1. Chapter Seven Activity-Based Costing and Management
COPYRIGHT © 2012 Nelson Education Ltd.

2. Learning Objectives
Explain why functional-based costing approaches may produce distorted costs
Explain how an activity-based costing system works for product costing
Describe activity-based customer and supplier costing
Explain how activity-based management can be used for cost reduction

3. OBJECTIVE  1
Explain why functional-based costing approaches may produce distorted costs

4. Functional-Based Costing Systems
Functional-based systems
Based on volume measures, such as
Direct labour hours
Machine hours
Two types:
Plantwide rates
Departmental rates
Often produce average costs that over- or understate individual product costs

5. Functional-Based Costing System Limitations
Two major factors impair their ability to assign overhead costs accurately:
Proportion of non-unit-related overhead costs to total overhead charge is large
Degree of product diversity is great

6. Unit and Non-Unit Activities
Unit-level-activities ---
Activities performed each time a unit is produced
Non-unit-level-activities ---
From the viewpoint of the subsequent process, transferred-in costs are a type of raw material cost

7. Non-Unit-Related Overhead Costs
What is needed for accurate cost assignment of non-unit-level activities?
Non-unit-level activity drivers
Factors that measure the consumption of non-unit-level activities by products and other cost objects

8. Product Diversity
Products consume overhead activities in systematically different proportions
Consumption Ratio ---
Proportion of each activity consumed by a product

9. Example: Cornerstone 7-1
How to Calculate Consumption Ratios
Activity Usage Measures
Deluxe
Regular
Total
Units produced 10
100
110
Prime costs
$800
$8,000
$8,800
Direct labour hours 20 80
100
Machine hours 10 40 50
Setup hours 3 1 4
Number of moves 6 4 10

10. Example Activity Cost Data Activity Activity Cost Setting up equipment
$1,200
Moving goods
800
Machining
1,500
Assembly
500
Total
$4,000

11. Example Calculate the consumption ratio for each product
Activity Driver
Overhead Activity
Deluxe
Regular
Setting up equipment
0.75
0.25
Setup hours
Three of four hours were spent setting up the Deluxe Model
¾ or 0.75
One of four hours was spent on the Regular model

12. Example Calculate the consumption ratio for each product
Activity Driver
Overhead Activity
Deluxe
Regular
Setting up equipment
0.75
0.25
Setup hours
Moving goods
0.60
0.40
# of moves
6 of the 10 moves were for the Deluxe model, 4 of the 10 were for the Regular model

13. Example Calculate the consumption ratio for each product
Activity Driver
Overhead Activity
Deluxe
Regular
Setting up equipment
0.75
0.25
Setup hours
Moving goods
0.60
0.40
# of moves
Machining
0.20
0.80
Machine hrs
Deluxe model used 10 of the 50 machine hours, while the Regular model used 40 hours

14. Example Calculate the consumption ratio for each product
Activity Driver
Overhead Activity
Deluxe
Regular
Setting up equipment
0.75
0.25
Setup hours
Moving goods
0.60
0.40
# of moves
Machining
0.20
0.80
Machine hrs
Assembly
0.20
0.80
Direct labour hours
Deluxe model used 20 of the 100 direct labour hours. Regular model used 80 hours

15. Deluxe model had Consumption Ratios ranging from 0.75 to 0.20
Example
Calculate the consumption ratio for each product.
Activity Driver
Overhead Activity
Deluxe
Regular
Setting up equipment
0.75
0.25
Setup hours
Moving goods
0.60
0.40
# of moves
Machining
0.20
0.80
Machine hrs
Assembly
0.20
0.80
Direct labour hours
Deluxe model had Consumption Ratios ranging from 0.75 to 0.20

16. Example: Cornerstone 7-2
How to Calculate Activity Ratios
Information:
Activity
Activity Cost
Setting up equipment
$1,200
Moving goods
800
Machining
1,500
Assembly
500

17. Example Driver Driver Quantity Setup hours 4 Number of moves 10
Information:
Driver
Driver Quantity
Setup hours 4
Number of moves 10
Machine hours 50
Direct labour hours
100

18. $5 per direct labour hour
Example
Required: Calculate activity rates
Setup rate
$1,200/4 setup hours
$300 per setup hour
Materials handling rate
$800/10 moves
$80 per move
$30 per machine hour
Machining rate
$1,500/50 machine hours
Assembly rate
$500/100 machine hours
$5 per direct labour hour

19. Example: Cornerstone 7-3
How to Calculate Activity-Based Unit Costs
Information:
Deluxe
Regular
Activity Rate
Units produced per year 10
100
Prime costs
$800
$8,000
Setup hours 3 1
$300
Number of moves 6 4
$ 80
Machine hours 10 40
$ 30
Direct labour hours 20 80
$ 5

20. Example Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups
Required: Calculate the unit cost for deluxe and regular models
Deluxe
Regular
Prime costs
$800
$8,000
Overhead costs:
Setups
900
300
$300 per setup × 3 setups
$300 per setup ×1 setup

21. Example Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups
Required: Calculate the unit cost for deluxe and regular models
Deluxe
Regular
Prime costs
$800
$8,000
Overhead costs:
Setups
900
300
Moving materials
480
320
$80 per move × 6 moves
$80 per move × 4 moves

22. Example Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups
Required: Calculate the unit cost for deluxe and regular models.
Deluxe
Regular
Prime costs
$800
$8,000
Overhead costs:
Setups
900
300
Moving materials
480
320
Machining
300
1,200
$30 per machine hour x 10 hours
$30 per machine hour x 40 hours

23. Example Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups
Required: Calculate the unit cost for deluxe and regular models
Deluxe
Regular
Prime costs
$800
$8,000
Overhead costs:
Setups
900
300
Moving materials
480
320
Machining
300
1,200
Assembly
100
400
$5 per direct labour hour × 20 hours
$5 per direct labour hour × 80 hours

24. Required: Calculate the unit cost for deluxe and regular models
Example
Required: Calculate the unit cost for deluxe and regular models
Deluxe
Regular
Prime costs
$800
$8,000
Overhead costs:
Setups
900
300
Moving materials
480
320
Machining
300
1,200
Assembly
100
400
Total manufacturing costs
$2,580
$10,220
$2,580 ÷ 10 units = $258 per unit
$10,220 ÷ 100 units = $ per unit

25. Explain how an activity-based costing system works for product costing
OBJECTIVE  2
Explain how an activity-based costing system works for product costing

26. Identifying Activities and Their Attributes
Activity Dictionary
Lists the activities in an organization along with some critical activity attributes
Activity Attributes
Financial and nonfinancial information items that describe individual items

27. Key Questions to Identify Activities
How many employees are in your department?
What do they do?
Do customers outside your department use any equipment?
What resources are used by each activity?
What are the outputs of each activity?
Who or what uses the activity output?
How much time do workers spend on each activity? Time on each activity by equipment?

28. Assigning Costs to Activities
Must determine how much it costs to perform each activity
Requires identification of resources being consumed
labour, materials, energy, and capital
Cost of resources is found in general ledger
Resources must be assigned using driver tracing
Work distribution matrix
Used to assign labour resources

29. Factors that measure the consumption of resources by activity
Resource Drivers
Factors that measure the consumption of resources by activity

30. Example: Cornerstone 7-4
How to Assign Resource Costs Using
Direct Tracing & Resource Drivers
Information:
Assume that each clerk is paid a salary of $30,000 ($150,000 total clerical cost for 5 clerks)
Required:
Assign the cost of labour to each of the activities in the credit department

31. Example Processing transactions $60,000 Preparing statements $45,000
Answering questions
$45,000
0.4 × $150,000
0.3 × $150,000
0.3 × $150,000

32. Assigning Costs to Products
Usage of the activity (as measured by activity drivers)
Predetermined activity rate x
To calculate this rate, the practical capacity of each activity must be determined

33. Describe activity-based customer and supplier costing
OBJECTIVE  3
Describe activity-based customer and supplier costing

34. Activity-Based Customer Costing
Customers are cost objects of fundamental interest
Customer management can produce significant gains in profit
Customers can consume customer-driven activities in different proportions
Assigning costs of customer service to customers the same as assigning manufacturing costs to products

35. Example: Cornerstone 7-5
HOW TO Calculate Activity-Based Customer Costs
Information:
Milan Company produces precision parts for 11 major buyers
One large customer
Accounts for 50% of sales
Ten smaller customers
Account for 50% of sales
Each purchases parts in roughly equal quantities
Parts orders placed are similar in size

36. Data concerning Milan’s customer activity follow:
Example
Information continued:
Data concerning Milan’s customer activity follow:
Large Customer
Ten Smaller Customers
Units purchased
500,000
500,000
Orders placed 2
200
Number of sales calls 10
210
Manufacturing costs
$3,000,000
$3,000,000
Order filling costs allocated
$202,000
$202,000
Sales force costs allocated
$110,000
$110,000

37. Assign costs to customers using an ABC approach
Example
Required:
Assign costs to customers using an ABC approach
Activity Rates
$404,000/202 orders
= $2,000 per order
$220,000/220 calls
= $1,000 per call

38. Assigning Costs to Customer Groups
Large Customer
Ten Smaller Customers
Order filling costs
$4,000
$400,000
$2,000 × 2
$2,000 × 200

39. Assigning Costs to Customer Groups
Large Customer
Ten Smaller Customers
Order filling costs
$4,000
$400,000
Sales force costs
10,000
210,000
$1,000 × 10
$1,000 × 210

40. Assigning Costs to Customer Groups
Large Customer
Ten Smaller Customers
Order filling costs
$4,000
$400,000
Sales force costs
10,000
210,000
$14,000
$610,000
The large customer costs much less to service that the smaller customers.

41. Supplier Costing Methodology
Cost of a supplier is much more than purchase price of the components or materials acquired
Assigning cost to suppliers is similar to cost assignments for products and customers

42. Example: Cornerstone 7-6
How to Calculate Activity-Based Supplier Costs
Information:
Purchasing manager uses two suppliers as sources of Part A1 and Part B2
Murray Inc.
Plata Associates
Consider two activities:
Repairing products
Because of part failure (bought from supplier)
Expediting products
Because supplier is late

43. Example
Information continued:
Activity cost information and other data needed for supplier costing follow:
I. Activity costs caused by suppliers
Activity
Costs
Repairing Products
$800,000
Expediting Products
$200,000

44. Example II. Supplier data Murray, Inc. Plata Assoc.
Information continued:
II. Supplier data
Murray, Inc.
Plata Assoc.
Part A1
Part B2
Part A1
Part B2
Unit purchase price
$20
$52
$24
$56
Units purchased
80,000
40,000
10,000
10,000
Failed units
1,600
380 10 10
Late shipments 60 40

45. Determine the cost of each supplier using ABC
Example
Required:
Determine the cost of each supplier using ABC
Activity Rates
Repair rate =
$800,000/2,000 =
$400 per failed part
Total failed units 1,

46. Determine the cost of each supplier using ABC
Example
Required:
Determine the cost of each supplier using ABC
Activity Rates
Repair rate =
$800,000/2,000 =
$400 per failed part
Expediting rate =
$200,000/100 =
$2,000 per late delivery
Total late shipments

47. Example Murray, Inc. Purchase cost $1,600,000 $2,080,000 Part A1
Part B2
Purchase cost
$1,600,000
$2,080,000
$20 × 80,000
$52 × 40,000

48. Example Plata Associates Purchase cost $240,000 $560,000 Part A1
Part B2
Purchase cost
$240,000
$560,000
$24 × 10,000
$56 × 10,000

49. Example Murray, Inc. Purchase cost $1,600,000 $2,080,000
Part A1
Part B2
Purchase cost
$1,600,000
$2,080,000
Reporting products
640,000
152,000
$400 × 1,600
$400 × 380

50. Example Plata Associates Purchase cost $240,000 $560,000
Part A1
Part B2
Purchase cost
$240,000
$560,000
Reporting products
4,000
4,000
$400 × 10
$400 × 10

51. Example Murray, Inc. Purchase cost $1,600,000 $2,080,000
Part A1
Part B2
Purchase cost
$1,600,000
$2,080,000
Reporting products
640,000
152,000
Expediting products
120,000
80,000
$2,000 × 60
$2,000 × 40

52. Example Plata Associates Purchase cost $240,000 $560,000
Part A1
Part B2
Purchase cost
$240,000
$560,000
Reporting products
4,000
4,000
Expediting products
Plata does not deliver parts late, therefore there are no expediting costs with Plata

53. Example Murray, Inc. Purchase cost $1,600,000 $2,080,000
Part A1
Part B2
Purchase cost
$1,600,000
$2,080,000
Reporting products
640,000
152,000
Expediting products
120,000
80,000
Total costs
$2,360,000
$2,312,000
Units
÷ 80,000
÷ 40,000
Total unit cost
$29.50
$57.80

54. Plata is the better choice with the lowest total unit cost
Example
Plata Associates
Part A1
Part B2
Purchase cost
$240,000
$560,000
Reporting products
4,000
4,000
Expediting products
Total costs
$244,000
$564,000
Units
÷ 10,000
÷ 10,000
Total unit cost
$24.40
$56.40
Plata is the better choice with the lowest total unit cost

55. Explain how activity-based management can be used for cost reduction
OBJECTIVE  4
Explain how activity-based management can be used for cost reduction

56. Process-Value Analysis
Focuses on cost reduction instead of cost assignment
Maximization of system-wide performance
Driver analysis
Activity analysis
Performance measurement

57. Activity Inputs and Outputs
Resources consumed by the activity in producing its output
Activity Outputs
Result or product of an activity

58. Driver Analysis: The Search for Root Causes
Activity Output Measure
Number of times activity is performed
Driver Analysis
Effort expended to identify those factors that are the root causes of activity costs

59. Activity Analysis
Process of identifying, describing, and evaluating the activities
It should produce four outcomes:
What activities are done
How many people perform the activities
Time and resources required to perform the activities
Assessment of the value of the activities to the organization

60. Value-Added Activities
Activities necessary to remain in business
Two types:
Value-added by mandate
Necessary to comply with legal mandate
Discretionary activities

61. Discretionary Value-Added Activities
Three conditions must be met simultaneously for the activity to be classified as value added:
Produces a change of state
Change of state was not achievable by preceding conditions
Enables other activities to be performed

62. Non-Value Added Activities
All activities other than those that are absolutely essential to remain in business
Examples:
Scheduling
Storing
Moving
Inspecting
Waiting
Challenge of activity analysis is to find ways to produce the good without using any of these activities

63. Cost Reduction Four Ways: Activity elimination Activity selection
Activity reduction
Activity sharing
Activity Elimination:
Once activities that fail to add value are identified, measures must be taken to rid the organization of these activities
Activity Selection:
Involves choosing among different sets of activities that are caused by competing strategies. The lowest-cost design strategy should be chosen
Activity Reduction:
Decreases the time and resources required by an activity. This approach focuses on improving efficiency
Activity Sharing:
Increases the efficiency by using economies of scale. This lowers the per-unit cost of the cost driver and the amount of cost traceable to the products that consume the activity

64. Example: Cornerstone 7-7
How to Assess Non-Value Added Costs
Information:
Consider the following two activities:
Performing warranty work, cost: $120,000
Warranty cost of the most efficient competition is $20,000
Purchasing components, cost: $200,000 (10,000 purchase orders)
Benchmarking study reveals that the most efficient level would use 5,000 purchase orders and entail a cost of $110,000

65. Example Determine the non-value-added cost of each activity
Warranty work
Is the activity non value-added or value-added?
Performing warranty work is a non value-added activity
Performing warranty work is a non value-added activity
Why? It is done to correct something that wasn’t done right the first time
How much is the non value-added cost?
$120,000

66. Example Determine the non-value-added cost of each activity Competitor
Is the activity non value-added or value-added?
Cost of the competitor is a non value-added activity
Cost of the competitor is a non value-added activity
Why? It has no bearing on the analysis
How much is the non value-added cost?
$200,000 - $110,000 = $90,000
Because the activity is not performed efficiently

67. Example Determine the non-value-added cost of each activity
Purchasing components is necessary (value-added) but it is not performed efficiently
Actual cost – benchmark study $200,000 - $110,000
$90,000 in non-value added cost

68. Activity Performance Measurement
Assess how well an activity was performed and the results achieved
Measures are both financial and nonfinancial
Three dimensions:
Efficiency
Quality
Time

69. Efficiency, Quality, & Time
Focuses on the relationship of activity inputs to activity outputs
Quality
Concerned with doing the activity right the first time
Time
Longer times usually mean more resource consumption and less ability to respond to customer demands

70. Example: Cornerstone 7-8
How to Calculate Cycle Time and Velocity
Assume that a company takes 10,000 hours to produce 20,000 units of a product
What is the velocity?
Velocity = 20,000/10,000 = 2 units per hour
Velocity is the number of units of output that can be produced in a given period of time
Cycle time is the length of time it takes to produce a unit of output from the time the raw materials are received until the good is delivered to finished goods inventory
What is the cycle time?
Cycle Time = 10,000/20,000 = ½ hour

71. Just-in-Time Systems
Goods pushed through system by present demand rather than on a fixed schedule based on anticipated demand
Each operation produces only what is necessary to satisfy the demand of the succeeding operation
Reduces all inventories to very low levels
Reduces inventory carrying costs
Emphasize total quality control (TQC) and continuous improvement in quality

72. Environmental Cost Management
Environmental costs are also known as environmental quality costs
Environmentally linked activities are activities performed because poor environmental quality may exist
Costs are associated with two subcategories:
control activities
failure activities
Environmental costs are classified into four analogous categories:
prevention costs
detection costs
internal failure costs, and
external failure costs