Chapter 5Activity-based Costing and Activity-based Management

Peanut-butter costing: using broad averages to assign costs uniformly

to cost objects
Product UNDERcosting: a product consumes a high level of resources
but is reported to have a low cost per unit
Product OVERcosting: a product consumes a low level of resources but
is reported to have a high cost per unit
Product under/overcosting causes managers to focus on the wrong
products
Product-cost cross-subsidization: if a company undercosts one product,
it will over cost at least one of its other products (and vice versa)
Very common in situations where peanut-butter costing is used
Refined Costing System: reduces the use of broad averages for
assigning costs and provides a better measurement of the costs of
indirect resources used by different cost objects
Reasons for refining a cost system:

Increase in Product Diversity (because products differ in the

demands they place on the resources needed to produce them.
Therefore, broad averages would distort the cost information)
Increase in Indirect Costs (because advancements in
product/process technology have caused increases in indirect
costs and decreases in direct costsesp. DML)

Competition in Production Markets (as competition increases,

management have an increasing desire to obtain more accurate
cost information in order to make better strategic decisions, like
how to price products and which to sell)
Guidelines for Refining a Cost System:

Direct-cost tracing (identify as many direct costs as is

economically feasible)
Indirect cost pools (increase the number of cost pools until each
pool is more homogenous)
All costs in a homogeneous cost pool have the same or a
similar cause-and-effect relationship with a single cost
driver that is used as the cost-allocation base
Cost-allocation bases (whenever possible, use the cost driver as
the cost-allocation base for each homogenous indirect-cost pool)

Activity-based Costing Systems: refines a costing system by identifying

individual activities as the fundamental cost objects
An activity is an event, task, or unit of work with a specified purpose

ABC systems identify activities in all functions of the value chain,

calculate costs of individual activities, and assign costs to cost objects
on the basis of the mix of activities needed to produce it

It is important for management to decide which activities make up the

ABC system
Part of this process is deciding whether certain tasks/activities should
be considered separate activities or combined into a single activity

An ABC system with many activities can become overly detailed

and unwieldy to operate

An ABC system with few activities may not be refined enough to

measure cause-and-effect relationships between cost drivers
and various indirect costs
Activities that have the same cost driver are typically combined into a
single activity (i.e. the maintenance, operations and process control of
molding machines are combined into one activitymolding machine
operationsbecause all of these use the same cost driver (molding
machine hours))
The activity list (or activity dictionary) forms the basis of the activitybased cost system
The cost of each activity and the related cost drivers must be identified
Direct-cost tracing. These costs can be traced in an economically
feasible way.
Indirect-cost pool. Determining costs of activity pools requires
assigning and reassigning costs accumulated in support departments
(i.e. HR) to each of the activity cost pools on the basis of how various
activities use each support departments resourcesaka first-stage
allocation
Cost-allocation bases. For each activity cost pool, the cost driver is
used as the cost allocation base, when possible. To identify cost
drivers, management considers various alternatives and uses their
knowledge of operations to choose among them
Benefits of ABC Systems:
More accurate costing of activities (due to structuring activity cost
pools more finely with cost drivers for each activity cost pool being
used as the cost-allocation base)
More accurate product costs (due to the allocation of these costs to the
products by measuring the cost-allocation bases of different activities
used by different products)
Activity-based costing attempts to identify the most relevant causeand-effect relationship for each activity pool, without restricting the
cost driver to only units of output or variables related to unites of
output (i.e. DML hours)

Cost Hierarchiescategorize various activity cost pools on the basis of

different types of cost drivers, or cost-allocation bases, or different degrees of
difficulty in determining cause-and-effect relationships
ABC systems commonly use a cost hierarchy with four levels: output
unit-level costs, batch-level costs, product-sustaining costs, and
facility-sustaining costs

Output unit-level costs: the costs of activities performed on each

individual unit of a product or service (i.e. machine operation
costs, such as cost of energy, machine depreciation, and repair,
related to the activity of running a machine)
Batch-level costs: the costs of activities related to a group of
units of a product rather than each individual unit of product (i.e.
machine setup costs are batch-level costs because, over time,
the cost of the setup activity increases with the number of setup
hours needed to produce batches)
Product-sustaining costs (service-sustaining costs): the costs of
activities undertaken to support individual products regardless of
the number of units or batches in which the units are produced
(i.e. R&D, costs of making engineering changes, and marketing
costs to launch new product)
Facility-sustaining costs: the costs of activities that cannot be
traced to individual products, but that support the organization
as a whole
Usually difficult to find a cause-and-effect relationship
between costs and the cost-allocation base
As a result, some companies choose not to allocate these
costs and instead deduct them as a separate lump-sum
amount from operating income
Allocating all costs to products becomes important when
management wants to set selling prices on the basis of an
amount of cost that includes all costs

The benefit of an activity-based costing system is that it provides

information to make better decisions
This benefit must be weighed against the measurement and
implementation osts of an ABC system
Signs of when an ABC system is likely to provide the most benefits:
A significant amount of indirect costs ate allocated using only one or
two cost pools
All or most indirect costs are identified as output unit-level costs
Products make diverse demands on resources because of differences in
volume, process stems, batch size, or complexity

Products that a company is well-suited to make and sell show small

profits; whereas products that a company is less suited to produce
show large profits
Operations staff has substantial disagreement with the reported cost of
manufacturing and marketing products and services
The main costs and limitations of an ABC system are the
measurements necessary to implement it
ABC systems require management to estimate costs of activity pools
and to identify and measure cost drivers for these pools to serve as
cost-allocation bases
Even basic ABC systems require many calculations to determine costs
of products
As improvements in information technology and accompanying
declines in measurement costs continue, more-detailed ABC systems
have become a practical alternative

ACTIVITY-BASED MANAGEMENT

Activity-based Management: a method of management decision making that

uses activity-based costing information to improve customer satisfaction and
profitability (including decisions about pricing and product mix, cost
reduction, process improvement, and product & process design)

Pricing and Product Mix decisions

Cost Reduction and Process Improvement Decisions

ABC systems give management information about the costs of making

and selling diverse productswith this information, managers are
better able to make pricing and product mix decisions (because
product costing will be more accurate)
Manufacturing and distribution personnel use ABC systems to focus on
how and where to reduce costs

Managers set cost reduction targets in terms of reducing costs

per unit of the cost-allocation base in different activity areas

The goal is to reduce costs by improving the efficiency or work

without compromising customer service or the perceived value
customers obtain from the product (in other words, take out only
those costs that are non-value added)

Another method of managing costs is to control physical cost

drivers

Design Decisions

Planning and Managing Activities

Management can evaluate how its current product and process designs
affect activities and costs as a way of identifying new designs to
reduce costs
Many companies implementing ABC systems for the first time analyze
actual costs to identify activity-cost pools and activity-cost rates

To be useful for planning, making decisions, and managing

activities, companies calculate a budgeted cost rate for each
activity and use these budgeted cost rates to cost products

At year-end, budgeted costs and actual costs are compared to provide

feedback on how well activities were managed and to make
adjustments for under-allocated or over-allocated indirect costs for
each activity

ACTIVITY-BASED COSTING AND DEPARTMENT-BASED COSTING SYSTEMS

Companies often use costing systems that have features of ABC

systems (i.e. multiple cost pools and multiple cost-allocation bases) but
that do not emphasize individual activities
Using department indirect cost rates to allocate costs to products
results in similar information as activity cost rates if:
A single activity accounts for a sizable proportion of the departments
costs; or
Significant costs are incurred on different activities within a
department, but each activity has the same cost driver and hence
cost-allocation base
From a purely product-costing standpoint, department and activity
indirect cost rates will also result in the same product costs if:
Significant costs are incurred for different activities with different costallocation bases within a department
But different products use resources from the different activity areas in
the same proportions
Do not assume that because department costing systems require the
creation of multiple indirect cost pools that they properly recognize the
drivers of costs within the departments, as well as how resources are
used by products
Emphasizing activities leads to more-focused and homogenous cost
pools, aids in identifying cost-allocation bases for activities that have a
better cause-and-effect relationship with the costs in activity cost
pools, and leads to better design and process decisions

ABC systems are used by managers to make better strategic decisions,

not for inventory valuation

CHAPTER 6MASTER BUDGET AND RESPONSIBILITY ACCOUNTING

Budgets and the Budgeting Cycle

Strategic Plans and Operating Plans

Budgeting is most useful when it is integrated with a companys

strategy

Strategy: how an organization matches its own capabilities with the

opportunities in the marketplace to accomplish its objectives

Budget: a quantitative expression of a proposed plan of action by

management for a specified period AND an aid to coordinate what
needs to be done to implement that plan
Includes both financial and non-financial aspects of the plan, and
serves as a blueprint for the company to follow in the upcoming
period
A financial budget quantifies managements expectations
regarding income, cash flows, and financial position

Budgets help managers assess strategic risks and opportunities by

providing them with feedback about the likely effects of their strategies
and plans
Long-run planning = Strategic plans; Short-run planning = Operating
plans

Budgeting Cycle and Master Budget

Well-managed companies usually cycle through the following

budgeting steps during the course of the fiscal year:
Plan the performance of the company as a whole and the
performance of its subunits
Senior management give subordinate managers a frame of
reference, a set of specific financial/non-financial
Management accountants help managers investigate variations
from plans (corrective action may follow)
Managers and management accountants take into account
market feedback, changed conditions, and their own
experiences as they begin to make plans for the next period
A master budget, the working document at the core of this process,
expresses managements operating and financial plans for a specified
period (usually a fiscal year), and it includes a set of budgeted financial
statements (aka pro forma statements)
Operating decisions deal with how to best use the limited
resources of an organization
Financing decisions deal with how to obtain the funds to acquire
those resources

Advantages of Budgets

Communication: making sure the goals are understood by all

employees

Budgets enable companys managers to measure actual performance

against predicted performance

They can overcome two limitations of using past performance as a

basis for judging actual results:
First limitation: past results often incorporate past miscues and
substandard performance
Second limitation: Future conditions can be expected to differ
from the past

Evaluating performance relative only to the budget creates an

incentive for subordinates to set a target that is relatively easy to
achieve
One of the most valuable benefits of budgeting is that it helps
managers gather relevant information for improving future
performance
It prompts senior management to ask questions about why
certain things occurred

Motivating Managers and Other Employees

Coordination: meshing and balancing all aspects of production or

service and all departments in a company in the best way for the
company to meet its goals

Framework for Judging Performance and Facilitating Learning

Provide a framework for judging performance and facilitating learning

Motivate managers and other employees

Coordination and Communication

Promote coordination and communication among subunits within the

company

Most employees are motivated to work more intensely to avoid failure

than to achieve success
Creating a little anxiety improves performance, but overly
ambitious and unachievable budgets increase anxiety without
motivation because employees see little chance of avoiding
failure

Challenges in Administering Budgets