Exercise 7-1: ABC Cost Hierarchy

Given:
Classify each of the following activities as either a unit-level, a batch-level, a product-level, or an
organization-sustaining activity. These activities occur at Greenwich Corporation, a company that
manufactures a variety of products.
Unit-level activities:

Activities that are performed each time a unit is produced.

Batch-level activities:

Activities that are performed each time a batch of goods is handled or processed,
regardless of how many units are in the batch. The amount of resource consumed
depends on the number of batches run rather than on the number of units in the
batch.

Product-level activities: Activities that relate to specific products that must be carried out regardless of how
many units are produced and sold or batches run.
Customer-level activities: Activities that are carried out to support customers but that are not related to
any specific product.
Organization-sustaining activities: Activities that are carried out regardless of which customers are served,
which products are produced, how many batches are run, or how many
units are made.
a. Various individuals manage the parts inventory.

Product-level

b. A clerk in the factory issues purchase orders for a job.

Batch-level

c. The personnel department trains new production workers

Organization-sustaining

d. The factory's general manager meets with other department heads such as
marketing to coordinate plans.

Organization-sustaining

e. Direct labor workers assemble products.

Unit-level

f.

Product-level

Engineers design new products.

g. The materials storekeeper issues raw materials to be used in jobs.

Batch-level

h. The maintenance department performs periodic preventive maintenance on

general-use equipment.

Organization-sustaining

r processed,
ource consumed
of units in the

ardless of how

ers are served,

run, or how many

ion-sustaining

ion-sustaining

ion-sustaining

Exercise 7-14: Cost Hierarchy

Given:
Green Glider Corporation makes golf carts that it sells directly to golf courses throughout the world.
Several basic models are available, which are modified to suit the needs of each particular golf course.
A golf course located in the Pacific Northwest, for example, would typically specify that its golf carts
come equipped with retractable rain-proof covers. In addition, each customer (i.e., golf course)
customizes its golf carts with its own color scheme and logo. The company typically makes all of the
golf carts for a customer before starting work on the next customer's golf carts.
Required:
Unit-level activities:

Activities that are performed each time a unit is produced.

Batch-level activities:

Activities that are performed each time a batch of goods is handled or processed,
regardless of how many units are in the batch. The amount of resource consumed
depends on the number of batches run rather than on the number of units in the
batch.

Product-level activities: Activities that relate to specific products that must be carried out regardless of how
many units are produced and sold or batches run.
Customer-level activities: Activities that are carried out to support customers but that are not related to
any specific product.
Organization-sustaining activities: Activities that are carried out regardless of which customers are served,
which products are produced, how many batches are run, or how many units are
made.
Classify each of the costs or activities below as unit-level, batch-level, product-level, customer-level, or
organization-sustaining. In this case, customers are golf courses, products are models of the golf cart,
a batch is a specific order from a customer, and units are individual golf carts.
a. The purchasing department orders the specific color of paint
specified by the customer from the company's supplier.

batch-level

b. A steering wheel is installed in a golf cart.

unit-level

c. An outside attorney draws up a new generic sales contract for the

company limiting Green Glider's liability in case of accidents that
involve its golf carts.

organization-sustaining

d. The company's paint shop makes a stencil for a customer's logo.

batch-level

e. A sales representative visits an old customer to check on how

the company's golf carts are working out and to try to make a
new sale.

customer-level

f.

batch-level

The accounts receivable department prepares the bill for a

? Or

completed order.
g. Electricity is used to heat and light the factory and the
administrative offices.

organization-sustaining

h. A golf cart is painted.

unit-level

i.

The company's engineer modifies the design of a model to

eliminate a potential safety problem.

product-level

j.

The marketing department has a catalogue printed and then mails

copies to golf course managers.

customer-level

k. Completed golf carts are individually tested on the company's

test track.

unit-level

l.

product-level

A new model golf cart is shipped to the leading golfing trade

magazine to be evaluated for the magazine's annual rating of
golf carts.

consumed

olf cart,

Problem 7-11: Comprehensive ABC Problem

Given:

Silicon Optics has supplied the following data for use in its ABC system:

Overhead Costs
Wages & salaries
Other overhead costs
Total overhead costs
Activity Cost Pool
DL support
Order processing
Customer support
Other

Wages & salaries

Other overhead costs

$350,000
200,000
$550,000
Activity Measure (Driver)
Number of DL Hours
Number of orders
Number of customers
These costs are not allocated
to products or customers
These are organization-sustaining activities.

Total Activity
10,000 DLHs
500 Orders
100 Customers

Distribution of Resource Consumption Across Activity Cost Pools

DL
Order
Customer
Support
Processing
Support
Other
Total
30%
35%
25%
10%
100%
25%
15%
20%
40%
100%

During the year, Silicon Optics completed an order for a special optical switch for a new customer, Indus
Telecom. This customer did not order any other products during the year. Data concerning that order
follow:
Data Concerning the Indus Telecom Order
Selling price
$295 per unit
Units ordered
100 units
Direct materials
$264 per unit
Direct labor-hours
0.50 DLH per unit
Direct labor rate
$25 per DLH
Required:
1. Prepare a report showing the first-stage allocations of overhead costs to the activity cost pools.
(See Exhibit 7-5)
DL
Order
Customer
Overhead Costs
Totals
Support
Processing
Support
Other
Wages & salaries
$350,000
$105,000
$122,500
$87,500
$35,000
Other overhead costs
200,000
50,000
30,000
40,000
80,000
Total overhead costs
$550,000
$155,000
$152,500
$127,500
$115,000
2. Compute the activity rates for the activity cost pools.
(See Exhibit 7-6)
DL
Order
Overhead Costs
Totals
Support
Processing
Total overhead costs
$550,000
$155,000
$152,500
Total activity measures
10,000
500

Customer
Support
$127,500
100

Other
$115,000
N/A

Rate per activity cost pool

$15.50
DLHs

$305.00
Orders

$1,275.00
Customers

3. Prepare a report showing the overhead costs for the order from Indus Telecom, including
customer support costs.
Indus Telecom
Cost
Pool
Driver
ABC Costs
Activity Cost Pool
Driver
Rate
Usage
Assigned
DL support
DLHs
$15.50
50
$775.00
Order processing
Orders
$305.00
1
305.00
Customer support
Customers
$1,275.00
1
1,275.00
Total support costs assigned to Indus Telecom
$2,355.00
4. Prepare a report showing the customer margin for Indus Telecom. (See Exhibit 7-11.)
ABC Analysis Customer Margin Report for Indus Telecom
Sales (100 units X $295)
Costs:
Direct Costs Traced
Direct materials ($264 per unit X 100 units)
Direct labor ($25 per DLH X .5 DLH X 100 units)
Indirect Support Costs Allocated Using ABC
DL support
Order processing
Customer support
Total Assigned Costs
Customer Margin

$29,500

$26,400
$1,250
$775
$305
$1,275
$30,005
($505)

Exercise 7A-4 Comprehensive Activity-Based Costing Exercise

1. Prepare a report showing the first-stage allocations of overhead costs to the activity cost pools.
(Same as E7-11)
DL
Order
Customer
Overhead Costs
Totals
Support
Processing
Support
Other
Wages & salaries
$350,000
$105,000
$122,500
$87,500
$35,000
Other overhead costs
200,000
50,000
30,000
40,000
80,000
Total overhead costs
$550,000
$155,000
$152,500
$127,500
$115,000
2. Compute the activity rates for the activity cost pools.
(Same as E7-11, but rates by Overhead costs within pools)
DL
Overhead Costs
Totals
Support
Wages & salaries
$350,000
$105,000
Other overhead costs
200,000
50,000
Total overhead costs
$550,000
$155,000

Pool
Order
Rate
Processing
$10.50
$122,500
$5.00
30,000
$15.50
$152,500
DLHs

Pool
Customer
Rate
Support
$245
$87,500
$60
40,000
$305 $127,500
Orders

3. Prepare a report showing the overhead costs for the order from Ides Telecom including customer support.
DL
Order
Customer
Total
Activity
Support
Processing
Support
Support

Expected measure of cost driver

Wages & Salaries
Other Overhead Costs
Total Costs

50

1
$525
$250
$775

1
$245
$60
$305

$875
$400
$1,275

$1,645
$710
$2,355

4. Prepare a report showing the customer margin for Indus Telecom

ABC Analysis Customer Margin Report for Indus Telecom
Sales (100 units X $295)
Costs:
Direct Costs Traced
Direct materials ($264 per unit X 100 units)
Direct labor ($25 per DLH X .5 DLH X 100 units)
Indirect Support Costs Allocated Using ABC
DL support
Order processing
Customer support
Total Assigned Costs
Customer Margin

$29,500

$26,400
$1,250
$775
$305
$1,275
$30,005
($505)

5. Prepare an action analysis report showing the customer margin for Indus Telecom. Direct materials should
be coded as a Green cost, direct labor and wages and salaries as Yellow costs, and other overhead costs as
Red costs.
Definition of an Action analysis report:

A report showing what costs have been assigned to a cost object, such as a
product or customer, and how difficult it would be to adjust the cost if there is
a change in activity.

Ease of Adjustment Codes:

"Green" costs are those costs that would adjust more or less automatically
to changes in activity without any action by managers.
"Yellow" costs are those costs that could be adjusted in response to changes
in activity, but such adjustments require management action; the adjustment
is not automatic.
"Red" costs are costs that could be adjusted to changes in activity only with
a great deal of difficulty and the adjustment would require management action

ABC Analysis Customer Margin Report for Indus Telecom

Sales (100 units X $295)
Costs:
Green costs:
Direct materials ($264 per unit X 100 units)
Green margin:
Yellow costs:
Direct labor ($25 per DLH X .5 DLH X 100 units)
Overhead: Wages and Salaries
Yellow margins:

$29,500

26,400
$3,100
$1,250
1,645

2,895
$205

Q6 No Indus Telcom Bu
0

0
0

Red costs:
Other overhead costs
Red margins:

710
($505)

Fixed

(710)
($710)
$205

6. What action, if any, do you recommend as a result of the above analysis?

While the company appears to have incurred a loss on its business with Indus Telecom, caution must be exercised.
The Green margin on the business was $3,100. Silicon Optics really incurred a loss on this business only if at least
$3,100 of the yellow and red costs ($2,895 + $710 = $3,605) would have been avoided if the Indus Telecom order
had been rejected.
For example, we don't know what specific costs are included in the "other overhead" category. If these costs are
committed fixed costs that cannot be avoided in the short run, then the company would have been worse off if the
Indus Telecom order had not been accepted.
Suppose that Indus Telecom will be submitting a similar order every year. As a general policy, the company might
consider turning down this business in the future. Costs that cannot be avoided in the short run, may be avoided in
the long run through the budgeting process or in some other manner. However, if the Indus Telecom business is
turned down, management must make sure that at least $3,100 of the yellow and red costs are really eliminated or the
resources represented by those costs are really redeployed to the constraint. If these costs remain unchanged, then
the company would be better off accepting rather than rejecting business from the Indus Telecom in the future.

Pool
Rate
$875
$400
$1,275
Customers

Other
$35,000
80,000
$115,000

Pool
Rate
N/A
N/A
N/A

ect, such as a
cost if there is

utomatically

se to changes
e adjustment

vity only with

agement action.

Indus Telcom Bus.

($29,500) Given-up

26,400 Saved

$1,250 Saved
1,645 Saved

$2,895
Less than $3,100 of

CM given up
0
($205) Net Decrease
Adv. of IT business

off if the

ted or the
ed, then

Exercise 7B-1:

Activity-Based Costing Product Costs for External Reports

Given:
Pryad Corporation makes ultra-lightweight backpacking tents. Data concerning the company's two
product lines appear below:
Deluxe
Standard
DM per unit
$60.00
$45.00
DL per unit
$9.60
$7.20
DL-hours per unit
0.80
0.60
Estimated annual production
10,000
70,000
The company has a traditional costing system in which MOH is applied to units based on DL-hours.
Data concerning MOH and DL-hours for the upcoming year appear below:
Estimated total MOH
Estimated total DL-Hours

$290,000
50,000

$5.80 per DLH

Required:
1. Determine the unit product costs of Deluxe and Standard products under the company's
traditional costing system
Deluxe
Standard
Direct Materials
$60.00
$45.00
Direct Labor
$9.60
$7.20
Applied MOH
Predetermined MOH
$5.80
DL-hours per unit
0.80
$4.64
Predetermined MOH
DL-hours per unit
Traditional Unit Cost

$5.80
0.60
$74.24

$3.48
$55.68

2. The company is considering replacing its traditional costing system for determining unit
product costs for external reports with an ABC system. The ABC system would have the
following three activity cost pools:
Estimated
Cost per
Overhead
Expected Activity
Activities
Driver
Driver
Costs
Deluxe
Standard
Supporting DL
DLHs
$3
$150,000
8,000
42,000
Batch setups
Setups
$240
60,000
200
50
Safety testing
Tests
$800
80,000
80
20
Total MOH Costs
$290,000
Determine the unit product costs of the Deluxe and Standard products under the ABC
system.
Units

Direct Materials
Direct Labor

10,000
Deluxe
$60.00
9.60

Total Direct Costs per Unit

Applied MOH
Driver
Cost/Driver
Supporting DL
DLHs
$3
Batch setups
Setups
$240
Safety testing
Tests
$800
Total MOH
Total Indirect Costs per Unit
Total Unit Product Costs -- ABC System

$69.60
Assigned MOH Costs
Deluxe
Standard
Total
$24,000
$126,000
$150,000
48,000
12,000
60,000
64,000
16,000
80,000
$136,000
$154,000
$290,000

$2.40
4.80
6.40
$13.60
$83.20

cted Activity
Total
50,000
250
100

Units
70,000
Standard
$45.00
7.20

$52.20

$1.80
0.17
0.23
$2.20
$54.40

Problem 7B-4:

ABC as an Alternative to Traditional Product Costing

Given:
Erte, Inc., manufactures two models of high-pressure steam valves, the XR7 model and the ZD5
model. Data regarding the two products follow:

Product
XR7
ZD5

DLHs
Annual
Per Unit Production
0.2
20,000
0.4
40,000

Total
DLHs
4,000
16,000

Additional information about the company follows:

a. Product XR7 requires $35 in direct materials per unit, and product ZD5 requires $25
b. The direct labor rate is $20 per hour
c. The company has always used DLHs as the base for applying MOH costs to products. MOH
costs totals $1,480,000 per year.
d. Product XR7 is more complex to manufacture than product ZD5 and requires the use of a
special milling machine.
e. Because of the special work required in (d) above, the company is considering the use of
ABC to apply overhead cost to products. Three activity cost pools have been identified and
the first-stage allocations have been completed. Data concerning these activity cost pools
appear below:
Estimated
Cost per
MOH
Expected Total Activity
Activity Pool
Driver
Driver
Costs
XR7
ZD5
Total
$720
$180,000
150
100
250
Mach. Setups
Setups
$300
300,000
1,000
0
1,000
Special Milling
MHRs
$50
1,000,000
4,000
16,000
20,000
General Factory
DLHs
$1,480,000
Total MOH Costs

DM per unit
DL per unit
DL-hours per unit
Total direct labor hours
Estimated annual production

XR7
$35.00
$4.00
0.20
4,000
20,000

ZD5
$25.00
$8.00
0.40
16,000
40,000

Required:
1. Assume that the company continues to use DLHs as the base for applying overhead cost to
products.
a. Compute the predetermined overhead rate.
Estimated total MOH Costs / Total DLHs = ($1,480,000 / (4,000 + 16,000) =
b. Determine the unit product cost of each product.

Direct Materials
Direct Labor
Applied MOH

XR7
$35.00
4.00

ZD5
$25.00
8.00

$74.00

Predetermined MOH
DL-hours per unit

$74.00
0.20

Predetermined MOH
DL-hours per unit
Traditional Unit Cost

$74.00
0.40

14.80

$53.80

29.60
$62.60

2. Assume that the company decides to use ABC to apply overhead costs to products.
a. Compute the activity rate for each activity cost pool. Also compute the amount of
overhead cost that would be applied to each product. (See 2.b. below)

Activity Pool

Driver

Mach. Setups
Special Milling

Setups
MHRs

General Factory
Total MOH Costs

DLHs

Cost per
Driver
$720
$300
$50

Estimated
MOH
Costs
$180,000
300,000
1,000,000
$1,480,000

Expected Total Activity

XR7
ZD5
150
100
1,000
0
4,000
16,000

b. Determine the unit product cost of each product.

Units
20,000
XR7
$35.00
4.00
$39.00

Direct Materials
Direct Labor
Total Direct Costs per Unit
Applied MOH

Driver

Mach. Setups
Special Milling
General Factory
Total MOH Costs

Setups
MHRs
DLHs

Cost/Driver
$720
$300
$50

Assigned MOH Costs

XR7
ZD5
Total
$108,000
$72,000
$180,000
300,000
0
300,000
200,000
800,000
1,000,000
$608,000
$872,000 $1,480,000

Total Indirect Costs per Unit

ABC System Unit Cost
Traditional Unit Cost

$5.40
15.00
10.00
$30.40
$69.40
$53.80

3. Explain why overhead cost shifted from the high-volume product to the low-volume product
under ABC.
Note that even under the ABC system 68% of the company's overhead costs continue to be applied to
products on the basis of DLHs. ($1,000,000/$1,480,000)
68%
Thus, the shift in overhead cost from the high-volume product ZD5 to the low-volume product XR7
occurred as a result of reassigning only 32% of the company's overhead costs.
The increase in unit product cost for XR7 can be explained as follows:
1. Special milling costs, which are traceable to XR7, have all been assigned to XR7.

XR7
$300,000
20,000
$15.00

Allocated Special Milling costs (traced)

Production volume
Special milling costs per unit

ZD5
$0
40,000
$0.00

2. Machine setup costs per unit differ significantly by product

XR7
Allocated setup costs
$108,000
Production volume
20,000
Setup cost per unit
$5.40

ZD5
$72,000
40,000
$1.80

XR7
$720
20,000
150
133.33
$5.40

ZD5
$720
40,000
100
400
$1.80

Setup costs per batch

Production volume
Number of setups
Batch size
Setup cost per unit
3. Consumption ratios differ by pool

Traditional
Overhead Costs

Driver
DLHs

XR7
4,000

Consumption
Ratio

20%

ZD5
16,000

Consumption
Ratio

80%

Overhead cost are allocated 20% to XR7 and 80% to ZD5 under the traditional costing system.

Activity-Based
Mach. Setups
Special Milling
General Factory

Driver
Setups
MHRs
DLHs

XR7
150
1,000
4,000

Consumption
Ratio

60%
100%
20%

Overhead costs are allocated as follows:

1. Setup costs -- 60% to XR7 and 40% to ZD5
2. Milling costs -- 100% to XR7 and 0% to ZD5
3. General Factory costs -- 20% to XR7 and 80% to ZD5

Modified Traditional Unit Cost

Traceable Costs
Direct Materials
Direct Labor
Special Milling
$300,000
Non-traceable Costs
Applied MOH
Predetermined MOH
$59.00
DL-hours per unit
0.20

20,000
XR7
$35.00
4.00
15.00

11.80

40,000
ZD5
$25.00
8.00

ZD5
100
0
16,000

Consumption
Ratio

40%
0%
80%

Predetermined MOH
DL-hours per unit
Total Unit Cost

$59.00
0.40

Traditional Unit Cost

Modified Traditional Unit Cost
ABC System Unit Cost

$65.80

23.60
$56.60

$53.80
$65.80
$69.40

$62.60
$56.60
$54.80

per DLH

ed Total Activity
Total
250
1,000
20,000

Units
40,000
ZD5
$25.00
8.00
$33.00

$1.80
0.00
20.00
$21.80
$54.80
$62.60

be applied to

me product XR7

Total
20,000

Total
250
1,000
20,000