ACTIVITY-BASED MANAGEMENT AND

ACTIVITY-BASED COSTING

Learning Objectives

After reading and studying Chapter 4, you should be able to answer the following questions:

1. In an activity-based management system, what are value-added and non-value-added activities?

2. How do value-added and non-value-added activities affect manufacturing cycle efficiency?

3. Why is it important to analyze the drivers of costs?

4. How are product costs computed using an activity-based costing system?

5. Under what conditions is activity-based costing useful in an organization and what information do
activity-based costing systems provide to management?

6. What criticisms have been directed at activity-based costing?

 Terminology

Activity: A repetitive action performed in fulfillment of business functions

Activity analysis: The process of studying activities to classify them and to devise ways to minimize or
eliminate activities that increase costs but provide little or no customer value

Activity-based costing: A cost accounting system that focuses on the various activities performed in an
organization and collects costs on the basis of the underlying nature and extent of those activities

Activity-based management (ABM): A management approach that focuses on controlling production or

performance activities to improve customer value and enhance profitability

Activity center: A segment of the production or service process for which management wants to
separately report the costs of the activities performed

Activity driver: A measure of the demands on activities and, thus, the resources consumed by products
and services; often indicates an activity’s output

Batch-level cost: A cost that is caused by a group of things being made, handled, or processed at a
single time

Business-value-added activity: An activity that is necessary for the operation of the business but for
which a customer would not want to pay

Continuous improvement: An ongoing process whose objective is to reduce cycle time, make products
and services with zero defects, reduce product costs on an ongoing basis, and simplify products and
processes

Cost driver analysis: The process of investigating, quantifying, and explaining the relationships of cost
drivers and their related costs

Cycle (lead) time: The time between the receipt to completion of an order for a product or service; it is
equal to value-added time plus non-value-added time

Idle time: The amount of (non-value-added) time spent storing inventory or waiting at a production
operation for processing

Inspection time: The (non-value-added) time taken to perform quality control activities other than what is
internal to the process

Manufacturing cycle efficiency (MCE): A ratio resulting from dividing the total value-added processing
time by total cycle time; it reflects the proportion of lead time that is value-added

Mass customization: Personalized production generally accomplished through the use of flexible
manufacturing systems; it reflects an organization’s increase in product variety from the same basic
component elements

Non-value-added activity (NVA): An activity that increases the time spent on a product or service but
does not increase its worth

Organization-level cost: A cost incurred to support the ongoing facility or operations

Pareto principle: A principle that suggests that in many situations, it is common to observe that
approximately 20 percent of “inputs” (choices) are responsible for 80 percent of “outputs” (selections); this
relationship is often referred to as the 20:80 rule
Process: A series of activities that, when performed together, satisfy a specific objective

Process complexity: Refers to the number of processes through which a product flows

Process map: A flowchart or diagram indicating every step that goes into making a product or providing a
service

Processing (service) time: The actual (value-added) time consumed performing the functions necessary
to manufacture a product

Product complexity: Refers to the number of components included in a product

Product- level (or process-level) cost: A cost that is caused by the development, production, or
acquisition of different items

Product variety: The number of different types of products produced or services rendered

Service cycle efficiency: A ratio resulting by dividing total actual service time by total cycle time

Transfer time: The (non-value-added) time consumed by moving products or components from one
place to another

Unit-level cost: A cost caused by the production or acquisition of a single unit of product or the delivery
of a single unit of service

Value added activity: An activity that increases the worth of a product or service to a customer and is
one for which the customer is willing to pay

Value chart: A visual representation indicating the value-added and non-value-added activities and time
spent in those activities from the beginning to the end of a process
 Lecture Outline

LO.1: In an activity-based management system, what are value-added and non-value-added

activities?

A. Introduction

1. To succeed in today’s global marketplace, companies must generate high-quality products or

services and have competitive cost structures.

2. An understanding of the drivers or underlying causes of costs is necessary to create cost

efficiencies.

3. Traditionally, a single driver (e.g., direct labor hours, or direct labor costs, or machine hours) was
used to establish predetermined overhead rates. However, many alternative activity bases are
available that can improve management information and enhance the competitive advantage of
an organization.

4. This module discusses activity-based management and activity-based costing which allow a more
direct focus on the actions that occur in an organization and the overhead costs that are created
by those actions.

B. Activity-Based Management

1. Product cost determination, although specifically designated as an accounting function, is a major

concern of all managers.

a. Customers purchase a product or service only if they perceive that it provides acceptable
value for the price.

2. Activity-Based Management focuses on controlling the activities incurred during the production
or performance process to improve customer value and enhance profitability.

a. Activity analysis is the process of studying activities to classify them as value-added or non-
value-added and to devise ways of minimizing or eliminating the activities that increase costs
but provide little or no customer value.

3. Value-Added versus Non-Value-Added Activities

a. An activity is a repetitive action performed in fulfillment of business functions.

i. Activities may be designated as value-added and non-value-added.

b. A value-added activity (VA) is an activity that increases the worth of a product or service to
the customer and for which the customer is willing to pay.

c. A non-value-added activity (NVA) is an activity that increases the time spent on a product
or service but does not increase its worth.

i. NVA activities can be reduced, redesigned, or eliminated without affecting the market
value or quality of a product or service.
 d. A business-value-added activity is an activity that is necessary for the operation of a
business (e.g., preparing sales invoices) but for which a customer would not want to pay.

e. Activities drive the consumption of resources, and, in turn, resource consumption drives
costs.

i. Companies that can reduce or eliminate NVA activities can obtain a larger profit margin.

f. A process is a series of activities that, when performed together, satisfy a specific objective.

g. A process map is a detailed flowchart that indicates every step that goes into making a
product or providing a service.

h. A value chart is a visual representation that identifies the stages and the time spent in those
stages from the beginning to the end of a process.

LO. 2: How do value-added and non-value-added activities affect manufacturing cycle efficiency?

4. Manufacturing Cycle Efficiency

a. There are four types of time that comprise the entire processing time of an entity:

i. Processing (or service) time is the actual time it takes to perform the functions
necessary to manufacture a product or perform a service; this quantity of time is value-
added;

ii. Inspection time is the time taken to perform quality control activities. Such time is non-
value-added time;

iii. Transfer time is the time consumed moving products or components from one place to
another. Such time is non-value-added time; and

iv. Idle time is the amount of time spent in storing inventory or waiting at a production
operation for processing. Such time is non-value-added time.

b. Inspection time, idle time, and transfer time all add no value. Therefore, cycle (lead) time is
equal to value-added processing time plus non-value-added time.

c. Manufacturing cycle efficiency (MCE) is a ratio resulting from dividing the value-added
processing time by total cycle time. The longer the cycle time, the longer time the product has
to “pull” costs to it

d. A service company would compute service cycle efficiency (SCE) by dividing the actual
service time by total cycle time.

i. Cycle time for a service company refers to the time between the service order and
service completion. All time spent on activities that are not actual service performance
are considered non-value-added for that job.

e. Most production processes add value to products only approximately 10 percent of the time
from the receipt of the raw material until shipment.
 i. A JIT manufacturing process may achieve higher efficiency, eliminating idle time for
storage and thus increasing MCE.

f. Cycle time in a retail environment is the time from ordering an item to the sale of that item to
a customer. Non-value-added activities include shipping time from the supplier, receiving
delays for counting merchandise, and any storage time between receipt and sale.

g. Non-value-added activities can be attributed to systemic, physical, and human factors.

i. For example, a systemic cause is the need to manufacture products in large batches to
minimize setup costs.

ii. For example, NVA activities caused by physical factors include having to move raw
materials from the receiving area to the manufacturing area.

iii. For example, NVA activities caused by human factors include increased cycle time due to
inadequate employee training.

h. The NVA activities that create the highest costs should be the ones management focuses its
efforts on diminishing or eliminating.

i. Constructing a value chart for selected products or services will help management
identify where the company is losing time and money through NVA activities.

i. The concentration of attention on the elimination of NVA activities should cause product
quality to increase and cycle time and cost to decrease.

LO.3: Why is it important to analyze the drivers of costs?

C. Cost Driver Analysis

1. All activities have cost drivers that consume resources and cause costs to be incurred.

a. Cost drivers are the factors having direct cause-effect relationships with costs.

i. A cost driver should be easy to understand, directly related to the activity being
performed, and appropriate for performance measurement.

b. A greater number of cost drivers can normally be identified than should be used for cost
allocation or activity elimination. Management should, therefore, restrict the cost drivers
chosen to a reasonable number and determine that the cost of measuring each cost driver
does not exceed the benefit of using it.

c. Costs have traditionally been accumulated into one or two cost pools —total factory overhead
or variable and fixed factory overhead.

d. Pooled costs have been assigned to products and services using one or two cost drivers—
direct labor hours and/or machine hours.

e. The use of single cost pools and single cost drivers may produce illogical product or service
costs in complex production (or service) environments.

2. Levels at Which Costs are Incurred

 a. Cost Driver Analysis is the process of investigating, quantifying, and explaining the
relationships of cost drivers and their related costs.

i. Cost driver analysis identifies the activities causing the costs to be incurred.

b. To determine a valid estimate of a product or service cost, costs should be accumulated by

cost level:

i. A unit-level cost is a cost that is caused by the production or acquisition of a single unit
of product or the delivery of a single unit of service.

ii. A batch-level cost is a cost that is caused by a group of things made, handled, or
processed at a single time.

iii. A product- level (or process-level) cost is a cost that is caused by the development,
production, or acquisition of different items.

iv. An organizational or facility-level cost is a cost incurred to support the ongoing facility
operations.

3. Cost Level Allocations Illustrated

a. costs are collected at the unit, batch, and product/process levels can be aggregated to
estimate a total product cost.

i. Because this approach ignores the product/period cost distinction required by GAAP, it is
not currently acceptable for external reporting.

LO. 4: How are product costs computed using an activity-based costing system?

D. Activity Based Costing

1. Activity-based costing (ABC) is a cost accounting system that focuses on the various activities
performed in an organization and collects costs on the basis of the underlying nature and extent
of those activities.

a. Recognizing that costs are incurred at different organizational levels, accumulating costs into
related cost pools, and using multiple cost drivers to assign costs to products and services
are the three fundamental components of activity-based costing.

b. ABC focuses on attaching costs to products and services based on the activities required to
produce, perform, distribute, or support those products and services.

2. Two-Step Allocation

a. Costs, after being initially recorded, are accumulated in activity center cost pools using first-
step cost drivers that reflect the appropriate level of cost incurrence (unit, batch, or
product/process).

i. An activity center is a segment of the production or service process for which

management wants to separately report the costs of the activities performed.
 b. Costs, after accumulation, are allocated out of the activity center cost pools and applied to
products and services using a second-step cost driver, referred to as an activity driver.

i. An activity driver is a measure of the demands placed on activities and, thus, the
resources consumed by products and services; it often indicates an activity’s output.

c. the two-step allocation process of tracing costs to products and services in an ABC system.

i. Costs at the lowest (unit) level of activity should be allocated to products by use of
volume-related drivers.

ii. Costs incurred at higher (batch and product/process) levels can also be allocated to
products by use of volume-related drivers, but the volume measure should include only
those units associated with the batch or the product/process – not with total production or
service volume.

d. some common drivers for various activity centers.

i. Three significant cost drivers that have traditionally been disregarded are related to
variety and complexity:

 Product variety (the number of different types of products made);

 Product complexity (the number of components included in a product); and

 Process complexity (the number of processes through which a product flows).

ii. These characteristics create additional overhead costs for activities such as
warehousing, purchasing, setups, and inspections – all of which can be seen as long-
term variable costs because they will increase as the number of products increase.

 Therefore, accountants should consider using drivers such as number of product

types, number of components, and number of necessary processes to assign such
costs to production.

3. Activity-Based Costing

a. Discrepancies in cost assignments between traditional and ABC methods are not uncommon.

i. Activity-based costing systems indicate that significant resources are consumed by low-
volume products and complex production operations.

ii. Activity-based costing systems typically shift a substantial amount of overhead cost from
standard high-volume products to premium special-order low-volume products.

iii. The ABC costs of moderately complex products and services (those that are neither
extremely simple nor complex nor are produced in extremely low or high volumes) tend to
remain approximately the same as costs calculated using traditional costing methods.

b. ABC is useful in companies having the following characteristics:

i. The production or performance of a wide variety of products or services;

 ii. High overhead costs that are not proportional to the unit volume of individual products;

iii. Significant automation that has made it increasingly more difficult to assign overhead to
products using the traditional direct labor or machine hour bases;

iv. Profit margins that are difficult to explain; and

v. Hard-to-make products that show big profits and easy-to-make products that show
losses.

LO.5: Under what conditions is activity-based costing useful in an organization and what
information do activity-based costing systems provide to management?

E. Determining Whether ABC is Appropriate

1. A vital loss of information may occur in an accounting system that ignores activity and cost
relationships.

a. There are some general operating activity clues that may alert managers to the need to
review the cost data being provided by their conventional accounting system:

i. Number and diversity of products or services produced;

ii. Diversity and differential degree of support services used for different products;

iii. Extent to which common processes are used;

iv. Effectiveness of current cost allocation methods; and

v. Rate of growth of period costs.

b. New information will change management decisions only if:

i. Management is free to set product/service prices;

ii. There are no strategic constraints in the company; and

iii. There is a climate and culture of cost reduction in the company.

2. Large Product Variety

a. Product variety refers to the number of different types of products made.

b. Mass customization refers to the relatively low-cost mass production of products to the
unique specifications of individual customers; it requires the use of flexible manufacturing
systems.

i. Mass customization does have some drawbacks:

 There can be too many choices, creating confusion for customers;

 Mass customization creates a tremendous opportunity for errors; and

 ii. When given a wide variety of choices, customers typically make selections based on the
Pareto Principle which suggests that in many situations, it is common to observe that
approximately 20 percent of “inputs” (choices) are responsible for 80 percent of “outputs”
(selections).

c. Most traditional cost systems do not provide information such as the number of different parts
that are used in a product so management cannot identify products made with low-volume or
unique components. ABC systems can gather this important information.

3. High Product/Process Complexity

a. Companies with complex products, services, or processes should investigate ways to reduce
complexity.

i. With ABC data, reengineering efforts can be focused on the primary causes of
process complexity and on the causes that create the highest levels of waste.

b. Process complexity can create difficulties for the people performing the operations or using
the machinery and therefore is indicative of abundant non-value-added activities that can
cause time delays and cost increases.

c. Complexity is acceptable only if it adds value from the customer’s point of view.

4. Lack of Commonality in Overhead Costs

a. Certain products and services create considerably more overhead costs than others.

i. While some of the additional costs may be caused by product variety or product
complexity, others may be related to a variety of support services.

ii. Some products require high levels of advertising, some use high-cost distribution
channels, and some require high technology machinery.

iii. Overhead related to specific products will be spread over all products if only one or two
overhead cost pools are used.

iv. The result is increased costs for some products that should be costed lower and lower
costs for some products that should be costed higher.

5. Irrationality of Current Cost Allocations

a. Managers and accountants need to ascertain whether the existing cost system still provides a
reasonable estimate of product or service cost if a company’s process or product/service line
has undergone one or more significant changes.

b. Many companies with automated production processes have experienced large increases in
overhead costs and large decreases in labor. In such firms, the use of direct labor as an
overhead allocation base produces extremely high application rates.

6. Changes in Business Environment

a. A change in the competitive environment in which a company operates may also mean a
need for better cost information. Increased competition may occur for several reasons:
 i. Other companies have recognized the profit potential of a particular product or service;

ii. The product or service has become cost-feasible to make or perform; or

iii. An industry has been deregulated.

b. Changes in management strategy can also signal a need for a new cost system.

c. Continuous improvement is an ongoing process of enhancing employee task performance,

level of product quality, and level of company service through eliminating non-value-added
activities to reduce lead time, making products (performing services) with zero defects,
reducing product costs on an ongoing basis, and simplifying products and processes.

d. The benefits from ABC are two-dimensional in that ABC improves product costs for
managerial decision making and improves the performance measurement process.

e. Traditional accounting systems focus attention on controlling cost incurrence, while ABC
concentrates on controlling the causes (activities) of the cost incurrence.

LO.6: What criticisms have been directed at activity-based costing?

F. Criticisms of Activity-Based Costing

1. ABC implementation necessitates a considerable amount of time and cost. Significant support is
needed throughout the firm for the implementation process to be successful.

2. Management must create an environment for change that overcomes a variety of individual,
organizational, and environmental barriers.

a. Individual barriers are typically related to fear of the unknown or shift in status quo; potential
loss of status; or a necessity to learn new skills.

b. Organizational barriers are often related to territorial, hierarchical, or corporate culture issues.

c. Environmental barriers are often built by employee groups (including unions), regulatory
agencies, or other stakeholders of interest.

3. ABC does not specifically comply with generally accepted accounting principles.

a. ABC suggests that some non-product costs such as those for R&D should be allocated to
products, whereas certain other traditionally designated product costs such as factory
depreciation should not be allocated to products.

4. Companies attempting to implement ABC systems as a cure-all for product failures, sales volume
declines, or financial losses will quickly find that the system is ineffective for those purposes.

5. Companies can implement ABC in support and in conjunction with total quality management, just-
in-time, or any other world-class methodologies.

a. Doing so will provide the firm’s customers with the best variety, price, quality, service, and
lead time possible.
b. ABC and ABM are effective in supporting continuous improvement, short lead times, and
flexible manufacturing by helping managers to:

i. identify and monitor significant technology costs;

ii. trace many technology costs directly to products;

iii. increase market share;

iv. identify the cost drivers that create or influence cost;

v. identify activities that do not contribute to perceived customer value (i.e., non-value-
added activities or waste);

vi. understand the impact of new technologies on all elements of performance;

vii. translate company goals into activity goals;

viii. analyze the performance of activities across business functions;

ix. analyze performance problems; and

x. promote standards of excellence.

c. a graph portraying efficiency and effectiveness of operations and indicates the quadrant in
which ABM and ABC will help organizations operate.
 Multiple Choice Questions

1. (LO.1) Activity-based management (ABM) focuses on improving customer value and enhancing
profitability. Which of the following is an impact of implementing ABM to control production
processes?
a. More effective performance evaluation
b. More accurate cost determination and control
c. More efficient production processes
d. All of the above

2. (LO.1) Select the incorrect statement from the following.

a. An activity is any repetitive action that is performed in fulfillment of a business function.
b. Non-value-added activities increase the time spent on a product but do not increase its worth.
c. The objective of activity-based management is to eliminate all non-value-added activities.
d. Activity analysis attempts to classify activities as value added or non-value-added.

3. (LO.1) All of the following are non-value-added time except:

a. inspection time.
b. move time.
c. processing time.
d. wait time.

4. (LO.2) Which of the following correctly computes manufacturing cycle efficiency?

a. Total Cycle Time – Total Value-Added Time.
b. Total Cycle Time / Total Value-Added Time.
c. Total Value-Added Time + Total Non-Value-Added Time.
d. Total Value-Added Time / Total Cycle Time.

5. (LO.2) The need to rework products because of a poorly designed training program is an example
of a non-value-added activity caused by
a. systemic factors.
b. physical factors.
c. human factors.
d. None of the above.

6. (LO3) All of the following are examples of batch-level costs except:

a. costs of engineering change orders.
b. purchase order costs.
c. inspection costs.
d. movement costs.

7. (LO.3) Select the incorrect matching of cost and cost level.

a. Unit level : Direct material
b. Facility level : Equipment maintenance
c. Product level : Product development
d. Batch level : Setup costs

8. (LO.4) Which costing system assigns costs within multiple cost pools to products using multiple
drivers?
a. Activity-based costing
b. Variable costing
c. Traditional costing
d. None of the above
9. (LO.4) E Corporation, which makes electronic components for NASA’s space shuttle, uses
activity-based costing. One of its activities is described below:

Est. Qty of Required for

Activity Cost Driver Cost Driver Cost Rate Current contract
(1) Quality control No. of units 210,000 units $0.14 17,500 units

Select the incorrect statement from the following.

a. $2,450 will be assigned to the contract on which the company is currently working.
b. The company’s annual estimated quality control costs cannot be determined from the
information provided.
c. Since the component is being built for the U.S. Government for use on the space shuttle, it is
not unusual for the company to inspect every unit produced.
d. It is likely that the company uses a different cost driver to assign other support costs such as
setup costs.

The next two questions are based on the following information:

P Company is considering using activity-based costing instead of its traditional costing system
because it believes its current system may be providing misleading information. The following
data shows the budgeted manufacturing overhead.

Budgeted Budgeted
Activity Cost Driver Activity Cost
Materials handling No. of parts handled 6,000,000 $720,000
Setup costs No. of setups 750 315,000
Machining costs Machine hours (MH) 30,000 540,000
Quality control No. of batches 500 225,000
Total overhead cost $1,800,000

The company also estimates that it will work 50,000 direct labor hours in the coming year. The
following information is provided for one of the company’s products for the coming year:

Direct material and Direct Labor

Direct materials cost per unit $4.40
Direct labor cost per unit
.05 DLH @ $15/DLH .75
Total $5.15

Sales and production data:

Expected sales 20,000 units
Batch size 5,000 units
Setups 2 per batch
Total parts per finished unit 5 parts
Machine hour required 80 MH per batch

10. (LO.4) If the organization uses a traditional full cost system, the cost per unit of this product for
the coming year will be
a. $6.95.
b. $6.11.
c. $5.44.
d. $5.39.
11. (LO.4) If the organization uses an activity-based cost system, the cost per unit of this product for
the coming year will be
a. $6.30.
b. $6.21.
c. $6.08.
d. $6.00.

12. (LO.5) The use of activity-based costing normally results in:

a. substantially lower unit costs for low-volume products than is reported by traditional product
costing.
b. equalizing setup costs for all product lines.
c. decreased setup costs being charged to low-volume products.
d. substantially greater unit costs for low-volume products than is reported by traditional product
costing.

13. (LO.5) Because of the changes that are occurring in the basic operations of many firms, all of the
following represent trends in the way indirect costs are allocated except:
a. treating direct labor as an indirect manufacturing cost in an automated factory.
b. using throughput time as an application base to increase awareness of the costs associated
with lengthened throughput time.
c. preferring plant-wide application rates that are applied to machine hours rather than incurring
the cost of detailed allocations.
d. using several machine cost pools to measure product costs on the basis of time in a machine
center.

14. (LO.5) Activity-Based Costing is appropriate for which of the following organizations?
a. One that produces and sells a wide variety of products.
b. One that produces and sells a single complex product.
c. One that provides a single service to customers.
d. All of the above

15. (LO.6) A number of barriers must be overcome to implement activity-based costing systems
successfully. Select the barrier that is not matched up properly with its type.
a. Fear of change Individual barrier
b. Regulatory agencies Environmental barrier
c. Corporate culture issues Organizational barrier
d. All of the above barriers are properly classified.