CHAPTER 5: ACTIVITY BASED COSTING

Practice Questions

PART I – Case Scenario based MCQs (30 Marks)

Case Scenario 1: Sigma Manufacturing Co.

Sigma Manufacturing Co. produces two types of high-precision components, Alpha and
Beta, for the aerospace industry. The company has traditionally used a single
overhead absorption rate based on direct labour hours. However, in recent years,
despite increasing sales, the profitability of product Alpha has been declining,
while Beta's profitability has been unexpectedly high. The management suspects that
their traditional costing system might be distorting product costs due to
increasing automation and product diversity. They are considering implementing an
Activity Based Costing (ABC) system.

The following data pertains to the last quarter:

Budgeted Information:
* Total Production Overheads: ₹ 12,00,000
* Total Direct Labour Hours: 40,000 hours

Production and Resource Consumption for the Quarter:

| Product | Units Produced | Direct Material Cost per Unit (₹) | Direct Labour
Hours per Unit |
| :------ | :------------- | :--------------------------------
| :---------------------------- |
| Alpha | 5,000 | 200 | 3
|
| Beta | 10,000 | 150 | 2
|

Analysis of Production Overheads for ABC implementation:

After a detailed analysis, the total production overheads of ₹ 12,00,000 were
identified with the following activities and their cost drivers:

| Activity Pool | Total Cost (₹) | Cost Driver | Activity

Volume (Total) |
| :-------------------- | :------------- | :-----------------------
| :---------------------- |
| Material Handling | 3,60,000 | Number of Material Moves | 1,200 moves
|
| Machine Set-up | 2,40,000 | Number of Set-ups | 800 set-ups
|
| Quality Inspection | 4,00,000 | Number of Inspections | 500
inspections |
| Assembly Support | 2,00,000 | Number of Assembled Units| 15,000 units
|

Activity Consumption per Product:

| Activity / Product | Alpha | Beta |

| :----------------- | :-------------- | :-------------- |
| Material Moves | 500 moves | 700 moves |
| Set-ups | 300 set-ups | 500 set-ups |
| Inspections | 200 inspections | 300 inspections |
| Assembled Units | 5,000 units | 10,000 units |

Based on the above information, answer the following multiple-choice questions:

Q1. Under the traditional costing system, what is the overhead absorption rate per
direct labour hour?
A. ₹ 20.00
B. ₹ 30.00
C. ₹ 40.00
D. ₹ 50.00
(2 Marks)

Q2. What is the total overhead cost allocated to product Alpha under the
traditional costing system?
A. ₹ 3,00,000
B. ₹ 4,50,000
C. ₹ 6,00,000
D. ₹ 7,50,000
(2 Marks)

Q3. Under the Activity Based Costing (ABC) system, what is the cost driver rate for
'Quality Inspection' activity?
A. ₹ 500 per inspection
B. ₹ 800 per inspection
C. ₹ 1,000 per inspection
D. ₹ 1,200 per inspection
(2 Marks)

Q4. What is the total overhead cost allocated to product Beta under the Activity
Based Costing (ABC) system?
A. ₹ 5,50,000
B. ₹ 6,50,000
C. ₹ 7,00,000
D. ₹ 7,50,000
(2 Marks)

Q5. What is the unit manufacturing cost for product Alpha under the Activity Based
Costing (ABC) system?
A. ₹ 320
B. ₹ 350
C. ₹ 380
D. ₹ 410
(2 Marks)

Q6. Which of the following statements best describes the primary reason for
adopting ABC in situations like Sigma Manufacturing Co.?
A. To reduce total fixed costs.
B. To simplify inventory valuation.
C. To provide more accurate product costs in diverse and automated
environments.
D. To comply with regulatory requirements.
(2 Marks)

Q7. In activity-based costing, costs are accumulated by activity using:

A. Cost drivers
B. Cost objects
C. Cost pools
D. Cost benefit analysis
(2 Marks)

Q8. Which of the following statements is TRUE regarding Activity Based Budgeting
(ABB)?
A. ABB focuses solely on financial planning, ignoring operational activities.
 B. ABB is a method of budgeting that starts from a zero base every period.
C. ABB reverses the ABC process to produce financial plans and budgets.
D. ABB is primarily used to control direct material costs.
(2 Marks)

Q9. Which of the following is NOT a benefit of Activity Based Costing?

A. More accurate product/service costing.
B. Enhanced pricing policies.
C. Automatic reduction of prime cost.
D. Identification of non-value-added activities.
(2 Marks)

Q10. A Cost Driver is:

A. An item of production overheads.
B. A common cost which is shared over cost centres.
C. A transaction that is a significant determinant of cost.
D. An activity which generates costs.
(2 Marks)

Q11. Which of the following is an example of a 'Batch-Level Activity'?

A. Designing a new product.
B. Inspecting every tenth item produced.
C. Setting up a machine for a production run.
D. Overall plant security.
(2 Marks)

Q12. Activity Based Management (ABM) primarily focuses on:

A. Minimizing direct labour hours in production.
B. Managing activities to continuously improve value received by customers.
C. Eliminating all fixed costs from the production process.
D. Maximizing sales revenue through aggressive marketing.
(2 Marks)

Q13. Which of the following best describes 'Cost Distortion' in costing systems?
A. The difference between actual costs and budgeted costs.
B. The misallocation of indirect costs to products or services.
C. The variance caused by inefficient use of resources.
D. The total overheads incurred by a company.
(2 Marks)

Q14. The primary factor prompting the development of Activity Based Costing was:
A. Decreasing market competition.
B. Increasing direct labour costs.
C. Growing overhead costs due to increased automation and product diversity.
D. Simpler production processes.
(2 Marks)

Q15. The 'Assembly Support' activity, if classified by cost hierarchy, would most
likely be a:
A. Unit-level activity
B. Batch-level activity
C. Product-level activity
D. Facility-level activity
(2 Marks)

PART II – Descriptive Questions (70 Marks)

Question 1 (Compulsory):
Super Solutions Ltd. manufactures two chemical compounds, X and Y, through a
complex process involving various activities. The company's management is concerned
about the accuracy of product costing and wishes to evaluate the implementation of
an Activity Based Costing (ABC) system.
The following budgeted data is available for the upcoming year:

Production Data:
| Product | Units Produced | Direct Material Cost per Unit (₹) | Direct Labour
Hours per Unit |
| :------ | :------------- | :--------------------------------
| :---------------------------- |
| X | 25,000 | 120 | 2
|
| Y | 15,000 | 180 | 3
|

Overhead Information:
* Total Manufacturing Overheads: ₹ 15,00,000
* Direct Labour Rate: ₹ 50 per hour

Activity Analysis and Cost Drivers:

The total manufacturing overheads are broken down into the following activity pools
with their respective cost drivers and total activity volumes:

| Activity Pool | Total Cost (₹) | Cost Driver | Total Activity

Volume |
| :------------------ | :------------- | :-----------------------
| :-------------------- |
| Design & Engineering| 3,00,000 | Number of Designs | 100 designs
|
| Set-up Costs | 4,50,000 | Number of Set-ups | 150 set-ups
|
| Quality Testing | 3,50,000 | Number of Tests | 700 tests
|
| Machine Maintenance | 4,00,000 | Machine Hours | 80,000 hours
|

Product-wise Consumption of Activities:

| Activity / Product | Product X | Product Y |

| :----------------- | :------------- | :------------- |
| Number of Designs | 60 designs | 40 designs |
| Number of Set-ups | 100 set-ups | 50 set-ups |
| Number of Tests | 400 tests | 300 tests |
| Machine Hours | 50,000 hours | 30,000 hours |

Required:
(i) **PREPARE** a statement showing the unit manufacturing cost for Product X and
Product Y using the **Traditional Costing System** (assuming overheads are absorbed
based on Direct Labour Hours). (6 Marks)
(ii) **PREPARE** a statement showing the unit manufacturing cost for Product X and
Product Y using the **Activity Based Costing (ABC) System**. (9 Marks)
(iii) **COMMENT** on the cost distortion (under-costing or over-costing) for each
product under the Traditional Costing System as compared to the ABC System. (5
Marks)

Question 2:
Innovative Gadgets Ltd. is assessing its profitability across different customer
segments. The company has identified that its existing traditional costing system,
which allocates all overheads based on sales revenue, may not accurately reflect
the actual cost to serve different customers. They decide to implement an Activity
Based Costing (ABC) approach for customer profitability analysis.

For the upcoming month, the following information is available:

Total Sales & Cost of Goods Sold:

* Total Sales Revenue: ₹ 50,00,000
* Total Cost of Goods Sold (COGS): ₹ 30,00,000

Identified Activities and Costs:

| Activity Area | Total Cost (₹) | Cost Driver | Total
Activity Volume |
| :------------------- | :------------- | :---------------------------
| :-------------------- |
| Order Processing | 8,00,000 | Number of Customer Orders | 2,000
orders |
| Sales Visits | 6,00,000 | Number of Sales Visits | 1,500
visits |
| Delivery Logistics | 4,00,000 | Number of Deliveries | 1,000
deliveries |
| After-Sales Support | 2,00,000 | Number of After-Sales Calls | 500 calls
|

Customer Segment Data (for the month):

The company serves two major customer segments: Large Retailers and Small
Businesses.

| Customer Segment | Sales Revenue (₹) | COGS (₹) | No. of Orders | No. of Sales
Visits | No. of Deliveries | No. of After-Sales Calls |
| :--------------- | :---------------- | :------- | :------------
| :------------------ | :---------------- | :----------------------- |
| Large Retailers | 35,00,000 | 21,00,000 | 800 | 500
| 400 | 150 |
| Small Businesses | 15,00,000 | 9,00,000 | 1,200 | 1,000
| 600 | 350 |

Required:
(i) **CALCULATE** the operating income and operating income as a percentage of
revenues for each customer segment using the **Traditional Costing System**
(allocating all non-COGS costs based on sales revenue). (5 Marks)
(ii) **COMPUTE** the activity cost driver rate for each of the four activity
areas. (4 Marks)
(iii) **PREPARE** a statement showing the operating income and operating income as
a percentage of revenues for each customer segment using the **Activity Based
Costing (ABC) System**. (8 Marks)
(iv) **DISCUSS** the new insights gained regarding customer profitability by
switching from the Traditional Costing System to the ABC System. (3 Marks)

Question 3:
(a) **EXPLAIN** the four levels of activities (Cost Hierarchy) identified under
Activity Based Costing, providing one example for each. (6 Marks)
(b) **DISCUSS** any four advantages of implementing Activity Based Costing in a
manufacturing concern. (4 Marks)
(c) **STATE** the problems associated with Traditional Costing Systems that led to
the development of Activity Based Costing. (4 Marks)

Question 4:
(a) **DISTINGUISH** between Value-Added Activities and Non-Value-Added Activities
as classified under Activity Based Management (ABM). Give two examples of each in a
typical manufacturing process. (6 Marks)
(b) **EXPLAIN** the concept of Activity Based Budgeting (ABB) and state its three
key elements. (4 Marks)
(c) **LIST** any four practical applications of Activity Based Costing (ABC) as a
decision-making tool. (4 Marks)

Question 5:
(a) **DISCUSS** the main limitations of Activity Based Costing. (5 Marks)
(b) A firm is considering introducing a new product line. The estimated total
overheads are ₹ 5,00,000. Under the traditional system, these would be absorbed
based on direct labour hours (total 10,000 hours). Under ABC, the firm identifies
two major activities for this new product line: 'Product Design' (estimated cost ₹
2,00,000, 50 designs expected) and 'Special Handling' (estimated cost ₹ 3,00,000,
1,000 handling operations).
The new product 'Nova' is expected to require 5 new designs, 20 special
handling operations, and 500 direct labour hours.
**CALCULATE** the overhead cost per unit for 'Nova' assuming 100 units are
produced:
(i) Using the **Traditional Costing System**.
(ii) Using the **Activity Based Costing System**.
**JUSTIFY** which method provides a more accurate overhead cost for 'Nova'. (5
Marks)