Activity-Based Costing

Shannon Anderson
Jesse H. Jones Graduate School of Management
Rice University
 Activity-Based Costing:
A response to “irrelevance,”
a preamble to strategic alignment

Shannon Anderson
Jesse H. Jones Graduate School of Management
Rice University
 Overview
 New Beginnings:
 Cost management in the new manufacturing setting
 Lessons from the field
 Articulation of the ABC model

 The Trajectory of ABC Research

 Investigating the economic model of ABC
 Implementing ABC
 Using ABC: Activity-based management
 Field Work and Cases:
Accounting Lag: The Obsolescence of Cost
Accounting Systems
(Kaplan, 1985)

“… to learn how firms are modifying their

accounting and control systems to help
them manage in the new manufacturing
environment, I visited a select set of
innovative firms.”
 Cases
 One Company reorganized manufacturing to create
One cost pool a
smooth production flow, but…
 benefits from reorganization were impossible to quantify… the
accounting system accumulated only total project costs… there
was no way to compute productivity measures or unit costs for
items being produced using the new manufacturing philosophy

 Two Companies implemented JIT and total quality

management…
 But continued to use a standard costing system that allocated all
costs based on often obsolete direct labor costs, even though
direct labor represented less than 10 percent of total
Inappropriate
manufacturing cost. cost driver
 Conclusion
“I had hoped to be able to document the incidence
and value of innovative accounting and control
systems for the new industrial competition…”

“I found that changes in accounting lag far behind

changes in the real production phenomena they
are supposed to represent.”
 Field Work and Cases
 Defining the Contours of Cost System Design
Did you know that Bob is
ranked #8 in all time
 Mayers Tap (Cooper, 1984) cumulative case unit sales
 Seligram, Inc. (Turney and Ittner, 1988) with 1.5 M units sold?
 Bridgeton Industries (Bost and Cooper, 1990)

 Identifying Activity-based Costing in Use

 Union Pacific (Kaplan, 1985)
 Schrader Bellows (Cooper & Wiess, 1985)
 John Deere Component Works (March & Kaplan, 1987) [#3 most popular
case]
 American Bank (Kallapur and Kaplan, 1987)
 New Beginnings:
The Design of Cost Management Systems
(Cooper and Kaplan, 1991)

“The previous academic approach

emphasized cost analysis for isolated, well-
specified decisions…

The new approach of this book emphasizes

principles of cost systems design.”
 Activity-based Costing
 Assign costs to ACTIVITIES that are associated with
 the production of particular products

 the delivery of particular services

 The COST DRIVERS used to assign costs reflect the

underlying unit of variability of the cost --- costs often
vary with activity level rather than production volume

 Costs often vary in a hierarchical fashion as compared to

unit production volume:
e.g., unit, batch, product, facility-sustaining
 Traditional vs. ABC Costing
Some products use no special
Overhead Costs: tooling and require no advanced
e.g., Salaries, Utilities, Toolingengineering support…

 Overhead costs
= 1000%
 Direct Labor Costs

Product A Cost per unit What does direct labor have to do

Direct Material $ 20 with overhead costs in an
automated setting with diverse
Direct Labor $ 50 processes?
Overhead $500 ($50 x 1000%)
Total $ 570
Traditional vs. ABC Costing
Multiple, manageable
Overhead Costs: e.g., Salaries, Utilities, Tooling activities

Process A Process A Design Engineering

Setup activity Running Costs Support Activities

 Proc A O/H costs  Proc A O/H costs  Eng’g O/H costs

 No. of Setups  No. of Mach. Hrs.  No. Eng’g changes

Appropriate cost drivers:

- variability: unit, batch, etc.
- measurement: frequency,
duration, direct charge
 Extensions & Refinements

 Assign costs to activities that are associated with new

cost objects
 the operation of particular processes
 the support of particular customers
 the use of particular suppliers

 Time-driven ABC:
 to reduce the cost of system implementation and maintenance
 to reflect the cost of unused capacity

 Use cost accounting data to affect future costs rather

than simply reflecting past costs… activity-based
management
 Field Work and Cases
 Beyond Products – e.g., costs of customers
 Kanthal (Kaplan, 1989) [Bob’s #1 most popular case]
 Cooperative Bank (Datar & Kaplan, 1995) [#4 most popular]
 Dakota Office Products (Kaplan, 2001)
 Owens and Minor (Narayanan & Brem, 2002)

 Beyond Costing – Activity-based Management

 Texas Instruments (Ittner & Kaplan, 1988)
 Indianapolis City Services (Kaplan, 1996) [#7 most popular]
 ABM: Using ABC for Performance
Management
Manage costs
 Continuous Improvement (Kaizen)
 Radical Redesign of Products or Processes (Target
costing, Business Process Re-engineering)

- Reduce the usage of the cost drivers

- Reduce the cost per unit of the driver

Set prices relative to competition and value

Eliminate unprofitable business
 Articulation of the ABC model
 One cost system isn’t enough (Kaplan, HBR 1988)
 Measure costs right: Make the right decisions (Cooper and
Kaplan, HBR 1988)
 Contribution margin analysis: No longer relevant/
Strategic cost management: The New Paradigm (Kaplan,
JMAR 1990)
 Profit priorities from activity-based costing (Cooper and Kaplan,
HBR 1991)
 Activity-based systems: Measuring the costs of resource
usage (Cooper and Kaplan, AH 1992)
The Influence of ABC on
Accounting Research:

Investigating the
Economic Model
 Investigating the Economic Model
Cost drivers and the cost hierarchy: Empirical Research
 Manufacturing overhead cost driver analysis (Foster & Gupta, 1990)
 Costs of product and process complexity (Banker et al. 1990)
 Simultaneous estimation of cost drivers (Datar et al. 1993)
 Are overhead costs strictly proportional to activity? Evidence
from hospital service departments (Noreen & Soderstrom, 1994)
 Measuring the impact of product mix heterogeneity on
manufacturing overhead cost (Anderson, 1995)
 An empirical analysis of manufacturing overhead cost drivers
(Banker, Potter & Schroeder, 1995)
 The activity-based cost hierarchy, production policies, and firm
profitability (Ittner, Larcker & Randall, 1997)
 A field study on the limitations of ABC when resources are
provided on a joint and indivisible basis (Maher & Marais, 1998)
 Investigating the Economic Model
Cost drivers and the cost hierarchy: Theory Research
 Cost driver optimization in ABC (Babad & Balachandran, 1993)
 A perspective on cost drivers (Dopuch, 1993)
 Aggregation, specification and measurement errors in product
costing (Datar & Gupta, 1994)
 Product costing and pricing (Banker & Hughes, 1994)
 Allocations of sunk capacity costs and joint costs in a linear
principal-agent model (Hemmer, 1996)
 On the efficiency of cost-based decision rules for capacity
planning (Balachandran, et al. 1997)
 Activity-based costing systems and incremental costs (Bromwich &
Hong 1999)
 Investigating the Economic Model
Cost management with hierarchical cost structure and
committed resources ≠ resource usage
 Strategic Cost Analysis: The evolution from managerial to
strategic accounting (Shank & Govindarajan, 1989)
 Manufacturing configuration, capacity and mix decisions
considering operational cost (Karmarkar & Kekre, 1987)
 Relevant costs, congestion and stochasticity in production
environments (Banker, Datar & Kekre, 1988)
 Explaining plant-level differences in manufacturing overhead:
structural and executional cost drivers in the world auto industry
(Ittner & MacDuffie, 1995)
 Direct and indirect effects of product mix characteristics on
capacity management decisions and operating performance
(Anderson, 2001)
 Are selling, general, and administrative costs "sticky"? (Anderson,
Banker & Janakiraman, 2003)
 Predicting earnings using a model based on cost variability and
cost stickiness (Banker & Chen, 2006)
The Influence of ABC on
Accounting Research

Implementing ABC
 Implementing ABC
ABC Implementation as Organizational Change
 A Behavioral Model for Implementing Cost Management Systems
(Shields & Young, 1989)
 Implementing an activity-based cost system (Cooper, 1990)
 Implementing New Knowledge: The Case of Activity-based
Costing (Argyris & Kaplan, 1994)
 A Framework for assessing cost management system changes:
The case of ABC implementation at General Motors, 1986-1993
(Anderson, 1995)
 An empirical analysis of firms’ implementation experiences with
activity-based costing (Shields, 1995)
 Towards explaining ABC failure: accounting and control in a
decentralized organization (Malmi, 1997)
 Cost and Effect: Using integrated cost systems to drive
profitability and performance (Kaplan and Cooper, 1998)
 Product diversity and costing system design choice: field study
evidence (Abernethy et al. 2001)
 Implementing ABC
ABC Implementation: an International Phenomena
 A Survey of ABC in the U.K.’s largest companies (Innes & Mitchell,
1995)
 Diffusion and accounting: The case of ABC in Norway (Bjornenak,
1997)
 National culture and ABC systems (Brewer, 1998)
 ABC costing diffusion across organizations: An exploratory
empirical analysis of Finnish firms (Malmi, 1999)
 ABC in the U.K.’s largest companies: A comparison of the 1994
and 1999 survey results (Innes et al., 2000)
 Note on a New Zealand replication of the Innes et al. U.K. ABC
survey (Cotton et al., 2003)
 Managers divided: Implementing ABC in a Portuguese
telecommunications company (Major & Hopper, 2005)
 Implementing ABC
Evaluating the Impact of ABC Implementation
Case and Field studies
 The impact of contextual and process factors on the evaluation of activity

based costing systems (Anderson & Young, 1999)

 Factors influencing the performance of activity based costing teams
(Anderson, Hesford & Young, 2002)
Large sample: surveys and archival financial data
 Measuring the success of activity-based cost management and its

determinants (Foster & Swenson 1997)

 The association between activity-based costing and manufacturing

performance (Ittner, Lanen & Larcker, 2002)

 The impact of ABC techniques on firm performance (Kennedy & Affleck-Graves, 2001)

 The association between ABC and improvement in financial performance

(Cagwin & Bouwman, 2002)
The Influence of ABC on
Accounting Research

Using ABC in decision-making:

Activity Based Management
 Using ABC in decision-making: ABM
 Implementing Activity-based Cost Management: Moving from
Analysis to Action (Cooper, Kaplan, Maisel, Morrissey & Oehm, 1992)
 Flexible budgeting in an ABC Framework (Kaplan, 1994)
 New Roles for Management Accountants (Kaplan, 1995)
 Cost and Effect: Using integrated cost systems to drive profitability
and performance (Kaplan & Cooper, 1998)
 Measuring and managing customer profitability (Kaplan & Narayanan, 2001)
 The incidence, perceived merit and antecedents of customer
accounting (Guilding & McManus, 2002)
 The value of ABC in competitive pricing decisions (Cardinaels et al., 2004)
 Interorganizational cost management and relational context (Cooper &
Slagmulder, 2004)
 The adoption of total cost of ownership for sourcing decisions
(Wouters et al., 2005)
 Using ABC in decision-making: ABM
Cognitive Effects of ABC on Decision-making
 An experimental investigation of the effect of cost information and
feedback on product cost decisions (Gupta & King, 1997)
 Fairness, Ethics and the effect of management accounting on
transactions costs (Luft, 1997)
 The effects of alternative types of feedback on product-related
decision performance (Briers et al. 1999)
 Cost knowledge and cost-based judgment performance (Dearman &
Shields, 2001)
 Avoiding accounting fixation: Determinants of cognitive adaptation
to differences in accounting method (Shields, 2005)
 Current Research Issues in ABC and
Cost Management
 Economics of modern production (and service)
 Increased infrastructure costs
 Cost behavior (e.g., “stickiness”)
 Interorganizational (boundary of the firm) cost
management: transaction costs, trust and intangible
assets
 Risk management: managing uncertainty and
volatility of costs
 Managerial Behavior
 Cognitive bias and other behavioral influences on
cost management decisions
 Agency issues in cost management
 Conclusion
“I had hoped to be able to document the incidence and value of
innovative accounting and control systems …”
“I found that changes in accounting lag far behind changes in the real
production phenomena they are supposed to represent.”

“Effective managerial accounting systems must

reflect the value-creating activities of
companies: in operations, in marketing and
sales, and in product and process
development…” (Kaplan, 1985)