Activity Based Costing and
Management Systems
• ABC systems focus on the activities and the
business processes as the foundation for
determining the cost of goods, services, processes,
or any cost object
• ABC systems attempt to address the problems
found with traditional costing systems, such as
ignoring volume differences, diversity, and
resource demands of different cost objects
ABC Basics
• ABC systems use a cost hierarchy: unit level,
batch level, product sustaining level, and facility
sustaining level
• ABC systems, as part of identifying the relevant
activities, also classify these activities into valueadded and non-value added activities, so it
becomes a management tool
• ABC systems recognize not only economies of
scale but economies of scope
• At the heart of ABC is a two stage allocation
process
The Two Stage Process in ABC
• Stage 1: Create homogeneous cost pools based on
activities and/or processes; e.g., group all purchasing costs
together, all set-up costs together, all delivery costs
together. This may take some work since most accounting
systems gather cost by account categories such as salaries,
depreciation, supplies, etc. and these accounts have to be
studied in order to break them down into homogeneous
costs pools
• Stage 2: Allocate from the cost pools to the cost object
(usually a product) using second stage cost drivers; e.g.,
number of deliveries, number of setups
Mapping Resource Expenses to Activities: Stage One
Salaries and Fringes
$313,000
A ctivity
P roc es s C us tom er O rders
Occupancy
$111,000
Equipment and
Technology
$146,000
Materials and Supplies
$30,000
Total
$600,000
S a la rie s
Eq u ip m e n t
M a te ria l
a nd
a nd
s a nd
F rin g e s
$
31,000
O ccu p a n cy T e ch n o lo g y
$
5,300
$
12,600
A u p p lie s T o ta l
$
800
$ 49,700
P urc has e M aterials
34,000
6,900
8,800
1,500
51,200
S c hedule P roduc tion O rders
22,000
1,200
18,400
300
41,900
M ove M aterials
13,000
2,100
22,300
3,600
41,000
S et-up M ac hines
42,000
700
4,800
200
47,700
Ins pec t Item s
19,000
13,000
19,700
800
52,500
M aintain P roduc t Info
36,000
2,800
14,500
400
53,700
P erform E ngineering C hanges
49,000
32,000
26,900
2,400
110,300
E x pedite O rders
14,000
900
700
500
16,100
Introduc e N ew produc ts
35,000
44,000
16,100
18,700
113,800
R es olve Q uality P roblem s
18,000
2,100
1,200
800
22,100
313,000
$ 111,000
146,000
$ 30,000
T o ta l
$
$
$ 600,000
An ABC Example
Supermarkets
Drugstores
$30,900
$10,500
$1,980
Average CGS per delivery
30,000
10,000
1,800
Gross Margin per delivery
900
500
180
Number of Deliveries
120
300
1,000
1,420
$180,000
$438,000
Average Revenue per delivery
Total Gross margin
$108,000
$150,000
Gross Margin %
2.9%
4.8%
MA and Pa
Total
9.1%
Other operating Costs
301,080
Operating Profit
136,920
Allocation of Other Costs
74,239
103,110
123,731
301,080
Distribution Line Profit
33,761
46,890
56,269
136,920
Profit Margin
0.9%
1.5%
2.8%
Other Costs are allocated in proportion to Gross Margin
301,080/438,000 = 68.7%; Ma and Pa = 68.7% * 180,000 = 123,731
An ABC Example, 2
The manager of this pharmaceutical distribution company
heard about ABC and thought it may be useful for his
operations. He identified 5 key activities, and their
corresponding cost drivers.
Activity
Cost Driver
Order Processing
Number of Orders
Line Item Ordering
Number of Line Items
Store Delivery
Number of Store Deliveries
Cartons Shipped to Stores
Number of Cartons shipped/delivery
Shelf Stacking at Store
Number of hours of shelf stacking
An ABC Example, 3
Each order consists of one or more line items. A line item represents
a single product (such as Extra Strength Tylenol. Each Store
delivery entails delivery of one or more cartons of products. Each
product is delivered in one or more separate cartons. The delivery
staff stock cartons directly onto display shelves in a store. Currently
there is no charge for this service, and not all customers use this
service.
An ABC Example, 4
The firm has finished Stage 1 and has assigned the following costs
to each of the five activity areas
Activity Area
Total Costs
Order Processing
$80,000
Total Units of Cost Driver
2,000 orders
Line Item Ordering
63,840
21,280 line items
Store Deliveries
71,000
Carton Deliveries
76,000
76,000 cartons
Shelf Stacking
10,240
640 hours
1,420 store deliveries
An ABC Example, 5
Other useful data by distribution line
1. Total number of orders
Supermarkets
Drugstores
Ma and Pa
140
360
1,500
14
12
10
120
300
1,000
80
16
0.6
0.1
2. Average number of line
items per order
3. Total number of store
deliveries
4. Average number of
cartons shipped per delivery 300
5. Average number of hours
of shelf stacking per delivery 3
An ABC Example, 6
First, calculate the cost driver rate for each cost pool.
Activity Area
Total Costs Total Units of Cost Driver
Cost Driver Rate
Order Processing
$80,000
$40/order
2,000 orders
Line Item Ordering
63,840
21,280 line items
Store Deliveries
71,000
Carton Deliveries
76,000
76,000 cartons
Shelf Stacking
10,240
640 hours
1,420 store deliveries
3/line item
50/store delivery
1/carton
16/hour
An ABC Example, 7
Next, allocate these costs to each distribution channel
Supermarkets
Drugstores
Ma and Pa
1. Orders
140*40=5,600
360*40=14,400
1,500*40=60,000
2. Average line items
14
12
10
2a. Total line items
1,960*3=5,880
4,320*3=12,960
15,000*3=45,000
3. Deliveries
120*50=6,000
300*50=15,000
1,000*50=50,000
4. Average # of cartons
300
80
16
4a. Total cartons
36,000*1=36,000 24,000*1=24,000 16,000*1=16,000
5. Average stacking hours
3
0.6
0.1
5a. Total Stacking hours
360*16=5,760
180*16=2,880
100*16=1,600
Totals (= 301,080)
59,240
69,240
172,600
An ABC Example, 8
Comparing ABC to Traditional Costing Profit: Supermarket
Traditional
ABC
$30,900
$30,900
Average CGS per delivery
30,000
30,000
Gross Margin per delivery
900
900
Number of Deliveries
120
120
Average Revenue per delivery
Total Gross margin
$108,000
$108,000
Allocation of Other Costs
74,239
59,240
Distribution Line Profit
33,761
48,760
Profit Margin
0.9%
1.3%
An ABC Example, 9
Comparing ABC to Traditional Costing Profit: Drugstores
Traditional
ABC
$10,500
$10,500
Average CGS per delivery
10,000
10,000
Gross Margin per delivery
500
500
Number of Deliveries
300
300
Average Revenue per delivery
Total Gross margin
Allocation of Other Costs
Distribution Line Profit
Profit Margin
$150,000
$150,000
103,110
69,240
46,890
80,760
1.5%
2.6%
An ABC Example, 10
Comparing ABC to Traditional Costing Profit: Ma and Pa
Traditional
ABC
$1,980
$1,980
Average CGS per delivery
1,800
1,800
Gross Margin per delivery
180
180
Average Revenue per delivery
Number of Deliveries
Total Gross margin
Allocation of Other Costs
Distribution Line Profit
Profit Margin
1,000
1,000
$180,000
$180,000
123,731
172,600
56,269
7,400
2.8%
0.4%
An ABC Example, 10
Summary Profit Comparison of Traditional vs. ABC
Traditional
ABC
Supermarket
33,761 (0.9%)
48,760 (1.3%)
Drugstores
46,890 (1.5%)
80,760 (2.6%)
Ma and Pa
56,269 (2.8%)
7,400 (0.4%)
Total
136,920
136,920
An ABC Example, 11
• Note that the total profit for the firm has not
changed at all as a result of using ABC vs.
traditional costing techniques
• So what’s the big deal??
• Some people argue that for many firms using ABC
is analogous to re-arranging the chairs on the deck
of the Titanic - it really doesn’t stop a firm from
failing
• also, ABC is not GAAP
– also, implementing ABC is a significant task
• This is true if figuring out new product costs is the
only thing ABC is used for
So What is the Value of ABC
• Like any accounting system, ABC is an
INFORMATION system - it provides info to assist
decision makers, but in and of itself this info
DOES NOTHING, unless management acts upon
it
• ABC provides insights into your business that
management was probably not aware of before
• The old system simply charged each line 68.7% of
its gross margin to arrive at product line
profitability - peanut butter costing
So What is the Value of ABC, 2
• The ABC system reveals however that the MA and PA
stores actually consume 95.9% of its gross margin with
other operating expenses
• This is because the MA and PA stores are more activity
intense, and thus more cost intensive
• Under the old system, MA and PA stores were charged
41.1% (180,000/438,000) of overhead, since this was their
share of gross margin
• However, if you look at the activities, you can see that MA
and PA stores account for well over 41.1% of the activities
(75% of the orders, 70% of the deliveries, etc)
How can managers act on this info
• Now that managers know the cost of these
activities, they can work to try and reduce those
costs
• Also, they can see why Ma and Pa stores are so
expensive (they order more often, they have more
deliveries, etc.) and they work with these stores to
try and reduce those activities; i.e., less frequent
ordering, less frequent deliveries
• Also, since part of ABC is activity identification
and classification as VA or NVA, managers can
attempt to eliminate or minimize NVA
When Would ABC not be Useful
(at least from a product costing view)
• If the company only has one product
• If all products use all resources in the same
proportions, which is the same proportion used to
allocate costs in a traditional system (little
diversity)
• Cost control is not critical at this stage for the
company (growth stage companies)
When Would ABC be most Useful
• The Willie Sutton rule
– large expenses in indirect and support resources
• High diversity (products, customers, processes)
• When a firm wants to better understand its
activities and the costs of those activities, even if
the firm only makes one product
Developing an ABC System, 1
• There are four sequential steps a firm would go
through o develop an ABC system
– Develop the activity dictionary
– determine how much the organization is spending on
each of its activities
– identify the organization’s products, services, and
customers
– select activity cost drivers that link activity costs to the
organization’s products, services, and customers
• transaction, duration, and intensity
Developing an ABC System, 2
• The goal of an ABC system should not be to
develop the most accurate, but one that balances
the cost of errors made from inaccurate estimates
with the cost of measurement
• Activity cost drivers are the central innovation of
ABC systems, but they are also the most costly