Test: Activity Based Costing - UGC NET MCQ

Kalpan and Cooper argue that volume-related cost drivers are unsuitable for allocating long-term variable costs to products under the Activity-Based Costing (ABC) system. This is because these costs are more intricately linked to the complexity and variety of products rather than simply the volume of production. Using such drivers can lead to misallocation of costs, as overhead costs are not solely determined by production volume but also by other factors like product diversity and intricacy.

Assertion Correctness: The assertion is correct as activity analysis is indeed vital in ABC to identify indirect cost relationships.

Reason Correctness: The reason is correct as it correctly draws a parallel between activity analysis in ABC and process mapping in lean manufacturing.

Explanation: The reason is the correct explanation of the assertion as both statements highlight the importance of detailed analysis in understanding and assigning costs accurately in Activity-Based Costing.

The traditional fixed and variable cost differentiation is deemed insufficient for designing a cost system within ABC because it doesn't adequately address the various cost behavior patterns. To create an effective cost system, a deeper understanding of costs related to volume, diversity, events, and time is necessary, which goes beyond the simplistic fixed versus variable cost paradigm.

Litt in one of his articles commented, “Activity-based costing (ABC) is an accounting technique that utilizes cost attachment rather than cost allocation to determine the actual cost of products and services”.

Key Points

1. The real beauty of an ABC model is that it forces organizations to adopt a cost management paradigm that focuses on understanding their processes.
2. Once an organization accepts this paradigm, they soon recognize that their products or services are produced through cross-functional business processes.
3. These processes contain a wide variety of activities that not only define the process but also, more importantly, reflect how effectively the process performs.
4.  It is based on the fact that cost objects consume activities and activities consume resources. It is this consumption of resources that drives costs. 

The ABC can be performed by:

1. Identifying activities
2. Determining the cost for each activity/ Collecting cost pools
3. Determining cost drivers (Cost drivers are the factors that affect the cost of an activity, e.g. poor quality)
4. Collecting activity data and computing activity rate using activity drivers
5. Calculating product cost by charging the cost to products

Thus, option 3 is the correct answer.

• Assertion is correct as ABC Costing does not fully replace traditional costing methods in meeting financial reporting needs.
• Reason is also true as traditional costing systems concentrate on direct costs and impose fixed costs on products.
• However, the Reason is not the correct explanation of the Assertion as the limitations of ABC Costing in financial reporting are not directly linked to the method's focus on direct costs versus fixed costs in traditional systems.

The correct answer is ​Time-driven Activity-based Costing (TDABC).

• In CRM, ​Customer Profitability Management (CPM) focuses on an organization’s most profitable customers and products with the aim of improving “bottom line” performance.
• Customer profitability management is a strategy-linked approach to identifying the relative profitability of different customer segments in order to devise strategies that add value to most-profitable customers, make less-profitable customers more profitable, stop or reduce the erosion of profit by unprofitable customers, or otherwise focus on long-term customer profitability.
• Often the small percentage of customers generate substantially more than 100% of profits, and the remaining customers are either breakeven or unprofitable.
• The backbone of a CPM system is a costing system that focuses on tracing and assigning costs to every customer segment without arbitrary broadly averaged cost allocations.
• The major challenge in implementing a CPM system is the selection and implementation of an accurate and informative costing system.
• Cost accuracy and visibility are important in CPM.
• Using time-driven activity-based costing provides costs that identify resource consumption by customers or customer segments.
• The signals provided by the CPM system, based on the full costing of traceable costs to customers and making visible business-sustaining costs, will lead management to consider strategies to increase profits.
• The signals could even lead to generating alternative courses of action.

The pivotal element in comprehending the allocation of overhead costs in transactions conducted by support departments and factory overheads to product lines under an Activity-Based Costing (ABC) system is the level of complexity and variety involved. Unlike traditional methods that primarily rely on volume-related drivers, ABC recognizes that overhead costs are influenced significantly by the diverse nature and intricacy of products. By using activity-based drivers that reflect these nuances, ABC provides a more accurate and fair representation of how overhead costs should be assigned.

The initial step in developing an ABC system involves identifying the main activities performed in the organization, such as manufacturing, assembly, purchasing, packing, and dispatching. This step is crucial as it sets the foundation for further analysis and allocation of costs based on the activities identified. By understanding and categorizing these activities, organizations can effectively allocate costs and resources to different processes, enhancing cost control and decision-making.

Assertion Correctness: The assertion is correct as activity pools in ABC are indeed crucial for grouping activities related to a product or service.

Reason Correctness: The reason is also correct as one of the steps in ABC involves assigning costs to activity pools.

Explanation: While both statements are true, the reason is not the correct explanation of the assertion. Although costs are assigned to activity pools, the mere assignment does not entirely elucidate why activity pools are essential in grouping activities for products or services.

• Assertion is correct as ABC Costing indeed focuses on costs related to product production.
• Reason is correct as activity-based costing enhances the accuracy of indirect cost allocation.
• The Reason is the correct explanation of the Assertion as ABC costing's emphasis on specific costs directly ties into its aim to refine indirect cost assignment.