Chapter 5

Activity-Based Costing
and Management

McGraw-Hill/Irwin Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved.
Learning Objective 5-1 – Compute product costs
under a traditional, volume-based product-costing
system.

5-2
Traditional, Volume Based
Costing System
Traditional, Volume Based
Costing System
 Traditional, Volume-Based
Product-Costing System
With these product costs, Patio Grill established target
selling prices (Cost × 120%).

496.00 x 1.20
5-5
Learning Objective 5-2 Explain how an activity-based
costing system operates, including the use of a two-stage procedure for
cost assignment, the identification of activity cost pools, and the
selection of cost drivers.

5-6
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.

5-7
Learning Objective 5-3 – Explain the concept of
cost levels, including unit-level, batch-level,
product-sustaining-level, and facility-level costs .

5-8
 Overhead Costs
Total budgeted cost = $4,896,000 Identification
Activity
must be
of Activity
done on Activity Cost Pools
each unit Cost
produced. Pools
Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level

Machinery Setup Engineering Facility

cost pool cost pool cost pool cost pool
$1,242,000 $210,000 $130,000 $2,300,000

Activity Activities needed to support Activity required in order

performed an entire product line for the production
on each process to occur.
batch
produced. 5-9
 Product-
Unit- Batch- Sustaining- Facility-
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1,242,000 $210,000 $130,000 $2,300,000

Purchasing
cost pool 300,000

Material-Handling
cost pool $340,000

Quality-Assurance
cost pool $110,000

Packaging/Shipping
cost pool $264,000
5-10
Learning Objectives 5-4 – Compute product costs
under an activity-based costing system.

5-11
 STAGE ONE – Machinery Cost Pool
Various overhead
Maintenance Lubrication
costs related
to machinery Depreciation Electricity

Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1,242,000

5-12
STAGE TWO – Machinery Cost Pool
Budgeted Machinery Costs $1,242,000
Budgeted Machine Hours 230,000=
$5.40/hour=

5-13
ABC Pool Cost Calculations –
First 4 activities
ABC Pool Cost Calculations –
Last 4 activities
 Product Cost from ABC
These are the new product costs when ABC is used.

5-16
Learning Objective 5-5 – Explain why
traditional, volume-based costing systems tend to
distort product costs.

5-17
 Distorted Product Costs
Both original and ABC target selling prices are
based on (Cost × 120%).

5-18
5-19
 Two Key Points

A large proportion of non- Product diversity

unit-level activities
When the consumption
A unit-level cost driver, such
ratios differ widely
as direct labor, machine
hours, or throughput, will between activities, no
not be able to assign the costs single cost driver will
of non-unit-level activities accurately assign the
accurately. resulting overhead costs.

5-20
Learning Objective 5-6 – Explain three criteria
for selecting cost drivers.

5-21
 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 Behavioral
Correlation Effects

Cost of
Measurement

5-22
Learning Objective 5-7 – Discuss several key
issues in activity-based costing, including data
collection and storyboarding.

5-23
 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
department’s 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 organization’s
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.
5-24
Learning Objective 5-8 – Explain the concepts of
activity-based management and two-dimensional
ABC.

5-25
Activity-Based Management

The use of
ABC costing
information
to help
management
make decisions
5-26
Activity-Based Management (ABM)
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.

5-27
Two-Dimensional ABC and
Activity-Based Management

Activities

5-28
Two-Dimensional ABC and Activity-Based
Management
Cost Assignment View

Resource costs

Activities

Cost Objects
5-29
 Two-Dimensional ABC and
Activity-Based Management
Cost Assignment View

Resource costs
Process View
Activity Analysis Activity Evaluation

Root Activity Performance

Causes Triggers Activities Measures

Cost Objects
5-30
Elimination of Non-Value-Added Costs
Activities

Non-value-
added
activities
Unnecessary Necessary

Reduce or Continually Evaluate

Eliminate
and Improve 5-31
 Using ABM to Eliminate Non-Value-Added
Activities and Costs
1. Identify Activities.
2. Identify Non-Value-Added Activities.
3. Understand Activity Linkages, Root Causes, and
Triggers.
Inspect Rework
Specify Select Receive Produce
finished defective
parts vendor parts goods
goods products

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

5-32
Using ABM to Eliminate Non-Value-Added
Activities and Costs

Process time

Inspection time Storage time

Move time Waiting time

5-33
Learning Objective 5-9 – Explain and execute a
customer-profitability analysis.

5-34
Customer Profitability Analysis

Customer profitability analysis uses

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

5-35
Customer Profitability Analysis
Required
special
packaging
Orders Demand
small fast
quantities service

Often
Orders
changes
frequently
orders

A costly customer
5-36
 Customer Profitability Analysis
Cost Drive
Customer-Related Activities Cost Driver Base Rate
Order processing Purchase orders $ 150
Sales contacts (phone calls, faxes, etc.) Contacts 100
Sales visits Visits 1,000
Shipment processing Shipments 200
Billing and collection Invoices 160
Design/engineering change orders Design changes 4,000
Special packaging Units packaged 40
Special handling Units handled 60

A company may use these customer

related costs to help determine the
profitability of each customer.

5-37
Customer Profitability Analysis
Customer Profitability
Cumulative Operating Income as a % of Total

125.0%

100.0%
Operating Income

75% of actual operating income

75.0%

50% of actual operating income

50.0%

25% of actual operating income

25.0%

0.0%
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20

5-38
Learning Objective 5-10 – Understand and
discuss how activity-based costing is used in service-
industry organizations.

5-39
ABC Costing in the Service Industry
The overall objectives of ABC in service
firms are no different than they are in
manufacturing companies.
Identify the activities
Create activity cost pools
Identify activity cost drivers
Follow similar steps discussed in chapter
End Chapter 5

5-41