Chapter 05 - Activity-Based Costing and Management

CHAPTER 5
ACTIVITY-BASED COSTING AND MANAGEMENT

Learning Objectives
1.

Compute product costs under a traditional, volume-based productcosting system.

2.

Explain how an activity-based costing system operates, including the

use of a two-stage procedure for cost assignment, the identification of
activity cost pools, and the selection of cost drivers.

3.

Explain the concept of cost levels, including unit-level, batch-level,

product-sustaining-level, and facility-level costs.

4.

Compute product costs under an activity-based costing system.

5.

Explain why traditional, volume-based costing systems tend to distort

product costs.

6.

Explain three criteria for selecting cost drivers.

7.

Discuss several key issues in activity-based costing, including data

collection and storyboarding.

8.

Explain the concept of activity-based management and twodimensional ABC.

9.

Explain and execute a customer-profitability analysis.

10.

Understand and discuss how activity-based costing is used in serviceindustry organizations.

11.

List and explain eight important features of just-in-time inventory and

production management systems (appendix).

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Chapter 05 - Activity-Based Costing and Management

Chapter Overview
I.
II.

Traditional, Volume-Based Costing Systems/Procedures

A.

B.

Activity-Based Costing (ABC) Systems

Stage one: Identification of cost pools
1. Unit-level activities
2. Batch-level activities
3. Product-sustaining activities
4. Facility-level activities
Stage two: Identification of cost drivers for each cost pool,
calculation of pool rates, and assignment of costs to products and
services

III.

Improved Costing Under ABC

IV.

Activity-Based Costing: Some Fine Points

A. Cost drivers
B. Storyboarding
C. Project teams
D. Activity compilation

V.

Activity-Based Management (ABM)

A. A focus on activities
B. Elimination of non-value-added activities and costs

VI.

Customer Profitability Analysis

VII.

Activity-Based Costing in the Service Industry

VIII.

Just-in-Time (JIT)
A. Nature of operation and goals
B. Just-in-time production and required features
C. Just-in-time purchasing and required features

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Chapter 05 - Activity-Based Costing and Management

Key Lecture Concepts

1.

TRADITIONAL, VOLUME-BASED COSTING SYSTEMS

The manufacturing and service environments have changed as a

result of ever-increasing international competition, technological
innovation, and advances in computerized systems.

Many companies still use traditional volume-based (sometimes

called throughput-based) costing systems (as described in
Chapters 3 and 4). These systems generally group overhead
into one cost pool and apply overhead to products based on
direct labor, with labor being a measure of volume.
Teaching Tip: A traditional volume-based, product-cost system may
function in a satisfactory manner for inventory valuation. The
overhead applied via the traditional product-costing system, however,
does not bear a close enough relationship to the resources required to
build different products or perform different services.

2.

In the past, accountants felt there was a high correlation

between overhead and labor. However, with increasing factory
computerization and automation (and the reduction of hands-on
labor), this is not always the case today.

ACTIVITY-BASED COSTING SYSTEMS

Many organizations are changing to activity-based costing

(ABC) systems. This system improves product costing and
management decision making, and involves two stages:

Stage one: The costs of an organization's significant

activities are first isolated into cost pools. The cost pools
(and related costs) fall into the following broad categories,
which collectively are known as a cost hierarchy:

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Chapter 05 - Activity-Based Costing and Management

Unit levelactivities that must be done for each

unit of production (e.g., machining)

Batch levelactivities that are performed for each

batch of product (e.g., setup, quality-assurance, and
receiving)

Product-sustaining levelactivities that are

performed to support an entire product line (e.g.,
engineering)

Facility (or general operations) levelactivities

that are required for the entire manufacturing
process to occur (e.g., plant management, plant
maintenance, and depreciation)

Stage two: The next step involves

identification of a cost driver for each pool. The system
then assigns overhead costs by using the cost drivers and
assessing the relative proportion of the activity consumed
by a product.

3.

This process results in the calculation of a pool rate,

a per-unit cost of the cost driver, and an eventual
cost for each product line.

IMPROVED COSTING UNDER ABC

Costing is improved when ABC is used, as the system identifies

products that were overcosted or undercosted by traditional
methods.

In many cases, traditional, volume-costing systems

overcost high-volume product lines and undercost
complex, relatively low-volume lines. Thus, high-volume
products essentially subsidize the low-volume lines.

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Chapter 05 - Activity-Based Costing and Management

4.

ABC uses multiple (and many non-unit) drivers

because more than one item drives the costs of an organization.
Not all activities are unit-level in nature, and ABC allows a user
to recognize batch-, product-sustaining, and facility-level
activities.

Costing is more equitable especially in the case of diverse

products (and widely varying consumption ratios, which show
the proportion of an activity consumed by a given product). No
single cost driver can accurately assign overhead when products
use activities differently and consume costs in a disproportionate
manner.

ACTIVITY-BASED COSTING: SOME FINE POINTS

Cost drivers: The degree of correlation between activity

consumption and consumption of the driver has a significant
impact on the accuracy of the ABC-costing effort.
Teaching Tip: For a service business, namely, a dialysis clinic, the
number of dialyzer treatments should be an appropriate cost driver to
trace the operating costs of dialyzing machines. Nursing
administration cost can be applied by using the number of treatments
as its cost driver. Finally, square footage, estimated kilowatt usage,
and number of patients are cost drivers that could be chosen for
assigning a hospitals facility-level costs.

In addition to the degree of correlation, the cost of

measurement as well as behavioral effects must be
considered in the selection of cost drivers.

An example of behavioral impact may be the choice

of the number of material moves to allocate
material-handling cost. Selection of such a base may
induce managers to reduce the number of times
materials are moved, thus reducing total materialhandling costs.

Storyboarding: Many firms prepare a process flow chart that

shows the activities and relationships among activities. This
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Chapter 05 - Activity-Based Costing and Management

procedure, called storyboarding, is needed to organize the

data in an ABC project.

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Chapter 05 - Activity-Based Costing and Management

5.

Project teams: A typical ABC project involves multidisciplinary

teams, with personnel selected from various functional areas.

Activity compilations: Many companies compile a complete

listing of all activities identified and used in an ABC analysis
(called an activity dictionary). Similarly, many firms create a
bill of activities, which is a complete listing of the activities
associated with a particular product or service.

ACTIVITY-BASED MANAGEMENT (ABM)

Activity-based management (ABM) refers to the use of

activity-based costing information to support organizational
strategy, improve operations, and manage costs.

An ABC system assigns resource cost to a company's cost

objects (i.e., the cost assignment viewpoint). With a process
viewpoint, the emphasis now is on the activities themselves
what causes them, the events that trigger them, and the related
linkages.

A goal of ABM is to identify and eliminate non-value-added

activities: activities that are either unnecessary and
dispensable, or necessary but inefficient and improvable.

Common examples of non-value-added activities include

move, wait, and storage time.

These activities give rise to non-value-added costs, or

costs that can be eliminated without deterioration of
product quality, performance, or perceived value.

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Chapter 05 - Activity-Based Costing and Management

Teaching Tip: Airlines provide a classic example that can be used

to illustrate non-value-added costs. When carriers began selling
tickets on-line through their Web sites, the firms were able to
reduce, or in some cases eliminate, the need for travel agents to
provide flight information and sell tickets (i.e., an activity).

6.

CUSTOMER PROFITABILITY ANALYSIS

Customer profitability analysis uses activity-based costing to

determine the activities, costs, and profit associated with
serving particular customers.

Factors that influence customer profitability include order

quantity, order frequency, special packaging and/or delivery
needs, engineering design changes, sales visits/contacts, and, in
general, customized services.

Customers can often be educated in terms of buying habits, with

the result being lower overall costs for both the purchaser and
the seller.

Appropriate tools of analysis include bar graphs, costs expressed

as a percentage of gross margin, and trend analyses.
Teaching Tip: Point out the interesting example in the text (p. 193) that
relates to customer-profitability analysis at Best Buy. In another (and
in this case, controversial) illustration, Sprint Nextel recently dropped
1,000 customers that were generating calls to service centers at a rate
40 to 50 times higher than average, thus straining the company's
ability to assist its other subscribers. See "Sprint Tells Gripers
Goodbye," The Kansas City Star, July 10, 2007, pp. A1, A4.

7.

ACTIVITY-BASED COSTING IN SERVICE ORGANIZATIONS

The overall objectives of ABC in service firms are identical to

those for manufacturing organizations.

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Chapter 05 - Activity-Based Costing and Management

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Chapter 05 - Activity-Based Costing and Management

8.

The general approach of identifying activities, cost pools, and

cost drivers is the same for service and manufacturing entities
as well.

APPENDIX: JUST-IN-TIME (JIT)

JIT inventory and production management is a

comprehensive control system in which no materials are
purchased and no products are manufactured until needed.

A primary goal of this system is to reduce or eliminate

inventories at every stage of production.

Such systems require the following features:

A smooth, uniform production rate

A pull method of coordinating steps in the production

process

Goods are produced only as needed at the next

stage, which eliminates and/or reduces work-inprocess inventory. This approach begins at the last
stage of manufacturing, with a message transmitted
to the preceding work center to send the materials
needed over the next few hours (i.e., the
withdrawal Kanban).

Purchase of materials and manufacture of subassemblies

in small lot sizes (to reduce storage and waiting time)

Quick and inexpensive setups of production machinery

High quality levels for raw material and finished products

(because of no back-up inventories)
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Chapter 05 - Activity-Based Costing and Management

Effective preventive maintenance of equipment (to avoid

downtime and production delays)

An atmosphere of teamwork to improve the production

process

Multiskilled workers and flexible facilities that can adapt to

various production needs and problems, and keep things
flowing smoothly

With JIT purchasing, materials and parts are purchased from

outside vendors only as needed. Such systems require the
following features:

Only a few supplierstotally reliable vendors that deliver

top-quality goods

Long-term contracts negotiated with suppliers

Materials and parts delivered in small lot sizes before they

are needed

Only minimal inspection of delivered materials and parts

(because of supplier reliability and the quality of items
purchased)

Grouped payments to vendors (to reduce paperwork)

Teaching Tip: JIT systems can sometimes backfire, as many of
Japan's car manufacturers recently learned. A 6.8-magnitude
earthquake damaged the production facilities of Riken Corp.,
which produces a very popular $1.50 piston ring, and the
inability to make timely deliveries brought a temporary halt to
roughly 70% of Japan's automotive production for several days.
See "A Key Strategy of Japan's Car Makers Backfires," The Wall
Street Journal, July 20, 2007, pp. B1, B5.

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Chapter 05 - Activity-Based Costing and Management

Teaching Overview
When I teach activity-based costing, I use exercises and problems that not
only overview product costing but also integrate the managerial aspects of
doing business (e.g., the ramifications of under- and overcosting of goods)
particularly in competitive marketplaces. Students can easily get bogged
down in the details of ABC calculations,
so the added feature of analysis is somewhat interesting to them. I always
stress that software is currently available to take care of the related number
crunching.
I recommend further in-class discussion of the Patio Grill case study and
discussion of Problem 5-50.
Teaching selected parts of this chapter will likely present a challenge for the
"traditional" instructor, as some of the subject matter is beyond the scope of
what is often considered "accounting and business" in nature. Furthermore,
a portion of the material deals with general concepts and is not totally
conducive to standing in front of the class and working problems. With
challenge, though, comes opportunity. I find that this chapter presents an
excellent opportunity to use (1) videos on high-tech manufacturing as well
as (2) outside speakers. It may be interesting to have a panel discussion of
manufacturers, with a focus on how business has changed in the last ten
years and the impact of various continuous-improvement techniques on
their firms.
It is also beneficial to have several speakers from service businesses to
discuss the elimination of non-value-added activities, a theme that is
common to both service businesses and manufacturing organizations.
Speakers on the topic of customer profitability analysis also lend additional
insights, given that many students never think about the fact that some
customers are more costly to service than others. A high cost-to-service
customer can easily destroy whatever gross margin is generated on a hardearned sale.
I recommend using Exercises 5-35 (college registration practices), 5-37
(identification of non-value-added costs), and 5-39 (activity-based
management) as a way to introduce selected topics.
Teaching Tip: You may want to introduce your students to "A Tale of Two Auto
Plants," which contrasts two manufacturing plants in Texas, one owned by General
Motors and the other owned by Toyota. The differences are eye-opening and quite
revealing. See The Wall Street Journal, May 24, 2006, pp. B1, B2.

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Chapter 05 - Activity-Based Costing and Management

Links to the Text

Homework Grid CHAPTER 5
Item No.
Exercises:
5-26
5-28
5-29
5-27
5-31
5-32
5-33
5-35
5-34
5-36
5-30
5-37
5-38
5-39
5-40
5-41
5-42
5-43
5-44
Problems:
5-50
5-47
5-48
5-49
5-45
5-46
5-51
5-52
5-53

Learnin
g
Objectiv
es
1,
2,
2,
1,
2,
2,
2,
2,
2,
2,
7,
2,
8
8
8,
8,

2, 4
3, 6
3
2, 4
5
5, 7
3, 7
4
3, 7
3, 6,
10
7, 10

10
10

8, 10
9
9
2, 3, 10
1,
7,
1,
2,
1,
1,
1,
5,
1,
1,
4,
2,

2, 4,
10
2, 4, 5
4
2, 4, 5
2, 7
2, 4,
7
2, 5, 8
2, 3,
7
3, 4

5-13

Completi
on
Time
(min.)
15
20
5
15
20
15
20
30
20
30
30
25
30
15
40 + time
at
restaurant
30
25
30
20
35

Special
Feature
s*

I
C
C
C
G, C
W

C
C, G
C
I

60
25
30
25
30
30
40
20

Chapter 05 - Activity-Based Costing and Management

5-57

1, 2, 3,
4, 5

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50

Chapter 05 - Activity-Based Costing and Management

5-55
5-58

Item No.
5-54
5-56
5-59
5-60
5-61
5-62
5-63
5-64
5-65
5-66
5-67
Cases:
5-68

1, 2, 4, 5
1, 2, 5, 4

45
60

G, C
E, C, G

Learnin
g
Objectiv
es
2, 3, 4,
5, 7
1, 2, 4,
5, 7
1, 2, 3,
4, 5
1, 2, 3,
4, 5
2, 5, 7
2, 5
8, 10
11
8
9
9

Completi
on
Time
(min.)
45

C, I

60

I, G

Special
Feature
s*

50
60

20
20
25
40
45
40
45

C
C
C

1, 2, 4,
45
5, 7
5-69
1, 2, 3,
60
4, 5
5-70
2, 5
60
5-71
2, 5, 7
20
* C = Business communication
E = Ethics
I = International
W = Web-based application

C
C
C, G
C
E, C
G = Group work

Links to the Ancillaries

Video Programs
McGraw-Hill has produced various videos that are relevant to the instruction
of managerial/cost accounting. Information about these videos (including a
description of those applicable to this chapter) appears in Appendix A.
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Chapter 05 - Activity-Based Costing and Management

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