Chapter 7: Activity-Based Costing and Management

SUMMARY OF LEARNING OBJECTIVES

LO 1. Explain why functional (or volume)-based costing approaches may

produce distorted costs.
. Overhead costs have increased in significance over time and in many firms
represent a
much higher percentage of product costs than direct labor.
. Many overhead activities are unrelated to the units produced.
. Functional-based costing systems are not able to assign the costs of these nonunit-
based overhead activities properly.
. Nonunit-based overhead activities often are consumed by products in different pro-
portions than are unit-based overhead activities. Because of this nonproportionality,
assigning overhead by using only unit-based drivers can distort product costs.
. If the nonunit-based overhead costs are a significant proportion of total overhead
costs, the inaccuracy in cost assignments can be a serious matter.

LO 2. Explain how an activity-based costing system works for product costing.

. Activities are identified and defined through the use of interviews and surveys. This
in-
formation allows an activity dictionary to be constructed.
. The activity dictionary lists activities and potential activity drivers, classifies
activities
as primary or secondary, and provides any other attributes deemed to be important.
. Resource costs are assigned to activities by using direct tracing and resource
drivers.
. The costs of secondary activities are ultimately assigned to primary activities by
using
activity drivers.
. Finally, the costs of primary activities are assigned to products, customers, and
other
cost objects.
. The cost assignment process is described by the following general steps: (1)
identifying
the major activities and building an activity dictionary, (2) determining the cost of
those activities, (3) identifying a measure of consumption for activity costs (activity
drivers), (4) calculating an activity rate, (5) measuring the demands placed on activi-
ties by each product, and (6) calculating product costs.

LO 3. Describe activity-based customer costing and activity-based supplier

costing.
. Tracing customer-driven costs to customers can provide significant
information to
managers.

. Accurate customer costs allow managers to make better pricing decisions,

customer mix decisions, and other customer-related decisions that improve
profitability.
. Tracing supplier-driven costs to suppliers can enable managers to choose the true
low-cost suppliers, producing a stronger competitive position and increased
profitability.

LO 4. Explain how activity-based management can be used for cost reduction.

. Assigning costs accurately is vital for good decision making.
. Assigning the costs of an activity accurately does not address the issue of whether
or not the activity should be performed or whether it is being performed efficiently.
. Activity-based management focuses on process-value analysis.
. Process-value analysis has three components: driver analysis, activity analysis,
and
performance evaluation. These three steps determine what activities are being done,
why they are being done, and how well they are done.
. Understanding the root causes of activities provides the opportunities to manage
activities so that costs can be reduced.
. Quality and environmental activities are particularly susceptible to activity-based
management.
. Quality costs are costs that are incurred because poor product quality exists or may
exist.
. Environmental costs are costs that are incurred because environmental
degradation
exists or may exist.

1. Limitations of Functional-Based Cost Accounting Systems

● Plant-wide and departmental rates based on direct labor hours,
machine hours, or other volume-based measures are used
successfully by many organizations.
○ However this approach to costing is equivalent to an averaging
approach and may produce distorted, or inaccurate costs.
 ●

● The need for more accurate product costs has forced many companies
to take a look at their costing procedures.

● Two major factors impair the ability of unit-based plant-wide and

departmental rates to assign overhead costs accurately:
○ The proportion of nonunit-related overhead costs to total
overhead costs is large.
○ The degree of product diversity is great.

2. Categorizing Costs under ABC

3. Product Diversity
● The presence of product diversity is also necessary for product cost
distortion to occur.
● Product diversity means that products consume overhead activities in
systematically different proportions.
● This may occur for several reasons, including differences in:
○ product size
○ product complexity
○ setup time
○ size of batches

4. Product Diversity and Product Costing Accuracy

● For unit-level overhead rates to fail, products must consume the non-
unit-level activities in proportions significantly different than the unit
● In a diverse product environment, activity-based costing promises
greater accuracy.

5. Activity-Based Product Costing

● Functional-based overhead costing involves two major stages:
○ Overhead costs are assigned to an organizational unit (plant or
department).
○ Overhead costs are then assigned to cost objects.

6. Activity Dictionary
● Interview-derived data is used to prepare an activity dictionary, which
lists the activities in an organization along with activity attributes.
● Examples: Financial and nonfinancial information items that describe
 individual activities
● Examples include:
○ types of resources consumed
○ amount (percentage) of time spent on an activity by workers
○ cost objects that consume the activity output (reason for
performing the activity)
○ measure of the activity output (activity driver)
○ activity name

7. Assigning Costs to Activities

● The next task is to determine how much it costs to perform each
activity.
● Requires identification of the resources being consumed by each
activity.
● The cost of labor, energy, materials, and capital is found in the general
ledger, but the money spent on each activity is not.
● A work distribution matrix is developed which identifies the amount
of labor consumed by each activity and is derived from the interview
process (or a written survey).
● Here is an example:

8. Assigning Costs to Products

● Activity costs are assigned to products by multiplying a predetermined
activity rate by the usage of the activity, as measured by activity
drivers.
● To calculate an activity rate, the practical capacity of each activity must
be determined.
● To assign costs, the amount of each activity consumed by each product
must also be known.

9. Activity-Based Customer Costing and Activity-Based Supplier Costing

● ABC systems originally became popular for their ability to improve
product-costing accuracy by tracing activity costs to the products that
consume the activities.
● ABC has expanded into areas upstream (i.e., before the production
section of the value chain—research and development, prototyping,
 etc.) and downstream (i.e., after the production section of the value
chain—marketing, distribution, customer service, etc.) from production.
● ABC often is used to more accurately determine the upstream costs of
suppliers and the downstream costs of customers.
○ Knowing the costs of suppliers and customers can be vital
information for improving a company’s profitability.

10. Process Value Analysis

● Process-value analysis is fundamental to activity-based management.
○ Activity-based management is a system-wide, integrated
approach that focuses management’s attention on activities with
the objective of improving customer value and profit achieved by
providing this value.
○ Process value analysis focuses on cost reduction instead of
cost assignment and emphasizes the maximization of system-
wide performance.

11. Driver Analysis: The Search for Root Causes

● Managing activities requires an understanding of what causes activity
costs. Every activity has inputs and outputs.
● Activity inputs are the resources consumed by the activity in
producing its output.
● Activity output is the result or product of an activity.
● An activity output measure is the number of times the activity is
performed. It is the quantifiable measure of the output.
● Driver analysis is the effort expended to identify those factors that are
the root causes of activity costs.

12. Activity Analysis: Identifying and Assessing Value Content

● The heart of process-value analysis is activity analysis.
● Activity analysis is the process of identifying, describing, and evaluating the
activities that an organization performs.
● Activity analysis produces four outcomes:
○ what activities are done
○ how many people perform the activities
○ The time and resources required to perform the activities
○ an assessment of the value of the activities to the organization,
including a recommendation to select and keep only those that add
value.
● Activities can be classified as value-added or nonvalue-added.

13. Activity Management Reduces Costs in Four Ways

Activity Elimination Focuses on nonvalue-added activities

Activity Reduction Decreases the time and resources required by an activity

 Activity Selection Involves choosing among different sets of activities that
are caused by competing strategies

Activity Sharing Increases the efficiency of necessary activities by using

economies of scale.

14. Quality Cost Management

● Activity-based management also is useful for understanding how quality costs
can be managed.
● Quality costs can be substantial in size and a source of significant savings if
managed effectively.
● Improving quality can produce significant improvements in profitability and
overall efficiency.
● Quality improvement can increase profitability in two ways:
○ by increasing customer demand and thus sales revenues
○ by decreasing costs

15. Quality Related Activities

● Quality-linked activities are those activities performed because poor quality
may or does exist.
● The costs of performing these activities are referred to as costs of quality.
● The definitions of quality-related activities imply four categories of quality
costs:
○ prevention costs
○ appraisal costs
○ internal failure costs
○ external failure costs
○ Costs of quality are associated with two subcategories of quality-
related activities: control activities and failure activities.

16. Environmental Cost Management

● Management of environmental costs is becoming a matter of high priority and
a significant competitive issue.
● Environmental costs are associated with the creation, detection, remediation,
and prevention of environmental degradation.
● Environmental costs are classified into the same four categories as quality
costs.

17. How Costs are Treated Under Activity–Based Costing

18. Classic Brass – An ABC Example

19. (1) Define Activities, Activity Cost Pools, and Activity Measures
(2) Assign Overhead Costs to Activity Cost Pools
(3) Calculate Activity Rates
The ABC team determines that Classic Brass will have these total activities for each
activity cost pool . . .
● 1,000 customer orders,
● 400 new designs,
● 20,000 machine-hours,
● 250 customer relations activities.
Activity-Based Costing at Classic Brass
（ 4） Assigning Overhead to Products
Classic Brass Information
Assigning Overhead to Customers
Let’s take a look at how Classic Brass system works for just one of the 250
customers – Windward Yachts who placed a total of three orders.