Chapter 5

Activity-Based Costing
and Management

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 5-1 – Compute product costs
under a traditional, volume-based product-costing
system.

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Traditional, Volume Based
Costing System
Traditional, Volume Based
Costing System
 Traditional, Volume-Based
Product-Costing System
With these product costs, Patio Grill established target
selling prices (Cost × 120%).

496.00 x 1.20
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Learning Objective 5-2 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.

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Activity Based Costing System (ABC)
ABC systems follow a two-stage procedure to assign
overhead costs to products.

Stage One
Identify significant activities and assign overhead costs
to each activity in proportion to resources used.
Stage Two
Identify cost drivers appropriate to each activity and
allocate overhead to the products.

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Learning Objective 5-3 – Explain the concept of
cost levels, including unit-level, batch-level,
product-sustaining-level, and facility-level costs .

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 Overhead Costs
Total budgeted cost = $4,896,000 Identification
Identification
Activity
must be
of
of Activity
Activity
done on Cost
Cost Pools
Pools
each unit Activity
produced. Cost
Pools
Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level

Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,242,000 $210,000 $130,000 $2,300,000

Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
produced. 5-9
 Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,242,000 $210,000 $130,000 $2,300,000

Purchasing
cost pool 300,000

Material-Handling
cost pool $340,000

Quality-Assurance
cost pool $110,000

Packaging/Shipping
cost pool $264,000
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Learning Objectives 5-4 – Compute product costs
under an activity-based costing system.

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 STAGE ONE – Machinery Cost Pool
Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,242,000

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STAGE TWO – Machinery Cost Pool
Budgeted Machinery Costs $1,242,000
Budgeted Machine Hours 230,000=
$5.40/hour=

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ABC Pool Cost Calculations –
First 4 activities
ABC Pool Cost Calculations –
Last 4 activities
 Product Cost from ABC
These are the new product costs when ABC is used.

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Learning Objective 5-5 – Explain why
traditional, volume-based costing systems tend to
distort product costs.

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 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 120%).

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5-19
 Two Key Points

A
A large
large proportion
proportion of of non-
non- Product
Product diversity
diversity
unit-level
unit-level activities
activities When
When thethe consumption
consumption
A
A unit-level
unit-level cost
cost driver,
driver, such
such ratios
ratios differ
differ widely
widely
as
as direct
direct labor,
labor, machine
machine
hours, between
between activities,
activities, no
no
hours, or
or throughput,
throughput, willwill
not
not be
be able
able to
to assign
assign the
the costs
costs
single
single cost
cost driver
driver will
will
of
of non-unit-level
non-unit-level activities
activities accurately
accurately assign
assign the
the
accurately.
accurately. resulting
resulting overhead
overhead costs.
costs.

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Learning Objective 5-6 – Explain three criteria
for selecting cost drivers.

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 Cost Drivers
A characteristic of an event or activity that results in
the incurrence of costs. In selecting a cost driver,
we must consider . . .

Degree of Behavioral
Correlation Effects

Cost of
Measurement

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Learning Objective 5-7 – Discuss several key
issues in activity-based costing, including data
collection and storyboarding.

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 COLLECTING ABC DATA
INTERVIEWS AND PAPER TRAILS - The information
for ABC systems initially comes from interviews with
employees in the support departments and a review of each
department’s records.

STORYBOARDING - A procedure used to develop a

detailed process flow chart, which visually represents activities
and the relationships among activities.

MULTIDISCIPLINARY ABC PROJECT TEAMS – To

gather information from all facets of an organization’s
operations, it is essential to involve personnel from a variety of
functional areas. A typical ABC project team includes
ACCOUNTING, FINANCE, PRODUCTION, OPERATIONS,
ENGINEERS, MARKETING, etc.
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Learning Objective 5-8 – Explain the concepts of
activity-based management and two-dimensional
ABC.

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Activity-Based Management

The use of
ABC costing
information
to help
management
make decisions
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Activity-Based Management (ABM)
Activity-based costing establishes relationships
between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.

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Two-Dimensional ABC and
Activity-Based Management

Activities

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Two-Dimensional ABC and Activity-Based
Management
Cost Assignment View

Resource
Resource costs
costs

Activities

Cost
Cost Objects
Objects
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 Two-Dimensional ABC and
Activity-Based Management
Cost Assignment View

Resource
Resource costs
costs
Process View
Activity Analysis Activity Evaluation

Root
Root Activity
Activity Performance
Performance
Causes
Causes Triggers
Triggers Activities Measures
Measures

Cost
Cost Objects
Objects
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Elimination of Non-Value-Added Costs
Activities

Non-value-
added
activities
Unnecessary Necessary

Reduce or Continually Evaluate

Eliminate
and Improve 5-31
 Using ABM to Eliminate Non-Value-Added
Activities and Costs
1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes, and
Triggers.
Inspect
Inspect Rework
Rework
Specify
Specify Select
Select Receive
Receive Produce
Produce finished
finished defective
defective
parts
parts vendor
vendor parts
parts goods
goods goods
goods products
products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

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Using ABM to Eliminate Non-Value-Added
Activities and Costs

Process time

Inspection time Storage time

Move time Waiting time

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Learning Objective 5-9 – Explain and execute a
customer-profitability analysis.

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Customer Profitability Analysis

Customer profitability analysis uses

activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

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Customer Profitability Analysis
Required
special
packaging
Orders Demand
small fast
quantities service

Often
Orders
changes
frequently
orders

A costly customer
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 Customer Profitability Analysis
Cost
CostDrive
Drive
Customer-Related
Customer-Related Activities
Activities Cost
CostDriver
DriverBase
Base Rate
Rate
Order
Orderprocessing
processing Purchase
Purchaseorders
orders $$ 150
150
Sales
Salescontacts
contacts(phone
(phonecalls,
calls,faxes,
faxes,etc.)
etc.) Contacts
Contacts 100
100
Sales
Salesvisits
visits Visits
Visits 1,000
1,000
Shipment
Shipmentprocessing
processing Shipments
Shipments 200
200
Billing
Billing and
and collection
collection Invoices
Invoices 160
160
Design/engineering
Design/engineering change
changeorders
orders Design
Design changes
changes 4,000
4,000
Special
Specialpackaging
packaging Units
Unitspackaged
packaged 40
40
Special
Specialhandling
handling Units
Unitshandled
handled 60
60

A
A company
company maymay useuse these
these customer
customer
related
related costs
costs toto help
help determine
determine the
the
profitability
profitability of
of each
each customer.
customer.

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Customer Profitability Analysis
Customer Profitability
Cumulative Operating Income as a % of Total

125.0%

100.0%
Operating Income

75% of actual operating income

75.0%

50% of actual operating income

50.0%

25% of actual operating income

25.0%

0.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

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Learning Objective 5-10 – Understand and
discuss how activity-based costing is used in service-
industry organizations.

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ABC Costing in the Service Industry
The overall objectives of ABC in service
firms are no different than they are in
manufacturing companies.
Identify the activities
Create activity cost pools
Identify activity cost drivers
Follow similar steps discussed in chapter
End Chapter 5

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