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Chapter 5: Problem 7

What are the key reasons for product cost differences between simple costing systems and ABC systems?

Short Answer

Expert verified
The key reasons for product cost differences between simple costing systems and ABC systems are the accuracy of cost allocation, complexity and diversity of products, overhead costs, and economies of scale. Simple costing systems allocate costs based on volume measures, which can sometimes lead to inaccurate cost allocation, especially for diverse products or when overhead costs are significant. ABC systems, on the other hand, allocate costs based on activities performed for each product, providing a more accurate and detailed representation of production costs.

Step by step solution

01

Define Simple Costing Systems

Simple costing systems, often referred to as traditional costing systems, allocate costs to products directly based on volume measures like labor hours or machine hours. These systems assume that volume is the main cause of overhead costs. They do not differentiate activities or functions in the production process that might cause overhead costs to vary.
02

Define Activity Based Costing Systems

Activity Based Costing (ABC) systems allocate costs to products based on the activities involved in the production process. It breaks down indirect costs into activities and assigns cost to each activity based on resources consumed. The costs of these activities are then assigned to products based on their usage of these activities.
03

Reasons for Differences in Cost Calculation

The following reasons can cause product cost differences between simple costing systems and ABC systems: 1. Accuracy of Cost Allocation: ABC systems tend to be more accurate as they take into account more detailed information about the activities involved in the production process. Simple costing systems may over-allocate costs to high-volume products and under-allocate costs to low-volume products as they use a single, volume-based cost driver. 2. Complexity and Diversity of Products: In an organization with diverse products requiring different levels and types of activities, ABC displays a more precise cost than simple costing. Simple costing might not be able to account for the intricate relationships between various production activities. 3. Overhead Costs: ABC recognizes the fact that many overhead costs are not driven by volume. If overhead constitutes a significant proportion of total cost, the two systems will likely produce notably different product costs. 4. Economies of Scale: In the case of economies of scale, ABC systems provide a more accurate picture, as with increasing production volume, less base cost is allocated per product, leading to a change in cost per product, which might not be reflected in simple costing systems.
04

Concluding Remarks

In conclusion, the key reasons for differences in product costs between simple and ABC systems lie in the level of detail and accuracy in allocating overhead costs based on activities performed for each product. ABC systems are designed to more accurately reflect the complexity of production activities, especially when these activities do not correlate purely with volume. Hence, ABC often leads to different, and generally more precise, product cost calculations than simple costing systems.

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Key Concepts

These are the key concepts you need to understand to accurately answer the question.

Simple Costing Systems
Simple costing systems, also known as traditional costing systems, streamline the cost allocation process by using a broad-brush approach. These systems typically allocate costs based on straightforward, easily measurable quantities like direct labor hours or machine hours. While this method is less time-consuming and more straightforward to implement, it rests on the assumption that these volume-based measures are the core drivers of overhead costs. However, this simplification can often lead to inaccuracies, particularly in diverse or complex production environments, where activities might not be proportionate to volume.

For instance, consider a factory that both assembles simple gadgets and manufactures precision instruments. While the assembly of gadgets might correlate well with labor hours, the production of precision instruments could be more intensive in other activities such as design or quality control, which aren't captured by labor hours alone.
Activity-Based Costing
Activity-Based Costing (ABC) addresses the core limitation of simple costing systems by providing a more nuanced view of cost allocation. ABC systems split indirect costs 鈥� costs that are not directly tied to the production of any one product 鈥� into individual activities such as designing, machining, and quality testing. The cost of each activity is calculated based on the resources it consumes, which in turn are allocated to products according to their actual usage of each activity.

By doing so, ABC better captures the complexities of modern manufacturing processes, where costs may be driven by factors beyond mere volume. For example, if a product requires extensive design work, ABC would allocate more design-related overhead to it, in contrast to a simple system that might only consider machine hours, thus misrepresenting the true cost.
Cost Allocation Accuracy
The accuracy of cost allocation is essential in providing meaningful financial information that can guide management decisions. Simple costing systems can inadvertently skew the perception of a product's profitability by overallocating costs to high-volume products and underallocating to low-volume, more complex products. Potential inaccuracies in cost allocation with simple methods stem from the broad generalizations they make about cost drivers.

In contrast, ABC enhances accuracy by looking at the micro-level of different activities, accounting for the unique ways products consume resources. For businesses with diverse product lines or those that engage in complex and varied production activities, ABC's more refined cost allocation leads to more precise product costing, better highlighting the cost-benefit dynamics of each product.
Overhead Costs
Overhead costs pose a challenge for cost accountants due to their indirect nature. They can range from factory rent to the salaries of management, and adequately allocating such costs to products requires a methodical approach. Simple costing systems might allocate overhead based on a single factor, usually a measure of volume, which could ignore other factors that contribute to overhead.

On the other hand, ABC systems acknowledge that overhead costs can result from various activities unrelated to volume. Consequently, ABC is especially beneficial when overhead makes up a substantial portion of total costs. By associating overhead more directly with the activities that incur them, ABC systems enable a deeper understanding of where and why costs are generated, leading to more informed pricing and investment decisions.

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Most popular questions from this chapter

(CMA, adapted) Plum Electronics, a division of Berry Corporation, manufactures two large-screen television models: the Mammoth, which has been produced since 2013 and sells for \(\$ 990\), and the Maximum, a newer model introduced in early 2015 that sells for \(\$ 1,254 .\) Based on the following income statement for the year ended November \(30,2017,\) senior management at Berry have decided to concentrate Plum's marketing resources on the Maximum model and to begin to phase out the Mammoth model because Maximum generates a much bigger operating income per unit. Details for cost of goods sold for Mammoth and Maximum are as follows: Plum's controller, Steve Jacobs, is advocating the use of activity-based costing and activity-based management and has gathered the following information about the company's manufacturing overhead costs for the year ended November 30,2017 After completing his analysis, Jacobs shows the results to Charles Clark, the Plum division president. Clark does not like what he sees. "If you show headquarters this analysis, they are going to ask us to phase out the Maximum line, which we have just introduced. This whole costing stuff has been a major problem for us. First Mammoth was not profitable and now Maximum. "Looking at the ABC analysis, I see two problems. First, we do many more activities than the ones you have listed. If you had included all activities, maybe your conclusions would be different. Second, you used number of setups and number of inspections as allocation bases. The numbers would be different had you used setup-hours and inspection-hours instead. I know that measurement problems precluded you from using these other cost-allocation bases, but I believe you ought to make some adjustments to our current numbers to compensate for these issues. I know you can do better. We can't afford to phase out either product." Jacobs knows that his numbers are fairly accurate. As a quick check, he calculates the profitability of Maximum and Mammoth using more and different allocation bases. The set of activities and activity rates he had used results in numbers that closely approximate those based on more detailed analyses. He is confident that headquarters, knowing that Maximum was introduced only recently, will not ask Plum to phase it out. He is also aware that a sizable portion of Clark's bonus is based on division revenues. Phasing out either product would adversely affect his bonus. Still, he feels some pressure from Clark to do something. 1\. Using activity-based costing, calculate the gross margin per unit of the Maximum and Mammoth models. 2\. Explain briefly why these numbers differ from the gross margin per unit of the Maximum and Mammoth models calculated using Plum's existing simple costing system. 3\. Comment on Clark's concerns about the accuracy and limitations of ABC. 4\. How might Plum find the ABC information helpful in managing its business? 5\. What should Steve Jacobs do in response to Clark's comments?

The job-costing system at Melody's Custom Framing has five indirect cost pools (purchasing, material handling, machine maintenance, product inspection, and packaging) The company is in the process of bidding on two jobs: Job \(220,\) an order of 17 intricate personalized frames, and Job 330 , an order of 5 standard personalized frames. The controller wants you to compare overhead allocated under the current simple job-costing system and a newly designed activity-based job-costing system. Total budgeted costs in each indirect-cost pool and the budgeted quantity of activity driver are as follows. Information related to Job 220 and Job 330 follows. Job 220 incurs more batch- level costs because it uses more types of materials that need to be purchased, moved, and inspected relative to Job 330 . 1\. Compute the total overhead allocated to each job under a simple costing system, where overhead is allocated based on machine-hours. 2\. Compute the total overhead allocated to each job under an activity-based costing system using the appropriate activity drivers. 3\. Explain why Melody's Custom Framing might favor the ABC job-costing system over the simple jobcosting system, especially in its bidding process.

Fitzgerald Supermarkets (FS) operates at capacity and decides to apply \(A B C\) analysis to three product lines: baked goods, milk and fruit juice, and frozen foods. It identifies four activities and their activity cost rates as follows: The revenues, cost of goods sold, store support costs, activities that account for the store support costs, and activity-area usage of the three product lines are as follows: Under its simple costing system, FS allocated support costs to products at the rate of \(30 \%\) of cost of goods sold. 1\. Use the simple costing system to prepare a product-line profitability report for FS. 2\. Use the ABC system to prepare a product-line profitability report for FS. 3\. What new insights does the ABC system in requirement 2 provide to FS managers?

Marshall Devices manufactures metal products and uses activity-based costing to allocate overhead costs to customer orders for pricing purposes. Many customer orders are won through competitive bidding based on costs. Direct material and direct manufacturing labor costs are traced directly to each order. Marshall's direct manufacturing labor rate is \(\$ 20\) per hour. The company reports the following budgeted yearly overhead costs: Marshall has established four activity cost pools and the following budgeted activity for each cost pool: Some customer orders require more complex designs, while others need simple designs. Marshall estimates that it will do 120 complex designs during a year, which will each take 11.75 hours for a total of 1,410 design-hours. It estimates it will do 180 simple designs, which will each take 6 hours for a total of 1,080 design-hours. Paul Napoli, Marshall's controller, has prepared the following estimates for distribution of the overhead costs across the four activity-cost pools: Order 277100 consists of four different metal products. Three products require a complex design and one requires a simple design. Order 277100 requires \(\$ 4,550\) of direct materials and 80 direct manufacturing labor-hours. 1\. Allocate the overhead costs to each activity cost pool. Calculate the activity rate for each pool. 2\. Determine the cost of Order 277100 . 3\. How does activity-based costing enhance Marshall's ability to price its orders? Suppose Marshall used a simple costing system to allocate all overhead costs to orders on the basis of direct manufacturing labor-hours. How might this have affected Marshall's pricing decision for Order \(227100 ?\) 4\. When designing its activity-based costing system, Marshall uses time- driven activity-based costing system (TDABC) for its design department. What does this approach allow Marshall to do? How would the cost of Order 277100 have been different if Marshall had used the number of customer designs rather than the number of custom design-hours to allocate costs to different customer orders? Which cost driver do you prefer for design support? Why?

Pharmahelp, Inc., a distributor of special pharmaceutical products, operates at capacity and has three main market segments: a. General supermarket chains b. Drugstore chains c. Mom-and-pop single-store pharmacies Rick Flair, the new controller of Pharmahelp, reported the following data for 2017 . For manyyears, Pharmahelp has used gross margin percentage [(Revenue - cost of goods sold) \div Revenue] to evaluate the relative profitability of its market segments. But Flair recently attended a seminar on activity-based costing and is considering using it at Pharmahelp to analyze and allocate "other operating costs." He meets with all the key managers and several of his operations and sales staff, and they agree that there are five key activities that drive other operating costs at Pharmahelp: Each customer order consists of one or more line items. A line item represents a single product (such as Extra-Strength Tylenol Tablets). Each product line item is delivered in one or more separate cartons. Each store delivery entails the delivery of one or more cartons of products to a customer. Pharmahelp's staff stacks cartons directly onto display shelves in customers' stores. Currently, there is no additional charge to the customer for shelf-stocking and not all customers use Pharmahelp for this activity. The level of each activity in the three market segments and the total cost incurred for each activity in 2017 is as follows: 1\. Compute the 2017 gross-margin percentage for each of Pharmahelp's three market segments. 2\. Compute the cost driver rates for each of the five activity areas. 3\. Use the activity-based costing information to allocate the \(\$ 301,080\) of "other operating costs" to each of the market segments. Compute the operating income for each market segment. 4\. Comment on the results. What new insights are available with the activity- based costing information?
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