Chapter Seven
Activity-Based Costing and
Management
COPYRIGHT © 2012 Nelson Education Ltd.
Learning Objectives
1. Explain why functional-based costing
approaches may produce distorted costs
2. Explain how an activity-based costing system
works for product costing
3. Describe activity-based customer and supplier
costing
4. Explain how activity-based management can
be used for cost reduction
7-2
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OBJECTIVE 1
Explain why functionalbased costing
approaches may produce
distorted costs
Functional-Based Costing
Systems
• Functional-based systems
– Based on volume measures, such as
• Direct labour hours
• Machine hours
– Two types:
• Plantwide rates
• Departmental rates
• Often produce average costs that over- or
understate individual product costs
7-4
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Functional-Based Costing
System Limitations
Two major factors impair their ability to
assign overhead costs accurately:
1. Proportion of non-unit-related overhead costs
to total overhead charge is large
2. Degree of product diversity is great
7-5
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Unit and Non-Unit Activities
Unit-level-activities --- Activities performed each
time a unit is produced
Non-unit-level-activities --- From the viewpoint
of the subsequent
process, transferredin costs are a type of
raw material cost
7-6
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Non-Unit-Related Overhead
Costs
What is needed for accurate cost assignment
of non-unit-level activities?
Non-unit-level activity drivers
Factors that measure the consumption
of non-unit-level activities by products
and other cost objects
7-7
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Product Diversity
Products consume overhead activities in
systematically different proportions
Consumption Ratio --- Proportion of each activity
consumed by a product
7-8
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Example: Cornerstone 7-1
How to Calculate Consumption Ratios
Activity Usage Measures
Deluxe
Units produced
Regular
Total
10
100
110
$800
$8,000
$8,800
Direct labour hours
20
80
100
Machine hours
10
40
50
Setup hours
3
1
4
Number of moves
6
4
10
Prime costs
7-9
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Example
Activity Cost Data
Activity
Activity Cost
Setting up equipment
$1,200
800
Moving goods
Machining
1,500
Assembly
500
Total
$4,000
7-10
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Example
Calculate the consumption ratio for each product
Overhead Activity Deluxe
Setting up equipment
Three of four hours were
spent setting up the Deluxe
Model
¾ or 0.75
Regular
Activity
Driver
0.25
Setup hours
0.75
One of four hours was spent
on the Regular model
7-11
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Calculate the consumption ratio for each product
Overhead Activity
Deluxe
Regular
Setting up equipment
0.75
0.60
0.25
0.40
Moving goods
Activity
Driver
Setup hours
# of moves
6 of the 10 moves were for the Deluxe model,
4 of the 10 were for the Regular model
7-12
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Calculate the consumption ratio for each product
Activity
Driver
Overhead Activity
Deluxe
Regular
Setting up equipment
Moving goods
0.75
0.60
0.25
0.40
Setup hours
# of moves
Machining
0.20
0.80
Machine hrs
Deluxe model used 10 of the 50 machine hours,
while the Regular model used 40 hours
7-13
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Calculate the consumption ratio for each product
Activity
Driver
Overhead Activity
Deluxe
Regular
Setting up equipment
Moving goods
0.75
0.60
0.25
0.40
Setup hours
# of moves
Machining
Assembly
0.20
0.20
0.80
0.80
Machine hrs
Direct
labour
hours
Deluxe model used 20 of the 100 direct
labour hours. Regular model used 80 hours
7-14
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Calculate the consumption ratio for each product.
Activity
Driver
Overhead Activity
Deluxe
Regular
Setting up equipment
0.25
0.40
Setup hours
Moving goods
0.75
0.60
Machining
Assembly
0.20
0.20
0.80
0.80
Machine hrs
# of moves
Direct labour
hours
Deluxe model had Consumption Ratios
ranging from 0.75 to 0.20
7-15
COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 7-2
How to Calculate Activity Ratios
Information:
Activity
Setting up equipment
Activity Cost
$1,200
Moving goods
800
Machining
1,500
Assembly
500
7-16
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Example
Information:
Driver
Driver Quantity
Setup hours
4
Number of moves
10
Machine hours
50
Direct labour hours
100
7-17
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required: Calculate activity rates
Setup rate
Materials
handling rate
$1,200/4 setup hours
$800/10 moves
$300 per setup hour
$80 per move
Machining rate
$1,500/50 machine
hours
$30 per machine
hour
Assembly rate
$500/100 machine
hours
$5 per direct
labour hour
7-18
COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 7-3
How to Calculate Activity-Based Unit Costs
Information:
Units produced
per year
Deluxe
Regular
10
100
Prime costs
$800
3
Setup hours
Number of moves
6
Machine hours
10
Direct labour hours 20
$8,000
1
4
40
80
Activity Rate
$300
$ 80
$ 30
$ 5
7-19
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required: Calculate the unit cost for deluxe and regular models
Deluxe
Prime costs
Overhead costs:
Setups
Regular
$800
$8,000
900
300
$300 per setup × 3 setups
$300 per setup ×1 setup
7-20
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required: Calculate the unit cost for deluxe and regular models
Deluxe
Prime costs
Overhead costs:
Setups
Moving materials
Regular
$800
$8,000
900
480
300
320
$80 per move × 6 moves
$80 per move × 4 moves
7-21
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required: Calculate the unit cost for deluxe and regular models.
Deluxe
Prime costs
Overhead costs:
Setups
Moving materials
Machining
$30 per machine hour
x 10 hours
Regular
$800
$8,000
900
480
300
300
320
1,200
$30 per machine hour
x 40 hours
7-22
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required: Calculate the unit cost for deluxe and regular models
Deluxe
Prime costs
Overhead costs:
Setups
Moving materials
Machining
Assembly
$5 per direct labour
hour × 20 hours
Regular
$800
$8,000
900
480
300
100
300
320
1,200
400
$5 per direct labour
hour × 80 hours
COPYRIGHT © 2012 Nelson Education Ltd.
7-23
Example
Required: Calculate the unit cost for deluxe and regular models
Deluxe
Prime costs
$800
Overhead costs:
900
Setups
480
Moving materials
Machining
300
Assembly
100
Total manufacturing costs $2,580
$2,580 ÷ 10 units =
$258 per unit
Regular
$8,000
300
320
1,200
400
$10,220
$10,220 ÷ 100 units =
$102.20 per unit
COPYRIGHT © 2012 Nelson Education Ltd.
7-24
OBJECTIVE 2
Explain how an activitybased costing system
works for product costing
Identifying Activities and
Their Attributes
Activity Dictionary
Lists the activities in an
organization along with
some critical activity
attributes
Activity Attributes
Financial and
nonfinancial information
items that describe
individual items
7-26
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Key Questions to Identify
Activities
1. How many employees are in your department?
2. What do they do?
3. Do customers outside your department use any
equipment?
4. What resources are used by each activity?
5. What are the outputs of each activity?
6. Who or what uses the activity output?
7. How much time do workers spend on each
activity? Time on each activity by equipment?
7-27
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Assigning Costs to
Activities
• Must determine how much it costs to perform each
activity
– Requires identification of resources being consumed
• labour, materials, energy, and capital
– Cost of resources is found in general ledger
– Resources must be assigned using driver tracing
• Work distribution matrix
– Used to assign labour resources
7-28
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Resource Drivers
Factors that measure the consumption of
resources by activity
7-29
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Example: Cornerstone 7-4
How to Assign Resource Costs Using
Direct Tracing & Resource Drivers
Information:
Assume that each clerk is paid a salary of $30,000
($150,000 total clerical cost for 5 clerks)
Required:
Assign the cost of labour to each of the activities
in the credit department
7-30
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Example
Processing transactions
Preparing statements
Answering questions
$60,000
$45,000
$45,000
0.4 × $150,000
0.3 × $150,000
0.3 × $150,000
7-31
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Assigning Costs to Products
Predetermined
activity rate
x
Usage of the activity
(as measured by
activity drivers)
To calculate this rate, the practical
capacity of each activity must be
determined
7-32
COPYRIGHT © 2012 Nelson Education Ltd.
OBJECTIVE 3
Describe activitybased customer and
supplier costing
Activity-Based Customer
Costing
• Customers are cost objects of fundamental
interest
• Customer management can produce
significant gains in profit
• Customers can consume customer-driven
activities in different proportions
• Assigning costs of customer service to
customers the same as assigning
manufacturing costs to products
7-34
COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 7-5
HOW TO Calculate Activity-Based Customer Costs
Information:
• Milan Company produces precision parts for
11 major buyers
– One large customer
• Accounts for 50% of sales
– Ten smaller customers
• Account for 50% of sales
• Each purchases parts in roughly equal quantities
• Parts orders placed are similar in size
7-35
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Example
Information continued:
Data concerning Milan’s customer activity follow:
Large
Customer
Units purchased
Ten Smaller
Customers
500,000
2
500,000
200
10
210
$3,000,000
$3,000,000
Order filling costs allocated
$202,000
$202,000
Sales force costs allocated
$110,000
$110,000
Orders placed
Number of sales calls
Manufacturing costs
7-36
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required:
Assign costs to customers using an ABC approach
Activity Rates
$404,000/202 orders
= $2,000 per order
$220,000/220 calls
= $1,000 per call
7-37
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Assigning Costs to
Customer Groups
Large
Customer
Order filling costs
Ten Smaller
Customers
$4,000
$2,000 × 2
$400,000
$2,000 × 200
7-38
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Assigning Costs to
Customer Groups
Large
Customer
Order filling costs
Sales force costs
$4,000
10,000
$1,000 × 10
Ten Smaller
Customers
$400,000
210,000
$1,000 × 210
7-39
COPYRIGHT © 2012 Nelson Education Ltd.
Assigning Costs to
Customer Groups
Large
Customer
Order filling costs
Sales force costs
Ten Smaller
Customers
$4,000
10,000
$400,000
210,000
$14,000
$610,000
The large customer costs much less to
service that the smaller customers.
7-40
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Supplier Costing
Methodology
• Cost of a supplier is much more than purchase
price of the components or materials acquired
• Assigning cost to suppliers is similar to cost
assignments for products and customers
7-41
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Example: Cornerstone 7-6
How to Calculate Activity-Based Supplier Costs
Information:
• Purchasing manager uses two suppliers as sources of
Part A1 and Part B2
– Murray Inc.
– Plata Associates
• Consider two activities:
– Repairing products
• Because of part failure (bought from supplier)
– Expediting products
• Because supplier is late
7-42
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Example
Information continued:
Activity cost information and other data needed for
supplier costing follow:
I. Activity costs caused by suppliers
Activity
Costs
Repairing Products
$800,000
Expediting Products
$200,000
7-43
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Example
Information continued:
II. Supplier data
Unit purchase price
Units purchased
Failed units
Late shipments
Murray, Inc.
Plata Assoc.
Part A1 Part B2
Part A1 Part B2
$20
$52
80,000 40,000
1,600
60
380
40
$24
$56
10,000 10,000
10
0
10
0
7-44
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Example
Required:
Determine the cost of each supplier using ABC
Activity Rates
Repair rate = $800,000/2,000 = $400 per
failed part
Total failed units
1,600 + 380 + 10 +10
7-45
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Required:
Determine the cost of each supplier using ABC
Activity Rates
Repair rate = $800,000/2,000 = $400 per
failed part
Expediting =
rate
$200,000/100 = $2,000 per
late delivery
Total late shipments 60 + 40
7-46
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Murray, Inc.
Purchase cost
Part A1
Part B2
$1,600,000
$2,080,000
$20 × 80,000
$52 × 40,000
7-47
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Example
Plata Associates
Part A1
Purchase cost
$240,000
$24 × 10,000
Part B2
$560,000
$56 × 10,000
7-48
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Example
Murray, Inc.
Purchase cost
Reporting products
Part A1
Part B2
$1,600,000
$2,080,000
152,000
640,000
$400 × 1,600
$400 × 380
7-49
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Example
Plata Associates
Part A1
Purchase cost
Reporting products
$240,000
4,000
$400 × 10
Part B2
$560,000
4,000
$400 × 10
7-50
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Murray, Inc.
Purchase cost
Part A1
Part B2
$1,600,000
Reporting products
640,000
$2,080,000
152,000
Expediting products
120,000
80,000
$2,000 × 60
$2,000 × 40
7-51
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Plata Associates
Part A1
Purchase cost
Reporting products
Expediting products
$240,000
4,000
0
Part B2
$560,000
4,000
0
Plata does not deliver parts late, therefore
there are no expediting costs with Plata
7-52
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Murray, Inc.
Purchase cost
Part A1
Part B2
$1,600,000
$2,080,000
152,000
Reporting products
640,000
Expediting products
120,000
Total costs
Units
Total unit cost
$2,360,000
80,000
$2,312,000
÷ 80,000
$29.50
÷ 40,000
$57.80
7-53
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Plata Associates
Part A1
Part B2
Purchase cost
Reporting products
Expediting products
$240,000
4,000
0
$560,000
4,000
0
Total costs
Units
Total unit cost
$244,000
$564,000
÷ 10,000
$56.40
÷ 10,000
$24.40
Plata is the better choice with the
lowest total unit cost
COPYRIGHT © 2012 Nelson Education Ltd.
7-54
OBJECTIVE 4
Explain how activitybased management can
be used for cost reduction
Process-Value Analysis
• Focuses on cost reduction instead of cost
assignment
• Maximization of system-wide performance
– Driver analysis
– Activity analysis
– Performance measurement
7-56
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Activity Inputs and Outputs
Activity Inputs
Resources consumed
by the activity in
producing its output
Activity Outputs
Result or product of an
activity
7-57
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Driver Analysis: The Search
for Root Causes
Activity Output
Measure
Number of times activity
is performed
Driver Analysis
Effort expended to
identify those factors
that are the root causes
of activity costs
7-58
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Activity Analysis
• Process of identifying, describing,
and evaluating the activities
• It should produce four outcomes:
– What activities are done
– How many people perform the activities
– Time and resources required to perform
the activities
– Assessment of the value of the activities
to the organization
7-59
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Value-Added Activities
• Activities necessary to remain in
business
• Two types:
– Value-added by mandate
• Necessary to comply with legal mandate
– Discretionary activities
7-60
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Discretionary Value-Added
Activities
Three conditions must be met
simultaneously for the activity to be
classified as value added:
1. Produces a change of state
2. Change of state was not achievable by
preceding conditions
3. Enables other activities to be performed
7-61
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Non-Value Added Activities
All activities other than those that are
absolutely essential to remain in business
Examples:
Scheduling
Storing
Moving
Inspecting
Waiting
Challenge of activity analysis is to find
ways to produce the good without using
any of these activities
7-62
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Cost Reduction
Four Ways:
1.
2.
3.
4.
Activity elimination
Activity selection
Activity reduction
Activity sharing
7-63
COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 7-7
How to Assess Non-Value Added Costs
Information:
Consider the following two activities:
• Performing warranty work, cost: $120,000
• Warranty cost of the most efficient competition is $20,000
• Purchasing components, cost: $200,000 (10,000
purchase orders)
• Benchmarking study reveals that the most efficient level
would use 5,000 purchase orders and entail a cost of
$110,000
7-64
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Determine the non-value-added cost of each activity
Warranty work
Is the activity non value-added or value-added?
Performing warranty work is a
non value-added activity
How much is the non value-added cost?
$120,000
7-65
COPYRIGHT © 2012 Nelson Education Ltd.
Example
Determine the non-value-added cost of each activity
Competitor
Is the activity non value-added or value-added?
Cost of the competitor is a non
value-added activity
How much is the non value-added cost?
$200,000 - $110,000 = $90,000
Because the activity is not performed efficiently
7-66
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Example
Determine the non-value-added cost of each activity
Purchasing components is necessary (valueadded) but it is not performed efficiently
Actual cost – benchmark study $200,000
- $110,000
$90,000 in non-value added cost
7-67
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Activity Performance
Measurement
• Assess how well an activity was performed and
the results achieved
• Measures are both financial and nonfinancial
• Three dimensions:
1. Efficiency
2. Quality
3. Time
7-68
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Efficiency, Quality, & Time
Efficiency
Focuses on the relationship
of activity inputs to activity
outputs
Quality
Concerned with doing the
activity right the first time
Time
Longer times usually mean
more resource consumption
and less ability to respond to
customer demands
7-69
COPYRIGHT © 2012 Nelson Education Ltd.
Example: Cornerstone 7-8
How to Calculate Cycle Time and Velocity
Assume that a company takes 10,000 hours to
produce 20,000 units of a product
What is the velocity?
Velocity = 20,000/10,000 = 2 units per hour
What is the cycle time?
Cycle Time = 10,000/20,000 = ½ hour
7-70
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Just-in-Time Systems
• Goods pushed through system by present
demand rather than on a fixed schedule based on
anticipated demand
• Each operation produces only what is necessary
to satisfy the demand of the succeeding operation
• Reduces all inventories to very low levels
• Reduces inventory carrying costs
7-71
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Environmental Cost
Management
• Environmental costs are also known as
environmental quality costs
• Environmentally linked activities are activities
performed because poor environmental quality
may exist
• Costs are associated with two subcategories:
• control activities
• failure activities
7-72
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