Activity-Based Costing

and Management

1
 Topic Contents
• Limitations of Functional-Based Cost Accounting
Systems
• Activity-Based Product Costing
• Activity-Based Customer Costing
• Activity-Based Supplier Costing
• Process-Value Analysis
• Quality Cost Management

2
 Limitations of Functional-Based Cost
Accounting Systems
• Non-Unit-Related Costs
– The use of either plantwide or departmental rates
assumes that the number of units produced
causes overhead costs to increase
– Some overhead costs are not driven by the
number of units produced
• Product Diversity
– Products consume overhead activities in different
proportions

3
 Nonunit-Related Overhead Costs
Unit level activities – activities that are
performed each time a unit is produced.

Nonunit level activities – activities that are not

performed each time a unit of product is
produced. The costs associated with these
nonunit level activities are unlikely to vary (i.e.
increase or decrease) the units produced.

4
 Nonunit-Related Overhead Costs
Nonunit-level activity drivers - (i.e., batch, product-
sustaining, and facility-sustaining) are factors that measure
the consumption of nonunit-level activities by products and
other cost objects.

Unit-level activity drivers – measure the consumption of

unit-level activities.

Activity drivers – are factors that measure the consumption

of activities by products and other cost objects and can be
classified as either unit-level or nonunit-level.

5
 Cost Hierarchies

A cost hierarchy is a categorization

of costs into different cost pools.

Cost drivers bases (cost-allocation bases)

Degrees of difficulty in determining

cause-and-effect relationships

6
 Cost Hierarchies
ABC systems commonly use a
four-part cost hierarchy to
identify cost-allocation bases:

1. Output unit-level costs

2. Batch-level costs

3. Product-sustaining costs

4. Facility-sustaining costs

7
 Output Unit-Level Costs

Description of Cost Driver:

varies with output volume (e.g., units);
traditional variable costs
These are resources sacrificed
on activities performed on each
individual unit of product or service.

Energy

Machine depreciation
Repairs
8
 Batch-Level Costs

Description of Cost Driver:

Varies with the number of batches produced
These are 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
9
 Product-Sustaining Costs
Description of Cost Driver:
Varies with the number of product lines

These are often called service-sustaining

costs and are resources sacrificed on
activities undertaken to support
individual products or services.

Design costs

Engineering costs
10
 Facility-Sustaining Costs

Description of Cost Driver:

Necessary to operate the plant facility but does
not vary with units, batches, or product lines
These are 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

11
 Calculating Consumption Ratios
Information: Refer to the activity usage information for Rio Novo’s
Porto Behlo Pant

Required:
Calculate the consumption ratios for each product.

12
 Calculating Consumption Ratios
Solution:
Step 1: Identify the activity driver for each activity
Step 2: Divide the amount of driver used for each product by the total driver
quantity

13
 Calculating Activity Rates
Information:
Rio Novo’s Porto Behlo plant activity cost and driver data follow:

Required:
Calculate the activity rates.

Solution:
Divide the activity cost by the total driver quantity.
14
 Calculating Activity Rates
Solution:
Divide the activity cost by the total driver quantity.

15
 Calculating the Activity-Based Unit Costs
Information:
Rio Novo’s Porto Behlo plant activity rate data for deluxe and
regular model follows:

Required:
Calculate the unit cost for deluxe and regular models.
16
 Calculating the Activity-Based Unit Costs

Solution:

17
 Calculating the Activity-Based Unit Costs

Using single unit-level overhead rate:

18
 Activity-Based Product Costing

Function-based overhead costing involves two

major stages:
1. Overhead costs are assigned to an
organizational unit (plant or department)
2. Over head costs are then assigned to cost
object.

19
 Activity-Based Product Costing
An activity-based costing (ABC) system is also
two-stage process:
1. Trace costs to activities.
2. Trace costs to cost objects.

The underlying assumption is that

activities consume resources, and cost objects,
in turn, consume activities.
20
 Activity-Based Product Costing
• ABC System emphasizes direct tracing and
driver tracing (exploiting cause-and-effect
relationships).

• Volume-based costing system tends to be

allocation-intensive (largely ignoring cause-
and-effect relationships).

21
 Design Steps for an ABC System
1. Identify, define, and classify activities and
key attributes
 Activity inventory – a list of identified activities
 Activity definition – financial and nonfinancial
descriptions of the activities
 Activity dictionary – activity name, description,
driver, and cost objects

– Set of Key Questions.

22
 Information need to know by the
interviewers.
• Activities consume labor. (labor resource)

• Activities are people doing things for other

people or the equipment provides the service
for someone by itself. (activity identification)

• Activities consume resources in addition to

labor. (resource identification)
23
 Information need to know by the
interviewers.
• Helps identify activity drivers. (potential activity
drivers.

• Identifies the cost object: products, other

activities, consumers, etc.) (potential cost objects
identified)

• Information assigns the cost of labor and

equipment to activities. (identifying resource
drivers.

24
Illustrative Example: Hemingway Bank
The activity dictionary for Hemingway’s credit card department. The three
products, classic, gold, and platinum credit cards, in turn, consume the
activities. It is not unusual for a typical organization to produce an activity
dictionary containing 200 to 300 activities.

25
 Design Steps for an ABC System
2. Assign the cost of resources to the activities
 Cost of performing each activity
 Use both direct and indirect tracing
 General ledger costs are unbundled and reassigned

A work distribution matrix identifies the amount of

labor consumed by each activity and is derived from
the interview process (or a written survey)

Resource drivers – are factors that measure the

consumption of resources by activities.

26
 Assigning Resource Costs to Activities by Using Direct
Tracing and Resource Drivers

Information:
Refer to the work distribution matrix (information obtained from the
interview) for Hemingway Bank’s credit card department. Assume that each
clerk is paid a salary of ₱30,000 (₱150,000 total clerical cost for five clerks).

Required:
Assign the cost of labor to each of the activities in the credit department.

27
Assigning Resource Costs to Activities by Using
Direct Tracing and Resource Drivers
Solution:
The amount of labor cost assigned to each activity is given
below.

28
Assigning Resource Costs to Activities by Using
Direct Tracing and Resource Drivers
The general ledger reveals that the cost per
computer is ₱1,200 per year, Thus, an additional
₱6,000 (5 x ₱1,200) would be assigned to three
activities based on relative usage:

• 70% to processing transactions (₱4,200)

• 20% to preparing statements (₱1,200)
• 10% to answering questions (₱600)
29
 3. Assigning Costs to Products
Illustrative Example: Hemingway Bank

Assuming that a practical activity capacity is equal to the total

activity usage by all products, the following actual data have
been collected for Hemingway’s credit card department:

30
 3. Assigning Costs to Products

Required:
By using the data and costs, calculate the activity rates
and the unit cost.

31
 3. Assigning Costs to Products
Solution:

32
 3. Assigning Costs to Products
Solution:

33
 Calculating Activity-Based Customer Costs
Information:
Milan Company produces precision parts of 11 major buyers. Of the 11 customers, one
accounts for 50% of the sales, with the remaining 10 accounting for the rest of the
sales. The 10 smaller customers purchase parts in roughly equal quantities. Orders
placed by the smaller customers are about the same size. Data concerning Milan’s
customer activity.

Required:
Assign costs to customers using an ABC approach.
34
Calculating Activity-Based Customer Costs
Solution:
The appropriate drivers are orders placed and number of sales calls. The activity rates
are:

The customer-driven costs can be assigned to each group of customers as follows:

35
 Calculating Activity-Based Supplier Cost
Information:
Assume that a purchasing manager uses two suppliers, Murray
Inc. & Plata Associates, as the source of two machine parts: Part
A1 and Part B2.Consider two activities: repairing products (under
warranty) and expediting products. Repairing products occurs
because of part failure (bought from suppliers). Expediting
products occurs because suppliers are late in delivering needed
parts. Activity cost information and other data needed for
supplier costing follow:

36
 Calculating Activity-Based Supplier Cost

Required:
Determine the cost of each supplier by using ABC.

37
 Calculating Activity-Based Supplier Cost

Solution:
The activity rates for assigning costs to suppliers are computed as follows:

38
 Calculating Activity-Based Supplier Cost
Using these rates and the activity data, the total purchasing cost per unit of
each component is computed:

39
The Relationship of Activity-Based Costing and
Activity-Based Management

Activity-based management (ABM) is a

systemwide, integrated approach that focuses
management’s attention on activities with the
objectives of improving customer value and the
profit achieved by providing this value. ABC is
the major source of information for activity-
based management.

40
The Relationship of Activity-Based Costing
and Activity-Based Management

The Two-Dimensional Activity-

Based Management Model

41
Process Value Analysis

Process value analysis is fundamental to activity-

based responsibility accounting, focuses on
accountability for activities rather than costs, and
emphasizes the maximization of systemwide
performance instead of individual performance.

Process value analysis is concerned with:

(1) Driver analysis
(2) Activity analysis
(3) Performance measurement

42
Process Value Analysis

Driver analysis is the effort expended to identify the

factors that are the root causes of activity costs.

Activity analysis is the process of identifying,

describing, and evaluating the activities an
organization performs.
Activity analysis should produce four outcomes:
1) What activities are performed.
2) How many people perform the activities.
3) The time and resources are required to
perform the activities.
4) An assessment of the value of the activities
to the organization. 43
Process Value Analysis

Activity can be classified as value added and

nonvalue-added.

Those activities necessary to remain in

business are called value-added activities.
Some activities – required activities – are
necessary to comply with legal matters.

Value-added costs are the costs to perform

value-added activities with perfect efficiency
44
 Process Value Analysis

All activities other than those essential to remain

in business are referred to as nonvalue-added
activities. These activities fail to produce a change in
the product’s state or those activities that replicate
work because it wasn’t done correctly the first time.

Nonvalue-added costs are costs that are caused

either by nonvalue-added activities or the efficient
performance of value-added activities.

45
Process Value Analysis

Nonvalue-added Activities
 Scheduling
 Moving
 Waiting
 Inspecting
 Storing

46
Process Value Analysis
Activity management can reduce costs in
four ways:
1. Activity elimination – ex. The activity of inspecting
incoming parts seems necessary to ensure that the
product using the parts functions according to
specifications can be eliminated by selecting suppliers
who are able to supply high-quality parts or who are
willing to improve their quality performance to achieve
this objective.

2. Activity selection – involves choosing among different

sets of activities that are caused by competing strategies.
Ex. Each product design strategy has its own set of
activities and associated costs. All other things being
equal, the lowest-cost design strategy should be chosen.
47
Process Value Analysis

Activity management can reduce costs in

four ways:

3. Activity reduction – decreases the time and

resources required by an activity. Ex. Finding ways
to reduce setup time – and thus lower the cost of
setups – is another example of the concept of
gradual reductions in activity costs.

4. Activity sharing – increases the efficiency of

necessary activities by using economies of scale. Ex.
A new product can be designed to use components
already being used by other products.

48
 Assessing Nonvalue-Added Costs
Information:
Consider the following two activities:

(1) Performing warranty work, cost ₱120,000. The warranty cost of the
most efficient competitor ₱20,000.
(2) Purchasing components, cost: ₱200,000 (10,000 purchase orders).

A benchmarking study reveals that the most efficient level will use 5,000
purchase orders and entail a cost of ₱100,000.

Required:
Determine the nonvalue-added cost of each activity.

49
 Assessing Nonvalue-Added Costs
Solution:
Determine the value content of each activity: Is the activity nonvalue-added
or value added?

1. Performing warranty work is nonvalue-added; it is done to correct

something that wasn’t done right the first time. Thus, the nonvalue-added
cost of performing warranty work is ₱120,000. The cost of the competitor
has no bearing on the analysis. Root causes for warranty work are
defective products.
2. Purchasing components is necessary so that materials are available to
produce products and, thus, is value-added. However, the activity is not
performed efficiently, as revealed by the benchmarking study. The cost per
purchase order is ₱20 (₱100,000/5,000). The nonvalue-added cost is
calculated as:
(Actual quantity – Value-added quantity) x Cost per purchase order
(10,000 – 5,000) x ₱20 = ₱100,000)
Or simply, ₱200,000 - ₱100,000
50
Process Value Analysis

Assessing Activity Performance

 Efficiency – focuses on the relationship of

activity inputs to activity outputs.

 Quality – is concerned with doing the

activity right the first time it is performed.

51
Process Value Analysis

Assessing Activity Performance

 Time
cycle time – is the length of time that it takes
to produce a unit of output from the time raw
materials are received (starting point of the cycle)
until the good is delivered to finished goods inventory
(finishing point of the cycle).
Cycle time = Time/Units produced

velocity – is the number of units of output that

can be produced for a given period of time.
Velocity = Units produced/Time

52
 Calculating Cycle Time and Velocity

Information:
Assume that Frost Company takes 10,000 hours
to produce 20,000 units of a product.

Required:
What is the velocity in hours? Cycle time in
hours? Cycle time in minutes?

53
 Calculating Cycle Time and Velocity
Solution:

54
 Quality Costs Management
• Quality-linked activities
– Activities performed because poor quality may or
does exist
– Control activities
• performed by an organization
• to prevent or detect poor quality
– Failure activities
• Performed by an organization or its customers
• In response to poor quality

55
 Costs of Quality
• Categories of quality costs
– Prevention costs: incurred to prevent poor quality in
product or services from being produced
– Appraisal costs: Incurred to determine whether products
and services are conforming
• Product acceptance: sample finished goods
• Process acceptance: sample goods while in process
– Internal failure costs: incurred because products or
services do not conform; discovered prior to delivery
– External failure costs: incurred because products or
services do not conform; discovered after delivery

56
 Costs of Quality

57
 Costs of Quality

58
 Costs of Quality
• Quality cost
– Observable
• Available from the accounting records
– Hidden
• Opportunity costs resulting from poor quality
• Estimating hidden quality costs
– The multiplier method
– The market research method

59
 Defining, Measuring, and Controlling
Environmental Costs
• Environmental costs: costs that are incurred because
poor environmental quality exists or may exist

Damage
- Direct degradation of the environment
- Indirect degradation (unnecessary usage)

Categories
– prevention costs
– detection costs
– internal failure costs
– external failure costs
60
 Defining, Measuring, and Controlling
Environmental Costs

61
 Defining, Measuring, and Controlling
Environmental Costs

62
 Defining, Measuring, and Controlling
Environmental Costs

63
 Defining, Measuring, and Controlling
Environmental Costs

64
 Defining, Measuring, and Controlling
Environmental Costs

Note: “S” = societal costs

65