to production departments and then in turn to products passing through those departments, as is
done with other overhead costs. At this point, do not be concerned about the preparation of a flexible budget;
simply note that the budget of the operating departments includes overhead costs allocated from the service
departments. The flexible budget will be explained in detail in Module 8.

In a nonmanufacturing situation, services are provided to what are referred to as operating departments;
otherwise, the process is similar to that used by manufacturers.

The basic areas of concern in allocating service department costs are:

selecting the proper allocation base

deciding what to do about interdepartmental (that is, reciprocal) services (The costs are allocated by
the direct method, the step method, or the reciprocal method.)

allocating costs by behaviour (fixed and variable)

avoiding allocation pitfalls

The process of allocation can be complex and should take into account the difficulties of arbitrary allocation
procedures. Nevertheless, cost must be allocated for financial reporting purposes. When there is no "true" or
"best" allocation procedure, the simplest one may be the most appropriate. Notice the suggested list of
allocation bases (or cost drivers) presented in Exhibit A-1 (Appendix A). All the allocation bases are
physical in nature, which means that the allocation is done in physical rather than value terms.

Once an allocation base has been selected, the method of allocating between service departments must be
decided.

Methods of cost allocation

The direct method ignores interservice department work and allocates all service department costs directly to

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operating departments, while the step method assumes the service goes only in one direction. It provides for
allocation of a department’s costs to other service departments as well as to operating departments in a
sequential manner. Exhibits A-2 and A-4 (Appendix A) illustrate these approaches. Work through each
example carefully.

The reciprocal method yields more precise results than the step method in cases where service departments
work for one another as well as for producing or operating departments. While the step method allocates
costs only forward and not backward, the reciprocal method allocates costs in both directions. Exhibit A-5
(Appendix A) illustrates the reciprocal method.

Fixed costs could reasonably be allocated on a basis that is different from variable costs. Fixed costs are
more often associated with capacity than with consumption.

There is an important problem in allocating fixed costs — the effect of the actions of one department on
another. This loss of control is important when responsibility is being assessed. A similar problem exists
when actual costs rather than budgeted costs are charged. The answers to the question of who should be
responsible represent significant behavioural issues that are beyond the scope of this course.

You should ensure that you understand the guidelines for allocating service department costs. The allocations
are needed to compute the predetermined overhead rates at the start of the period as well as the actual
overhead incurred at the end of the period. The variance analysis studied in earlier modules should be
considered in relation to the timing of the overhead allocation. (Detailed variance analysis will be covered in
Module 7.)

Activity 5-1 Allocation of service department costs

This activity helps you understand the development and application of multiple overhead rates when there is
more than one cost driver.

Online chapter summary

This topic marks the end of the textbook coverage of service department costing. To ensure you understand
this material and the corresponding terminology, read the summary on page 752, work through the review
problems on pages 753-754, and go to the Online Learning Centre, click on Contents, choose Appendix A,
select Chapter Summary and review the material thoroughly. If you are unclear on how to access or use this
site, refer to the Online Learning Centre (OLC) Guide in the course navigation pane.

5.6 Computer illustration 5-2: Step method and direct method of

cost allocation
LEVEL 1

Computer illustration 5-2 demonstrates how you would use a spreadsheet program to construct a worksheet
to calculate the allocation of service department costs using (a) the step method and (b) the direct method of

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cost allocation.

Material provided

A partially completed worksheet M5P2, which you will complete.

A completed solution worksheet M5P2S, to which you can compare your work.

Required

Interdepartmental cost allocations can be calculated using the step method, the direct method, and the
reciprocal method. Appendix A of the text explains these methods. This computer illustration demonstrates
how you can construct a cost allocation worksheet to perform cost allocations using the step method and the
direct method. You should first read pages 739-744 and study Exhibits A-2 and A-4 carefully. Then use the
following procedure to complete the worksheet.

Procedure

1. Open the file MA1M5P2.

2. Study the structure of the worksheet. Notice that the worksheet is set up to resemble Exhibits A-2 and
A-4. The data table is in rows 5 to 14. Calculations for the step method of cost allocation are located in
rows 16 to 28; calculations for the direct method are in rows 31 to 43. The worksheet is designed so
that you can move between the three areas (data table, step method, and direct method) by pressing
PGUP and PGDN.

The allocation of overheads for hospital administration and custodial services is based on labour-hours
and space occupied, respectively, as shown in Exhibits A-2 and A-4.

3. Move to row 25 and examine the formulas that calculate the allocation of hospital administration costs
based on labour-hours. After you have examined these formulas and understood the techniques used,
move to cells C26, D26, E26, and F28 and note that these cells are empty. Enter the appropriate
formulas in these cells, using space occupied as the basis of allocation. Compare the results with
Exhibit A-4. Correct your formulas if your worksheet does not show the same results.

4. In a similar manner, examine the formulas used in the direct method (rows 31 to 43). Examine
carefully the formulas in row 41, which calculate the allocation of custodial services costs. Next move
the cell pointer to row 40 and notice that cells D40 and E40 are empty. Notice also that cell F43 is
empty. Enter the appropriate formulas in these cells. Compare the results with Exhibit A-2. Correct
your formulas if your worksheet does not show the same results.

5. Save the completed worksheet. If your results do not match Exhibits A-2 and A-4, follow steps 6 and
7. Otherwise, go to step 8.

6. Print a copy of the formulas in the range B21 to F43.

7. Click the sheet tab M5P2S and compare the solution with your printout from step 6. Correct any
errors.

8. Use the solution worksheet M5P2S to perform the following what-if analysis:

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What if:
a. the hospital administration cost to be allocated is $420,000?
b. the hospital administration cost is $420,000, and the custodial services cost is $94,000?

Run these two situations through the solution worksheet. You should obtain the following results:

Total costs after allocations

Laboratory Daily patient care
Case a: Step method: $ 414,667 $1,045,333
Direct method: $ 427,500 $ 1,032,500

Case b: Step method: $ 415,067 $ 1,048,933

Direct method: $ 427,900 $ 1,036,100

From the results, you can see the ease with which sensitivity analysis can be performed using spreadsheets.

Audio lectures
Audio lectures are available for this module. System requirements and instructions on how to access the
online lectures are included.

Module 5 summary
On the one hand, Module 5 consists of activity-based costing (ABC), and on the other hand, it discusses the
treatment of costs of service departments.

ABC is a response to many weaknesses of traditional cost accounting especially with regard to overhead
costs. Topic 5.1 contrasts ABC with the traditional uses of plant-wide and departmental overhead rates.

Since the activities link overhead costs to cost objects, Topic 5.2 traces overhead resources consumed to the
concerned cost objects.

Topic 5.3 goes beyond a simple comparison of traditional costing and ABC in that it also evaluates the ABC
method, sets out the fundamental requirements to its implementation, and discusses the situations where the
method is appropriate.

Topic 5.4 brings out the cost distortions as a result of the use of traditional costing methods while ABC gives
a more realistic and accurate picture of product costs.

Although not involved directly in product or operating activities, the costs incurred by service departments
are crucial to the organizations. Topic 5.5 deals with the methods of allocation of these costs to
manufacturing or operating departments.

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Finally, Topic 5.6 discusses two allocation methods of service department costs and conducts a sensitivity
analysis pertaining thereto.

Module 5 self-test
Question 1

Computer question

Before you attempt this question, you should work through Computer illustration 5-1.

Textbook, Case 8-25, pages 376-378.

Required

Use the procedure described below to complete worksheet M5Q1. From this worksheet, answer the
following questions:

1. Compute the predetermined overhead rate that the company used during the year. (You should assume
that there was no under- or overapplied overhead for the year.)

2. Materials and labour costs per unit for the two products are as follows:

B-10 C-20
Direct Materials $60 $90
Direct labour 12 18

Using these data and the rate computed in (1) above, determine the unit product cost of each product.

3. What is the cost of producing one unit of each product using the six activities as a base for overhead
cost allocation?

4. What is the net income or loss for the year for product C-20 using the activities as a base for overhead
cost allocation? Would you recommend that the company expand sales of the C-20? Explain.

5. From the data you have prepared in (3) above, why do you suppose the C-20 "just seems to sell itself”?

6. If you were president of Hammer Products, Inc., what strategy would you follow from this point
forward to improve the company’s overall profits?

Procedure

1. Carefully read the case.

2. Open the file MA1M5Q1.

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3. Examine the layout of the worksheet. The range A4 to G22 forms the data table. All relevant data
required to answer parts (1) to (4) are included in this data table.

4. Move the cell pointer to cell A24. The range A24 to G33 has been allocated to answer part (3) using
the same format as in Computer illustration 5-1.

5. Move the cell pointer to cell A35. The range A35 to G38 has been set up to calculate the gross margin
per unit under the two overhead allocation methods.

6. Move the cell pointer to display rows 41 to 51. You will find a partially completed income statement.
You will need to input the necessary formulas.

7. Enter the required formulas in cells D27 and D30 to G33 to calculate the cost of production per unit
under the two overhead allocation methods.

8. Beginning in row 36, enter the necessary formulas to calculate the gross margin per unit for each
model under both calculation methods.

9. Beginning in row 46, enter the required formulas to complete the income statement.

10. After you have completed parts (1) to (4), save a copy of the worksheet.

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Managerial Accounting,
Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson Limited. Adapted with permission.

Solution

Question 2

Computer question

Before you attempt this question, you should work through Computer illustrations 5-1 and 5-2.

Description

Exercise A-1, page 755.

Required

Using the step method, follow the procedure described below to complete worksheet M5Q2. From this
worksheet, answer the following questions:

1. What is the total cost of overhead after allocation in the prep department?

2. Now assume that the total overhead cost before allocation for the equipment maintenance department
was $72,000 instead of $36,000. What is the total cost of overhead after allocation in the finishing
department?

Procedure

You have been provided with a partially completed worksheet M5Q2. You are to complete the worksheet,
following these steps:

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1. Open the file MA1M5Q2.

2. Examine the data table in cells A4 to G13 and note that all the values given in the problem have been
pre-entered for you.

3. Cells A15 to G27 are set up for your solution. Construct the appropriate formulas in these cells. Do not
calculate the cost allocations by hand or enter the calculated values into these cells. This procedure
would defeat the purpose of using worksheets.

4. Save the completed worksheet.

5. Make the necessary adjustments to the worksheet to answer Requirement 2.

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Managerial Accounting,
Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson Limited. Adapted with permission.

Solution

Question 3

Multiple choice

a. Which of the following are the most appropriate cost drivers for the activity listed:

Activity Cost drivers

1) Issuing purchase orders for materials - number of orders; quantity of materials
ordered

2) Hiring of new employees by personnel - number of hires; number of employees hired

department

3) Testing of new products in testing centre - number of tests; cost of tests

4) Machine set-ups for production of various - number of set-ups; direct labour cost of
products machinists

b. The following schedule represents what type of cost allocation method?

Janitorial Medical
Services Servies Cutting Milling Assembly
$350,000 $596,000
(350,000) 14,000 $ 70,000 $ 56,000 $210,000
(610,000) 183,000 122,000 305,000
$ 0 $ 0 $253,000 $178,000 $515,000

1. Reciprocal
2. Direct
3. Step-down

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4. Plant-wide

c. How would the movement about the plant of materials received on the receiving dock be accounted
for?

1. As an unit-level activity
2. As a batch-level activity
3. As a product-level activity
4. As an organization-sustaining activity

d. Which of the following costs would least likely be part of the product design activity cost pool?

1. Janitor’s salary
2. Amortization expense for computers
3. Utilities expense
4. Chief executive officer’s salary

e. Activity-based costing can be applied to which of the following?

1. Manufacturing activities only

2. Merchandising activities only
3. Service activities only
4. Any activity

f. Which of the following statements best describes a cost driver?

1. It is a variable that causes an activity to increase or decrease.

2. It is always based on direct labour hours.
3. It is used for manufacturing and merchandising activities only.
4. It changes during the operating cycle.

g. What is a system of assigning costs to departments and products based on more than one cost driver
called?

1. Responsibility costing
2. Variable costing
3. Activity-based costing
4. Cost driver costing

h. Which of the following is true about the reciprocal?

1. It is a less accurate method of allocation than the direct method.

2. It cannot be used when a company has more than two service departments.
3. It is a simpler allocation method than the step-down method.
4. It takes into consideration interdepartmental services.

i. Which of the following terms applies to an account that accumulates costs a company incurs to support
an activity?

1. Controllable
2. Uncontrollable
3. Cost driver

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4. Cost pool

j. When using an activity-based costing system, which of the following is true?

1. One cost driver must be selected.

2. Traceable costs are allocated between cost pools.
3. An appropriate rate must be calculated for each cost pool.
4. Uncontrollable costs are ignored.

Solution

Question 4

Multiple choice

Answer items (a) and (b) using the following information:

Acklin Company has two products: A and B. The annual production and sales of Product A is 550 units and
of Product B is 1,000 units. The company has traditionally used direct labour-hours as the basis for applying
all manufacturing overhead to products. Product A requires 0.6 direct labour-hour per unit and Product B
requires 1.32 direct labour-hours per unit. The total estimated overhead for next period is $29,865.

The company is considering switching to an activity-based costing system for the purpose of computing unit
product costs for external reports. The new activity-based costing system would have two overhead activity
centres — Activity 1 and Activity 2 — with estimated overhead costs and expected activity as follows:

a. What is the predetermined overhead rate under the traditional costing system?

1. $ 10.04
2. $ 18.10
3. $ 19.27
4. $ 29.87

b. What is the overhead allocated to Product A for Activity 2 under the activity-based costing system
(rounded to the nearest whole dollar)?

1. $ 13,599
2. $ 14,526
3. $ 15,866
4. $ 16,290

User the following information to answer (c), (d), and (e):

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Actual Service Dept. Production Production Dept.

Service Department Costs Department Overhead Costs
Cafeteria $80,000 Milling $120,000
Janitorial 100,000 Assembly $160,000

The cafeteria costs are allocated to janitorial, milling, and assembly at the ratio of 1:6:3 respectively.
The janitorial costs are allocated between the cafeteria, milling, and assembly on the basis of the
following respective square footages: 1,000; 5,000; and 2,000.

c. What amount of the Cafeteria costs are allocated to the Assembly department using the step-down
method (assuming the cafeteria is allocated first)?

1. $ 24,000
2. $ 26,667
3. $ 45,714
4. $ 48,000

d. What amount is allocated to the Assembly department from Janitorial using the step-down method
(assuming the cafeteria is allocated first)?

1. $ 25,000
2. $ 27,000
3. $ 28,571
4. $ 30,857

e. What amount of the Janitorial costs are allocated to the Assembly department using the direct method?

1. $ 25,000
2. $ 27,000
3. $ 28,571
4. $ 30,857

f. Consider the following information for the period:

The total set-up costs for the period are $324,000. Using activity-based costing, what is the total set-up
cost allocated to Product B?

Product A Product B
Units produced 800 72,000
Number of set-ups 40 60
Direct labour hours per unit 8 2

1. $ 64,800
2. $ 194,400
3. $ 259,200
4. $ 320,440

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Use the following information to answer (g) and (h):

Oiler Inc. uses activity-based costing to apply predetermined overhead rates to each of its three activity
centres. Estimated costs and activities for the current year are presented below:

Activity Estimated Expected

centre overhead cost activity

Activity 1 $42,000 2,800

Activity 2 22,500 3,000
Activity 3 36,540 2,900

Actual costs and activities for the current year were as follows:

Activity Actual Actual

centre overhead cost activity

Activity 1 $42,940 2,825

Activity 2 17,910 2,985
Activity 3 34,980 2,915

g. What should be the amount of overhead applied for Activity 1 during the year?

1. $ 32,809
2. $ 42,000
3. $ 42,375
4. $ 42,560

h. What was the overhead overapplied or underapplied for Activity 3 for the year?

1. $ 180 underapplied
2. $ 180 overapplied
3. $ 1,749 underapplied
4. $ 1,749 overapplied

Answer items (i) and (j) using the following information:

Lister Corporation has two service departments and two producing departments. Budgeted overhead
costs and budgeted activity in the various departments for last year are shown below:

Recreational Cutting Assembly

cost Cafeteria department department

Departmental costs $180,000 $120,000 $560,000 $240,000

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Square metres occupied 2,000 3,000 4,000 1,000

Number of employees 4 10 40 60
Machine-hours 32,000 18,000

i. Assume that Lister uses the direct method of allocation assigning the most appropriate cost driver to
each activity. What would be the amount of recreational costs allocated to the Assembly department?

1. $ 36,000
2. $ 54,000
3. $ 64,800
4. $108,000

j. Assume that Lister uses the direct method of allocation assigning the most appropriate cost driver to
each activity. What would be the predetermined overhead rate in the Cutting department?

1. $ 17.50
2. $ 19.25
3. $ 21.25
4. $ 23.50

Solution

Question 5

Textbook, Problem 8-21, page 371.

Solution

Question 6

Textbook, Case A-15, pages 762-763.

Solution

Self-test - Content Links

Solution 1

Computer solution

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 Management Accounting Fundamentals [MA1]

Requirement 1
The predetermined overhead rate is $48.00 per direct labour-hour.

Requirement 2

The cost to produce one unit of B-10 is $120.00 and one unit of C-20 is $180.00.

Requirement 3

Using activities as a base, the cost to produce one unit of B-10 is $99.20 and one unit of C-20 is $304.80.

Activity Cost Pool (a) (b) (a) ÷ (b)

Total Cost Total Activity Activity Rate
Machine setups $416,000 3,200 setups $130 per setup
Quality Control $720,000 18,000 inspect. $40 per inspection
Purchase orders $180,000 2,400 orders $75 Per order
Soldering $900,000 400,000 Joints $2.25 Per joint
Shipments $264,000 1,200 Shipmts $220 Per shipment
Machine related $1,120,000 140,000 MHRs $8 Per MHR

The manufacturing overhead cost that would be applied to each model can be computed as follows:

Before we can determine the unit product cost under activity-based costing, we must first take the overhead
costs applied to each model above and express them on a per-unit basis:

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Requirement 4
The net loss for product C-20 was $848,000. The company should not expand sales of C-20 because it is
losing money on each sale.

Solution printout

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 Management Accounting Fundamentals [MA1]

Formula printout

Requirement 5

It is not surprising that the C-20 "sells itself" since the company is selling it below the cost to manufacture.
This also explains why Borst Company could not meet Hammer Products’ price. Because Hammer is selling
so much below cost, it is unlikely that there is anything else on the market at a comparable price, so there is
no competition.

Requirement 6

Three possible ones are (a) raise the selling price of the C-20 enough to provide a satisfactory margin; (b)
investigate ways to reduce the manufacturing costs of the C-20 (fewer set-ups, etc.) without sacrificing
quality; and (c) discontinue the C-20 and focus all available resources on the B-10. The price of the B-10
might even be decreased slightly to increase the volume of sales.

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 Management Accounting Fundamentals [MA1]

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.

Solution 2

Computer solution

Requirement 1

The total cost of overhead allocated to the prep department is $327,500.

Solution printout

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 Management Accounting Fundamentals [MA1]

The following alternative solution shows the percentages of usage to be allocated to each department.

1 (84,000 × 60) ÷ 1,200; (84,000 × 240) ÷ 1,200; (84,000 × 600) ÷ 1,200; (84,000 × 300) ÷ 1,200

2 (72,000 × 1) ÷ 10; (72,000 × 2) ÷ 10; (72,000 × 7) ÷ 10

3 (60,000 × 1)÷ 4; (60,000 × 3) ÷ 4

Requirement 2

The total cost of overhead allocated to the finishing department is $642,000.

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Solution printout

Formula printout

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 Management Accounting Fundamentals [MA1]

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Adapted with permission.

Solution 3

Multiple Choice

a. 2)

The number of hires and number of employees hired would both be appropriate cost drivers for the
hiring of new employees by the Personnel department.

b. 3)

The schedule represents the step-down method of allocating Service department costs to three
Production departments since Janitorial is first allocated to the remaining cost centres, including
Medical, which is then allocated to the Production departments.

c. 2)

The movement about the plant of materials received on the receiving dock would be accounted for as a
batch-level activity since the activity is performed each time a batch is handled or processed.

d. 4)

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The chief executive officer’s salary would be least likely to be part of the product design activity cost
pool since it is not directly or indirectly related to it.

e. 4)

Activity-based costing can be applied to any activity; it is not industry specific.

f. 1)

A cost driver is a variable that causes an activity to increase or decrease.

g. 3)

Activity-based costing is a system of assigning costs to departments and products based on more than
one cost driver.

h. 4)

The reciprocal method of allocating Service department costs which takes into consideration
interdepartmental services and is more accurate than the direct method, can be used when a company
has more than two service departments, but is a more complex method of allocation than either the
step-down or direct methods.

i. 4)

A cost pool is a temporary account that accumulates costs a company incurs to support an activity.

j. 3)

When using an activity-based costing system, an appropriate rate must be calculated for each cost
pool.

Solution 4

Multiple choice

a. 2)

0.6 × 550 = 330; 1.32 × 1,000 = 1,320; 330 + 1,320 = 1,650; $29,865 ÷ 1,650 = $18.10 per direct
labour-hour.

b. 1)

$15,865 ÷ 1,050 = $15.11; $15.11 × 900 = $13,599.

c. 1)

$80,000 × (3 ÷ 10) = $24,000.

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d. 4)

($100,000 + $8,000) × (2,000 ÷ 7,000) = $30,857.

e. 3)

$100,000 × (2,000 ÷ 7,000) = $28,571.

f. 2)

$324,000 ÷ 100 = $3,240 × 60 = $194,400.

g. 3)

$42,000 ÷ 2,800 = $15; $15 × 2,825 = $42,375.

h. 4)

$36,540 ÷ 2,900 = $12.60; $12.60 × 2,915 = $36,729 applied – $34,980 actual = $1,749 overapplied.

i. 4)

$180,000 × (60 ÷ 100) = $108,000.

j. 3)

$180,000 × 40 ÷ 100 = $72,000; $120,000 × 40 ÷ 100 = $48,000; $560,000 + $72,000 + $48,000 =

$680,000; $680,000 ÷ 32,000 = $21.25.

Solution 5

Problem 8-21

1. The company expects to work 60,000 direct labour-hours during the year, computed as follows:

Mono-circuit: 40,000 units × 1 DLH per unit 40,000

Bi-circuit: 10,000 units × 2 DLH per unit 20,000
Total direct labour-hours 60,000

Using direct labour-hours as the base, the predetermined manufacturing overhead rate would be:

Estimated overhead cost $3,000,000

= = $50 per DLH
Estimated direct labour-hours 60,000 DLHs

The unit product cost of each product would be:

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 Management Accounting Fundamentals [MA1]

Mono-circuit Bi-circuit
Direct materials (given) $ 40 $ 80
Direct labour (given) 18 36
Manufacturing overhead:
$50 per DLH × 1 DLH and 2 DLHs 50 100
Total unit product cost $108 $216

2. The predetermined overhead rates would be computed as follows:

(a) (b) (a) ÷ (b)

Estimated Overhead Expected Predetermined Overhead
Activity Centre Costs Activity Rate
Maintaining
parts inventory $360,000 900 part types $400 per part type
Processing
purchase orders $540,000 3,000 orders $180 per order
Quality control $600,000 8,000 tests $75 per test
Machine-related $1,500,000 50,000 MHs $30 per MH

3. a.

b. Using activity-based costing, the unit product cost of each product would be:

Mono-circuit Bi-circuit
Direct materials $40.00 $ 80.00
Direct labour 18.00 36.00
Manufacturing overhead: (above) 30.75 177.00

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Total unit product cost $88.75 $293.00

4. Although the bi-circuit accounts for only 20% of the company’s total production, it is responsible for
two-thirds of the part types carried in inventory and 60% of the machine-hours. It is also responsible
for one-third of the purchase orders and three-fourths of the quality control tests. These factors have
been concealed as a result of using direct labour-hours as the base for assigning overhead cost to
products. Since the bi-circuit is responsible for a majority of the activity in the company, under
activity-based costing it is assigned a larger amount of overhead cost.

Managers should be cautious about drawing firm conclusions about the profitability of products from
the above activity-based cost analysis. The ABC system used in this company is not completely
suitable for making decisions. Product costs probably include costs of idle capacity and organization-
sustaining costs. They also exclude nonmanufacturing costs that may be caused by the products.
Nevertheless, the above analysis is suggestive. The bi-circuit may not be as profitable as management
believes, and this may be the reason for the company's declining profits. Note that from part (1), the
unit product cost of the bi-circuit is $216. In part (3), however, the activity-based costing system sets
the unit product cost of the bi-circuit at $293. This is a difference of $77 per unit. If the unit product
cost of $216 is being used to set the selling price for the bi-circuit, the selling price may not be high
enough to cover the company's costs.

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Reproduced with permission.

Solution 6

Case A-15

1. Step method:

Custodial Machinery
Cafeteria Services Maintenance Milling Finishing
Total costs before allocations $320,000 $65,400 $93,600 $416,000 $166,000
Allocations:
Cafeteria (@$640 per employee)* (320,000) 25,600 38,400 64,000 192,000
Custodial Services (@ $13.00 per sq. m.)** (91,000) 13,000 52,000 26,000
Machinery Maintenance (4/5; 1/5) (145,000) 116,000 29,000
Total overhead after allocations $ 0 $ 0 $ 0 $648,000 $413,000
Divide by machine-hours ÷ 160,000
Divide by direct labour-hours ÷ 70,000
Predetermined
overhead rate $ 4.05 $ 5.90

* Based on 40 + 60 + 100 + 300 = 500 employees.

** Based on 1,000 + 4,000 + 2,000 = 7,000 sq. m.

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The following alternative solution shows the percentages of usage to be allocated to each department.

1 (320,000 × 40) ÷ 500; (320,000 × 60) ÷ 500; (320,000 × 100) ÷ 500; (320,000 × 300) ÷ 500

2 (91,000 × 1,000) ÷ 7,000; (91,000 × 4,000) ÷ 7,000; (91,000 × 2,000) ÷ 7,0000

3 145,000 × 160 ÷ 200; 145,000 × 40 ÷ 200

2. Direct method:

Custodial Machinery
Cafeteria Services Maintenance Milling Finishing
Total costs before allocations $320,000 $65,400 $93,600 $416,000 $166,000
Allocations:
Cafeteria (1/4; 3/4)* (320,000) 80,000 240,000
Custodial Services (2/3; 1/3)** (65,400) 43,600 21,800
Machinery Maintenance (4/5; 1/5) (93,600) 74,880 18,720
Total overhead after allocations $ 0 $ 0 $ 0 $614,480 $446,520
Divide by machine-hours ÷ 160,000
Divide by direct labour-hours ÷ 70,000
Predetermined overhead rate $ 3.84 $ 6.38

* Based on 100 + 300 = 400 employees.

** Based on 4,000 + 2,000 = 6,000 sq. m.

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3. a. The amount of overhead cost assigned to the job would be:

b. The step method provides a better basis for computing predetermined overhead rates than the direct
method because it gives recognition to services provided between service departments. If this
interdepartmental service is not recognized, then either too much or too little of a service department's
costs may be allocated to a producing department. The result will be an inaccuracy in the producing
department's predetermined overhead rate.

For example, notice from the computations in (2) above that using the direct method and ignoring
interdepartmental services causes the predetermined overhead rate in the Milling Department to fall to
only $3.84 per MH (from $4.05 per MH when the step method is used), and causes the predetermined
overhead rate in the Finishing Department to rise to $6.38 (from $5.90 when the step method is used).
These inaccuracies in the predetermined overhead rate can cause corresponding inaccuracies in bids for
jobs. Since the direct method in this case understates the rate in the Milling Department and overstates
the rate in the Finishing Department, it is not surprising that the company tends to bid low on jobs
requiring a lot of milling work and tends to bid too high on jobs that require a lot of finishing work.

Source: Ray H. Garrison, Eric W. Noreen, G.R. Chesley, and Raymond F. Carroll, Solutions Manual to
accompany Managerial Accounting, Sixth Canadian Edition. Copyright © 2004, by McGraw-Hill Ryerson
Limited. Reproduced with permission.

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