Chapter 5

Activity-Based
Costing and
Management

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning
Objective
1

5-2

Traditional, Volume-Based
Product-Costing System
Aerotech produces three complex printed circuit
boards referred to as Mode I, Mode II, and Mode
III.
The following information is obtained from
company records:

5-3

Traditional, Volume-Based
Product-Costing System

Additional information includes:

Manufacturing overhead is determined as follows

5-4

Traditional, Volume-Based
Product-Costing System

Budgeted manufacturing overhead

Budgeted direct-labor hours

$3,894,000
118,000

= $33 per hour

5-5

Traditional, Volume-Based
Product-Costing System

With these product costs, Aerotech established

target selling prices (Cost 125%).

209.00 x 1.25
5-6

Learning
Objective
2

5-7

Activity Based Costing System

(ABC)
ABC systems follow a two-stage procedure
to assign overhead costs to products.

Stage One
Identify significant activities and assign overhead costs
to each activity in proportion to resources used.

Stage Two
Identify cost drivers appropriate to each activity and
allocate overhead to the products.

5-8

Learning
Objective
3

5-9

Overhead Costs
Activity
must be
done on
each unit
produced.

Total budgeted cost = $3,894,000

Activity
Cost
Pools

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Activity
performed
on each
batch
produced.

Activities needed to support

an entire product line

Identification
Identification
of
of Activity
Activity
Cost
Cost Pools
Pools

Facility
Level
Facility
cost pool
$507,400

Activity required in order

for the production
process to occur.
5-10

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Facility
Level
Facility
cost pool
$507,400

Receiving/Inspection
cost pool $200,000
Material-Handling
cost pool $600,000
Quality-Assurance
cost pool $421,000
Packaging/Shipping
cost pool $250,000
5-11

Learning
Objectives
3&4

5-12

STAGE ONE
Various overhead
costs related
to machinery

Activity
cost
pool

Maintenance

Lubrication

Depreciation

Electricity

Computer Support

Calibration

Machinery Cost Pool

Total budgeted cost = $1,212,600

5-13

STAGE TWO
Calculate
the pool
rate

Budgeted Machinery Costs = $1,212,600

Budgeted Machine Hours
43,000
= $28.20/hour

Cost
Assignment

5-14

STAGE ONE
Calculation of
total setup cost

Activity
cost
pool

Setup Cost Pool

Total budgeted cost = $3,000

5-15

STAGE TWO
Calculate
the pool
rate

Budgeted Setup Costs

Planned Production Runs

= $3,000
15 runs
= $200 per run

Cost
Assignment

5-16

STAGE ONE
Various overhead
costs related
to engineering

Activity
cost
pool

Engineering salaries

Engineering software

Engineering supplies

Depreciation

Engineering Cost Pool

Total budgeted cost = $700,000

5-17

STAGE TWO
Allocate based
on engineering
transactions

Engineering Cost Pool

Total budgeted cost = $700,000

Cost
Assignment

5-18

STAGE ONE
Various overhead
costs related
to general
operations

Activity
cost
pool

Plant depr.

Property taxes

Plant mgmt.

Insurance

Plant maint.

Security

Facility Cost Pool

Total budgeted cost = $507,400

5-19

STAGE TWO
Calculate
the pool
rate

Budgeted Facilities Cost

= $507,400
Budgeted Direct-Labor Hours
118,000
= $4.30/hour

Cost
Assignment

5-20

Other Overhead Costs

Receiving and Inspection Cost Pool

Board
Overhead
Mode I
$ 200,000
Mode II
200,000
Mode III
200,000

%
6%
24%
70%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.20
=
2.40
=
35.00

Material-Handling Cost Pool

Board
Overhead
Mode I
$ 600,000
Mode II
600,000
Mode III
600,000

%
7%
30%
63%

Units
10,000
20,000
4,000

= Cost/Unit
= $
4.20
=
9.00
=
94.50

Quality-Assurance Cost Pool

Board
Overhead
Mode I
$ 421,000
Mode II
421,000
Mode III
421,000

%
20%
40%
40%

Units
10,000
20,000
4,000

= Cost/Unit
= $
8.42
=
8.42
=
42.10

Packaging and Shipping Cost Pool

Board
Overhead
Mode I
$ 250,000
Mode II
250,000
Mode III
250,000

%
4%
30%
66%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.00
=
3.75
=
41.25
5-21

Other Overhead Costs

Receiving and Inspection Cost Pool

Board
Overhead
Mode I
$ 200,000
Mode II
200,000
Mode III
200,000

%
6%
24%
70%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.20
=
2.40
=
35.00

Material-Handling Cost Pool

Board
Overhead
Mode I
$ 600,000
Mode II
600,000
Mode III
600,000

$14.82

%
7%
30%
63%

Units
10,000
20,000
4,000

= Cost/Unit
= $
4.20
=
9.00
=
94.50

Quality-Assurance Cost Pool

Board
Overhead
Mode I
$ 421,000
Mode II
421,000
Mode III
421,000

%
20%
40%
40%

Units
10,000
20,000
4,000

= Cost/Unit
= $
8.42
=
8.42
=
42.10

Packaging and Shipping Cost Pool

Board
Overhead
Mode I
$ 250,000
Mode II
250,000
Mode III
250,000

%
4%
30%
66%

Units
10,000
20,000
4,000

= Cost/Unit
= $
1.00
=
3.75
=
41.25
5-22

Product Cost from ABC

These are the new product costs when Aerotech
uses ABC.

5-23

Learning
Objective
5

5-24

Distorted Product Costs

Both original and ABC target selling prices are
based on (Cost 125%).

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 1.25]

[$183.44 1.25]
5-25

Distorted Product Costs

Can you identify any problems Aerotech is likely
to face as a result of this distortion?

Traditional costing understates the cost

of complex, low volume products.
5-26

Two Key Points

A
A large
large proportion
proportion of
of nonnonunit-level
unit-level activities
activities
A
A unit-level
unit-level cost
cost driver,
driver,
such
such as
as direct
direct labor,
labor,
machine
machine hours,
hours, or
or
throughput,
throughput, will
will not
not be
be
able
able to
to assign
assign the
the costs
costs
of
of non-unit-level
non-unit-level activities
activities
accurately.
accurately.

Product
Product diversity
diversity
When
When the
the
consumption
consumption ratios
ratios
differ
differ widely
widely between
between
activities,
activities, no
no single
single
cost
cost driver
driver will
will
accurately
accurately assign
assign the
the
resulting
resulting overhead
overhead
costs.
costs.

5-27

Learning
Objective
6

5-28

Cost Drivers
A characteristic of an event or activity that results
in the incurrence of costs. In selecting a cost
driver, we must consider . . .
Degree of
Correlation

Behavioral
Effects
Cost of
Measurement
5-29

Learning
Objective
7

5-30

COLLECTING ABC DATA

INTERVIEWS AND PAPER TRAILS - The information
for ABC systems initially comes from interviews with
employees in the support departments and a review of each
departments records.

STORYBOARDING - A procedure used to develop a

detailed process flow chart, which visually represents activities
and the relationships among activities.

MULTIDISCIPLINARY ABC PROJECT TEAMS To

gather information from all facets of an organizations
operations, it is essential to involve personnel from a variety of
functional areas. A typical ABC project team includes
ACCOUNTING, FINANCE, PRODUCTION, OPERATIONS,
ENGINEERS, MARKETING etc.
5-31

Learning
Objective
8

5-32

Activity-Based Management

The use of
ABC costing
information
to help
management
make decisions
5-33

Activity-Based Management
Activity-based costing establishes relationships
between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.

5-34

Two-Dimensional ABC and

Activity-Based Management

Activities

5-35

Two-Dimensional ABC and

Activity-Based Management
Cost Assignment View

Resource
Resource costs
costs

Activities

Cost
Cost Objects
Objects
5-36

Two-Dimensional ABC and

Activity-Based Management
Cost Assignment View

Resource
Resource costs
costs
Process View
Activity Analysis

Root
Root
Causes
Causes

Activity
Activity
Triggers
Triggers

Activity Evaluation

Activities

Performance
Performance
Measures
Measures

Cost
Cost Objects
Objects
5-37

Elimination of Non-Value-Added
Costs
Activities

Nonvalueadded
activities
Unnecessary

Necessary

Reduce or
Eliminate

Continually Evaluate
and Improve

5-38

Using ABM to Eliminate NonValue-Added Activities and Costs

1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes,

and Triggers.

Specify
Specify
parts
parts

Select
Select
vendor
vendor

Receive
Receive
parts
parts

Produce
Produce
goods
goods

Inspect
Inspect
finished
finished
goods
goods

Rework
Rework
defective
defective
products
products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.
5-39

Using ABM to Eliminate NonValue-Added Activities and Costs

Process time

Inspection time

Move time

Storage time

Waiting time
5-40

Learning
Objective
9

5-41

Customer Profitability Analysis

Customer profitability analysis uses
activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

5-42

Customer Profitability Analysis

Required
special
packaging.
Orders
small
quantities.

Often
changes
orders.

A costly
customer

Demand
fast
service.

Orders
frequently.

5-43

Customer Profitability Analysis

A
A company
company may
may use
use these
these customer
customer
related
related costs
costs to
to help
help determine
determine the
the
profitability
profitability of
of each
each customer.
customer.
5-44

Customer Profitability Analysis

Cumulative Operating Income as a % of Total
Operating Income

Customer Profitability
125.0%

100.0%

75.0%

50.0%

25.0%

75% of actual operating income

50% of actual operating income

25% of actual operating income

0.0%
1

4 5

8 9 10 11 12 13 14 15 16 17 18 19 20
5-45

Learning
Objective
10

5-46

Activity-Based Management in the

Service Industry
Customer
Profitability
Analysis

Activity
Analysis

5-47

Learning
Objective
11

5-48

Just-in-Time Inventory and

Production Management

No materials are purchased and no products

are manufactured until they are needed.
The
The primary
primary goal
goal of
of aa
JIT
JIT production
production system
system is
is
to
to reduce
reduce or
or eliminate
eliminate
inventories
inventories at
at every
every
stage
stage of
of production.
production.

5-49

Key Features of the JIT Approach

Smooth, uniform production rate
Pull method of production

Purchase is small lot sizes

Quick, inexpensive setups

High quality materials

Effective preventive maintenance

Teamwork
Multiskilled workers
5-50

JIT Purchasing
Long-term
Long-term
contracts
contracts with
with
suppliers.
suppliers.
Only
Only aa few
few
suppliers.
suppliers.

Parts
Parts delivered
delivered
in
in small
small lots.
lots.

Grouped
Grouped
payments
payments to
to
vendor.
vendor.

Minimal
Minimal
inspection
inspection of
of
materials.
materials.
5-51

End of Chapter 5
This is
my kind of cost
pool!

5-52