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Chapter 8

Activity-Based Costing
Learning Objectives
1. Understand the potential effects of using reported product costs for decision making.
2. Explain how a two-stage product costing system works.
3. Compare and contrast plantwide and departmental allocation method.
4. Explain how activity-based costing and a two-stage product system are related.
5. Compute product costs using activity-based costing.
6. Compare activity-based product costing to traditional department product costing
methods.
7. Demonstrate the flow of costs through accounts using activity-based costing.
8. Apply activity-based costing to marketing and administrative services.

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Chapter Outline
I.
II.

III.

IV.
V.

VI.
VII.
VIII.
IX.
X.

REPORTED PRODUCT COSTS AND DECISION MAKING


A. Dropping a product
B. The death spiral
TWO-STAGE COST ALLOCATION
A. Two-stage cost allocation and the choice of cost drivers
B. Plantwide versus department-specific rates
C. Choice of cost allocation methods: A cost-benefit decision
ACTIVITY-BASED COSTING
Developing activity-based costs
Identifying activities that use resources
Choosing cost drivers
Computing a cost rate per cost driver
COST HIERARCHIES
ACTIVITY-BASED COSTING ILLUSTRATED
A. Step 1: Identify the activities
B. Step 2: Identify the cost drivers
C. Step 3: Compute the cost driver rates
D. Step 4: Assign costs using activity-based costing
E. Unit costs compared
COST FLOW THROUGH ACCOUNTS
CHOICE OF ACTIVITY BASES IN MODERN PRODUCTION SETTINGS
ACTIVITY-BASED COSTING IN ADMINISTRATION
WHO USES ABC?
SUMMARY

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Fundamentals of Cost Accounting

Key Concepts
LO1 Understand the potential effects of using reported product costs for
decision making.
Basic approach to product costing involves assigning direct costs to products and allocating
manufacturing overhead costs to products.
For financial reporting purposes, the product costs computed are used primarily for
developing inventory balances and cost of goods sold amounts, and are based on
traditional systems that allocate manufacturing costs using a handful of allocation bases
(e.g., direct labor, direct materials, or machine utilization).
Once a predetermined overhead rate is calculated from the cost accounting system, it is
applied as if all overhead were variable with respect to the allocation base, which is not
true in most cases.
There are two reasons:
(1) Some of the overhead items could be fixed, and reducing the number of units
produced does not result in lower fixed costs. Examples of fixed costs include cost of
supervision, machine and plant depreciation, and miscellaneous items that do not vary
with the allocation base.
2) Some of the overhead items could vary, but with cost drivers other than the chosen
few.
If managers attempt to recover the costs with a smaller number of units, they are likely
to meet resistance in the market, resulting in demand for even fewer units. With the
smaller production, the reported product costs increase even more.
Death spiral is a phenomenon that begins by attempting to increase price to meet
higher reported product costs, losing market share, reporting still higher costs, and so on
until the firm is pricing itself out of business.
Death spiral may occur when the demand falls while fixed costs remain the same. Death
spiral may also occur when capacity (and associated fixed overhead costs) increases in
anticipation of increased demand in the future. Either way, the prices go up in order to
recover the ever higher reported product costs in a vicious cycle that eventually drives
away remaining customers.
[Assign Problems 8-30, 8-31, 8-36, 8-38, 8-39]

LO2 Explain how a two-stage product costing system works.

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The basic approach in product costing is to allocate costs in the cost pools that record
manufacturing costs and assign, or allocate, these costs to the products or services of interest, by
using appropriate cost allocation bases or cost drivers.
Alternative cost-allocation approaches should be evaluated based on
(1) decision usefulness, and
(2) cost-benefit considerations.
Two-stage approach to product costing involves the following:
Direct costs
Direct materials,
Direct labor
Indirect costs
Manufacturing
overhead

(First stage)

(Second stage)

Products or
services

Cost pools

The first-stage cost objects (cost pools) are the overhead accounts (e.g., machine-related
costs and direct labor-related costs) captured by the cost accounting system. Exhibit 8.4
shows such an example.
The two-stage approach separates plant, or manufacturing, overhead into two or more
cost pools based on the account in which the costs were recorded.
The allocation in the first stage permits selection of multiple cost drivers that were used
to allocate costs to products.
Another common choice for first-stage cost objects is to use departments or lines within
the plant, as shown in Exhibit 8.5.
The allocation of overhead costs to departments is not as simple as it is when overhead
accounts are used because the costs are not necessarily recorded at the department level.
Complexity and special handling required during production may distort the product
costs reported when the traditional costing method is used. The two-stage system, on the
other hand, allows the firm to develop product costing systems that more closely align the
allocation of costs with the use of resources.
[Assign Exercises 8-20, 8-21]

LO3 Compare and contrast plantwide and departmental allocation method.


The single-stage approach was first introduced in Chapter 5 and depicted below:
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Direct costs
Direct materials,
Direct labor
Indirect costs
Manufacturing
overhead

(Single stage)

Products or
services

The plantwide allocation method is an allocation method that uses one cost pool (of
indirect costs) for the entire plant (e.g., an entire factory, store, hospital, or other multidepartment segment of a company), as in the single stage approach. It uses one overhead
allocation rate, or one set of rates, for all of the departments in a particular plant.
Although it is called plantwide allocation, this allocation concept can be used in both
manufacturing and nonmanufacturing organizations.
In plantwide allocation, all overhead costs are recorded in one cost pool in the
Manufacturing Overhead (Actual) account for the plant without regard to the department
or activity that caused them. A single overhead rate is used to apply overhead to products,
crediting Manufacturing Overhead Applied account.
Example: If overhead is applied using a predetermined rate per machine hour, the
amount of the credit to the Manufacturing Overhead Applied account and the amount of
the debit to Work in Process for overhead costs equal the rate per machine hour times
the total number of machine-hours worked.
Companies using a single plantwide rate generally use an allocation base related to the
volume of output, such as direct labor hours, machine hours, volume of activity, or
materials costs.
======================

Demonstration Problem 1
ABC Manufacturing, Inc. produces three gadgets (Ace, Best, and Champ) in two departments,
Machining and Assembly. Each product requires one hour of direct labor for completion. The
following table provided production and cost data for the year.

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Number of units
Machine hours
Direct materials
Direct labor
Overhead
Machining
Assembly
Total overhead
Tot costs

Ace
25,000
2,500

Best
15,000
1,500

Champ
5,000
2,000

Total
45,000
6,000

$1,000,000
375,000

$450,000
225,000

$275,000
75,000

$1,725,000
675,000
900,000
450,000
1,350,000
$3,750,000

Required:
Use the plantwide allocation method to determine the unit cost for each product. The allocation
bases to choose from are
1. Machine hours.
2. Direct labor costs.
Solution:
1. The overhead allocation rate when machine hours were used as the allocation base was
$225 per machine hour (= $1,350,000 / 6,000 machine hours). The unit cost report would
show the following:
Units produced
Machine hours per unit
Direct materials
Direct labor
Applied overhead ($225 per machine hour)
Unit cost

Ace
25,000
0.1

Best
15,000
0.1

Champ
5,000
0.4

$40.0
15.0
22.5
$77.5

$30.0
15.0
22.5
$67.5

$55.0
15.0
90.0
$160.0

2. The overhead allocation rate when direct hour costs were used as the allocation base was
200% (= $1,350,000 / $675,000). The unit cost report would show the following:
Units produced
Direct materials
Direct labor
Applied overhead (200% direct labor costs)
Unit cost

Ace
25,000

Best
15,000

Champ
5,000

$40.0
15.0
30.0
$85.0

$30.0
15.0
30.0
$75.0

$55.0
15.0
30.0
$100.0

Please note that the same results can be obtained using the number of units produced as the
allocation base because each product requires one hour of direct labor for completion and the
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Fundamentals of Cost Accounting

direct labor costs are in direct proportion to the number of units produced. The overhead
allocation rate would be $30 per unit (= $1,350,000 / 45,000 units) as shown above.
======================
The department allocation method uses a separate cost pool for each department.
Each department has its own overhead allocation rate or set of rates. This is a variation of
the two-stage allocation approach in which the cost pools happen to be departments.
If the company manufactures products that are quite similar and all use the same set of
resources, the plantwide rate is probably sufficient. If there are multiple products that
require manufacturing facilities in many different ways, departmental rates provide a
better picture of the use of manufacturing resources by the different products.
The choice between a plantwide rate and departmental rates is based on the costs and
benefits of the information inherent in each system. Any incremental costs of additional
information must be justified by an increase in benefits from improved decisions.
======================

Demonstration Problem 2
(Continued from Demonstration Problem 1)
Considering the nature of the production processes, the cost accountant of ABC Manufacturing
decided to experiment with the department-specific allocation approach and determined that the
Machining Department can use machine hours as the allocation base for overhead assignment
while the Assembly Department can use direct labor costs instead.
Required:
Use the department allocation method to determine the unit cost for each product.
Solution:
For the Machining Department, the overhead allocation rate would be $150 per machine hour
(= $900,000 / 6,000 machine hours). For the Assembly Department, the overhead allocation
rate would be 66.67% (= $450,000 / $675,000).
Units produced
Machine hours per unit
Direct materials
Direct labor
Applied overhead
Machining ($150 per machine hour)
Assembly (66.67% direct labor costs)
Unit cost
Instructors Manual, Chapter 8

Ace
25,000
0.1

Best
15,000
0.1

Champ
5,000
0.4

$40.0
15.0

$30.0
15.0

$55.0
15.0

15.0
10.0
$80.0

15.0
10.0
$70.0

60.0
10.0
$140.0

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======================
[Assign Exercises 8-25, 8-26, 8-27, Problems 8-32, 8-33, 8-34, 8-35, 8-37, 8-38, 8-39]

LO4 Explain how activity-based costing and a two-stage product system are
related.
Activity-based costing (ABC) is a two-stage product costing method that first assigns costs to
activities and then allocates them to products based on the products consumption of activities.
The cost pools in the two-stage approach now accumulate activity-related costs.
An activity is any discrete task that an organization undertakes to make or deliver a
product or service.
Activity-based costing is based on the concept that products consume activities and
activities consume resources.
Activity-based costing can be used by any organization that wants a better
understanding of the costs of the goods and services it provides, including manufacturing,
service, and even nonprofit organizations.
Activity-based costing involves the following four steps:
(1) Identify the activities that consume resources and assign costs to them.
(2) Identify the cost driver(s) associated with each activity. A cost driver is any factor
that causes, or drives, an activitys costs.
(3) Compute a cost rate per cost driver unit or transaction. Each activity could have
multiple cost drivers.
(4) Assign costs to products by multiplying the cost driver rate by the volume of cost
driver units consumed by the product.
Identifying activities that use resources is the most interesting and challenging part of
the process, from which much of the value of activity-based costing comes. A costbenefit consideration dictates that companies identify only the most important activities.
Examples of cost drivers are shown in Exhibit 8.10.
Cost drivers are selected based on three criteria:
(1) Causal relation. Ideally, choose a cost driver that causes the cost.
(2) Benefits received. Choose a cost driver to assign costs in proportion to benefits
received.
(3) Reasonableness or fairness. When the first two criteria fail, assign costs on the basis
of fairness or reasonableness.
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Fundamentals of Cost Accounting

For any indirect cost, a predetermined rate can be computed as follows:


Predetermined rate =

Estimated indirect cost


.
Estimated volume of allocation base

For activity-based costing, the first stage consists of activities. Each activity has an
associated cost pool and requires a cost driver rate using the formula above.
The second stage in a two-stage system using activity-based costing allocates costs to
products by multiplying the cost driver rates by the number of units of the cost driver
(i.e., volume of activities consumed) in each product. Exhibit 8.11 illustrates such a
process.
The distinctive feature of activity-based costing is that it recognizes that overhead costs
are caused by activities and that activities may not be caused solely by volume, but by
other types of activities. Cost drivers for the activities should reflect the cost incurrence
in the activity, even if cost is not caused by volume.
Cost hierarchy represents a classification of cost drivers into general levels of activity,
volume, batch, product, etc. Four possible levels of cost hierarchy include
(1) volume-related,
(2) batch-related,
(3) product-related, and
(4) facility-related.
Exhibit 8.12 provides example costs and cost drivers associated with each of the four
levels.
No one activity-based costing system must have four levels in the hierarchy, and some
can have more than four.
[Assign Exercises 8-22, 8-23, 8-24, 8-25, 8-26, 8-27]

LO5 Compute product costs using activity-based costing.


In this section, the reported product costs under activity-based costing are computed in a
comprehensive example.
Step 1: Identify the activities. A cost accountant interviewed the production manager to
determine the major activities used in the manufacturing process.
Step 2: Identify the cost drivers. The cost accountant interviewed production
supervisors, who in turn discussed with line employees, to determine the cost drivers and
the expected volume of each driver. The information is presented in Exhibit 8.13.

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Step 3: Compute the cost driver rates. Once the overhead costs incurred in the facility
were determined, the cost accountant calculated the cost driver rates by dividing
overhead cost by the estimated volume for each activity identified in Step 1. Exhibit 8.14
shows the calculation.
Step 4: Assign costs using activity-based costing. Exhibit 8.15 shows the cost flow
diagram that assigns costs to activity pools in the first stage and allocates activity costs to
products in the second stage. For each product, the direct costs (direct materials and
direct labor) are the same regardless of the costing methods used. The difference is in the
assignment of overhead costs.
There are two ways to calculate unit cost for each product.
(1) The total cost of production for each product is calculated first. Then the total cost is
divided by the number of units produced to arrive at the unit cost. This approach is shown
in Exhibit 8.16.
(2) The cost driver rate per unit of product for each of the cost drivers can be calculated
first, which then is multiplied by the volume of activity consumption per unit of product.
The resulting sum across the cost drivers will also determine the unit cost.
======================

Demonstration Problem 3
(Continued from Demonstration Problems 2 and 3)
The cost accountant of ABC Manufacturing attended a workshop on activity-based costing and
was impressed by the results. After consulting with the production personnel, he prepared the
following information on cost drivers and the estimated volume for each driver.
Activity
Machining
Setup
Machining
Assembly
Assembly
Inspection

Cost driver
Number of setups
Machine hours
Direct labor hours
Number of inspections

Cost driver volume


Ace
Best
Champ
125
75
50
2,500
1,500
2,000
25,000
50

15,000
25

5,000
25

Total
250
6,000
45,000
100

The cost accountant also determined how much overhead costs were incurred in each of the four
activities as follows:

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Activity
Machining
Setup
Machining
Total Machining department overhead
Assembly
Assembly
Inspection
Total Assembly department overhead
Total overhead costs

Overhead costs
$150,000
750,000
$900,000
$360,000
90,000
$450,000
$1,350,000

Required:
1. Determine the cost driver rate for each activity cost pool.
2. Use the activity-based costing method to determine the unit cost for each product.
3. Summarize and comment the results.
Solution:
1.
Activity
Machining
Setup
Machining
Assembly
Assembly
Inspection

Cost drive rate


$600 per setup (= $150,000 / 250 setups)
$125 per machine hour (= $750,000 / 6,000 machine hours)
$8 per direct labor hour (= $360,000 / 45,000 direct labor hours)
$900 per inspection (= $90,000 / 100 inspections)

2.
In the following table, the total costs are divided by the number of units to arrive at the unit
cost for each product.
Direct materials
Direct labor
Applied overhead
Setup ($600 per setup)
Machining ($125 per machine hour)
Assembly ($8 per direct labor hour)
Inspection ($900 per inspection)
Total overhead costs
Total costs
Number of units
Unit cost

Instructors Manual, Chapter 8

Ace
$1,000,000
375,000

Best
$450,000
225,000

Champ
$275,000
75,000

$75,000
312,500
200,000
45,000
$632,500
$2,007,500
25,000
$80.3

$45,000
187,500
120,000
22,500
$375,000
$1,050,000
15,000
$70.0

$30,000
250,000
40,000
22,500
$342,500
$692,500
5,000
$138.5

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Alternatively, the following table shows direct calculation of unit cost for each product based
on consumption of the activities for each unit of the products.
Units produced
Number of setups per unit
Machine hours per unit
Direct labor hours per unit
Number of inspections per unit
Direct materials
Direct labor
Applied overhead
Setup ($600 per setup)
Machining ($125 per machine hour)
Assembly ($8 per direct labor hour)
Inspection ($900 per inspection)
Unit cost

Ace
25,000
0.005
0.1
1
0.002

Best
15,000
0.005
0.1
1
0.00167

Champ
5,000
0.01
0.4
1
0.005

$40.0
15.0

$30.0
15.0

$55.0
15.0

3.0
12.5
8.0
1.8
$80.3

3.0
12.5
8.0
1.5
$70.0

6.0
50.0
8.0
4.5
$138.5

3.
In summary, a comparison of the methods used to calculate unit cost for each product is
presented below.
Plantwide rate based on machine hours
Plantwide rate based on direct labor costs
Department rates
Activity-based costing

Ace
$77.5
85.0
80.0
80.3

Best
$67.5
75.0
70.0
70.0

Champ
$160.0
100.0
140.0
138.5

In this series of demonstration problems, both the plantwide allocation methods distort
product costs while the department allocation method and activity-based costing produce
comparable numbers that portray consumption of resources closer to reality. Since it is less
costly to implement the department allocation method than the activity-based costing
method, the managers of ABC Manufacturing should probably use the department allocation
method to handle overhead costs in the future.
======================
[Assign Exercises 8-24, 8-25, 8-26, 8-27, Problem 8-30, 8-31, 8-32, 8-33, 8-34, 8-35, 8-37, 8-38,
8-39]

LO6 Compare activity-based product costing to traditional department


product costing methods.
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As summarized in Exhibit 8.17, both the plantwide rate and the department rate systems
assumed that overhead was incurred proportionally with the volume of output. The activity-based
costing system recognized that overhead was related to activity use, not necessarily to the
volume of output.
Different cost allocation methods result in different estimates of how much it costs to
make a product.
Activity-based costing provides more detailed measures of costs than do plantwide or
department allocation methods.
Production also benefits because activity-based costing provides better information
about how much each activity costs. It helps identify cost drivers that previously were
unknown.
Activity-based costing provides more information about product costs but requires more
record keeping.
Installing activity-based costing requires teamwork between accounting, production,
marketing, management, and other nonaccounting people.
[Assign Exercises 8-28, 8-29, Problem 8-30, 8-31, 8-32, 8-33, 8-34, 8-35, 8-36, 8-37, 8-38, 8-39]

LO7 Demonstrate the flow of costs through accounts using activity-based


costing.
Exhibit 8.18 shows the flow of costs through accounts using activity-based costing.
Early industries were labor intensive, and much of the overhead cost was related to the support
of labor. At that time, it made sense to allocate overhead to products based on the amount of
labor in the products.
Nowadays, labor is still a major product cost in many companies, especially service
organizations such as consulting, law, and public accounting firms. In those cases,
overhead is often allocated to products (jobs) on the basis of the amount of labor in the
product.
When the labor component drops in the products and overhead cost increases,
companies that continue to allocate overhead to products based on direct labor are
experiencing substantial rate increases. Even small errors in cost allocation can be
magnified many times. It also sends the wrong signal that direct labor is more expensive
than it really is and drives managers to reduce the already slim labor content of products.
The magnitude of the overhead rate based on direct labor is of less concern when all
resources are used proportionally.
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In modern manufacturing settings, proportionality between machine hours and direct


labor hours is much less.
Costs are a function of both volume and complexity.
Low-volume products often require more machine setups for a given level of production
output because they are produced in smaller batches.
Low-volume product adds complexity to the operation by disrupting the production
flow of the high-volume items.
Volume-based allocation methods allocate a high proportion of overhead costs to highvolume products, which subsidize low-volume products and hide the cost effects of
keeping a large number of low-volume products. The result is that high-volume products
tend to be overcosted while low-volume products undercosted.

LO8 Apply activity-based costing to marketing and administrative services.


Activity-based costing can be applied to administrative activities. The principles and methods
are the same as those discussed earlier.
Activity-based costing in administration involves these steps:
(1) Identify the activities that consume resources.
(2) Identify the cost driver associated with each activity.
(3) Compute a cost rate per cost driver for each unit or transaction.
(4) Assign costs to the marketing or administration activity by multiplying the cost driver
rate by the volume of cost driver units consumed for that activity.
Instead of computing the cost of a product, accountants compute the cost of performing
an administrative service.
Time is a common factor (and therefore a cost driver) for an administrative function or a
service industry. Exhibit 8.19 shows other common cost drivers in a typical purchasing
department for various activities performed.
There are three problems with identifying users of ABC.
(1) ABC means different things to different observers.
(2) ABC can be applied in parts of an organization and not everywhere.
(3) While firms may publicly announce the adoption of ABC, they are less likely to announce its
discontinuance.
The adopters of ABC include a wide range of organizations with various sizes.
All organizations are interested in getting better cost information for decision making.
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Chapter Quiz
1.
a.
b.
c.
d.

Death spiral
Happens when managers try to set higher prices to recover increasing reported costs.
Occurs when capacity is reduced.
May happen when the market share is gaining.
Has to do with costs other than overhead.

Answer: a
2.
a.
b.
c.
d.

In a two-stage cost allocation system,


The first stage involves assigning overhead costs to cost pools.
The cost pools may be departments.
Each cost pool requires an allocation rate.
All of the above.

Answer: d
3.

LO1

LO2

One of the cost pools at Toylands Store is Personnel department that provides recruiting
and training for Sales and Administrative departments and has an estimated overhead of
$45,000. Sales department has 12 employees and Administrative department has 3. How
much of the overhead cost of the Personnel department should be allocated to the Sales
department?
a. $9,000.
b. $22,000.
c. $36,000.
d. $38,000.
Answer: c
LO2
$45,000 / (12 + 3) = $3,000 per employees.
$3,000 12 employees at Sales department = $36,000.

The following information is for questions 4 7.


The accountant of Toylands Manufacturing collected the following information:
Activity
Machining Dept.
Setup
Machining
Packaging Dept.
Assembly
Inspection

Overhead costs Cost driver

Instructors Manual, Chapter 8

$200,000 Number of setups


700,000 Machine hours
300,000 Direct labor hours
180,000 Number of inspections

Product X1

Product X2

200
20,000

50
15,000

40,000
120

60,000
60

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4.

If Toylands Manufacturing uses a plantwide rate based on direct labor hours to allocate
overhead costs, how much is product X1s share of overhead?
a. $324,000.
b. $416,000.
c. $638,000.
d. $552,000.
Answer: d
LO2
$200,000 + $700,000 + $300,000 + $180,000 = $1,380,000.
$1,380,000 / (40,000 + 60,000) = $13.8 per direct labor hour.
$13.8 40,000 direct labor hours = $552,000.

5.

If the department allocation method is used, what is the overhead rate for the Machining
department with machine hours as the allocation base?
a. $39.43 per machine hour.
b. $13.71 per machine hour.
c. $20 per machine hour.
d. $25.71 per machine hour.
Answer: d
LO2
$700,000 + $200,000 = $900,000.
$900,000 / (20,000 + 15,000) = $25.71 per machine hour.

6.

When activity-based costing is used, what is product X2s share of the Packaging
department overhead costs?
a. $270,000.
b. $240,000.
c. $580,000.
d. $380,000.
Answer: b
LO4, LO5
$300,000 / (40,000 + 60,000) = $3 per direct labor hour.
$180,000 / (120 + 60) = $1,000 per inspection.
$3 per direct labor 60,000 direct labor hours + $1,000 per inspection 60 inspections =
$240,000.

7.

When activity-based costing is used, how much of the overhead cost is allocated to
product X1?
a. $580,000.
b. $800,000.
c. $950,000.
d. $670,000.
Answer: b
LO4, LO5
$200,000 / (200 + 50) = $800 per setup.
$700,000 / (20,000 + 15,000) = $20 per machine hour.

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$800 per setup 200 setups + $20 per machine hour 20,000 machine hours + $3 per direct
labor hour 40,000 direct labor hours + $1,000 per inspection 120 inspections = $800,000.
8.
a.
b.
c.
d.

Which of the following is true of activity-based costing relative to traditional costing?


Less detailed cost measures.
Accounting department can handle all the work.
More cost pools.
Less costly to implement.

Answer: c
9.
a.
b.
c.
d.

Activity-based costing can be beneficial to


Banks.
Nonprofit organizations.
Law firms
All of the above.

Answer: d
10.
a.
b.
c.
d.

LO6

LO8

Low-volume products, relative to high-volume ones,


Entail less complexity during production.
Often require more machine setups.
Will not disrupt the production flow of high-volume items.
Are usually undercosted.

Answer: b

LO7

Instructors Manual, Chapter 8

The McGraw-Hill Companies, Inc., 2006


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