Activity-Based Management

and Activity-Based Costing

Cost Accounting:
Foundations and Evolutions, 8e
Kinney ● Raiborn

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Learning Objectives
 In an activity-based management system, what are
value-added and non-value-added activities?
 How do value-added and non-value-added activities affect
manufacturing cycle efficiency?
 Why is it important to analyze the drivers of costs?
 How are product costs computed using an activity-based
costing system?
 Under what conditions is activity-based costing useful in
an organization and what information do activity-based
costing systems provide to management?
 What criticisms have been directed at activity-based
costing?

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Activity-Based Management
 Focuses on activities during
production and performance process
 An activity is a repetitive action
performed in fulfillment of a business
function
 Improves the value received by
customers
 Enhances profitability

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 Activity-Based Management
 Activity analysis  Operational control
 Cost driver analysis  Quality management
 Activity-based  Business process
costing improvement
 Performance
 Continuous measurement
improvement

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Benefits of Activity-Based
Management
 External benefits  Internal benefits
 Increased customer  More efficient
value production
 Enhanced profitability  More accurate cost
determination
 More effective
performance
evaluation

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Activity Analysis
Value-added activity Non-value-added activity
 Increases worth of  Increases time spent on
product or service to a product or service but does
customer not increase worth
 Customer is willing to pay  Unnecessary from customer
for it perspective
 Can be reduced, redesigned
or eliminated without
affecting market value or
quality
 Business-value-added
activities are essential

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 Process
 A process is a series of activities that,
when performed together, satisfy a
specific objective
 Production

 Distribution

 Selling

 Administration

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Activity Analysis
 Create a Process Map (detailed flowchart) for
each process
 Identify each step
 Create Value Chart
 Identify stages and time spent in stages from
beginning to end of process

Value-Added Non-Value-Added
Processing Time Inspection Time
Service Time Transfer Time
Idle Time

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Cycle Time

 Eliminate or minimize activities that add the

most time and cost and the least value

Cycle Value- Non-

Time = Added + Value-Added
Time Time

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Manufacturing Cycle Efficiency
Manufacturing Value-Added
Cycle Efficiency = Processing Time
(MCE) Total Cycle Time

 100% efficiency unrealistic

 Reducing non-value-added activities will
increase MCE
 Value-added activity usually represents about
10% of total cycle time
 Just-in-time (JIT) increases MCE
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Non-Value-Added Activities

 Attributed to following factors

 Systemic

 Physical

 Human

 Eliminating or reducing non-value-added

activities that create the most costs will
 Increase product/service quality
 Decrease cycle time and cost
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Cost Driver Analysis

 Cost drivers are factors that have a

direct cause–effect relationship to a cost
 Limit the number of cost drivers
 Cost of measurement should not exceed
benefit of using the cost driver
 Easy to understand
 Directly related to the activity being
performed
 Appropriate for measurement
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A Management Tool

 Combine:
 Activity analysis
 What activities are non-value-added?

 Cost driver analysis

 What causes costs to be incurred?

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Cost Drivers

 Unit-level costs
 direct material, direct labor
 Batch-level costs
 setup, inspection
 Product/process-level costs
 engineering changes, product development
 Organizational or facility costs
 building depreciation, plant manager’s salary

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Product Cost Behavior

 Unit-level costs are variable in relation

to change in production volume
 Batch, product/process, and
organizational level costs are variable
for reasons other than changes in
production volume

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 Product Cost
Unit-Level Allocate over number
Cost per unit
Costs of units produced

Batch-Level Allocate over number Cost per unit

Costs of units in batch in batch

Allocate over number

Product/Process- Cost per unit
Level Costs of units produced in
related product line in product line

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 Product and Company
Unit
Profitability Batch
Product
Total product revenue
<Total product cost>
Net product margin
+/– All other net product margins
Total margin provided by products
<Organizational/facility-level costs>
Company profit or loss

Not
GAAP
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Activity-Based Costing
 Recognizes several levels of costs
 Accumulates costs into related cost
pools
 Uses multiple cost drivers to assign
costs to products and services

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 When to Use ABC
 Companies use ABC when:
 They have a wide variety of products or services
 High overhead costs are not proportional to the unit
volume of individual products
 Automation makes it difficult to assign overhead to
products using direct labor or machine hours
 Profit margins are difficult to explain
 Hard-to-make products show big profits and easy-
to-make products show losses

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Two-Step Allocation
 Collect costs in general ledger and subsidiary accounts
 Identify activity centers
 Choosing an activity center
 Geographical proximity of equipment
 Centers of managerial responsibility
 Magnitude of product costs
 Choose a manageable number of activity centers
 Accumulate costs into activity center cost pools
 Identify cost drivers
 Costs in each cost pool are
 Driven by homogenous activities
 Strictly proportional to the activity
 Allocate costs to products and services
 Activity driver measures demands placed on activities, thus, the
resources consumed by products/services
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Activity Drivers
 Reports requested  Repair hours
 Job change actions  Material requisitions
 Hiring actions  Purchase requisitions
 Training hours  Space occupied
 Transactions processed  Set-ups
 Engineering changes  Moves
 Defects discovered  Employees

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Activity-Based Costing

Record Activity
Costs in GL Driver

Accumulate in
Activity Center
Cost Cost Pools
Driver
Cost
Objects

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Traditional vs. ABC Costing

 When ABC is implemented

 Cost is reduced for high-volume,

standard products
 Cost is increased for low-volume,

complex specialty products

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Long-Term Variable Costs

 Cost drivers
 Product variety—number of different

types of products
 Product complexity—number of

processes through which a product

flows

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ABC Costing Considerations

 Number and diversity of products/services

produced
 Diversity and differential degree of support
services used for different products
 Extent to which common processes are used
 Effectiveness of current cost allocation
methods
 Rate of growth of period costs

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Use ABC Costing for…
1. Product Variety and Process
Complexity
2. Lack of Commonality in Overhead
Costs
3. Problems with Current Cost
Allocations
4. Changes in Business Environment

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Continuous Improvement
 Eliminates non-value-added activities to reduce
cycle time
 Makes products/performs services with zero
defects
 Reduces product costs on an ongoing basis
 Simplifies products and processes

ABC Costing Supports

Continuous Improvement

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Criticisms of ABC

 Significant amount of time and cost

to implement
 Must overcome barriers to change
 Does not conform to GAAP

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Advantages of ABC and ABM

 Identify and monitor  Understand the impact of

significant technology costs new technologies on all
 Trace technology costs elements of performance
directly to products  Translate company goals
 Increase market share into activity goals
 Identify the cost drivers that  Analyze the performance of
create or influence cost activities across business
 Identify activities that do not functions
contribute to perceived  Analyze performance
customer value problems
 Promote standards of
excellence

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© 2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in
a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
 Questions
 What are the differences between activity-
based costing and traditional cost
accounting?
 What are cost drivers and activity drivers?
 What are two advantages and two criticisms
of activity-based costing?

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 Potential Ethical Issues
 Ignoring non-value-added activities
 Using non-value label to eliminate jobs
 Misclassifying activities to allocate costs away from
lower volume products to justify lower selling prices
 Selecting an inappropriate cost driver to distort cost
calculations
 Using ABC to eliminate a vendor or customer
 Using ABC to eliminate funding of social or
environmental causes
 Using ABC to transfer cost from fixed price contracts
to cost-plus contracts

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