ch04 - ABC

Activity-Based Cost
Management Systems
Chapter 4
2003 Prentice Hall Business Publishing, PowerPoint

supplement to Management Accounting, 4rd ed., Atkinson,
Problems With Simple Cost

Accounting Systems: The Cooper
Pen Company Example
Cooper Pen had been the low-cost producer
of blue pens and black pens, with profit
margins exceeding 20% of sales
Several years ago Cooper Pen expanded
their business by extending their product
line into products with premium selling
prices
4-2
The Cooper Pen Company Example

Five years ago red pens were introduced
The same basic production technology
Could be sold at a price that was 3% higher than for
blue and black pens
Last year purple pens were added

Could be sold at a 10% price premium
The controller of Cooper Pen was disappointed

with the most recent quarters financial results
Overall profitability for all four together had decreased
The red and purple pens, however, were more profitable
than the blue and black pens
4-3
Total Profitability by Product

Blue
Black
Red
Purple
Total
Units
50,000
40,000
9,000
1,000
100,000
Price
$ 4.50
$ 4.50
$ 4.65
$ 4.95
Sales
$225,000
$180,000
$41,850
$4,950
$451,800
Material
75,000
60,000
14,040
1,650
150,690
Labor
30,000
24,000
5,400
600
60,000
Overhead
90,000
72,000
16,200
1,800
180,000
Total Mfg.
Expenses
195,000
156,000
35,640
4,050
390,690
$ 30,000 $ 24,000
$ 6,210
$ 900 $ 61,110
Gross
Margin
G.M. %
13.3%
13.3%
14.8%
18.2%

13.5%
4-4
Concern at Cooper Pen

The controller of Cooper Pen wondered whether
the company should continue to deemphasize the
blue and black commodity products and keep
introducing new specialty colored pens
Coopers manufacturing manager commented on
how the introduction of colored pens had changed
the production environment:
Everything ran smoothly when producing just
blue and black pens in long production runs
Difficulties started when the red pens were
introduced and required more changeovers
4-5
Changes Caused by New Pens (1 of 2)

Making black ink was simple; there was not even
a need to clean out the residual blue ink from
the previous run if enough black ink was
dumped in to cover it up
Red required Cooper to stop production, empty
the vats, clean out all remnants of the previous
color, and then start the production of the red ink
Even small traces of the blue or black ink
created quality problems
The ink for the purple pens also had demanding
specifications, though not quite as demanding
as the red ink
4-6
Changes Caused by New Pens (2 of 2)

Cooper Pens was also spending more time on
purchasing and scheduling activities and
keeping track of existing, backlogged, and future
orders
Coopers manufacturing manager was
concerned about rumors that new colors may be
introduced in the near future
He did not think they had any more capability to
handle additional confusion and complexity in the
operations
Last years new computer system helped to

reduce some of the confusion
4-7
Pen Production At Coopers

Pen production at the factory involved:
Preparing and mixing the ink for the different color pens
Inserting the ink into the pens in a semiautomated
process
Packing and shipping the pens in a manual stage
Each product had a:

Bill of materials that identified the quantity and cost of
direct materials required for the product
Routing sheet that identified the sequence of operations
required for each operating step
This information was used to calculate the labor

expenses for each of the four products
From this information, it was easy to calculate the direct
materials costs and direct labor costs for each color pen
4-8
Coopers Indirect Cost Allocation

Because it was a small company and historically
had produced only a narrow range of products,
Cooper used a simple costing system
All the plants indirect expenses were aggregated at
the plant level and allocated to products based on
each products direct labor cost
Currently the cost systems overhead burden rate was
300% of direct labor cost
Before the new specialty products were introduced,
the overhead rate was only 200% of direct labor cost

4-9
Cooper Pens Cost System

Coopers management accountants designed
the system years ago when:
Production operations were mostly manual
Total indirect costs were less than direct labor costs
Coopers two products had similar production
volumes and batch sizes
Given the high cost of measuring and recording

information, the accountants at the time judged
correctly that a complex costing system would
cost more to operate than the benefits it would
provide
4-10
A Changed Production Environment

Direct labor costs have decreased and indirect
expenses have increased as a result of
automation
As custom low-volume products, such as red
and purple pens were added, Cooper needed:
More scheduling
More setups
More quality control personnel
A computer to track orders and product specifications

4-11
An Outdated Cost System

Cooper operates with only a single cost center,
the plant
Most complex companies use many cost centers for
cost accumulation
Even if Cooper Pen used multiple production

and service department cost centers, it could still
encounter severe distortions in its reported
product costs:
In an environment of high product variety, using only
unit-level drivers (such as direct labor costs) to
allocate overhead costs to products could lead to
product cost distortion
4-12
Reason for Cost Distortions (1 of 3)

A complex factory has a much larger production support
staff because it requires more people to:
schedule machine and
production runs
perform setups
inspect produced items after
setup
move materials
ship orders
expedite orders
rework defective items
design new products

improve existing products
negotiate with vendors
schedule materials receipts
order, receive, and inspect
incoming materials and parts
update and maintain the much
larger computer-based
information system
A complex factory generally also operates with higher

levels of idle time, setup time, overtime, inventory, rework,
and scrap
4-13

Because the factory has the same physical
output, it has roughly the same cost of materials
(ignoring the slightly higher acquisition costs for
smaller orders of specialty colors and other
materials)
Because all pens are about the same complexity,
each pen would require the same number of
direct labor hours and machine hours to produce
The Cooper Pen Company factory has about the
same property taxes, security costs, and heating
bills as before, but it has much higher indirect and
support costs because of its more varied product
mix and complex production tasks
4-14

On a per unit basis, high-volume standard blue and black
pens require about the same amount of direct labor costs
(the allocation basis) as the low volume color pens
Therefore, the traditional costing system would report
essentially identical product costs for all products,
standard and specialty, irrespective of their relative
production volumes
This would hold true even if the cost system had
multiple production and service cost centers
Clearly, however, considerably more indirect and support
resources are required on a per-unit basis for the lowvolume, newly designed products than for the highvolume, standard blue and black pens
4-15
Activity-Based Cost Systems

Activity-based cost systems have been
developed to eliminate this major source of cost
distortion
Activity-based cost (ABC) management systems
use a simple two-stage approach similar to but
more general than traditional cost systems
The next slide compares the essential elements
of the two systems

4-16
Traditional v. ABC System
Traditional:
Uses actual departments or
cost centers for accumulating
and redistributing costs
Asks how much of an
allocation basis (usually
based on volume) is used by
the production department
Service department
expenses are allocated to a
production department based
on the ratio of the allocation
basis used by the production
department
ABC:
Uses activities, for
accumulating costs and
redistributing costs
Asks what activities are
being performed by the
resources of the service
department
Resource expenses are
assigned to activities based
on how much of the
resource is required or used
to perform the activities

4-17
Tracing Costs to Activities

Heres how an ABC system works, using
the Cooper Pen Company as an example:
The controller started an analysis of indirect
expenses, beginning with indirect labor
The controller interviewed department heads in
charge of indirect labor and found that the
people in these departments performed three
main activities

4-18
Indirect Labor Activities (1 of 2)

50% of indirect labor was involved in what the
controller called handle production runs
Scheduling production orders
Purchasing, preparing, and releasing materials
Inspecting the first few units produced each time the
process was changed to a new-colored pen
40% of indirect labor actually performed the

physical changeover from one color pen to
another, an activity that she labeled perform
setups
Change to Black pens takes 2.4 hours
Change to Red or Purple pens takes 5.6 hours
4-19
Indirect Labor Activities (2 of 2)

10% of the time was spent on activities the
controller called support products: maintaining
records on the four products, such as:
Making up the bill of materials and routing information
Monitoring and maintaining a minimum supply of raw
materials and finished goods inventory for each
product
Improving the production processes
Performing engineering changes for the products

4-20
First Steps in Design of An ABC System
As she conducted the interviews, the controller

was performing the first two steps for designing
an activity-based cost system:
1) Develop the activity dictionary: the list of major
activities performed by both the factorys
human and physical resources
2) Obtain sufficient information to assign resource
expenses to each activity in the activity
dictionary (50% of indirect labor to handle
production runs, 40% to perform setups, and
10% to support products)
4-21
Computer System Expenses (1 of 2)

The controller next turned her attention to the
$30,000 of expenses needed to operate the
companys computer system and interviewed the
manager of the data center and the manager of
the management information system department
20% of computer expenses should be assigned
to support products, an activity already
defined in her activity dictionary, because it was
used to keep records on the four products,
including:
Production process
Associated engineering change notice information
4-22
Computer System Expenses (2 of 2)

About 80% of the computer resource was
involved in the production run activity and
seemed to relate well to the handle production
runs activity already defined:
Schedule production runs in the factory
Order and pay for the materials required in each
production run
Since each production run was made for a particular
customer, also included in this activity was the
computer time required to:
Prepare shipping documents
Invoice a customer
Collect from a customer
4-23
Other Overhead Expenses

There were three remaining categories of
overhead expense:
Machine depreciation
Machine maintenance
Energy to operate the machines
These expenses were incurred to supply

machine capacity to produce the pens:
A practical capability of 10,000 hours of productive
time could be supplied to pen production
The controller labeled this production activity

run machines
4-24
Identifying Cost Hierarchies

The controller noted that even though she had defined
only four activities for Coopers indirect costs, they
represented the three different levels of the
manufacturing cost hierarchy:
ACTIVITY
COST HIERARCHY
RUN MACHINES
UNIT LEVEL
HANDLE PRODUCTION RUNS
BATCH LEVEL
SETUP MACHINES
BATCH LEVEL
SUPPORT PRODUCTS
PRODUCT SUSTAINING
Finding at least one activity for each hierarchy level gave

her confidence that the complexity of the manufacturing
process could be represented well enough by the
activity-based cost system
4-25
Benefits from Half an ABC System

The ABC model was only half completed (costs
have not yet been driven down to products), yet it
had already provided some important insights:
Now the controller could see why Cooper Pens was
incurring expenditures for resources instead of seeing
categories of expenses
In particular she saw how expensive activities such as
handling production runs and setting up machines were
The ABC model shifted the focus from what the

money was being spent on (labor, equipment,
supplies) to what the resources acquired by
spending were actually doing
4-26
From ABC to ABM (1 of 2)

In the past, industrial engineers at Cooper Pen
had studied labor and materials usage closely:
These had been the high cost resources
They were also the primary cost categories featured by
Coopers traditional cost system
The high overhead rate on direct labor seemed to
amplify any benefits from direct labor cost savings that
the industrial engineers could achieve

4-27
From ABC to ABM (2 of 2)

It would be worthwhile to have industrial
engineers study the way Cooper handled and
scheduled production runs and how the
employees set up machines to uncover new
opportunities for cost reduction and process
improvement projects
This is an example of operational activity-based
management (ABM), where managers use
information collected by the ABC system at the
activity level to identify opportunities for reducing
costs in indirect and support activities
4-28
Tracing Costs From Activities To Products

The controller next turned her attention to
understanding the demands for these
activities by the four different products
By understanding how products use
activities, she would be able to relate the
cost of performing activities to individual
products

4-29
Activity Cost Drivers

Activity cost drivers represent the quantity of activities
used to produce individual products
The controller identified the following activity cost drivers
for the activities in her activity dictionary:
ACTIVITY
ACTIVITY COST DRIVER
HANDLE PRODUCTION RUNS
PRODUCTION RUNS
SET UP MACHINES
SETUP HOURS
SUPPORT PRODUCTS
NUMBER OF PRODUCTS
RUN MACHINES
MACHINE HOURS
PROVIDE FRINGE BENEFITS
LABOR DOLLARS

4-30
Completing the ABC Model (1 of 2)

Once the activity cost drivers had been
determined, the controller obtained
quantitative information on:
The total quantity of each activity cost driver
The quantity of cost driver used by each
product

4-31
Completing the ABC Model (2 of 2)

The controller now had sufficient
information to estimate a complete
activity-based cost model for Cooper
Pens factory
She calculated the activity cost driver rate
(ACDR) by dividing the activity expense by
the total quantity of the activity cost driver
She then multiplied the activity cost driver rate
by the quantity of each activity cost driver
used by each of the four products
4-32
Activity Cost Drivers

Activity Cost
Driver
Blue
Black
Red
Purple
Total**
DL hr/unit
0.02
0.02
0.02
0.02
2,000
Mach. hr/unit
0.1
0.1
0.1
0.1
10,000
Prod. runs
70
65
50
15
200
2.4
5.6
5.6
--
Total setup hr
280
156
280
84
800
# of products
50,000
40,000
9,000
1,000
Setup time/run
**Total = per unit

X quantity

4-33
Activity Cost Driver Rates (ACDR)

Activity
Expense
Handle
Production Runs
$66,000
Set up machines
$33,600
Support
Products
$14,400
Run Machines
$42,000
Activity Cost
Driver
Driver Quantity
ACDR
Number of
production runs
200
$330 per
Number of
setup hours
800
Number of
products
Number of
machine hours
10,000
run
$42 per
setup hr
$3,600
per product
$4.20 per
machine hr
$156,000

4-34
Activity Expenses Assigned

Blue
Black
Red
Purple
Total
$23,100
$21,450
$16,500
$4,950
$66,000
Set up
machines
11,760
6,552
11,760
3,528
33,600
Support
Products
3,600
3,600
3,600
3,600
14,400
Run
Machines
21,000
16,800
3,780
420
42,000
$ 48,402 $ 35,640 $ 12,498
$ 156,000
Handle
Production
Runs
Total Costs
Assigned
$ 59,460

4-35
ABC Profitability Report

The controller combined the activity expense analysis for
each product with their direct materials and labor costs
to obtain a new ABC profitability report
The results from the activity-based costing system were
quite different from the results based on the traditional
cost system
The controller now understood why the profitability of
Cooper Pen has deteriorated in recent years:
The two specialty products, which the previous cost system had
reported as the most profitable, were in fact the most
unprofitable, and losing lots of money
The company had added large quantities of overhead resources
to enable these products to be designed and produced, but their
incremental revenue did not cover those costs
4-36
Total ABC Profitability by Product

Blue
Sales
Black
Red
Purple
Total
$225,000 $180,000
$41,850
$4,950 $451,800
1,650 150,690
Material
75,000
60,000
14,040
Labor
30,000
24,000
5,400
600
60,000
40%
fringe on
DL
12,000
9,600
2,160
240
24,000
Support
59,460
48,402
35,640
12,498 156,000
176,460 142,002
57,240
14,988 390,690
Total Mfg.
Expenses
Gross
Margin
G.M. %
$ 48,540 $ 37,998 $(15,390) $(10,038) $ 61,110

21.6%
21.1%
-36.8%
-202.8%

13.5%
4-37
Using ABC to Improve Profitability (1 of 2)

The ABC information provides managers
with numerous insights about how to
increase the profitability of Cooper Pen:
Increase either their sales volume or prices to
compensate for the large batch and productsustaining expenses of the red and purple pens
Impose minimum order sizes to eliminate short,
unprofitable production runs
Try to increase demand for the highly profitable
black and blue pens, which could generate new
revenues that exceed their incremental costs
4-38
Using ABC to Improve Profitability (2 of 2)

Improve processes, particularly the processes
performing batch and product-sustaining activities
Manufacturing personnel can redirect their attention:
From trying to run their production equipment faster, in
order to improve the performance of unit-level activities
To learning how to reduce setup times, in order to
improve the performance of batch-level activities so that
small batches of the specialty products would require
fewer resources to produce and be less expensive
The goal of these ABM actions is to enable the company

to produce the same volume and mix of products with
fewer resources
This leads to lower costs for producing low-volume, specialty
products, and reduces the pressure to raise prices or impose
minimum order sizes on customers in order to make such
products profitable
4-39
Selecting Activity Cost Drivers (1 of 2)

Activity cost drivers are the central innovation of activitybased cost systems
They are also the most costly to measure
Particularly the quantity of each activity cost driver
used by each product
Accordingly, it is important to understand the issues
involved in selecting activity cost drivers
The selection of an activity cost driver reflects a
subjective trade-off between accuracy and the cost of
measurement
An ABC system with 50 activity cost drivers and 2,000
products would require that 100,000 data elements be
estimated
4-40
Selecting Activity Cost Drivers (2 of 2)

Because of the large number of potential activity-to-product
linkages, management accountants attempt to economize
on the number of different activity cost drivers
Activities triggered by the same event may all use the
same activity cost driver
For example, preparing production orders, scheduling production
runs, performing first part inspections, and moving materials may
all use the number of production runs
ABC system designers choose from three different types of

activity cost drivers:
Transaction
Duration
Intensity (direct charging)
The choice of a transaction, duration, or intensity cost

driver can occur for almost any activity
4-41
Transaction Drivers
Least expensive type of cost driver
Also the least accurate
They assume that the same quantity of resources is
required every time an activity is performed
For example, a transaction driver such as the number of setups
assumes that all setups take about the same time to perform
For many activities, the variation in the quantity of

resources used by each is small enough that a transaction
driver will be fine for assigning activity expenses to the cost
object
E.g., all setup times are between 30 and 35 minutes
If the amount of resources required to perform the activity

varies considerably from product to product then more
accurate and more expensive types of cost drivers should
be used
E.g., Setup times range from 30 minutes to 6 hours
4-42
Duration Drivers
Represent the amount of time required to perform an activity
Should be used when significant variations exist in the
amount of activity required for different outputs
A transaction driver such as number of setups will overcost the
resources required to set up simple products and undercost the
resources required for complex products
More expensive to implement because they require an

estimate of time needed each time an activity is performed
The choice between a duration driver and a transactional
driver is, as always, one of economics:
Balancing the benefits of increased accuracy against the costs of
increased measurement

4-43
Intensity Drivers
Directly charge for the resources used each time an activity
is performed
A duration driver, such as setup cost per hour, assumes
that all hours are equally costly but does not reflect the
higher costs that may be required on some setups:
E.g., extra personnel, more skilled personnel, more expensive
machinery
Activity costs may have to be charged directly to the

output, based on work orders or other records that
accumulate the activity expenses incurred for that output
Intensity drivers are the most accurate activity cost drivers
but the most expensive to implement
Intensity drivers should be used only when the resources
associated with performing an activity are both expensive
and variable each time an activity is performed unless the
measurements are inexpensive
4-44
Designing an ABC System (1 of 2)

Sometimes ABC system designers get
carried away with the potential capabilities
of an activity-based cost system
For product costing and customer costing
purposes, most companies:
Limit their activity dictionary to 30 to 50
different activities
Choose activity cost drivers that can be
obtained simply and are available within their
organizations existing information system
4-45
Designing an ABC System (2 of 2)

The goal of an ABC system should be to have
the best cost system -- not the most accurate
one
The ABC system designer should balance the
cost of errors resulting from inaccurate
estimates with the cost of measurement
Most of the benefits from a more accurate cost
system can be obtained with simple ABC
systems

4-46
Measuring The Cost

Of Resource Capacity (1 of 2)
The calculation of activity cost driver rates are
sometime based on the capacity actually used
Analysts can obtain a better estimate for the cost
of resources required to handle each production
run by dividing activity expenses by the practical
capacity of work the resources could perform
Otherwise, the activity cost driver rates
overestimate the cost of the activity provided
The cost of unused capacity should not be
assigned to products produced or customers
served during a period
4-47
Measuring The Cost

Of Resource Capacity (2 of 2)
The activity cost driver rate should reflect the
underlying efficiency of the process: the cost of
resources to handle each production order
This efficiency is measured better by using the
capacity of the resources supplied as the
denominator when calculating activity cost driver
rates
Still, the cost of unused capacity should not be
ignored

4-48
Cost of Unused Capacity (1 of 2)

The cost of unused capacity remains someones or
some departments responsibility
Usually you can assign unused capacity after analyzing
the decision that authorized the level of capacity supplied
For example, if the capacity was acquired to meet anticipated
demands from a particular customer or a particular market
segment, then the costs of unused capacity due to lower than
expected demands can be assigned to the person or
organizational unit responsible for that customer or segment
Such an assignment is done on a lump-sum basis; it will

be treated as a sustaining, not a unit-level, expense.

4-49
Cost of Unused Capacity (2 of 2)

If the unused capacity relates to a particular product line
then the cost of unused capacity is assigned to that
product line, where the demand failed to materialize
Unused capacity should not be treated as a general cost,
to be shared across all product lines
In making assignment of unused capacity costs, we
trace the costs at the level in the organization where
decisions are made that affect the supply of capacity
resources and the demand for those resources
The lump-sum assignment of unused capacity costs
provides feedback to managers on their supply and
demand decisions
4-50
Fixed and Variable Expenses

Most indirect expenses assigned by an ABC
system are committed costs
Committed costs become variable via a two-step
procedure:
First, demands for resources change either because of
changes in the quantity of activities performed or
because of changes in the efficiency of performing
activities
Second, managers must make decisions to change the
supply of committed resources, either up or down, to
meet the new level of demand for the activities
performed by these resources
4-51
Activity in Excess of Capacity

If activity volumes exceed the capacity of existing
resources, the result is
Bottlenecks
Shortages
Increased pace of activity
Delays
Poor-quality work
Such shortages occur often on machines, but can also

occur in human resources who perform support activities
Facing such shortages, companies typically make
committed costs variable
They relieve the bottleneck by spending more to increase the
supply of resources to perform work
This is why many indirect costs increase over time
4-52
Decreased Demand for Resources

Demands for indirect and support resources also can
decline
Consciously through activity-based management
Inadvertently through competitive or economy-wide forces that lead
to declines in sales
Should the demands for batch and product-sustaining

resources decrease, few immediate spending reductions
will be noticed
Even for many unit-level resources, such as machines and
direct labor, reduced demands for work does not
immediately lead to spending decreases
The reduced demand for organizational resources lowers
the cost of resources used, but this decrease is offset by an
equivalent increase in the cost of unused capacity
4-53
Making Committed Costs

Variable Downward
After unused capacity has been created,
committed costs will vary downward if, and only
if, managers actively reduce the supply of
unused resources
What makes a resource cost variable
downward is not inherent in the nature of the
resource
It is a function of management decisions
To reduce the demands for the resource
To lower the spending on it
4-54
Managers Make Costs Fixed (1 of 2)

Organizations often create unused capacity
through activity-based management actions
Process improvement
Repricing to modify the product mix
Imposing minimum order sizes on customers
They keep existing resources in place, when

demands for the activities performed by the
resources have diminished
They also fail to find new activities that could be
done by the unused resources already in place
4-55
Managers Make Costs Fixed (2 of 2)

The organization receives no benefits from its activity-based
management decisions that reduced the demands on their
resources if capacity is not reduced or redeployed
The failure to capture benefits from activity-based
management is not because their costs are fixed
The failure occurs because managers are unwilling or unable to take
advantage of the unused capacity they have created by
Spending less on capacity resources
Increasing the volume of work processed by the capacity
resources
The cost of these resources is only fixed if managers do

not exploit the opportunities from the unused capacity they
helped to create
Making decisions based solely upon resource usage (the
ABC system) may not increase profits if managers are not
prepared to reduce spending to align resource supply with
future lower levels of demand
4-56
Problems Implementing ABC (1 of 3)

Several problems arise in practice from the
common approach to activity-based costing that
assigns many resource expenses to activities
based on interviews, surveys, and direct
observation of production and support processes
The interview and survey processes are time consuming
and costly
This front-end cost to an ABC analysis is often a
barrier to widespread ABC adoption

4-57

Inaccuracies and bias may affect the accuracy of cost
driver rates derived from individuals subjective
estimates of their past or future behavior
Companies must periodically repeat the interviewing
and surveying processes if they want to keep their
activity-based cost systems updated
High updating cost leads to infrequent updates of
many ABC systems and, eventually, to obsolete cost
driver estimates
Adding new activities to the system is also difficult,
requiring re-estimates of the relative amount of resource
time and effort required by the new activity
4-58

A more subtle and serious problem arises from the
interview or survey process
People estimating how much time they spend on a
list of activities handed to them invariably report
percentages that add up to 100%
Few individuals report that a significant percentage
of their time is idle or unused
Accordingly, the cost driver rates calculated
from this process assume that resources are
working at full capacity
But operations at capacity are more the
exception than the rule
4-59
Time-Driven ABC:
An Alternative Approach
Several companies have overcome these
problems by using a new approach for
estimating their ABC models
The insight for the new approach is
simple:
Most ABC systems use a large number of
transactional cost drivers that assume each
occurrence of the event (a production run, a
customer order, a product to support)
consumes the same quantity of resources
4-60
Time-Driven ABC:
This homogeneity assumption provides
the foundation for an alternative approach
to estimating cost driver rates. The new
approach requires two new estimates:
The unit cost of supplying capacity, and
The consumption of capacity (unit times) by
each activity

4-61
Unit Cost Estimate (1 of 3)

The new procedure starts with the same
information used by a traditional ABC approach:
The cost of resources that supply capacity and
The practical capacity of the resources supplied
Practical capacity is often estimated as a
percentage (e.g., 80% or 85%) of theoretical
capacity
This estimate allows time (e.g., 15 20%) for
nonproductive time:
For personnel, time for breaks, arrival and
departure, and communication and reading
unrelated to actual work performance
4-62

For machines, an allowance for downtime due to
maintenance, repair, and scheduling fluctuations
With estimates of the cost of supplying capacity

and practical capacity, the analyst can calculate
the unit cost of supplying capacity:
Unit cost =
Cost of capacity supplied
Practical capacity of resources supplied

4-63

For example, assume that indirect labor
employees supply about 2,500 hours of labor in
total each quarter at a cost of $84,000. The
practical capacity (at 80% of theoretical) is about
2,000 hours per quarter, leading to a unit cost
(per hour) of supplying indirect labor capacity of:
$84,000
Indirect labor cost per hour =
2000 hours
= $42 per hour
4-64
Unit Time Estimate

The second piece of new information is an estimate of
time used each time a committed resource performs a
transactional activity
Precision is not critical
Rough accuracy is sufficient
Estimates for the indirect labor from the Cooper Pen
example are:
Resource
Activity
Unit Time
Indirect
Labor
Production Run
5 hours
Support Products 50 hours

4-65
Cost Driver Rate

Assume similar calculations regarding computer
resources produced estimates of $60 per hour and 2
hours per production run
The cost driver rate for the activity, handle production
runs, can now be calculated as the costs of using
indirect labor and the computer for each production run:
Unit Cost
Unit Time
Cost Driver
Indirect Labor Resource
$42 per hour
5 hours/run
$210 per run
+ Computer Resource
$60 per hour
2 hours/run
120 per run
= Activity Cost Driver Rate

$330 per
run
4-66
Advantages of Time-Driven ABC

Managers may easily update their time-driven
ABC model to reflect changes in their operating
conditions
They can incorporate the new knowledge by providing
reasonable estimates about the unit times required for
different activities for each type of product
Managers may also easily update the activity

cost driver rates
Changes in the prices of resources supplied affect the
hourly cost rate
Activity cost driver rates change when there has been
a shift in the efficiency of the activity
4-67
Tracing Marketing-Related
Costs to Customers
The costs of marketing, selling, and distribution expenses
have been increasing rapidly in recent years
Result of increased importance of customer satisfaction
and market-oriented strategies
Many of these expenses do not relate to individual
products or product lines but are associated with:
Individual customers
Market segments
Distribution channels
Companies need to understand the cost of selling to and
serving their diverse customer base
4-68
Alpha Beta Example (1 of 7)

Assume Alpha and Beta are customers generating about
equal revenue and seen as equally valuable customers
Using a conventional cost accounting system, marketing,
selling, distribution, and administrative (MSDA) expenses
were allocated to customers at a rate of 35% of Sales
Sales
ALPHA
$320,000
BETA
$315,000
CGS
154,000
156,000
$166,000
$159,000
112,000
110,250
$ 54,000
$ 48,750
16.9%
15.5%
Gross Margin
MSDA expenses (@35% of Sales)
Operating profit
Profit percentage
In many respects, however, the customers were not similar

4-69

Betas account manager spent a huge amount of time
on that account
Beta required a great deal of hand-holding and was
continually inquiring whether the company could modify
products to meet its specific needs
Betas account required many technical resources, in
addition to marketing resources
Beta also:
Tended to place many small orders for special products
Required expedited delivery
Tended to pay slowly
All of which increased the demands on the order processing,
invoicing, and accounts receivable process
4-70

Alpha, on the other hand:
Ordered only a few products and in large quantities
Placed its orders predictably and with long lead times
Required little sales and technical support
The Accounting Manager in Marketing knew that

Alpha was a much more profitable customer than
the financial statements were currently reporting
He launched an activity-based cost study of the
companys marketing, selling, distribution, and
administrative costs
4-71

The multifunctional project team:
Studied the resource spending of the various accounts
Identified the activities performed by the resources
Selected activity cost drivers that could link each
activity to individual customers
The Accounting Manager used:

Transactional activity cost drivers
Number of orders, number of mailings
Duration drivers
Estimated time and effort
Intensity drivers when he had readily-available data

Actual freight and travel expenses
4-72

The manager also used a customer cost
hierarchy that was similar to the manufacturing
cost hierarchy
Some activities were order-related
Handle customer orders
Ship to customers
Others were customer-sustaining
Service customers
Travel to customers
Provide marketing and technical support

4-73

The picture of relative profitability of Alpha and Beta
shifted dramatically
Alpha
Beta
$166,000
$159,000
Marketing & tech. support
7,000
54,000
Travel to customer
1,200
7,200
100
100
4,000
42,000
Handle customer orders
500
18,000
Warehouse inventory
800
8,800
Ship to customers
12,600
42,000
Total activity expenses
26,200
172,100
$ 139,800
$ (13,100)
43.7%
(4.2%)
Gross Margin (as previously)
Distribute sales catalog

Service customers
Operating profit
Profit percentage

4-74

As the manager suspected, Alpha Company was
a highly profitable customer
Its ordering and support activities placed few
demands on the companys marketing, selling,
distribution, and administrative resources
Almost all the gross margin earned by selling to Alpha
dropped to the operating margin bottom line
Beta Company was now seen to be the most

unprofitable customer that the company had
While the manager intuitively sensed that Alpha
was a more profitable customer than Beta, he
had no idea of the magnitude of the difference
4-75
ABC Customer Analysis

The output from an ABC customer analysis is often
portrayed as a whale curve
A plot of cumulative profitability versus the number of
customers
Customers are ranked, on the horizontal axis from most
profitable to least profitable (or most unprofitable)

4-76
Customer Profitability
Cumulative sales follow the usual 20-80 rule
20% of the customers provide 80% of the sales
A whale curve for cumulative profitability typically reveals:
The most profitable 20% of customers generate between
150% and 300% of total profits
The middle 70% of customers break even
The least profitable 10% of customers lose 50% - 200%
of total profits, leaving the company with its 100% of total
profits
It is not unusual for some of the largest customers to turn
out being the most unprofitable
The largest customers are either the companys most
profitable or its most unprofitable
They are rarely in the middle
4-77
Managing Customer Profitability (1 of 3)

High-profit customers, such as Alpha, appear in
the left section of the profitability whale curve
These customers should be cherished and
protected
They could be vulnerable to competitive
inroads
The managers of a company serving them
should be prepared to offer discounts,
incentives, and special services to retain the
loyalty of these valuable customers if a
competitor threatens
4-78

The challenging customers, like Beta, appear on
the right tail of the whale curve, dragging the
companys profitability down with their low
margins and high cost-to-serve
The high cost of serving such customers can be
caused by their:
Unpredictable order pattern
Small order quantities for customized
products
Nonstandard logistics and delivery
requirements
Large demands on technical and sales
personnel
4-79

The opportunities for a company to transform its
unprofitable customers into profitable ones is
perhaps the most powerful benefit the
companys managers can receive from an
activity-based costing system
Managers have a full range of actions for
transforming unprofitable customers into
profitable ones
Process improvements
Activity-based pricing
Managing customer relationships
4-80
Process Improvements
Managers should first examine their internal operations
to see where they can improve their own processes to
lower the costs of serving customers
If customers are migrating to smaller order sizes:
Strive to reduce batch-related costs, such as setup
and order handling
Electronic systems greatly lower the cost of
processing large quantities of small orders
If customers prefer suppliers offering high variety
Try to customize products at the latest possible stage
Use information technology to enhance the linkages
from design to manufacturing
4-81
Activity-Based Pricing
Pricing is the most powerful tool a company can
use to transform unprofitable customers into
profitable ones
Activity-based pricing establishes a base price
for producing and delivering a standard quantity
for each standard product
To this base price, the company provides a menu of
options, with associated prices, for any special
services requested by the customer
Special services may be priced just to cover

costs or also to earn a margin
Activity-based pricing prices orders, not products
4-82
Managing Relationships
Companies can transform unprofitable customers into
profitable ones by persuading the customer to use a
greater scope of the companys products and services
The margins from such increased business
purchases contribute to covering customer-sustaining
costs
If these efforts fail, the company may then contemplate
firing the customer
Some customers may be unprofitable only because it is
the start of the relationship with the company
Companies can afford to be more tolerant of newly-acquired
unprofitable customers than they can of unprofitable customers
they have served for 10 or more years
4-83
ABC at Service Companies (1 of 2)

Although ABC had its origins in manufacturing
companies, many service organizations today are
obtaining great benefits from this approach
In practice, the actual construction of an ABC model is
nearly identical for both types of companies
This should not be surprising since, in manufacturing
companies, the ABC system focuses on the service
component of the company

4-84
ABC at Service Companies (2 of 2)

Service companies in general are ideal
candidates for activity-based costing
Virtually all costs are indirect and appear fixed
They often do not have direct, traceable costs to
serve as convenient allocation bases
They must supply virtually all their resources in
advance to provide the capacity to perform work for
customers during each period

4-85
Implementation Issues (1 of 2)
Not all ABC systems have been sustained or contributed
to higher profitability for the company
Some companies have experienced difficulties and frustrations
in building and using activity-based cost and profitability models
for some of the following reasons
Lack of clear business purpose

The project may start in Accounting/Finance, and nobody
outside the department understands what changes need to be
made and why
Lack of senior management commitment

The group (usually Accounting/Finance) that initiates the project
probably does not have the authority to make decisions about
processes, product designs, etc., without full senior
management support
4-86
Implementation Issues (2 of 2)
Delegating the project to consultants
Consultants are usually not familiar enough with the businesss
organization and problems and may not be able to build
management consensus
Poor ABC model design

The model may be too complicated to build and maintain and too
complex for managers to understand and act upon
Or the model may use arbitrary allocations that merely create
different distortions than the old system
The new data requirements may increase the workload of other
functions without increasing the benefits to them
Individual and organizational resistance to change

People may feel threatened by the suggestion that their work
might be improved
Resistance may be overt, but it may be more subtle and passive
4-87
If you have any comments or suggestions concerning

this PowerPoint presentation, please contact:
Terry M. Lease
(terry.lease@sonoma.edu)
Sonoma State University

4-88

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Activity-Based Cost

2003 Prentice Hall Business Publishing, PowerPoint

Problems With Simple Cost

The Cooper Pen Company Example

Last year purple pens were added

The controller of Cooper Pen was disappointed

Total Profitability by Product

2003 Prentice Hall Business Publishing, PowerPoint

Concern at Cooper Pen

Changes Caused by New Pens (1 of 2)

Changes Caused by New Pens (2 of 2)

Last years new computer system helped to

Pen Production At Coopers

Each product had a:

This information was used to calculate the labor

Coopers Indirect Cost Allocation

2003 Prentice Hall Business Publishing, PowerPoint

Cooper Pens Cost System

Given the high cost of measuring and recording

A Changed Production Environment

2003 Prentice Hall Business Publishing, PowerPoint

An Outdated Cost System

Even if Cooper Pen used multiple production

Reason for Cost Distortions (1 of 3)

design new products

A complex factory generally also operates with higher

Reason for Cost Distortions (2 of 3)

Reason for Cost Distortions (3 of 3)

Activity-Based Cost Systems

2003 Prentice Hall Business Publishing, PowerPoint

Traditional v. ABC System

2003 Prentice Hall Business Publishing, PowerPoint

Tracing Costs to Activities

2003 Prentice Hall Business Publishing, PowerPoint

Indirect Labor Activities (1 of 2)

40% of indirect labor actually performed the

Indirect Labor Activities (2 of 2)

2003 Prentice Hall Business Publishing, PowerPoint

First Steps in Design of An ABC System

As she conducted the interviews, the controller

Computer System Expenses (1 of 2)

Computer System Expenses (2 of 2)

Other Overhead Expenses

These expenses were incurred to supply

The controller labeled this production activity

Identifying Cost Hierarchies

HANDLE PRODUCTION RUNS

Finding at least one activity for each hierarchy level gave

Benefits from Half an ABC System

The ABC model shifted the focus from what the

From ABC to ABM (1 of 2)

2003 Prentice Hall Business Publishing, PowerPoint

From ABC to ABM (2 of 2)

Tracing Costs From Activities To Products

2003 Prentice Hall Business Publishing, PowerPoint

Activity Cost Drivers

ACTIVITY COST DRIVER

HANDLE PRODUCTION RUNS

PROVIDE FRINGE BENEFITS

2003 Prentice Hall Business Publishing, PowerPoint

Completing the ABC Model (1 of 2)

2003 Prentice Hall Business Publishing, PowerPoint

Completing the ABC Model (2 of 2)

Activity Cost Drivers