Book cover for Horngren’s Cost Accounting

Horngren’s Cost Accounting

Srikant M. Datar, Madhav V. Rajan

ISBN #9780134475585

16th Edition

1,010 Questions

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58,980 Students Helped

Homework Questions

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Summary
Learning Objectives
Key Concepts
Example Problems
Explanations
Common Mistakes

Summary

This chapter emphasizes the drawbacks of traditional broad averaging approaches in cost allocation, which often result in undercosting and overcosting of products, ultimately leading to cross?subsidization errors. By introducing Activity?Based Costing (ABC), the chapter illustrates a more accurate alternative that uses relevant cost drivers and a well-defined cost hierarchy, thereby supporting better strategic decisions in pricing, product mix, and overall profitability. Real-world cases, such as those from Plastim Corporation and the Mayo Clinic example, further highlight the practical applications and benefits of refined costing systems.

Learning Objectives

1

Explain the limitations of broad averaging in cost allocation and its impacts on product costing, including undercosting and overcosting.

2

Define and analyze the concept of cost cross?subsidization and its effects on strategic decisions such as pricing, product mix, and profitability.

3

Describe how Activity?Based Costing (ABC) uses relevant cost drivers and a cost hierarchy to provide a more accurate costing analysis.

4

Evaluate the benefits and challenges of implementing refined costing systems like ABC in various business environments.

5

Apply the five-step decision-making process and other refined systems to real-world organizational scenarios, such as those experienced at Plastim Corporation.

Key Concepts

CONCEPT

DEFINITION

Broad Averaging

A traditional cost allocation method that assigns overhead costs on the basis of a single volume-based measure, often leading to inaccuracies in reflecting the actual resource usage by different products or services.

Undercosting

When the allocated cost for a product or service is less than the true cost incurred, typically occurring when a cost allocation system fails to capture the unique resource usage.

Overcosting

When the allocated cost for a product or service is more than the true cost incurred, often as a result of broad averaging that does not differentiate among resource usage patterns.

Product-Cost Cross‑Subsidization

A situation in which errors in cost allocation cause one product's cost error (overcosting) to be balanced by another's error (undercosting), potentially leading to inappropriate strategic decisions.

Activity‑Based Costing (ABC)

A refined costing system that assigns overhead costs to products or services based on the actual activities and cost drivers that generate those costs, using a cost hierarchy for more precise cost information.

Cost Drivers

Factors that cause changes in the cost of an activity, which are used in ABC to more accurately assign overhead costs.

Cost Hierarchy

A classification system in costing that groups costs according to the level at which they are incurred (e.g., unit-level, batch-level, product-level, etc.) to improve accuracy in cost allocation.

Example Problems

Example 1

What is broad averaging, and what consequences can it have on costs?

Example 2

Why should managers worry about product overcosting or undercosting?

Example 3

What is costing system refinement? Describe three guidelines for refinement.

Example 4

What is an activity-based approach to designing a costing system?

Example 5

Describe four levels of a cost hierarchy.
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Step-by-Step Explanations

QUESTION

How can one identify if a cost allocation system is leading to product-cost cross‑subsidization?

STEP-BY-STEP ANSWER:

Step 1: Identify the overhead allocation method being used. Check if it is a broad averaging approach that allocates costs uniformly.
Step 2: Analyze the resource usage of different products or services to determine whether unique activities or cost drivers exist.
Step 3: Compare the allocated overhead costs against the actual resource consumption for each product or service.
Step 4: Detect any significant discrepancies where one product appears to be undercosted while another is overcosted.
Step 5: Conclude that these discrepancies indicate cost cross‑subsidization, where errors in allocation counterbalance each other.
Final Answer: A system showing discrepancies between allocated costs and actual resource usage, with some products undercosted and others overcosted, is indicative of product-cost cross‑subsidization.

Analyzing Cost Cross‑Subsidization

QUESTION

What steps are involved in transitioning from a simple costing system to an ABC system?

STEP-BY-STEP ANSWER:

Step 1: Identify and define the various activities involved in the production or service process.
Step 2: Determine the cost drivers associated with each activity.
Step 3: Collect data on the consumption of resources by each activity.
Step 4: Allocate overhead costs to activities based on the identified cost drivers.
Step 5: Finally, assign the activity costs to products or services based on their usage of these activities.
Final Answer: Transitioning to an ABC system involves identifying activities, defining cost drivers, collecting resource usage data, allocating overhead to activities, and assigning those costs to products based on their consumption.

Implementing Activity‑Based Costing (ABC)

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Common Mistakes

  • Assuming that broad averaging methods sufficiently capture the nuances of resource consumption.
  • Confusing undercosting with simply low overhead allocation rather than recognizing it as a misallocation error.
  • Ignoring the potential for cost cross?subsidization when errors in one product’s costing are offset by another.
  • Implementing ABC systems without proper analysis of relevant cost drivers and the underlying cost hierarchy.
  • Overlooking the strategic implications of inaccurate product costing on pricing and profitability decisions.