Question

Why is direct labor a poor base for allocating overhead in many companies? Why ing to implement What are unit-level, batch-level, product-level, customer-level, and organization-sustaining activities? 7-2 7-3 top management support and cross-functional involvement crucial when attempt- are activity-based costing system? an 7-4 What types of costs should not be assigned to products in an activity-based costing system? are there two stages of allocation in activity-based costing? 7-5 Why Why is the first stage of the allocation process in activity-based costing often based on interviews? When activity-based costing is used, why do manufacturing overhead costs often shift from high-volume products to low-volume products? How can the activity rates (i.e., cost per activity) for the various activities be used to target process improvements? Why is the activity-based costing described in this chapter unacceptable for external finan- cial reports? 7-6 7-7 7-8 7-9 7-10

Answer 1

7-2) With advancement of technology, many tasks that were previously done by direct labors are now being performed by machineries and automated equipments and tools which does not require labor involvement and are components of overhead.The management of new products and services require more overhead resources like production designers and production schedulers which has no connections with direct labor hours or machine hours.As a result, the unit product costs will be distorted and therefore will mislead us if used for the purposes of decision making.This is why direct labor is a poor base for allocating overhead in many companies.

7-3) Top management support is crucial  when attempting to implement an ABC system. If there is no leadership from top management some managers may be reluctant to change and if the top managers do not support the implementation of ABC system and continue with the old ways, their subordinates will quickly get the message that ABC is not important and they will abandon the initiative of implementation of ABC. Time and time again, when accountants have attempted to implement an ABC system on their own without top-management support and active cooperation from other managers, the results have been ignored.Hence, we can say that the success of ABC system depends on the top management support

Cross-functional involvement is crucial when attempting to implement an ABC system because the design and implementation of the ABC system is the responsibility of the cross-functional team.Moreover, there will not be any resistance from others if the cross functional teams are involved in implementation of ABC system.

7-4) Unit-level activities: Unit-level activity is an activity performed on each individual product or service. In other words, the unit level activities refer to the activities performed on every unit of product. These activities are performed on every product and thus directly proportional to the number of the units produced.At this level, the cost drivers are volume based.

Batch-level activities: The activities which are performed on every batch are termed as batch-level activities.In other words,batch-level activities  are related to costs incurred every time a batch is produced, regardless of how big the production run is. Batch-level cost drivers include machine setups, maintenance, purchase orders and quality tests.

Product-level activities: The product-level activities are related to a specific product only.These activities include all the activities which are concerned with making and designing of a product irrespective of batch and number of units produced.In other words, product-level activity. is an activity performed to support production of a specific product or service regardless of how many batches are run or how many items are produced.

Customer-level activities- Customer-level activities refer to activities that relate to a specific customer and include activities    that are not tied to any specific product. For example- sales calls, etc

Organization-sustaining activities: Organization-sustaining activities refers to the actions taken to maintain the operations of a business. These activities include activities such as cost of an audit, filing information with government agencies ,arranging for loans, preparing annual reports to shareholders,etc.Organization-sustaining activities are not specifically associated with a specific product or customer.

7-5) The types of costs that should not be assigned to products in an activity-based costing system are as follows-

• Organization- sustaining costs
• Cost of idle capacity
• Customer-level costs

As per ABC, all these costs are period expenses rather than product costs.

7-6) There are two stages of allocation in activity-based costing because as per ABC the costs must be first allocated to activity cost pools and then they are allocated from the activity cost pools to products, customers, and other cost objects.

7-7) The first stage of the allocation process in activity-based costing often based on interviews because the process of identifying the major activities of the organization consumes a lot of time and is costly and cumbersome process. Thus, the entity conducts interviews in order to identify the major cost objects to which the costs can be allocated as interview consumes less time and is less expensive.

7-8 )When activity-based costing is used, manufacturing overhead costs shift from high-volume products to low-volume products because in an activity-based costing system, batch-level and product-level costs are assigned more appropriately. This results in shifting product-level costs back to the products that causes the manufacturing overhead costs shift away from the high-volume products to low-volume products.However,  in traditional cost systems, product-level costs are spread across all products using direct labor-hours or some other allocation base related to volume. As a consequence, high-volume products are assigned the bulk of such costs.

7-9) Activity rates help the managers to know about the average cost of resources consumed in carrying out a particular activity. An activity consuming a high average cost can be a good item for process improvements.The process of Benchmarking can be used to identify those activities having abnormally large costs.Through benchmarking process the managers get to know whether any other organization is able to carry out the same activity at a significantly lower cost and if it is so then it can be supposed that improvement is possible.

7-10) The activity-based costing described in this chapter unacceptable for external financial reports because of the following reasons:

• In the activity-based costing the product costs exclude some manufacturing costs and include some non manufacturing costs.
• There can be manipulations by the management in the activity-based costing system and that is why the auditors are not comfortable with ABC system.
• The activity-based costing does not comply with the Generally Accepted Accounting Principles (GAAP).  
• The external reports are less detailed than internal reports which are prepared for decision making.
• The first stage allocations in ABC system is based on interviews rather than being based on verifiable and objective data.