CHAPTER

Activity-Based Cost
Management Systems

Central Focus and Learning Objectives

This chapter presents fundamental concepts relating to activity-based cost
systems. After studying this chapter, students should be able to:
1. Understand how traditional cost systems, using only unit level drivers,
distort product and customer costs
2. Describe why companies producing a more varied and complex mix of
products have higher costs than companies producing only a narrow
range of products
3. Design an activity-based cost system by linking resource costs to the
activities performed, and then to cost objects, such as products and
customers
4. Appreciate the role for choosing appropriate activity cost drivers
when tracing activity costs to products and customers
5. Use the information from a well-designed activity-based cost system
to improve operations and make better decisions about products and
customers
6. Understand the importance of measuring the practical capacity of
resources and the cost of unused capacity
7. Assign marketing, distribution, and selling expenses to customers
8. Analyze and manage customer profitability
9. Appreciate the role for activity-based cost systems for service
companies
10. Discuss the barriers for implementing activity-based cost systems and
how these might be overcome

Activity-Based Cost Management Systems 1

Chapter overview Chapter 4 introduces activity-based cost systems. The chapter
contains a comprehensive discussion of the limitations of traditional
cost systems such as those described in chapter 4, and the
conceptual foundation for ABC.
The Cooper Pen Company problem provides an easily-understood
illustration of the mechanics of an activity-based system: tracing
costs to activities and then to products using activity cost drivers.
The authors include a comprehensive discussion of the selection of
activity cost drivers, including transaction drivers, duration drivers,
and intensity drivers.
Other issues addressed in this chapter include the cost of capacity
and the impact of the cost of unused capacity on product costs,
tracing marketing, selling, and distribution expenses to customers,
customer profitability, and the use of ABC in service organizations.
The chapter concludes with a review of issues encountered in the
implementation of ABC systems.

Teaching tips Students often miss the point that the use of multiple, unit-level
cost drivers does not constitute an activity-based cost system.
Even the use of several unit-level drivers fails to capture the
complexity and diversity of processes when a wide range of
products are produced. The costs of complexity and diversity are
only revealed when batch, product-sustaining, and facility level
drivers are employed.
Implementation of ABC can cause significant organizational
stress, particularly if done badly. The implementation barriers
discussed at the end of the chapter are especially important.
It is important for students to realize that the benefits from ABC
do not arise spontaneously. The benefits occur when ABC
highlights unprofitable products, unprofitable customers, and
operational inefficiencies and management takes action to
improve profitability or operational efficiency. It is often these
changes, or the prospect of them, that give rise to organizational
and personal resistance to ABC.

Activity-Based Cost Management Systems 2

Recommended There are a number of excellent cases covering various aspects of
cases ABC. I find that the Destin Brass and John Deere Component
Works cases work especially well for communicating the mechanics
and conceptual foundation for both traditional product costing and
ABC.
1. Destin Brass is an excellent introductory case on traditional cost
systems and ABC. (HBS case no. 9-190-089; teaching note is
HBS no. 5-191-029. See also Destin Rides Again in Cases
From Management Accounting Practice, vol. 14, p. 79 and the
accompanying Instructors Manual, which suggests a number of
extensions to the original HBS case, including CVP analysis and
product line profitability analysis.
2. The John Deere Component Works case series is a more
complex case which has interesting strategic overtones. (HBS
no. 9-187-107 (A) and 9-187-108 (B); teaching note is 5-188-
049).
3. Activity-Based Management at Stream International (HBS no.
9-196-134; teaching note is 5-198-079) is a good case for
discussion of implementation issues.
4. Indianapolis: Activity-Based Costing of City Services (HBS no.
9-196-115 (A) case and 9-196-117 (B) case; teaching note is 5-
198-066) provides an opportunity to examine the use of ABC in
the context of government services.
5. Maxwell Appliance Controls (HBS no. 9-192-058) provides an
excellent overview of the ABC design process.

Chapter outline I.
Learning Objective 1:
Understand how
traditional cost
systems, using only
unit level drivers,
distort product and
customer costs.
Discuss the Cooper Pen Company case from the chapter to
illustrate the distortions induced by traditional systems.
A. Note the role of unit level drivers in traditional cost
systems
B. Introduce batch, product sustaining, and facility level
drivers
1. Batch level drivers vary in proportion to the number of
batches or production runs.
2. Product sustaining drivers are those necessary to
maintain different product lines.
3. Facility level drivers are those activities necessary to
maintain production capability, and are essentially a
reflection of capacity.

Activity-Based Cost Management Systems 3

Learning Objective 2: II.
Describe why
companies producing
a more varied and
complex mix of
products have higher
costs than companies
producing only a
narrow range of
products.
Learning Objective 3: III. Use problem 4-29 to illustrate (a) the distortions that are likely
Design an activity- to arise with traditional costing systems and (b) the design of
based cost system by an activity-based system.
linking resource costs
to the activities
performed, and then to
cost objects, such as
products and
customers.
Learning Objective 4: IV.
Appreciate the role for
choosing appropriate
activity cost drivers
when tracing activity
costs to products and
customers.
Complex, diverse product lines require more support
(overhead) costs than simple, narrow product lines.
A. Each different variation (model, style, color, etc.) may
require a variety of special activities:separate engineering
drawings, specifications, and testing
1. separate production capability (production lines,
machinery, workers with different skills)
2. special materials, along with inventories and material
control systems
3. service organizations are as susceptible to these
problems as manufacturing firms. For example, an
office supply distributor is likely to find that customers
who place infrequent but large orders for standard
items are more profitable than those which place
frequent small orders for specialty items. However,
traditional accounting systems make it virtually
impossible to differentiate between such customers.
B. Illustrations might include the auto industry, which is a
classic example of product proliferation. Several years
ago, Chevrolet produced as many as 51 different model
cars under 12 nameplates; Chevy truck nameplates
covered 288 models. In a cost cutting move, GM
announced that the number of truck nameplates would be
reducedto 219!
This learning objective stresses the importance of selecting a
sufficiently broad range of activity drivers to assure that the
product cost reflects as much of the diversity and complexity
of the manufacturing process as possible . As noted earlier, the
use of multiple unit level drivers does not constitute an ABC
system. Work through problem 4-37 in class.
Activity-Based Cost Management Systems 4
Learning Objective 5: V. Activity-based management is the use of information derived
Use the information from the ABC analysis to improve operations: increase
from a well-designed efficiency, eliminate non value-added activities, and reduce
activity-based cost costs. Problem 4-34 provides students with an opportunity to
system to improve
use ABC information to improve manufacturing processes.
operations and make
better decisions about
products and
customers.

Learning Objective 6: VI. As noted in the text, the use of actual driver quantities can
Understand the lead to distortions in product costs simply because of the
importance of difference between the capacity of the resource supplied and
measuring the used.
practical capacity of
A. Practical capacity should be used as a denominator to
resources and the cost
of unused capacity. avoid distortions induced by the cost of unused capacity.
B. Excess capacity should not be arbitrarily assigned to the
products produced during the period. However, excess
capacity costs should not be ignored.
C. Analysis may reveal the cost object to which excess
capacity costs should be assigned.

Learning Objective 7: VII. Customers can differ greatly in their contribution to profits.
Assign marketing,
distribution, and
selling expenses to
customers.
Learning Objective 8:
Analyze customer
profitability.
Historically, managers have not attempted to develop accurate
estimates of the marketing, distribution, and selling expenses
associated with different customers. This has led to false
assumptions about customer profitability. ABC provides a
mechanism for developing a better understanding of these
costs.
A. Refer to Exhibit 4-10 and ask students for examples from
their own experience (either as customers or as sellers of
goods or services).
B. Work through problem 4-35 in class.

Learning Objective 9: VIII. Although ABC was initially developed in manufacturing firms,
Appreciate the role for service organizations may find useful applications for ABC as
activity-based cost well.
systems for service A. Note that all service firm costs are indirect, and the charge
companies.
to the customer or client often varies with the level of
expertise (or hierarchical status) of the provider of the
service (e.g., technician, junior engineer, senior engineer,
manager, partner).
B. If clients are billed at an average rate, clients who use
the services of lower level personnel will be paying more
than they should for the services they use. Similarly, clients
who use the services of partners and mangers will be
paying less than their fair share of the costs incurred to
provide the services to them.

Activity-Based Cost Management Systems 5

Learning Objective IX. The text mentions a number of barriers to implementation:
10: Discuss the A. Lack of clear business purpose
barriers for B. Lack of senior management commitment
implementing activity- C. Delegation of the project to consultants
based cost systems
D. Poor ABC model design
and how these might
be overcome. E. Individual and organizational resistance to change

Activity-Based Cost Management Systems 6

Chapter quiz

1. The use of unit-based cost drivers has the following consequences:

a. simple products are undercosted
b. complex products are overcosted
c. (a) and (b)
d. none of the above

2. Products might consume different amounts of resources because of:

a. variations in the number of batches produced.
b. differences in the effort required to serve customers.
c. differences in the number of engineering changes required.
d. all of the above

3. Which of the following is not a potential benefit of activity-based costing?

a. elimination of bottlenecks due to downtime on a critical machine
b. elimination of non value added activity
c. enhanced financial reporting
d. one-time cash flow impact of reduced need for inventory

4. Design of an ABC system requires that:

a. resource costs be linked to the activities performed.
b. job cost sheet be redesigned.
c. the cost of activities have to be linked to cost objects.
d. (a) and (c)

5. Suppose budgeted capacity for widgets is 800 units. Practical capacity is 1,000 units.
Support costs for the period are $16,000. The cost driver rate:
a. is found by dividing support costs by budgeted capacity.
b. is found by dividing support costs by practical capacity.
c. should reflect the underlying efficiency of the process.
d. (b) and (c)

6. Activity-based costing systems yield more accurate product costs than conventional
cost systems because they use more cost drivers to assign support costs to products.
a. true
b. false

7. Which of the following statements most accurately explains why selling and
administrative costs have been largely ignored under conventional costing systems?
a. selling and administrative costs are very hard to quantify except at exorbitant cost
of measurement
b. selling and administrative costshave been negligible in amount relative total costs
c. selling and administrative costs are not inventoriable under GAAP
d. none of the above

Activity-Based Cost Management Systems 7

8. Which of the following is least likely to be a barrier in ABC implementation?
a. computer hardware and software problems
b. individual resistance to change
c. organizational resistance to change
d. lack of senior management commitment

9. Organizational resistance to change may arise when ABC models reveal:

a. unprofitable products.
b. unprofitable customers.
c. inefficiencies in operations.
d. all of the above

10. The goal of a properly constructed ABC system is

a. the most accurate product costs possible.
b. the system that uses the most cost drivers, thus assuring greater accuracy.
c. a system that balances the cost of errors in cost estimation with the cost of
measurement.
d. none of the above

Activity-Based Cost Management Systems 8

Solutions to chapter quiz
1. d
2. d
3. c
4. d
5. d
6. b
7. c
8. a
9. d
10. c

Activity-Based Cost Management Systems 9