Chapter 7 Managerial Accounting

What happens when product cost information is distorted?

It leads to poor decisions and unexpected results, as jobs may appear profitable when they’re not, and vice versa.

Why do companies use Activity-Based Costing (ABC)?

Because managers question cost accuracy when profits don’t meet expectations or when bids are lost despite minimal pricing.

Direct materials and labor vs. Manufacturing Overhead

Direct materials/labor are traceable and easy to calculate. Manufacturing overhead (MOH) is less traceable and harder to allocate accurately.

What is a major challenge in product costing today?

Increased manufacturing overhead (up to 40%) makes errors in overhead allocation more impactful.

What is Activity-Based Costing?

A technique that assigns costs to products/customers based on the activities they require.

What is an Activity in ABC?

An event that consumes resources (e.g., setting up machines, processing orders).

What is the ABC Costing Goal?

To allocate costs based on how much of a resource is consumed by each activity required for a product.

Is overhead allocation a problem for all companies?

No — it depends on product similarity, complexity, and facility use.

Signs ABC may help a company

• Complex product bids accepted more than simple ones - High volume jobs show losses - Special processing jobs often accepted - Some departments are at capacity while others are idle.

Does ABC benefit GAAP financials?

No — GAAP uses aggregate product costs. ABC includes selling/admin expenses and is for internal decision-making.

What does ABC costing include that GAAP doesn’t?

Selling and administrative costs — all costs incurred to deliver a product.

What is a downside of ABC?

Time-consuming to analyze activities and allocate costs. Managers must weigh the cost vs. decision-making benefits.

What are the five categories of activity costs in ABC?

1. Unit-level 2. Batch-level 3. Product-level 4. Customer-level 5. Organization-level.

What are unit-level activities?

Incurred for each unit produced. Cost increases with the number of units.

What's a good way to allocate unit-level costs?

Use traditional methods like direct labor hours (DLH) or machine hours (MH).

What are batch-level activities?

Incurred for each group or batch of items produced/handled at once.

What are product-level activities?

Support specific products or processes regardless of volume; e.g., product design, testing.

What are customer-level activities?

Incurred to support specific customers; not based on the number of units or products sold.

Are customer-level costs part of product cost?

No — they support customers, not products.

What are organization-level activities?

Support the company as a whole (e.g., HR, plant maintenance); not based on production volume.

Which activity levels are included in product costs under ABC?

Unit-level, batch-level, and product-level.

What is Step 1 in ABC: Identify Activities?

Ask 'What do you do?' and measure the time/resources each activity uses.

Why is activity identification detail important?

Too much detail increases classification errors; too little reduces accuracy.

What is Step 2 in ABC: Develop Activity Cost Pools?

Group costs by shared drivers/resources. This is the first stage allocation.

What is First Stage Allocation?

Assigning costs to activity cost pools before assigning to cost objects (like products).

What is Step 3 in ABC: Calculate Activity Cost Pool Rates?

Activity Rate = Total Activity Cost Pool / Total Activity Driver Volume.

What is an Activity Rate used for?

To allocate costs based on how much of an activity a product/service uses.

What is Step 4 in ABC: Allocate Costs to Cost Objects?

Multiply the activity rate by the number of cost driver units used by each cost object (product/service).

What are cost objects in ABC?

Products, services, or customers that consume activities and incur costs.

What is Step 5 in ABC: Calculate Unit Product Costs?

Add the allocated activity costs and divide by the number of units produced.

What is the Unit Product Cost Formula (ABC)?

Unit Product Cost = (Direct Materials + Direct Labor + MOH allocated using ABC) ÷ Number of units produced.

ABC vs. Traditional Costing

ABC allocates overhead using multiple cost pools based on activity usage; Traditional uses one or two cost drivers (e.g., DLH or MH) to allocate all overhead.

When is traditional costing okay to use?

When products are similar in volume and complexity, and overhead is low.

What are the benefits of ABC?

More accurate cost allocation, better product pricing, identifies inefficient activities, informs management decisions.

What are the drawbacks of ABC?

Time-consuming to implement, costly to maintain, requires lots of data, may face resistance from staff.

What is Activity-Based Management (ABM)?

Uses ABC info to improve operations and profitability by managing activities and reducing costs.

What is the ABM Strategy Focus?

Eliminate non–value-added activities, improve value-added activities, better allocate resources.

What is a value-added activity?

Adds worth to the product/service; the customer is willing to pay for it.

What are examples of value-added activities?

Assembling a product, providing customer support, delivering products.

What is a non–value-added activity?

Does not enhance the product and can often be eliminated without reducing value.

What are examples of non–value-added activities?

Rework, excess inventory storage, unnecessary movement of materials.

What is the goal of ABM?

Reduce or eliminate non–value-added activities to improve efficiency and lower costs.

Does ABC help with budgeting?

Yes — it helps create more accurate, activity-based budgets by predicting resource needs.

What is Activity-Based Budgeting (ABB)?

Forecasts future costs by estimating activity levels and resources required.

How does ABB differ from traditional budgeting?

ABB focuses on activities and resource drivers, while traditional budgeting focuses on departmental spending.

What are examples of Activity Cost Pools?

Machine Setup, Quality Control, Purchasing, Shipping, Customer Service.

What is an example of Activity Driver for Machine Setup?

Number of setups.

What is an example of Activity Driver for Purchasing?

Number of purchase orders.

What is an example of Activity Driver for Shipping?

Number of shipments or weight of items.

What is an example of Activity Driver for Quality Control?

Number of inspections or testing hours.

When is ABC most useful?

When products vary in complexity, require different resources, and overhead is significant

How many overhead allocations are there in ABC?

Multiple — one per activity cost pool used by the cost object.

Why aren't organization-level costs assigned to products in ABC?

Because they support the entire company and are not tied to any one product.

What happens when switching from traditional costing to ABC?

Overhead shifts from high-volume/simple products to low-volume/complex products, better reflecting resource use.

Impact of non–value-added activities on cost

They increase product costs without adding customer value, reducing profitability.

Why raising the price of an unprofitable product isn’t always smart

Customers may leave if prices rise. Managers must first explore cost reduction or activity efficiency before increasing price.