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ACTIVITY-BASED MANAGEMENT AND COSTING measurement, drawing on ABC as its major source of data. Using ABC data,
ABM focuses on how to redirect and improve the use of resources to increase
INTRODUCTION the value created for customers and other stakeholders (Pete & Cardos, 2011).

Activity-based management (ABM) and activity-based costing (ABC) have Activity analysis is the primary component of activity-based management.
brought about radical change in cost management systems. ABM is formerly This is the process of studying activities to classify and to devise ways of
applicable only to manufacturing organizations. The principles and minimizing or eliminating the activities that increase costs but provide little or
philosophies of activity-based is now applied equally to service companies, no customer value. In a business context, an activity is any repetitive action
government agencies and process industries. The acronym itself has evolved that is performed to fulfill a business function.
from ABC to ABCM (activity-based cost management) to ABM, and the
application of ABC evolved from a manufacturing product costing orientation Value-Added (VA) versus Non-Value-Added (NVA) Activities
to a management philosophy of activity management applied in industries and
organizations other than manufacturing. Value can be defined as “the favor that something is held to deserve; the
importance, worth, or usefulness of something”. The Institute of Value
ABC and ABM have been around for more than 15 years. Most forward- Management defines value as “the relationship between satisfying needs and
thinking companies have implemented them, or are in the process of doing so. expectations and the resources required to achieve them” and “getting what
you require for what you will pay”. Activities can be classified into value-added
ABC is not a method of costing, but a technique for managing the organization and non-value added activities.
better. It is an exercise which measures the cost and performance of activities,
resources and the objects which consume them in order to generate more Value-added activity increases the worth of a product or service to a
accurate and meaningful information for decision-making. ABM draws on ABC customer and is one for which the customer is willing to pay. VA activities
to provide management reporting and decision-making. change the form, fit, or function of a product or service. They include
designing/assembling products, ordering raw materials, preparing engineering
ABM supports business excellence by providing information to facilitate long- drawing, making informed decisions, innovating, etc. (Grealou, 2015).
term strategic decisions about on product mix and sourcing. It allows product
designers to understand the impact of different designs on cost and flexibility Non-value-added activity increases the time spent on a product or service
and then to modify their designs accordingly. ABM also supports the quest for but does not increase its worth. NVA activities are unnecessary from the
continuous improvement by allowing management to gain new insights into customer’s perspective. Typical NVA activities include reviewing, counting
activity performance by focusing attention on the sources of demand for parts, inspecting, testing/checking, filling information, obtaining multiple
activities and by permitting management to create behavioral incentives to approval, revising / reworking, reporting (Grealou, 2015).
improve one or more aspects of the business (The Chartered Institute of
Management Accountants, 2001). Therefore, NVA activities can be reduced, redesigned, or eliminated without
affecting the product’s or service’s market value or quality. Often an easy way
ACTIVITY-BASED MANAGEMENT to determine the value provided by an activity is to ask “WHY” five (5) times:
if the answers represent valid business reasons, the activity generally adds
Activity-based management (ABM) is subsequently defined by the value; otherwise, it adds no value.
Consortium for Advanced Manufacturing-International (CAM-I) as a discipline
that focuses on the management of activities as the route to improving the Businesses can also engage in some activities that are essential (or appear to
value received by the customer and the profit achieved by providing this value. be essential) to business operations but for which customers would not
ABM includes cost driver analysis, activity analysis, and performance

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willingly choose to pay. These activities are known as business-value added processes occur horizontally across organizational functions, thus, overlap
activities. multiple functional areas.

Business-value added activities are the indispensable indirect expenses of For each distinct process, a process map (or detailed flowchart) should be
producing the products or selling the merchandise or services. However, prepared to indicate every step in every area that goes into making or doing
business value-added costs do not add value to the product, merchandise or something. Some steps included on the process map are necessary and,
service. For manufacturing, retail and service businesses, business value- therefore, must be performed for the process to be completed. Other steps
added costs are those administrative and selling expenses. Administrative reflect those activities for which a valid business answer to the “why” question
expenses include employee salaries and wages, building rent or mortgage cannot be found and, as such, are unnecessary.
expense and office supplies expense. Selling expenses are the commissions
and advertising costs paid. Manufacturing firms also include indirect labor as After a process map has been developed, the time needed to perform the
a business value-added cost. activities should be noted and classified in one of four (4) ways:
· Processing (Service) Time is the actual time spent in performing all the
For instance, companies must prepare invoices for documenting sales and necessary functions in manufacturing the product or in performing the
collections. Customers realize invoice preparation must occur, that it creates service. This time is VA.
costs, and that its costs must be covered by product-selling prices. However, · Inspection Time is the time required to perform quality control other than
because invoice preparation adds no direct value to products and services, what is internal to the process. This time is usually considered NVA unless
customers would prefer not to pay for this activity through a higher selling price. the consumer would actually be willing to pay for it (such as in the
pharmaceutical or food industries).
From a management perspective, the cost of making products or performing · Transfer Time is the time consumed in moving products or components
services must be determined so that the company can charge a price for the from one place to another. This time is NVA.
items that is high enough to cover costs and produce profits. Activities · Idle Time is the time goods spend in storage or waiting at a production
consume resources, and, in turn, resource consumption increases costs. Most operation for processing. This time is NVA.
prices are set by the marketplace rather than by an attempt to cover the costs
incurred by an individual company; therefore, companies that reduce or Cycle or Lead Time is the time from the receipt to the completion of an order
eliminate NVA activities will obtain a larger profit margin when selling at market for a product or service. This is computed by adding value-added processing
price than those companies with higher costs. Additionally, if a company can time and non-value-added time.
sell at less than the “going” market price because costs have declined, that
company might be able to increase its market share. !"#$%&'()%*&+",&-*$./&!01*& = &23&!01*& 4 &523&!01*

To begin activity analysis, managers should first identify organizational Although viewing inspection time and transfer time as non-value-added
processes. activities is theoretically correct, few companies can completely eliminate all
quality control functions and all transfer time. Companies should view VA and
Process is a series of activities that, when performed together, satisfy a NVA activities as occurring on a range and try to eliminate or minimize those
specific objective. activities that add the most time and cost, and the least value.

Companies engage in processes for production, distribution, selling,

administration, and other company functions. Processes should be defined
before a company tries to determine relationships among activities. Most

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MANUFACTURING CYCLE EFFICIENCY products to reduce or eliminate

the need for new setups
Manufacturing Cycle Efficiency (MCE) is computed by dividing total value- Physical The need to move goods Redesign plant and/or
added processing time by total cycle time. because of inefficient reconfigure machinery to
plant or machine layout improve product flow and
Total&Value < Added&Time alleviate machine bottlenecks
6$789$)#8,07:&'()%*&;990)0*7)( =
!"#$%&'()%*&!01* Human The need to rework Hire employees with the right
products because of skill; set or train them in the
'()%*&!01*& = &>,")*??07:&!01* 4 @7?B*)#0"7&!01* 4 !,$7?9*,&!01* 4 @.%*&!01* errors made by right skills; have employees
employees who have accept responsibility for their
A just-in-time (JIT) manufacturing process seeks to achieve substantially improper skills or received work and strive for total quality
higher efficiency by producing components and goods at the precise time they inadequate control; emphasize the proper
are needed by either the next production station or the consumer. Thus, the training; delays caused by performance measures related
use of JIT eliminates a significant amount of idle time (especially in storage) people who waste time by to production times
and substantially increases manufacturing cycle efficiency. JIT also often socializing at work
relies on the use of automated technologies, such as flexible manufacturing
systems, which reduce processing time and increase MCE. COST DRIVER ANALYSIS

In a retail environment, cycle time relates to the time between ordering and Companies engage in many activities that consume resources and cause
selling an item. NVA activities in retail include shipping time from the supplier, costs to be incurred. All activities have cost drivers as the factors that have
delays spent counting merchandise in the Receiving Department, and any direct cause and effect relationships to a cost. Many cost drivers can be
storage time between receipt and sale. In a service company, cycle time refers identified for an individual business unit. For example, cost drivers for factory
to the time between service order and service completion. All time spent on insurance are value of property, plant, and equipment; number of accidents or
activities that are not actual service performance or are “non-activities” (such claims occurring in a period; and inventory size. Cost drivers are classified as
as delays in beginning a job) are considered NVA activities for that job. A either volume-related (such as labor or machine hours) or non-volume-related
service company computes service cycle efficiency by dividing total actual (such as setups, work orders, or distance traveled), which generally reflect the
service time by total cycle time. incurrence of specific transactions.

!"#$%&3)#8$%&C*,D0)*&!01*& More cost drivers can generally be identified for a given activity than should be
C*,D0)*&'()%*&;990)0*7)( =
!"#$%&'()%*&!01* used for cost accumulation or activity elimination. Management should limit the
cost drivers selected to a reasonable number and make certain that the cost
Non-value-added activities are attributable to three (3) types of factors: of measuring a driver does not exceed the benefit of using it. A cost driver
should be easy to understand, directly related to the activity being performed,
FACTOR EXAMPLE CHANGE and appropriate for performance measurement.

Systematic The need to manufacture Invest in new equipment that Costs have traditionally been accumulated into one (total factory overhead) or
products in large batches has shorter setup times or can two (variable and fixed factory overhead) groups of costs, generally known as
to minimize setup cost be adapted to the production of pools. These pooled costs have then been assigned to products or services
multiple products; redesign using one or two drivers, such as direct labor hours and/or machine hours.
Such a procedure causes few, if any, problems for financial statement

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preparation. However, the use of a minimal number of cost pools or cost Unit-Level Cost Assignment
Batch-Level Cost Assignment
drivers can produce illogical product or service costs for internal managerial >IJGHHH ÷ KLGHHH = >HMNH
use in complex production (or service) environments. Analyzing the cost # of
Cost
Cost
Cost # of Cost
Cost
drivers in conjunction with activity analysis can highlight activities that do not per per parts in per
Parts assignment Assignment
Part Batch Batch Part
add value and, as such, can be targeted for elimination to reduce costs and
increase profitability. This information provides the basis for management’s Type A 30,000 P0.50 P15,000 P9,000 30,000 P0.30 P9,000
decisions for improving the process, benchmarking against competitors, and Type B 6,000 P0.50 P3,000 P9,000 6,000 P1.50 P9,000
Total 36,000
increasing profitability.

Levels at Which Costs Are Incurred The unit-level method assigns the majority of setup cost to Type A parts.
However, because setup cost is actually created by a batch-level driver, the
The accounting system must first recognize that costs are created and incurred batch-level cost assignments are more appropriate. The batch-level
because their drivers occur at different levels to reflect more complex perspective shows the commonality of the cost to the parts within the batch
environments. This realization requires using cost driver analysis, which and is more indicative of the relationship between the activity (setup) and the
investigates, quantifies, and explains the relationships of drivers to their driver (different production runs).
related costs. Traditionally, cost drivers were viewed as existing only at the
unit level: for example, labor hours or machine time expended to produce a Product-Level (Process-Level) Costs are caused by development,
product or render a service. These unit-level costs are caused by the production, or acquisition of different items.
production or acquisition of a single unit of product or the delivery of a single
unit of service. Other drivers and their costs are incurred for broader-based Assume that the engineering department issued five (5) engineering change
categories or levels of activity. These broader-based activity levels have orders (ECOs) during May. Of these ECOs, four (4) relate to Product R, one
successively wider scopes of influence on products and product types. The relates to Product S, and none relate to Product T. Each ECO costs P6,000 to
levels are batch, product or process, and organizational or facility. issue. During May, the company produced a total of 7,500 units of product:
1,000 units of Product R, 1,500 units of Product S, and 5,000 units of Product
Batch-Level Costs are caused by a group of things being made, handled, or T. If ECO costs are treated as unit-level costs, the following allocations would
processed at a single time, such as the cost of machine setup. occur:
N&;'O? × >LGHHH&B*,&;'O = >KHGHHH&#"#$%&;'O&)"?#
Assume that P9,000 will be incurred to prepare a machine in forming product
Unit-Level Cost Assignment
parts. Two (2) different part types are to be manufactured during the day; Product-Level Cost Assignment
>KHGHHH ÷ PGNHH = >QMHH
therefore, two (2) setups will be needed at a total cost of P18,000. The first
setup will generate 30,000 Type A parts; the machine will then be reset to # of Cost per Cost # of Cost per Cost
generate 6,000 Type B parts. These specific quantities of parts are needed for Parts Part assignment ECOs ECO Assignment
production because the company is on a just-in-time production system. As Product R 1,000 P4.00 P 4,000 4 P6,000 P24,000
the following calculations show, the cost per unit depends on whether setup Product S 1,500 P4.00 P 6,000 1 P6,000 P 6,000
costs are considered unit-level or batch-level costs. Product T 5,000 P4.00 P20,000 0
Total 7,500 P30,000 5 P30,000
E&?*#8B? × >FGHHH = >IJGHHH&#"#$%&?*#8B&)"?#
Note that the unit-level method inappropriately assigns P20,000 of ECO cost
to Product T, which had no ECOs issued for it. Using a product- or process-
level driver (number of ECOs) for ECO costs would assign P24,000 of costs

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to Product R and P6,000 to Product S, but these costs do not attach solely to Data for LDR Manufacturing is presented to illustrate the difference in
the current month’s production. The ECO cost should be allocated to all information that would result from recognizing multiple cost levels. Prior to
Product R and Product S units manufactured while these ECOs are in effect recognizing different levels of costs, LDR accumulated and allocated its factory
because the changed design will benefit all that production. Since future overhead costs among its three (3) products (C, D, and E) on a machine-hour
production of Products R and S is unknown at the end of May, no per-unit cost basis. Each product requires one (1) machine hour, but Product D is a low-
is shown in the product-level cost assignment table. If management believes volume, special-order line. The cost information in the first section indicates
it is necessary to assign such costs, estimates can be made about future that all three (3) products are profitable to produce and sell. After analyzing
production levels. If the estimates are reasonable, no significant product cost company activities, LDR’s cost accountant began capturing costs at the
distortions should arise for either internal or external reporting. different levels and assigning those costs to products based on appropriate
cost drivers. Individual details for this overhead assignment are not shown, but
Organizational-Level Costs are incurred for the sole purpose of supporting the final assignments and resulting product profitability figures are presented
facility operations. Such costs are common to many different activities and in the second section. This more refined approach to assigning costs shows
products or services and can be assigned to products only on an arbitrary that Product D is actually unprofitable for the company to produce.
basis. Although organizational-level costs should theoretically not be assigned
to products at all, some companies attach them to goods produced or services
rendered because the amounts are insignificant relative to all other costs. Total overhead cost P1,505,250
Total machine hours 111,500
Accountants have traditionally (and incorrectly) assumed that when costs did Overhead rate per machine hour P13.50
not vary with changes in production at the unit level, those costs were fixed
rather than variable. In reality, batch-, product/process-, and organizational-
level costs are all variable, but they vary for reasons other than changes in PRODUCT C PRODUCT D PRODUCT E
(5,000 units) (1,500 units) (105,000 units) TOTAL
production volume. Therefore, to determine a valid estimate of product or
service cost, costs should be accumulated by cost level. Because unit-, batch- Unit Total Unit Total Unit Total
, and product/process-level costs are all associated with units of products or Product
P50.0 P250,000 P45.0 P67,500 P40.0 P4,200,000 P4,517,500
Revenue
services (merely at different levels), these costs can be summed at the
Product
product/service level to match with the revenues generated by product sales. Costs
Organizational-level costs are not product related, so they should be Direct P20.0 P100,000 P20.0 P30,000 P 9.0 P945,000
subtracted only in total from net product revenues. Overhead 13.5 67,500 13.5 20,250 13.5 1,417,500
Total P33.5 P167,500 P33.5 P50,250 P22.5 P2,362,500 (2,580,250)
Net
Cost Level Allocations Illustrated Income
P82,500 P17,250 P1,837,500 P1,937,250

Each product cost is multiplied by the number of units sold,

and that amount (cost of goods sold) is subtracted from total product revenues PRODUCT C PRODUCT D PRODUCT E
to obtain a product line profit or loss amount. These computations would be (5,000 units) (1,500 units) (105,000 units) TOTAL
performed for each product line and summed to determine net product income Unit Total Unit Total Unit Total
or loss from which the unassigned organizational-level costs would be Product
P50.0 P250,000 P45.0 P67,500 P40.0 P4,200,000 P4,517,500
Revenue
subtracted to find company profit or loss for internal management use. In this Product Costs
model, the traditional distinction between product and period costs can be Direct P20.0 P100,000 P20.0 P30,000 P 9.0 P945,000
ignored. The emphasis is on modifying product profitability analysis to focus Overhead
- Unit Level P 8.0 P40,000 P12.0 P18,000 P6.0 P630,000
on internal management purposes rather than on external reporting. - Batch Level 9.0 45,000 19.0 28,500 3.0 315,000

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- Product Level 3.0 15,000 15.0 22,500 2.0 210,000 Management should consider the following issues in defining these centers:
Total P40.0 P200,000 P66.0 P99,000 P20.0 P2,100,000 (2,399,000)
Product line · geographical proximity of equipment
income or P50,000 (P31,500) P2,100,000 P2,118,500 · defined centers of managerial responsibility
(loss)
Organizational
(181,250) · magnitude of product costs
-level costs
· the need to keep the number of activity centers manageable
Net Income P1,937,250

Activity Driver measures the demands placed on activities, thus, the

Accountants have traditionally accumulated costs as transactions occurred, resources consumed by products and services. An activity driver often
thus, focused on the cost’s amount rather than its source. However, this lack indicates an activity’s output.
of consideration for underlying causes of costs has often resulted in both a
lack of ability to control costs and flawed product cost data. Traditional cost Significant cost drivers that have traditionally been disregarded are related to
allocations tend to subsidize low-volume specialty products by misallocating variety and complexity:
overhead to high-volume, standard products. This problem occurs because · Product Variety – the number of different types of products made
costs of the extra activities needed to make specialty products are assigned · Product Complexity – the number of components included in a
using the one or very few drivers of traditional costing—and usually these product
drivers are volume based (Raiborn & Kinney, 2013). · Process Complexity – the number of processes through which a
product flows
ACTIVITY-BASED COSTING These characteristics create additional overhead costs for activities such as
warehousing, purchasing, setups, and inspections – all of which can be seen
Activity-based costing (ABC) is a cost accounting system that focuses on as “long-term variable costs” – because they will increase as the number and
an organization’s activities and collects costs on the basis of the underlying types of products increase. Therefore, accountants should consider using
nature and extent of those activities. items such as number of product types, number of components, and number
of necessary processes as the cost drivers for applying ABC.
Multiple predetermined OH rates are then calculated using the various cost
drivers of organizational activities. ABC focuses on attaching costs to products Activity-Based Costing Illustrated
and services based on the activities conducted to produce, perform, distribute,
and support those products and services. The three (3) fundamental Factory Maintenance Department: The conventional system assigns this
components of activity-based costing are: department’s human resources costs to products using direct labor hours
(DLHs). The department had nine (9) employees and incurred P450,000 (or
· recognizing that costs are incurred at different organizational levels; P50,000 per employee) of human resources costs in 20CY. During the same
· accumulating costs into related cost pools; and year, expected DLHs had been 200,000 and 10,000 units of Z4395 were
· using multiple cost drivers to assign costs to products and services. produced using 3,000 DLHs.

Costs in an ABC system are accumulated in activity center cost pools after Additional data are available:
being recorded in the general ledger and sub-ledger accounts.
Activity Centers Costs Activity Drivers
Activity Center refers to any part of the production or service process for Regular maintenance P250,000 500,000 MHs
which management wants a separate reporting of costs. Preventive maintenance P100,000 5,000 setups
Repairs P100,000 100,000 machine starts

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10,000 units of Z4395 One of the company’s products is Z4395, a rather complex unit with relatively
Machine Hours 30,000 low demand. Note that the cost allocated to it with the activity-based costing
system is 132% higher than the cost allocated with the traditional allocation
Number of Setups 30
system (P1.564 vs. P0.675). Discrepancies in cost assignments between
Number of Machine Starts 40
traditional and activity-based costing methods are not uncommon.
Required: Determine the production cost per unit using ABC and traditional
Activity-based costing systems indicate that significant resources are
method of costing.
consumed by low-volume products and complex production operations.
Studies have shown that, after the implementation of activity-based costing,
ABC Costing: 1st step: Determine the pool rates:
the costs of high-volume standard products determined by the ABC system
are often anywhere from 10 to 30 percent lower than costs determined by
Regular maintenance P250,000 ÷ 500,000 MHs P0.5/MH traditional cost systems. Costs assigned to low-volume complex specialty
Preventive maintenance P100,000 ÷ 5,000 setups P20/setup products tend to increase from 100 to 500 percent after implementing ABC,
P100,000 ÷ 100,000 although some cases have shown significantly higher percentage increases in
Repairs P1/machine start
machine starts costs. Thus, ABC typically shifts a substantial amount of overhead cost from
standard high-volume products to premium special-order low-volume
2nd step: Allocate the overhead using the pool rates determined. products.

Regular maintenance 30,000 x P0.5/MH P15,000 The ABC costs of moderately complex products and services (those that are
Preventive maintenance 30 x P20/setup 600 neither extremely simple nor complex nor produced in extremely low or high
Repairs 40 x P1/machine start 40 volumes) tend to remain approximately the same as the costs calculated using
TOTAL P15,640 traditional costing methods.
Divided by 10,000
Cost allocated per unit P1.564/unit

Traditional Costing is computed by dividing the overhead cost by the level of

activity to arrive at the overhead rate. References:
de Leon, N. D., & de Leon, Jr., G. M. (2014). Cost accounting. Manila CIty: GIC
Traditional cost per DLH is P2.25 (or P450,000 ÷ 200,000) Enterprises & Co., Inc.
Guerrero, P. (2015). Cost accounting: principles and procedural applications, 2014-
Allocation to Z4395 = (3,000 x P2.25) = P6,750 ÷ 10,000 = P0.675/unit
2015 Edition. Manila: GIC Enterprises and Co. Inc.
Horngen, C. T., Datar, S. M., & Rajan, M. (2013). Cost accounting: a managerial
The process begins by gathering information about the activities and costs for emphasis. New Jersey, New Jersey, United States of America: Pearson
a factory maintenance department. Costs are then assigned to specific Prentice Hall.
products based on activities. This department allocates its total human Raiborn, C. A., & Kinney, M. R. (2013). Cost accounting . Pasig City: Cengage Learning
resources cost among the three (3) activities performed in that department Asia Pte Ltd (Philippine Branch).
based on the number of employees in each area. This allocation reflects the Rante, G. A. (2016). Cost accounting. Mandaluyong City: Millenium Books, Inc.
fact that occurrences of a specific activity, rather than volume of production or The Chartered Institute of Management Accountants. (2001). Technical Briefing.
service, drive work performed in the department. Developing and promoting strategy, 6.

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