1. Activity Based Costing and Management Systems
ABC systems focus on the activities and the business processes as the foundation for determining the cost of goods, services, processes, or any cost object
ABC systems attempt to address the problems found with traditional costing systems, such as ignoring volume differences, diversity, and resource demands of different cost objects

2. ABC Basics
ABC systems use a cost hierarchy: unit level, batch level, product sustaining level, and facility sustaining level
ABC systems, as part of identifying the relevant activities, also classify these activities into value-added and non-value added activities, so it becomes a management tool
ABC systems recognize not only economies of scale but economies of scope
At the heart of ABC is a two stage allocation process

3. The Two Stage Process in ABC
Stage 1: Create homogeneous cost pools based on activities and/or processes; e.g., group all purchasing costs together, all set-up costs together, all delivery costs together. This may take some work since most accounting systems gather cost by account categories such as salaries, depreciation, supplies, etc. and these accounts have to be studied in order to break them down into homogeneous costs pools
Stage 2: Allocate from the cost pools to the cost object (usually a product) using second stage cost drivers; e.g., number of deliveries, number of setups

4. Mapping Resource Expenses to Activities: Stage One
Salaries and Fringes
$313,000
Occupancy
$111,000
Equipment and Technology
$146,000
Materials and Supplies
$30,000
Total
$600,000

5. An ABC Example Supermarkets Drugstores MA and Pa Total
Average Revenue per delivery $30,900 $10, $1,980
Average CGS per delivery 30, , ,800
Gross Margin per delivery
Number of Deliveries , ,420
Total Gross margin $108,000 $150, $180,000 $438,000
Gross Margin % 2.9% 4.8% %
Other operating Costs ,080
Operating Profit ,920
Allocation of Other Costs 74, , , ,080
Distribution Line Profit 33, , , ,920
Profit Margin 0.9% 1.5% %
Other Costs are allocated in proportion to Gross Margin
301,080/438,000 = 68.7%; Ma and Pa = 68.7% * 180,000 = 123,731

6. An ABC Example, 2
The manager of this pharmaceutical distribution company heard about ABC and thought it may be useful for his operations. He identified 5 key activities, and their corresponding cost drivers.
Activity Cost Driver
Order Processing Number of Orders
Line Item Ordering Number of Line Items
Store Delivery Number of Store Deliveries
Cartons Shipped to Stores Number of Cartons shipped/delivery
Shelf Stacking at Store Number of hours of shelf stacking

7. An ABC Example, 3
Each order consists of one or more line items. A line item represents a single product (such as Extra Strength Tylenol. Each Store delivery entails delivery of one or more cartons of products. Each product is delivered in one or more separate cartons. The delivery staff stock cartons directly onto display shelves in a store. Currently there is no charge for this service, and not all customers use this service.

8. An ABC Example, 4
The firm has finished Stage 1 and has assigned the following costs to each of the five activity areas
Activity Area Total Costs Total Units of Cost Driver
Order Processing $80, ,000 orders
Line Item Ordering 63, ,280 line items
Store Deliveries 71, ,420 store deliveries
Carton Deliveries 76, ,000 cartons
Shelf Stacking 10, hours

9. An ABC Example, 5 Other useful data by distribution line
Supermarkets Drugstores Ma and Pa
1. Total number of orders ,500
2. Average number of line
items per order
3. Total number of store
deliveries ,000
4. Average number of
cartons shipped per delivery
5. Average number of hours
of shelf stacking per delivery

10. An ABC Example, 6
First, calculate the cost driver rate for each cost pool.
Activity Area Total Costs Total Units of Cost Driver Cost Driver Rate
Order Processing $80, ,000 orders $40/order
Line Item Ordering 63, ,280 line items 3/line item
Store Deliveries 71, ,420 store deliveries 50/store delivery
Carton Deliveries 76, ,000 cartons /carton
Shelf Stacking 10, hours 16/hour

11. An ABC Example, 7
Next, allocate these costs to each distribution channel
Supermarkets Drugstores Ma and Pa
1. Orders 140*40=5, *40=14,400 1,500*40=60,000
2. Average line items
2a. Total line items 1,960*3=5,880 4,320*3=12,960 15,000*3=45,000
3. Deliveries 120*50=6, *50=15,000 1,000*50=50,000
4. Average # of cartons
4a. Total cartons 36,000*1=36,000 24,000*1=24,000 16,000*1=16,000
5. Average stacking hours
5a. Total Stacking hours 360*16=5, *16=2, *16=1,600
Totals (= 301,080) 59, , ,600

12. An ABC Example, 8
Comparing ABC to Traditional Costing Profit: Supermarket
Traditional ABC
Average Revenue per delivery $30,900 $30,900
Average CGS per delivery 30, ,000
Gross Margin per delivery
Number of Deliveries
Total Gross margin $108,000 $108,000
Allocation of Other Costs 74, ,240
Distribution Line Profit 33, ,760
Profit Margin 0.9% 1.3%

13. An ABC Example, 9
Comparing ABC to Traditional Costing Profit: Drugstores
Traditional ABC
Average Revenue per delivery $10, $10,500
Average CGS per delivery 10, ,000
Gross Margin per delivery
Number of Deliveries
Total Gross margin $150, $150,000
Allocation of Other Costs , ,240
Distribution Line Profit , ,760
Profit Margin 1.5% 2.6%

14. An ABC Example, 10
Comparing ABC to Traditional Costing Profit: Ma and Pa
Traditional ABC
Average Revenue per delivery $1,980 $1,980
Average CGS per delivery 1, ,800
Gross Margin per delivery
Number of Deliveries 1, ,000
Total Gross margin $180,000 $180,000
Allocation of Other Costs , ,600
Distribution Line Profit , ,400
Profit Margin 2.8% 0.4%

15. An ABC Example, 10 Summary Profit Comparison of Traditional vs. ABC
Traditional ABC
Supermarket 33,761 (0.9%) 48,760 (1.3%)
Drugstores 46,890 (1.5%) 80,760 (2.6%)
Ma and Pa 56,269 (2.8%) ,400 (0.4%)
Total 136, ,920

16. An ABC Example, 11
Note that the total profit for the firm has not changed at all as a result of using ABC vs. traditional costing techniques
So what’s the big deal??
Some people argue that for many firms using ABC is analogous to re-arranging the chairs on the deck of the Titanic - it really doesn’t stop a firm from failing
also, ABC is not GAAP
also, implementing ABC is a significant task
This is true if figuring out new product costs is the only thing ABC is used for

17. So What is the Value of ABC
Like any accounting system, ABC is an INFORMATION system - it provides info to assist decision makers, but in and of itself this info DOES NOTHING, unless management acts upon it
ABC provides insights into your business that management was probably not aware of before
The old system simply charged each line 68.7% of its gross margin to arrive at product line profitability - peanut butter costing

18. So What is the Value of ABC, 2
The ABC system reveals however that the MA and PA stores actually consume 95.9% of its gross margin with other operating expenses
This is because the MA and PA stores are more activity intense, and thus more cost intensive
Under the old system, MA and PA stores were charged 41.1% (180,000/438,000) of overhead, since this was their share of gross margin
However, if you look at the activities, you can see that MA and PA stores account for well over 41.1% of the activities (75% of the orders, 70% of the deliveries, etc)

19. How can managers act on this info
Now that managers know the cost of these activities, they can work to try and reduce those costs
Also, they can see why Ma and Pa stores are so expensive (they order more often, they have more deliveries, etc.) and they work with these stores to try and reduce those activities; i.e., less frequent ordering, less frequent deliveries
Also, since part of ABC is activity identification and classification as VA or NVA, managers can attempt to eliminate or minimize NVA

20. When Would ABC not be Useful (at least from a product costing view)
If the company only has one product
If all products use all resources in the same proportions, which is the same proportion used to allocate costs in a traditional system (little diversity)
Cost control is not critical at this stage for the company (growth stage companies)

21. When Would ABC be most Useful
The Willie Sutton rule
large expenses in indirect and support resources
High diversity (products, customers, processes)
When a firm wants to better understand its activities and the costs of those activities, even if the firm only makes one product

22. Developing an ABC System, 1
There are four sequential steps a firm would go through o develop an ABC system
Develop the activity dictionary
determine how much the organization is spending on each of its activities
identify the organization’s products, services, and customers
select activity cost drivers that link activity costs to the organization’s products, services, and customers
transaction, duration, and intensity

23. Developing an ABC System, 2
The goal of an ABC system should not be to develop the most accurate, but one that balances the cost of errors made from inaccurate estimates with the cost of measurement
Activity cost drivers are the central innovation of ABC systems, but they are also the most costly