Test 4: Activity Based Costing: answer key

Question 1 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. Vikram Autoparts Ltd manufactures two components: Standard and Custom. The company currently uses a traditional absorption costing system, absorbing overheads based on direct labour hours. The budgeted annual production is 10,000 units of Standard and 2,000 units of Custom. Standard requires 2 direct labour hours per unit, while Custom requires 4 direct labour hours per unit. Total budgeted overheads are ₹14,00,000. Management is considering switching to an Activity Based Costing (ABC) system due to increasing competition and suspected product cost distortions. An analysis of overheads reveals three main activity pools: Setup costs ₹4,00,000 (Standard: 50 setups, Custom: 150 setups); Inspection costs ₹3,00,000 (Standard: 200 hours, Custom: 400 hours); and Machining costs ₹7,00,000 (Standard: 30,000 machine hours, Custom: 10,000 machine hours). The company sells Standard at ₹500 per unit and Custom at ₹1,200 per unit. The management wants to analyse product profitability and adjust pricing strategies. There is no opening or closing work-in-progress inventory.

What is the traditional overhead absorption rate per direct labour hour for Vikram Autoparts Ltd?

1. ₹40
2. ₹50 (correct answer)
3. ₹60
4. ₹70

Answer: B — ₹50

Explanation. Total direct labour hours = (10,000 units × 2 hrs) + (2,000 units × 4 hrs) = 20,000 + 8,000 = 28,000 hours. Traditional overhead rate = Total overheads ÷ Total direct labour hours = ₹14,00,000 ÷ 28,000 hours = ₹50 per direct labour hour. Option a uses 35,000 hours. Option c uses 23,333 hours. Option d uses 20,000 hours (only Standard's hours).

Where it goes wrong. Using only the high-volume product's labour hours or the total number of units as the denominator.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 2 · 2 marks · Chapter 5: Activity Based Costing · hard

What is the ABC overhead cost per unit for the Custom component?

1. ₹337.50 (correct answer)
2. ₹300.00
3. ₹275.00
4. ₹250.00

Answer: A — ₹337.50

Explanation. Setup rate = ₹4,00,000 ÷ 200 = ₹2,000. Inspection rate = ₹3,00,000 ÷ 600 = ₹500. Machining rate = ₹7,00,000 ÷ 40,000 = ₹17.50. Custom ABC Overhead = (150 × ₹2,000) + (400 × ₹500) + (10,000 × ₹17.50) = ₹3,00,000 + ₹2,00,000 + ₹1,75,000 = ₹6,75,000. Per unit = ₹6,75,000 ÷ 2,000 units = ₹337.50. Option b is the traditional cost per unit.

Where it goes wrong. Using total units produced to calculate per-unit cost rather than assigning activity costs first based on driver consumption.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 3 · 2 marks · Chapter 5: Activity Based Costing · medium

What is the amount of cost distortion (over/under costing) for the Standard component under the traditional system compared to ABC?

1. Overcosted by ₹27.50 per unit (correct answer)
2. Undercosted by ₹27.50 per unit
3. Overcosted by ₹137.50 per unit
4. Undercosted by ₹137.50 per unit

Answer: A — Overcosted by ₹27.50 per unit

Explanation. Standard Traditional OH = 2 hours × ₹50 = ₹100. Standard ABC OH: Setup (50 × 2000 / 10000 = ₹10); Inspection (200 × 500 / 10000 = ₹10); Machining (30000 × 17.5 / 10000 = ₹52.50). Total ABC = ₹72.50. The traditional system assigns ₹100, which is higher than the ABC cost of ₹72.50. Therefore, Standard is overcosted by ₹27.50 per unit. Option b reverses the direction. Option c is the distortion for Custom.

Where it goes wrong. Reversing the overcosting/undercosting relationship (thinking a higher traditional cost means it is undercosted).

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 4 · 2 marks · Chapter 5: Activity Based Costing · hard

Based on the ABC analysis, what strategic pricing action should Vikram Autoparts Ltd consider for the Custom component?

1. Decrease the selling price to gain market share
2. Increase the selling price or discontinue the product as it is significantly undercosted (correct answer)
3. Keep the price unchanged as the traditional cost is accurate
4. Increase the price of the Standard component to subsidize Custom

Answer: B — Increase the selling price or discontinue the product as it is significantly undercosted

Explanation. Custom is undercosted under the traditional system. Traditional cost per unit: (4 hrs × ₹50) = ₹200. ABC cost is ₹337.50. With a selling price of ₹1,200, the company is earning a smaller margin than anticipated. To improve profitability, the company should increase the price of Custom to reflect its true resource consumption or review its product mix. Option a would worsen profitability.

Where it goes wrong. Assuming the traditional cost is accurate and reducing the price to compete, which would result in selling below the actual cost.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 5 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. Apex Electricals Ltd produces two models of switches: Basic and Premium. The company sells 20,000 units of Basic at ₹100 per unit and 5,000 units of Premium at ₹250 per unit. Under the existing traditional costing system, overheads of ₹18,00,000 are absorbed based on direct labour hours. Basic takes 1 hour per unit, and Premium takes 2 hours per unit. The company is evaluating an ABC system to make better strategic pricing decisions. The overheads are classified into three activities: Setup costs ₹6,00,000 (Basic: 100 setups, Premium: 100 setups); Material handling costs ₹4,00,000 (Basic: 500 moves, Premium: 500 moves); and Machining costs ₹9,00,000 (Basic: 20,000 machine hours, Premium: 10,000 machine hours). Prime cost per unit is ₹40 for Basic and ₹80 for Premium. The management is concerned that their pricing strategy might be causing them to lose market share on one product while losing money on the other. They require a margin comparison under both costing methods to decide whether to increase the price of Premium or reduce the price of Basic.

What is the traditional overhead cost per unit for the Basic switch?

1. ₹40
2. ₹50
3. ₹60 (correct answer)
4. ₹70

Answer: C — ₹60

Explanation. Total direct labour hours = (20,000 × 1) + (5,000 × 2) = 30,000 hours. Traditional overhead rate = ₹18,00,000 ÷ 30,000 = ₹60 per labour hour. Basic requires 1 hour per unit, so the traditional overhead cost is ₹60 per unit. Option a uses 2 hours. Option b uses a rate of ₹50. Option d is an arithmetic error.

Where it goes wrong. Using the machine hours or total units instead of direct labour hours to derive the traditional absorption rate.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 6 · 2 marks · Chapter 5: Activity Based Costing · hard

What is the total ABC overhead cost assigned to the Premium switch?

1. ₹8,00,000 (correct answer)
2. ₹6,00,000
3. ₹10,00,000
4. ₹12,00,000

Answer: A — ₹8,00,000

Explanation. Setup rate = ₹6,00,000 ÷ 200 = ₹3,000. Handling rate = ₹4,00,000 ÷ 1,000 = ₹400. Machining rate = ₹9,00,000 ÷ 30,000 = ₹30. Premium overhead = (100 setups × ₹3,000) + (500 moves × ₹400) + (10,000 hrs × ₹30) = ₹3,00,000 + ₹2,00,000 + ₹3,00,000 = ₹8,00,000. Option c is the total cost for Basic. Option b omits one pool.

Where it goes wrong. Using the total units to allocate overheads rather than assigning costs based on actual activity consumption.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 7 · 2 marks · Chapter 5: Activity Based Costing · medium

What is the difference in the gross margin per unit for the Premium switch between ABC and traditional costing?

1. ₹40 higher under ABC
2. ₹40 lower under ABC (correct answer)
3. ₹120 higher under ABC
4. ₹120 lower under ABC

Answer: B — ₹40 lower under ABC

Explanation. Traditional overhead per unit for Premium = 2 hours × ₹60 = ₹120. ABC overhead per unit = ₹8,00,000 ÷ 5,000 units = ₹160. ABC assigns ₹40 more overhead per unit to Premium. Since the selling price is constant, the gross margin under ABC will be ₹40 lower per unit compared to the traditional method. Options a, c, and d misinterpret the impact on margin.

Where it goes wrong. Confusing overhead cost difference with the gross margin difference, or reversing the direction of the margin change.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 8 · 2 marks · Chapter 5: Activity Based Costing · hard

Given that the Basic switch is overcosted under the traditional system by ₹5 per unit and Premium is undercosted, what is the most appropriate strategic decision for Apex Electricals Ltd?

1. Increase the price of Basic and decrease the price of Premium
2. Decrease the price of Basic and increase the price of Premium (correct answer)
3. Discontinue the Premium product immediately
4. Increase the price of both products equally

Answer: B — Decrease the price of Basic and increase the price of Premium

Explanation. The traditional system overcosts Basic and undercosts Premium. This means Basic is being priced too high (potentially losing market share), while Premium is priced too low (potentially losing money). The strategic action is to reduce the price of Basic to be more competitive and increase the price of Premium to reflect its true cost. Option a would worsen the distortion.

Where it goes wrong. Assuming the traditional cost is correct and raising prices on the already overcosted product while cutting prices on the undercosted product.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 9 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. Zenith Consumer Care Ltd distributes its products through three customer channels: Retail (X), Wholesale (Y), and Online (Z). The revenue generated by each channel is ₹20,00,000, ₹10,00,000, and ₹10,00,000 respectively. The company traditionally allocates customer-level operating costs (totaling ₹8,00,000) based on sales revenue. However, to better understand channel profitability, the company adopts ABC and identifies three activities: Order processing cost ₹2,00,000 (driven by number of orders: X=1,000, Y=500, Z=2,500); Delivery cost ₹4,00,000 (driven by number of deliveries: X=500, Y=200, Z=300); and Shelf-stocking cost ₹2,00,000 (driven by shelf-stocking hours: X=100, Y=100, Z=300). The management suspects that the high-volume, low-order-size Online channel is heavily subsidized by the other channels under the traditional system. They need to evaluate the operating income of each channel under both costing systems to make strategic decisions about channel focus and pricing.

Under the traditional system, what is the customer-level operating cost allocated to the Online (Z) channel?

1. ₹2,00,000 (correct answer)
2. ₹3,00,000
3. ₹4,00,000
4. ₹1,50,000

Answer: A — ₹2,00,000

Explanation. Traditional allocation is based on sales revenue. Total revenue = ₹20,00,000 (X) + ₹10,00,000 (Y) + ₹10,00,000 (Z) = ₹40,00,000. Online (Z) represents 25% of total revenue (₹10,00,000 ÷ ₹40,00,000). Allocated cost = 25% of ₹8,00,000 = ₹2,00,000. Option c is the cost for Retail (X). Option b is a miscalculation.

Where it goes wrong. Allocating based on the number of orders or deliveries instead of sales revenue for the traditional method.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 10 · 2 marks · Chapter 5: Activity Based Costing · hard

What is the ABC order processing activity rate per order?

1. ₹40
2. ₹50 (correct answer)
3. ₹60
4. ₹70

Answer: B — ₹50

Explanation. Total orders = 1,000 (X) + 500 (Y) + 2,500 (Z) = 4,000 orders. Order processing rate = ₹2,00,000 ÷ 4,000 orders = ₹50 per order. Option a uses 5,000 orders. Option c uses 3,333 orders. Option d uses 2,857 orders. This rate will be used to allocate costs to channels based on their actual order volume.

Where it goes wrong. Using total sales revenue or total deliveries instead of the actual number of orders in the denominator.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 11 · 2 marks · Chapter 5: Activity Based Costing · medium

What is the operating income for the Online (Z) channel under the ABC system?

1. ₹6,35,000 (correct answer)
2. ₹7,00,000
3. ₹7,55,000
4. ₹8,00,000

Answer: A — ₹6,35,000

Explanation. ABC cost for Z: Order processing (2,500 × ₹50 = ₹1,25,000); Delivery (300 × ₹400 = ₹1,20,000); Shelf-stocking (300 × ₹400 = ₹1,20,000). Total ABC cost = ₹3,65,000. Operating income = Revenue − ABC Cost = ₹10,00,000 − ₹3,65,000 = ₹6,35,000. Option c is the profit under traditional costing (₹10,00,000 - ₹2,00,000 = ₹8,00,000? No, ₹10L - ₹2.9L = ₹7.1L. Recalc: 10L - 3.65L = 6.35L). Option b uses incorrect rates.

Where it goes wrong. Using the traditional allocated cost instead of the ABC cost, which underestimates the true cost of serving the Online channel.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 12 · 2 marks · Chapter 5: Activity Based Costing · hard

Which channel was cross-subsidizing the others under the traditional costing system, and what is the amount of over/under costing?

1. Wholesale was overcosted by ₹50,000
2. Online was overcosted by ₹1,65,000
3. Retail was undercosted by ₹1,10,000
4. Online was undercosted by ₹1,65,000 (correct answer)

Answer: D — Online was undercosted by ₹1,65,000

Explanation. Traditional cost for Z = ₹2,00,000. ABC cost for Z = ₹3,65,000. Online is undercosted by ₹1,65,000 (3,65,000 − 2,00,000) under the traditional system. This means the Online channel consumes more resources than it is charged for, and the other channels (Retail and Wholesale) are cross-subsidizing it. Option a is incorrect as Wholesale was overcosted by ₹55,000 (₹2,00,000 vs ₹1,45,000).

Where it goes wrong. Confusing the direction of cross-subsidization, assuming the high-revenue channel is overcosted rather than undercosted.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 13 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. Which of the following conditions most strongly indicates the need for an Activity Based Costing system over a traditional costing system?

Which of the following conditions most strongly indicates the need for an Activity Based Costing system over a traditional costing system?

1. A company produces a single, homogeneous product with high production volume
2. Direct labour is the primary cost driver and overheads are relatively low
3. A company produces a diverse range of products with significantly different production volumes and complexities (correct answer)
4. The company's overhead costs are largely fixed and do not vary with any activity

Answer: C — A company produces a diverse range of products with significantly different production volumes and complexities

Explanation. ABC is most beneficial when there is product diversity (high and low volume products, complex and simple products) and high overhead costs driven by non-volume-related activities (e.g., setups, inspections). Option a and b describe situations where traditional costing works well. Option d describes facility-sustaining costs, which ABC also struggles to allocate accurately.

Where it goes wrong. Believing ABC is always superior, even for homogeneous products with low overheads, rather than recognizing the specific conditions where it adds value.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 14 · 2 marks · Chapter 5: Activity Based Costing · hard

Scenario. A company produces 5,000 units of Product A and 1,000 units of Product B. Traditional costing absorbs overheads at ₹40 per machine hour. Product A requires 2 machine hours, and Product B requires 5 machine hours. What is the total overhead assigned to Product B under traditional costing?

A company produces 5,000 units of Product A and 1,000 units of Product B. Traditional costing absorbs overheads at ₹40 per machine hour. Product A requires 2 machine hours, and Product B requires 5 machine hours. What is the total overhead assigned to Product B under traditional costing?

1. ₹1,00,000
2. ₹2,00,000 (correct answer)
3. ₹2,40,000
4. ₹4,00,000

Answer: B — ₹2,00,000

Explanation. Traditional overhead per unit of B = 5 hours × ₹40 = ₹200. Total overhead assigned to B = 1,000 units × ₹200 = ₹2,00,000. Option a uses 2.5 hours. Option c is the total overhead for Product A (5,000 × 2 × 40 = ₹4,00,000). Option d is a miscalculation.

Where it goes wrong. Multiplying the total machine hours by the overhead rate instead of assigning the rate to the specific product based on its actual hours.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 15 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. Under an ABC system, an activity pool of ₹5,00,000 is driven by 2,500 setups. If Product X requires 800 setups, what is the setup cost assigned to Product X?

Under an ABC system, an activity pool of ₹5,00,000 is driven by 2,500 setups. If Product X requires 800 setups, what is the setup cost assigned to Product X?

1. ₹1,20,000
2. ₹1,60,000 (correct answer)
3. ₹1,80,000
4. ₹2,00,000

Answer: B — ₹1,60,000

Explanation. Setup rate = ₹5,00,000 ÷ 2,500 = ₹200 per setup. Cost assigned to Product X = 800 setups × ₹200 = ₹1,60,000. Option a uses 600 setups. Option c uses 900 setups. Option d uses 1,000 setups. This demonstrates the precise tracing of costs based on actual activity consumption.

Where it goes wrong. Dividing the total pool by the number of units produced instead of the number of setups to find the activity rate.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 16 · 2 marks · Chapter 5: Activity Based Costing · hard

Scenario. A traditional costing system uses direct labour hours to absorb overheads, resulting in a product cost of ₹150 for Product A. Under ABC, the cost is determined to be ₹135. Which of the following statements is true?

A traditional costing system uses direct labour hours to absorb overheads, resulting in a product cost of ₹150 for Product A. Under ABC, the cost is determined to be ₹135. Which of the following statements is true?

1. Product A is overcosted by ₹15 under the traditional system (correct answer)
2. Product A is undercosted by ₹15 under the traditional system
3. Product A is cross-subsidized by other products under ABC
4. The traditional system is more accurate for Product A

Answer: A — Product A is overcosted by ₹15 under the traditional system

Explanation. The traditional cost is ₹150, but the true cost according to ABC is ₹135. The traditional system assigns ₹15 more than the actual cost, meaning Product A is overcosted. This overcosting often happens to high-volume products in traditional systems because they absorb more overhead simply due to higher labour or machine hours, even if they don't consume the most non-volume activities. Option b reverses the direction.

Where it goes wrong. Assuming a higher traditional cost means the product is undercosted and needs a price increase.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 17 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. In a highly automated factory with high overheads and low direct labour, which of the following is the most likely consequence of using a traditional direct labour-based absorption costing system?

In a highly automated factory with high overheads and low direct labour, which of the following is the most likely consequence of using a traditional direct labour-based absorption costing system?

1. Accurate allocation of overheads to all products
2. Overcosting of low-volume, complex products
3. Undercosting of high-volume, simple products
4. Overcosting of high-volume, simple products (correct answer)

Answer: D — Overcosting of high-volume, simple products

Explanation. When overheads are high and direct labour is low, traditional systems based on labour hours tend to overcost high-volume, simple products because they require more labour hours overall, absorbing a disproportionate share of overheads. Conversely, low-volume, complex products that consume significant non-volume activities (like setups) are undercosted. Option b describes the opposite effect.

Where it goes wrong. Assuming high-volume products should be charged the most overhead, failing to recognize that overheads are driven by activities, not just volume.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 18 · 2 marks · Chapter 5: Activity Based Costing · hard

Scenario. How does ABC primarily improve strategic pricing decisions?

How does ABC primarily improve strategic pricing decisions?

1. By providing more accurate product cost information, revealing which products are profitable or unprofitable (correct answer)
2. By allowing companies to arbitrarily increase prices to cover overheads
3. By eliminating all non-value-added activities without needing cost data
4. By focusing solely on the direct costs of production

Answer: A — By providing more accurate product cost information, revealing which products are profitable or unprofitable

Explanation. ABC improves pricing decisions by providing more accurate product costs, which helps reveal true profitability. This enables managers to identify products that are overcosted (and potentially overpriced, losing market share) or undercosted (and potentially underpriced, losing money). Option b is unethical and impractical. Option c is incorrect as ABC data is needed to identify non-value-added activities. Option d ignores overheads.

Where it goes wrong. Thinking ABC is used to justify arbitrary price hikes, rather than to inform competitive and cost-based pricing strategies.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 19 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. A company uses a traditional machine-hour based system. Product Y requires 10 machine hours per unit and is produced in 100 units. Product Z requires 2 machine hours per unit and is produced in 1,000 units. The total overhead rate is ₹50 per machine hour. Which product is most likely undercosted and why?

A company uses a traditional machine-hour based system. Product Y requires 10 machine hours per unit and is produced in 100 units. Product Z requires 2 machine hours per unit and is produced in 1,000 units. The total overhead rate is ₹50 per machine hour. Which product is most likely undercosted and why?

1. Product Y, because it requires more machine hours
2. Product Z, because it requires fewer machine hours but more setups (correct answer)
3. Product Y, because it is a low-volume complex product
4. Product Z, because it is a high-volume simple product

Answer: B — Product Z, because it requires fewer machine hours but more setups

Explanation. Product Z has higher total volume and thus absorbs most of the overhead (1000 units × 2 hrs = 2000 hrs vs 100 units × 10 hrs = 1000 hrs). If Z is a simple product requiring few setups, but is absorbing two-thirds of the overhead based on volume, it is undercosted. Y, the low-volume complex product, is overcosted. Option a misinterprets the total cost.

Where it goes wrong. Equating high unit-level machine hours with high total overhead absorption, missing the impact of production volume and non-volume activities.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 20 · 2 marks · Chapter 5: Activity Based Costing · hard

Scenario. Which of the following is a primary limitation of traditional volume-based costing systems that ABC aims to address?

Which of the following is a primary limitation of traditional volume-based costing systems that ABC aims to address?

1. Inability to calculate direct material costs
2. Use of multiple activity bases for overhead allocation
3. Assumption that all overheads are driven by production volume (correct answer)
4. Failure to allocate customer-level costs

Answer: C — Assumption that all overheads are driven by production volume

Explanation. Traditional costing systems often assume that all overheads vary with production volume (like direct labour or machine hours). ABC recognizes that many overheads are driven by activities like setups, inspections, and engineering, which are not strictly volume-related. Option a is false as direct materials are easily traced. Option b describes ABC, not traditional. Option d is a feature ABC can address but the root limitation is the volume assumption.

Where it goes wrong. Confusing a symptom of traditional costing (poor customer cost allocation) with its fundamental underlying assumption (volume drives all costs).

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 21 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. A company sells Product X for ₹200. The traditional cost is ₹150, while the ABC cost is ₹170. What is the gross margin per unit under both systems?

A company sells Product X for ₹200. The traditional cost is ₹150, while the ABC cost is ₹170. What is the gross margin per unit under both systems?

1. Traditional: ₹50; ABC: ₹30 (correct answer)
2. Traditional: ₹50; ABC: ₹70
3. Traditional: ₹30; ABC: ₹50
4. Traditional: ₹70; ABC: ₹50

Answer: A — Traditional: ₹50; ABC: ₹30

Explanation. Gross Margin = Selling Price − Cost. Traditional Margin = ₹200 − ₹150 = ₹50. ABC Margin = ₹200 − ₹170 = ₹30. The traditional system shows a higher margin because it undercosts the product relative to the ABC system. Option b reverses the ABC margin. Option c and d swap the costs.

Where it goes wrong. Subtracting the margin from the price to find the cost, or mixing up the traditional and ABC cost figures.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 22 · 2 marks · Chapter 5: Activity Based Costing · hard

Scenario. The concept of cross-subsidization in traditional costing means that:

The concept of cross-subsidization in traditional costing means that:

1. High-volume products are subsidizing the overhead costs of low-volume products (correct answer)
2. Direct costs are subsidizing indirect costs
3. Actual costs are higher than budgeted costs
4. All products are charged the same overhead rate

Answer: A — High-volume products are subsidizing the overhead costs of low-volume products

Explanation. In traditional costing, high-volume simple products absorb a large share of overheads due to volume-based allocation, even if they don't consume the corresponding activities. This over-allocation effectively means the high-volume products are subsidizing the low-volume, more complex products, which are undercosted. Option b is incorrect as direct costs are directly traced. Option c is a variance issue. Option d is not necessarily true.

Where it goes wrong. Misunderstanding which products bear the burden of cross-subsidization, thinking low-volume products subsidize high-volume ones.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 23 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. An inspection activity has a total cost of ₹9,00,000. The total inspection hours are 3,000. Product A consumes 1,200 inspection hours. What is the inspection cost assigned to Product A?

An inspection activity has a total cost of ₹9,00,000. The total inspection hours are 3,000. Product A consumes 1,200 inspection hours. What is the inspection cost assigned to Product A?

1. ₹2,70,000
2. ₹3,00,000
3. ₹3,60,000 (correct answer)
4. ₹4,00,000

Answer: C — ₹3,60,000

Explanation. Inspection rate = ₹9,00,000 ÷ 3,000 hours = ₹300 per inspection hour. Cost assigned to Product A = 1,200 hours × ₹300 = ₹3,60,000. Option a uses 900 hours. Option b uses 1,000 hours. Option d uses 1,333 hours. This illustrates the accurate tracing of inspection costs to the specific product consuming the activity.

Where it goes wrong. Assigning costs based on total units produced rather than the specific driver (inspection hours) consumed by the product.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 24 · 2 marks · Chapter 5: Activity Based Costing · hard

Scenario. If ABC reveals that a product is significantly undercosted, a company may consider:

If ABC reveals that a product is significantly undercosted, a company may consider:

1. Increasing its selling price to improve profitability (correct answer)
2. Decreasing its selling price to gain market share
3. Discontinuing the product regardless of its profitability
4. Allocating more overhead to it under the traditional system

Answer: A — Increasing its selling price to improve profitability

Explanation. If a product is undercosted, its current selling price may not be covering its true cost, leading to hidden losses. Raising the price is a strategic option to align revenue with actual resource consumption. Option b would worsen the loss. Option c is premature without further analysis. Option d is irrelevant as traditional systems are being phased out.

Where it goes wrong. Assuming undercosting means the product is a strong seller and reducing the price to boost volume, which would increase losses.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)

Question 25 · 2 marks · Chapter 5: Activity Based Costing · medium

Scenario. What is the primary reason ABC provides more accurate product costs than traditional costing?

What is the primary reason ABC provides more accurate product costs than traditional costing?

1. It uses a single, company-wide overhead rate
2. It allocates overheads based on the activities that actually cause the costs to be incurred (correct answer)
3. It ignores direct costs and focuses only on overheads
4. It is cheaper and easier to implement than traditional costing

Answer: B — It allocates overheads based on the activities that actually cause the costs to be incurred

Explanation. ABC improves accuracy by identifying activities that consume resources and using appropriate cost drivers to assign costs to products based on their actual consumption of those activities. Option a describes a traditional blanket rate. Option c is false as ABC includes direct costs in total product cost. Option d is false as ABC is typically more expensive to implement.

Where it goes wrong. Believing ABC is accurate because it is simpler or ignores direct costs, rather than understanding its causal allocation principle.

Authority. ICAI SM: Cost and Management Accounting, Chapter 5 (Activity Based Costing)