Lecture 10

Activity Based Costing and

Management

What is ABC?
Activity Based Costing (ABC) is meant for providing
more accurate ways of assigning the costs of
indirect and support resources to cost objects.
Six steps involved in ABC:
Identify the costs of support resources to be allocated
Identify the activities being performed by the
organizations support resources.
Trace the resource expenses of the support resources to
the activities.
Identify a cost driver for each activity
Calculate an activity cost driver rate
Use the above rate to drive the activity cost to products.
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Steps involved in ABC

Form cost pools
ABC use activities as the basis for forming cost
pools. Not by business functions or departments
or other similar concepts.
Four different types of activities:

Unit-level activities
Batch-level activities
Product or customer level activities
Facility-level activities

Determine the costs in each cost pool.

Examine each type of expense and relate that part of
the expense that corresponds to the identified cost pool.
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Steps involved in ABC

Decide on which costs to allocate
Profit margin is the appropriate profit metric when
assessing long-term decisions.
Need to identify controllable costs.

Identify cost drivers

Ideally, choose a measure that has the strongest
causal relation with the costs in the cost pool.

Measure the denominator volume

Use practical capacity and not actual level of
activity
This leads to unallocated activity cost
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Designing a good ABC

system
Is ABC just a more complex and
expensive way to perform cost
allocations?
No! ABC is linked to underlying
economic events.

Stress on cost-and-effect
relationship.
Tradeoff between accuracy and cost
of measurement
Activity drivers can be based on
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When does the traditional

costing systems fail?

When a large proportion of activities are at non-unit level

When there is product diversity
When the consumption of common resources are hetrogenous
Some indicators
Sales are increasing but profits are declining
Complex products are very profitable but simple products are losing
money
High profit products are not offered by the competitors
Overhead rates are very high and increasing over time
Direct labor is a small percentage of total costs
Results of bids are difficult to explain
Competitors high volume products seem to be priced very low
Line managers/marketing managers ignore costs reported by
accountants.
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Activity Based Management

Product planning
Customer planning
Resources planning
Product planning
ABC cost is the floor for setting the price
in the long run.
Refine prices
Refine product mix
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Customer Planning:
Grouping Costs Differently

Customers Vary In Their

Profitability

Low-Profit Customers

High-Profit Customers

Small order sizes

Unpredictable ordering
pattern, hard to plan for
Frequent order change
requests
Demand immediate
deliveries
Need to carry inventory to
satisfy customer
demands
Require more
customization

Large order sizes

Predictable ordering
patterns, easy to plan for
Minimal order change
requests
Planned deliveries
Minimal inventory
requirements
Require minimal
customization
Less pre-sales support

Whale Curve

Activity Based Management

Customer Planning
Customer profitability analysis
Sales and administration costs are
relatively high in some industries
Classify customers into
Low cost to serve but generate high profit
margins
Low costs to serve and generate low profit
margins
High costs to serve and generate high profit
margins
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High costs to serve but generate low profit

Activity Based Management

Resource Planning
ABC creates a map of how a product
consumes activities and, thereby, resources
We can use the activity map and production
forecasts to generate the demand for resources
Same as generating the demand for materials or labor

We can match with supply of resources to

reduce unneeded capacity
Reporting of unused capacity is useful in drawing
managerial attention to capacity supplied but not used

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