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1.

Unit-level activities are activities performed each and every time a unit of a
product is produced. The five most commonly used unit-level drivers are:

Units produced
Direct labor hours
Direct labor dollars
Machine hours

Direct material dollars

Unit-level drivers increase as units produced increase. Thus, the use of only
unit-based drivers to assign OH to products assumes that all overhead
consumed by products is highly correlated with the number of units produced.
To the extent that this assumption is true, functional-based costing can produce
accurate cost assignments.
2. Of course, to cause a significant cost distortion, overhead costs must be a
significant percentage of total manufacturing costs. For some manufacturers,
overhead costs are a small percentage (e.g., 5 percent or less), and the system
in which these costs are assigned is not a major issue.
3. However, that the OH costs are a significant percentage of total manufacturing
costs, at least two major factors can impair the ability of the unit-based
plantwide and departmental rates to assign overhead costs accurately: (1) the
proportion of non-unit-related overhead costs to total overhead costs is large,
and (2) the degree of product diversity is great.
4. The use of either plantwide rates or departmental rates assumes that a
products consumption of overhead resources is related strictly to the units
produced. But what if there are overhead activities that are unrelated to the
number of units produced? Setup costs, for example, are incurred each time a
batch of products is produced. A batch may consist of 1,000 or 10,000 units,
and the cost of setup is the same. Yet, as more setups are done, setup costs
increase. The number of setups, not the number of units produced, is the cause
of setup costs.
Furthermore, product engineering costs may depend on the number of different
engineering work orders rather than the units produced of any given product.

5. Thus, unit-level drivers cannot assign these costs accurately to products. In fact,
using only unit-level drivers to assign non-unit-related overhead costs can
create distorted product costs. The severity of this distortion depends on what
proportion of total overhead costs these non-unit-based costs represent.
6. For example, each products demands for the setup and material-moving
activities are more logically related to the number of production runs and the
number of moves, respectively. These non-unit activities represent 50 percent
($360,000/$720,000) of the total overhead costsa significant percentage.
Notice that the low-volume product, scented cards, uses one and one-half times
as many runs as do the regular cards (60/40) and one and one-half as many
moves (180/120). However, use of direct labor hours, a unit-based activity
driver, and a plantwide rate assigns eight times more setup and materials
handling costs to the regular cards than to the scented. Thus, we have product
diversity, and we should expect product cost distortion because the quantity of
unit-based overhead that each product consumes does not vary in direct
proportion to the quantity consumed of non-unit-based overhead.
7. The activity-based cost assignment duplicates the pattern of overhead
consumption and is therefore the most accurate of the three costs shown in
Exhibit 4-7. Functional-based costing undercosts the scented cards and
overcosts the regular cards. In fact, the ABC assignment increases the cost of
the scented cards by at least $8.80 per box and decreases the cost of the
regular cards by at least $0.88.
Thus, in the presence of significant non-unit overhead costs and product
diversity, using only unit-based activity drivers can lead to one product
subsidizing another (as the regular cards are subsidizing the scented cards).
This subsidy could create the appearance that one group of products is highly
profitable and can adversely impact the pricing and competitiveness of another
group of products. In a highly competitive environment, the more accurate the
cost information, the better the planning and decision making.
8. ABC Users.
First, multiple products are needed. ABC offers no increase in product costing

accuracy for a single-product setting.


Second, there must be product diversity. If products consume non-unit-level
activities

in

the same proportion as

unit-level

activities, then

assignments will be the same as functional-based assignments.

ABC

Third, non-unit-level overhead must be a significant percentage of production

cost. If it is not, then it hardly matters how it is assigned.


Thus, firms that have plants with multiple products, high product diversity, and
significant non-unit-level overhead are candidates for an ABC system.
9.