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

Processimprovements
improvements
Activity- Value-
Based
Based + Added
Added = ••Improve
Improvecustomer
customervalue
value
Costing
Costing Analysis
Analysis ••Reduce
Reducecosts
costs
ABC vs. ABM
ABC ABM adds:

 An
An improved
improvedunder-
under- 
 Identifies
Identifiesvalue-
value-
standing
standingofof the
the way
way added
resources addedandand non-value-
non-value-
resourcesareareused
used added
addedactivities.

?
in activities.
in the
thecurrent
current
processes.
processes. 
 Identifies
Identifiesthe
the customer-
customer-
 perceived
perceivedvalue
valueof
of each
each
 Measures
Measuresproduct
product activity.
costs
costsmore
more activity.
accurately
accurately byby 
 Identifies
Identifiesopportunities
opportunities toto
analyzing
analyzing costs
costs enhance
associated enhance value-added
value-added
associatedwith
with activities
activities and
andreduce
reduce or
or
identified
identified activities
activities eliminate
in eliminatenon-value-added
non-value-added
in the
theprocesses.
processes. activities
activities
The Importance Of Customer-Perceived Value

Activities
Activities

Create
Createoutcomes
outcomes
and
andconsume
consumeresources
resources

VALUE-ADDED
VALUE-ADDEDACTIVITIES
ACTIVITIES NON-VALUE-ADDED
NON-VALUE-ADDED
enhance
enhancethethevalue
valueofofproducts
products ACTIVITIES
ACTIVITIES
and
andservices
servicesin
inthe
theeyes
eyesof
of do
donot
notcontribute
contributeto
tocustomer
customer
the
thecustomer
customerwhile
whilemeeting
meeting perceived
perceivedvalue.
value.
the
thegoals
goalsof
ofthe
theorganization.
organization.
Eliminating Non-Value-Added Activities

Why
Whydo doorganizations
organizationshave
haveincentives
incentives
to
to eliminate
eliminate non-value
non-valueadded
addedactivities?
activities?

Competitors
Competitorsareare The
Theorganization
organizationcan can
constantly
constantlystriving
striving apply
applythe
thefreed-up
freed-up
to
tocreate
createmore
morevalue
value resources
resourcesto tovalue-
value-
for
forcustomers
customersatat added
addedactivities
activitiesoror
lower
lowercost.
cost. distribute
distributethem
themto tothe
the
owners
ownersandand
employees
employeesof ofthe
the
Competition
Competitioncan
can organization.
organization.
appear
appearquickly.
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
The test
test for
for value
value
added
addedactivities
activities

Would
Wouldan
anexternal
external Would
Wouldthe
theorganization
organization
customer
customerencourage
encourage be
bemore
morelikely
likelyto
to
the
theorganization
organizationtotodo
do reach
reachits
itsgoal
goalbyby
more
moreof
ofthe
theactivity?
activity? performing
performingthat
thatactivity?
activity?

If the answer
IfIfIf
thethe
the
answer
answer
answer is
is
is “yes”
is “yes” to
to
YES
NO
YES
NO “no”,
“no”, itit is
is non-
non- YES
NO
YES
NO
both
both ititis
is
value-added.
value-added.
value-added.
value-added.
Tasks Required by Activity-Based Management

Twin
Twinobjectives
objectives
ofof
ABM
ABM

Identify
Identifynon-value-added
non-value-added Identify
Identifyvalue-added
value-added
activities
activitiestotobe
beeliminated
eliminatedoror activities
activitiestotobe
beenhanced.
enhanced.
reduced.
reduced.
Redesign
Redesignprocesses
processestotoeliminate
eliminatewasteful
wastefulspending
spendingon
on
non-value-added
non-value-addedactivities.
activities.