Activity-Based Costing and Management: Managerial Accounting: The Cornerstone of Business Decisions, 4e

Chapter 7:
Activity-Based Costing and

Management
Managerial Accounting:
The Cornerstone of Business Decisions, 4e
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted
in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
Learning Objectives
1. Explain why functional (or volume)-based costing
approaches may produce distorted costs.
2. Explain how an activity-based costing system works for
product costing.
3. Describe activity-based customer costing and activity-based
supplier costing.
4. Explain how activity-based management can be used for cost
reduction.
© 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
1 Limitations of Functional-Based
Cost Accounting Systems
►Plantwide and departmental rates based on
direct labor hours, machine hours, or other
volume-based measures have been used for
decades to assign overhead costs to products
and continue to be used successfully by many
organizations.
► However, for many settings, this approach to
costing is equivalent to an averaging approach and
may produce distorted, or inaccurate, costs.
Cost Accounting Systems (continued)
Product cost
distortions can be
damaging, Continuous
Improvement Total Quality
particularly for those Management
firms whose
business
environment is
characterized by :
Cost Accounting Systems (continued)
►The need for more accurate product costs has
forced many companies to take a serious look
at their costing procedures.
►Two major factors impair the ability of unit-
based plant-wide and departmental rates to
assign overhead costs accurately:
1. The proportion of nonunit-related overhead
costs to total overhead costs is large.
2. The degree of product diversity is great.
1 Nonunit-Related Overhead Costs
►The use of either plantwide rates or departmental
rates assumes that a product’s consumption of
overhead resources is related strictly to the units
produced.
►For unit-level activities (or activities that are performed
each time a unit is produced), this assumption makes
sense.
► But if there are nonunit-level activities (or activities that are
not performed each time a unit of product is produced), the
costs associated with these nonunit-level activities are
unlikely to vary (i.e., increase or decrease) with units
produced.
1 Categorizing Costs under ABC
1 Activity Drivers and the
Consumption of Activities
►Nonunit-level activity drivers (i.e., batch, product-
sustaining, and facility-sustaining) are factors that
measure the consumption of nonunit-level activities
by products and other cost objects, whereas unit-
level activity drivers measure the consumption of
unit-level activities.
►Activity drivers are factors that measure the
consumption of activities by products and other cost
objects and can be classified as either unit-level or
nonunit-level.
1 Distorted Product Costs
►Using only unit-based activity drivers to assign
nonunit-related overhead costs can create distorted
product costs.
►The severity of this distortion depends on what proportion
of total overhead costs these nonunit-based costs
represent.
►If nonunit- based overhead costs are only a small
percentage of total overhead costs, then the
distortion of product costs will be quite small.
►In such a case, using unit-based activity drivers to assign
overhead costs is acceptable.
1 Product Diversity
►The presence of product diversity is also necessary
for product cost distortion to occur.
►Product diversity means that products consume
overhead activities in systematically different
proportions.
►This may occur for several reasons, including differences
in:
1. product size
2. product complexity
3. setup time
4. size of batches
1 Consumption Ratio
►Regardless of the nature of the product diversity,
product cost will be distorted whenever the quantity
of unit-based overhead that a product consumes
does not vary in direct proportion to the quantity
consumed of nonunit-based overhead.
►The proportion of each activity consumed by a
product is defined as the consumption ratio and is
calculated as:
Amount of Activity Driver per Product
Total Driver Quantity
Cornerstone 7-1
1 Calculating Consumption Ratios
Cornerstone 7-1
1 Calculating Consumption Ratios (continued)
Cornerstone 7-2
1 Calculating Activity Rates
Cornerstone 7-3
1 Calculating Activity-Based Unit Costs
Cornerstone 7-3
1 Calculating Activity-Based Unit Costs (continued)
1 Comparison of Functional-Based
and Activity-Based Product Costs
►A plantwide rate based on direct labor hours is
calculated as follows:
►The activity-based cost assignment reflects the pattern of

overhead consumption and is, therefore, the most
accurate.
►Activity-based product costing reveals that functional-
based costing undercosts the low volume deluxe models
and overcosts the high volume regular models.
1 Product Diversity and
Product Costing Accuracy
►For unit-level overhead rates to fail, products must
consume the non-unit-level activities in proportions
significantly different than the unit-level activities.
►The key message of the relationship analysis is that
in a diverse product environment, activity-based
costing promises greater accuracy. Given the
importance of making decisions based on accurate
facts, a detailed look at activity-based costing is
certainly merited.
1 Product Diversity and Product
Costing Accuracy
2 Activity-Based Product Costing
►Functional-based overhead costing involves
two major stages:
1. Overhead costs are assigned to an organizational
unit (plant or department).
2. Overhead costs are then assigned to cost
objects.
2 Activity-Based Product Costing
(continued)
2 Identifying Activities and
Their Attributes
►An activity is action taken or work performed
by equipment or people for other people.
►Identifying activities usually is accomplished
by interviewing managers or representatives
of functional work areas (departments).
2
Questions for Identifying Activities
and Their Attributes
► A set of key questions is asked in which answers provide
much of the data needed for an ABC system. Here are some
examples:
1. How many employees are in your department? (Activities consume
labor.)
2. What do they do (please describe)? (Activities are people doing
things for other people.)
3. Do customers outside your department use any equipment?
(Activities also can be equipment working for other people. In other
words, the equipment provides the service for someone by itself).
4. What resources are used by each activity (equipment, materials,
energy)? (Activities consume resources in addition to labor.)
5. What are the outputs of each activity? (Helps to identify activity
drivers.)
2 Activity Dictionary
►Interview-derived data are used to prepare an
Activity dictionary, which lists the activities in an
organization along with some critical activity
attributes (financial and nonfinancial information
items that describe individual activities). Examples
include:
1. types of resources consumed
2. amount (percentage) of time spent on an activity by workers
3. cost objects that consume the activity output (reason for performing
the activity)
4. measure of the activity output (activity driver)
5. activity name
Activity Dictionary Example
2
for a Credit Card Department
2 Assigning Costs to Activities
► Once activities are identified and described, the next task is to determine
how much it costs to perform each activity.
► This determination requires identification of the resources being
consumed by each activity.
► The cost of labor, energy, materials, and capital is found in the general
ledger, but the money spent on each activity is not revealed.
► Thus, a work distribution matrix is developed which identifies the amount
of labor consumed by each activity and is derived from the interview
process (or a written survey). Here is an example:
2 Resource Drivers
► Both direct tracing and driver tracing are used to assign
resource costs to activities.
► If the resource is shared by several activities (as is the case of
the clerical resource), then the assignment is driver tracing,
and the drivers are called resource drivers, which are factors
that measure the consumption of resources by activities.
► Once resource drivers are identified, then the costs of the
resource can be assigned to the activity.
Cornerstone 7-4
2 Assigning Resource Costs to Activities
By Using Direct Tracing and Resource Drivers
Information:
Refer to the work distribution matrix for Hemingway Bank’s credit card
department below. Assume that each clerk is paid a salary of $30,000
($150,000 total clerical costs for five clerks).
2 Assigning Costs to Products
►Activity costs are assigned to products by multiplying

a predetermined activity rate by the usage of the
activity, as measured by activity drivers.
►To calculate an activity rate, the practical capacity of
each activity must be determined.
►To assign costs, the amount of each activity
consumed by each product must also be known.
3 Activity-Based Customer Costing
and Activity-Based Supplier Costing
► ABC systems originally became popular for their ability to
improve product-costing accuracy by tracing activity costs to
the products that consume the activities.
► However, since the beginning of the 21st century, the use of ABC has
expanded into areas upstream (i.e., before the production section of
the value chain—research and development, prototyping, etc.) and
downstream (i.e., after the production section of the value chain—
marketing, distribution, customer service, etc.) from production.
► Specifically, ABC often is used to more accurately determine
the upstream costs of suppliers and the downstream costs of
customers.
► Knowing the costs of suppliers and customers can be vital information
for improving a company’s profitability.
3
Cumulative Customer Profitability
► A high-tech producer of semiconductors, implemented ABC
customer costing and discovered that 10 percent of its
customers were responsible for about 90 percent of its
profits. It also discovered it was actually losing money on
about 50 percent of its customers. It worked to convert its
unprofitable customers into profitable ones and invited those
who would not provide a fair return to take their business
elsewhere.
► As a consequence, company sales decreased, but its profit
tripled.
► The following slide depicts this interesting yet common
relationship between customers and their contribution to
company profitability.
3 The Whale Curve of Cumulative
Customer Profitability
3
Activity-Based Customer Costing
►Customers are cost objects of fundamental interest.

►Knowing how much it costs to service different
customers can be vital information for the following
purposes:
►setting pricing
►determining customer mix
►improving profitability
►Furthermore, because of diversity of customers,
multiple drivers are needed to trace costs accurately.
3 Customer Costing versus
Product Costing
►Assigning the costs of customer service to customers
is done in the same way that manufacturing costs
are assigned to products.
►Customer-driven activities such as order entry, order
picking, shipping etc; are identified and listed in an
activity dictionary.
►The cost of the resources consumed is assigned to
activities, and the cost of the activities is assigned to
individual customers.
►The same model and procedures that apply to
products apply to customers as well.
3 Cornerstone 7-5
Calculating Activity-Based Customer Costs
Cornerstone 7-5
3 Calculating Activity-Based Customer Costs
(continued)
3
Activity-Based Supplier Costing
►ABC can also help managers identify the true cost of
a firm’s suppliers.
►The cost of a supplier is much more than the purchase
price of the components or materials acquired.
►Just like customers, suppliers can affect many
internal activities of a firm and significantly increase
the cost of purchasing.
►Supplier-driven activities should be identified and listed in
an activity dictionary.
Cornerstone 7-6
3 Calculating Activity-Based Supplier Costs
Cornerstone 7-6
(continued)
Solution:
Using this data, the activity rates for assigning costs to suppliers are
computed as follows:
Cornerstone 7-6
(continued)
3 You Decide
Managing Customer Profitability
As a consultant, you recently implemented an activity-based customer-profitability
system. In your written report to management, you classified the customers of the
company into one of four categories based on current profitability and the potential
for future profitability:
High Profitability, Substantial Future Potential High Profitability, Limited Future Potential
Low Profitability, Substantial Future Potential Low Profitability, Limited Future Potential
After discussing the report with the CEO, he asks you to answer the following
questions:
How would you manage the customers in each of the four categories?
You Decide
3
Managing Customer Profitability (continued)
For highly profitable customers, and especially those with long-term potential,
special efforts should be made to retain these customers as it is much more expensive to
attract new customers. Offering these customers special discounts and new products and
service lines coupled with managing their costs-to-serve to a lower level and improving
business processes are ways to increase customer satisfaction while at the same time
maintaining or increasing profitability. For customers with low profitability but substantial
potential, the goal is to move these customers up to a high profitability state. Pricing policies or
initiatives related to both the order and the transactions caused by the order is one way to
increase profitability (e.g., activity-based pricing is based on the costs-to-serve, something
clearly revealed by the ABC customer model). Another way is to lower the costs to serve by
improving activity efficiency and eliminating nonvalue-added activities. The final category of
customers (low-profitability and limited potential) is managed up or out—these customers
need to be made profitable quickly or simply dropped.
Knowing customer profitability is important because not every revenue dollar
contributes equally to overall profitability. Thus, it is critical for a manager to
understand the net profit contribution that each customer makes to the company.
Understanding individual customer profitability and the associated drivers allows
managers to take actions to sustain and maintain profitable customers and transform
unprofitable customers into profitable customers.
4 Process Value Analysis
►Process-value analysis is fundamental to activity-based
management.
►Activity-based management is a system-wide,
integrated approach that focuses management’s
attention on activities with the objective of improving
customer value and profit achieved by providing this
value.
►Process value analysis focuses on cost reduction
instead of cost assignment and emphasizes the
maximization of system-wide performance.
4 Process Value Analysis Model
Process-Value Analysis is concerned with:
►Driver analysis
►Activity analysis
►Performance measurement
Driver Analysis:
4
The Search for Root Causes
►Managing activities requires an understanding of what
causes activity costs. Every activity has inputs and
outputs.
►Activity inputs are the resources consumed by the
activity in producing its output. Activity output is the
result or product of an activity.
►An activity output measure is the number of times the
activity is performed. It is the quantifiable measure of
the output. For example, the number of moves or
distance moved are possible output measures for the
material moving activity.
►Driver analysis is the effort expended to identify those
factors that are the root causes of activity costs.
Activity Analysis: Identifying and
4
Assessing Value Content
► The heart of process-value analysis is activity analysis.
► Activity analysis is the process of identifying, describing,
and evaluating the activities that an organization
performs.
► Activity analysis produces four outcomes:
1. what activities are done
2. how many people perform the activities
3. the time and resources required to perform the activities
4. an assessment of the value of the activities to the organization,
including a recommendation to select and keep only those that
add value.
► Activities can be classified as value-added or nonvalue-
added.
4 Value-Added Activities
►Those activities necessary to remain in business are called
value-added activities.
►Some activities are value-added by mandate.
►Activities required by the SEC and IRS
►The remaining activities in the firm are discretionary.
►A discretionary activity is classified as value-added provided it
simultaneously satisfies all of the following conditions:
1. The activity produces a change of state.
2. The change of state was not achievable by preceding activities.
3. The activity enables other activities to be performed.
4 Nonvalue-Added Activities
►All activities other than those that are absolutely
essential to remain in business, and therefore
considered unnecessary, are referred to as nonvalue-
added activities.
►A nonvalue-added activity can be identified by its failure
to satisfy any one of the three previous defining
conditions for adding value.
► For example, inspection is nonvalue-added because it is a state-detection
activity, not a state-changing activity.
4
Nonvalue-Added Costs
►Costs that are caused either by nonvalue-added
activities or the inefficient performance of valued-
added activities.
►For nonvalue-added activities, the nonvalue-added cost is
the cost of the activity itself.
►For inefficient value-added activities, the activity cost
must be broken into its value-added and nonvalue-added
components.
►The value-added component is the waste-free
component of the value-added activity and is,
therefore, the value-added standard.
Examples of Nonvalue-Added
Activities
►In the manufacturing operation, the following major
activities are often cited as wasteful and unnecessary:
►Scheduling: An activity that uses time and resources to
determine when different products have access to processes
►Moving: An activity that uses time and resources to move raw
materials, work in process, and finished goods from one
department to another.
►Waiting: An activity in which raw materials or work in process
use time and resources by waiting on the next process.
►Inspecting: An activity in which time and resources are spent
ensuring that the product meets specifications.
►Storing: An activity that uses time and resources while a good
or raw material is held in inventory.
Activity Management
4
Reduces Costs in Four Ways
* Activity * Activity selection

elimination focuses involves choosing among
different sets of activities
on nonvalue-added that are caused by
activities. competing strategies.
* Activity reduction * Activity sharing

decreases the time increases the efficiency
and resources of necessary activities by
required by an using economies of
activity. scale.
Cornerstone 7-7
4 Assessing Nonvalue-Added Costs
4 Activity Performance Measurement
►Assessing how well activities (and processes) are
performed is fundamental to management’s efforts to
improve profitability.
►Activity performance measures exist in both financial
and nonfinancial forms.
►Measures of activity performance center on three major
dimensions:
1. Efficiency - the relationship of activity inputs to activity outputs.
2. Time - time required to perform an activity.
3. Quality - doing the activity right the first time it is performed.
4 Cycle Time and Velocity
►Cycle time and velocity are two operational measures of
time-based performance.
►Cycle time measures it measures how long it takes to
produce an output from start to finish.
►Time/Units produced
►In a manufacturing process, cycle time is the length of time that it
takes to produce a unit of output from the time raw materials are
received (starting point of the cycle) until the good is delivered to
finished goods inventory (finishing point of the cycle).
►Velocity is the number of units of output that can be
produced in a given period of time
►Units produced/Time
►Velocity is the reciprocal of cycle time.
Cornerstone 7-8
4 Calculating Cycle Time and Velocity
4 Quality Cost Management
►Activity-based management also is useful for
understanding how quality costs can be managed.
►Quality costs can be substantial in size and a source of
significant savings if managed effectively.
►Improving quality can produce significant improvements
in profitability and overall efficiency.
►Quality improvement can increase profitability in two
ways:
►by increasing customer demand and thus sales revenues
►by decreasing costs
4 Quality Related Activities
►Quality-linked activities are those activities performed
because poor quality may or does exist.
►The costs of performing these activities are referred to
as costs of quality.
►The definitions of quality-related activities imply four
categories of quality costs:
►prevention costs
►appraisal costs
►internal failure costs
►external failure costs
►Thus, the costs of quality are associated with two subcategories of
quality-related activities: control activities and failure activities.
4 Control Activities
►Control activities are performed by an organization to
prevent or detect poor quality (because poor quality
may exist).
►Control costs are the costs of performing control activities.
►Control activities are made up of prevention and
appraisal activities.
►Prevention costs are incurred to prevent poor quality in the
products or services being produced.
►Appraisal costs are incurred to determine whether products
and services are conforming to their requirements or
customer needs.
4 Failure Activities
►Failure activities are performed by an organization or
its customers in response to poor quality (poor quality
does exist).
►Failure costs are the costs incurred by an organization
because failure activities are performed.
►Internal failure costs are incurred when products and services
do not conform to specifications or customer needs before
being shipped.
►External failure costs are incurred when products and
services fail to conform to requirements or satisfy customer
needs after being delivered to customers.
4 Environmental Cost Management
►For many organizations, management of
environmental costs is becoming a matter of
high priority and a significant competitive issue.
►Environmental costs are associated with the
creation, detection, remediation, and prevention
of environmental degradation.
►Environmental costs are classified into the same four
categories as quality costs.

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Chapter 7:

Activity-Based Costing and

►The activity-based cost assignment reflects the pattern of

►Activity costs are assigned to products by multiplying

►Customers are cost objects of fundamental interest.

* Activity * Activity selection

* Activity reduction * Activity sharing

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