Chapter 05 – Activity-Based Costing and Customer Profitability Analysis
Chapter 5
Activity-Based Costing and Customer Profitability Analysis
Learning Objectives
LO 5-1 Explain the strategic role of activity-based costing.
LO 5-2 Describe activity-based costing (ABC), the steps in developing an ABC system, and the
benefits and limitations of an ABC system.
LO 5-3 Determine product costs under both the volume-based method and the activity-based
method and contrast the two.
LO 5-4 Explain activity-based management (ABM).
LO 5-5 Describe how ABC/M is used in manufacturing companies, service companies, and
governmental organizations.
LO 5-6 Use an activity-based approach to analyze customer profitability.
LO 5-7 Identify key factors for successful ABC/M implementation.
New in this Edition
Two new “Real World Focus” items; one on ABC to support sustainability initiatives and the
other on the use of TDABC.
Five revised end-of-chapter research problems
Teaching Suggestions
A thorough coverage of activity-based costing and activity-based management is an important
part of the development of strategic cost management. Knowing the “true” costs is critical to attain a
better result for all firms and organizations. It is particularly important for firms with complex operations,
where analysis of cost flows and product profitability are important. Moreover, the concept of activity
analysis has important implications for many cost management methods. For these reasons, we have put
the coverage of ABC very early in the book. This allows us to include activity-based concepts when other
topics are covered in later chapters.
Our teaching plan for ABC costing is to begin with a thorough coverage of the benefits and
limitations of ABC systems, including a discussion of why and when they are preferred to other cost
systems. The coverage focuses on the comparison of the volume-based and ABC systems, looking
particularly at the effects of the systems on such strategic decisions as product line additions or deletions.
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Chapter 05 – Activity-Based Costing and Customer Profitability Analysis
Assignment Matrix
End-of-Chapter Exercises & Problems Learning Objectives Text Features
7e
EOC
6e
EOC
Transition
6e to 7e
X = included in Connect
Time
1. Strategic Role /objectives of ABC
2. Describe ABC and its steps
3. Volume based and ABC costs
4. Explain ABM
5. Describe how ABM is used
6. Customer profitability
7. ABC/M implementation factors
Strategy
Service
International
Ethics
Sustainability
Brief exercises
5-16 5-16 X 05 min. X
5-17 5-17 X 05 min. X
5-18 5-18 X 05 min. X
5-19 5-19 X 05 min. X
5-20 5-20 X 05 min. X
5-21 5-21 X 05 min. X
5-22 5-22 X 05 min. X
5-23 5-23 X 05 min. X
Exercises
5-24 5-24 – 25 min X X
5-25 Moved to 5-27
5-25 5-27 X 05 min X
5-26 5-26 X 05 min X
5-27 Moved to 5-25
5-27 5-25 X 20 min X X X
5-28 5-28 X 25 min X
5-29 5-29 X 15 min X
5-30 5-30 X 05 min X X
5-31 5-31 20 min X X
5-32 5-32 X 25 min X X X X
5-33 5-33 X 25 min X X X
5-34 5-34 – 15 min X X X X X
Continued on next page …
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Chapter 5 assignment matrix continued
End-of-Chapter Exercises & Problems Learning Objectives Text Features
7e
EOC
6e
EOC
Transition
6e to 7e
X = included in Connect
Time
1. Strategic Role /objectives of ABC
2. Describe ABC and its steps
3. Volume based and ABC costs
4. Explain ABM
5. Describe how ABM is used
6. Customer profitability
7. ABC/M implementation factors
Strategy
Service
International
Ethics
Sustainability
5-35 5-35 X 25 min X
5-36 5-36 X 25 min X
5-37 5-37 – 10 min X X
Problems
5-38 5-38 Revised – 25 min X X X
5-39 5-39 –25 min X X X
5-40 5-40 Revised – 40 min X X X
5-41 5-41 Revised – 35 min X X X X
5-42 Moved to 5-44
5-42 5-43 Moved to 5-42 – 40 min X X X
5-43 5-44 Moved to 5-43 – 25 min X X X X
5-45 Moved to 5-50
5-44 5-42 –35 min X X X
5-45 5-50 – 30 min X X X X X
5-46 5-46 Revised – 20 min X X X
5-47 5-47 Revised – 20 min X X X X
5-48 5-48 –30 min X X X X
5-49 5-49 –45 min X X
5-50 5-45 – 5 min X X X
5-50 Moved to 5-45
5-51 5-51 –30 min X X X
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Chapter 05 – Activity-Based Costing and Customer Profitability Analysis
Lecture Notes
A. Volume-based Costing. Volume-based costing can be a good strategic choice for some firms. It is
generally appropriate when common costs are relatively small or when activities supporting the
production of the product or service are relatively homogenous across different product lines.
Volume-based overhead rate
1. Plantwide overhead rate
Budgeted (total) overhead
Budgeted (total) direct labor or machine hours
2. Departmental overhead rate
Budgeted departmental overhead
Budgeted departmental direct labor or machine hours
Example:
Volume-based overhead rate:
Division 1 Division 2 Plant Total
DLH 1,000 200 1,200
MH 400 2,000 2,400
Budget $OH $5,000 $7,000 $12,000
Overhead rate:
Per DLH $ 5.00 $35.00 $10.00
Per MH $12.50 $ 3.50 $ 5.00
Departmental Rates Plantwide Rates
Required resources to manufacture one unit each of Widget and Gidget:
Division 1 Division 2 Total
DLH MH DLH MH DLH MH
Widget 20 1 10 5 30 6
Gidget 2 10 6 20 8 30
Factory OH applied to:
Widget Gidget
Using Plantwide rate:
Based on DLH rate $10 x 30 = $300 $10 x 8 = $ 80
Based on MH rate $5 x 6 = $ 30 $5 x 30 = $150
Using departmental rate:
Based on DLH $5 x 20 + $3.5 x 5 = $117.50
Based on MH $5 x 2 + $3.5 x 20 = $80
What is Widget’s “true” OH per unit? $300, $30, or $117.50?
What is Gidget’s “true” OH per unit? $80 or $150?
Limitation of volume-based costing systems
One major limitation of volume-based costing systems is the use of a single plant-wide factory
overhead rate such as direct labor hours or volume-based departmental rates such as machine hours
and direct materials cost to firms with diverse products, processes, and volume. They produce
inaccurate product costs when more factory overhead costs such as setup and materials handling costs
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Chapter 05 – Activity-Based Costing and Customer Profitability Analysis
are not volume-based, and when firms produce a diverse mix of products with different volume, sizes,
and complexities. In summary, a volume-based costing system is likely to suffer from the following
weaknesses:
B. Comparison of Volume-based and Activity-based Costing Systems.
1. Volume-based Two-stage allocation process
a. First stage — overhead costs are assigned to cost centers (e.g. departments or individual
operations).
b. Second stage — costs are applied from departments to individual jobs or products using
volume as the main factor.
Note: Where diversity exists between products (e.g. lot size, complexity of
production), overhead costs assignments based on volume will not provide accurate
product costs. Typically high-volume products have higher and low-volume products have
lower cost than their “true” cost.
The two stage cost allocation procedures is illustrated for both the volume-based and the
activity-based methods:
2. Activity-Based Costing (ABC) is a costing approach that assigns costs to products or services
based on their consumption of resources via activities required for the manufacturing of the
products or providing services. It is based on the premise that a firm’s products or services are
performed by activities and that the required activities incur costs. Cost of resources are assigned
to activities, then activities are assigned to cost objects based on their use. ABC recognizes the
causal relationships of cost drivers to activities. ABC’s major advantage is that it improves the
traceability of overhead costs thus minimizes distortion of product costs.
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EXHIBIT 5.2
The Activity-Based Two-Stage
Procedure
EXHIBIT 5.1
The Volume-Based Two-Stage
Procedure
Input Information
Resources
Performance EvaluationActivities
Chapter 05 – Activity-Based Costing and Customer Profitability Analysis
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Products and Services