Lecture 10: Activity Based Costing and Management

The use of technology has increased both in manufacturing and nonmanufacturing sectors over the past fifty years. As a consequence, many firms are
finding that indirect costs have become a higher proportion of total product costs.
Automation and computing systems have increased the indirect costs of many
organizations and in many cases have replaced significant amount of direct labor.
As the proportion of indirect costs to direct costs increases, firms are taking a closer
look at how indirect costs are related to the different products. Without an accurate
tracing of indirect costs to products, organizations are likely to make poor product
mix and pricing decisions. Activity Based Costing (ABC) is a procedure that
attempts to provide more accurate product costs. Activity Based Management
refers to a collection of techniques used by firms to enhance long term productivity
and profitability and these techniques use the information provided by activity
based costing systems.
ABC helps managers to dramatically enhance the accuracy of the product
costing systems. ABC systems recognize that many organizational resources are
required not for physical production of units of product but to provide a broad array
of support activities that enable a variety of products and services to be produced
for a diverse group of customers. In some sense, the goal of ABC is to measure and
then price out all the resources used for activities that support the production and
delivery of products and services to customers. In any ABC system, we can
potentially identify six crucial steps. They are
(1) identifying the costs of support resources to be allocated
(2) linking the support resources to a set of activities performed in the
organization
(3) find a mechanism to trace to cost of support resources to the identified
activities
(4) identify a physical measure for the activity (and this can be called cost
driver)
(5) based on the cost of activity identified in step (3) and the physical
measure of activity in step (4), calculate an activity cost driver rate
(6) finally, use this activity cost driver rate to allocate costs of support
resources to products.
While these steps seem very similar to the steps behind cost allocation
procedure discussed in modules 3 and 9, the principles behind ABC are vastly
different. Let us now see these differences in detail.

The first step involves identifying the costs of support resources to be

allocated and forming cost pools. In a non-ABC system (i.e. traditional cost
accounting systems), it is customary that these cost pools are formed along the
lines of business functions (for example, maintenance cost) or departments (for
example, the quality assurance department) or divisions (for example, purchase
division). On the other hand, under ABC, we form cost pools by the activities that
make up a business process. A business process is nothing but a collection of
activities. For example, purchasing is a business process. Instead of collecting
costs related to purchasing function and forming a purchasing cost pool, we identify
the activities that comprise the business function that we call purchasing and
collect costs for each of the identified business activities within the purchasing
function. This approach of collecting costs by activities is crucial to the ABC
concept. Another important difference in ABC versus the traditional system of cost
allocation is the recognition of activity hierarchy in ABC. We have already seen this
concept in module 3. Generally speaking, the organizational activities can be
classified into one of four categories. First type of activity is called unit level
activities. Such activities represent work performed for every unit of product or
service produced. The quantity of resources used by unit-level activities is
proportional to products production and sales volume. For American Airlines, unitlevel activities include printing out boarding pass and checking bags as these
activities increase or decrease in proportion to the number of passengers flying.
The second type of activities is referred to as batch level activities. They pertain to
a group of units. For example, if a mechanic checks each aircraft every day, then
that is a batch related activity. American Airlines is not performing this activity for
each passenger. This activity is being performed only once for the several hundred
passengers flying in that aircraft. Product or customer level activities relate to
activities pertaining to a specific product or a specific customer. For example, if a
group of American Airlines employees performs a set of activities to comply with a
set of regulatory requirements imposed by the authorities of Gatwick airport in
London, these activities are being performed only to those flights that fly into
Gatwick airport. Since this set of activities enable American Airlines to offer routes
that fly into London Gatwick airport, this would be an example of a product level
activity. Assume that American Airlines has a contract with the state of Texas that
offers concessional prices to the state employees. In this case, the activities
performed by American Airlines in connection with the state contract, such as
analysts pricing every route originating from Texas would be an example of
customer-level activity as these activities are being performed for only one
customer, the state of Texas. The final class of activities is called facility-level
activities. These activities are performed to sustain the business. For example, the
activity performed by the general administrative staff at the corporate headquarters
of American Airlines is an example of facility-level activities as this activity is not
specific to any passenger, or aircraft, or route or any customer but pertains to the
business as a whole. In ABC, we would avoid combining costs corresponding to
more than one type of activity into a single cost pool. Usually, firms accounting

systems organize accounts by the kind of expense. For each kind of expense, we
will analyze the expense and segregate the expenses corresponding to each type of
activity so that we dont mix costs belonging to different types of activities.
Another difference between the ABC and non-ABC systems is the decision of
what costs should be allocated. Let us assume that we are trying to allocate a
particular capacity cost. Let us further assume that we are interested in measuring
the profit margin of a product as accurately as possible. In this case, we should
allocate only that part of the capacity cost that is controllable for the decision to
make or eliminate that particular product. If we do that, then the products profit
margin will reflect whether the product is profitable from the standpoint of the
decision to continue to offer or discontinue the product from the product portfolio.
On the other hand, in a non-ABC system, typically we allocate all capacity costs, not
just the controllable portion of the capacity costs. In an ABC system, we choose
that measure that has the strongest causal relationship to the underlying costs in
the cost pool. In a non-ABC system, we choose a cost driver more based on
convenience from the measurement perspective. Unlike a non-ABC system, ABC
systems use practical capacity as the denominator volume when calculating
allocation rates. In a non-ABC system, we always use the actual volume of activity
as the denominator volume. For example, assume that you are using labor hours to
allocate a particular cost pool. Also, assume that you have 10,000 labor hours of
maximum possible capacity but you are planning to use only 8,000 hours of labor
hours for the budgeted production. A non-ABC system will use 8,000 as the
denominator volume for the calculation of allocation rate but an ABC system will
use 10,000 hours as the denominator volume. This will lead to a part of the cost not
being allocated to products. The unallocated cost corresponds to the cost of
capacity that is not being used. Highlighting the cost of unused capacity is valuable
for managers for managing costs.
Now, let us consider a few aspects that you may want to keep in mind when
you design a ABC system. First, realize that an ABC system relies on the ability of
tracing back from any cost assignments to the underlying economic events. A
complex and expensive cost allocation system need not necessarily have this
capability. On the other hand, if activity drivers are chosen on the basis of causeand-effect relationship, then such as system is more likely to give you the capability
to relate the cost assignments to the underlying economic events. Finally, keep in
mind that there is always a tradeoff between accuracy of the costing system and
the cost of running the costing system. All other things remaining the same, you
should try to economize on the number of activity cost drivers in the system and try
to keep the measurement cost of activity cost drivers as low as possible. Generally
speaking, we have three different types of activity cost drivers. Activity cost drivers
may be based on transactions or based on duration of activity or based on intensity
of activity. For example, assume that you are trying to choose quality assurance
costs to products. Two possible activity cost drivers for this activity are number of

inspections performed and the time spent on inspections. While the first driver is
based on transactions, the second driver is based on the duration of this activity.
The first is easier and less costly to measure than the second one. For tracking the
second activity cost driver, we need to measure the time that it takes to conduct
each and every quality inspection in the firm. It takes more effort and time to track
this driver than just counting the number of inspections performed. We should go
for the duration type of activity cost driver only if the time taken to perform quality
inspections drastically differs across products. Otherwise, it would suffice if we
allocate quality costs in proportion to the number of inspections performed for each
product. Finally, there is a third type of activity cost driver that is called intensity
cost driver and this is much more expensive to track than the duration type drivers.
This involves, measuring the cost of each and every inspection and charge it to the
products like a direct cost. Unless there is a solid reason to go for this option, one
should not be choosing this option.
Traditional cost accounting systems fail for three reasons. If the firm has a
large proportion of activities performed that are not unit-level activities, or if there is
tremendous product diversity in the product portfolio or if the consumption pattern
of common resources is not the same across the products, then an ABC system can
provide more accurate product costs than a traditional non-ABC system. If one or
more of these three conditions prevail in the organization, then a non-ABC system
will result in high volume or generic products being allocated more costs than what
they should be allocated and low volume or customized products being allocated
less than what they should be allocated. In other words, the high volume products
will subsidize the low volume products and this will make the low volume products
appear more profitable and the high volume products appear less profitable or even
loss making. Some of the indicators that you may need a ABC system include:
1) While sales are increasing, profits are declining. This is because the
increased activity associated with increasing sales increase the costs more
than proportionately.
2) Non-ABC system will usually undercost the complex products and overcost
simple products. Therefore the complex products will appear more
profitable than what it should be.
3) Competitors who realize the true cost of manufacturing the complex
products will refrain from offering them
4) You will notice that the overhead rates are very high and they tend to
increase even higher over time
5) Direct labor costs is relatively a minor part of overall cost structure and
you are assigning many indirect costs using direct labor hours or direct
labor cost.
6) When you bid for complex products with a huge profit markup you get the
business. However, you are not successful with bids for simple products
even with very low profit margin.

7) You notice that competitors seem to be selling high volume products at an

unbelievably low price.
8) Line managers and marketing managers in your firm tend to ignore costs
reported by accountants in making pricing or other decisions.
ABC systems are not only useful in improving the product costing system but
they are also useful in improving long term profitability by managing products,
customers and resources in a much better manner. By providing an accurate
estimate of the product margin from each product, it helps managers to allocate
common resources to more profitable products on a preferential basis. While
pricing is a strategic decision that has to take into consideration competition and
other product market parameters, ABC cost often provides the minimum acceptable
price in the long run. Managers can refine the selling prices and the optimal
product mix in a much better fashion with costs provided by ABC systems.
In addition to helping managers understand manufacturing costs, ABC
systems also enable managers identify profitability of individual customers. Look at
how we calculate product profitability. Revenue from products minus variable costs
for the products will provide product level contribution margin. If you subtract
capacity and other indirect resource costs consumed by the product, which are
identified in an ABC system, you will get the product profit margin. Finally
subtracting the non-controllable costs for the products, you will get the overall
profit. It is possible to replace product by customer, at least for major customers, in
the above scheme to get the individual customer profitability.
ABC identifies the characteristics that cause some customers to be more
expensive to serve than others. Some of these characteristics are listed in this
table. A high cost-to-serve customer is one who orders more frequently customized
products in small quantities in an unpredictable pattern and often change order
requests. Further, this type of customers demand immediate deliveries and force us
to carry more inventory to cater to their demands. They also require frequent sales
calls and rigid in their requirements and delay payments.
Firms usually have a whale curve of cumulative product and customer
profitability and this pattern is detectable with an ABC system. If you rank order the
customers in terms of profitability and plot the cumulative profits of the firm from
the customers, then it resembles the back of a whale. What this tells you is that, on
the average, a firm loses money from the least profitable customers and they
usually make up about one fifth of all customers.
Firms can benefit from such an analysis especially in industries where selling
and administration costs are relatively high. Based on this analysis, firms can
classify customers into four categories. The first category of customers cost less to
serve but generate high profit margins. Perhaps, the products are crucial to these
customers and we have a good supplier-customer match here. These customers

should be watched closely since they are vulnerable to poaching by competitors.

The second category of customers is also less costly to serve but generate low profit
margins. By working closely with these customers, we need to keep the costs to
serve these customers at the same level or even further reduce. The third group
of customers is those that are costly serve but pay top dollar that compensates the
high cost to serve. For such customers, we can contemplate a wide variety of
menu-based pricing where the price is determined not only by the product but also
by the cost to serve as a function of the level of service demanded. The last group
of customers is the most interesting set and they are more expensive to serve and
generate low profit margins. We have to modify our relationship with these
customers and try to at least break even with them. It could be in the form of either
reducing the level of service these customers demand or increasing the selling price
or reducing any discount they get or the credit period or any combination of these
recommendations.
By estimating product costs based on resource usage, ABC system enables a
firm to plan the capacity levels required optimally. The firm is in a much better
position with information generated from an ABC system to predict the demand for
capacity resources. Whenever product portfolio changes, using this information,
firms can add the necessary additional capacity or reduce the unwanted capacity as
the case may be. Since ABC isolates the cost of excess capacity and highlights that,
managers will be forced to find profitable ways of dealing with this excess capacity.