Chapter 4:

Activity-Based Management
and Activity-Based Costing
Cost Accounting:
Foundations and Evolutions, 8e
Kinney Raiborn

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Learning Objectives

In an activity-based management system, what are

value-added and non-value-added activities?
How do value-added and non-value-added activities affect
manufacturing cycle efficiency?
Why is it important to analyze the drivers of costs?
How are product costs computed using an activity-based
costing system?
Under what conditions is activity-based costing useful in
an organization and what information do activity-based
costing systems provide to management?
What criticisms have been directed at activity-based
costing?

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Activity-Based Management

Focuses on activities during

production and performance process

An activity is a repetitive action

performed in fulfillment of a business
function

Improves the value received by

customers
Enhances profitability

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Activity-Based Management

Activity analysis
Cost driver analysis
Activity-based
costing
Continuous
improvement

Operational control
Quality management
Business process
improvement
Performance
measurement

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Benefits of Activity-Based
Management

External benefits

Increased customer
value
Enhanced profitability

Internal benefits

More efficient
production
More accurate cost
determination
More effective
performance
evaluation

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Activity Analysis
Value-added activity

Increases worth of
product or service to a
customer
Customer is willing to pay
for it

Non-value-added activity

Increases time spent on

product or service but does
not increase worth
Unnecessary from customer
perspective
Can be reduced, redesigned
or eliminated without
affecting market value or
quality
Business-value-added
activities are essential

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Process

A process is a series of activities that,

when performed together, satisfy a
specific objective
Production
Distribution
Selling
Administration

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Activity Analysis

Create a Process Map (detailed flowchart) for

each process

Identify each step

Create Value Chart

Identify stages and time spent in stages from

beginning to end of process
Value-Added
Processing Time
Service Time

Non-Value-Added
Inspection Time
Transfer Time
Idle Time

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Cycle Time

Eliminate or minimize activities that add the

most time and cost and the least value

Cycle
Time

ValueAdded
Time

NonValue-Added
Time

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Manufacturing Cycle Efficiency

Manufacturing
Cycle Efficiency
(MCE)

Value-Added
Processing Time
Total Cycle Time

100% efficiency unrealistic

Reducing non-value-added activities will
increase MCE
Value-added activity usually represents about
10% of total cycle time
Just-in-time (JIT) increases MCE

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Non-Value-Added Activities

Attributed to following factors

Systemic
Physical
Human

Eliminating or reducing non-value-added

activities that create the most costs will

Increase product/service quality

Decrease cycle time and cost

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Cost Driver Analysis

Cost drivers are factors that have a

direct causeeffect relationship to a cost

Limit the number of cost drivers

Cost of measurement should not exceed
benefit of using the cost driver
Easy to understand
Directly related to the activity being
performed
Appropriate for measurement

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A Management Tool

Combine:

Activity analysis
What activities are non-value-added?
Cost driver analysis
What causes costs to be incurred?

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Cost Drivers

Unit-level costs

Batch-level costs

setup, inspection

Product/process-level costs

direct material, direct labor

engineering changes, product development

Organizational or facility costs

building depreciation, plant managers salary

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Product Cost Behavior

Unit-level costs are variable in relation
to change in production volume
Batch, product/process, and
organizational level costs are variable
for reasons other than changes in
production volume

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Product Cost
Unit-Level
Costs

Allocate over number

of units produced

Cost per unit

Batch-Level
Costs

Allocate over number

of units in batch

Cost per unit

in batch

Allocate over number

Product/Processof units produced in

Level Costs

related product line

Cost per unit

in product line

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Product and Company

Profitability

Unit
Batch
Product

Total product revenue

<Total product cost>
Net product margin
+/ All other net product margins
Total margin provided by products
<Organizational/facility-level costs>
Company profit or loss
Not
GAAP

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or duplicated, in whole or in part, except for use as permitted in a license

2011 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a
license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Activity-Based Costing
Recognizes several levels of costs
Accumulates costs into related cost
pools
Uses multiple cost drivers to assign
costs to products and services

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When to Use ABC

Companies use ABC when:

They have a wide variety of products or services

High overhead costs are not proportional to the unit
volume of individual products
Automation makes it difficult to assign overhead to
products using direct labor or machine hours
Profit margins are difficult to explain
Hard-to-make products show big profits and easyto-make products show losses

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Two-Step Allocation

Collect costs in general ledger and subsidiary accounts

Identify activity centers

Choosing an activity center

Choose a manageable number of activity centers

Accumulate costs into activity center cost pools

Identify cost drivers

Costs in each cost pool are

Geographical proximity of equipment

Centers of managerial responsibility
Magnitude of product costs

Driven by homogenous activities

Strictly proportional to the activity

Allocate costs to products and services

Activity driver measures demands placed on activities, thus, the

resources consumed by products/services

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Activity Drivers

Reports requested
Job change actions
Hiring actions
Training hours
Transactions processed
Engineering changes
Defects discovered

Repair hours
Material requisitions
Purchase requisitions
Space occupied
Set-ups
Moves
Employees

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Activity-Based Costing
Record
Costs in GL

Cost
Driver

Activity
Driver
Accumulate in
Activity Center
Cost Pools

Cost
Objects

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Traditional vs. ABC Costing

When ABC is implemented

Cost is reduced for high-volume,
standard products
Cost is increased for low-volume,
complex specialty products

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Long-Term Variable Costs

Cost drivers
Product varietynumber of different
types of products
Product complexitynumber of
processes through which a product
flows

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ABC Costing Considerations

Number and diversity of products/services

produced
Diversity and differential degree of support
services used for different products
Extent to which common processes are used
Effectiveness of current cost allocation
methods
Rate of growth of period costs

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Use ABC Costing for

1.

2.

3.

4.

Product Variety and Process

Complexity
Lack of Commonality in Overhead
Costs
Problems with Current Cost
Allocations
Changes in Business Environment

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Use ABC Costing for

Product Variety and Process Complexity

1.

Caused by mass customization

Too many choices, opportunity for errors

Pareto Principle
Commonality of parts

Reduced by

Simultaneous (or Concurrent) Engineering

Design for Manufacturability

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Use ABC Costing when

2. Lack of Commonality in Overhead Costs

Some products/services use substantially more

overhead than others

3. Problems with Current Cost Allocations

Significant changes in process with no change

in cost allocations
Expense majority of period costs when incurred

4. Changes in Business Environment

Increase in competition or change in

management strategy

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Continuous Improvement

Eliminates non-value-added activities to reduce

cycle time
Makes products/performs services with zero
defects
Reduces product costs on an ongoing basis
Simplifies products and processes

ABC Costing Supports

Continuous Improvement
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Criticisms of ABC
Significant amount of time and cost
to implement
Must overcome barriers to change
Does not conform to GAAP

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Advantages of ABC and ABM

Identify and monitor

significant technology costs
Trace technology costs
directly to products
Increase market share
Identify the cost drivers that
create or influence cost
Identify activities that do not
contribute to perceived
customer value

Understand the impact of

new technologies on all
elements of performance
Translate company goals
into activity goals
Analyze the performance of
activities across business
functions
Analyze performance
problems
Promote standards of
excellence

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Questions

What are the differences between activitybased costing and traditional cost
accounting?
What are cost drivers and activity drivers?
What are two advantages and two criticisms
of activity-based costing?

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or duplicated, in whole or in part, except for use as permitted in a license

Potential Ethical Issues

Ignoring non-value-added activities

Using non-value label to eliminate jobs
Misclassifying activities to allocate costs away from
lower volume products to justify lower selling prices
Selecting an inappropriate cost driver to distort cost
calculations
Using ABC to eliminate a vendor or customer
Using ABC to eliminate funding of social or
environmental causes
Using ABC to transfer cost from fixed price contracts
to cost-plus contracts

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