Chapter 5

Activity-Based
Costing and
Management

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Learning
Objective
1

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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:

Production:
Units
Runs

Mode I

Mode II

Mode III

10,000
1 run of 10,000
units

20,000
4 runs of
5,000 units

4,000
10 runs of
400 units
1-3

Traditional, Volume-Based
Product-Costing System
Direct materials
Direct labor
Manufacturing overhead
Total

Mode I
50.00
60.00
99.00
209.00

Mode II
$
90.00
80.00
132.00
$
302.00

Mode III
$
20.00
40.00
66.00
$
126.00

Additional information includes:

Direct materials
Direct labor (hr/board)
Setup time (hr/run)
Machine time (hr/board)

Mode I
50.00
3
10
1

Mode II
$
90.00
4
10
1.25

Mode III
$
20.00
2
10
2

Manufacturing overhead is determined as follows

1-4

Traditional, Volume-Based
Product-Costing System
Mode I
10,000
3
30,000

Units produced
Direct labor (hr/unit)
Total hours

Mode II
20,000
4
80,000

Total hours required

118,000

Budgeted manufacturing overhead

Budgeted direct-labor hours

$3,894,000
118,000

Mode I
Direct labor (hr/unit)
Overhead rate per hour
Overhead per unit

Mode III
4,000
2
8,000

$
$

= $33 per hour

Mode II
3
33
99

$
$

Mode III
4
33
132

$
$

2
33
66
1-5

Traditional, Volume-Based
Product-Costing System
With these product costs, Aerotech established
target selling prices (Cost 125%).
Direct materials
Direct labor
Manufacturing overhead
Total

Cost per unit

Target selling price

Mode I
Mode II
Mode III
50.00 $
90.00 $
20.00
60.00
80.00
40.00
99.00
132.00
66.00
209.00 $
302.00 $
126.00

Mode I
209.00
261.25

Mode II
$
302.00
377.50

Mode III
$
126.00
157.50

209.00 x 1.25
1-6

Learning
Objective
2

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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.

1-8

Learning
Objective
3

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Overhead Costs
Total budgeted cost = $3,894,000
Activity
must be
done on
each unit
produced.

Activity
Cost
Pools

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Activity
performed
on each
batch
produced.

Activities needed to support

an entire product line

Identification
of Activity
Cost Pools

Facility
Level
Facility
cost pool
$507,400

Activity required in order

for the production
process to occur.

1-10

Unit
Level

Batch
Level

ProductSustaining
Level

Machinery
cost pool
$1,212,600

Setup
cost pool
$3,000

Engineering
cost pool
$700,000

Facility
Level
Facility
cost pool
$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
1-11

Learning
Objectives
3&4

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

STAGE ONE
Various overhead
costs related
to machinery

Activity
cost
pool

Maintenance

Lubrication

Depreciation

Electricity

Computer Support

Calibration

Machinery Cost Pool

Total budgeted cost = $1,212,600

1-13

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

Budgeted Machinery Costs

$1,212,600
Budgeted Machine Hours =
43,000
$28.20/hour

Mode I:
$28.20 per hr.
1 hr. per unit
$28.20 per unit

Mode II:
$28.20 per hr.
1.25 hr. per unit
$35.25 per unit

Mode III:
$28.20 per hr.
2 hr. per unit
$56.40 per unit
1-14

STAGE ONE
Calculation of
total setup cost

Activity
cost
pool

Total budgeted setup cost

$20 per hour
10 hr. per setup
$200 cost per setup
15 production runs
$ 3,000 Total

Setup Cost Pool

Total budgeted cost = $3,000
1-15

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

=
Budgeted Setup Costs
Planned Production Runs

Mode I: (1 Run)
$200 per run
10,000 units per run
= $.02 per unit

$3,000
15 runs
= $200 per run

Mode II: (4 Runs)

$200 per run
5,000 units per run
= $.04 per unit

Mode III: (10 Runs)

$200 per run
400 units per run
= $.50 per unit
1-16

STAGE ONE
Various overhead
costs related
to engineering

Activity
cost
pool

Engineering salaries

Engineering software

Engineering supplies

Depreciation

Engineering Cost Pool

Total budgeted cost = $700,000

1-17

STAGE TWO
Allocate based
on engineering
transactions

Cost
Assignment

Engineering Cost Pool

Total budgeted cost = $700,000

Mode I:
25% $700,000
10,000 units
= $17.50 per unit

Mode II:
45% $700,000
20,000 units
= $15.75 per unit

Mode III:
30% $700,000
4,000 units
= $52.50 per unit
1-18

STAGE ONE
Various overhead
costs related
to general
operations

Activity
cost
pool

Plant depr.

Property taxes

Plant mgmt.

Insurance

Plant maint.

Security

Facility Cost Pool

Total budgeted cost = $507,400

1-19

STAGE TWO
Calculate
the pool
rate

Cost
Assignment

=
Budgeted Facilities Cost
$507,400
Budgeted Direct-Labor Hours = 118,000
$4.30/hour

Mode I:
$4.30 per hr.

3 hr. per unit

$12.90 per unit

Mode II:
$4.30 per hr.

4 hr. per unit

$17.20 per unit

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 pe c t ion Cos t P ool
Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 200,000
200,000
200,000

%
6%
24%
70%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
1.20
=
2.40
=
35.00

Mat e rial-Han dlin g Cos t P ool

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 600,000
600,000
600,000

%
7%
30%
63%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
4.20
=
9.00
=
94.50

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

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 421,000
421,000
421,000

%
20%
40%
40%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
8.42
=
8.42
=
42.10

P ac kagin g an d Sh ippin g Cos t P ool

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 250,000
250,000
250,000

%
4%
30%
66%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
1.00
=
3.75
=
41.25
1-21

Other Overhead Costs

Re c e ivin g an d In s pe c t ion Cos t P ool
Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 200,000
200,000
200,000

%
6%
24%
70%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
1.20
=
2.40
=
35.00

Mat e rial-Han dlin g Cos t P ool

Board
Mode I
Mode II
Mode III

$14.82

Ove rh e ad
$ 600,000
600,000
600,000

%
7%
30%
63%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
4.20
=
9.00
=
94.50

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

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 421,000
421,000
421,000

%
20%
40%
40%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
8.42
=
8.42
=
42.10

P ac kagin g an d Sh ippin g Cos t P ool

Board
Mode I
Mode II
Mode III

Ove rh e ad
$ 250,000
250,000
250,000

%
4%
30%
66%

Un its
10,000
20,000
4,000

= Cos t/Un it
= $
1.00
=
3.75
=
41.25
1-22

Product Cost from ABC

These are the new product costs when Aerotech
uses ABC.
Mode I
Direct materials $ 50.00
Direct labor
60.00
Machinery
28.20
Setup
0.02
Engineering
17.50
Facilities
12.90
Other
14.82
Total
$ 183.44

Mode II
$ 90.00
80.00
35.25
0.04
15.75
17.20
23.57
$ 261.81

Mode III
$ 20.00
40.00
56.40
0.50
52.50
8.60
212.85
$ 390.85
1-23

Learning
Objective
5

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Distorted Product Costs

Both original and ABC target selling prices are based
on (Cost 125%).
Tradition al cos tin g
ABC cos tin g
Origin al targe t s e llin g price
ABC targe t s e llin g price

Mode I
$
209.00
183.44

Mode II
$
302.00
261.81

Mode III
$ 126.00
390.85

261.25
229.30

377.50
327.26

157.50
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]
1-25

Distorted Product Costs

Can you identify any problems Aerotech is likely to
face as a result of this distortion?
Mode I
Tradition al cos tin g
$ 209.00
ABC cos tin g
183.44
Cos t dis tortion pe r u n it
25.56
Un its produ ce d
10,000
Total cos t dis tortion
255,600

Mode II
$ 302.00
261.81
40.19
20,000
803,800

Mode III
$ 126.00
390.85
(264.85)
4,000
(1,059,400)

Traditional costing understates the cost

of complex, low volume products.
1-26

Two Key Points

A large proportion of nonunit-level activities
A unit-level cost driver,
such as direct labor,
machine hours, or
throughput, will not be
able to assign the costs
of non-unit-level activities
accurately.

Product diversity
When the
consumption ratios
differ widely between
activities, no single
cost driver will
accurately assign the
resulting overhead
costs.

1-27

Learning
Objective
6

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Correlation

Behavioral
Effects
Cost of
Measurement
1-29

Learning
Objective
7

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

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
departments 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.
1-31

Learning
Objective
8

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Activity-Based Management

The use of
ABC costing
information
to help
management
make decisions
1-33

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.

1-34

Two-Dimensional ABC and

Activity-Based Management

Activities

1-35

Two-Dimensional ABC and

Activity-Based Management
Cost Assignment View

Resource costs

Activities

Cost Objects
1-36

Two-Dimensional ABC and

Activity-Based Management
Cost Assignment View

Resource costs
Process View
Activity Analysis

Root
Causes

Activity
Triggers

Activity Evaluation

Activities

Performance
Measures

Cost Objects
1-37

Elimination of Non-Value-Added
Costs
Activities

Nonvalueadded
activities
Unnecessary

Necessar
y

Reduce or
Eliminate

Continually Evaluate
and Improve
1-38

Using ABM to Eliminate NonValue-Added Activities and Costs

1. Identify Activities.

2. Identify Non-Value-Added Activities.

3. Understand Activity Linkages, Root Causes,

and Triggers.
Specify
parts

Select
vendor

Receive
parts

Produce
goods

Inspect
finished
goods

Rework
defective
products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.
1-39

Using ABM to Eliminate NonValue-Added Activities and Costs

Process time

Inspection time

Move time

Storage time

Waiting time
1-40

Learning
Objective
9

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Customer Profitability Analysis

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

1-42

Customer Profitability Analysis

Required
special
packaging.
Orders
small
quantities.

Demand
fast
service.

Often
changes
orders.

Orders
frequently.

A costly customer
1-43

Customer Profitability Analysis

Customer-Related Activities
Order processing
Sales contacts (phone calls, faxes, etc.)
Sales visits
Shipment processing
Billing and collection
Design/engineering change orders
Special packaging
Special handling

Cost Driver Base

Purchase orders
Contacts
Visits
Shipments
Invoices
Design changes
Units packaged
Units handled

Cost Drive
Rate
$
150
100
1,000
200
160
4,000
40
60

A company may use these customer

related costs to help determine the
profitability of each customer.
1-44

Customer Profitability Analysis

Cumulative Operating Income as a % of Total
Operating Income

Customer Profitability
125.0%

100.0%

75.0%

50.0%

25.0%

75% of actual operating income

50% of actual operating income

25% of actual operating income

0.0%
1

4 5

8 9 10 11 12 13 14 15 16 17 18 19 20
1-45

Learning
Objective
10

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Activity-Based Management in the

Service Industry
Customer
Profitability
Analysis

Activity
Analysis

1-47

Learning
Objective
11

McGraw-Hill/Irwin

Copyright 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

Just-in-Time Inventory and

Production Management
No materials are purchased and no products
are manufactured until they are needed.

The primary goal of a

JIT production system is
to reduce or eliminate
inventories at every
stage of production.

1-49

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
1-50

JIT Purchasing
Long-term
contracts with
suppliers.

Only a few
suppliers.

Parts delivered
in small lots.

Grouped
payments to
vendor.

Minimal
inspection of
materials.
1-51

End of Chapter 5
This is
my kind of cost
pool!

1-52