Final answer:
Earl is correct that activity-based costing (ABC) uses many different activity bases, or cost drivers, to apply overhead costs. Direct materials and direct labor are directly traced to products, not applied via cost drivers. ABC offers a more accurate reflection of how products consume resources and contributes to strategic decision-making about production and pricing.
Step-by-step explanation:
The question revolves around activity-based costing (ABC), which is a more precise method of allocating overhead costs to products or services based on the activities that drive those costs. In response to the student's inquiry, Earl is correct in stating that many different activity bases are used in applying overhead in ABC. Unlike traditional costing that might use a single cost driver, ABC acknowledges that products consume different resources differently, therefore multiple cost drivers are used to assign overhead costs more accurately.
Each cost pool, or grouping of similar overhead costs, is associated with its own unique cost driver in ABC. Cost drivers are activities that cause costs to be incurred, such as machine hours, labor hours, or the number of setups. Direct materials and direct labor, however, are not applied to work-in-process based upon cost drivers; they are traced directly to products and services because they are directly attributable to the production.
Understanding the breakdown of total costs into fixed cost, marginal cost, average total cost, and average variable cost provides valuable insights into costing and pricing decisions. This knowledge, when combined with sales and revenue analysis, is pertinent to determining the profit-maximizing production quantity and pricing strategy within a given market structure.