Activity-Based
Costing
CHAPTER 5
McGraw-Hill/Irwin
Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Activity-Based Costing

Activity-Based Costing (ABC) is a relatively recent development in
management accounting.
The Problem of Using Only Measures
of Production Volume to Allocate
Overhead

Companies commonly use labor hours or machine hours as
allocation bases for assigning overhead to products. This
“Traditional Approach” assumes that all costs are proportional to
production volume. In reality this is not true. For example, setup
costs are not proportional. A setup might work for a 400,000 unit
production run just as well as a 200,000 production run. As a result,
low-volume items are under costed and high-volume items are over
costed.
The ABC Approach
In the ABC Approach, companies identify the major activities that cause
overhead costs to be incurred. Some of these are related to
production volume, but others are not. The steps are as follows:
1.
Identify activities.
2.
Group costs of activities into cost pools.
3.
Identify measures of activities (the cost drivers)
4.
Relate costs to products using the cost drivers.
Major Activities
Following are examples of major activities under ABC:
1.
2.
Processing purchase orders.
Handling materials and parts.
3.
Inspecting incoming material and parts.
4.
Setting up equipment.
5.
Producing goods using manufacturing equipment.
6.
Supervising assembly workers.
7.
Inspecting finished goods.
8.
Packing customer orders.
Cost Drivers
Following are examples of cost drivers under ABC:
1.
Number of purchase orders processed.
2.
Number of material requisitions.
3.
Number of receipts.
4.
Number of setups.
5.
Number of machine hours.
6.
Number of assembly labor hours.
7.
Number of inspections.
8.
Number of boxes shipped.
Associated Costs

Costs associated with the preceding major activities have to do with
salaries and wages, depreciation on equipment and the like.
Pros and Cons of ABC
Benefits: First, ABC is less likely than traditional costing to under cost
or over cost products. Second, ABC may lead to improvements in cost
control.
Limitations: It’s expensive relative to a traditional system!
Activity-Based Management
Activity-Based Management (ABM) is a management tool with the goal
of improving efficiency and effectiveness. It is similar to ABC, except
that where ABC focuses on cost measurement, ABM focuses on the
activities themselves.
Activity-Based Management (ABM)
Evaluates the
costs and values
of process
activities . . .
ActivityBased
Costing
+
ValueAdded
Analysis
. . . To identify
opportunities
to improve
efficiency.
• Process improvements
=
• Improve customer
value
• Reduce costs
ABC vs. ABM
ABC
 An improved understanding of the way
resources are used
in the current
processes.
 Measures product
costs more
accurately by
analyzing costs
associated with
identified activities
in the processes.
ABM adds:
 Identifies valueadded and non-valueadded activities.
 Identifies the customerperceived value of each
activity.
 Identifies opportunities to
enhance value-added
activities and reduce or
eliminate non-valueadded
activities
?
The Importance Of CustomerPerceived Value
Activities
Create outcomes
and consume resources
VALUE-ADDED ACTIVITIES
enhance the value of products
and services in the eyes of
the customer while meeting
the goals of the organization.
NON-VALUE-ADDED
ACTIVITIES
do not contribute to customer
perceived value.
Eliminating Non-Value-Added
Activities
Why do organizations have incentives
to eliminate non-value added activities?
Competitors are
constantly striving
to create more
value for customers
at lower cost.
Competition can
appear quickly.
The organization can
apply the freed-up
resources to valueadded activities or
distribute them to the
owners and
employees of the
organization.
Likely Sources of Non-Value-Added
Activities
Producing defective products
Producing to
build up
inventory
Waiting time
for processing
Time and effort
to move products
from place to place
Transporting
workers to
work sites
Identifying Value-Added Activities
The test for value
added activities
Would an external
customer encourage
the organization to do
more of the activity?
YES
NO
Would the organization
be more likely to
reach its goal by
performing that activity?
If the answer
If the answer is
is “yes” to
“no”, it is nonboth it is
value-added.
value-added.
YES
NO
Tasks Required by Activity-Based
Management
Twin objectives
of
ABM
Identify non-value-added
activities to be eliminated
or reduced.
Identify value-added
activities to be enhanced.
Redesign processes to eliminate wasteful spending on
non-value-added activities.