Chapter 5
Activity-based Cost Systems
See also: Kaplan/Atkinson 3rd ed. Ch.4
Cooper/Kaplan: Cost and Effect,
Harvard Business School Press 1998
1
Example of misleading traditional cost system

Cole Corporation manufactures two types of lenses
for automobile rear lights out of plastic material
– a normal lens (NL) and a complex lens (CL).




lenses are molded using machines
redesigned according to the requirements of the customers
(model changes)
To cost products, Cole currently uses a single
indirect-cost rate job costing system.
The cost objects are the total costs of manufacturing
and distributing 80,000 normal lenses (NL) and
20,000 complex lenses (CL).
2
Application to two products


Normal Lenses (NL) Complex Lenses (CL)
Direct materials
$1,520,000
$ 920,000
Direct mfg. labor
800,000
260,000
Total direct costs
$2,320,000
$1,180,000
Direct cost per unit: $2,320,000 ÷ 80,000 $1,180,000 ÷ 20,000
= $29
= $59
 total direct labor hrs.
36,000
14,000



Indirect costs
direct manufacturing labor hrs.
Indirect cost rate =
$2,900,000
50,000
$2,900,000 ÷ 50,000
= $58
3
Product cost
Normal Lenses (NL) Complex Lenses (CL)

Direct costs
+ Allocated costs
=
cost per unit
Selling price:
Margin
Margin %age
$2,320,000
(= 36,000 × $58)
$2,088,000
$4,408,000
$1,180,000
(=14,000 × $58)
$ 812,000
$1,992,000
$4,408,000 ÷ 80,000 $1,992,000 ÷ 20,000
= $ 55.10
$ 60
$ 4.90
8.2%
= $ 99.60
$142
$ 42.40
29.9%
4
Refining a Costing System
Guidelines
 Direct-cost tracing – Classify as many of the total costs
as direct costs as is economically feasible.
 Indirect-cost pools – Expand the number of cost pools
until each of these pools is homogeneous.
 Cost-allocation basis – Identify the preferred costallocation base for each indirect-cost pool.
5
Activity-Based Costing System

ABC systems refine costing systems by focusing on
individual activities as the fundamental cost object

they measure utilization of each activity by cost objects and
assign the cost of the activity accordingly
total cost of activity
per period
(“cost pool”)
cost driver units
used by cost object

×
total utilization of
activity per period
Cost driver
rate
=
= Cost driver
rate
overhead cost
assigned
to cost object
6
Activity-based Costing: the fundamental
idea:
Indirect labor
Resource:
Prepare
tooling
# setups


# setup hrs.
Product,
Customer:
Set up
machines
# maint. hrs.
Cost driver
rate:
Maintain
machines
# moves
Activity
cost driver:
Move
materials
# receipts
Activity:
Inspect
incoming
materials



7
General Procedure

Determine the set of activities j performed in each
department (cost center)
 determine a Cost Driver for each activity j measuring
the causal relationship between



resource consumption of the activity and its
utilization by products or customers
assign (budgeted) resource costs to activities j
 each activity is assigned a cost pool Cj
8
General Procedure (cont’d)
determine the total level xj of budgeted utilization
of the activity
C
 determine the cost driver rate = j
xj


Determine (actual) usage xjl of cost driver j by
each user l

Activity-based cost assignment to user l:
Sj
xjl Cj
xj
9
Key step: Assigning resource costs to
activities


Resource costs per activity is an important piece of
information to management
This is usually done by interviews with department
managers on



activities performed
the proportion of working time usually spent on each
activity
no excessive precision required
10
Separate cost driver rates for committed and
flexible cost
Resources 
Driver
expense activity level rate
Committed
Flexible
C1j
C2j
total
C1j + C2j
Budgeted
xj = capacity C1j / xj
C2j / xj
xj
(expected)
C1j C2j
xj + xj

C1j + C2j
xj + xj
in general
11
Cost Hierarchies

1
2
3
4
ABC systems commonly use a four-level cost
hierarchy to identify cost-allocation bases:
Output unit-level cost
Batch level costs
Product-sustaining costs
Facility-sustaining costs
12
Functions of activities



Unit level activities
(sales volume-related)
batch level activities
(related to # of batches
of saleable output)
product-sustaining
(activities enabling the
production of saleable
output)
•
customer sustaining
(activities enabling to
sell products to individual
customers or markets)
(Costs that may be assigned only to broader output categories)
13
Cost hierarchy

Output Unit-Level Costs


Batch-Level Costs


resources sacrificed on activities that are related to a group of units of product(s)
or service(s) rather than to each individual unit of product or service.
 Setup hours
 Procurement costs
Product-Sustaining or service-sustaining costs


resources sacrificed on activities performed on each individual unit of product or
service.
 Energy
 Machine depreciation
 Repairs
resources sacrificed on activities supporting individual products or services.
 Design costs
 Engineering costs
Facility-Sustaining Costs

resources sacrificed on activities that cannot be traced to individual products or
services but support the organization as a whole
 General administration
 Rent
 Building security
14
Types of activity cost drivers
Accounting
cost

Number of transactions
 duration of transaction


if time consumed varies among
individual instances of the activity
intensity or direct charging

number of staff of different wage groups
assigned to an activity per time unit
 resources actually used for the
individual instance of an activity
15
Appropriate number of cost drivers



Small cost pools do not alter unit costs much
if additional information has to be acquired on a cost
driver consider the information cost and compare it
to the benefit of the better decision
do not add a cost driver which is an approximate
linear combination of cost drivers already used

existing cost pools should share in the cost that would be
assigned to that pool according to the weights of the linear
combination
16
Implementing Activity-Based Costing
Step 1: Identify the chosen cost objects.

The objective is to calculate the total costs of designing,
assembling, and distributing S and C.
Step 2: Identify the direct costs of the product.


Cole identifies direct materials costs and direct manufacturing
labor as direct costs.
Cleaning and maintenance costs of $360,000 are also identified
as direct costs of the lenses.
 Cleaning and maintenance costs of $360,000 are direct batchlevel-costs.
 Why? Because these costs consist of workers’ wages for
maintenance of machines after each batch of phones is run.
 The old cost system classified cleaning and maintenance
costs as part of the $2,900,000 indirect costs.
 Recall that indirect costs were allocated to products using
direct manufacturing labor-hours.
17
Primary purposes of Activity-based Cost
Systems

Analysis of decisions on the structure and design of
productive system




not used for management control purposes


more transparency of the factors causing costs
phasing out non-value-added activities
sporadic stand-alone analyses, not integrated in on-line
accounting system
otherwise management will have an incentive to choose cost
drivers strategically
Decision facilitating for Activity-based Management
(ABM)
18
Activity-Based Management

ABM describes management decisions that use
activity-based costing information to satisfy
customers and improve profits.
– Product pricing and mix decisions
– Cost reduction and process improvement
decisions
– Design decisions
19
ABM decisions

Product Pricing and Mix Decisions



Cost Reduction and Process Improvement Decisions



ABC gives management insight into the cost structures for
making and selling diverse products.
provides more accurate product cost information and more
detailed information on costs of activities and the drivers of
those costs.
Manufacturing and distribution personnel use ABC systems
to focus on cost reduction efforts.
Managers set cost-reduction targets in terms of reducing the
cost per unit of the cost-allocation base.
Design Decisions


Management can identify and evaluate new designs to
improve performance by evaluating how product and process
designs affect activities and costs.
Companies can work with their customers to evaluate the
costs and prices of alternative design choices.
20
Critique

ABC systems are full cost systems



they average fixed costs over products according to cost
driver utilization: every individual unit carries the same cost
per unit of driver utilized
costs for which a cost driver is not available (e.g. leading a
department) are allocated to cost pools of measurable
activities
For change management decisions an incremental
costing approach is more adequate, when the size of
the cost pool will not change proportionally with the
cost driver (non-linearities in the cost function) due to



fixed costs
economies of scale
economies of scope
21
CC-Problems

5-35 (=11), requirements 1.-3. (10%)
 5-29 (=11.5-30)
( 5%)
 5-31 (=11.5-32)
( 5%)
 5-17 (=11.5-19)
( 5%)
 5-19 (Excel)(=11.5-21,5-22)
( 8%)
 5-23 (=11.5-24)
( 8%)
 5-33
(10%)
22