CHAPTER 12
ACTIVITY- BASED MANAGEMENT
Many firms that operate in today’s rapidly changing environment must not only know what it currently
costs to do things, but they must continually re-examine why and how they do things. Continuous
improvement involves improving performance by searching for ways to eliminate waste. Activity-based
costing and activity-based management are important tools in this ongoing improvement effort.
LEARNING OBJECTIVES
After studying Chapter 12, students should be able to:
1. Describe how activity-based management and activity-based costing differ.
2. Define process value analysis.
3. Describe activity-based financial performance measurement.
4. Discuss the implementation issues associated with an activity-based management system.
5. Explain how activity-based management is a form of responsibility accounting, and tell how it differs
from financial-based responsibility accounting.
KEY TOPICS
The following major topics are covered in this chapter (related learning objectives are listed for each
topic):
1. The Relationship of Activity-Based Costing and Activity-Based Management (LO 1)
2. Process Value Analysis (LO 2)
3. Financial Measures of Activity Efficiency (LO 3)
4. Implementing Activity-Based Management (LO 4)
5. Financial-Based versus Activity-Based Responsibility Accounting (LO 5)
I. THE RELATIONSHIP OF ACTIVITY-BASED COSTING AND ACTIVITY-BASED
MANAGEMENT
A major focus in the new manufacturing environment is eliminating waste. Often, the process of
continuous improvement is the key method of eliminating waste. Processes are made up of activities that
are linked to perform a specific objective. In order to improve processes, a firm must improve the ways in
which activities are performed. The management of activities, not costs, is the key to successful control
for firms operating in continuous improvement environments.
Activity-based management (ABM) is a systemwide, integrated approach that focuses management’s
attention on activities with the objectives of improving customer value and the profit achieved by
providing this value. ABM has two dimensions: a cost dimension and a process dimension. The cost
dimension provides cost information about resources, activities, and cost objects of interest. The objective
of the cost dimension is improving the accuracy of cost assignments. The process dimension provides
information about what activities are performed, why they are performed, and how well they are
performed. This objective of the process dimension is cost reduction. Exhibit 12.1 (p. 632) in the text
presents the two-dimensional ABM model.
II. PROCESS VALUE ANALYSIS
Process value analysis (PVA) is fundamental to activity-based responsibility accounting, focuses on
accountability for activities rather than costs, and emphasizes the maximization of systemwide
performance instead of individual performance. Additionally, process value analysis is concerned with
driver analysis, activity analysis, and performance measurement.
A. Driver Analysis
Managing activities requires an understanding of what factors cause activities to be performed and what
causes activity costs to change. Activities consume inputs (resources) and produce outputs.
An activity driver is an output measure that calculates the demand that a cost object places on an activity.
Driver analysis is the effort expended to identify those factors that are the root causes of activity costs.
Once a root cause has been determined, action can be taken to improve an activity.
B. Activity Analysis
Activity analysis is the process of identifying, describing, and evaluating the activities an organization
performs. Activity analysis should produce the following four outcomes:
1. What activities are performed.
2. How many people perform the activities.
3. The time and resources required to perform the activities.
4. An assessment of the value of the activities to the organization, including a recommendation to
select and keep only those that add value.
As mentioned earlier, a major focus of the new manufacturing environment is the elimination of non-
value-added activities. Value-added activities are activities necessary to remain in business. Value-added
activities contribute to customer value and/or help meet an organization’s needs. Activities that comply
with legal mandates are value-added because they exist to meet organizational needs. In order for a
discretionary activity to be value-added, it must meet the following conditions:
1. The activity produces a change of state.
2. The change of state was not achievable by preceding activities.
3. The activity enables other activities to be performed.
Non-value-added activities are unnecessary and are not valued by internal or external customers. Non-
value-added activities often are those that fail to produce a change in state or those that replicate work
because it wasn’t done correctly the first time. In the manufacturing operation, five major activities are
often cited as wasteful and unnecessary:
1. Scheduling. An activity that uses time and resources to determine when different products have
access to processes (or when and how many setups must be done) and how much will be
produced.
2. Moving. An activity that uses time and resources to move materials, work in process, and finished
goods from one department to another.
3. Waiting. An activity in which materials or work in process use time and resources by waiting on
the next process.
4. Inspecting. An activity in which time and resources are spent ensuring that the product meets
specification.
5. Storing. An activity that uses time and resources while a good or material is held in inventory.
Kaizen costing involves efforts to reduce the costs of existing products and processes. Activity
management is a fundamental part of kaizen costing.
Activity management can reduce costs in four ways:
1. Activity elimination
2. Activity selection
3. Activity reduction
4. Activity sharing
Activity elimination focuses on eliminating non-value-added activities. Activity selection involves
choosing among various sets of activities that are caused by competing strategies. Activity reduction
decreases the time and resources required by an activity. Activity sharing increases the efficiency of
necessary activities by using economies of scale.
C. Assessing Activity Performance
Assessing how well activities (and processes) are performed is fundamental to management’s efforts to
improve profitability. Activity performance measures exist in both financial and nonfinancial forms.
These measures are designed to assess how well an activity was performed and the results achieved. They
are also designed to reveal if constant improvement is being realized. Measures of activity performance
center on three major dimensions: (1) efficiency, (2) quality, and (3) time. Efficiency is concerned with
the relationship of activity outputs to activity inputs. Quality is concerned with doing the activity right the
first time it is performed.
III. FINANCIAL MEASURES OF ACTIVITY EFFICIENCY
Financial measures of performance should provide specific information about the dollar effects of
activity performance changes. They should indicate both potential and actual savings. Financial measures
of activity efficiency include:
1. Value- and non-value added activity costs
2. Trends in activity costs
3. Kaizen standard setting
4. Benchmarking
5. Activity flexible budgeting
6. Activity capacity management
A. Reporting Value- and Non-Value-Added Costs
A company’s accounting system should distinguish between value-added costs and non-value-added costs
because improving activity performance requires eliminating non-value-added activities and optimized
value-added activities. A firm should identify and formally report the value- and non-value-added costs of
each activity. Performance reports should highlight the costs of non-value-added costs. By highlighting
these costs, managers can focus on measures to reduce them and to eventually eliminate them.
Formulas for computing value-added costs and non-value-added costs are as follows:
Value-added costs = SQ × SP
Non-value-added costs = (AQ − SQ) × SP
where
SQ = The value-added output level for an activity
SP = The standard price per unit of activity output measure
AQ = The actual quantity used of flexible resources or the practical activity capacity
acquired for committed resources
Cornerstone 12.1 (p. 639) illustrates the power of these concepts.
B. Trend Reporting of Non-Value-Added Costs
As managers take actions to improve activities, a way to see if cost reductions are following as expected
is through trend reports. Trend reports compare the costs for each activity over time and also reveal the
amount of cost reduction still available. Cost reduction for value-added activities focuses on increasing
the efficiency of these activities while the cost reduction goal for non-value-added activities is their
eventual elimination.
C. Drivers and Behavioral Effects
If a team’s performance is affected by its ability to reduce non-value-added costs, then the selection of
activity drivers (as output measures) and the way the drivers are used can affect behavior. For example, if
the output measure for setup costs is chosen as setup time, an incentive is created for workers to reduce
setup time. Since the value-added standard for setup costs calls for complete elimination, then the
incentive to drive setup time to zero is compatible with the company’s objectives, and the induced
behavior is beneficial.
D. The Role of Kaizen Standards
Kaizen costing is concerned with reducing the costs of existing products and processes. Controlling this
cost reduction process is accomplished through the repetitive use of two major subcycles:
1. The kaizen or continuous improvement cycle.
2. The maintenance cycle.
The kaizen subcycle is defined by a Plan-Do-Check-Act sequence. The maintenance subcycle follows a
traditional Establish-Do-Check-Act sequence.
E. Benchmarking
Another approach to standard setting that is used to help identify opportunities for activity improvement
is called benchmarking. Benchmarking uses best practices found within and outside the organization as
the standard for evaluating activity performance.
Within an organization, different units (e.g., different plant sites) that perform the same activities are
compared. The unit with the best performance for a given activity sets the standard.
The three types of external benchmarking are competitive benchmarking, functional benchmarking, and
generic benchmarking. Competitive benchmarking is a comparison of activity performance with direct
competitors. Functional benchmarking is a comparison with firms that are in the same industry but do not
compete in the same markets. Generic benchmarking studies the best practices of noncompetitors outside
a firm’s industry.
F. Activity Flexible Budgeting
Activity flexible budgeting is the prediction of what activity costs will be as activity output changes. In a
unit-based approach, budgeted costs for the actual level of activity are obtained by assuming that a single
unit-based driver drives all costs. A cost formula is developed for each cost item as a function of the
driver. If costs vary with respect to more than one driver, the solution is to build flexible budget formulas
for more than one driver.
G. Activity Capacity Management
Activity capacity is the number of times an activity can be performed. Activity drivers measure activity
capacity. The activity volume variance is the difference between the actual activity level acquired and the
value-added standard quantity of activity that should be used, multiplied by the budgeted activity rate:
Activity volume variance = (AQ – SQ) × SP
The unused capacity variance is the difference between activity availability and activity usage, multiplied
by the budgeted activity:
Unused capacity variance = (AU – AQ) × SP
Cornerstone 12.5 (p. 649) in the text illustrates the calculation of these variances.
IV. IMPLEMENTING ACTIVITY-BASED MANAGEMENT
Activity-based management (ABM) can be viewed as an information system that has the broad objectives
of: 1. Improving decision making by providing accurate cost information.
2. Reducing costs by encouraging and supporting continuous improvement efforts.
The first objective is the domain of activity-based costing (ABC), while the second objective belongs to
process value analysis (PVA).
Exhibit 12.7 (p. 652) presents the ABM implementation model, which includes 10 steps that define an
ABM implementation.
One of the main reasons that ABM implementation efforts fail is a lack of support by higher-level
management. Not integrating the new system is another major reason for an ABM system failure.
V. FINANCIAL-BASED VERSUS ACTIVITY-BASED RESPONSIBILITY ACCOUNTING
Responsibility accounting is a fundamental tool of managerial control and is defined by four essential
elements:
1. Assigning responsibility
2. Establishing performance measures or benchmarks
3. Evaluating performance
4. Assigning rewards
The responsibility accounting system for a stable environment is referred to as the financial-based
responsibility accounting system. A financial-based responsibility accounting system assigns
responsibility to organizational units and expresses performance measures in financial terms. An activity-
based responsibility accounting system, on the other hand, is the responsibility accounting system
developed for those firms operating in continuous improvement environments. Activity-based
responsibility accounting assigns responsibility to processes and uses both financial and nonfinancial
measures of performance.
A. Assigning Responsibility
The responsibility assignments in a financial-based responsibility accounting system include:
1. Organizational units
2. Local operating efficiency
3. Individual accountability
4. Financial outcomes
The responsibility assignments in an activity-based responsibility accounting system include:
1. Processes
2. Systemwide efficiency
3. Team accountability
4. Financial outcomes
In a continuous improvement environment, financial-based responsibility involves continuously
enhancing revenues, reducing costs, and improving asset utilization.
Changing processes involves process improvement, process innovation, and process creation. Process
improvement refers to incremental and constant increases in the efficiency of an existing process. Process
innovation (business reengineering) refers to the performance of a process in a radically new way with
the objective of achieving dramatic improvements in response time, quality, and efficiency. Process
creation refers to the installation of an entirely new process with the objective of meeting customer and
financial objectives.
B. Establishing Performance Measures
The performance measures in a financial-based responsibility accounting system include:
1. Organizational unit budgets
2. Standard costing
3. Static standards
4. Currently attainable standards
The performance measures in an activity-based responsibility accounting system include:
1. Process-oriented standards
2. Value-added standards
3. Dynamic standards
4. Optimal standards
C. Evaluating Performance
Performance evaluation in a financial-based responsibility accounting system includes:
1. Financial efficiency
2. Controllable costs
3. Actual versus standard
4. Financial measures
Performance evaluation in an activity-based responsibility accounting system includes:
1. Time reductions
2. Quality improvements
3. Cost reductions
4. Trend measurement
D. Assigning Rewards
Rewards in a financial-based responsibility accounting system include:
1. Financial performance basis
2. Individual rewards
3. Salary increases
4. Promotions
5. Bonuses and profit sharing
Rewards in an activity-based responsibility accounting system include:
1. Multidimensional performance basis
2. Group rewards
3. Salary increases
4. Promotions
5. Bonuses, profit sharing, and gainsharing
Teaching hint: Ask students how an activity-based view of responsibility accounting differs from the
financial-based view. This question should provide the opportunity for some good discussion. Exercise
12.17 can be used effectively here.
VI. INFORMATION ABOUT EXERCISES, PROBLEMS, AND CASES
Exercises and problems are described on the following page according to coverage of content, learning
objective(s), and level of difficulty. The time required to solve the problems is roughly proportional to the
level of difficulty.
In general, basic exercises/problems are fairly simple and straightforward. The text material is relatively
brief; only one or two concepts are covered. Basic exercises and problems should take about 15 to 20
minutes each.
Moderate exercises/problems may take longer and involve more concepts. These problems may have a
“twist” and require more thought. Moderate exercises and problems may take 20 to 40 minutes each.
Challenging problems are more comprehensive and may cover more concepts. The text material is
relatively longer and may include some ambiguity. Challenging problems may take 60 to 90 minutes
each.
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
CS 12.1
Value- and Non-Value-Added Cost Reporting
LO 3
Basic
CS 12.2
Trend Reporting for Non-Value-Added Costs
LO 3
Basic
CS 12.3
Kaizen Costing
LO 3
Basic
CS 12.4
Activity-Based Flexible Budgeting
LO 3
Basic
CS 12.5
Activity Capacity Management
LO 3
Basic
12.6
ABC versus ABM
LO 1, 2
Basic
12.7
Root Cause (Driver Analysis)
LO 2
Basic
12.8
Non-Value-Added Activities: Non-Value-Added Cost
LO 2
Basic
12.9
Root Cause (Driver Analysis)
LO 2
Basic
12.10
Process Improvement and Innovation
LO 2, 5
Basic
12.11
Process Improvement and Innovation
LO 2, 5
Basic
12.12
Value- and Non-Value-Added Costs, Unused Capacity
LO 2, 3
Basic
12.13
Calculation of Value- and Non-Value-Added Costs,
Activity Volume and Unused Capacity Variances
LO 2, 3, 4
Basic
12.14
Cost Report, Value-Added and Non-Value-Added
Costs
LO 2, 3
Basic
12.15
Trend Report, Non-Value-Added Costs
LO 2, 3
Basic
12.16
Implementation of Activity-Based Management
LO 4
Basic
12.17
Financial-Based versus Activity-Based Responsibility
Accounting
LO 5
Moderate
12.18
CPA-Type Exercise
LO 2
Basic
12.19
CPA-Type Exercise
LO 2
Basic
12.20
CPA-Type Exercise
LO 2
Basic
12.21
CPA-Type Exercise
LO 2
Basic
12.22
CPA-Type Exercise
LO 3
Basic
12.23
ABM Implementation, Activity Analysis, Activity
Drivers, Driver Analysis, Behavioral Effects
LO 1, 2, 4
Moderate
12.24
ABM, Kaizen Costing
LO 2, 3, 5
Moderate
12.25
Activity Flexible Budgeting, Performance Report,
Volume Variance
LO 3
Moderate
Cornerstone
Exercise (CS)/
Exercise/
Problem/Case
Topic
Learning
Objective
Degree of
Difficulty
12.26
Activity-Based Management, Non-Value-Added Costs,
Target Costs, Kaizen Costing
LO 2, 3
Moderate
12.27
Value-Added and Kaizen Standards, Non-Value-Added
Costs, Volume Variance, Unused Capacity
LO 3
Challenging
12.28
Benchmarking and Non-Value-Added Costs, Target
Costing
LO 2, 3
Challenging
12.29
Financial versus Activity Flexible Budgeting
LO 2, 3, 5
Challenging
12.30
Activity Flexible Budgeting, Non-Value-Added Costs
LO 2, 3, 5
Challenging
12.31
Cyber Research Case
LO 1, 2, 3
Challenging
LIST OF ILLUSTRATIONS
Illustration
Topic
Exhibit 12.1
The Two-Dimensional Activity-Based Management Model
Exhibit 12.2
Formulas for Value- and Non-Value-Added Costs
Exhibit 12.3
Kaizen Cost Reduction Process
Exhibit 12.4
Flexible Budget: Direct Labor Hours
Exhibit 12.5
Activity Flexible Budget
Exhibit 12.6
Activity-Based Performance Report
Exhibit 12.7
ABM Implementation Model
Exhibit 12.8
The Responsibility Accounting Model
Exhibit 12.9
Responsibility Assignments Compared
Exhibit 12.10
Performance Measures Compared
Exhibit 12.11
Performance Evaluation Compared
Exhibit 12.12
Rewards Compared