Activity-Based Costing and

Management
 Unit Cost is used for:

• Inventory valuation
• Income Determination
• Evaluating & continous improvement
• Decision making
 Traditional costing system &
Activity-based costing system
COSTING SYSTEM:
- TRADITIONAL COSTING SYSTEM/CONVENTIONAL COSTING
- ACTIVITY-BASED COSTING SYSTEM
Conventional cost accounting system:
focus on unit of particular product.
costs are allocated or traced to a product because
each unit of a product is assumed to consume
resources.
Conventional allocation bases measure only attribut
of unit:
• number of direct labor hours
• machine hours
• material cost
• Percentage of Direct material cost or direct labor cost
 ABC system:
 Focus on the activities performed to produce
products in the manufacturing process.
 Costs are traced from activities to products
based on each product’s consumption of the
activities.
 The allocation bases used in ABC are
measures of activities performed
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
1-6
 Traditional, Volume-Based Product-Costing
System
Mo d e I Mo d e I I Mo d e I I I
Direct mat erials $ 50.00 $ 90.00 $ 20.00
Direct lab o r 60.00 80.00 40.00
Man u f act u rin g o verh ead 99.00 132.00 66.00
To t al $ 209.00 $ 302.00 $ 126.00

Additional information:
Mode I Mode II Mode III
Direct materials $ 50.00 $ 90.00 $ 20.00
Direct labor (hr/board) 3 4 2
Setup time (hr/run) 10 10 10
Machine time (hr/board) 1 1.25 2
Traditional, Volume-Based Product-Costing
System
Mode I Mode II Mode III
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

Budgeted direct-labor hours 118,000 = $33 per hour
 Traditional, Volume-Based Product-Costing
System
With these product costs, Aerotech established target
selling prices (Cost × 125%).
Mode I Mode II Mode III
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

Mod e I Mod e I I Mo d e II I
Co st p er u nit $ 209.00 $ 302.00 $ 126.00
Targ et sellin g p rice 261.25 377.50 157.50

209.00 x 1.25
 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.
 Overhead Costs
Total budgeted cost = $3,894,000 Identification
Identification
Activity
must be
of
of Activity
Activity
done on Cost
Cost Pools
Pools
each unit Activity
produced. Cost
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. 1-11
 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
1-12
 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

1-13
 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
$28.20 per unit $35.25 per unit
Cost
Assignment
Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit 1-14
 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
1-15
 STAGE TWO
=
Calculate Budgeted Setup Costs $3,000
the pool Planned Production Runs 15 runs
rate = per run
$200

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 1-16
 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700,000

1-17
 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
= $17.50 per unit = $15.75 per unit
Cost
Assignment
Mode III:
30% × $700,000
4,000 units
= $52.50 per unit
1-18
 STAGE ONE
Various overhead Plant depr. Property taxes
costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507,400

1-19
 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 1-20
 Other Overhead Costs
Re c e ivin g an d In s pec t io n Cos t P o ol
Board Ove rh e ad × % ÷ Un its = Cos t/Un it
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

Mat e ria l-Ha n dlin g Co s t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
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

Qu alit y-As s u ran c e Cos t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/Un it
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

P ackagin g an d Sh ippin g Cos t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
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
1-21
 Other Overhead Costs
Re c e ivin g an d In s pec t io n Cos t P o ol
Board Ove rh e ad × % ÷ Un its = Cos t/Un it
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

Mat e ria l-Ha n dlin g Co s t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
$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

Qu alit y-As s u ran c e Cos t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/Un it
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

P ackagin g an d Sh ippin g Cos t P ool

Board Ove rh e ad × % ÷ Un its = Cos t/U n it
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
1-22
 Product Cost from ABC
These are the new product costs when Aerotech uses ABC.

Mode I Mode II Mode III

Direct materials $ 50.00 $ 90.00 $ 20.00
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

1-23
 Distorted Product Costs
Both original and ABC target selling prices are based on
(Cost × 125%).
Mode I Mode II Mode III
Tradition al cos tin g $ 209.00 $ 302.00 $ 126.00
ABC cos tin g 183.44 261.81 390.85

Origin al targe t s e llin g price 261.25 377.50 157.50

ABC targe t s e llin g price 229.30 327.26 488.56

The selling price of Mode I and II are reduced

and the selling price for Mode III is increased.
[$209.00 × 1.25] [$183.44 × 1.25]
1-24
 Distorted Product Costs
Can you identify any problems Aerotech is likely to face as
a result of this distortion?
Mode I Mode II Mode III
Tradition al cos tin g $ 209.00 $ 302.00 $ 126.00
ABC cos tin g 183.44 261.81 390.85
Cos t dis tortion pe r u n it 25.56 40.19 (264.85)
Un its produ ce d 10,000 20,000 4,000
Total cos t dis tortion 255,600 803,800 (1,059,400)

Traditional costing understates the cost

of complex, low volume products.
1-25
 Two Key Points

AA large
large proportion
proportion of of non-
non- Product
Product diversity
diversity
unit-level
unit-level activities
activities
AA unit-level When
When the
the consumption
consumption
unit-level cost
cost driver,
driver, such
such
as
as direct
direct labor,
labor, machine
machine ratios
ratios differ
differ widely
widely
hours,
hours, or
or throughput,
throughput, will
will not
not between
between activities,
activities, no
no
be
be able
able to
to assign
assign the
the costs
costs ofof single
single cost
cost driver
driver will
will
non-unit-level
non-unit-level activities
activities accurately
accurately assign
assign the
the
accurately.
accurately. resulting
resulting overhead
overhead costs.
costs.

1-26
 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

1-27
 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 organizations 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.

1-28
Activity-Based Management

The use of
ABC costing
information
to help
management
make decisions
1-29
Activity-Based Management
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.

1-30
Two-Dimensional ABC and Activity-Based
Management

Activities

1-31
 Two-Dimensional ABC and Activity-Based
Management
Cost Assignment View

Resource
Resource costs
costs
Process View
Activity Analysis Activity Evaluation

Root
Root Activity
Activity Performance
Performance
Causes
Causes Triggers
Triggers Activities Measures
Measures

Cost
Cost Objects
Objects
1-32
Elimination of Non-Value-Added Costs

Activities

Nonvalue-added
activities

Unnecessary Necessary

Reduce or Continually Evaluate

Eliminate and Improve
1-33
 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
Inspect Rework
Rework
Specify
Specify Select
Select Receive
Receive Produce
Produce finished
finished defective
defective
parts
parts vendor
vendor parts
parts goods
goods goods
goods products
products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

1-34
Using ABM to Eliminate Non-Value-Added
Activities and Costs

Process time

Inspection time Storage time

Move time Waiting time

1-35
Customer Profitability Analysis

Customer profitability analysis uses

activity-based costing to determine
the activities, costs, and profit associated
with serving particular customers.

1-36
Customer Profitability Analysis
Required
special
packaging.
Orders Demand
small fast
quantities. service.

Often
Orders
changes
frequently.
orders.

A costly customer
1-37
 Customer Profitability Analysis
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

AA company
company maymay use
use these
these customer
customer
related
related costs
costs to
to help
help determine
determine the
the
profitability
profitability of
of each
each customer.
customer.
1-38
Customer Profitability Analysis
Customer Profitability
Cumulative Operating Income as a % of Total

125.0%

100.0%
Operating Income

75% of actual operating income

75.0%

50% of actual operating income

50.0%

25% of actual operating income

25.0%

0.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

1-39
Activity-Based Management in the Service
Industry

Customer Activity
Profitability Analysis
Analysis

1-40
 Just-in-Time Inventory and Production
Management
No materials are purchased and no products are
manufactured until they are needed.

The
The primary
primary goal
goal of
of aa
JIT
JIT production
production system
system isis
to
to reduce
reduce or
or eliminate
eliminate
inventories
inventories at
at every
every
stage
stage of
of production.
production.

1-41
Key Features of the JIT Approach
Smooth, uniform production rate
Pull method of production
Purchase is small lot sizes
Quick, inexpensive setups
High quality materials
Effective preventive maintenance
Teamwork
Multiskilled workers
1-42
 JIT Purchasing
Long-term
Long-term
contracts
contracts with
with
suppliers.
suppliers.

Only
Only aa few
few Parts
Parts delivered
delivered
suppliers.
suppliers. in
in small
small lots.
lots.

Grouped
Grouped Minimal
Minimal
payments
payments to
to inspection
inspection of
of
vendor.
vendor. materials.
materials.
1-43
 Example
Example
Large Customer Ten Smaller Customers
(50% of sales) (50% of sales)

Units purchased 500,000 500,000

Orders placed 2 200
Number of sales calls 10 210
Manufacturing cost $3,000,000 $3,000,000
Order-filling costs
allocated $202,000 $202,000
Sales-force costs
allocated $110,000 $110,000
 0rder filling cost = 404.000/202 = 2000/0rder
Sales force cost = 220.000/220 =1.000/call

Order filling cost

Large customer = 2 X 2000 + 10x 1000 = 14.000

10 x2000 + 210 x 1000 = 230.000

 Large customer Small customer
Order filling cost 2 x 2000 = 4.000 2000x200 =400.000
Sal;es force cost 10 x 1000 = 10.000 210 x 1000 = 210.000
Total cost 14.000 610.000
 Example
Example

The purchasing manager uses two suppliers,

Murray Inc. and Plata Associates, as the source of
two machine parts: Part A1 and Part B2.

Activity Costs
Repairing products $800,000
Expending products 200,000
 Example
Example
Murray Inc. Plata Associates
Part A 1 Part B2 Part A 1 Part B2
Unit purchase price $20 $52 $24 $56
Units purchased 80,000 40,000 10,000 10,000
Failed units 1,600 380 10 10
Late shipments 60 40 0 0

Repair rate = $800,000 ÷ 2,000 = $400 per failed part

Expediting rate = $200,000 ÷ 100 = $2,000 per late
(1,600 + 380 + 10 + 10)
delivery
60 + 40
 Example
Example
Murray Inc. Plata Associates
Part A 1 Part B2 Part A 1 Part B2
Purchase cost $1,600,000 $2,080,000 $240,000 $560,000
Repairing products 640,000 152,000 4,000 4,000
Expediting products 120,000 80,000
Total costs $2,360,000 $2,312,000 $244,000 $564,000
Units ÷ 80,000 ÷ 40,000 ÷ 10,000 ÷ 10,000
Total unit cost $ 29.50 $ 57.80 $ 24.40 $ 56.40
 The Balanced Scorecard translates
an organization’s mission and
strategy into operational objectives
and performance measures for four
different perspectives:
 The financial perspective
 The customer perspective
The
Balanced  The internal business
Scorecard process perspective
 The learning and growth
perspective
Strategy, according to Robert Kaplan and
David Norton, is defined as
“. . . choosing the market and customer
segments the business unit intends to serve,
identifying the critical internal and business
processes that the unit must excel at to
deliver the value propositions to customers
in the targeted market segments, and
selecting the individual and organizational
capabilities required for the internal,
customer, and financial objectives.”
 Vision and Strategy

Financial Customer Process Infrastructure

Objectives

Measures
Strategy-
Translation
Process
Targets

Initiatives
Financial Increase Sales Increase Profits

Increase Market Increase Customer

Customer Share Satisfaction

Reduce Defective
Process Redesign Products Units

Infra- Testable
Testable Strategy
Strategy
Quality Training
structure Illustrated
Illustrated
 Summary of Objectives and Measures:
Financial Perspective
Objectives Measures

Revenue Growth:
Increase the number of new Percentage of revenue products
from new products
Create new applications Percentage of repeat
customers
Develop new customers and Percentage of revenue from
markets new sources
Adopt a new pricing strategy Product and customer
profitability
 Objectives Measures

Cost Reduction:
Reduce unit product cost Unit product cost

Reduce unit customer cost Unit customer cost

Reduce distribution channel cost Cost per distribution channel

Asset Utilization:
Improve asset utilization Return on investment
Economic value added
Summary of Objectives and Measures:
Customer Perspective
Objectives Measures
Core:
Increase market share
Increase customer retention
Increase customer acquisition
Increase customer satisfaction
Increase customer profitability
Market share (percentage of
market)
Percentage of repeat
customers
Number of new customers
Ratings from customer
surveys
Customer profitability
 Objectives Measures

Performance Value:
Decrease price Price
Decrease postpurchase costs Postpurchase costs
Improve product functionality Ratings from customer
surveys
Improve product quality Percentage of returns
Increase delivery reliability On-time delivery percentage
Aging schedule
Improve product image and Ratings from customer
reputation surveys
 Actual Conversion Cost per Unit
Standard costs per minute = $1,600,000/400,000
= $4 per minute
Actual cycle time = 60 minutes/10 units
= 6 minutes per unit
Actual conversion costs = $4 x 6
= $24 per unit
Theoretical Conversion Cost per Unit
Theoretical cycle time = 60 minutes/12 units
= 5 minutes per unit
Theoretical conversion
costs = $4 x 5
= $20 per unit
Summary of Objectives and Measures:
Process Perspective
Objectives Measures

Innovation:
Increase the number of new
products
Increase proprietary products
Decrease new product
development time
Number of new products vs.
planned
Percentage of revenue from
proprietary products
Time to market (from start
to finish)
 Objectives Measures

Operations:
Increase product quality Quality costs
Output yields
Percentage of defective units
Increase process efficiency Unit cost trends
Output/input(s)
Decrease process time Cycle time and velocity
MCE
Postsales Service:
Increase service quality First-pass yields
Increase service efficiency Cost trends
Output/input(s)
Decrease service time Cycle time
Summary of Objectives and Measures:
Learning and Growth Perspective
Objectives Measures

Increase employee capabilities Employee satisfaction ratings

Employee turnover
percentage
Employee productivity
(revenue/employee)
Hours of training
Strategic job coverage ratio
(percentage of critical job
requirements filled)
 Objectives Measures

Increase motivation and Suggestions per employee

alignment Suggestions implemented per
employee
Increase information systems Percentage of processes with
capabilities real-time feedback
capabilities
Percentage of customer-
facing
employees with on-line
access to customer and
product information
 This is
my kind of cost
pool!

1-63