CORNERSTONES
of Managerial Accounting, 6e
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CHAPTER 7: ACTIVITY-BASED
COSTING AND MANAGEMENT
Cornerstones of Managerial
Accounting, 6e
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Limitations of Functional-Based
Cost Accounting Systems
 Plant-wide and departmental rates based on
direct labor hours, machine hours, or other
volume-based measures are used successfully
by many organizations.
 However this approach to costing is equivalent to an
averaging approach and may produce distorted, or
inaccurate costs.
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Limitations of Functional-Based
Cost Accounting Systems (continued)
Product cost
distortions can be
damaging,
particularly for those
firms whose
business
environment is
characterized by :
Continuous
Improvement
Total Quality
Management
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Limitations of Functional-Based
Cost Accounting Systems (continued)
 The need for more accurate product costs has
forced many companies to take a look at their
costing procedures.
 Two major factors impair the ability of unit-based
plant-wide and departmental rates to assign
overhead costs accurately:
 The proportion of nonunit-related overhead costs to
total overhead costs is large.
 The degree of product diversity is great.
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Categorizing Costs under ABC
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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:
 product size
 product complexity
 setup time
 size of batches
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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
 In a diverse product environment, activity-based
costing promises greater accuracy.
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Activity-Based Product Costing
 Functional-based overhead costing involves two
major stages:
 Overhead costs are assigned to an organizational unit
(plant or department).
 Overhead costs are then assigned to cost objects.
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Activity Dictionary
 Interview-derived data is used to prepare an
activity dictionary, which lists the activities in an
organization along with activity attributes.
 Examples: Financial and nonfinancial information
items that describe individual activities.
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Activity Dictionary (cont.)
 Examples include:
 types of resources consumed
 amount (percentage) of time spent on an activity by
workers
 cost objects that consume the activity output (reason for
performing the activity)
 measure of the activity output (activity driver)
 activity name
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Assigning Costs to Activities
 The next task is to determine how much it costs
to perform each activity.
 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.
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Assigning Costs to Activities (cont.)
 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:
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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.
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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.
 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.
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Activity-Based Customer Costing
and Activity-Based Supplier Costing
 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.
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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.
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Driver Analysis:
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.
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Driver Analysis: The Search for Root
Causes (cont.)
 An activity output measure is the number of
times the activity is performed. It is the
quantifiable measure of the output.
 Driver analysis is the effort expended to identify
those factors that are the root causes of activity
costs.
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Activity Analysis: Identifying and
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.
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Activity Analysis: Identifying and
Assessing Value Content (cont.)
 Activity analysis produces four outcomes:
 what activities are done
 how many people perform the activities
 the time and resources required to perform the activities
 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.
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Activity Management
Reduces Costs in Four Ways
* Activity elimination
* Activity selection
focuses on nonvalue-added
activities.
involves choosing among
different sets of activities
that are caused by
competing strategies.
* Activity reduction
* Activity sharing
decreases the time and
resources required by an
activity.
increases the efficiency of
necessary activities by
using economies of scale.
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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.
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Quality Cost Management (cont.)
 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
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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.
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Quality Related Activities (cont.)
 The definitions of quality-related activities imply
four categories of quality costs:
 prevention costs
 appraisal costs
 internal failure costs
 external failure costs
 Costs of quality are associated with two subcategories
of quality-related activities: control activities and
failure activities.
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Environmental Cost Management
 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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Additional slides
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license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Manufacturing
costs
Nonmanufacturing
costs
Traditional
product costing
ABC
product costing
 ABC assigns both types of costs to products.
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Traditional
product costing
Nonmanufacturing
costs
Some
All
Manufacturing
costs
ABC
product costing
 ABC does not assign all manufacturing costs to products.
How Costs are Treated Under
Activity–Based Costing
Level of complexity
ABC differs from traditional cost accounting in three ways.
Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Number of cost pools
 ABC uses more cost pools.
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.
Each ABC cost pool has its
own unique measure of activity.
Traditional cost systems usually rely
on volume measures such as direct labor
hours and/or machine hours to allocate
all overhead costs to products.
 ABC uses more cost pools.
How Costs are Treated Under
Activity–Based Costing
Activity
An event that causes the
consumption of overhead
resources.
Activity
Cost Pool
A “cost bucket” in which
costs related to a particular
activity measure are
accumulated.
$$
$
$ $
$
How Costs are Treated Under
Activity–Based Costing
ABC defines
five levels of activity
that largely do not relate
to the volume of units
produced.
Traditional cost systems usually rely on volume
measures such as direct labor hours and/or machine
hours to allocate all overhead costs to products.
How Costs are Treated Under
Activity–Based Costing
Unit-Level
Activity
Batch-Level
Activity
Manufacturing
companies typically combine
their activities into five
classifications.
Product-Level
Activity
Organizationsustaining
Activity
Customer-Level
Activity
Classic Brass – An ABC Example
Classic Brass
Income Statement
Year Ended December 31, 2005
Sales
Cost of goods sold
Direct materials
Direct labor
Manufacturing overhead
Gross margin
Selling and administrative expenses
Shipping expenses
Marketing expenses
General administrative expenses
Net operating income
loss
$ 3,200,000
$
975,000
351,250
1,000,000
2,326,250
873,750
65,000
300,000
510,000
$
875,000
(1,250)
Manufacturing overhead is allocated to products using
a single plantwide overhead rate based on machine hours.
Define Activities, Activity Cost Pools,
and Activity Measures
At Classic Brass, the ABC team, selected the following
activity cost pools and activity measures:
Define Activities, Activity Cost Pools,
and Activity Measures
 Customer Orders - assigned all costs of resources that
are consumed by taking and processing customer
orders.
 Product Designs - assigned all costs of resources
consumed by designing products.
 Order Size - assigned all costs of resources consumed
as a consequence of the number of units produced.
 Customer Relations – assigned all costs associated
with maintaining relations with customers.
 Other – assigned all overhead costs that are not
associated with the other cost pools.
Assign Overhead Costs
to Activity Cost Pools
Assign Overhead Costs
to Activity Cost Pools
Direct materials, direct labor, and shipping are excluded
because Classic Brass’ existing cost system can directly
trace these costs to products or customer orders.
Assign Overhead Costs
to Activity Cost Pools
At Classic Brass the following distribution of resource
consumption across activity cost pools is determined.
Assign Overhead Costs
to Activity Cost Pools
Indirect factory wages
$500,000
Percent consumed by customer orders
25%
$125,000
Assign Overhead Costs
to Activity Cost Pools
Factory equipment depreciation
$300,000
Percent consumed by customer orders
20%
$ 60,000
Assign Overhead Costs
to Activity Cost Pools
Calculate Activity Rates
The ABC team determines that Classic Brass will
have these total activities for each activity cost pool .
..
 1,000 customer orders,
 400 new designs,
 20,000 machine-hours,
 250 customer relations activities.
Now the team can compute the individual
activity rates by dividing the total cost for
each activity by the total activity levels.
Calculate Activity Rates
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Order
Size
Customer
Orders
Product
Design
Customer
Relations
Cost Objects:
Products, Customer Orders, Customers
Other
Activity-Based Costing at Classic Brass
Direct
Materials
Direct
Labor
Shipping
Costs
Overhead Costs
First-Stage Allocation
Customer
Orders
Product
Design
Order
Size
Customer
Relations
Other
Second-Stage Allocations
$/Order
$/Design
$/MH
$/Customer
Cost Objects:
Products, Customer Orders, Customers
Unallocated
Assigning Overhead to Products
Classic Brass Information
Standard Stanchions
1. Requires no new design resources.
2. 30,000 units ordered with 600 separate orders.
3. Each stanchion requires 35 minutes of machine
time for a total of 17,500 machine-hours.
Custom Compass Housing
1. Requires new design resources.
2. 400 separate orders.
3. 400 custom designs prepared.
4. 1,250 compass housings produced, requiring 2
machine-hours each for a total of 2,500 machine-hours.
Assigning Overhead to Products
Assigning Overhead to Customers
Let’s take a look at how Classic Brass system works
for just one of the 250 customers – Windward Yachts
who placed a total of three orders.
Orders
1. Two orders for 150 standard stanchions per order.
2. One order for a custom compass housing.
Machine-hours
1. The 300 standard stanchions required 175 machine-hours.
2. The custom compass housing required 2 machine hours.
Assigning Overhead to Customers