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# 10/10/2019

Activity-Based Cost
Systems

Chapter 5

## Activity-Based Cost Systems

 Activity-based cost systems have been developed
to eliminate distortion

##  Activity-based cost (ABC) assign resource

expenses to activities on the basis of how much of
the resource each activity uses

 Uses actual departments or cost centers for accumulating
and redistributing costs

##  Asks how much of an allocation basis (usually based on

volume) is used by the production department

##  Service department expenses are allocated to a

production department based on the ratio of the
allocation basis used by the production department

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ABC System
 Uses activities, for accumulating costs and
redistributing costs
 Asks what activities are being performed by the
resources of the service department
 Resource expenses are assigned to activities based
on how much of the resource is required or used to
perform the activities

## First Steps in Design of an ABC System

 Develop the activity dictionary—the list of major
activities performed by both the factory’s human and
physical resources
 Obtain sufficient information to assign resource
expenses to each activity in the activity dictionary
 The ABC model shifts the focus from what the money
was being spent on (labor, equipment, supplies) to
what the resources acquired by spending are actually
doing

## Activity Cost Drivers

 Activity cost drivers represent the quantity of
activities used to produce individual products:
ACTIVITY ACTIVITY COST DRIVER
HANDLE PRODUCTION RUNS PRODUCTION RUNS
SET UP MACHINES SETUP HOURS
SUPPORT PRODUCTS NUMBER OF PRODUCTS
RUN MACHINES MACHINE HOURS
PROVIDE FRINGE BENEFITS LABOR DOLLARS

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## Completing the ABC Model

 Once drivers have been determined, the following is
needed:
– The total quantity of each activity cost driver
– The quantity of cost driver used by each product
 Calculate the activity cost driver rate (ACDR) by
dividing the activity expense by the total quantity of
the activity cost driver
 Multiply the activity cost driver rate by the quantity of
each activity cost driver used by each of the four
products

##  Ericson had been the low-cost producer of chocolate and

vanilla ice cream, with profit margins exceeding 20% of
sales
 Several years ago Ericson expanded their business by
extending their product line into products with premium
selling prices
 Five years ago strawberry ice cream was introduced
– The same basic production technology
– Could be sold at a price that was 3% higher than for
vanilla and chocolate
 Last year mocha-almond ice cream was added
– Could be sold at a 10% price premium
 The controller of Ericson was disappointed with the most
recent quarter’s financial results 8

## Total Profitability by Product

vanilla chocolate strawberry Mocha- Total
almond
Units 50,000 40,000 9,000 1,000 100,000
Price \$ 4.50 \$ 4.50 \$ 4.65 \$ 4.95
Sales \$225,00 \$180,000 \$41,850 \$4,950 \$451,800
0
Material 75,000 60,000 14,040 1,650 150,690
Labor 30,000 24,000 5,400 600 60,000
Overhead 90,000 72,000 16,200 1,800 180,000
Total Mfg. 195,000 156,000 35,640 4,050 390,690
Expenses
Gross \$ 30,000 \$ 24,000 \$ 6,210 \$ 900 \$ 61,110
Margin
9
G.M. % 13.3% 13.3% 14.8% 18.2% 13.5%

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Management’s Concern
 The controller wondered whether the company
should continue to deemphasize the chocolate and
vanilla products and keep introducing new
 Ericson’s manufacturing manager commented on
how the introduction of specialty flavors had
changed the production environment
 As it was a small company and historically had
produced only a narrow range of products,
Ericson used a simple costing system
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## – All the plant’s indirect expenses were

aggregated at the plant level and allocated to
products based on each product’s direct labor
cost
– Currently the cost system’s overhead burden
rate was 300% of direct labor cost
– Before the new specialty products were
introduced, the overhead rate was only 200%
of direct labor cost

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##  Ericson’s management accountants

designed the system years ago when:
– Production operations were mostly manual
– Total indirect costs were less than direct labor
costs
– Ericson’s two products had similar production
volumes and batch sizes

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## Changes in the Production Environment

 Direct labor costs have decreased and indirect
expenses have increased as a result of automation
 As specialty low-volume products were added,
Ericson needed:
– More scheduling
– More setups
– More quality control personnel
– A computer to track orders and product specifications

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## An Outdated Cost System

 Ericson operates with only a single cost
center
 Even if Ericson used multiple production
and service department cost centers, it
could still encounter severe distortions in
its reported product costs

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## Reason for Cost Distortions

• A complex factory has a much larger production support
staff because it requires more people to:

## – schedule machine and – design new products

production runs – improve existing products
– perform setups – negotiate with vendors
– inspect produced items after – schedule materials receipts
setup – order, receive, and inspect
– move materials incoming materials and
parts
– ship orders – update and maintain the
– expedite orders much larger computer-based
– rework defective items information system

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## Reason for Cost Distortions

 Because the factory has the same physical output, it has
roughly the same cost of materials
 The company’s factory has about the same property
taxes, security costs, and heating bills as before, but it
has much higher indirect and support costs because of
its more varied product mix and complex production
 On a per unit basis, high-volume standard flavors
require about the same amount of direct labor costs (the
allocation basis) as the low volume flavors
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## Reason for Cost Distortions

 The traditional costing system would report essentially
specialty, irrespective of their relative production
volumes
 Clearly, however, considerably more indirect and
support resources are required on a per-unit basis for
the low-volume specialty products than for the high-
volume, standard products (batch related costs)

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## 1) Develop the activity dictionary: the list of

major activities performed by both the
factory’s human and physical resources
2) Obtain sufficient information to assign
resource expenses to each activity in the
activity dictionary

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## Tracing Costs to Activities

ABC at Ericson :
– The controller started an analysis of indirect
expenses, beginning with indirect labor
– The controller interviewed department heads in
charge of indirect labor and found that the people in
these departments performed three main activities

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## Indirect Labor Activities

 50% of indirect labor was involved in what the
controller called “handle production runs”
 40% of indirect labor actually performed the physical
changeover from one flavor to another, an activity
that she labeled “perform setups”
 10% of the time was spent on activities the controller
called “support products”

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## Computer System Expenses

20% of computer expenses should be assigned to
“support products,” an activity already defined in her
activity dictionary, because it was used to keep
records on the four products
80% of the computer resource was involved in the
production run activity and seemed to relate well to
the “handle production runs” activities

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 There were three remaining categories of overhead
expense:
– Machine depreciation
– Machine maintenance
– Energy to operate the machines
 These expenses were incurred to supply machine
capacity to produce the ice cream:
 The controller labeled this production activity “run
machines”

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##  The four activities for Ericson’s indirect costs represent

the three different levels of the manufacturing cost
hierarchy:
Activity Cost Hierarchy
Run Machines Unit Level
Handle Production Runs Batch Level
Setup Machines Batch Level
Support Products Product Sustaining

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##  The ABC model shifts the focus:

 From what the money was being spent on (labor,
equipment, supplies)
 To what the resources acquired by the spending
are actually doing

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##  Operational activity-based management (ABM)

- managers use information collected by the
ABC system at the activity level to identify
opportunities for reducing costs in indirect and
support activities

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## Activity Cost Drivers

Activity cost drivers represent the quantity of activities used
to produce individual products:

## HANDLE PRODUCTION RUNS PRODUCTION RUNS

SET UP MACHINES SETUP HOURS
SUPPORT PRODUCTS NUMBER OF PRODUCTS
RUN MACHINES MACHINE HOURS
PROVIDE FRINGE BENEFITS LABOR DOLLARS

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## Completing the ABC Model

 Once the activity cost drivers had been determined, the
following quantitative information is needed:
– The total quantity of each activity cost driver
– The quantity of cost driver used by each product
 Calculate the activity cost driver rate (ACDR) by dividing
the activity expense by the total quantity of the activity
cost driver
 Multiply the activity cost driver rate by the quantity of
each activity cost driver used by each of the four products

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## Activity Cost Drivers

Activity Cost Mocha-
Driver Vanilla Chocolate Strawberry almond Total**
DL hr/unit 0.02 0.02 0.02 0.02 2,000
Mach. hr/unit 0.1 0.1 0.1 0.1 10,000

## Prod. runs 70 65 50 15 200

Setup 4 2.4 5.6 5.6 --
time/run
Total setup hr 280 156 280 84 800
# of products 1 1 1 1 4

**Total = per
unit X quantity 50,000 40,000 9,000 1,000

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## Activity Cost Driver Rates (ACDR)

Activity Activity Cost Driver
Expense Driver Quantity ACDR
Handle \$66,000 Number of 200 \$330 per
Production Runs production runs run
Set up machines \$33,600 Number of 800 \$42 per
setup hours setup hr
Support \$14,400 Number of 4 \$3,600
Products products per product
Run Machines \$42,000 Number of 10,000 \$4.20 per
machine hours machine hr
\$156,000

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## Activity Expenses Assigned

Mocha-
Vanilla Chocolate Strawberry almond Total
Handle
Production \$23,100 \$21,450 \$16,500 \$4,950 \$66,000
Runs
Set up 11,760 6,552 11,760 3,528 33,600
machines
Support 3,600 3,600 3,600 3,600 14,400
Products
Run 21,000 16,800 3,780 420 42,000
Machines
Total Costs
Assigned \$ 59,460 \$ 48,402 \$ 35,640 \$ 12,498 \$ 156,000

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## ABC Profitability Report

ABC profitability report:
 The results from the activity-based costing system were
quite different from the results based on the traditional
cost system
– The two specialty products, which the previous cost system had
reported as the most profitable, were in fact the most
unprofitable.
to enable these products to be designed and produced, but their
incremental revenue did not cover those costs

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## Total ABC Profitability by Product

Mocha-
Vanilla Chocolate Strawberry almond Total
Sales \$225,000 \$180,000 \$41,850 \$4,950 \$451,800
Material 75,000 60,000 14,040 1,650 150,690
Labor 30,000 24,000 5,400 600 60,000
40% 12,000 9,600 2,160 240 24,000
fringe on
DL
Support 59,460 48,402 35,640 12,498 156,000
Total Mfg. 176,460 142,002 57,240 14,988 390,690
Expenses
Gross \$ 48,540 \$ 37,998 \$(15,390) \$(10,038) \$ 61,110
Margin
G.M. % 21.6% 21.1% -36.8% -202.8% 13.5%
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## Using ABC to Improve Profitability

 The ABC information provides managers with numerous
insights about how to increase the company’s profitability:
– Increase either their sales volume or prices for the specialty
products
– Impose minimum order sizes to eliminate short, unprofitable
production runs
– Increase demand for the highly profitable standard products
– The goal of these ABM actions is to enable the company to
produce the same volume and mix of products with fewer
resources

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## Problems Implementing ABC

 Problems may arise in practice from activity-based
costing
 It assigns many resource expenses to activities based on
interviews, surveys, and direct observation of production
and support processes
 these activities are time-consuming and expensive

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## Problems Implementing ABC

 Inaccuracies and bias may affect the accuracy of cost
driver rates derived from individuals’ subjective
estimates of their past or future behavior.
 Companies must periodically repeat the interviewing and
surveying processes if they want to keep their activity-
based cost systems updated.
 Adding new activities to the system is also difficult,
requiring re-estimates of the relative amount of resource
time and effort required by the new activity.

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## Problems Implementing ABC

 A more subtle and serious problem arises from the
interview or survey process
– People estimating how much time they spend on a list of
activities handed to them invariably report percentages that
– Few individuals report that a significant percentage of their
time is idle or unused

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##  The calculation of activity cost driver rates are sometime

based on the capacity actually used
 Analysts can obtain a better estimate for the cost of
resources required to handle each production run by
dividing activity expenses by the practical capacity of
work the resources could perform
 The cost of unused capacity should not be assigned to
products produced or customers served during a period

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## Cost of Unused Capacity

 The cost of unused capacity remains someone’s, or some
department’s responsibility
 Usually you can assign unused capacity after analyzing
the decision that authorized the level of capacity supplied
 Such an assignment is done on a lump-sum basis; it will
be treated as a sustaining, not a unit-level, expense.

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## Cost of Unused Capacity

 If the unused capacity relates to a particular product line
then the cost of unused capacity is assigned to that
product line, where the demand failed to materialize
 In making assignment of unused capacity costs, trace the
costs at the level in the organization where decisions are
made that affect the supply of capacity resources and the
demand for those resources
 The lump-sum assignment of unused capacity costs
provides feedback to managers on their supply and
demand decisions

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## Measuring the Cost of Resource Capacity

 The activity cost driver rate should reflect the underlying
efficiency of the process: the cost of resources to handle
each production order
 This efficiency is measured better by using the capacity of
the resources supplied as the denominator when
calculating activity cost driver rates
 The cost of unused capacity should not be ignored, but
can not be entirely eliminated

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## Fixed and Variable Expenses

 Most indirect expenses assigned by an ABC system are
committed costs
 Committed costs become variable via a two-step
procedure:
– Demands for resources change either because of
changes in the quantity of activities performed or
because of changes in the efficiency of performing
activities
– Managers must make decisions to change the supply
of committed resources to meet the new level of
demand for the activities performed by these resources

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## Making Committed Costs Variable

 After unused capacity has been created, committed costs
will vary downward if managers actively reduce the
supply of unused resources
 A resource cost varies downward if management acts:
– To reduce the demands for the resource
– To lower the spending on it

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## Activity in Excess of Capacity

 If activity volumes exceed the capacity of existing
resources, the result is bottlenecks, shortages,
increased pace of activity, delays, and poor-
quality work
 Facing such shortages, companies typically make
committed costs variable

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##  Demands for indirect and support resources also can

decline
 Even for many unit-level resources reduced demands for
work does not immediately lead to spending decreases
 The reduced demand for organizational resources lowers
the cost of resources used, but this decrease is offset by an
equivalent increase in the cost of unused capacity

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## Managers Make Costs Fixed

 Organizations often create unused capacity through
activity-based management actions
 They keep existing resources in place, when demands for
the activities performed by the resources have
diminished
 They also fail to find new activities that could be done
by the unused resources already in place

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## Managers Make Costs Fixed

 The organization receives no benefits from activity-
based management decisions that reduce demands on
their resources if capacity is not reduced or redeployed
 Failure to capture benefits from activity-based
management is not because their costs are “fixed”
 The cost of these resources is only “fixed” if managers
do not exploit the opportunities from the unused capacity
they helped to create

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## Managers Make Costs Fixed

 Making decisions based solely upon resource usage
may not increase profits if managers are not prepared to
reduce spending to align resource supply with future
lower levels of demand

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## Tracing Marketing-Related Costs to Customers

 The costs of marketing, selling, and distribution
expenses have been increasing rapidly in recent years
 Many of these expenses do not relate to individual
products or product lines but are associated with them.
 Companies need to understand the cost of selling to
and serving their diverse customer base.
 To do that selling costs must be disassociated with the
product and associated with the customers that drive
selling costs.

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