Chapter 5

Activity-Based Costing
and
Activity-Based Management

Activity Based Costing System (ABC)

ABC systems follow a two-stage procedure to assign overhead
costs to products.
Stage One: Identify significant activities and assign overhead costs to each activity in
proportion to resources used.
Stage Two: Identify cost drivers appropriate to each activity and allocate overhead to the
products.
Assigning Overhead to product costs is a difficult process.
Lets begin by identifying our major activities.
The first stage identifies significant activities in the production process and assigns overhead costs to each activity in
accordance with the cost of the organizations resources used by the activity. The overhead costs assigned to each activity
comprise an activity cost pool.
Overhead assigned to activities are called activities cost pools.
After assigning overhead costs to activity cost pools in stage one, cost drivers appropriate for each cost pool are identified in
stage two. Then the overhead costs are allocated from each activity cost pool to each product line in proportion to the
amount of the cost driver consumed by the product line.
5-2

Cost Hierarchies

ABC uses a four-level cost structure to determine how far down the production
cycle costs should be pushed:
Unit-level (output-level)
Batch-level
Product-sustaining-level
Facility-sustaining-level

 Aerotech identified eight activity cost pools, which fall into four broad
categories: unit level, batch level, product-sustaining level and facility
level.
The activity at the unit level must be applied to each unit produced.
The activity at the batch level must be performed one time for each
batch that goes into production.
The product-sustaining activities are required to support the entire
product line, but not needed for each unit or batch.
Facility-level activities are required in order for the entire production
process to occur.

Overhead Costs
Activity
must be
done on
each unit
produced.

Identification
of Activity
Cost Pools

Total budgeted cost = $3,894,000

Activity
Cost
Pools

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Activity
performed
on each
batch
produced.

Activities needed to support

an entire product line

Facility
Level
Facility
cost pool
$507,400

Activity required in order

for the production
process to occur.
5-5

STAGE ONE
Various overhead
costs related
to machinery

Activity
cost
pool

Maintenance

Lubrication

Depreciation

Electricity

Computer Support

Calibration

Machinery Cost Pool

Total budgeted cost = $1,212,600

Aerotech estimated the costs of maintenance, lubrication, depreciation, electricity, computer support and calibration. These
costs are added together. The sum is the machinery cost pool budgeted cost.
5-6

Calculate
the pool
rate
Cost
Assignment
Aerotech selected machine hours for
the cost driver, since a product that
uses more machine hours should
bear a larger share of machinerelated costs.
The budgeted machinery costs are
divided by the budgeted number of
machine hours to arrive at the
machinery cost pool rate.

STAGE TWO
Budgeted Machinery Costs
Budgeted Machine Hours

Mode I:
$28.20 per hr.
1 hr. per unit
$28.20 per unit

$1,212,600 =
43,000
$28.20/hour =

Mode II:
$28.20 per hr.
1.25 hr. per unit
$35.25 per unit

Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit

Then, for each circuit board, the machinery cost pool rate is multiplied by the number of machine hours per board
5-7

Distorted Product Costs

Tr a d i t i o n a l c o s t i n g
AB C c o s t i n g
Co s t d i s t o r t i o n pe r u n i t
U n i t s pr o d u c e d
To t a l c o s t d i s t o r t i o n

Can you identify any problems Aerotech

is likely to face as a result of this distortion?
Mo d e I
$ 2 0 9 .0 0
1 8 3 .4 4
2 5 .5 6
1 0 ,0 0 0
2 5 5 ,6 0 0

Mo d e I I
$ 3 0 2 .0 0
2 6 1 .8 1
4 0 .1 9
2 0 ,0 0 0
8 0 3 ,8 0 0

Mo d e I I I
$
1 2 6 .0 0
3 9 0 .8 5
( 2 6 4 .8 5 )
4 ,0 0 0
( 1 ,0 5 9 ,4 0 0 )

Traditional costing understates the cost of complex, low volume products

The cost per unit under ABC costing is deducted from the traditional costing unit cost.
This is cost distortion per unit.
The problem with cost distortion is more evident when the cost distortion per unit is multiplied by the number of units
produced.
The essence of the problem is that the traditional, volume-based costing system was over costing the high-volume product lines
(Modes I and II) and under costing the complex, relatively low volume product line (Mode III).
The high-volume products basically subsidized the low volume line.
The activity-based costing system revealed this problem by more accurately assigning overhead costs to the three product lines.
When the costs are understated, so is the selling price. See problem 1&2

5-8

ABC vs Simple Costing

ABC is generally perceived to produce superior costing

figures due to the use of multiple drivers across multiple
levels

ABC is only as good as the drivers selected, and their actual

relationship to costs. Poorly chosen drivers will produce
inaccurate costs, even with ABC

Conclusions

Each method is mathematically correct

Each method is acceptable

Each method yields a different cost figure, which will lead

to different Gross Margin calculations

Only Overhead is involved. Total Costs for the entire firm

remain the same they are just allocated to different cost
objects within the firm

Selection of the appropriate method and drivers should be

based on experience, industry practices, as well as a costbenefit analysis of each option under consideration

A Cautionary Tale

A number of critical decisions can be made using this

information;
Should one product be pushed over another?
Should one product be dropped?

Accounting for overhead costs is an imprecise science.

Accordingly, best efforts should be put forward to arrive
at a cost that is fair and reasonable.

Rationale for Selecting a More

Refined Costing System

Increase in product diversity

Increase in Indirect Costs

Advances in information technology

Competition in foreign markets

Three guidelines are presented for refining a costing system.

Direct-cost tracing. Identify as many direct costs as is
economically feasible.

Indirect-cost pools. Expand the number of cost pools so that each

pool is somewhat homogeneous. Each cost in the pool has a similar
cause-and-effect relationship with a single cost driver.
Cost-allocation bases. The cost driver serves as the cost allocation
base for each homogeneous indirect-cost pool.
Step 1:

Identify the products that are the chosen cost objects.

Step 2:

Identify the direct costs of the products.

Step 3:

Select the activities and cost-allocation bases to use for

allocating indirect costs to the products.

Step 4:

Identify the indirect costs associated with each cost-allocation

base (activity).

Step 5:

Compute the rate per unit of each cost-allocation base

(activity) used to allocate indirect costs to the products.

Step 6:

Compute the indirect costs allocated to the products.

Step 7:

Compute the total costs of the products by adding all direct and
indirect costs assigned to the products.

Cost Drivers

Behavioral
Effects

Degree of
Correlation

A characteristic of an event or activity that results

in the incurrence of costs. In selecting a cost driver,
we must consider . . .

Cost of
Measurement

A cost driver is a characteristic of an

event or activity that results in the
incurrence of costs.
In activity-based costing systems, the
most significant cost drivers are
identified.
Then a database is created, which
shows how these cost drivers are
distributed across products.
Three factors are important in
selecting appropriate cost drivers.

The first is the degree of

correlation. The concept of an
activity-based costing system is
to infer how each product line
consumes the activity by
observing how each product
line consumes the cost drive,
that is, how closely the two are
correlated.
The closer the correlation, the
more accurate the cost
assignments will be.
Designing any information
system entails cost-benefit
trade-offs.

The more activity cost pools there are in an

activity-based costing system, the greater will be
the accuracy of the cost assignments. However,
more activity cost pools also entail more cost
drivers, which results in greater costs of
implementing and maintaining the system.

Information systems have the potential not only to

facilitate decisions but also to influence the
behavior of decision makers.
This can be good or bad, depending on the
behavioral effects.
In identifying cost drivers, an ABC analyst should
consider the possible behavioral consequences.
Dysfunctional behavioral effects are also possible
5-14

COLLECTING ABC DATA

INTERVIEWS AND PAPER TRAILS - The information for ABC systems initially
comes from interviews with employees in the support departments and a review of
each departments records.

STORYBOARDING - A procedure used to develop a detailed process flow chart,

which visually represents activities and the relationships among activities.
A storyboarding session identifies the key activities involved in each department.
These activities are written on small cards and placed on a large board in the order they are
accomplished.
After several storyboarding sessions, a completed storyboard emerges, recording key activity
information vital to the ABC project.

MULTIDISCIPLINARY ABC PROJECT TEAMS To gather information from all

facets of an organizations operations, it is essential to involve personnel from a variety
of functional areas. A typical ABC project team includes ACCOUNTING, FINANCE,
PRODUCTION, OPERATIONS, ENGINEERS, MARKETING etc.

5-15

Activity-Based Management
Using activity-based
costing (ABC)
information to
support
organizational
strategy, improve
operations, and
manage costs is called
activity-based
management or ABM.

The use of
ABC costing information
to help
management
make decisions

5-16

Activity-Based Management
Activity-based costing establishes relationships
between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.

5-17

Activity-Based Management

A method of management that used ABC as an integral

part in critical decision-making situations, including:
Pricing & product-mix decisions
Cost reduction & process improvement decisions
Design decisions
Planning & managing activities

Two-Dimensional ABC and ActivityBased Management

The vertical element of
the model is the cost
assignment view of an
ABC system.
Cost assignment in an
ABC system uses a twostage cost allocation to
assign the costs of
resources to the firms
cost objects.

Cost Assignment View

Resource costs

Activities

Cost Object :Any

product, service,
customer, activity
or organizational
unit to
which
costs are
assigned for
some
management
purpose.

Cost Objects
5-19

Two-Dimensional ABC and Activity-Based Management

The horizontal element of the model is the process view of an ABC system. The emphasis
now is on the activities themselves, the various processes by which work is accomplished in
the organization. The left-hand side is the activity analysis. This is the identification and
description of the activities conducted in the enterprise.
The right-hand side is
Activity analysis also
Cost Assignment View
the evaluation of
identifies the root causes of
activities through
activities, the events that
performance
trigger activities, and the
Resource costs
measures.
linkages among activities.

Process View

Activity Evaluation

Activity Analysis

Root
Causes

Activity
Triggers

Activities

Cost Objects

Performance
Measures
It is these processes
of activity analysis
and evaluation that
comprise activitybased management.
5-20

Elimination of Non-Value-Added Costs

An important goal of activitybased management is to
identify and eliminate non
value-added activities and
costs.

Activities

Non-value-added activities are

operations that are either (1)
unnecessary and dispensable or
(2) necessary, but inefficient
and improvable.

Nonvalue-added
activities
Unnecessary
Reduce or
Eliminate

Non-value-added costs, which

result from such activities, are
the costs of activities that can
be eliminated without
deterioration of product quality,
performance, or perceived
value.

Necessary
Continually Evaluate
and Improve
5-21

Using ABM to Eliminate Non-ValueAdded Activities and Costs

1. Identify Activities.

2. Identify Non-Value-Added Activities.

3. Understand Activity Linkages, Root Causes, and

Triggers.
Specify
parts

Select
vendor

Receive
parts

Produce
goods

Inspect
finished
goods

Rework
defective
products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.
5-22

 There are a few steps that provide a strategy for eliminating

non value-added costs in both manufacturing and service
industry firms.
Step one identifies all of the organizations significant
activities.

The resulting activity list should be broken down to the most

fundamental level practical.
In step two, the non value-added activities are identified.

Three criteria for determining whether an activity adds value

are as follows:
Is the activity necessary?
Is the activity efficiently performed?
Is an activity sometimes value-added and sometimes nonvalue-added?
In identifying non value-added activities, it is critical to
understand the ways in which activities are linked together.

 The following chain of activities provides an example:

The rework of defective units is a non-value-added activity.
The rework is triggered by the identification of defective products during
inspection.
The root cause of the rework, however, could lie in any one of a number of
preceding activities.
Perhaps the part specifications were in error. Or an unreliable vendor was selected.
Maybe the wrong parts were received. Or the production activity is to blame.
A set of linked activities (such as that depicted above) is called a process.
Sometimes activity analysis is referred to as process value analysis (PVA).
By continually measuring the performance of all activities, and comparing
performance with benchmarks, managements attention may be directed to
unnecessary or inefficient activities.
Non-value-added costs should be highlighted in activity center cost reports.
By identifying non-value-added activities, and reporting their costs, management
can strive toward the ongoing goals of process improvement and elimination of
non-value-added costs.

Using ABM to Eliminate Non-ValueAdded

Activities
and
Costs
One approach that costmanagement analysts find
helpful in identifying nonvalue-added activities is to
categorize the ways in which
time is spent in a production
process.

Inspection time

Move time

Process time

In most manufacturing
operations, time is spent in
the five ways

Storage time

Waiting time

See
problem

5-25

Signals that Suggest that ABC

Implementation Could Help a Firm:

Significant overhead costs allocated using one or two cost

pools

Most or all overhead is considered unit-level

Products that consume different amounts of resources

Products that a firm should successfully make and sell

consistently show small profits

Operations

staff

disagreeing

with

manufacturing and marketing costs

accounting

over

Customer Profitability Analysis

Customer profitability analysis uses
activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.
If managers have a
good understanding
of which customers
are generating the
greatest profit, they
can make moreinformed decisions
about customer
service.

5-27

Customer Profitability Analysis

Required
special
packaging.

Many factors can result in

some customers being more
profitable than others.
Customers that order in small
quantities, order frequently,
often change their orders,
require special packaging or
handling, demand faster
delivery, or need special parts
or engineering design generally
are less profitable than
customers who demand less in
terms of customized services.

Orders
small
quantities.

Often
changes
orders.

Demand
fast
service.

Orders
frequently.

A costly customer
5-28

Customer Profitability Analysis

Customer-Related Activities
Order processing
Sales contacts (phone calls, faxes, etc.)
Sales visits
Shipment processing
Billing and collection
Design/engineering change orders
Special packaging
Special handling

The first step is an activity based

costing analysis of certain
customer-related costs that could
affect a customers profitability.

Cost Driver Base

Purchase orders
Contacts
Visits
Shipments
Invoices
Design changes
Units packaged
Units handled

Cost Drive
Rate
$
150
100
1,000
200
160
4,000
40
60

A company may use these customer

related costs to help determine the
profitability of each customer.

Recall that ABC analysis relies on a cost hierarchy with cost levels, such as unitlevel, batch-level, product-line-level, customer-level, and facility- or generaloperations-level costs.
In this use of activity-based costing, the cost management team will focus on the
customer-related costs.
A company may then use these costs to determine the profitability of each
customer.

5-29

It is a common
and useful way
of presenting a
customerprofitability
analysis to
management.
See
problem

Customer Profitability Analysis

Customer Profitability
Cumulative Operating Income as a % of Total
Operating Income

A graphical
portrayal of the
complete
customerprofitability
analysis is
called a
customerprofitability
profile.

125.0%

100.0%

75% of actual operating income

75.0%

50% of actual operating income

50.0%
25% of actual operating income

25.0%

0.0%
1

4 5

8 9 10 11 12 13 14 15 16 17 18 19 20
5-30