Chapter 5 – Activity-Based Costing and Activity-Based Management
Broad Averaging and Its Consequences
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also known as peanut-butter costing (because you simply spread the cost evenly over a variety of
cost objects)
this often leads to product undercosting and product overcosting
o Product undercosting—a product is reported to have a low cost per unit but consumes a
higher level of resources per unit
o Product overcosting—a product is reported to have a high cost per unit but consumes a lower
level of resources per unit
Pizza
Beer
Total
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Matthew
$12
$4
$16
Mark
$15
$8
$23
John
$18
$24
$42
Total
$45
$36
$81
Average
$15
$12
$27
Product-cost cross-subsidization means that if a company undercosts one of its products, it will
overcost at least one of its other products.
Try-It! (5-1)
Amherst Metal Works produces two types of metal lamps. Amherst manufactures 20,000 basic lamps and
5,000 designer lamps. Its simple costing system uses a single indirect-cost pool and allocates costs to the
two lamps on the basis of direct manufacturing labor-hours. It provides the following budgeted cost
information:
Direct materials per lamp
Direct manufacturing labor per lamp
Direct manufacturing labor rate per hour
Indirect manufacturing costs
Basic Lamps
Designer Lamps
$9
0.5 hours
$20
$15
0.6 hours
$20
Total
$234,000
Calculate the total budgeted costs of the basic and designer lamps using Amherst’s simple costing system.
Refining a Costing System
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A refined costing system reduces the use of broad averages for assigning the cost of resources to
cost objects (such as jobs, products, and services) and provides better measurement of the costs of
indirect resources used by different cost objects, no matter how differently various cost objects use
indirect resources.
Three reasons:
o 1. Increase in product diversity.
o 2. Increase in indirect costs with different cost drivers.
o 3. Competition in product markets.
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Guidelines for Refining a Costing System
1. Direct-cost tracing – Identify as many direct costs as is economically feasible.
2. Indirect-cost pools – Expand the number of indirect-cost pools until each pool is more
homogeneous. All costs in a homogeneous cost pool have the same or a similar cause-and-effect (or
benefits-received) relationship with a single cost driver that is used as the cost-allocation base.
• e.g., machining costs (cost driver: machine-hours) should be a separate pool from distribution
cost (cost driver: cubic feet of product delivered)
3. Cost-allocation bases – As we describe later in the chapter, whenever possible, managers should use
the cost driver (the cause of indirect costs) as the cost-allocation base for each homogeneous
indirect-cost pool (the effect).
Activity-Based Costing
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Activity-based costing (ABC) refines a costing system by identifying individual activities as the
fundamental cost objects.
An activity is an event, task, or unit of work with a specified purpose—for example, designing
products, setting up machines, operating machines, or distributing products.
Example: A company produces 60,000 simple lenses and 15,000 complex lenses. One batch of production
can produce 240 simple lenses or 50 complex lenses. It takes 2 hours to set up a batch of simple lenses, and
5 hours to set up a batch of complex lenses. Given that setup costs amount to $300,000, how much of the
setup costs should be allocated to the simple lenses and the complex lenses? Compare the results if the
company used simple costing based on direct labor-hours (simple lenses: 30,000 hours; complex lenses:
10,000 hours; setup cost per direct labor-hours: $7.50).
Cost Hierarchies
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2.
3.
4.
A cost hierarchy categorizes various activity cost pools on the basis of the different types of cost
drivers, cost-allocation bases, or different degrees of difficulty in determining cause-and-effect (or
benefits-received) relationships.
Output unit-level costs are the costs of activities performed on each individual unit of a product or
service. (e.g., machine operating costs – energy, depreciation, repairs)
Batch-level costs are the costs of activities related to a group of units of a product or service rather
than each individual unit of product or service. (e.g., setup costs per batch, material-handling and
quality-inspection costs associated with batches, costs of placing purchase orders)
Product-sustaining costs (service-sustaining costs) are the costs of activities undertaken to support
individual products or services regardless of the number of units or batches in which the units are
produced or services provided. (e.g., design costs, marketing costs on product launches, R&D costs)
Facility-sustaining costs are the costs of activities that managers cannot trace to individual products
or services but that support the organization as a whole. (e.g., general administration costs – top
management compensation, rent, building security)
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Activity-Based Management
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Activity-based management (ABM) is a method of management decision making that uses activitybased costing information to improve customer satisfaction and profitability.
o Pricing and Product-Mix Decisions
o Cost Reduction and Process Improvement Decisions
o Design Decisions
o Planning and Managing Activities
Try-It! (5-2)
Amherst Metal Works produces two types of metal lamps. Amherst manufactures 20,000 basic lamps and
5,000 designer lamps. Its activity-based costing system uses two indirect-cost pools. One cost pool is for
setup costs and the other for general manufacturing overhead. Amherst allocates setup costs to the two
lamps based on setup labor-hours and general manufacturing overhead costs on the basis of direct
manufacturing labor-hours. It provides the following budgeted cost information:
Direct materials per lamp
Direct manufacturing labor-hours per lamp
Direct manufacturing labor rate per hour
Setup costs
Lamps produced per batch
Setup-hours per batch
General manufacturing overhead costs
Basic Lamps
Designer Lamps
$9
0.5 hours
$20
$15
0.6 hours
$20
Total
$114,000
250
1 hour
50
3 hours
$120,000
Calculate the total budgeted costs of the basic and designer lamps using Amherst’s activity-based costing
system.
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