Activity Based Costing and Management Systems

Activity Based Costing and Activity Based Costing and Management SystemsManagement Systems

• ABC systems focus on the activities and the ABC systems focus on the activities and the business processes as the foundation for business processes as the foundation for determining the cost of goods, services, processes, determining the cost of goods, services, processes, or any cost objector any cost object

• ABC systems attempt to address the problems ABC systems attempt to address the problems found with traditional costing systems, such as found with traditional costing systems, such as ignoring volume differences, diversity, and ignoring volume differences, diversity, and resource demands of different cost objectsresource demands of different cost objects

ABC BasicsABC Basics• ABC systems use a cost hierarchy: unit level, ABC systems use a cost hierarchy: unit level,

batch level, product sustaining level, and facility batch level, product sustaining level, and facility sustaining levelsustaining level

• ABC systems, as part of identifying the relevant ABC systems, as part of identifying the relevant activities, also classify these activities into value-activities, also classify these activities into value-added and non-value added activities, so it added and non-value added activities, so it becomes a management toolbecomes a management tool

• ABC systems recognize not only economies of ABC systems recognize not only economies of scale but economies of scopescale but economies of scope

• At the heart of ABC is a two stage allocation At the heart of ABC is a two stage allocation processprocess

The Two Stage Process in ABCThe Two Stage Process in ABC

• Stage 1: Create homogeneous cost pools based on Stage 1: Create homogeneous cost pools based on activities and/or processes; e.g., group all purchasing costs activities and/or processes; e.g., group all purchasing costs together, all set-up costs together, all delivery costs together, all set-up costs together, all delivery costs together. This may take some work since most accounting together. This may take some work since most accounting systems gather cost by account categories such as salaries, systems gather cost by account categories such as salaries, depreciation, supplies, etc. and these accounts have to be depreciation, supplies, etc. and these accounts have to be studied in order to break them down into homogeneous studied in order to break them down into homogeneous costs poolscosts pools

• Stage 2: Allocate from the cost pools to the cost object Stage 2: Allocate from the cost pools to the cost object (usually a product) using second stage cost drivers; e.g., (usually a product) using second stage cost drivers; e.g., number of deliveries, number of setupsnumber of deliveries, number of setups

Mapping Resource Expenses to Activities: Stage OneMapping Resource Expenses to Activities: Stage One

Salaries and Fringes$313,000

Occupancy$111,000

Equipment and Technology

$146,000

Materials and Supplies$30,000

Activity

Salaries andFringes Occupancy

Equipment andTechnology

Materials and Aupplies Total

Process Customer Orders 31,000$ 5,300$ 12,600$ 800$ 49,700$ Purchase Materials 34,000 6,900 8,800 1,500 51,200Schedule Production Orders 22,000 1,200 18,400 300 41,900Move Materials 13,000 2,100 22,300 3,600 41,000Set-up Machines 42,000 700 4,800 200 47,700Inspect Items 19,000 13,000 19,700 800 52,500Maintain Product Info 36,000 2,800 14,500 400 53,700Perform Engineering Changes 49,000 32,000 26,900 2,400 110,300Expedite Orders 14,000 900 700 500 16,100Introduce New products 35,000 44,000 16,100 18,700 113,800Resolve Quality Problems 18,000 2,100 1,200 800 22,100Total 313,000$ 111,000$ 146,000$ 30,000$ 600,000$

Total$600,000

An ABC ExampleAn ABC Example

Supermarkets Drugstores MA and Pa Total

Average Revenue per delivery $30,900 $10,500 $1,980

Average CGS per delivery 30,000 10,000 1,800

Gross Margin per delivery 900 500 180

Number of Deliveries 120 300 1,000 1,420

Total Gross margin $108,000 $150,000 $180,000 $438,000

Gross Margin % 2.9% 4.8% 9.1%

Other operating Costs 301,080

Operating Profit 136,920

Allocation of Other Costs 74,239 103,110 123,731 301,080

Distribution Line Profit 33,761 46,890 56,269 136,920

Profit Margin 0.9% 1.5% 2.8%

Other Costs are allocated in proportion to Gross Margin

301,080/438,000 = 68.7%; Ma and Pa = 68.7% * 180,000 = 123,731

An ABC Example, 2An 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


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.


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 2,000 orders

Line Item Ordering 63,840 21,280 line items

Store Deliveries 71,000 1,420 store deliveries

Carton Deliveries 76,000 76,000 cartons

Shelf Stacking 10,240 640 hours


Other useful data by distribution line

Supermarkets Drugstores Ma and Pa

1. Total number of orders 140 360 1,500

2. Average number of line

items per order 14 12 10

3. Total number of store

deliveries 120 300 1,000

4. Average number of

cartons shipped per delivery 300 80 16

5. Average number of hours

of shelf stacking per delivery 3 0.6 0.1


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 2,000 orders $40/order

Line Item Ordering 63,840 21,280 line items 3/line item

Store Deliveries 71,000 1,420 store deliveries 50/store delivery

Carton Deliveries 76,000 76,000 cartons 1/carton

Shelf Stacking 10,240 640 hours 16/hour


Next, allocate these costs to each distribution channel

Supermarkets Drugstores Ma and Pa

1. Orders 140*40=5,600 360*40=14,400 1,500*40=60,000

2. Average line items 14 12 10

2a. Total line items 1,960*3=5,880 4,320*3=12,960 15,000*3=45,000

3. Deliveries 120*50=6,000 300*50=15,000 1,000*50=50,000

4. Average # of cartons 300 80 16

4a. Total cartons 36,000*1=36,000 24,000*1=24,000 16,000*1=16,000

5. Average stacking hours 3 0.6 0.1

5a. Total Stacking hours 360*16=5,760 180*16=2,880 100*16=1,600

Totals (= 301,080) 59,240 69,240 172,600


Comparing ABC to Traditional Costing Profit: Supermarket

Traditional ABC

Average Revenue per delivery $30,900 $30,900

Average CGS per delivery 30,000 30,000

Gross Margin per delivery 900 900

Number of Deliveries 120 120

Total Gross margin $108,000 $108,000

Allocation of Other Costs 74,239 59,240

Distribution Line Profit 33,761 48,760

Profit Margin 0.9% 1.3%


Comparing ABC to Traditional Costing Profit: Drugstores

Traditional ABC

Average Revenue per delivery $10,500 $10,500



Number of Deliveries 300 300






Comparing ABC to Traditional Costing Profit: Ma and Pa

Traditional ABCAverage Revenue per delivery $1,980 $1,980



Number of Deliveries 1,000 1,000






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%) 7,400 (0.4%)

Total 136,920 136,920


• Note that the total profit for the firm has not Note that the total profit for the firm has not changed at all as a result of using ABC vs. changed at all as a result of using ABC vs. traditional costing techniquestraditional costing techniques

• So what’s the big deal??So what’s the big deal??• Some people argue that for many firms using ABC Some people argue that for many firms using ABC

is analogous to re-arranging the chairs on the deck is analogous to re-arranging the chairs on the deck of the Titanic - it really doesn’t stop a firm from of the Titanic - it really doesn’t stop a firm from failingfailing

• also, ABC is not GAAPalso, ABC is not GAAP– also, implementing ABC is a significant taskalso, implementing ABC is a significant task

• This is true if figuring out new product costs is the This is true if figuring out new product costs is the only thing ABC is used foronly thing ABC is used for

So What is the Value of ABCSo What is the Value of ABC• Like any accounting system, ABC is an Like any accounting system, ABC is an

INFORMATION system - it provides info to INFORMATION system - it provides info to assist decision makers, but in and of itself this info assist decision makers, but in and of itself this info DOES NOTHING, unless management acts upon DOES NOTHING, unless management acts upon itit

• ABC provides insights into your business that ABC provides insights into your business that management was probably not aware of beforemanagement was probably not aware of before

• The old system simply charged each line 68.7% of The old system simply charged each line 68.7% of its gross margin to arrive at product line its gross margin to arrive at product line profitability - peanut butter costingprofitability - peanut butter costing

So What is the Value of ABC, 2So What is the Value of ABC, 2

• The ABC system reveals however that the MA and PA The ABC system reveals however that the MA and PA stores actually consume 95.9% of its gross margin with stores actually consume 95.9% of its gross margin with other operating expensesother operating expenses

• This is because the MA and PA stores are more activity This is because the MA and PA stores are more activity intense, and thus more cost intensiveintense, and thus more cost intensive

• Under the old system, MA and PA stores were charged Under the old system, MA and PA stores were charged 41.1% (180,000/438,000) of overhead, since this was their 41.1% (180,000/438,000) of overhead, since this was their share of gross marginshare of gross margin

• However, if you look at the activities, you can see that MA However, if you look at the activities, you can see that MA and PA stores account for well over 41.1% of the activities and PA stores account for well over 41.1% of the activities (75% of the orders, 70% of the deliveries, etc)(75% of the orders, 70% of the deliveries, etc)

How can managers act on this infoHow can managers act on this info

• Now that managers know the cost of these Now that managers know the cost of these activities, they can work to try and reduce those activities, they can work to try and reduce those costscosts

• Also, they can see why Ma and Pa stores are so Also, they can see why Ma and Pa stores are so expensive (they order more often, they have more expensive (they order more often, they have more deliveries, etc.) and they work with these stores to deliveries, etc.) and they work with these stores to try and reduce those activities; i.e., less frequent try and reduce those activities; i.e., less frequent ordering, less frequent deliveriesordering, less frequent deliveries

• Also, since part of ABC is activity identification Also, since part of ABC is activity identification and classification as VA or NVA, managers can and classification as VA or NVA, managers can attempt to eliminate or minimize NVAattempt to eliminate or minimize NVA

When Would ABC not be UsefulWhen Would ABC not be Useful(at least from a product costing view)(at least from a product costing view)

• If the company only has one productIf the company only has one product• If all products use all resources in the same If all products use all resources in the same

proportions, which is the same proportion used to proportions, which is the same proportion used to allocate costs in a traditional system (little allocate costs in a traditional system (little diversity)diversity)

• Cost control is not critical at this stage for the Cost control is not critical at this stage for the company (growth stage companies)company (growth stage companies)

When Would ABC be most UsefulWhen Would ABC be most Useful

• The Willie Sutton ruleThe Willie Sutton rule– large expenses in indirect and support resourceslarge expenses in indirect and support resources

• High diversity (products, customers, processes)High diversity (products, customers, processes)• When a firm wants to better understand its When a firm wants to better understand its

activities and the costs of those activities, even if activities and the costs of those activities, even if the firm only makes one productthe firm only makes one product

Developing an ABC System, 1Developing an ABC System, 1

• There are four sequential steps a firm would go There are four sequential steps a firm would go through o develop an ABC systemthrough o develop an ABC system– Develop the activity dictionaryDevelop the activity dictionary

– determine how much the organization is spending on determine how much the organization is spending on each of its activitieseach of its activities

– identify the organization’s products, services, and identify the organization’s products, services, and customerscustomers

– select activity cost drivers that link activity costs to the select activity cost drivers that link activity costs to the organization’s products, services, and customersorganization’s products, services, and customers

• transaction, duration, and intensitytransaction, duration, and intensity

Developing an ABC System, 2Developing an ABC System, 2

• The goal of an ABC system should not be to The goal of an ABC system should not be to develop the most accurate, but one that balances develop the most accurate, but one that balances the cost of errors made from inaccurate estimates the cost of errors made from inaccurate estimates with the cost of measurementwith the cost of measurement

• Activity cost drivers are the central innovation of Activity cost drivers are the central innovation of ABC systems, but they are also the most costlyABC systems, but they are also the most costly

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Activity Based Costing and Management Systems