BA 252 Introduction to Management Accounting
Activity-Based Cost Management Systems
? Jonathan Kellogg is the owner and CEO of Booth Motors.
? Booth Motors is an automobile dealership with four other lines of business.
1 Used cars
4 Finance and insurance
? Kellogg felt that as one of the largest auto dealerships in the Midwest, Booth should
be earning much more than one percent pre-tax margin on sales.
? The existing accounting system allocates operating expenses to each department
based on sales.
Learning Objective 1
Understand how traditional cost systems, using only unit-level drivers, distort
product and customer costs.
Traditional Manufacturing Costing Systems
? Traditionally, job-order and process costing systems have assigned direct labor and
direct materials costs to products.
? Indirect costs were accumulated as support department expenses.
? These expenses were allocated to production departments in a simple proportion.
? Historically, Cooper Pen had been a low cost producer of BLUE and BLACK pens.
? Recently, these product lines have expanded into two new products.
? The plant’s indirect expenses, about $180,000 per quarter, were aggregated at the
plant level and allocated to products based on direct labor.
? The overhead burden rate was 300% of direct labor costs.
? The controller of Cooper Pen Company wondered whether they should continue to
de-emphasize their commodity products, and to keep introducing the new specialty
– Page 160 Exhibit 6-1
? Traditional costing systems distort product costs.
? They use unit level drivers, such as direct labor dollars, for allocating production
center expenses to products.
Learning Objective 2
Describe why factories producing a more varied and complex mix of products have
higher costs than factories producing only a narrow range of products.
Simple and Complex Factories
BA 242 Chapter 5 Notes Page 2 of 7
? A simple factory has little need for a cost system to calculate the cost of its product. ? A complex factory requires many resources to support a highly varied product mix. ? Complex factories require a cost accounting system to trace expenses to its various products.
? Traditional cost systems will under-estimate the cost of resources required for specialty, low-volume products.
? These systems will over-estimate the resource cost of high volume, standard products.
? Activity-based cost systems have been developed to eliminate this source of cost distortion.
? Page 191
? Question 1 – 5
Learning Objective 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.
Activity-Based Cost Management Systems
? Activity-based cost-management systems trace indirect and support expenses accurately to individual products, services, and customers.
? ABC systems use a simple two-stage approach similar to traditional cost systems. ? However, instead of using cost centers for accumulating costs, it uses activities. ? What do managers do in an activity-based management?
? Managers use information collected by the ABC system at the activity level to identify promising opportunities for reducing costs in indirect and support activities. ? The controller of Cooper Pen Company developed an activity-based cost system. ? How are overhead rates determined under activity-based costing?
1 Identify the activities performed.
2 Determine the cost of performing each activity.
3 Identify a cost driver for each activity.
4 Determine the number of units of the cost driver made available by the resources
committed to each activity.
5 Divide the activity cost by the number of cost driver units made available to
determine the activity overhead rate.
? An activity dictionary is the list of the major activities performed by an organization’s resources.
Tracing Costs to Activities
? ABC allocation procedures trace all overhead costs to activity cost pools.
Handle Production Runs
BA 242 Chapter 5 Notes Page 3 of 7
? What are examples of production activities?
? Exhibits 5-2 & 5-3, page 166
Learning Objective 4
Appreciate the role for choosing appropriate activity cost drivers when tracing
activity costs to products and customers.
Tracing Costs From Activities to Products
? Activity cost drivers identify the linkage between activities and cost objects.
? What are some examples of cost objects?
? What is an activity cost driver?
? It is a unit of measurement for the level (or quantity) of the activity performed.
? What is a cost driver rate?
? It is a rate obtained by dividing the activity expense by the total quantity of the
activity cost driver.
? What are some examples of cost drivers?
Handle Production Runs -- Production Runs
Support Products -- Number of Products
Setup Machines -- Setup Hours
Run Machines -- Machine Hours
? Exhibit 5-5 & 5-6, Page 169
? Exhibit 5-7 & 5-8; Page 170
More Questions and a Problem
? Page 191 Question 6, 7, 9, & 10
? Page 195 Problem 29
Learning Objective 5
Use the information from a well-designed activity-based cost system to improve
operations and make better decisions about products and customers.
? A bill of activities is the set of activities and their costs associated with individual
? Activity-based management (ABM) involves decisions on pricing, distribution,
product design, and minimum order sizes so that loss products can become
Activity-Based Cost systems
? Activity cost drivers are the central innovation of activity-based cost systems.
BA 242 Chapter 5 Notes Page 4 of 7
? They are also the most costly aspects of ABC systems.
? The selection of an activity cost driver reflects a subjective trade-off between
accuracy and the cost of measurement.
? ABC system designers can choose from three different types of activity cost drivers.
? Transaction drivers count how often an activity is performed. ? What are some examples?
– number of setups
– number of receipts
– number of products supported
? Duration drivers represent the amount of time required to perform an activity. ? What are some examples?
– setup hours
– inspection hours
– direct labor hours
? Intensity drivers directly charge for the resources used each time an activity is
? What are some examples?
– actual time
– specific resources committed
? Intensity drivers may be simulated with a weighted index approach.
? The goal of a properly constructed ABC system is to have a cost system that
balances the cost of errors made from inaccurate estimates with the cost of
Learning Objective 6
Understand the importance of measuring the practical capacity of resources and
the cost of unused capacity.
Measuring the Cost of Resource Capacity
? Practical capacity represents the maximum output that could be handled efficiently. ? The activity cost driver rate should reflect the underlying efficiency of the process.
? How should the activity cost driver rate be computed?
? The numerator represents the cost of supplying resource capacity to do work.
? The denominator should match the numerator by representing the quantity of
work the resources can perform.
? The cost of unused capacity is the cost of capacity available but not utilized.
? There are two ways for organizations to actively manage unused capacity.
1 Increase the volume of business.
2 Reduce the supply of unused resources.
Learning Objective 7
Assign marketing, distribution, and selling expenses to customers.
Marketing, Selling, and Distribution Expenses
BA 242 Chapter 5 Notes Page 5 of 7
? The costs of marketing, selling, and distribution expenses have been increasing rapidly. ? Many of these expenses do not relate to individual products or product-lines. ? These expenses are associated with individual customers, market segments, and distribution channels.
? What are examples of marketing, selling, and distribution activities?
Travel to Customers
Distribute Sales Catalog
Provide Marketing and Technical Support
Warehouse Inventory for Customers
? What are examples of activity cost drivers?
Number of Mailings
Time Spent on Customers
Quantity of Inventory and space required
Learning Objective 8
Analyze customer profitability.
Customer Profitability Exhibit 5-10, Page 180
Learning Objective 9
Appreciate the role for activity-based cost systems for service companies.
? Why are service companies ideal candidates for activity-based costing? ? The majority of their costs are indirect and appear to be fixed. ? The variable cost is essentially zero.
? Why do service companies need to identify the differential profitability of
? Because the variation in demand for organizational resources is much more
customer-driven than in manufacturing organizations.
Learning Objective 10
Discuss the barriers for implementing activity-based cost systems and how these
might be overcome.
Barriers to Implementing ABC
? What are some of the barriers to implementing ABC systems? ? Lack of clear business purpose
? Lack of senior management commitment
? Delegating the project to consultants
? Poor ABC model design
? Individual and organizational resistance to change
BA 242 Chapter 5 Notes Page 6 of 7
BA 242 Chapter 5 Notes Page 7 of 7
? Jonathan Kellogg and his controller developed an activity-based cost model of Booth Motors.
? They identified activities for three of the product lines.
– New Vehicle Department
– Finance & Insurance
? What did the product line analysis show?
? Profits from financing and insuring new and used cars accounted for nearly 50% of total dealer profitability.
? The profitable car line had the lowest average days on lot.
? Seemingly, most popular car lines were unprofitable.