1. Chapter 5 Activity-based Cost Systems
See also: Kaplan/Atkinson 3rd ed. Ch.4
Cooper/Kaplan: Cost and Effect,
Harvard Business School Press 1998

2. Example of misleading traditional cost system
Cole Corporation manufactures two types of lenses for automobile rear lights out of plastic material – a normal lens (NL) and a complex lens (CL).
lenses are molded using machines
redesigned according to the requirements of the customers (model changes)
To cost products, Cole currently uses a single indirect-cost rate job costing system.
The cost objects are the total costs of manufacturing and distributing 80,000 normal lenses (NL) and 20,000 complex lenses (CL).

3. Application to two products
Normal Lenses (NL) Complex Lenses (CL)
Direct materials $1,520,000 $ 920,000
Direct mfg. labor , ,000
Total direct costs $2,320,000 $1,180,000
Direct cost per unit: $2,320,000 ÷ 80,000 $1,180,000 ÷ 20,000
= $ = $59
total direct labor hrs. 36, ,000
Indirect costs $2,900,000
direct manufacturing labor hrs ,000
Indirect cost rate = $2,900,000 ÷ 50,000
= $58

4. Product cost Direct costs $2,320,000 $1,180,000
Normal Lenses (NL) Complex Lenses (CL)
Direct costs $2,320,000 $1,180,000
+ Allocated costs (= 36,000 × $58) (=14,000 × $58)
$2,088,000 $ 812,000
= $4,408,000 $1,992,000
cost per unit $4,408,000 ÷ 80,000 $1,992,000 ÷ 20,000
= $ = $ 99.60
Selling price: $ $142
Margin $ $
Margin %age % %

5. Refining a Costing System
Guidelines
Direct-cost tracing – Classify as many of the total costs as direct costs as is economically feasible.
Indirect-cost pools – Expand the number of cost pools until each of these pools is homogeneous.
Cost-allocation basis – Identify the preferred cost-allocation base for each indirect-cost pool.

6. Activity-Based Costing System
ABC systems refine costing systems by focusing on individual activities as the fundamental cost object
they measure utilization of each activity by cost objects and assign the cost of the activity accordingly
total cost of activity
per period
(“cost pool”)
total utilization of
activity per period
Cost driver
rate =
cost driver units
used by cost object
Cost driver
rate
overhead cost
assigned
to cost object × =

7. Activity-based Costing: the fundamental idea:
Resource:
Indirect labor
Inspect
incoming
materials
Move
materials
Maintain
machines
Set up
machines
Prepare
tooling
Activity:
Activity
cost driver:
# receipts
# moves
# maint. hrs.
# setup hrs.
# setups     
Cost driver
rate:
$ per receipt
$ per move
$ per setup
$ per maint.hr.
$ per setup hr.
Product,
Customer:

8. General Procedure
Determine the set of activities j performed in each department (cost center)
determine a Cost Driver for each activity j measuring the causal relationship between
resource consumption of the activity and its
utilization by products or customers
assign (budgeted) resource costs to activities j
each activity is assigned a cost pool Cj

9. General Procedure (cont’d)
determine the total level xj of budgeted utilization of the activity
determine the cost driver rate =
Determine (actual) usage xjl of cost driver j by each user l
Activity-based cost assignment to user l: Cj xj S j
xjl Cj xj

10. Key step: Assigning resource costs to activities
Resource costs per activity is an important piece of information to management
This is usually done by interviews with department managers on
activities performed
the proportion of working time usually spent on each activity
no excessive precision required

11. Separate cost driver rates for committed and flexible cost
C1j C2j
xj xj +
C1j + C2j
xj + xj 
in general

12. Cost Hierarchies
ABC systems commonly use a four-level cost hierarchy to identify cost-allocation bases:
Output unit-level cost
Batch level costs
Product-sustaining costs
Facility-sustaining costs

13. Functions of activities
Unit level activities
batch level activities
product-sustaining • customer sustaining
(sales volume-related)
(related to # of batches
of saleable output)
(activities enabling the
production of saleable
output)
(activities enabling to
sell products to individual
customers or markets)
(Costs that may be assigned only to broader output categories)

14. Cost hierarchy Output Unit-Level Costs Batch-Level Costs
resources sacrificed on activities performed on each individual unit of product or service.
Energy
Machine depreciation
Repairs
Batch-Level Costs
resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service.
Setup hours
Procurement costs
Product-Sustaining or service-sustaining costs
resources sacrificed on activities supporting individual products or services.
Design costs
Engineering costs
Facility-Sustaining Costs
resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole
General administration
Rent
Building security

15. Types of activity cost drivers
Accounting
cost
Number of transactions
duration of transaction
if time consumed varies among individual instances of the activity
intensity or direct charging
number of staff of different wage groups assigned to an activity per time unit
resources actually used for the individual instance of an activity

16. Appropriate number of cost drivers
Small cost pools do not alter unit costs much
if additional information has to be acquired on a cost driver consider the information cost and compare it to the benefit of the better decision
do not add a cost driver which is an approximate linear combination of cost drivers already used
existing cost pools should share in the cost that would be assigned to that pool according to the weights of the linear combination

17. Implementing Activity-Based Costing
Step 1: Identify the chosen cost objects.
The objective is to calculate the total costs of designing, assembling, and distributing S and C.
Step 2: Identify the direct costs of the product.
Cole identifies direct materials costs and direct manufacturing labor as direct costs.
Cleaning and maintenance costs of $360,000 are also identified as direct costs of the lenses.
Cleaning and maintenance costs of $360,000 are direct batch-level-costs.
Why? Because these costs consist of workers’ wages for maintenance of machines after each batch of phones is run.
The old cost system classified cleaning and maintenance costs as part of the $2,900,000 indirect costs.
Recall that indirect costs were allocated to products using direct manufacturing labor-hours.

18. Primary purposes of Activity-based Cost Systems
Analysis of decisions on the structure and design of productive system
more transparency of the factors causing costs
phasing out non-value-added activities
sporadic stand-alone analyses, not integrated in on-line accounting system
not used for management control purposes
otherwise management will have an incentive to choose cost drivers strategically
Decision facilitating for Activity-based Management (ABM)

19. Activity-Based Management
ABM describes management decisions that use activity-based costing information to satisfy customers and improve profits.
Product pricing and mix decisions
Cost reduction and process improvement decisions
Design decisions

20. ABM decisions Product Pricing and Mix Decisions
ABC gives management insight into the cost structures for making and selling diverse products.
provides more accurate product cost information and more detailed information on costs of activities and the drivers of those costs.
Cost Reduction and Process Improvement Decisions
Manufacturing and distribution personnel use ABC systems to focus on cost reduction efforts.
Managers set cost-reduction targets in terms of reducing the cost per unit of the cost-allocation base.
Design Decisions
Management can identify and evaluate new designs to improve performance by evaluating how product and process designs affect activities and costs.
Companies can work with their customers to evaluate the costs and prices of alternative design choices.

21. Critique ABC systems are full cost systems
they average fixed costs over products according to cost driver utilization: every individual unit carries the same cost per unit of driver utilized
costs for which a cost driver is not available (e.g. leading a department) are allocated to cost pools of measurable activities
For change management decisions an incremental costing approach is more adequate, when the size of the cost pool will not change proportionally with the cost driver (non-linearities in the cost function) due to
fixed costs
economies of scale
economies of scope

22. CC-Problems 5-35 (=11), requirements 1.-3. (10%) 5-29 (=11.5-30) ( 5%)
5-29 (= ) ( 5%)
5-31 (= ) ( 5%)
5-17 (= ) ( 5%)
5-19 (Excel)(= ,5-22) ( 8%)
5-23 (= ) ( 8%)
(10%)