chapter 7 – activity-based costing and activity...

77 Activity-Based Costing and Activity-Based Management

Unit SummariesUnit 7.1 – Activity-Based Costing

Unit 7.1 introduces the concept of activity-based costing. Exhibit 7-1 provides an illustration of the basic concept. Students will learn how to identify and classify activities as unit-level, batch-level, product-level, customer-level, or organization-level.

Unit 7.2 – Developing Activity-Based Product CostsThe mechanics of developing activity-based product costs are presented in this unit using C&C Sports’ manufacturing overhead costs. Exhibit 7-10 provides a graphical illustration of the activity-based cost of each of the company’s three products.

Unit 7.3 – Activity-Based ManagementThis unit introduces students to the concept of activity-based management. The discussion provides students a glimpse of how activity-based cost information can be used to improve the operations and profitability of the organization.

Running Case RecapBased on results of variance analysis examined in Chapter 6, C&C Sports’ managers realize that they must better understand the company’s cost drivers and choose to explore activity-based costing.

Motivating the Chapter with The PitchC&C Sports’ managers were perplexed by the operating results in 2011 and were trying to understand why the company did not achieve its profit target, even though the company sold more award jackets than were budgeted. Penny Townsley reports that operations have become more complex with the addition of award jackets to the product mix. Jonathan Smith, vice president of marketing, has heard customers commenting that C&C’s jackets are of higher quality than competitors’, yet the sales price is lower. Before plans can be made for the coming year, the managers realize that they must gather additional information about the costs to produce award jackets.

Assignment Classification by Learning Objective

Learning Objective Exercises Problems Cases1. Classify activities as unit-level, batch-level, product-level,

customer-level, or organization-level. (Unit 7.1)1, 2

2. Calculate activity-based product costs. (Unit 7.2) 3, 4, 5, 6, 9 14, 15, 16, 17, 18,19, 20,

21, 22

23

3. Explain the difference between traditional product costs and activity-based product costs. (Unit 7.3)

7, 8, 9 16, 21, 22

4. Distinguish between value-added and non-value-added activities. (Unit 7.3)

10, 11

5. Explain how information about activities can be used to make 12, 13 17, 18,19, 20,

Davis and Davis, Managerial Accounting Instructor’s Manual

decisions. (Unit 7.3) 21, 22

Assignment Characteristics

Number DescriptionLearning

ObjectivesBloom Levelsa

CMA Adapted

Difficulty Level

Estimated Time (min.)

E7-1 Classify activities 1E7-2 Classify activities 1E7-3 Identify activity cost drivers 2E7-4 Select appropriate activity cost

drivers2

E7-5 Calculate activity-based overhead rates

2

E7-6 Allocate overhead to products using activity-based costing

2

E7-7 Calculate traditional and activity-based product costs

3

E7-8 Explaining the differences between traditional and activity-based product costs

3

E7-9 Calculate traditional and activity-based product costs

2, 3

E7-10 Identify value-added and non-value-added activities

4

E7-11 Identify value-added and non-value-added activities

4

E7-12 Evaluat effects of changing activities on product costs

5

E7-13 Manage activities to improve product profitability

5

P7-14 Allocate activity-based overhead costs in a service setting

2

P7-15 Calculate traditional and activity-based product costs

2

P7-16 Compare traditional and activity-based product costs

2, 3

P7-17 Allocate selling expenses using activity-based costing

2, 5


2, 5

P7-19 Calculate activity-based product costs

2, 5


2, 5


2, 3, 5


2, 3, 5

C7-23 Calculate activity-based product costs

aK=knowledge, C=comprehension, AP = application, AN=analysis S=synthesis, E=evaluation

7-2

Chapter 7 – Activity-Based Costing and Activity-Based Management

Chapter Summary

Unit 7.1

LO 1 Classify activities as unit-level, batch-level, product-level, customer-level, or organization-level. Unit-level activities are performed for each individual unit. Since each unit of a particular product requires the same level of activity, each unit consumes the same amount of resources that provide for that activity. The total level of activity performed varies proportionately with the number of units produced.

Batch-level activities are performed on groups, or batches, of products at one time. Since the activity is based on the existence of the batch rather than on the number of units in the batch, a batch consumes the same quantity of resources whether it includes 20 units or 2,000 units.

Product-level activities, also referred to as product-sustaining activities, support the products or services provided by the company. These activities are performed for the entire product line, regardless of how many units or batches are produced.

Customer-level activities are performed for specific customers. These activities, and the resources consumed to perform them, do not affect product costs. Rather, the resources are consumed in the delivery of customer support services, and the associated costs are then used to determine the cost to serve a particular customer.

Organization-level activities are required to provide productive capacity and to keep the business in operation. Although these activities do not provide identifiable benefits to specific products or services, without them there would be no business.

Unit 7.2

LO 2 Calculate activity-based product costs. Step 1: Identify activities.Step 2: Develop activity cost pools.Step 3: Calculate activity cost pool rates.

Activity rate = Totalactivity cost pool resources

Total activity driver volume

Step 4: Allocate costs to products or services.

Allocated cost = Activity rate × Activity driver consumption

Step 5: Calculate unit product costs.

Total direct materials cost+ Total direct labor cost+ Allocated activity cost 1+ Allocated activity cost 2*= Total product cost÷ Number of units produced= Unit product cost

*This calculation will have as many allocated costs as there are activity cost pools.

7-3


Unit 7.3

LO 3 Explain the difference between traditional product costs and activity-based product costs. The difference between traditional product costs and activity-based product costs lies in the way manufacturing overhead is allocated and in the inclusion of selling and administrative costs as a component of product cost. (Direct materials and direct labor costs do not differ between the two methods.) Activity-based product costs are based on the consumption of activities by each product rather than on consumption of the overhead base as in the traditional method.

LO 4 Distinguish between value-added and non-value-added activities. Value-added activities are those activities that create the product or service the customer wants to buy. Non-value-added activities are those activities that consume resources but do not contribute to the product’s value.

LO 5 Explain how information about activities can be used to make decisions. Activity-based management uses activity-based costing information to manage business activities. Decisions regarding pricing, customer profitability, distribution channel profitability, and process improvement can all benefit from the use of activity-based costing information.

Related ReadingWilliam O. Stratton, Denis Desroches, Raef A. Lawson, and Toby Hatch, “Activity-Based Costing: Is It Still Relevant?,” Management Accounting Quarterly, Spring 2009, 31-40.

This article presents results of a survey of 348 manufacturing and service companies. Results show that ABC is still used to support a variety of decisions. Available online without graphics at http://findarticles.com/p/articles/mi_m0OOL/is_3_10/ai_n32406926/ and with graphics to IMA members at https://www.imanet.org/publications_maq_back_issue_spring2009.asp.

Bobby E. Waldrup, John B. MacArthur, and Jeffrey E. Michelman, “Does Your Costing System Need a Tune-up?,” Strategic Finance, June 2009, 47-51.

This article provides a perspective on how ABS systems may become less useful over time. Is uses a case of a municipal utility company to put an ailing ABC system in context and talks about how a CIO jump-started the company’s ABC system. Available online without graphics at http://findarticles.com/p/articles/mi_hb6421/is_12_90/ai_n32151590/ and with graphics to IMA members at https://www.imanet.org/publications_sfm_bi_june2009.asp.

Sidney J. Baxendale, “Activity-based Costing for the Small Business: A Primer,” Business Horizons, January/February 2001, 61-68.

This article applies ABC to a small business. A numeric case is used to illustrate product costing under traditional and ABC approaches to product costing.

Gary Cokins, Activity-based Cost Management: An Executive’s Guide¸ John Wiley & Sons, 2001.

Gary Cokins, Alan Stratton, and Jack Helbling, An ABC Manager’s Primer, McGraw-Hill, 1993.These two books provide good introductions to ABC and activity-based cost management.

John Miller, Andrew Muras, and Robert Vecchio, “Zippo Lights Up with ABC/M,” The Journal of Corporate Accounting & Finance, March/April 2006, 47-56.

This article describes Zippo’s implementation of an ABC/M tool. It also includes a discussion of how the ABC/M information is used to assess customer profitability. Available online at http://www3.interscience.wiley.com/cgi-bin/fulltext/112412057/PDFSTART.

7-4

http://www3.interscience.wiley.com/cgi-bin/fulltext/112412057/PDFSTART

https://www.imanet.org/publications_sfm_bi_june2009.asp

http://findarticles.com/p/articles/mi_hb6421/is_12_90/ai_n32151590/

https://www.imanet.org/publications_maq_back_issue_spring2009.asp

http://findarticles.com/p/articles/mi_m0OOL/is_3_10/ai_n32406926/


Gunther Friedl, Hans-Ulrich Küpper, and Burkhard Pedell, “Relevance Added: Combining ABC with German Cost Accounting,” Strategic Finance, June 2005, 56-61. Available online without graphics at http://www.allbusiness.com/accounting/604706-1.html and with graphics to IMA members at http://www.imanet.org/publications_sfm_bi_jun2005.asp.

Carl Smith, “Going for GPK,” Strategic Finance, April 2005, 35-39. Available online at http://www.imanet.org/pdf/2994.pdf.

Paul Sharman, “Bring on German Cost Accounting,” Strategic Finance,” December 2003, 30-38. Available online at http://www.focusedmanagement.com/knowledge_base/articles/fmi_articles/middle/German_Cost_Accounting_pt2.pdf. .

Paul Sharman and Kurt Vikas, “Lessons from German Cost Accounting,” Strategic Finance, December 2004, 28-35. Available online at http://www.imanet.org/pdf/2800.pdf.

Kip Krumwiede, “Rewards and Realities of German Cost Accounting,” Strategic Finance, April 2005, 27-34. Available online at http://www.imanet.org/pdf/2993.pdf.

These five articles (and you can find others) provide basic information about GPK, or German Cost Accounting. This method of developing product costs has been in use in Germany for over 40 years. Some of the articles talk about the relationship between ABC and GPK.

Additional CasesJohn K. Shank, “Tijuana Bronze Machining,” Cases in Cost Management: A Strategic Emphasis, 3rd Edition, Cengage Learning: 2006

This case provides practice in ABC calculations. Discussion can be directed toward activity-based management issues as well.

Gail Kaciuba and Gary H. Siegel, “Activity-Based Management in a Medical Practice: A Case Study Emphasizing the AICPA’s Core Competencies,” Issues in Accounting Education, November 2009, 553-577.

This case provides an example of using activity-based costing and management in a service setting. This case provides practice in ABC calculations. Discussion can be directed toward activity-based management issues as well.

Edward Blocher, Karen Shastri, David E. Stout, and Monte R. Swain, Instructional Case: Blue Ridge Revisited – Integrating ABC and OROS Quick® Software, Journal of Accounting Education, June 2009, 85 - 103.

This case demonstrates the use of OROS Quick activity-based costing software. While the case focuses more on customer profitability, it can be used to demonstrate general activity-based costing model building. The software can be downloaded for free.

Critical Thinking ExerciseRead Cheryl Lu-Lien Tan, “Making Washer-Dryers a Fashion Statement, “The Wall Street Journal,” January 13,2005

Questions When Viking Range Corp. began offering its 30-inch range 0in colors other than black, white or graphite,

the new color alternatives required a change to the production process. “ ‘We just don’t do enough volume of it so you have to put the panels through the paint process separately,’ says Brent Bailey, Viking’s design director.” Discuss Bailey’s statement in the context of activity-based costing.

7-5

http://www.imanet.org/pdf/2993.pdf


http://www.focusedmanagement.com/knowledge_base/articles/fmi_articles/middle/German_Cost_Accounting_pt2.pdf

http://www.focusedmanagement.com/knowledge_base/articles/fmi_articles/middle/German_Cost_Accounting_pt2.pdf


http://www.imanet.org/publications_sfm_bi_jun2005.asp

http://www.allbusiness.com/accounting/604706-1.html


With the smaller volume of colored ranges, the batch size for the paint process was decreased. Assuming that the cost of painting a batch of panels does not vary with the number of panels painted, the cost of painting a colored panel will be higher than the cost of painting a standard color panel.

When Viking Range Corp. began offering its 30-inch in colors other than black, white or graphite, it added $225 to the price for the extra color. As a manager at Viking Range Corp., how would you justify this increased price?The smaller batch size in painting will result in a higher cost per panel. The separate loading of these panels in the paint process likely requires additional labor resources. Special paint colors may have a higher purchase price than standard paint colors. All three factors would result in a higher unit cost for colored ranges than standard color ranges, therefore requiring a higher sales price to cover the additional costs.

7-6


PowerPoint Slide Notes

Review what’s happened at C&C Sports. Variance analysis pointed out some issues that require attention. It appears that increasing jacket production had unexpected consequences. Managers will now look at activity-based costing to help understand the causes of those variances and better plan for the future.

Use this demonstration to illustrate how the use of a single plant-wide overhead rate, as done in traditional costing, can distort the overhead costs assigned to particular products. After reviewing the single rate model, advance the slide to reveal how the two products (red and blue) actually work through the factory. Point out that each has a different path. Some resources are devoted to a single product, yet under the traditional model, all products are assigned some of that cost. This results in overcosting products that don’t use the resource and undercosting those that do use the resource.

This slide further illustrates the concept behind activity-based costing with examples from C&C Sports. Emphasize that once resources are acquired, they are consumed through activity to produce the final product. So the cost of those resources should be assigned to the products made through those activities.

7-7


This example will help students better understand cost drivers. Assuming that only one batch of fabric is moved at the time, the jerseys will consume three times the forklift use that the jackets do, even though the production time is identical. So direct labor hours is not a good cost driver for the forklift resource. This may help explain why C&C Sport experienced some of the overhead variances it did when jacket production was increased.

Review the definitions of the five types of activities.

Discuss unit-level activities in more detail. For C&C Sports, the sewing function is a good example of a unit-level activity. If you make one more jersey, you have to use more sewing machine time.

Discuss the idea of batches. C&C Sports makes its pants in batches of 50, jerseys in batches of 35, and jackets in batches of 5. Every time a new batch of 50 pants is started, the forklift is used to move the fabric from the warehouse to the cutting department. Reiterate that the number of units produced in the batch has no effect on the batch-level activity.

7-8


Discuss how some resources are consumed at the product level. The creation of patterns at C&C Sports is a good example of this. If a new line of pants or jerseys is introduced, new patterns must be made.

Customer-level activities are typically general and administrative in nature. This differs from many of the unit-level, batch-level, and product-level activities that are components of manufacturing overhead. These costs do not affect product cost (DM, DL, MOH) but do affect the cost of providing service to a customer.

Organization-sustaining activities are those that provide productive capacity and support for the entire organization. Reiterate that these costs are not allocated to products when developing activity-based product costs.

Point out that under GAAP used for external financial reporting purposes, all manufacturing overhead costs are allocated to products. However, under activity-based costing used for internal decision making, these costs are not allocated in determining unit product cost. Also, under activity-based costing, selling, general and administrative costs are considered part of product cost.

7-9


Present these five steps for calculating ABC product costs.

Discuss how to identify activities. This may require observation of workers and discussion with those workers of what they do. Once the activities have been identified, show how overhead costs are divided into activity costs pools. The basic step is linking the costs of providing resources with the activities that consume them. Pick one of the activity cost pools and discuss what costs might be included. Point out that the General activity cost pool includes all the organization-sustaining activities.

Show how to calculate an activity-cost pool rate. Point out that this is the same process that was used in chapter 4 to calculate the predetermined overhead rate under traditional costing. Discuss how an activity rate is not needed for the Chenille Machine activity cost pool because jackets are the only product that uses that resource.

7-10


Demonstrate how activity cost pool rates and activity cost driver consumption are used to allocate overhead costs to products.

Show how to complete the ABC calculation by determining the overhead cost per unit to add to the direct material and direct labor costs per unit.

Review this comparison of traditional and ABC costing for C&C Sports’ three products. Point out that under traditional costing, pants and jerseys were over-costed, while jackets were under-costed.

The previous slide illustrates how this happened at C&C Sports.

Discuss how there is no single right answer to the level of granularity used to create activity cost pools or the selection of activity cost drivers. But in making those choices, one must recognize the limitations of data collection capabilities and the cost/benefit trade-off between more and fewer activity cost pools.

7-11


7-12


When faced with a need to reduce costs, many companies’ first reaction is to reduce headcount. But this action does nothing to reduce the workload. It could lead to overtime for remaining employees since the same amount of work must be done with fewer people. It’s even possible that labor costs could increase because of the overtime.

The first place to look for reducing costs is to look at the workload for activities that can be reduced or eliminated. Once the right work is being done, then the company can look at whether it has the right number of employees.

Companies should strive to eliminate non-value-added activities when possible. Only those activities that customers are willing to pay for are truly value-added. It is unlikely that all non-value-added can be eliminated.

Review this chart to illustrate how companies are using activity-based costing information to improve their operations.

This chart summarizes the result of C&C Sports’ activity-based costing analysis. Discuss with the students how and why product costs have changed.

7-13


Students often think that implementing activity-based costing changes production costs. Emphasize that the costs do not change, only the allocation of the costs change. You may want to use a pie analogy; ABC doesn’t change the size of the pie, it just changes the size of the individual slices.

Use this slide to review ABC.

7-14


7-15

chapter 7 – activity-based costing and activity...

Documents