Activity-Based Costing and Management: Seventh Edition

Examples of Managerial Accounting
Seventh Edition
Chapter 5
Activity-Based
Costing and
Management
© 2019 Cengage. All rights reserved.

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 (1 of 3)
• 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

• Product cost distortions can be damaging, particularly
for those firms whose business environment is
characterized by:
• Continuous improvement
• Small Profit Margins
• Increasing Competitive Pressures
• Total Quality Management
• Total Customer Satisfaction
• Sophisticated Technology
• Intense Worldwide Competition

• 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
plantwide 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

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

Categorizing Costs under ABC
Type of Cost Description of Cost Driver Example
Unit-level Varies with output volume Cost of indirect materials for

(e.g., units); traditional labeling each bottle of Victoria’s
variable costs Secret perfume
Batch-level Varies with the number of Cost of setting up laser engraving
batches produced equipment for each batch of
Epilog key chains
Product- Varies with the number of Cost of inventory handling and
sustaining product lines warranty servicing of different
brands carried by Best Buy
electronics store
Facility- Necessary to operate the Cost of General Motors plant
sustaining plant facility but does not manager salary
vary with units, batches, or
product lines

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

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

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

Here’s How It’s Used: IN YOUR
LIFE (1 of 7)
Carsen, Kambry, and Joseph had each just won the
individual championship in their conference’s wrestling
tournament. Carsen wrestled in the heavyweight class
(183 to 285 pounds), Kambry in the 105-pound class for
women, and Joseph in the 149-pound class. The three
were friends from high school and agreed to meet for
lunch at a well-known pizzeria. Upon arriving, they each
ordered a salad. Kambry ordered a small salad ($2.00),
Joseph ordered a medium salad ($3.00), and Carsen
ordered a large salad ($4.00).

LIFE (2 of 7)
For drinks, Carsen ordered a fruit smoothie ($3.50) and a
glass of water ($0.00), Kambry ordered only water to drink
($0.00), and Joseph ordered a soft drink ($1.50). They
then ordered a large supreme pizza ($18.00) and agreed
to share the cost of the pizza. The pizza came with 12
slices. Carsen ate eight slices of the pizza, Joseph ate
three slices, and Kambry ate one slice.
When it came time to pay for the lunch, each agreed to
pay for their respective salads and drinks. Kambry then
proposed splitting the cost of the pizza equally among the
three (thus,

LIFE (3 of 7)
each would pay $6.00 for the shared pizza). Under this
proposal, the cost of lunch for each would be calculated
as follows: $13.50 ($4.00 + $3.50 + $6.00) for Carsen,
$10.50 ($3.00 + $1.50 + $6.00) for Joseph, and $8.00
($2.00 + $6.00) for Kambry.
Joseph considered this proposal and then offered an
alternative to Kambry’s average costing approach. He
proposed sharing the cost of the pizza in proportion to the
cost of the salads as the salad choices reflected the
differences in their

LIFE (4 of 7)
appetites. Under this approach, Carsen would pay $8.00
for his pizza [(4/9) × $18], increasing his lunch cost to
$15.50; Joseph would pay $6.00, leaving his lunch cost
unchanged; and Kambry would pay $4.00, decreasing her
lunch cost to $6.00.
Carsen considered both offers but expressed a different
view. “Listen,” he said, “I ate the lion’s share of the pizza
and therefore should pay the most.” “I suggest that we pay
in proportion to what we ate. There are 12 slices of pizza
and that means each slice costs about $1.50. So I’ll pay
$12.00 for my

LIFE (5 of 7)
share of the pizza, Kambry you will pay $1.50, and Joseph
you will pay $4.50.” Under the second proposal, the cost
of the lunch for each would be $19.50 (Carsen), $9.00
(Joseph), and $3.50 (Kambry).
Joseph, a business major, learned several lessons about
costing from this experience. First, he noted that the cost
object is the lunch of each person. Second, some of the
costs are exclusive to each person (the salads and drinks)
and therefore are directly traceable and posed no
controversy or problem.

Here’s How It’s Used: IN YOUR LIFE
(6 of 7)
Third, the pizza cost (like overhead costs) is a shared cost
and was the source of concern. He realized that shared
costs are often allocated to units (e.g., number of lunches)
based on average consumption and, thus, may not be
related to the unit’s consumption of the shared resource
(like Kambry’s proposal) or that they can be allocated
using a measure that is correlated with consumption of the
shared resource like the size of the salads. He concluded
that Kambry’s proposal would work well if they all ate
about the same amount of pizza but that physical size
diversity precluded this possibility.

LIFE (7 of 7)
His proposal to use salad size (as measured by its cost)
considered size diversity to some extent but failed to
consider individual complexities (i.e., product complexity)
such as Carsen’s love of pizza and the need that he and
Kambry had to monitor calories in order to maintain their
wrestling weight classifications. Thus, Carsen’s proposal
to measure consumption by slices of pizza made more
sense as it reflected both size diversity and product
complexity and, thus, represented a more accurate and
fair way of assigning this cost to each person.

Consumption Ratio (1 of 2)
• 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 cost of shared resources should be assigned in
proportion to the amount of the resources consumed
• Since activities represent bundles of resources
consumed by products, it is reasonable to assign
activity costs in proportion to the amount of activity
consumed

Consumption Ratio (2 of 2)
• Activity drivers measure activity output and thus can be

used as measures of activity consumption
• 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

Example 5.1: How to Calculate
Consumption Ratios (1 of 4)
Exhibit 5.2 Product-Costing Data for Rio Novo’s Porto
Behlo Plant
Activity Usage Activity Usage Activity Usage

Measures: Deluxe Measures: Regular Measures: Total
Units produced 10 100 110
Prime costs $800 $8,000 $8,800
Direct labor hours 20 80 100
Machine hours 10 40 50
Setup hours 3 1 4
Number of moves 6 4 10

Activity Cost Data (Overhead Activity Cost Data (Overhead

Activities): Activity Activities): Activity Cost
Setting up equipment $1,000
Moving goods 1,000
Machining 1,500
Assembly 500
Total $4,000

Refer to the activity usage information for Rio Novo’s
Porto Behlo plant in Exhibit 5.2.
Required:
Calculate the consumption ratios for each product.
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.

Consumption Ratios : Consumption Ratios :

Overhead Acitvity Activity Driver
Deluxe Model Regular Model
a a
Setting up equipment 0.75 0.25 Setup hours
b b
Moving goods 0.60 0.40 Number of moves
c c
Machining 0.20 0.80 Machine hours
d d
Assembly 0.20 0.80 Direct labour hours
a3/4 (deluxe) and 1/4(regular).

b6/10 (deluxe) and 4/10(regular).
c10/50 (deluxe) and 40/50(regular).
d20/100 (deluxe) and 80/100(regular).

Solving the Problem of Cost Distortion
(1 of 2)
• Cost distortion can be solved using activity rates
• Instead of assigning the overhead costs using a single,
plantwide rate, a rate faor each overhead activity can
be calculated and used to assign overhead costs
• An activity rate is the means by which activity costs are
assigned to products
• A rate for each activity is calculated by dividing the
activity cost by an activity driver
• A cause-and-effect relationship is the basis for
choosing the activity driver used in the rate calculations
divided by units produced then yield the unit cost

Example 5.2: How to Calculate Activity
Rates (1 of 2)
Rio Novo’s Porto Behlo plant activity cost and driver
data follow:
Activity Activity Cost Driver Driver

($) Quantity
Setting up equipment 1,000 Setup hours 4
Moving goods 1,000 Number of moves 10
Machining 1,500 Machine hours 50
Assembly 500 Direct labor hours 100

Example 5.2: How to Calculate Activity
Rates (2 of 2)
Required:
Calculate the activity rates.
Solution:
Divide the activity cost by the total driver quantity:
Setup rate: $1,000/4 setup hours = $250 per setup hour
Materials handling rate: $1,000/10 moves = $100 per move
Machining rate: $1,500/50 machine hours = $30 per
machine hour
Assembly rate: $500/100 direct labor hours = $5 per direct
labor hour

Solving the Problem of Cost Distortion
(2 of 2)
• To increase the accuracy of overhead cost
assignments, causal factors, called activity drivers, are
chosen that measure the amount of activity consumed
by a product
• The activity rate multiplied by the amount used of each
activity determines the amount of activity cost assigned
to a particular product
• The sum of all such assigned activity costs is the total
amount of overhead consumed by a product
• Overhead costs plus prime costs divided by units
produced then yield the unit cost

Example 5.3: How to Calculate Activity-
Based Unit Costs (1 of 2)
Rio Novo’s Porto Behlo plant activity cost and driver data
follow:
Deluxe Regular Activity Rate
Units produced per year 10 100
Prime costs $800 $8,000
Setup hours 3 1 $250
Number of moves 6 4 $100
Machine hours 10 40 $ 30
Direct labor hours 20 80 $5
Required:
Calculate the unit cost for deluxe and regular models.
Based Unit Costs (2 of 2)
Solution:

Comparison of Functional- and Activity-
Based Product Costs
• A plantwide rate based on direct labor hours is calculated
as follows
Total Overhead Costs

Overhead 
Total Direct Labor Hours
• 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

Product Diversity and Product Costing
Accuracy (1 of 2)
• For unit-level overhead rates to fail, products must
consume the nonunit-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

Product Diversity and Product Costing
Accuracy (2 of 2)

Activity-Based Product Costing (1 of 2)
• 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

Activity-Based Product Costing (2 of 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)

Questions for Identifying Activities and
Their Attributes (1 of 3)
• 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)
• 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)
• Who or what uses the activity output? (Identifies the
cost object: products, other activities, customers, etc.)

• How much time do workers spend on each activity?
Time on each activity by equipment? (Information
assigns the cost of labor and equipment to
activities)

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

Activity Dictionary Example for a Credit
Card Department
Activity Name Activity Description Cost Object(s) Activity Driver

Processing Sorting, keying, and Credit cards Number of
transactions verifying transactions
Preparing Reviewing, printing, Credit cards Number of
statements stuffing, and mailing statements
Answering Answering, logging, Credit cards Number of cards
questions reviewing database,
and making call backs
Providing Accessing accounts, Credit cards, Number of teller
automatic tellers withdrawing funds checking and transactions
savings accounts

Assigning Costs to Activities (1 of 2)
• The next task is to determine how much it costs to

perform each activity
• The cost of labor, energy, materials, and capital is
found in the general ledger, but the amount spent on
each activity is not revealed
• For shared resources, driver tracing is used, and the
drivers used to assign resource costs to activities are
called resource drivers, which are factors that
measure the consumption of resources by activities

Assigning Costs to Activities (2 of 2)
• 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:
Activity Percentage of Time per Activity

Processing Transactions 40%
Preparing statements 30%
Answering questions 30%

Example 5.4: How to Assign Resource Costs to Activities by
Using Direct Tracing and Resource Drivers (1 of 2)
Refer to the work distribution matrix for Hemingway Bank’s

credit card department in Exhibit 5.7. Assume that each
clerk is paid a salary of $30,000 ($150,000 total clerical cost
for five clerks). Furthermore, each clerk has a computer.
The general ledger reveals that the cost per computer is
$1,200 per year. Computer time is 70% transaction
processing, 20% statement preparation, and 10%
answering questions.
Required:
Assign the cost of labor and the cost of computers to each
of the activities in the credit department. Is this assignment
driver tracing or direct tracing?
Example 5.4: How to Assign Resource
Costs to Activities by Using Direct Tracing
and Resource Drivers (2 of 2)
Solution:
The amount of labor and computer cost assigned to each
activity is given below.
Activity Labor Cost Computer Cost Total
Processing transactions $60,000 (0.40 × $150,000) $4,200 (0.70 × $6,000) $64,200
Preparing statements $45,000 (0.30 × $150,000) $1,200 (0.20 × $6,000) $46,200
Answering questions $45,000 (0.30 × $150,000) $600 (0.10 × $6,000) $45,600
Labor and computers are both shared resources, and their

costs are assigned using a resource driver.

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

Here’s How It’s Used:
SUSTAINABILITY (1 of 5)
Baxter International Inc. is a large health care company
headquartered in Deerfield, Illinois. Baxter is well known
for its environmental performance and reporting. Its annual
sustainability report contains a fairly detailed
environmental financial report. For many years, Baxter has
followed an ecoefficiency paradigm, believing that
environmental performance can be improved while
simultaneously improving economic performance.

The environmental financial report not only details
environmental costs such as pollution controls, waste
disposal, carbon taxes, and remediation, but it also
discloses income, savings, and cost avoidance or
environmental initiatives for the current year and the prior
four years. For each year reported, it adds the cost
avoidance from initiatives started in the prior six years and
realized in the stated year. Using that total number, the
income, savings, and cost avoidance for 2010 to 2014
ranged from $0.6 million (2014) to $100.4 million (2010),
supporting the view that ecoefficiency really works for
Baxter.*

While Baxter is at the forefront of disclosing environmental
performance to outside parties, there is a real opportunity
for Baxter and others to enhance their environmental
performance capabilities by using activity-based costing to
identify and break out environmental costs from overhead,
a practice recommended by both the International
Federation of Accountants and the United Nations Division
for Sustainable Development.**

Assigning resource costs to environmental activities,
identifying drivers, and then using these drivers to assign
environmental costs to products can produce valuable
managerial information. For example, ABC assignments
may reveal that a particular product is responsible for
much more toxic waste than other products. This
information may then lead to a more efficient and
environmentally friendly design for the product or its
associated processes.

It could also reveal that when the environmental costs are
accurately assigned that the product is unprofitable and
that improving environmental performance is obtained
simply by dropping the product.
*Baxter 2014 Sustainability Report.
**Mark Lemmon and Anthony Pembler, “Environmental
Sustainability:
Activity-Based Costing/Management,” Environmental
Sustainability
Guidance, 2014: CPA, Canada.

Activity-Based Customer Costing and
Activity-Based Supplier Costing (1 of 2)
• 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

Activity-Based Customer Costing and
Activity-Based Supplier Costing (2 of 2)
• 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

Cumulative Customer Profitability (1 of 2)
• 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

Cumulative Customer Profitability (2 of 2)
• 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

Whale Curve of Cumulative Customer
Profitability

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

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 using activity drivers
• Knowing the costs of individual customers or customer
types can be helpful in setting prices, determining the
best customer
Based Customer Costs (1 of 4)
Milan Company produces precision parts for 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 follow:

Large Customer Ten Smaller Customers
Units purchased 500,000 500,000
Orders placed 2 200
Number of sales calls 10 210
Manufacturing costs $3,000,000 $3,000,000
Order filling costs allocated* $ 202,000 $ 202,000
Sales force costs allocated* $ 110,000 $ 110,000
*Allocated based on sales volume.

Currently, customer-driven costs are assigned to customers
based on units sold, a unit-level driver.
Required:
Assign costs to customers using an ABC approach.
Solution:
The appropriate drivers are orders placed and number of
sales calls. The activity rates are:
$404,000/202 orders = $2,000 per order
$220,000/220 calls = $1,000 per call
Using this information, the customer-driven costs can be
assigned to each group of customers
as follows:


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

Supplier Costing (1 of 2)
• Assigning the costs of supplier-related activities to
suppliers follows the same pattern as ABC product and
customer costing
• Examples of supplier-driven activities are purchasing,
receiving, inspection of incoming components,
reworking products (due to defective supplier
components), expediting products (due to late deliveries
of supplies), and warranty work (due to defective
supplier components)

Supplier Costing (2 of 2)
• The cost of the resources consumed is assigned to
these activities, and then activity drivers assign the
resulting activity cost to individual suppliers
• These costs are then added to direct purchase costs.
• This outcome enables managers to improve their
evaluation and selection of suppliers, with the objective
of reducing total supplier costs

Based Supplier Costs (1 of 4)
Assume that a purchasing manager uses two suppliers,
Murray Inc. and 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:
I. Activity Costs Caused by Suppliers (e.g., failed parts or
late delivery)

Activity Costs
Repairing products $800,000
Expediting products $200,000
II. Supplier Data

Murray Inc.: Murray Inc.: Plata Associates: Plata Associates:
Part A1 Part B2 Part A1 Part B2
Unit purchase price $ 20 $ 52 $ 24 $ 56
Units purchased 80,000 40,000 10,000 10,000
Failed units 1,600 380 10 10
Late shipments 60 40 0 0
Required:
Determine the cost of each supplier by using ABC.
Solution:
Using the above data, the activity rates for assigning costs to
suppliers are computed as follows:
Repair Rate = $800,000/2,000* units
= $400 per failed unit
*(1,600 + 380 + 10 + 10)
Expediting Rate = $200,000/100** late shipments
= $2,000 per late shipment
**(60 + 40)
Using these rates and the activity data, the total purchasing cost
per unit of each component is computed:


Here’s How It’s Used: AT A SMALL
CONSULTING FIRM (1 of 5)
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 question:
How would you manage the customers in each of the
four categories?
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.

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

Process-Value Analysis Model
Process-Value Analysis is concerned with:

• Driver analysis
• Activity analysis
• Performance measurement

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

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

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

Nonvalue-Added Activities (1 of 2)
• 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

Nonvalue-Added Activities (2 of 2)
• Costs that are caused either by nonvalue-added

activities or the inefficient performance of value-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

Examples of Nonvalue-Added Activities
(1 of 2)
• 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 (or when and how many setups must be
done) and how much will be produced
– Moving: An activity that uses time and resources to
move raw materials, work in process, and finished
goods from one department to another

Examples of Nonvalue-Added Activities
(2 of 2)
• 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

Activity Management Reduces Costs in
Four Ways
• * Activity elimination focuses on nonvalue-added
activities.
• * Activity selection involves choosing among
different sets of activities that are caused by
competing strategies.
• * Activity reduction decreases the time and
resources required by an activity.
• * Activity sharing increases the efficiency of
necessary activities by using economies of scale.

Here’s How It’s Used: AT KICKER
(1 of 3)
For Stillwater Designs, warranty work is a significant
cost. Warranty work associated with defective products
is typically labeled a nonvalue-added cost. Stillwater
Designs recognizes the nonvalue-added nature of this
activity and takes measures to eliminate the causes of
the defective units. The company tracks return failures
(over time) and provides this information to its research
and development (R&D) department. R&D then uses
this information to make design improvements on
existing models (running changes) as well as to change
the design on future models.

(2 of 3)
The objective of the design changes is to reduce the
demand for the warranty activity, thus reducing warranty
cost.
However, not all Kicker warranty costs can be classified
as nonvalue-added. When products are returned,
customer service decides whether or not the problem is
covered under warranty. Sometimes, problems are
covered even though they are not attributable to a
defective product.

(3 of 3)
When the company decides to replace a nondefective
product, it is making a conscious decision to increase
customer satisfaction and brand loyalty. This part of the
warranty cost is a “marketing warranty cost” and could
be classified as a value-added cost. For example,
customers sometimes buy amplifiers that are more
powerful than the subwoofers can handle, resulting in
burnt voice coils. By replacing the product (even though
technically it’s the customer’s fault), the customer will be
more likely to buy again and to provide good word-of-
mouth advertising for Kicker products.

Assessing Nonvalue-Added Costs
• Nonvalue-added costs are caused either by

nonvalue-added activities or value-added activities
performed inefficiently
• Determining the nonvalue-added cost is followed by a
root-cause analysis and then by the selection of an
approach to reduce the waste found in the activity

Example 5.7: How to Assess Nonvalue-
Added Costs (1 of 3)
Consider the following two activities: (1) Performing
warranty work, cost: $120,000. The warranty cost of the
most efficient competitor is $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.

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) × Cost per Purchase Order
(10,000 – 5,000) × $20 = $100,000
(or simply, $200,000 – $100,000)

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

Cycle Time and Velocity (1 of 3)
• Cycle time and velocity are two operational measures
of time-based performance that measure the time it
takes for a firm to respond to such things as customer
orders, customer complaints, and the development of
new products
• The objective is to reduce cycle time (increase velocity)
and thus improve response time, making the firm more
competitive

• Cycle time measures how long it takes to produce an

output from start to finish
Time
Cycle 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)

• Velocity is the number of units of output that can be

produced in a given period of time
Units produced
Velocity 
Time
• Velocity is the reciprocal of cycle time

Example 5.8: How to Calculate Cycle Time
and Velocity
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?
Solution:
Velocity = 20,000/10,000 = 2 units per hour
Cycle Time = 10,000/20,000 = 1/2 hour
= 10,000 (60 minutes)/20,000 = 30 minutes

Activity-Based Costing and Management: Seventh Edition

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Examples of Managerial Accounting

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

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• The use of either plantwide rates or departmental rates

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Type of Cost Description of Cost Driver Example

Unit-level Varies with output volume Cost of indirect materials for

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• Using only unit-based activity drivers to assign nonunit-

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• The presence of product diversity is also necessary for

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• Regardless of the nature of the product diversity,

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• Activity drivers measure activity output and thus can be

Amount of Activity Driver per Product

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Activity Usage Activity Usage Activity Usage

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Activity Cost Data (Overhead Activity Cost Data (Overhead

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Consumption Ratios : Consumption Ratios :

a3/4 (deluxe) and 1/4(regular).

c10/50 (deluxe) and 40/50(regular).

d20/100 (deluxe) and 80/100(regular).

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Activity Activity Cost Driver Driver

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Total Overhead Costs

• The activity-based cost assignment reflects the pattern

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• Functional-based overhead costing involves two major

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• An activity is action taken or work performed by

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Activity Name Activity Description Cost Object(s) Activity Driver

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• The next task is to determine how much it costs to

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