Chapter 1

Activity-based costing and activity-based management

Outcome:

By the end of this session you should be able to:

 use ABC to derive 'long-run' costs appropriate for use in decision making.
 explain activity-based management and its uses in improving the efficiency of
repetitive overhead activities.
 use direct and activity-based cost methods in tracing costs to 'cost objects' such as
customers or distribution channels.
 compare these costs with appropriate revenues to establish 'tiered' contribution levels,
as in the activity-based cost hierarchy.
 use direct customer profitability and distribution channel profitability and answer
questions relating to these areas.

Basics revisited
In traditional absorption costing, overheads are charged to products using a pre-determined
overhead absorption rate (OAR). This OAR is based upon the volume of activity.

A full unit cost is then computed, in order to satisfy financial accounting requirements.

However, full product costs are not suitable for decision-making purposes. Instead, decisions
should be based on a decision-relevant approach using relevant/incremental cash flows.

Within this approach, decisions such as introducing new products and special pricing
decisions should be based on a study of only those incremental revenues and expenses that
will vary with respect to the particular decision.

Cooper and Kaplan have developed a more refined approach for assigning overheads to
products and computing product cost: activity – based costing (ABC). ABC provides
product-cost information that is useful for decision-making purposes.

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 Stage 1 Stage 2

Activity cost pools Cost driver rates

Material handling Cost per material movement
Procurement Cost per purchase order
Set-up Cost per set-up

The ABC procedure

Step1:

Identify the organisation’s major activities. A suitable rule thumb is to apply the 80/20 rule:
identify the 20% of activities that generate 80% of the overheads, and analyse these in detail.

Step 2:

Estimate the cost associated with preforming each activity. These costs are collected into cost
pools.

Step 3:

Identify the factors that influence the cost pools: cost drivers. For example, the number of set-
ups will influence the cost of setting up machinery.

Step 4:

Calculate a cost driver rate = (Cost pool/level of cost drivers)

Step 5:

Charge the overheads to the products by applying the cost driver rates to the activity usage of
the products.

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Example 1

A company is changing its costing system from traditional absorption costing based on labour
hours to an ABC system. It has overheads of $156,000, which are related to taking material
deliveries. The delivery information about each product is given below:

Product X Product Y Product Z

Total units required 1,000 2,000 3,000
Delivery size 200 400 1,000

Total labour costs are $360,000 for 45,000 hours. Each unit of each product takes the same
number of direct hours.

Assuming that the company uses the number of deliveries as its cost driver, what is the
increase or decrease in unit costs for Z arising from the change from AC (absorption costing)
to ABC?

A. $0.50 increase
B. $0.50 decrease
C. $14 increase
D. $14 decrease

Solution
D: It is worth noting that the labour cost is not needed here: it is a direct cost and will not
change, regardless of the method used. We will calculate the overhead cost per unit under
both systems, and calculate the difference.

Absorption Costing (AC): since the time per unit is the same for each product, the overheads
per unit will also be the same.

$156,000/6,000 units = $26 (we would get the same answer using labour hours)

ABC: Number of deliveries for X 1,000/200 = 5; for Y 2,000/400 = 5 deliveries and for Z
3,000/1,000 = 3 deliveries. So in total = 13 deliveries.

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Cost per delivery $156,000/13 = $12,000

Cost per unit of Z: ($12,000 per deliver x 3 deliveries) / (Total units required 3,000 units) =
$12

Decrease $26 -$12 = $14

Exercise 1: Manufacturing Business (From 2019 textbook)

A manufacturing business makes a product in two models, model M1 and model M2. Details
of the two products are as follows.
Model M1 Model M2
Annual sales 8,000 units 8,000 units
Number of sales orders 60 250
Sales price per unit $54 $73
Direct material cost per unit $11 $21
Direct labour hours per unit 2.0 hours 2.5 hours
Direct labour rate per hour $8 $8
Special parts per unit 2 8
Production batch size 2,000 units 100 units
Setups per batch 1 3

Cost driver
Setup costs $97,600 Number of setups
Material handling costs $42,000 Number of batches
Special part handling costs $50,000 Number of special parts
Invoicing $31,000 Number of sales orders
Other overheads $108,000 Direct labour hours
Total overheads $328,600

A customer has indicated an interest in placing an order for either model M1 or M2, and the
sales manager wished to try to sell the higher-priced model M2.

Required:

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a. Calculate the profit per unit for each model, using ABC
b. Using the information above identify which product the sales manager should try to sell
on the basis of the information provided by your ABC analysis.

ABC: BENEFITS AND LIMITATIONS

Benefits
o More accurate product-line costings where non-volume related overheads are significant
and a diverse product line is manufactured.
o Flexible enough to analyse costs by cost objects other than products such as processes,
areas of managerial responsibility and customers.
o Provides a reliable indication of long-run variable product cost which is particularly
relevant to managerial decision-making at a strategic level.
o Provides meaningful financial (periodic cost driver rates)and non-financial (periodic cost
driver volumes) measures which are relevant for cost management and performance
assessment at an operational level.
o Aids identification and understanding of cost behaviour and thus has the potential to
improve cost estimation
o Provides a more logical, acceptable and comprehensible basis for costing work.

Limitations

o Little evidence to date that ABC improves corporate profitability.

o ABC information is historic and internally orientated and therefore lacks direct relevance
for future strategic decisions.
o Practical problems such as cost driver selection.
o Its novelty is questionable. It may be viewed as simply a rigorous application of
conventional costing procedures.

ACTIVITY-BASED MANAGEMENT (ABM)

What is ABM?

o Is a system of management which uses activity-based cost information for a variety of

purposes including…..

ABM has 5 basic information outputs:

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 1. Cost of activities and business processes
2. Cost of non-value added activities
3. Activity-based performance measures
4. Accurate product/service costs
5. Costs drivers

DIRECT PRODUCT PROFITABILITY (DPP)

DPP is used primarily within the retail sector. DPP involves the attribution of both the
purchase price and other indirect costs (for example distribution, warehousing and retailing)
to each product line.

Thus a net profit, as opposed to a gross profit, can be identified for each product. The cost
attribution process utilises a variety of measures (for example warehousing space and
transport time) to reflect the resource consumption of individual products.

$ $
Selling price 1.50
Less: bought-in price (0.80)
Gross margin 0.70

Less: direct product cost: (0.56)

Transport costs 0.18
Warehouse costs 0.16
Store costs 0.22

Direct Product Profit 0.14

The benefits of DPP may be summarised as:

o Better cost analysis

o Better pricing decisions
o Better management of store and warehouse space
o The rationalisation of product ranges
o Better merchandising decisions

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Example 2: DPP

A supermarket wholesaler sells over 40,000 product lines to retailers who visit the store. It
has 45,000 m3 of general storage including 100 m3 of cold storage. General overheads are
$90,000 and additional cold storage costs are $5,000. Two of the products sold are single
frozen desserts (FD) and trays of 48 cans of soft drink (SD). Only frozen desserts are kept in
cooled storage.

The wholesaler pays $0.4 for a FD, which is 0.03 m3 and sells for $4. The trays of SD are 0.3
m3 and are bought for $5 and sold for $30.

Calculated to two decimal places, the net profit per FD is:

And per crate of SD is:

Solution

The cold storage was included in the space of general storage, and therefore the frozen
desserts should be allocated a share of the general costs as well as the cold storage costs.

General storage = $90,000/45,000 = $2 m3

Cold storage = $5,000/100 = $50 m3

Net profit of FD = $4 – $0.4 – 0.03 x ($50 +$2)] = $2.04

Net profit of SD = $30 - $5 – (0.3 m3 x $2) = $24.40

CUSTOMER PROFITABILITY ANALYSIS (CPA)

Customer profitability analysis is ‘the analysis of revenue streams and service costs
associated with specific customers or customer groups’.

o The cost to serve:

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 Different customers or categories of customers will each use different amounts of these
activities, and so customer profitability profiles can be built up, and customers can be
charged according to the cost to serve them.

A bank’s activities for a customer will include the following of activities:

 Withdrawal of cash
 Unauthorised overdraft
 Request for a statement
 Stopping a cheque
 Returning a cheque because of insufficient funds

o Customer profitability curve

When an organisation analyses the profitability of its customers, it is not unusual to find
that a Pareto curve exists (80/20 rule).

DISTRIBUTION CHANNEL PROFITABILITY

Distribution channels are the means of transacting with customers.

o Direct channels:

 Sales teams
 Telephone
 Shops
 Internet

o Indirect channels:

 Retailers
 Wholesalers
 Resellers
 Agents

Different channels will differ in profitability. Activity based costing information makes this
possible because it creates cost pools for activities.

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Channels will use some activities but not all, and different channels will have different
‘activity profiles’. This makes channel profitability analysis possible and allows companies to
build up distribution channel profitability profiles. It can be possible therefore for a company
to identify costly distribution channels for low margin products or services which they are
supplying through direct channels, and which may best be offered through indirect channels.
This would result in reduced channel distribution costs, and a better profitability profile for
the product or service.