CHAPTER 5

ACTIVITY-BASED COSTING AND ACTIVITY-BASED

MANAGEMENT
LEARNING OBJECTIVES
1. Explain undercosting and overcosting of products or services

2. Present three guidelines for refining a costing system

3. Distinguish between the traditional and the activity-based costing approaches to designing a costing
system

4. Describe a four-part cost hierarchy

5. Cost products or services using activity-based costing

6. Use activity-based costing systems for activity-based management

7. Compare activity-based costing systems and department-costing systems

8. Evaluate the costs and benefits of implementing activity-based costing systems

CHAPTER OVERVIEW
Chapter 5 emphasizes the allocation of indirect costs within a costing system. Companies need to
accurately measure resources used in producing different products and providing different services.
Tracing costs in an economically feasible way to products and services is not the difficult part of
assigning costs. Allocating indirect costs provides the challenge. Companies produce an increasing
variety of products and services and have ever-increasing amounts of indirect costs to allocate to them. A
costing system provides managers with information for many different purposes, with one important
purpose, accurate costs of products or services.

Costing systems may need to be refined for accurate measurement of consumption of indirect costs.
Activity-based costing (ABC) assists some companies in cost management decisions in pricing, product-
mix, product design, and efficiency, for example. Guidelines are presented for refining a costing system.
Situations in which erroneous impressions about product or service cost exist are described in the first
part of the chapter to draw attention to the critical need for accurate information in making better
decisions for an organization. The information generated by a costing system is used in decision making
as is highlighted by a discussion of activity-based management near the end of the chapter.

Helpful comparisons are made between the traditional costing system described in the previous chapter
and the activity-based costing approach illustrated in this chapter. The many benefits gained from
refining a costing system are noted along with steps in implementing an activity-based costing system.
Costs and limitations of using an activity-based costing system approach are also described.
The selection of appropriate or preferred cost-allocation bases is an important step for allocating indirect
costs. Activity-based costing focuses on the cause-and-effect criterion for choosing allocation bases.
CHAPTER OUTLINE
I. Indirect-cost allocation in job-costing system
I
A. Reflects underlying structure of operations
II
1. Different jobs, products, or services consume indirect costs alike (identical or at least
similar)

a. Single cost pool and a single indirect-cost rate for allocation

b. Simple costing system will suffice for job-costing purposes

2. Different jobs, products, or services (cost objects) consume indirect costs differently

a. Multiple cost pools and multiple indirect-cost rates for allocation

b. Measure of how different jobs, products, or services use organizational resources

B. Provides information about the cost of a job, product, or service

1. Accurate information when indirect-cost allocation matches indirect-cost consumption

Learning Objective 1:
Explain undercosting and overcosting of products or services

2. Misleading information when indirect-cost allocation does not match resource

consumption

a. Cost smoothing or peanut-butter costing: broad averages used to uniformly assign

costs though resources used nonuniformly

i. Product undercosting – product consumes a high level of resource but is

reported to have a low cost per unit: may result in bringing in fewer revenues than
costs of resources used

ii. Product overcosting – product consumes a low level of resources but is reported to
have a high cost per unit: may result in losing market share to competitors producing
similar products or providing similar services

b. Production-cost cross-subsidization: if undercost a product will overcost at least one

other product

i. Results from cost assigned uniformly (broadly averaged) across multiple

products without recognizing amounts of resources used by which products

ii. Effects of cost smoothing on direct and indirect costs described through text example

64 Chapter 5
 iii. Questions the system of allocating overhead costs and need for improvement or
refinement of such system

Do multiple choice 1. Assign Exercise 5-16.

Learning Objective 2:
Present three guidelines for refining a costing system

C. Can be changed or refined (refined costing system) to better measure costs of overhead resources used
by different cost objects even though used differently [Exhibit 5-1]

1. Direct-cost tracing: classify as many of the total costs as direct costs as is economically
feasible—reducing amount of costs classified as indirect

2. Indirect-cost pools: expand number of these pools as needed until each of these pools is
more homogeneous – costs that have same or similar cause-and-effect (or benefits-received)
relationship with the cost-allocation base

3. Cost-allocation bases: use cause-and-effect criterion, where possible, to identify the cost-
allocation base for each indirect-cost pool

Do multiple choice 2. Assign Problems 5-29, 5-30 and 5-31.

Learning Objective 3:
Distinguish between the traditional and the activity-based costing approaches to designing a costing
system

II. Activity-based costing, a tool for refining a costing system by focusing on individual activities as
fundamental cost objects

A. Purpose: underlying structure of operations looked at in greater detail for more understanding
of how resources used and, hence, more accurate costing

B. Features (refer to section on “refining cost systems”)

1. Costs reclassified as direct rather than indirect by subdividing existing cost pools

2. Smaller cost pools created by linking to different activities through cause-and-effect

relationships with the cost-allocation base

3. Measures of activities performed used as cost-allocation bases

Do multiple choice 3. Assign Exercise 5-18.

Learning Objective 4:
Describe a four-part cost hierarchy

C. Cost hierarchy: highlighted when identifying cause-and-effect relationships

1. Categorized by different cost pool on the basis of types of cost drivers or cost-allocation
bases

Activity-Based Costing and Activity-Based Management 65

 a. Output unit-level costs: costs of activities performed on each individual unit of product
or service [cost driver is a unit of output]

b. Batch-level costs: costs of activities related to a group of units of products or services

[cost driver is group of units of output]
2. Categorized by different degrees of difficulty in determining cause-and-effect (or benefits-
received) relationships

a. Product-sustaining costs (or service-sustaining costs): costs of activities undertaken to

support individual products or services regardless of the number of units or batches in
which the units are produced

b. Facility-sustaining costs: costs of activities that cannot be traced to individual products

or services but support the organization as a whole

i. Difficult to find good cause-and-effect relationship causing some companies to

deduct them as a whole from operating income rather than allocating them

ii. Important to allocate when management wants to set selling prices using basis of an
amount of cost that includes all costs

Do multiple choice 4. Assign Exercise 5-17.

D. Implementation example – using seven-step approach to costing and the three guidelines for
refining costing systems [Exhibits 5-2 and 5-3]

Learning Objective 5:
Cost products or services using activity-based costing

1. Identify the products that are the chosen cost objects

a. Goal to first calculate the total costs of the products

b. Then to calculate the per-unit cost of products

2. Identify the direct costs of the products

a. Costs identified as output-unit costs

b. Costs identified as batch-level costs

3. Select the cost-allocation bases to use for allocating indirect costs to the product

a. Identify the activities

b. Define the number of activity-cost pools for grouping costs by identifying the cost-
allocation bases

c. Consider the availability of reliable data and measures in choosing a cost-allocation

base

4. Identify the indirect costs associated with each cost-allocation base

a. Some costs directly identified with a particular activity

66 Chapter 5
 b. Other costs may need to be allocated to activities before the costs of the activities
can be allocated to the products

5. Compute the rate per unit of each cost-allocation base used to allocate indirect costs to
the products

6. Compute the indirect costs allocated to the products

7. Compute the total costs of the products by adding all direct and indirect costs assigned to
the products

Do multiple choice 5–7. Assign Exercise 5-23.

E. Key features [Exhibit 5-4]

1. Focus of ABC systems on long-run decisions

a. All resources used by products identified regardless of how individual costs behave
in the short run

b. More of the costs can be managed and fewer costs are regarded as fixed and given

2. Recognition of hierarchy of costs

a. Critical when allocating costs to products

b. Easy to use to calculate total costs

Learning Objective 6:
Use activity-based costing systems for activity-based management

F. Usage in management decisions—Activity-based management (ABM)

1. Used for more than obtaining better product costs

2. Used in management decisions for satisfying customers and improving profitability

a. Pricing and product-mix decisions

b. Cost reduction and process improvement decisions

i. Analysis of factors that cause costs to be incurred

ii. Use of nonfinancial and financial cost-allocation bases

c. Design decisions

d. Planning and managing decisions

i. Budgeted costs for activities and budgeted cost rates—normal costing used

ii. Feedback from comparing budgeted to actual costs on how well activities managed

Do multiple choice 8. Assign Exercise 5-24 (Exercise 6-24 adds activity-based budgeting).

Learning Objective 7:

Activity-Based Costing and Activity-Based Management 67

Compare activity-based costing systems and department-costing systems.

III. Activity-based costing compared to department-costing systems

A. Activity-based costing—a further refinement of department-costing systems

1. Activities within a department may incur significant costs but have different cost drivers

2. Activities within a department may not use resources in the same proportion

B. Departmental indirect-cost rates for allocating costs to products could result in same product
costs as activity-based costing if:

1. A single activity accounts for a sizable fraction of the department’s cost

2. Significant costs incurred on different activities but each activity has same cost-allocation
base

3. Significant costs incurred on different activities with different cost-allocation bases

within a department but different products use resources from the different activity areas in
the same proportions

C. Benefits of activity-based costing must be balanced against its costs and limitations

Do multiple choice 9. Assign Problem 5-32.

Learning Objective 8:
Evaluate the costs and benefits of implementing activity-based costing systems.

IV. Implementing ABC systems [Surveys of Company Practice] [Concepts in Action]

A. Choice of level of detail and when ABC likely to provide the most benefit

1. Significant amounts of indirect costs allocated using only one or two cost pools

2. All or most indirect costs identified as output-unit level costs

3. Products make diverse demands on resources because of differences in volume, process

steps, batch size, or complexity

4. Products a company is well suited to made and sell show small profits but products a
company is less well suited to produce and sell show large profits

5. Operations staff significantly disagree with the accounting staff about the costs of
manufacturing and marketing products and services

B. Necessary measurements are main costs and limitations of an ABC system

1. Many calculations required to determine costs of products and services

a. Activity-cost rates need to be updated regularly

b. Detailed system increases opportunity for error

68 Chapter 5
 2. Allocation bases used for which data readily available rather than preferred allocation
bases

Do multiple choice 10. Assign Exercise 5-26, Problem 5-35 (Exercise 14-21 adds customer
profitability).

CHAPTER QUIZ SOLUTIONS: 1.d 2.c 3.a 4.d 5.a 6.b 7.d 8.c 9.c 10.b

CHAPTER QUIZ
1. Production-cost cross-subsidization results from

a. allocating indirect costs to multiple products.

b. assigning traced costs to each product.
c. assigning costs to different products using varied costing systems within the same organization.
d. assigning broadly averaged costs across multiple products without recognizing amounts of
resources used by which products.

2. In refining a cost system

a. total direct costs are unchanged because they can be traced in an economically feasible way to the
product and traced costs are more accurate.
b. the costs are grouped in homogeneous pools of the same or similar amounts.
c. the criterion of cause-and-effect is used to relate indirect costs to a factor that systematically
links to a cost object.
d. the organization looks for cost-allocation bases that will provide a uniform spreading of indirect
costs to each product.

Question 3 is based on the following data:

The average cost data are for In-Sync Fixtures Company's (a retailer) only two product lines, Marblette
and Italian Marble.
Marblette Italian Marble
Purchase volume 20,000 1,000
Purchase cost per unit $50 $250
Shipments received 12 12
Hours used per shipment* 5 3
*
These data were accumulated after a careful activity analysis.

Currently, In-Sync Fixtures uses a traditional costing system with indirect costs allocated using
purchased cost of goods as a basis. In-Sync Fixtures is considering refining the allocation of their
receiving costs of $40,000. They realize that the Italian Marble is heavier and requires more care than
the Marblette but that the Marblette comes in larger volume.

3. Which statement can be made using the results of the activity analysis performed by In-Sync Fixtures?

a. The use of this refined activity-based costing system will increase the accuracy of the
resulting product costs because a more appropriate cost driver will be used as the allocation
base.
b. The traditional allocation method currently being used is causing product-cost cross-
subsidization with the product line Marblette being undercosted.

Activity-Based Costing and Activity-Based Management 69

 c. The cost allocated to the Italian Marble product line under the current traditional system is
more than the activity-based costing allocated cost.
d. The use of this refined activity-based costing system will increase the accuracy of the
resulting product costs because it probably will cost less to trace the costs to the product lines.

4. Building or plant security is an example of

a. unit-level costs. c. product-sustaining costs.

b. batch-level costs. d. facility-sustaining costs.

5. The allocation of indirect costs in an activity-based costing system

a. may require other costs to be allocated to activities before the costs of the activities can be
allocated to the products.
b. is simplified because more costs are identified as direct costs.
c. requires the use of heterogeneous cost pools.
d. is simplified because a limited number of activities are identified as cost objects.
Information for questions 6 and 7 is given below.
Chris has a custom curtain and chair cover shop. The job-costing system was designed using an
activity-based approach. There are two direct-cost categories (direct materials and direct labor) and
three indirect cost pools. These three cost pools represent three activity areas of work at the shop.
Activity Area Cost Driver used for Allocation Cost-Allocation Rate
Materials handling Number of pieces in the pattern $ 2.00 per piece
Stitching Number of pieces in the pattern $25.00 per piece
Assembly/Installation Direct labor hours $15.00 per hour

In October Chris made and installed five sets of curtains and chair covers for clients. A set includes
curtains for two windows and coverings for three chairs. The direct labor rate is $20.00 per hour.
Cost data for curtains and covers follows:
Direct Direct

Units Material Number Labor

Produced Costs of Pieces Hours
Curtains 10 $2,000 1 20
Chair coverings 15 $3,375 6 90

6. The cost for a set of curtains and chair coverings would be

a. $5,375. b. $2,385. c. $2,085. d. $1,253.
7. The indirect costs for the shop in October were
a. $11,925. b. $5,375. c. $4,900. d. $4,350.
8. Evaluating customer reaction of the trade-off of giving up some features of a product for a lower
price would best fit which category of management decisions under activity-based management?
a. Pricing and product-mix decisions c. Design decisions
b. Cost reduction decisions d. Discretionary decisions
9. Which of the following statements is more representative of activity-based costing in comparison to a
department-costing system?

70 Chapter 5
 a. The use of multiple cost-allocation bases.
b. The use of indirect-cost rates for significant resource use.
c. The use of the cause-and-effect criterion.
d. The use of multiple cost pools.

10. A significant limitation of activity-based costing is the

a. attention given to indirect cost allocation.
b. many necessary calculations.
c. operations staff’s attitude toward the accounting staff.
d. use it makes of technology.
WRITING/DISCUSSION EXERCISES
1. Explain undercosting and overcosting of products or services

Why should the management cost accountants be the first to recognize cost smoothing or
over/undercosting? Decision makers look to management cost accountants for useful information
when making decisions about pricing, product mix, process improvements, and design, for example.
Accountants have an ethical obligation to provide information that is objective, reliable, and relevant.
They also have an ethical obligation for competence.

In gathering data to prepare reports for pricing or mix decisions, accountants should note effects of
product costs on profitability over a period of time and a range of products. Because the costing system
design is based on the operational structure of the organization, the costs should reflect those operations.
Consistent losses or high profits should alert the competent accountant to either investigate further or
bring the issue to the attention of management for their consideration.

2. Present three guidelines for refining a costing system

Whose work is it to “refine” a costing system? Though the costing system is the responsibility
of the accountants, the underlying basis for it is the structure of operations. If the costing system is not
following operational structure because of changes to that structure and therefore needs to be refined,
those people involved with operations should be involved in the refinement process. Activity-based
costing, as a refinement to an existing costing system, requires that major or key activities be defined for
their role in incurring indirect costs. A team of people who represent key activities should be brought
together to identify the activities and should definitely include a representative from accounting.

From the information put together by the team, the accounting group can build an appropriate system for
accumulating and assigning costs. The system will be more expensive to operate and maintain, and that
should be a consideration in the decision to refine an existing costing system.
3. Distinguish between the traditional and the activity-based costing approaches to designing a
costing system

If activity-based costing is so good why has it not been used before? In many ways,
activity-based costing was the “traditional” method before it became known as ABC. Operating
managers must be familiar with the activities required to manufacture the company’s products or provide
their services, and in the early stages of a company, this knowledge would be the basis for the
organization’s structure and accounting. Changes occur. Technological and marketplace changes usually
impact the operational portion of companies in a more cost/beneficial manner before corresponding
changes occur for the staff areas of companies. Also, many changes are small and specific to one area,
with the broader understanding of possible consequences not readily or accurately envisioned for making
corresponding changes in other areas.

Activity-Based Costing and Activity-Based Management 71

Consider a workplace using automation and sophisticated computers rather than people, as some
managers did. Without people (direct manufacturing labor), would direct manufacturing labor be a
useful cost driver for developing a product cost? The costing system would have to change to accurately
reflect such a workplace.

72 Chapter 5
4. Describe a four-part cost hierarchy

As a cost reduction measure for batch-level costs, the number of units processed per
batch were increased. What effect could this have on company-wide costs? An increase in
the number of units per batch processed may be an acceptable means of reducing costs, but a danger
exists in increasing the units per batch to reduce the cost per unit or per batch. If the increase in number
of units is per batch only so that fewer batches result in the same total number of units processed, thus
reducing setup costs, such a measure could be helpful to company-wide costs.

If, however, the increase in the number of units per batch or setup is done solely to reduce a per batch cost
and more units of product are processed in total with no increase in sales volume, inventory will build up
and result in increased costs to the company. The company should look for ways to reduce the setup
costs in order to reduce batch sizes and batch costs.

The just-in-time philosophy advocates no inventory of in-process or finished goods. Under that system
batch sizes would be continually reduced resulting in more setups, but the cost of the setup would receive
the attention for cost reduction, not the setup cost per unit.

5. Cost products or services using activity-based costing

Activity-based costing has so many advantages, increased accuracy for product costing
and added value for decision making, why is it a more recent development in costing
systems? Costing systems do develop from the underlying structure of operations. Recent changes in
the variety of products and the complexity in how resources are used have necessitated refinements and
changes to the traditional or existing costing systems. At the time traditional or existing costing systems
developed, they were improvements or refinements to the then existing systems.

Technological advances have made it possible to design and use costing systems with the amount of
detail and calculations required by ABC. Those same technological advances made possible the changes
in the variety of products and complexity in how resources are used for companies.

Accounting, through such a mechanism as a costing system, responds to changes in operations while at
the same time providing the information that is acted upon to initiate change in those operations.

6. Use activity-based costing systems for activity-based management

Can a company (organization) use activity-based costing and not have activity-based
management? Yes, a company could implement activity-based costing and gain value in determining
better product costs but not use the fullness of the information to influence decision making. If the
information from activity-based costing is used to manage the activities, then activity-based management
is employed.

Using activity-based costing without using activity-based management is similar to an earlier era, late
1960s and the 1970s, when U. S. managers used numbers as numbers to manage.* Numbers are symbols
for a wealth of information, and when they are used as symbols with understanding of what they
represent, numbers are helpful. If used without that understanding, they can be dangerous. The same
situation could occur with activity-based costing and activity-based management. Activity-based costing
is a whole company approach and works best when so employed through activity-based management and
activity-based budgeting.
*(See “The Next American Frontier” by Robert B. Reich in the March 1983 issue of The Atlantic Monthly)

Activity-Based Costing and Activity-Based Management 73

7. Compare activity-based costing and department-costing systems

Wouldn’t a company benefit from structuring their departments to match the defined
activities used in ABC so that costs would be easier to assign to the activities when they
were also the department’s? Activity-based costing is an approach to “costing a product,” which is
an accounting responsibility. Departments are created for reasons other than to develop the cost of the
product. Departments may exist along the categories of the value chain, for example. In some instances, a
key activity would be housed within a single department. In other instances, more than one key or
defined activity might operate within the same department. Though the activities generated large amounts
of indirect costs, had different cost drivers, and used resources in different proportions, they could be
within the same category of the value chain, such as manufacturing, and, thus, be one department. In yet
other instances, a defined or key activity for generating indirect costs might span more than one
department. The costing system is to reflect the underlying structure of operations, not vice versa.

Evaluate the costs and benefits of implementing activity-based costing systems

Is it possible that when all the signs point to the need for costing system refinement,
specifically ABC, that it is really too late to do anything? ABC is so expensive and time-
intensive in its implementation that it’s possible that a company couldn’t get it done in
time to be effective. In some instances, the situation described above might actually exist. Sometimes
a company does wait too long to make changes and are bought out by another company rather than
initiate and make necessary changes. This is not usually the case. Recognizing that a problem exists is
usually the first step in developing a solution. Managers do not have to wait until a complete revamping
of the system is developed to take advantage of information gained from working toward a solution.
Problem solving or decision making is a process, and sometimes on the way to solving one problem, other
problems are solved, thereby negating the need to solve what was considered the original problem. In
deciding to implement ABC, for example, the company could refine their department indirect-cost rates
by use of multiple cost-pools and multiple cost-allocation bases and find those to be adequate. ABC isn’t
appropriate for every company. Consideration and study of ABC may provide benefit to any company.

74 Chapter 5
SUGGESTED READINGS
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Bamber, L. & Hughes II, K., “Activity-Based Costing in the Service Sector: The Buckeye National Bank,”
Issues in Accounting Education (August 2001) p.381 [28p].

Beasley, M., Carello, J. and Hermanson, D., “Just Say ‘No’,” Strategic Finance (May 1999) p.52 [6p].

Brewer, P., “An Approach To Organizing a Management Accounting Curriculum,” Issues in Accounting
Education (May 2000) p.211 [25p].

Brewer, P., Campbell, R., & McClure, R., “Wilson Electronics (A) and (B): An ABC Capstone
Experience,” Issues in Accounting Education (August 2000) p.413 [46p].

Cokins, G., “Learning To Love ABC,” Journal of Accountancy (August 1999) p.37 [3p].

———, “If Activity-Based Costing Is the Answer,” IIE (August 1997) p.38 [5p].

Damitio, J., Hayes, G. and Kintzele, P., “Integrating ABC and ABM at Dow Chemical,” Management
Accounting Quarterly (Winter 2000) p.22 [5p].

Drake, A., Haka, S. and Ravenscroft, S., “An ABC Simulation Focusing on Incentives and Innovation,”
Issues in Accounting Education (August 2001) p.443 [29p].
Foster, G. and Swenson, D., “Measuring the Success of Activity-Based Cost Management and Its
Determinants,” Journal of Management Accounting Research (Fall 1997) p.109 [33p].

Hicks, D., “Yes, ABC Is for Small Business, Too,” Journal of Accountancy (August 1999) p.41 [3p].

Krumwiede, K., “The Implementation Stages of Activity-Based Costing and the Impact of Contextual and
Organizational Factors,” Journal of Management Accounting Research (1997-V10) p.239 [39p].

McGowan, A., “Perceived Benefits of ABCM Implementation,” Accounting Horizons (March 1998) p.31
[20p].
Miller, J., Implementing Activity-Based Management in Daily Operations (1996), John Wiley & Sons, Inc.,
New York. [Selected by the Trustees of IMA Foundation for Applied Research, Inc., as being of
interest to IMA members.]

Platt, D. & Towry, K., “Pecos Products: A Project Introducing Complexity into the Study of Activity-Based
Costing,” Issues in Accounting Education (February 2001) p.99 [26p].

Activity-Based Costing and Activity-Based Management 75