Chapter 7 PDF

CORNERSTONES
of Managerial Accounting, 6e
CHAPTER 7:
ACTIVITY-BASED COSTING AND
MANAGEMENT
Cornerstones of Managerial
Accounting, 6e
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Learning Objectives
1. Explain why functional (or volume)-based
costing approaches may produce distorted
costs.
2. Explain how an activity-based costing system
works for product costing.
3. Describe activity-based customer costing and
activity-based supplier costing.
4. Explain how activity-based management can
be used for cost reduction.
Limitations of Functional-Based
Cost Accounting Systems
 Plantwide and departmental rates based on direct
labor hours, machine hours, or other volume-
based measures have been used for decades to
assign overhead costs to products and continue
to be used successfully by many organizations.
 However, for many settings, this approach to costing is
equivalent to an averaging approach and may produce
distorted, or inaccurate, costs.
LO-1
Cost Accounting Systems (cont.)
Product cost
distortions can be
damaging,
particularly for those
firms whose
business
environment is
characterized by :
LO-1
Cost Accounting Systems (cont.)
 The need for more accurate product costs has
forced many companies to take a serious 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.
LO-1
Nonunit-Related Overhead Costs
 The use of either plantwide rates or departmental
rates assumes that a product’s consumption of
overhead resources is related strictly to the units
produced.
 For unit-level activities (or activities that are performed
each time a unit is produced), this assumption makes
sense.
 If there are nonunit-level activities (or 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) with units produced. LO-1
Categorizing Costs under ABC
LO-1
Activity Drivers and the
Consumption of Activities
 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.
LO-1
Distorted Product Costs
 Using only unit-based activity drivers to assign
nonunit-related overhead costs can create
distorted product costs.
 The severity of this distortion depends on what
proportion of total overhead costs these nonunit-based
costs represent.
 If nonunit- based overhead costs are only a small
percentage of total overhead costs, then the
distortion of product costs will be quite small.
 In such a case, using unit-based activity drivers to
assign overhead costs is acceptable. LO-1
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 LO-1
Consumption Ratio
 Regardless of the nature of the product diversity,
product cost will be distorted whenever the
quantity of unit-based overhead that a product
consumes does not vary in direct proportion to
the quantity consumed of nonunit-based
overhead.
 The proportion of each activity consumed by a
product is defined as the consumption ratio and
is calculated as:
Amount of Activity Driver per Product
Total Driver Quantity
LO-1
Cornerstone 7.1
Calculating Consumption Ratios
LO-1
Cornerstone 7.2
Calculating Activity Rates
LO-1
Cornerstone 7.3
Calculating Activity-Based Unit
Costs
LO-1
Cornerstone 7.3
Calculating Activity-Based Unit
Costs
LO-1
Comparison of Functional-Based and
Activity-Based Product Costs
 A plantwide rate based on direct labor hours is
calculated as follows:
 The activity-based cost assignment reflects the

pattern of overhead consumption and is the most
accurate.
 Activity-based product costing reveals that
functional-based costing undercosts the low
volume deluxe models and overcosts the high
volume regular models. LO-1
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-
level activities.
 The key message of the relationship analysis is
that in a diverse product environment, activity-
based costing promises greater accuracy.
 Given the importance of making decisions based
on accurate facts, a detailed look at activity-
based costing is needed.
LO-1
Product Diversity and Product
Costing Accuracy
LO-1
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.
LO-2
Activity-Based Product Costing
(cont.)
LO-2
Identifying Activities and
Their Attributes
 An activity is action taken or work performed by
equipment or people for other people.
 Identifying activities usually is accomplished by
interviewing managers or representatives of
functional work areas (departments).
LO-2
Questions for Identifying Activities
and Their Attributes
 A set of key questions is asked in which answers
provide much of the data needed for an ABC
system. Here are some examples:
 How many employees are in your department?
(Activities consume labor.)
 What do they do (please describe)? (Activities are
people doing things for other people.)
 Do customers outside your department use any
equipment? (Activities also can be equipment working
for other people. In other words, the equipment provides
the service for someone by itself).
LO-2
Questions for Identifying Activities
and Their Attributes (cont.)
 What resources are used by each activity (equipment,
materials, energy)? (Activities consume resources in
addition to labor.)
 What are the outputs of each activity? (Helps to identify
activity drivers.)
LO-2
Activity Dictionary
 Interview-derived data are used to prepare an
Activity dictionary, which lists the activities in an
organization along with some critical activity
attributes (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
LO-2
Activity Dictionary Example
for a Credit Card Department
LO-2
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.
LO-2
Assigning Costs to Activities
 Thus, 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:
LO-2
Resource Drivers
 Both direct tracing and driver tracing are used to
assign resource costs to activities.
 If the resource is shared by several activities (as
is the case of the clerical resource), then the
assignment is driver tracing, and the drivers are
called resource drivers, which are factors that
measure the consumption of resources by
activities.
 Once resource drivers are identified, then the
costs of the resource can be assigned to the
activity.
LO-2
Cornerstone 7.4
Assigning Resource Costs to Activities:
Direct Tracing, Resource Drivers
LO-2
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.
LO-2
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.
LO-3
Activity-Based Customer Costing and
Activity-Based Supplier Costing (cont.)
 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.
LO-3
Cumulative Customer Profitability
 A high-tech producer of semiconductors,
implemented ABC customer costing and
discovered that 10% of its customers were
responsible for about 90% of its profits.
 It also discovered it was actually losing money on
about 50% of its customers.
 It worked to convert its unprofitable customers
into profitable ones and invited those who would
not provide a fair return to take their business
elsewhere.
LO-3
Cumulative Customer
Profitability (cont.)
 As a consequence, company sales decreased,
but its profit tripled.
 The following slide depicts this interesting yet
common relationship between customers and
their contribution to company profitability.
LO-3
The Whale Curve of Cumulative
Customer Profitability
LO-3
Activity-Based Customer Costing
 Customers are cost objects of fundamental
interest.
 Knowing how much it costs to service different
customers can be vital information for the
following purposes:
 setting pricing
 determining customer mix
 improving profitability
 Furthermore, because of diversity of customers,
multiple drivers are needed to trace costs
accurately.
LO-3
Customer Costing versus
Product Costing
 Assigning the costs of customer service to
customers is done in the same way that
manufacturing costs are assigned to products.
 Customer-driven activities such as order entry,
order picking, shipping etc.; are identified and
listed in an activity dictionary.
 The cost of the resources consumed is assigned
to activities, and the cost of the activities is
assigned to individual customers.
 The same model and procedures that apply to
products apply to customers as well.
LO-3
Cornerstone 7.5
Calculating Activity-Based Customer
Costs
LO-3
Cornerstone 7.5
Calculating Activity-Based Customer
Costs
LO-3
Activity-Based Supplier Costing
 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.
LO-3
Cornerstone 7.6
Calculating Activity-Based Supplier
Costs
LO-3
Cornerstone 7.6
Costs
LO-3
Cornerstone 7.6
Costs
LO-3
Managing Customer Profitability
As a consultant, you recently implemented an activity-based customer-profitability
system. In your written report to management, you classified the customers of the
company into one of four categories based on current profitability and the potential
for future profitability:
• High Profitability, Substantial Future Potential

• High Profitability, Limited Future Potential
• Low Profitability, Substantial Future Potential
• Low Profitability, Limited Future Potential
After discussing the report with the CEO, he asks you to answer the following
questions:
How would you manage the customers in each of the four categories?
LO-3
Managing Customer Profitability (cont.)
For highly profitable customers, and especially those with long-term potential,
special efforts should be made to retain these customers as it is much more expensive to
attract new customers. Offering these customers special discounts and new products and
service lines coupled with managing their costs-to-serve to a lower level and improving
business processes are ways to increase customer satisfaction while at the same time
maintaining or increasing profitability. For customers with low profitability but substantial
potential, the goal is to move these customers up to a high profitability state. Pricing policies or
initiatives related to both the order and the transactions caused by the order is one way to
increase profitability (e.g., activity-based pricing is based on the costs-to-serve, something
clearly revealed by the ABC customer model). Another way is to lower the costs to serve by
improving activity efficiency and eliminating nonvalue-added activities. The final category of
customers (low-profitability and limited potential) is managed up or out—these customers
need to be made profitable quickly or simply dropped.
Knowing customer profitability is important because not every revenue dollar
contributes equally to overall profitability. Thus, it is critical for a manager to
understand the net profit contribution that each customer makes to the company.
Understanding individual customer profitability and the associated drivers allows
managers to take actions to sustain and maintain profitable customers and transform
unprofitable customers into profitable customers. LO-3
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.
LO-4
Process Value Analysis Model
 Process-Value Analysis is concerned with:
 Driver analysis
 Activity analysis
 Performance measurement
LO-4
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.
LO-4
Driver Analysis:
The Search for Root Causes (cont.)
 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.
LO-4
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.
LO-4
Activity Analysis: Identifying and
Assessing Value Content (cont.)
 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.
LO-4
Value-Added Activities
 Those activities necessary to remain in business are
called value-added activities.
 Some activities are value-added by mandate.
 Activities required by the SEC and IRS
 The remaining activities in the firm are discretionary.
 A discretionary activity is classified as value-added provided
it simultaneously satisfies all of the following conditions:
 The activity produces a change of state.
 The change of state was not achievable by preceding activities.
 The activity enables other activities to be performed.
LO-4
Nonvalue-Added Activities
 All activities other than those that are absolutely
essential to remain in business, and therefore
considered unnecessary, are referred to as
nonvalue-added activities.
 A nonvalue-added activity can be identified by its
failure to satisfy any one of the three previous
defining conditions for adding value.
 For example, inspection is nonvalue-added because it
is a state-detection activity, not a state-changing activity.
LO-4
Nonvalue-Added Costs
 Costs that are caused either by nonvalue-added
activities or the inefficient performance of valued-
added activities.
 For nonvalue-added activities, the nonvalue-added
cost is the cost of the activity itself.
 For inefficient value-added activities, the activity cost
must be broken into its value-added and nonvalue-
added components.
 The value-added component is the waste-free
component of the value-added activity and is,
therefore, the value-added standard. LO-4
Examples of Nonvalue-Added
Activities
 In the manufacturing operation, the following
major activities are often cited as wasteful and
unnecessary:
 Scheduling: An activity that uses time and resources to
determine when different products have access to
processes
 Moving: An activity that uses time and resources to
move raw materials, work in process, and finished
goods from one department to another.
LO-4
Examples of Nonvalue-Added
Activities (cont.)
 Waiting: An activity in which raw materials or work in
process use time and resources by waiting on the next
process.
 Inspecting: An activity in which time and resources are
spent ensuring that the product meets specifications.
 Storing: An activity that uses time and resources while
a good or raw material is held in inventory.
LO-4
Activity Management
Reduces Costs in Four Ways
* Activity selection
* Activity elimination involves choosing among
focuses on nonvalue- different sets of activities
added activities. that are caused by
competing strategies.
* Activity reduction * Activity sharing

decreases the time and increases the efficiency
resources required by an of necessary activities by
activity. using economies of scale.
LO-4
Cornerstone 7.7
Assessing Nonvalue-Added Costs
LO-4
Activity Performance
Measurement
 Assessing how well activities (and processes) are
performed is fundamental to management’s efforts to
improve profitability.
 Activity performance measures exist in both financial
and nonfinancial forms.
 Measures of activity performance center on three
major dimensions:
 Efficiency - the relationship of activity inputs to activity
outputs.
 Time - time required to perform an activity.
 Quality - doing the activity right the first time it is performed.
LO-4
Cycle Time and Velocity
 Cycle time and velocity are two operational
measures of time-based performance.
 Cycle time measures it measures how long it
takes to produce an output from start to finish.
 Time/Units produced
 In a manufacturing process, 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).
LO-4
Cycle Time and Velocity (cont.)
 Velocity is the number of units of output that can
be produced in a given period of time
 Units produced/Time
 Velocity is the reciprocal of cycle time.
LO-4
Cornerstone 7.8
Calculating Cycle Time and Velocity
LO-4
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.
LO-4
Quality Cost Management (cont.)
 Quality improvement can increase profitability in
two ways:
 by increasing customer demand and thus sales
revenues
 by decreasing costs
LO-4
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
 The costs of quality are associated with two
subcategories of quality-related activities: control
activities and failure activities.
LO-4
Control Activities
 Control activities are performed by an
organization to prevent or detect poor quality
(because poor quality may exist).
 Control costs are the costs of performing control
activities.
 Control activities are made up of prevention and
appraisal activities.
 Prevention costs are incurred to prevent poor quality
in the products or services being produced.
 Appraisal costs are incurred to determine whether
products and services are conforming to their
requirements or customer needs. LO-4
Failure Activities
 Failure activities are performed by an
organization or its customers in response to poor
quality (poor quality does exist).
 Failure costs are the costs incurred by an
organization because failure activities are
performed.
 Internal failure costs are incurred when products and
services do not conform to specifications or customer
needs before being shipped.
 External failure costs are incurred when products and
services fail to conform to requirements or satisfy
customer needs after being delivered to customers. LO-4
Environmental
Cost Management
 For many organizations, 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.
LO-4

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CORNERSTONES

 The activity-based cost assignment reflects the

• High Profitability, Substantial Future Potential

* Activity reduction * Activity sharing

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