Chapter 7
Chapter 7
Activity-Based Costing and
Management
Key Topics:
–Traditional versus ABC systems
–Activities and their identification
–Cost hierarchy
–ABC procedures
–ABM
–Benefits and costs of ABC and ABM
–Uncertainties

Traditional Overhead Cost
Allocation System
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ABC Cost Allocation System
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What Are Activities, and
How Are They Identified?
• Activity
Type of task or function performed in an organization
• Activity Identification
* Tracking the use of resources
* Using the cost hierarchy
* Grouping homogeneous costs
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Cost Hierarchy
• Organization-sustaining activities
– Activities and costs associated with overall organization (lease of headquarters office space, salary of CEO)
• Facility-sustaining activities
– Activities and costs associated with single manufacturing plant or service facility (property taxes, plant manager salary)
• Customer-sustaining activities
– Activities and costs associated with a single customer (costs of ordering and delivery)
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Cost Hierarchy
• Product-sustaining activities
– Activities or costs associated with product line or one single product (advertising, depreciation)
• Batch-level activities
– Activities or costs associated with each batch of product (set-up costs, electricity)
• Unit-level activities
– Activities or costs associated with each unit
(indirect materials, indirect labor)
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ABC Procedures
1.Identify the relevant cost object
2.Identify activities
3.Assign (trace and allocate) costs to activity based cost pools
4.For each ABC cost pool, choose a cost driver
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ABC Procedures
5.For each ABC cost pool, calculate an allocation rate
Allocation Rate = Activity Cost/Volume of Cost Driver
6.For each ABC cost pool, allocate activity costs to the cost object
Allocation = Allocation Rate * Actual Volume of Activity
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Using ABC
7.21 Palmer Company uses an activity based costing system. It has the following manufacturing activity areas and has chosen related cost drivers.
Activity
Machine setup
Material handling
Machining
Assembly
Inspection
Cost Driver
Number of setups
Number of parts
Machine hours
Direct labor hours
Number of finished units
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Develop allocation rate
(not shown in textbook problem)
Activity
Machine setup
Material handling
Machining
Assembly
Inspection
Cost Driver
Number of setups
Number of parts
$200,000
$320,000
$208,000
$66,000
$264,000
4,000
640,000
Machine hours
Direct labor hours
8,000
3,000
Number of finished units 22,000

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Cost allocation rates

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Product information

Developing ABC unit cost
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Selection of Cost Drivers
• Need cause and effect relationship between cost driver and activity costs
• Requires judgment in choosing and evaluating potential cost drivers
• Examples
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What Is Activity Based
Management (ABM)?
The process of using ABC information to evaluate the costs and benefits of production and internal support activities and to identify and implement opportunities for improvements in profitability, efficiency, and quality within an organization
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ABM Applied
• Customer profitability
• Product and process design
* Focus resources on value-added activities
* Reduce or eliminate non-valueadded activities
* Target and kaizen costing
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ABM Applied
• Environmental costs
• Quality
* Prevention activities
* Appraisal activities
* Production activities
* Post-sales activities
• Constrained resources
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Benefits
• Increase awareness of cause and effect relationships
• Promote performance improvements
• Identify non-value-added activities
• Motivate cost reduction
• Reduce arbitrariness in cost measurement
• Optimize use of constrained resources
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Costs
• System design
• Accounting system modifications
• Employee training
• Higher costs when:
* There are more activities
* Activities are complex
* ABC system is complex
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Uncertainties in ABC and
ABM Implementation
• Choice of activities
• Choice of cost drivers
• Inability to foresee all possible uses of information
• Choice of denominator in allocation rate
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