CHAPTER 5: ACTIVITY-BASED COSTING AND CUSTOMER PROFITABILITY ANALYSIS

Topics: Activity-based costing, Costs, Management accounting Pages: 25 (10662 words) Published: October 26, 2014

CHAPTER 5: ACTIVITY-BASED COSTING AND CUSTOMER PROFITABILITY ANALYSIS QUESTIONS

5-1Undercosting a product may appear to have increased the reported profit the product earned (assuming the firm did not lower its selling price because of the reported lower product cost). However, the increased profit is, at best, a twist in truth. Costs of the product not charged to the product itself are borne by other products of the firm. Worse, undercosting a product may result in managers erroneously believing the product to be more profitable than other products and shifting the limited resource the firm has into manufacturing, promotion, and sales of the product when, in fact, other products are more profitable to the firm. Severe cost distortions may lead firms not to drop unprofitable products because the cost data show these products are profitable. 5-2Overcosting does not increase revenues. A firm can increase the selling price of a product, thereby increasing the total revenue from the product only if the market allows. Increases in the selling price of a product without experiencing noticeable decrease in the sales quantity of the product is likely an indication that the product was not priced properly, which might be a result of undercosting of the product. Furthermore, overcosting a product is likely accompanied by undercosting of the firm’s other products and, as a result, underpricing of one or more of the firm’s other products. When a firm sets a high selling price that is a result of overcosting, competitors also are likely to enter the market and take away the firm’s market share. A firm also may drop or de-emphasize an erroneously overcosted product when it erroneously believes the product is either unprofitable or having a low-margin. 5-3Product costs are likely distorted when a firm uses a volume-based rate if the plant has more than one activity in its operations and not all activities consume overhead in the same proportion. The more diverse the product mixes of the plant are in volume, sizes, manufacturing processes, or product complexities, the greater the cost distortions are likely to be in using a volume-based rate. 5-4Activity-based costing recognizes that resources are spent on activities and the cost of a product or service is the sum of the costs of activities performed in manufacturing the product or providing the service. An activity-based costing system traces costs to the activity that consumes resources. Costs are determined based on the activities performed for cost objects and their underlying cost drivers that consume resources. Product or service costs determined using activity-based costing reflect costs of resources consumed for activities performed in manufacturing products or providing services. In contrast, a volume-based costing system uses cost allocations to channel indirect costs to products or services. As a result, the cost of a product or service often bears little or no relationship to activities performed in the manufacturing of the product or service. 5-5 Based on the activities of most manufacturing firms, the general levels of cost hierarchy of an activity-based costing system are: Unit-level cost;

Batch-level cost;
Product-level cost; and
Facility-level cost.
5-6 In an activity-based costing system, the second-stage procedure in tracing costs to products or services is a process by which the costs of activities or activity pools are assigned to cost objects using one or more appropriate activity consumption cost drivers. 5-7All firms should use an ABC system when the benefits of such a system exceed the costs of implementing it. It is especially beneficial to firms with product diversity and/or process complexity. 5-8Unit-level activities are activities performed on individual units of product or service. The frequency of a unit-level activity varies in proportion with the units of product manufactured or service provided. Examples of unit-level activities are using...
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