ACTIVITY-BASED COSTING

and CUSTOMER
PROFITABILITY ANALYSIS
 STRATEGIC ROLE OF ABC
 Activity-based costing (ABC) is a method for
determining accurate costs.
 While ABC is a relatively recent innovation in cost
accounting, it is rapidly being adopted by companies
across many industries and within government and
not-for-profit organizations.
 ROLE OF VOLUME-BASED COSTING
 Volume-based costing can be a good strategic choice for some
firms. It is appropriate generally when direct costs are the major
cost of the product or service and activities supporting the
production of the product or service are relatively simple, low-
cost, and homogenous across different product lines.
 EXAMPLES:
 a firm that manufactures paper
 products or a firm that produces certain agricultural products
 ACTIVITY- is a specific task or action of work done.
 single action or
 aggregation of several actions.

 RESOURCE- is an economic element needed or consumed in

performing activities.
 Example: Salaries and supplies- manufacturing activities.


COST DRIVER -is a factor that causes or relates to a change in the
cost of an activity.

 RESOURCE CONSUMPTION COST DRIVER or an ACTIVITY

CONSUMPTION COST DRIVER.

A RESOURCE CONSUMPTION COST DRIVER
 is a measure of the amount of resources consumed by an activity.
 It is the cost driver for assigning a resource cost, consumed by or
related to an activity, to a particular activity or cost pool.
 Examples: number of items in a purchase or sales order, changes
in product design, and machine-hours.


An ACTIVITY CONSUMPTION COST DRIVER
-measures how much of an activity a cost object uses. It is used to
assign activity cost pool costs to cost objects.
 Examples: number of machine-hours in the manufacturing of
product X,or the number of batches used to manufacture Product Y.
 ACTIVITY-BASED COSTING (ABC)
-is a costing approach that assigns resource costs to cost
objects such as products, services, or customers based on
activities performed for the cost objects.
 Firm’s products or services are the results of activities and
activities use resources which incur costs.
 ABC assigns factory overhead costs to cost objects such as
products or services by identifying the resources and activities
as well as their costs and amounts needed to produce output.
TWO-STAGE COST ASSIGNMENT PROCEDURE

 A two-stage cost assignment procedure assigns

resource costs such as factory overhead costs to
activity cost pools and then to cost objects to
determine the amount of resource costs for each of
the cost objects.
TWO-STAGE COST ASSIGNMENT PROCEDURE
 STEPS IN DEVELOPING AN ACTIVITY-BASED COSTING
SYSTEM
STEP 1: IDENTIFY RESOURCE COST AND ACTIVITIES
LEVELS OF ACTIVITIES
-To identify resource costs for various activities, a firm classifies all activities according
to the way in which the activities consume resources.
1. Unit-level activity is performed for each individual unit of product or service of
the firm.
 A unit-level activity is volume-based. The required activity varies in
proportion with the quantity of the cost object.
 Examples: direct materials, direct labor-hours, inserting a component, and inspecting
every unit.
2. A batch-level activity is performed for each batch or group of units of products or
services.
 Examples: setting up machines, placing purchase orders, scheduling production,
conducting inspections by batch, handling materials, and expediting production.
STEPS IN DEVELOPING AN ABC SYSTEM

3. A product-level activity supports the production of a specific product or

service.
 Examples: designing products, purchasing parts required for products, and
engaging in engineering changes to modify products.
4. A facility-level activity supports operations in general. These activities
are not caused by products or customer service needs and cannot be traced to
individual units, batches, or products.
 Examples: providing security for the plant performing maintenance of general
purpose machines, managing the plant, incurring factory property taxes and
insurance, and closing the books each month
ACTIVITY Activity level
Exhibit 5.3 Using direct materials Unit
Activities and
Activity Using direct labor-hours Unit
levels at Using machine hours Unit
Siemens Staring production orders Batch
Electric Motor
Works Adding special Batch
components
STEPS IN DEVELOPING AN ABC SYSTEM

STEP 2: ASSIGN RESOURCE COSTS TO ACTIVITIES

 Activity-based costing uses resource consumption cost drivers to assign resource
costs to activities. Because activities drive the cost of resources used in operations, a
firm should choose resource consumption cost drivers based on cause-and-effect
relationships.
 Typical resource consumption cost drivers:
(1) labor-hours for labor intensive activities;
(2) employees for payroll-related activities;
(3) setups for batch-related activities;
(4) moves for materials-handling activities;
(5) machine-hours for machine repair and maintenance;
(6) square feet for general maintenance and cleaning activities
STEPS IN DEVELOPING AN ABC SYSTEM
 The cost of the resources can be assigned to activities by direct tracing or
estimation
 DIRECT TRACING requires measuring the actual usage of resources by
activities.
 When direct tracing is not available, department managers and
supervisors need to estimate the amount or percentage of time (or effort)
employees spend on each identified activity.
Resource Resource consumption
Exhibit 5.4 resource driver
and resource
consumption cost Personnel Number of workers
drivers at AT & T’s Storeroom Number of items picked for an
New River Valley Plant order
Engineers Time worked
Materials management Time worked
Accounting Time worked
Research and development Number of new codes
developed
STEPS IN DEVELOPING AN ABC SYSTEM

STEP 3: ASSIGN ACTIVITY COSTS TO COST OBJECTS

 The final step is to assign costs of activities or activity cost pools
to cost objects based on the appropriate activity consumption
cost drivers. Outputs are the cost objects for which firms or
organizations perform activities.
 Typical outputs for a cost system are products and services;
however, outputs also can include customers, projects, or
business units.
 BENEFITS OF ACTIVITY-BASED COSTING

1. Better profitability measures

2. Better decision making
3. Process improvement
4. Cost estimation
5. Cost of unused capacity
 COMPARISON OF VOLUME-BASED AND ACTIVITY-
BASED COSTING
Haymarket BioTech Inc. (HBT) produces and sells two secure communications
systems, AW(Anywhere) and SZ(SecureZone). AW uses satellite technology and allows
customers to communicate anywhere on the earth. SZ uses similar technology except
it allows communication between two parties that are within 10 miles of each other.
HBT operates in a very small but competitive industry. The customers are
governmental and corporate customers for which these products are critical; the
customers rely on HBT’s ability to quickly adapt its products to threats from devices
that would compromise the security of the products. SZ has been successful for
nearly 10 years and has undergone a number of improvements in this time; sales are
expected to continue to grow at 8–10 percent per year. AW, a more recent product,
has also been successful, but demand has not been as strong and sales growth is
expected to be 3–5 percent per year. Because of the higher profitability of the AW
system , HBT is considering an extensive advertising campaign to boost sales of AW,
and to make plans for reallocating manufacturing facilities from SZ to AW to make this
possible. HBT has the following operating data for the two products.
VOLUME-BASED COSTING

AW SZ
Production volume 5,000 20,000
Selling price $400.00 $200.00
Unit direct materials and $200.00 $80.00
labor
Direct labor-hours 25,000 75,000
Direct labor-hours per unit 5 3.75
The volume-based costing system assigns factory overhead (OH) based on direct labor-
hours (DLH). The firm has a total budgeted overhead of $2,000,000. Since the firm
budgeted 100,000 direct labor-hours for the year, the overhead rate is $20 per direct
labor-hour.

Total overhead $2,000,000

Total DLH 25,000 +75,000 = 100,000
Overhead rate per DLH $ 20.00
VOLUME-BASED COSTING

AW SZ
Unit selling price $400 $200
Unit manufacturing
cost:
Direct materials and $200 $80
labor
Factory overhead 100 75
Cost per unit 300 155
Profit margin $100 $45
Since the firm uses 25,000 direct labor-hours to manufacture 5,000 units of AW,
the factory overhead assigned to AW is $500,000 in total and $100 per unit:

Total OH assigned to AW $20 x 25,000= $500,000

Number of units of AW 5,000
Factory overhead per unit of AW $100.00
VOLUME-BASED COSTING

The factory overhead for SZ is $1,500,000 in total and $75 per unit
since the firm spent 75,000 direct labor-hours to manufacture
20,000 units of SZ:

Total OH assigned to SZ $20x75,000=

$1,500,000
Number of units of SZ
20,000
Factory overhead per unit of SZ $
75.00
 ACTIVITY-BASED COSTING

In using activity-based costing, HBT identified the following activities, budgeted costs,
and activity consumption cost drivers—the information necessary to complete Step 3:
assign activity costs to cost objects.
Activity Budgeted Cost Activity Consumption Cost Driver
Engineering $ 125,000 Engineering hours
Setups 300,000 Number of setups
Machine operation 1,500,000 Machine-hours
Packing 75,000 Number of packing orders
Total $2,000,000

HBT also gathered the following operating data pertaining to each of its products:

AW SZ Total
Engineering hours 5,000 7,500 12,500
Number of setups 200 100 300
Machine hours 50,000 100,000 150,000
Number of packing orders 5,000 10,000 15,000
The cost driver rate for each activity consumption cost driver
is calculated as follows:
Activity Consumption Cost Budgeted Cost Budgeted Activity Activity
Consumption Rate
Driver Consumption
Engineering hours $ 125,000 12,500 $ 10 per
hour
Number of setups 300,000 300 1,000 per
setup
Machine hours 1,500,000 150,000 10 per
hour
Factory overhead costs are assigned to both products by these calculations:
Number of packing orders 75,000
AW (5,000 units) 15,000 5 per
order
Activity Consumption Activity Activity Total
Overhead Overhead
Cost Driver Consumption Rate Consumption
Per Unit
Engineering hours $ 10 5,000 $50,000
$10
Number of setups 1,000 200 200,000
40
Machine hours 10 50,000 500,000
 AW (5,000 units)

Activity Consumption Activity Activity Total Overhead

Overhead
Cost Driver Consumption Rate Consumption
Per Unit
Engineering hours $ 10 5,000 $50,000
$10
Number of setups 1,000 200 200,000
40
Machine hours 10 SZ(20,000 units)
50,000 500,000
100
Activity
Number ofConsumption
packing orders Activity
5 Activity
5,000 Total
25,000Overhead
5 Overhead
Cost Driver
Overhead cost per unit Consumption Rate Consumption $775,000
$155Per Unit
Engineering hours $ 10 7,500 $ 75,000
$ 3.75
Number of setups 1,000 100 100,000
5.00
Machine hours 10 100,000 1,000,000
50.00
EXHIBIT 5.6 Product Profitability Analysis under the ABC Costing System
(5,000 AW (20, 000 units)
SZ units)
Unit selling price $400
$200.00
Unit manufacturing cost
Direct materials and labor $200 $80.00
Factory overhead:
Engineering $ 10 $ 3.75
Setups 40 5.00
Machine running 100 50.00
Packing 5 155 2.50 61.25
Cost per unit 355
141.25 EXHIBIT 5.7 Comparison of Alternative Costing Approaches
Profit margin AW$ 45 $
58.75
SZ
Unit overhead cost
Volume-based $100
$75.00
Activity-based 155
61.25
Difference $ 55
$13.75
 ACTIVITY-BASED MANAGEMENT
-manages resources and activities to improve the value of products
or services to customers and increase the firm’s competitiveness
and profitability.
 ABM draws on ABC as its major source of information and focuses
on the efficiency and effectiveness of key business processes and
activities.
 ABM improves management’s focus on the firm’s critical success
factors and enhances its competitive advantage
 It can be classified into two categories: OPERATIONAL ABM
AND STRATEGIC ABM.
OPERATIONAL ABM
 enhances operational efficiency and asset utilization and lowers costs; its focuses are on doing
things right and performing activities more efficiently.
 use management techniques such as activity analysis, business process improvement, total
quality management, and performance measurement.

STRATEGIC ABM
 attemps to alter the demand for activities and increase profitability through improved activity
efficiency. Focuses on choosing appropriate activities for the operation, eliminating nonessential
activities and selecting the most profitable customers.
 Uses management techniques such as process design, customer profitability analysis, and
value-chain analysis

EXHIBIT 5.8 The Role of ABC/M Tools

Critical Questions ABC/M Tools
What do we do? Activity analysis
How much does it cost? Activity-based costing
How well do we do it? Performance measurement, including the balanced
scorecard
How can we do it better? Benchmarking, total quality management,
 ACTIVITY ANALYSIS
To be competitive a firm must assess each of its activities based on
its need by the product or customer, its efficiency, and its value
content.
 A firm performs an activity for one of the following reasons:
 It is required to meet the specification of the product or service
or satisfy customer demand.
 It is required to sustain the organization.
 It is deemed beneficial to the firm.
 VALUE-ADDED ANALYSIS
 A high-value-added activity increases the value of the product or service to
the customers. Removal of a high-value-added activity decreases perceptively the
value of the product or service to the customer.

A HIGH-VALUE-ADDED ACTIVITY is one that, if eliminated, would affect the accuracy and EXHIBIT
effectiveness of the newscast and decrease total viewers as well as ratings for that time slot. 5.10
1. Activities that augment accuracy Television
• Verification of story sources and acquired information. News
2. Activities that augment effectiveness Broadcastin
• Efficient electronic journalism to ensure effective taped segments. g Firm’s
• Newscast story order planned so that viewers can follow from one story to the next. High-Value-
Added and
A LOW-VALUE-ADDED ACTIVITY is one that, if eliminated, would not affect the accuracy and Low-Value-
effectiveness of the newscast. The activity contributes nothing to the quest for viewer retention Added
and improved ratings. Activities
• Developing stories not used in a newscast.
• Assigning more than one person to develop each facet of the same news story.
 LOW-VALUE-ADDED ACTIVITY
-consumes time, resources, or space, but adds little in satisfying
customer needs. If eliminated, customer value or satisfaction
decreases inperceptively or remains unchanged.

EXHIBIT 5.11 A Classification of High-Value- Added and Low-Value-Added Activities

ACTIVITY HIGH-VALUE-ADDED LOW-VALUE ADDED
Designing product X
Setting up X
Waiting X
Moving X
Processing X
Reworking X
Repairing X
Storing X
Inspecting X
Delivering product X
 CUSTOMER PROFITABILITY ANALYSIS
-identifies customer service activities and cost drivers and determines profitability
of each customer or group of customers.
Customer profitability analysis allows managers to:
 Identify most profitable customers.
 Manage each customer’s costs-to-serve.
 Introduce profitable new products and services.
 Discontinue unprofitable products, services, or customers.
 Shift a customer’s purchase mix toward higher-margin products and service lines.
 Offer discounts to gain more volume with low costs-to-serve customers.
 Choose types of after-sale services to provide
 CUSTOMER COST ANALYSIS
Identifies activities and cost drivers to service customers before and
after sales, not including product costs.
Customer costs can be classified into the following categories:
1.CUSTOMER UNIT-LEVEL COST —resources consumed for each
unit sold to a customer.
 Examples: sales commissions based on the number of units sold or
sales dollars, shipping cost when the freight charge is based on the
number of units shipped, and cost of restocking each of the
returned units.
2.CUSTOMER BATCH-LEVEL COST —resources consumed for
each sales transaction.
Examples: order-processing costs, invoicing costs, and recording of
sales returns or allowances every time a return or allowance is
CUSTOMER COST ANALYSIS

3.CUSTOMER-SUSTAINING COST —resources consumed to service a

customer regardless of the number of units or batches sold.
Examples :salespersons’ travel costs to visit customers, monthly statement
processing costs, and collection costs for late payments.
4.DISTRIBUTION-CHANNEL COST —resources consumed in each
distribution channel the firm uses to service customers.
Examples: operating costs of regional warehouses that serve major
customers and centralized distribution centers that serve small retail
outlets.
5.SALES-SUSTAINING COST —resources consumed to sustain sales
and service activities that cannot be traced to an individual unit, batch,
customer, or distribution channel.
Examples: general corporate expenditures for sales activities, and salary,
fringe benefits, and bonus of the general sales manager.
EXHIBIT 5.17 CUSTOMER-RELATED ACTIVITY, COST DRIVER, COST RATE, AND
COST CATEGORY, WINSOME OFFICE SUPPLY

Activity Cost Driver and Rate Cost

Category
Order taking $30 per order Customer
batch-level
Order processing $20 per order Customer batch-
level
and $1 per item Customer
unit-level

Delivery $100 per trip, and Customer

batch-level
$1 per mile Customer batch-
level
Expedited order taking,
processing, and delivery $800 per order Customer batch-
level

Customer visit $200 per visit Customer-

 CUSTOMER PROFITABILITY ANALYSIS
-combines customer revenues and customer cost analyses
to assess customer profitability and helps identify actions
to improve customer profitability.
 CUSTOMER LIFETIME VALUE AND
CUSTOMER EQUITY
 Customer lifetime value (CLV) is calculated as the
net present value of all estimated future profits from
the customer.
 CLV can be used to measure the value of a customer or
group of customers and to determine how marketing
and support services should be allocated to these
customers to improve the firm’s overall profitability.
 CUSTOMER EQUITY (CE)
 An extension of CLV which is the sum of the CLVs for all the
firm’s customers.
 viewed as a measure of total corporate value
 The goal of using CE is to provide a roadmap for the firm to use
in implementing its strategy.
 B2C (business to customer relationship)
 B2B (business to business)
 3 CATEGORIES OF DRIVERS OF CE
 Value equity is the value the customers place on the firm’s products or
services because of the quality or features relative to the price. Value equity is
higher when the customers think that the value (quality and features) are high
relative to the price.
 Brand equity is the perception of the firm’s products and services that
are not explained by objective attributes. Brand equity is shaped by the firm’s
marketing strategy. The key subdrivers of brand equity are brand awareness,
customer attitude toward the brand, and customer perception of brand ethics.
 Retention equity consists of programs and relationship-building
activities that increase customer loyalty- loyalty programs that provide special
benefits for customers that buy frequently, affinity programs that allow
customers to benefit from lower prices on products from other companies, and
consistent customer service, among others.
IMPLEMENTATIONS OF
ABC SYSTEM
 MULTISTAGE ACTIVITY-BASED COSTING

-is where resource costs are assigned to certain

activities which in turn are assigned to other
activities before being assigned to the final cost
objects- the firms products, services, or customers.
 RESOURCE CONSUMPTION ACCOUNTING (RCA)

 Resource consumption accounting (RCA) is an adaptation of

ABC that emphasizes resource consumption by greatly increasing
the number of resource cost pools, which allows more direct
tracing of resource costs to cost objects than an ABC system with
fewer cost centers.
 It is particularly appropriate for large organizations with repetitive
operations and high-level information systems.
 Important concepts in RCA include variable costing, resource
interrelationships, detail level cost information at the resource
level, the treatment of idle or excess capacity, and the use of
replacement cost depreciation.
RESOURCE CONSUMPTION ACCOUNTING (RCA)
1. There is a focus on variable costing as the goal of RCA is to trace
costs directly to cost objects by the use of many cost centers and by
avoiding any cost allocations that do not reflect the use of the
resource by the cost object.
2. Interrelationships among activities and resource pools are
considered directly in RCA.
3. Important advantage-detailed cost information is available at the
resource level so that cost information can be aggregated or tracked
at many levels between resources and objects.
4. RCA is able to attribute the cost of idle or excess capacity to the
appropriate cost center.
5. RCA approach utilizes a measure of depreciation based on
replacement cost; depreciation expense is based on an estimated
replacement cost for the asset rather than purchase cost, as in
TIME-DRIVEN ACTIVITY-BASED COSTING (TDABC)
 assigns resource costs directly to cost objects using the
cost per time unit of supplying the resource, rather than
first assigning costs to activities and then from activities
to cost objects.
 TDABC provides a direct way to measure unused
capacity.
 A difference between TDABC and ABC is that TDABC is
capacity-sensitive and computes a standard activity cost
using standard rates.
 A disadvantage of TDABC is its reliance on the accuracy
of the time estimates; also, the effort to determine these