Activity-Based

Costing
CHAPTER 5

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
Activity-Based Costing
 Activity-Based Costing (ABC) is a relatively recent development in
management accounting.
The Problem of Using Only Measures
of Production Volume to Allocate
Overhead
 Companies commonly use labor hours or machine hours as
allocation bases for assigning overhead to products. This
“Traditional Approach” assumes that all costs are proportional to
production volume. In reality this is not true. For example, setup
costs are not proportional. A setup might work for a 400,000 unit
production run just as well as a 200,000 production run. As a result,
low-volume items are under costed and high-volume items are over
costed.
The ABC Approach

In the ABC Approach, companies identify the major activities that cause
overhead costs to be incurred. Some of these are related to
production volume, but others are not. The steps are as follows:
1. Identify activities.
2. Group costs of activities into cost pools.
3. Identify measures of activities (the cost drivers)
4. Relate costs to products using the cost drivers.
Major Activities

Following are examples of major activities under ABC:

1. Processing purchase orders.
2. Handling materials and parts.
3. Inspecting incoming material and parts.
4. Setting up equipment.
5. Producing goods using manufacturing equipment.
6. Supervising assembly workers.
7. Inspecting finished goods.
8. Packing customer orders.
Associated Costs

 Costs associated with the preceding major activities have to do with

salaries and wages, depreciation on equipment and the like.
Cost Drivers

Following are examples of cost drivers under ABC:

1. Number of purchase orders processed.
2. Number of material requisitions.
3. Number of receipts.
4. Number of setups.
5. Number of machine hours.
6. Number of assembly labor hours.
7. Number of inspections.
8. Number of boxes shipped.
Pros and Cons of ABC

Benefits: First, ABC is less likely than traditional costing to under cost
or over cost products. Second, ABC may lead to improvements in cost
control.

Limitations: It’s expensive relative to a traditional system!

Activity-Based Management

Activity-Based Management (ABM) is a management tool with the goal

of improving efficiency and effectiveness. It is similar to ABC, except
that where ABC focuses on cost measurement, ABM focuses on the
activities themselves.
Activity-Based Management (ABM)

Evaluates the . . . To identify

costs and values opportunities
of process to improve
activities . . . efficiency.

Activity- Value- • Process improvements

Based + Added = • Improve customer
Costing Analysis value
• Reduce costs
ABC vs. ABM
ABC ABM adds:
 An improved under-  Identifies value-
standing of the way added and non-value-
resources are used added activities.
in the current
 Identifies the customer-

?
processes.
perceived value of each
 Measures product activity.
costs more
accurately by  Identifies opportunities to
analyzing costs enhance value-added
associated with activities and reduce or
identified activities eliminate non-value-
in the processes. added
activities
The Importance Of Customer-
Perceived Value
Activities

Create outcomes
and consume resources

VALUE-ADDED ACTIVITIES
NON-VALUE-ADDED
enhance the value of products
ACTIVITIES
and services in the eyes of
do not contribute to customer
the customer while meeting
perceived value.
the goals of the organization.
Eliminating Non-Value-Added
Activities
Why do organizations have incentives
to eliminate non-value added activities?

Competitors are The organization can

constantly striving apply the freed-up
to create more resources to value-
value for customers added activities or
at lower cost. distribute them to the
owners and
employees of the
Competition can organization.
appear quickly.
Likely Sources of Non-Value-Added
Activities
Producing defective products

Producing to
build up Time and effort
inventory to move products
from place to place

Waiting time Transporting

for processing workers to
work sites
Identifying Value-Added Activities

The test for value

added activities

Would an external Would the organization

customer encourage be more likely to
the organization to do reach its goal by
more of the activity? performing that activity?

If the answer
If the answer is
is “yes” to
YES
NO “no”, it is non- YES
NO
both it is
value-added.
value-added.
Tasks Required by Activity-Based
Management
Twin objectives
of
ABM

Identify non-value-added
Identify value-added
activities to be eliminated
activities to be enhanced.
or reduced.
Redesign processes to eliminate wasteful spending on
non-value-added activities.