Chapter 05 – Activity-Based Costing and Management
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CHAPTER 5
ACTIVITY-BASED COSTING AND MANAGEMENT
Learning Objectives
1. Compute product costs under a traditional, volume-based product-costing
system.
2. Explain how an activity-based costing system operates, including the use of a
3. Explain the concept of cost levels, including unit-level, batch-level, product-
sustaining-level, and facility-level costs.
5. Explain why traditional, volume-based costing systems tend to distort product
costs.
7. Discuss several key issues in activity-based costing, including data collection and
storyboarding.
9. Explain and execute a customer-profitability analysis.
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Chapter Overview
I. Traditional, Volume-Based Product-Costing Systems
II. Activity-Based Costing (ABC) Systems
A. Stage one: Overhead costs are assigned to activity cost pools.
B. Identification of cost pools
1. Unit-level activities
3. Product-sustaining activities
4. Facility-level activities
B. Stage two: Overhead costs are assigned to products.
III. Activity-Based Costing: Some Key Issues
A. Cost drivers
B. Collecting ABC data
2. Storyboarding
3. Multidisciplinary ABC project teams
C. Activity dictionary and bill of activities
IV. Activity-Based Management (ABM)
A. Two-dimensional ABC
B. Using ABM to identify non-value-added activities and costs
A focus on activities
V. Customer Profitability Analysis
VI. Activity-Based Costing in the Service Industry
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Key Lecture Concepts
I. Traditional, Volume-Based Product-Costing Systems
• The manufacturing and service environments have changed as a result of
ever-increasing international competition, technological innovation, and
advances in computerized systems.
• Many companies still use traditional volume-based (sometimes called
throughput-based) costing systems (as described in Chapters 3 and 4).
Teaching Tip: A traditional volume-based, product-cost system may function in a
satisfactory manner for inventory valuation. The overhead applied via the
• In the past, accountants felt there was a high correlation between
overhead and labor. However, with increasing factory computerization
and automation (and the reduction of hands-on labor), this is not always
the case today.
II. Activity-Based Costing (ABC) Systems
• Many organizations are changing to activity-based costing (ABC)
systems. ABC systems improve product costing and management
decision making. It follows a two-stage procedure to assign overhead
costs to products.
➢ Stage one: The costs of an organization’s significant activities are
first isolated into cost pools. The cost pools (and related costs) fall
into the following four broad categories, which collectively are
known as a cost hierarchy:
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➢ Stage two: The next step involves identification of a cost driver for
each pool. The system then assigns overhead costs by using the
cost drivers and assessing the relative proportion of the activity
consumed by a product.
• Costing is improved when ABC is used because the system identifies
products that were overcosted or undercosted by traditional methods.
➢ In many cases, traditional, volume-costing systems overcost high-
• ABC uses multiple drivers because more than one item drives the costs of
an organization. Not all activities are unit-level in nature, and ABC allows
a user to also recognize batch-level, product-sustaining level, and facility-
level activities.
• Costing is more equitable especially in the case of diverse products (and
widely varying consumption ratios, which show the proportion of an
III. Activity-Based Costing: Some Key Issues
• A cost driver is a characteristic of an event or activity that results in the
incurrence of costs. Three factors are important when selecting the most
appropriate costs driver: the degree of correlation, cost of measurement,
and behavioral effects.
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➢ The degree of correlation between activity consumption and
consumption of the driver has a significant impact on the accuracy
of the ABC-costing effort.
Teaching Tip: For a service business, for example, a dialysis clinic, the number of
dialyzer treatments should be an appropriate cost driver to trace the operating
➢ Cost assignment accuracy is increased when the number of activity
cost pools is increased. However, that requires more cost drivers,
which will result in higher costs.
➢ Behavioral effects must be considered in the selection of cost
drivers.
▪ An example of behavioral impact may be the choice of the
number of material moves to allocate material-handling cost.
• Collecting ABC data is necessary to analyze documents in order to assign
costs of activities to product lines on the basis of the amount of activity
generated by each product.
➢ Interviews and paper trails are often used.
➢ Many firms prepare a process flow chart that shows the activities
• Many companies compile a complete listing of all activities identified and
used in an ABC analysis (called an activity dictionary). Similarly, many
firms create a bill of activities, which is a complete listing of the activities
associated with a particular product or service.
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IV. Activity-Based Management (ABM)
• Activity-based management (ABM) refers to the use of activity-based
costing information to support organizational strategy, improve
operations, and manage costs.
• An ABC system assigns resource cost to a company’s cost objects (i.e., the
cost assignment viewpoint). With a process viewpoint, the emphasis now is
• A goal of ABM is to identify and eliminate non-value-added activities:
activities that are either (1) unnecessary and dispensable or (2) necessary,
but inefficient and improvable.
➢ Common examples of non-value-added activities include move,
wait, and storage times.
➢ These activities give rise to non-value-added costs, or costs that can
be eliminated without deterioration of product quality,
performance, or perceived value.
Teaching Tip: Airlines provide a classic example that can be used to
illustrate non-value-added costs. When carriers began selling tickets on–
V. Customer Profitability Analysis
• Customer profitability analysis uses activity-based costing to determine
the activities, costs, and profits associated with serving particular
customers.
• Appropriate tools of analysis include bar graphs, costs expressed as a
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percentage of gross margin, and trend analyses.
Teaching Tip: Point out the interesting example in the text (p. 187) that relates the
customer-profitability analysis at Bank One Corp.
VI. Activity-Based Costing in the Service Industry
• The overall objectives of ABC in service firms are identical to those for
manufacturing organizations.
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Teaching Overview
When I teach activity-based costing, I use exercises and problems that not only
overview product costing but also integrate the managerial aspects of doing business
(e.g., the ramifications of under- and overcosting of goods), particularly in competitive
marketplaces. Students can easily get bogged down in the details of ABC calculations,
so the added feature of analysis is somewhat interesting to them. I always stress that
software is currently available to take care of the related number crunching.
I recommend further in-class discussion of the Patio Grill case study and discussion of
Problem 5-50.
Teaching selected parts of this chapter will likely present a challenge for the
“traditional” instructor, as some of the subject matter is beyond the scope of what is
often considered “accounting and business” in nature. Furthermore, a portion of the
material deals with general concepts and is not totally conducive to standing in front of
the class and working problems. With challenge, though, comes opportunity. I find
that this chapter presents an excellent opportunity to use (1) videos on high-tech
manufacturing as well as (2) outside speakers. It may be interesting to have a panel
discussion of manufacturers, with a focus on how business has changed in the last ten
years and the impact of various continuous-improvement techniques on their firms.
I recommend using Exercises 5-35 (college registration practices), 5-37 (identification of
non-value-added costs), and 5-39 (activity-based management) as a way to introduce
selected topics.
Teaching Tip: You may want to introduce your students to “A Tale of Two Auto Plants,” which
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Links to the Text
Homework Grid – CHAPTER 5
Item No.
Learning
Objectives
Special
Features*
Exercises:
5-26
1, 2, 4
5-27
2, 3
I
5-28
2, 3
5-29
1, 2, 4, 5
G
5-30
2, 5
W
5-31
2, 5, 6
5-32
2, 3, 6, 7
5-33
2, 4, 6
5-34
2, 3, 6, 7
W
5-35
2, 3, 6, 7,
10
W, G
5-36
2, 8, 10
C
5-37
8
5-38
8
5-39
8, 10
5-40
8, 10
W
5-41
8, 10
W, G
5-42
9
5-43
9
W
5-44
2, 3, 10
Problems:
5-45
1, 2, 3, 4, 8
I
5-46
1, 2, 3, 4, 5
5-47
2, 3, 4
5-48
1, 2, 3, 4, 5
5-49
1, 2, 3, 4, 5
5-50
1, 2, 3, 4, 5
5-51
1, 2, 5, 8
W
5-52
1, 2, 5
5-53
4, 5
5-54
1, 2, 3, 4, 5
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Item No.
Learning
Objectives
Special
Features*
5-55
1, 2, 3, 4, 5
I, G, S
5-56
1, 2, 5, 8
E, W, G
5-57
1, 2, 3, 4, 5
I, W
5-58
1, 2, 4, 5, 8
W, S, G
5-59
1, 2, 3, 4, 5,
8
S
5-60
1, 2, 3, 4, 5,
8
G
5-61
2, 8
W
5-62
2, 5
5-63
8, 10
W
5-64
11
5-65
8
5-66
9
5-67
9
W
Cases:
5-68
1, 2, 3, 4, 5,
8
G, S
5-69
1, 2, 3, 4, 5
W, G
5-70
8
W
5-71
5, 8
W, E
* W = Written response E = Ethical issue G = Group work
I = International C = Internet use S = Spreadsheet