MA - CH 6 - Activity Based Management

Chapter 6
Activity-Based Management
Strategic Advantage of ABC
Strengths and Weaknesses of ABC
Activity Reduction, Activity Elimination,
Activity Selection, and Activity Sharing
1-1
Cost distortion is absent even though a
complex cost structure is present in Vanilla
Company, because the product line is not
diverse. This illustrates the specific meaning
of a diverse product line in ABC.
2
Regardless of products’ very different uses,
sizes, prices, and costs, as long as all
products consume the same mix of costs,
the product line is not diverse in the sense
the term is used in ABC. Without a diverse
product line, cost distortion cannot occur.
3
• It is important to understand that the preceding discussion is
realistic concerning sales prices. Many high-volume products
tend to become standardized, commodity-type items. These
products often face intense price competition that drives
market prices down to a level at which efficient producers
earn just enough profit to stay in the business.
• Low-volume products, in contrast, are often customized,

specialty items that face little or no price competition because
they are close to being one-of-a-kind products.
4
As indicated in the preceding quotation, ABC
produces more credible product cost information
but is nonetheless a system of allocation.
Particularly for plant-level costs, ABC has little or
no advantage over traditional costing. All product
costing systems arbitrarily allocate plant-level
costs to products. Further, in a year of low volume
both ABC and traditional costing report high unit
costs.
5
6
Benefits and Limitations of ABC Systems
Benefits Limitations
 Better profitability measures  Some costs may require
due to more accurate costs allocations to departments
 Identification of value-added and products based on
vs. non-value-added activities arbitrary volume measures
and associated costs  Some costs that can be
 Information for process identified with specific
improvement products are omitted
 Improved cost estimation  Expensive and time-
 Helps identify and control the consuming to develop and
cost of unused capacity implement
 Possible managerial
resistance to ABC results
Traditional, Volume-Based Product-Costing
System
• Aerotech produces three complex printed circuit

boards referred to as Mode I, Mode II, and Mode
III.
• The following information is obtained from
company records:
Mode I Mode II Mode III

Production:
Units 10,000 20,000 4,000
Runs 1 run of 10,000 4 runs of 10 runs of
units 5,000 units 400 units
5-7
System

Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00
Additional information includes:

Direct labor (hr/board) 3 4 2
Setup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2
Manufacturing overhead is determined as follows

5-8
System
Units produced 10,000 20,000 4,000
Direct labor (hr/unit) 3 4 2
Total hours 30,000 80,000 8,000
Total hours required 118,000
Budgeted manufacturing overhead $3,894,000

= $33 per hour
Budgeted direct-labor hours 118,000

Direct labor (hr/unit) 3 4 2
Overhead rate per hour $ 33 $ 33 $ 33
Overhead per unit $ 99 $ 132 $ 66
5-9
System
With these product costs, Aerotech established
target selling prices (Cost × 125%).
Direct labor 60.00 80.00 40.00
Manufacturing overhead 99.00 132.00 66.00
Total $ 209.00 $ 302.00 $ 126.00

Cost per unit $ 209.00 $ 302.00 $ 126.00
Target selling price 261.25 377.50 157.50
209.00 x 1.25
5-10
Activity Based Costing System (ABC)
ABC systems follow a two-stage procedure to assign

overhead costs to products.
Stage One
Identify significant activities and assign overhead costs
to each activity in proportion to resources used.
Stage Two
Identify cost drivers appropriate to each activity and
allocate overhead to the products.
5-11
Overhead Costs
Total budgeted cost = $3,894,000 Identification
Activity
of Activity
must be
done on Activity Cost Pools
each unit Cost
produced. Pools
Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level
Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400
Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
produced. 5-12
Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,212,600 $3,000 $700,000 $507,400
Receiving/Inspection
cost pool $200,000
Material-Handling
cost pool $600,000
Quality-Assurance
cost pool $421,000
Packaging/Shipping
cost pool $250,000
5-13
STAGE ONE
Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity
Computer Support Calibration
Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,212,600
5-14
STAGE TWO
Calculate Budgeted Machinery Costs = $1,212,600
the pool Budgeted Machine Hours 43,000
rate = $28.20/hour
Mode I: Mode II:

$28.20 per hr. $28.20 per hr.
1 hr. per unit 1.25 hr. per unit
Cost $28.20 per unit $35.25 per unit
Assignment
Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit
5-15
STAGE ONE
Total budgeted setup cost
Calculation of $20 per hour
total setup cost 10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total
Activity
cost Setup Cost Pool
pool Total budgeted cost = $3,000
5-16
STAGE TWO
Calculate Budgeted Setup Costs = $3,000
the pool Planned Production Runs 15 runs
rate = $200 per run
Mode I: (1 Run) Mode II: (4 Runs)

$200 per run $200 per run
10,000 units per run 5,000 units per run
Cost = $.02 per unit = $.04 per unit
Assignment
Mode III: (10 Runs)
$200 per run
400 units per run
= $.50 per unit
5-17
STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation
Activity
cost Engineering Cost Pool
5-18
STAGE TWO
Allocate based Engineering Cost Pool
on engineering
Total budgeted cost = $700,000
transactions
Mode I: Mode II:

25% × $700,000 45% × $700,000
10,000 units 20,000 units
Cost = $17.50 per unit = $15.75 per unit
Assignment
Mode III:
30% × $700,000
4,000 units
= $52.50 per unit
5-19
STAGE ONE
Various overhead Plant depr. Property taxes
costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security
Activity
cost Facility Cost Pool
5-20
STAGE TWO
Calculate Budgeted Facilities Cost = $507,400
the pool Budgeted Direct-Labor Hours 118,000
rate = $4.30/hour
Mode I: Mode II:

$4.30 per hr. $4.30 per hr.
× 3 hr. per unit × 4 hr. per unit
Cost $12.90 per unit $17.20 per unit
Assignment
Mode III:
$4.30 per hr.
× 2 hr. per unit
$8.60 per unit
5-21
Other Overhead Costs
Receiving and Inspection Cost Pool
Board Overhead × % ÷ Units = Cost/Unit
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00
Material-Handling Cost Pool

Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50
Quality-Assurance Cost Pool

Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10
Packaging and Shipping Cost Pool

Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25
5-22
Other Overhead Costs
Receiving and Inspection Cost Pool
Mode I $ 200,000 × 6% ÷ 10,000 = $ 1.20
Mode II 200,000 × 24% ÷ 20,000 = 2.40
Mode III 200,000 × 70% ÷ 4,000 = 35.00
Material-Handling Cost Pool

$14.82 Mode I $ 600,000 × 7% ÷ 10,000 = $ 4.20
Mode II 600,000 × 30% ÷ 20,000 = 9.00
Mode III 600,000 × 63% ÷ 4,000 = 94.50
Quality-Assurance Cost Pool

Mode I $ 421,000 × 20% ÷ 10,000 = $ 8.42
Mode II 421,000 × 40% ÷ 20,000 = 8.42
Mode III 421,000 × 40% ÷ 4,000 = 42.10
Packaging and Shipping Cost Pool

Mode I $ 250,000 × 4% ÷ 10,000 = $ 1.00
Mode II 250,000 × 30% ÷ 20,000 = 3.75
Mode III 250,000 × 66% ÷ 4,000 = 41.25
5-23
Product Cost from ABC
These are the new product costs when Aerotech

uses ABC.
Direct labor 60.00 80.00 40.00
Machinery 28.20 35.25 56.40
Setup 0.02 0.04 0.50
Engineering 17.50 15.75 52.50
Facilities 12.90 17.20 8.60
Other 14.82 23.57 212.85
Total $ 183.44 $ 261.81 $ 390.85
5-24
Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 125%).

Traditional costing $ 209.00 $ 302.00 $ 126.00
ABC costing 183.44 261.81 390.85
Original target selling price 261.25 377.50 157.50

ABC target selling price 229.30 327.26 488.56
The selling price of Mode I and II are decreased,

while the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]
5-25
Distorted Product Costs
Can you identify any problems Aerotech is likely
to face as a result of this distortion?

Traditional costing $ 209.00 $ 302.00 $ 126.00
ABC costing 183.44 261.81 390.85
Cost distortion per unit 25.56 40.19 (264.85)
Units produced 10,000 20,000 4,000
Total cost distortion 255,600 803,800 (1,059,400)
Traditional costing understates the cost

of complex, low volume products.
5-26
Two Key Points
A large proportion of non- Product diversity

unit-level activities
When the consumption
A unit-level cost driver, ratios differ widely
such as direct labor, between activities, no
machine hours, or
single cost driver will
throughput, will not be
able to assign the costs accurately assign the
of non-unit-level activities resulting overhead
accurately. costs.
5-27
Cost Drivers
A characteristic of an event or activity that results

in the incurrence of costs. In selecting a cost
driver, we must consider . . .
Degree of Behavioral
Correlation Effects
Cost of
Measurement
5-28
COLLECTING ABC DATA
INTERVIEWS AND PAPER TRAILS - The information

for ABC systems initially comes from interviews with
employees in the support departments and a review of each
department’s records.
STORYBOARDING - A procedure used to develop a

detailed process flow chart, which visually represents activities
and the relationships among activities.
MULTIDISCIPLINARY ABC PROJECT TEAMS – To

gather information from all facets of an organization’s
operations, it is essential to involve personnel from a variety of
functional areas. A typical ABC project team includes
ACCOUNTING, FINANCE, PRODUCTION, OPERATIONS,
ENGINEERS, MARKETING, etc.
5-29
The use of
ABC costing
information
to help
management
make decisions
5-30
• A method of management decision-making that uses
A B C information to improve customer satisfaction
and profitability.
• Activity-based management (ABM) is the use of
information obtained from ABC to make
improvements in a firm. Beyond the improved
decisions discussed in the preceding section, ABC
information can help management position the firm
to take better advantage of its strengths.
• We define ABM broadly to include decisions about
pricing and product mix, cost reduction, process
improvement and product and process design. 31
ABC and Service/Merchandising Firms
AB C implementation is widespread in a variety of

applications outside manufacturing:
• Health Care
• Banking
• Telecommunications
• Retailing
• Transportation
Copyright © 2021 Pearson Education Ltd.

Activity-based costing establishes relationships

between overhead costs and activities so that
we can better allocate overhead costs.
Activity-based management focuses
on managing activities to reduce costs.
5-33
Two-Dimensional ABC and Activity-Based
Management
Activities
5-34
Management
Cost Assignment View
Resource costs
Activities
Cost Objects
5-35
Management
Cost Assignment View
Resource costs
Process View
Activity Analysis Activity Evaluation
Root Activity Performance

Causes Triggers Activities Measures
Cost Objects
5-36
How Costs are Treated Under
Activity–Based Costing
ABC differs from traditional cost accounting in three ways.

Level of complexity
Activity–Based
Costing
Departmental
Overhead
Rates
Plantwide
Overhead
Rate
Number of cost pools

 ABC uses more cost pools.
37
ABM manages activities to improve the value of
products or services to customers and increase the
firm’s competitiveness and profitability:
– ABC is its major source of information as it focuses on the

efficiency and effectiveness of key business processes
and activities
– Improves management’s focus on the firm’s critical
success factors thereby enhancing the firm’s competitive
advantage
– ABM applications can be classified into two categories:
• Operational ABM enhances operational efficiency and asset
utilization and lowers costs; its focuses on doing things right
and performing activities more efficiently
• Strategic ABM attempts to alter the demand for activities and

increase profitability through improved activity efficiency
In general, there are four ways in which activities
can be managed to achieve improvements in a
process:
1.Activity reduction: reducing the time or effort

required to perform the activity.
2.Activity elimination: eliminating the activity entirely.
40
Elimination of Non-Value-Added Costs
Activities
Non-value-
added
activities
Unnecessary Necessary
Reduce or Continually Evaluate

Eliminate and Improve
5-41
3.Activity selection: selecting the low-cost
alternative from a set of design alternatives.
4.Activity sharing: making changes that

permit the sharing of activities with other
products to yield economies of scale.
42
Others are not necessary; these are called non-
value-added activities, or simply waste. One
goal of TQM is to eliminate non-value-added
activities and reduce those that cannot be
eliminated. Activity cost information can make
important contributions to a TQM effort,
because ABC can reveal which non-value-added
activities have high costs.
43
Once management starts thinking in terms
of avoiding non-value-added activity, the
nature of setups becomes clearer: it is
another non-value-added activity.
Customers do not want the product more,
nor are they willing to pay more for it,
because of the huge amount of resources
expended in setting up.
44
• Purposes:
• Focus on which activities create more or larger
economic value-added (EVA) (找出EVA是由哪項作
業創造出來的)
• Identify and measure which activities or procedures
can increase EVA (分辨並衡量哪一項作業或程序可
增加EVA)
45
• Benefits:
• 可以將共用成本與資源追溯到各作業或EVA 中心
• 營業管理者瞭解如何協助創造EVA
• 設立優先順序且計算EVA效益，以投資於新科技和持
續改善的開創行動上。
• 因為已設立各業務(或服務)單位的EVA，移轉價格即
有了經濟基礎。
• 可分辨出最適當的EVA 中心(including by product
categories, customer, business units, and business
processes)。結合EVA動因於利益分享計劃中。
46
ABC/M Tools
Some key ABC/M tools:

– In activity analysis an organization assesses each of its
activities based on its need by the product or the
customer, its efficiency, and its value content
• A firm performs activities for one of the following three
reasons:
– It is required to meet product specifications or to satisfy
the customer
– It is required to sustain the organization, or
– It is deemed beneficial to the firm
– Value-added analyses are performed in an effort to
eliminate activities that add little or no value to the
customer; resource consumption can be reduced and the
firm can focus on activities that increase customer
satisfaction
ABC/M Tools (continued)
High-value-added activities:
– Increase significantly the value of the product or

service; removal would reduce the value of the
product or service
• High-value-added activities are those that: are necessary to

meet customer requirements/needs, enhance purchased
materials or components, contribute to customer
satisfaction, and are critical steps in a business process
ABC/M Tools (continued)
Low-value-added activities:
– Consume time, resources, or space and add little in

satisfying customer needs
• Low-value-added activities are those that: can be

eliminated without affecting the form/fit/function of the
product or service, begin with the prefix “re” (i.e., are
duplicate services), and are performed to monitor quality
problems
Using ABM to Eliminate Non-Value-Added
Activities and Costs
1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes,

and Triggers.
Inspect Rework
Specify Select Receive Produce
finished defective
parts vendor parts goods
goods products
4. Establish Performance Measures.
5. Report Non-Value-Added Costs.

5-50
Using ABM to Eliminate Non-Value-Added
Activities and Costs
Process time
Inspection time Storage time
Move time Waiting time
5-51
Customer Profitability Analysis
Customer profitability analysis uses

activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.
5-52
ABC/M can be used to estimate customer-related costs
and in therefore in assessing the profitability of a
specific customer or group of customers
– Customer profitability analysis identifies customer service

activities and cost drivers and determines profitability for each
customer or group; this process allows the firm to chose its
customer mix, an appropriate offering of after-sale services,
what discounts to offer, etc.
– Customer cost analysis is the first step in a customer

profitability analysis; it identifies activities and cost drivers to
service customers before and after sales
Required
special
packaging
Orders Demand
small fast
quantities service
Often
Orders
changes
frequently
orders
A costly customer
5-54
Cost Drive
Customer-Related Activities Cost Driver Base Rate
Order processing Purchase orders $ 150
Sales contacts (phone calls, faxes, etc.) Contacts 100
Sales visits Visits 1,000
Shipment processing Shipments 200
Billing and collection Invoices 160
Design/engineering change orders Design changes 4,000
Special packaging Units packaged 40
Special handling Units handled 60
A company may use these customer

related costs to help determine the
profitability of each customer.
5-55
Customer Profitability
Cumulative Operating Income as a % of Total
125.0%
100.0%
Operating Income
75% of actual operating income

75.0%

50.0%

25.0%
0.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
5-56
Exercise
ABC, wholesale, customer profitability. Ramirez

Wholesalers operates at capacity and sells furniture
items to four department-store chains (customers).
Mr. Ramirez commented, “We apply ABC to deter-
mine product-line profitability. The same ideas apply
to customer profitability, and we should find out our
customer profitability as well.” Ramirez Wholesalers
sends catalogs to corporate purchasing departments
on a monthly basis. The customers are entitled to
return unsold merchandise within a six-month period
from the purchase date and receive a full purchase
price refund. The following data were collected from
last year’s operations:
Exercise
Chain
1 2 3 4
Gross sales $50,000 $30,000 $100,000 $70,000
Sales returns:
Number of 100 26 60 40
items
Amount $10,000 $ 5,000 $ 7,000 $ 6,000
Number of
orders:
Regular 40 150 50 70
Rush 10 50 10 30
Ramirez has calculated the following activity rates:

Activity Cost-Driver Rate
Regular order processing $20 per regular order
Rush order processing $100 per rush order
Returned items processing $10 per item
Catalogs and customer $1,000 per customer
support
Exercise
1. Customers pay the transportation costs. The cost

of goods sold averages 80% of sales. Determine
the contribution to profit from each chain last year.
2. Comment on your solution.
Solution: Chain
1 2 3 4
(1) Gross sales $50,000 $30,000 $100,000 $70,000
Sales returns 10,000 5,000 7,000 6,000
Net sales 40,000 25,000 93,000 64,000
Cost of goods sold (80%) 32,000 20,000 74,400 51,200
Gross margin 8,000 5,000 18,600 12,800

Customer-related costs:
Regular orders
$20 × 40; 150; 50; 70 800 3,000 1,000 1,400
Rush orders
$100 × 10; 50; 10; 30 1,000 5,000 1,000 3,000
Returned items
$10 × 100; 26; 60; 40 1,000 260 600 400
Catalogs and customer 1,000 1,000 1,000 1,000
support
Customer related costs 3,800 9,260 3,600 5,800
Contribution (loss) $4,200 $(4,260) $15,000 $7,000
margin
Contribution (loss) 8.4% (14.2%) 15.0% 10.0%
margin as percentage of
gross sales
Exercise
Solution:
(2) The analysis indicates that customers’ profitability (loss)
contribution varies widely from (14.2%) to 15.0%.
Immediate attention to Chain 2 is required which is
currently showing a loss contribution. The chain has a
disproportionate number of both regular orders and
rush orders. Ramirez should work with the
management of Chain 2 to find ways to reduce the
number of orders while maintaining or increasing the
sales volume. If this is not possible, Ramirez should
consider dropping Chain 2 if it can save the customer-
related costs.
Chain 1 has a disproportionate number of the items
returned as well as sale returns. The causes of these
should be investigated so that the profitability
contribution of Chain 1 could be improved.
Within a single facility, ABC information can
show the inefficiency of producing special-
order, customized products on equipment
designed for long production runs. Managers
may have known all along that it is not very
efficient to produce a batch of two units in a
plant designed for large batches. However,
ABC can show just how expensive it is, and
the result is often surprising.
62
Once ABC shows the cost of setups, TQM
seeks ways to reduce it. At best, a flexible
manufacturing system (FMS) eliminates
the setup problem, the need to find
optimal batch sizes, and the batch-level
costs of setting up.
63
(1)Behavioral Changes
The design of products is a third area in

which activity cost information can be used.
Traditional costing shows product costs as
the sum of direct material, direct labor, and
applied overhead based on labor or some
other volume measure.
64
If designers know the product
must be sold for a certain
price to be competitive, they
will make design decisions
that reduce reported unit cost
below that price.
65
Another problem with design decisions
is that traditional costing systems do not
capture the cost of ordering, receiving,
and inspecting complex components or
subassemblies. These costs can be
substantial.
66
Activity cost information, in
contrast, can show the cost
of each significant activity,
including ordering,
receiving, and inspecting
purchased components.
67
In short, ABC provides information that can
elicit the desired behavior because it permits
designers to make cost-based design
decisions logically. The best a traditional
system can do is accurately capture the costs
of unit-level activities, but it then distorts them
by allocating batch- and product-level costs
using the same unit-level allocation bases.
68
(2)Cost Control
A final area in which activity-based

information is useful to management is in
controlling costs. Activity cost reporting
provides an alternative to traditional
responsibility reporting and can help reduce
dysfunctional behavior.
69

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MA - CH 6 - Activity Based Management

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Chapter 6

• Low-volume products, in contrast, are often customized,

Benefits and Limitations of ABC Systems

• Aerotech produces three complex printed circuit

Mode I Mode II Mode III

Mode I Mode II Mode III

Additional information includes:

Manufacturing overhead is determined as follows

Total hours required 118,000

Budgeted manufacturing overhead $3,894,000

Mode I Mode II Mode III

Mode I Mode II Mode III

ABC systems follow a two-stage procedure to assign

Machinery Setup Engineering Facility

Activity Activities needed to support Activity required in order

Computer Support Calibration

Mode I: Mode II:

Mode I: (1 Run) Mode II: (4 Runs)

Mode I: Mode II:

Mode I: Mode II:

Material-Handling Cost Pool

Quality-Assurance Cost Pool

Packaging and Shipping Cost Pool

Material-Handling Cost Pool

Quality-Assurance Cost Pool

Packaging and Shipping Cost Pool

These are the new product costs when Aerotech

Mode I Mode II Mode III

Original target selling price 261.25 377.50 157.50

The selling price of Mode I and II are decreased,

Mode I Mode II Mode III

Traditional costing understates the cost

A large proportion of non- Product diversity

A characteristic of an event or activity that results

INTERVIEWS AND PAPER TRAILS - The information

STORYBOARDING - A procedure used to develop a

MULTIDISCIPLINARY ABC PROJECT TEAMS – To

AB C implementation is widespread in a variety of

Copyright © 2021 Pearson Education Ltd.

Activity-based costing establishes relationships

Cost Assignment View

Cost Assignment View

Root Activity Performance

ABC differs from traditional cost accounting in three ways.

Number of cost pools

– ABC is its major source of information as it focuses on the

• Strategic ABM attempts to alter the demand for activities and

1.Activity reduction: reducing the time or effort

Reduce or Continually Evaluate

4.Activity sharing: making changes that

Some key ABC/M tools:

– Increase significantly the value of the product or

• High-value-added activities are those that: are necessary to

– Consume time, resources, or space and add little in

• Low-value-added activities are those that: can be

2. Identify Non-Value-Added Activities.

3. Understand Activity Linkages, Root Causes,

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

Inspection time Storage time

Move time Waiting time

Customer profitability analysis uses

– Customer profitability analysis identifies customer service