Activity-Based Costing

Classic Pen Company Case

 Problems With Simple Cost Accounting
Systems: The Classic Pen Company
Example
 Classic Pen had been the low-cost producer
of blue pens and black pens, with profit
margins exceeding 20% of sales
 Several years ago Classic Pen expanded
their business by extending their product line
into products with premium selling prices
 The Classic 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 Classic Pen was disappointed
with the most recent quarter’s 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
 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. 195,000 156,000 35,640 4,050 390,690
Expenses
Gross $ 30,000 $ 24,000 $ 6,210 $ 900 $ 61,110
Margin
G.M. % 13.3% 13.3% 14.8% 18.2% 13.5%
 Concern at Classic Pen
 The controller of Classic Pen wondered whether
the company should continue to deemphasize the
blue and black commodity products and keep
introducing new specialty colored pens
 Classic’s 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

 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 Classic 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
 Changes Caused by New Pens
(2 of 2)
 Classic Pens was also spending more time on
purchasing and scheduling activities and
keeping track of existing, backlogged, and future
orders
 Classic’s 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 year’s new computer system helped to
reduce some of the confusion
 Pen Production At Classic’s
 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
 Classic’s Indirect Cost
Allocation
 Because it was a small company and historically
had produced only a narrow range of products,
Classic used a simple costing system
 All the plant’s indirect expenses were aggregated at
the plant level and allocated to products based on
each product’s direct labor cost
 Currently the cost system’s 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
 Classic Pen’s Cost System
 Classic’s management accountants designed the
system years ago when:
 Production operations were mostly manual
 Total indirect costs were less than direct labor costs
 Classic’s 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
 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, Classic needed:
 More scheduling
 More setups
 More quality control personnel
 A computer to track orders and product specifications
 An Outdated Cost System
 Classic operates with only a single cost center, the
plant
 Most complex companies use many cost centers for cost
accumulation
 Even if Classic 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
 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  design new products
production runs  improve existing products
 perform setups  negotiate with vendors
 inspect produced items after  schedule materials receipts
setup  order, receive, and inspect
 move materials incoming materials and parts
 ship orders  update and maintain the much
 expedite orders larger computer-based
 rework defective items information system

• A complex factory generally also operates with higher

levels of idle time, setup time, overtime, inventory, rework,
and scrap
Reason for Cost Distortions (2 of 3)
 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 Classic 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
 Reason for Cost Distortions (3 of 3)
 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 low-
volume, newly designed products than for the high-
volume, standard blue and black pens
 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
 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
 Tracing Costs to Activities
 Here’s how an ABC system works, using
the Classic 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
 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
 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
 First Step 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 factory’s
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”)
 Computer System Expenses (1 of 2)
 The controller next turned her attention to the
$30,000 of expenses needed to operate the
company’s 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
 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
 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”
 Identifying Cost Hierarchies
 The controller noted that even though she had defined only
four activities for Classic’s 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
 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 Classic 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
 From ABC to ABM (1 of 2)
 In the past, industrial engineers at Classic Pen
had studied labor and materials usage closely:
 These had been the high cost resources
 They were also the primary cost categories featured by
Classic’s 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
 From ABC to ABM (2 of 2)
 It would be worthwhile to have industrial engineers
study the way Classic 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
 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
 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
 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
 Completing the ABC Model (2 of 2)
 The controller now had sufficient
information to estimate a complete activity-
based cost model for Classic Pen’s 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
 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

Setup time/run 4 2.4 5.6 5.6 --
Total setup hr 280 156 280 84 800
# of products 1 1 1 1 4

**Total = per unit

X quantity 50,000 40,000 9,000 1,000
 Activity Cost Driver Rates (ACDR)
Activity Activity Cost Driver
Expense Driver Quantity ACDR
Handle $66,000 Number of 200 $330 per
Production Runs production runs run
Set up machines $33,600 Number of 800 $42 per
setup hours setup hr
Support $14,400 Number of 4 $3,600
Products products per product
Run Machines $42,000 Number of 10,000 $4.20 per
machine hours machine hr
$156,000
 Activity Expenses Assigned
Blue Black Red Purple Total
Handle
Production $23,100 $21,450 $16,500 $4,950 $66,000
Runs
Set up 11,760 6,552 11,760 3,528 33,600
machines
Support 3,600 3,600 3,600 3,600 14,400
Products
Run 21,000 16,800 3,780 420 42,000
Machines
Total Costs
Assigned $ 59,460 $ 48,402 $ 35,640 $ 12,498 $ 156,000
 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
Classic 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
 Total ABC Profitability by Product
Blue Black Red Purple Total
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
40% 12,000 9,600 2,160 240 24,000
fringe on
DL
Support 59,460 48,402 35,640 12,498 156,000
Total Mfg. 176,460 142,002 57,240 14,988 390,690
Expenses
Gross $ 48,540 $ 37,998 $(15,390) $(10,038) $ 61,110
Margin
G.M. % 21.6% 21.1% -36.8% -202.8% 13.5%
 Using ABC to Improve Profitability (1 of 2)
 The ABC information provides managers
with numerous insights about how to
increase the profitability of Classic Pen:
 Increase either their sales volume or prices to
compensate for the large batch and product-
sustaining 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
 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
 Selecting Activity Cost Drivers (1 of 2)
 Activity cost drivers are the central innovation of activity-
based 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
 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
 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
 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
 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
 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 organization’s
existing information system
 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
 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
 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
 Cost of Unused Capacity (1 of 2)
 The cost of unused capacity remains someone’s or
some department’s 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.
 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
 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
 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
 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
 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
 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
 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
 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
Problems Implementing ABC (2 of
3)
 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
 Problems Implementing ABC (3 of 3)
 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

 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
 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
 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
 Unit Cost Estimate (2 of 3)
 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
 Unit Cost Estimate (3 of 3)
 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
 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 Classic Pen example
are:

Resource Activity Unit Time

Indirect Production Run 5 hours
Labor
Support Products 50 hours
 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
 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
 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
 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
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
 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
 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
 Implementation Issues (2 of 2)
 Delegating the project to consultants
 Consultants are usually not familiar enough with the business’s
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