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Managerial The ABC design team presented the results of its work in a meeting
attended by all of the top managers of Classic Brass, including the president
Accounting
John Towers, the production manager Susan Richter, the marketing man-
in Action ager Tom Olafson, and the accounting manager Mary Goodman. The ABC
team brought with them to the meeting copies of the chart showing the
ABC design (Exhibit 8–6), the tables showing the product margins for the
stanchions and compass housing under the company’s old cost accounting
ssic Brass, system (Exhibit 8–7), the tables showing the ABC analysis of the same prod-
a I
Cl nc ucts (Exhibit 8–9), and the action analysis (Exhibit 8–12). After the formal
.
presentation by the ABC team, the following discussion took place:
John:I would like to personally thank the ABC team for all of the work
they have done and for an extremely interesting presentation. I am now
beginning to wonder about a lot of the decisions we have made in the
past using our old cost accounting system.
Mary:I hope I don’t have to remind anyone that I have been warning
everyone for quite some time about this problem.
John:No, you don’t have to remind us Mary. I guess we just didn’t
understand the problem before.
John:Tom, why did we accept this order for standard stanchions in the
first place if our old cost accounting system was telling us it was a big
money loser?
Tom:Windward Yachts, the company that ordered the stanchions, has
asked us to do a lot of custom work like the compass housing in the past.
To get that work, we felt we had to accept their orders for money-losing
standard products.
John:According to this ABC analysis, we had it all backwards. We are
losing money on the custom products and making a fistful on the
standard products.
Susan:I never did believe we were making a lot of money on the custom
jobs. You ought to see all of the problems they create for us in
production.
Tom:I hate to admit it, but the custom jobs always seem to give us
headaches in marketing too.
John:Why don’t we just stop soliciting custom work? This seems like a no-
brainer to me. If we are losing money on custom jobs like the compass
housing, why not suggest to our customers that they go elsewhere for
that kind of work?
Tom:Wait a minute, we would lose a lot of sales.
Susan:So what, we would save a lot more costs.
Mary:Maybe yes, maybe no. Some of the costs would not disappear if we
were to drop all of those products.
Tom:Like what?
Mary:Well Tom, part of your salary is included in the costs of the ABC
model.
Tom:Where? I don’t see anything listed that looks like my salary.
Mary:Tom, when the ABC team interviewed you they asked you what
percentage of your time was spent in handling customer orders and how
much was spent dealing with new product design issues. Am I correct?
Tom:Sure, but what’s the point?
Mary:I believe you said that about 10% of your time is spent dealing with
new products. As a consequence, 10% of your salary was allocated to the
Product Design cost pool. If we were to drop all of the products requiring
design work, would you be willing to take a 10% pay cut?
Tom:I trust you’re joking.
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Chapter 8: Activity-Based Costing: A Tool to Aid Decision Making 359
Mary:Do you see the problem? Just because 10% of your time is spent on
custom products doesn’t mean that the company would save 10% of your
salary if the custom products were dropped. Before we take a drastic
action like dropping the custom products, we should identify which costs
are really relevant.
John:I think I see what you are driving at. We wouldn’t want to drop a lot
of products just to find that our costs really haven’t changed much. It is
true that dropping the products would free up resources like Tom’s time,
but we had better be sure we have some good use for those resources
beforewe take such an action.
Mary:That’s why we put together the action analysis.
John:What’s this red margin at the bottom of the action analysis? Isn’t
that a product margin?
Mary:Yes, it is. However, we call it a red margin because we should stop
and think very, very carefully before taking any actions based on that
margin.
John:Why is that?
Mary:We subtracted the costs of factory equipment depreciation to arrive
at that red margin. We doubt that we could avoid any of that cost if we
were to drop custom orders. We use the same machines on custom orders
that we use on standard products. The factory equipment has no resale
value, and it does not wear out through use.
John:What about this yellow margin?
Mary:Yellow means proceed with a great deal of caution. To get to the
yellow margin we deducted from sales a lot of costs that could be
adjusted only if the managers involved are willing to eliminate resources
or shift them elsewhere in the organization.
John:If I understand the yellow margin correctly, the apparent loss of
$1,018 on the custom stanchions is the result of the indirect factory wages
of $1,145.
Susan:Right, that’s basically the wages of our design engineers.
John:I wouldn’t want to lay off any of our designers. Could we turn them
into salespersons?
Tom:I’d love to have Shueli Park join our marketing team.
Susan:No way, she’s our best designer.
John:Okay, I get the picture. We are not going to be cutting anyone’s
wages, we aren’t going to be laying off anyone, and it looks like we may
have problems getting agreement about moving people around. Where
does that leave us?
Mary:What about raising prices on our custom products?
Tom:We should be able to do that. We have been undercutting the
competition to make sure we got custom work. We were doing that
because we thought custom work was very profitable.
John:Why don’t we just charge directly for design work?
Tom: Some of our competitors already charge for design work. However, I
don’t think we would be able to charge enough to cover our design costs.
John:What about design work, can we do anything to make it more
efficient so it costs us less? I’m not going to lay anyone off, but if we make
the design process more efficient, we could lower the charge for design
work and spread those costs across more customers.
Susan: That may be possible. I’ll form a TQM team to look at it.
John:Let’s get some benchmark data on design costs. If we set our minds
to it, I’m sure we can be world class in no time.
Susan:Okay. Mary, will you help with the benchmark data?
Mary:Sure.
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360 Part II: The Central Theme: Planning and Control
Tom: There is another approach we can take too. Windward Yachts
probably doesn’t really need a custom compass housing. One of our
standard compass housings would work just fine. If we start charging for
the design work, I think they will see that it would be in their own
interests to use the lower-cost standard product.
John: Let’s meet again in about a week to discuss our progress. Is there
anything else on the agenda for today?
The points raised in the preceding discussion are extremely important. By meas-
uring the resources consumed by products (and other cost objects), a “best practice”
ABC system provides a much better basis for decision making than a traditional cost
accounting system that spreads overhead costs around without much regard for what
might be causing the overhead. Awell-designed ABC system provides managers with
estimates of potentially relevant costs that can be a very useful starting point for man-
agement analysis.
Activity-Based Costing and External Reports
Since activity-based costing generally provides more accurate product costs than tradi-
tional costing methods, why isn’t it used for external reports? Some companies douse
activity-based costing in their external reports, but most do not. There are a number of
reasons for this. First, external reports are less detailed than internal reports prepared for
decision making. On the external reports, individual product costs are not reported. Cost
of goods sold and inventory valuations are disclosed, but there is no breakdown of these
accounts by product. If some products are undercosted and some are overcosted, the
errors tend to cancel each other when the product costs are added together.
Second, it is often very difficult to make changes in a company’s accounting sys-
tem. The official cost accounting systems in most large companies are usually embed-
ded in complex computer programs that have been modified in-house over the course
of many years. It is extremely difficult to make changes in such computer programs
without causing numerous bugs.
Third, an ABC system such as the one described in this chapter may not conform
to generally accepted accounting principles (GAAP). As discussed in Chapter 2, prod-
uct costs computed for external reports must include all of the manufacturing costs and
only manufacturing costs; but in an ABC system as described in this chapter, product
costs exclude some manufacturing costs and include some nonmanufacturing costs. It
is possible to adjust the ABC data at the end of the period to conform to GAAP, but that
requires more work.
Fourth, auditors are likely to be uncomfortable with allocations that are based on
interviews with the company’s personnel. Such subjective data can be easily manipu-
lated by management to make earnings and other key variables look more favourable.
For all of these reasons, most companies confine their ABC efforts to special
studies for management, and they do not attempt to integrate activity-based costing
into their formal cost accounting systems.
A Simplified Approach to Activity-Based Costing
If an action analysis like Exhibit 8–12 is not prepared, the process of computing prod-
uct margins under activity-based costing can be considerably simplified. The first-
stage allocation shown in Exhibit 8–4 is still necessary, but the remainder of the
computations can be streamlined.
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Chapter 8: Activity-Based Costing: A Tool to Aid Decision Making 361
To use the simplified approach after the first-stage allocation is completed, com-
Objective 8
pute activity rates for each activity cost pool as follows:
Use the simplified
approach to compute
activity-based costs
and margins.
÷
Note that these activity rates are exactly the same as the activity rates at the bottom of
Exhibit 8–5. If there is to be no activity analysis, the other numbers in Exhibit 8–5 are not
needed and do not have to be computed.
Using these activity rates, the product and customer margins can be directly computed
as follows:
CustomerProfitabilityAnalysis(cid:209)WindwardYachts
ProductmarginsofproductsorderedbyWindwardYachts:
Standardstanchionproductmargin(seeabove) $ 5,030
Customcompasshousingproductmargin(seeabove) (1,114)
Totalproductmargins 3,916
Less:Customerrelationsoverhead(seeabove) 3,675
Customermargin $ 241
Note that the numbers in this report match the numbers that appear in Exhibit 8–9. This
simplified approach allows one to compute product and customer margins without
having to do the detailed computations in all of the cells of Exhibit 8–5 and Exhibits
8–8Aand 8–8B. However, this simplified approach does not provide the data that are
needed to construct an action analysis.
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362 Part II: The Central Theme: Planning and Control
Activity-Based Costing and Service Industries
Although initially conceived as a tool for manufacturing companies, activity-based
costing is also being used in service industries. Successful implementation of an activ-
ity-based costing system depends on identifying the key activities that generate costs
and being able to keep track of how many of those activities are performed for each
service that is provided.
Two common problems exist in service firms that sometimes make implementa-
tion of activity-based costing relatively difficult. One problem is that a larger propor-
tion of costs in service industries tend to be facility-level costs that cannot be traced to
any particular billable service provided by the firm. Another problem is that it is more
difficult to capture activity data in service companies, because so many of the activi-
ties tend to involve nonrepetitive human tasks that cannot be easily recorded.11
Nevertheless, activity-based costing systems have been implemented in a number of
service firms, including railroads, hospitals, banks, and data services companies.
Our discussion in this chapter has focused on the use of activity-based costing in
manufacturing companies. We will defer further discussion of its use in service-type
operations to Chapter 16, where we discuss its specific application in greater depth.
Focus on Current Practice
A 1992 survey of 352 large Canadian companies that in the United States. Given that 9% of U.K.
states that 67% had not considered activity-based companies had considered ABC and rejected it,
costing (ABC) while 14% had implemented or acceptance in Canada appears to be higher than
were implementing ABC and 15% were currently in the U.K. The manufacturing sector shows the
assessing the methodology; 4% had considered highest rate of development, while resource,
ABC and decided not to implement it. The devel- retail, and communications sectors are further
opment of ABC in Canada appears to be behind behind.12
International Use of Activity-Based Costing
Activity-based costing was pioneered in the United States, although several of the
early field studies were performed by American researchers on German companies.
The concept is relatively new, with the term activity-based costinghaving been coined
by the management of John Deere Company within the last 15 years.
To date, activity-based costing has not spread as rapidly throughout the world as
has JITand TQM. Perhaps the reason is traceable to the costs of implementation and
to the fact that it is sometimes difficult to collect the data needed to operate the system.
In Japan, activity-based costing is rarely used. Instead, Japanese managers seem to pre-
fer volume measures such as direct labour-hours to assign overhead cost to products.
This preference, according to Japanese researchers, can be explained by the fact that
Japanese managers are “convinced that reducing direct labour is essential for ongoing
cost improvement.”13It is argued that by using direct labour as an overhead allocation
11. William Rotch, “Activity-Based Costing in Service Industries,” Journal of Cost Management(Summer
1990), p. 8.
12. “Activity-Based Costing,” Management Accounting Issues Paper 3 (Hamilton, ON: Society of
Management Accountants of Canada, 1993) pp. 9–13.
13. Toshiro Hiromoto, “Another Hidden Edge—Japanese Management Accounting,” Harvard Business
Review(July–August 1988), p. 23.
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Chapter 8: Activity-Based Costing: A Tool to Aid Decision Making 363
base, managers are forced to watch direct labour more closely and to seek ways to
reduce it. In short, Japanese managers tend to be more concerned about cost reduction
and working toward specific long-term company goals than they are about obtaining
more accurate product costs.
The most extensive application of activity-based costing has been in the United
States, with some applications having been made in Europe, particularly in Germany
and Northern Europe.
Summary
Traditional cost accounting methods suffer from several defects that can result in dis-
torted costs for decision-making purposes. All manufacturing costs—even those that
are not caused by any specific product—are allocated to products. And nonmanufac-
turing costs that are caused by products are not assigned to products. Traditional meth-
ods also allocate the costs of idle capacity to products. In effect, products are charged
for resources that they do not use. And finally, traditional methods tend to place too
much reliance on unit-level allocation bases such as direct labour and machine-hours.
This results in overcosting high-volume products and undercosting low-volume prod-
ucts and can lead to mistakes when making decisions.
Activity-based costing estimates the costs of the resources consumed by cost objects
such as products and customers. The approach taken in activity-based costing assumes that
cost objects generate activities that in turn consume costly resources. Activities form the
link between costs and cost objects. Activity-based costing is concerned with overhead—
both manufacturing overhead and selling, general, and administrative overhead. The
accounting for direct labour and direct material is usually unaffected.
The steps that are involved in computing ABC product costs are summarized in
Exhibit 8–13. Use this exhibit to trace through the key exhibits in the chapter.
To build an ABC system, companies typically choose a small set of activities that
summarize much of the work performed in overhead departments. Associated with each
activity is an activity cost pool. To the extent possible, overhead costs are directly traced to
these activity cost pools. The remaining overhead costs are assigned to the activity cost
pools in the first-stage allocation. Interviews with managers often form the basis for these
allocations.
An activity rate is computed for each cost pool by dividing the costs assigned to the
cost pool by the measure of activity for the cost pool. Activity rates provide useful infor-
mation to managers concerning the costs of carrying out overhead activities. Aparticularly
high cost for an activity may trigger efforts to improve the way the activity is carried out in
the organization.
In the second-stage allocation, the activity rates are used to apply costs to cost objects
such as products and customers. The costs computed under activity-based costing are often
quite different from the costs generated by a company’s traditional cost accounting system.
While the ABC system is almost certainly more accurate, managers should nevertheless
exercise caution before making decisions based on the ABC data. Avital part of any activ-
ity-based analysis of product or customer profitability is an action analysis that identifies
who is ultimately responsible for each cost and the ease with which the cost can be
adjusted.
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364 Part II: The Central Theme: Planning and Control
Exhibit 8–13 How the
Exhibit 8–2
ABC Steps Fit Together Overhead Costs (both Manufacturing and Non-Manufacturing) at Classic Brass
Production Department:
Indirect factory wages . . . . . . . . . . . . . . . . . $500,000
Factory equipment depreciation . . . . . . . 300,000
Exhibit 8–3
Results of Interviews: Distribution of Activities
Customer
Orders
25% (cid:1) $500,000
Exhibit 8–4
First-Stage Allocations to Activity Cost Pools
$125,000 (cid:3) 1,000 orders
Exhibit 8–5
Computation of Activity Rates
Customer Product
Orders Design
1 order (cid:1) $125 per order
Exhibit 8–8B
Computation of the Overhead Cost of One Order for One Unit of the Custom Compass Housing
Activity Cost Pools
Product
Design
Exhibit 8–12
Action Analysis of Custom Compass Housing:
Activity-Based Costing System
CustomCompassHousing
Sales(seeExhibit8—7) $ 650
Greencosts:
Directmaterials(seeExhibit8—7) $ 13
Shippingcosts(seeExhibit8— 25 38
Greenmargin 612
Yellowcosts:
Directlabour(seeExhibit8—7) 50
Indirectfactorywages(seeExhibit8—8B) 1,145
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Chapter 8: Activity-Based Costing: A Tool to Aid Decision Making 365
Review Problem: Activity-Based Costing
Ferris Corporation makes a single product—a fire-resistant commercial filing cabinet—that it
sells to office furniture distributors. The company has a simple ABC system that it uses for inter-
nal decision making. The company has two overhead departments whose costs are listed below:
Manufacturing overhead . . . . . . . . . . . . . . . $500,000
Selling and administrative overhead . . . . . . . 300,000
Total overhead costs . . . . . . . . . . . . . . . . . $800,000
The company’s ABC system has the following activity cost pools and activity measures:
Activity Cost Pool Activity Measure
Volume related . . . . . . . . . . . . . Number of units
Order related . . . . . . . . . . . . . Number of orders
Customer support . . . . . . . . . . Number of customers
Other . . . . . . . . . . . . . . . . . . . Not applicable
Costs assigned to the “Other” activity cost pool have no activity measure; they consist of the
costs of unused capacity and organization-sustaining costs—neither of which are assigned to
products, orders, or customers.
Ferris Corporation distributes the costs of manufacturing overhead and of selling and
administrative overhead to the activity cost pools based on employee interviews, the results of
which are reported below:
Distribution of Resource Consumption Across Activities
Volume Order Customer
Related Related Support Other Total
Manufacturing overhead . . . . . . . . . . 50% 35% 5% 10% 100%
Selling and administrative overhead . . 10% 45% 25% 20% 100%
Total activity . . . . . . . . . . . . . . . . 1,000 250 100
units orders customers
Required 1. Perform the first-stage allocations of overhead costs to the activity cost pools as in
Exhibit8–4.
2. Compute activity rates for the activity cost pools as in Exhibit 8–5.
3. OfficeMart is one of Ferris Corporation’s customers. Last year, OfficeMart ordered filing
cabinets four different times. OfficeMart ordered a total of 80 filing cabinets during the
year. Construct a table as in Exhibit 8–8Ashowing the overhead costs of these 80 units
and four orders.
4. The selling price of a filing cabinet is $595. The cost of direct materials is $180 per filing
cabinet, and direct labour is $50 per filing cabinet. What is the product margin on the 80
filing cabinets ordered by OfficeMart? How profitable is OfficeMart as a customer? See
Exhibit 8–9 for an example of how to complete this report.
5. Management of Ferris Corporation has assigned ease of adjustment codes to the various
costs as follows:
Ease of
Cost Adjustment Code
Direct materials . . . . . . . . . . . . . . . Green
Direct labour . . . . . . . . . . . . . . . . . Yellow
Manufacturing overhead . . . . . . . . . Yellow
Selling and administrative overhead . Red
Prepare an activity analysis of the OfficeMart orders as in Exhibit 8–12.
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Solution to 1. The first-stage allocation of costs to the activity cost pools appears below:
Review Problem
Activity Cost Pools
Volume Order Customer
Related Related Support Other Total
Manufacturing overhead . . . . . . . . . . $250,000 $175,000 $ 25,000 $ 50,000 $500,000
Selling and administrative overhead . . 30,000 135,000 75,000 60,000 300,000
Total cost . . . . . . . . . . . . . . . . . . . $280,000 $310,000 $100,000 $110,000 $800,000
2. The activity rates for the activity cost pools are:
Volume Order Customer
Related Related Support
Manufacturing overhead . . . . . . . . . . . . . $250 $ 700 $ 250
Selling and administrative overhead . . . . . 30 540 750
Total cost . . . . . . . . . . . . . . . . . . . . . . $280 $1,240 $1,000
3. The overhead cost for the four orders of a total of 80 filing cabinets would be computed
asfollows:
Volume Order
Related Related Total
Activity . . . . . . . . . . . . . . . . . . . . . . . 80 units 4 orders
Manufacturing overhead . . . . . . . . . . . $20,000 $2,800 $22,800
Selling and administrative overhead . . 2,400 2,160 4,560
Total cost . . . . . . . . . . . . . . . . . . . . $22,400 $4,960 $27,360
4. The product and customer margins can be computed as follows:
Filing Cabinet Product Margin
Sales ($595 (cid:3)80) . . . . . . . . . . . . . . . . . . . . . . . $47,600
Cost:
Direct materials ($180 (cid:3)80) . . . . . . . . . . . . . $14,400
Direct labour ($50 (cid:3)80) . . . . . . . . . . . . . . . . 4,000
Volume-related overhead (above) . . . . . . . . . . 22,400
Order-related overhead (above) . . . . . . . . . . . 4,960 45,760
Product margin . . . . . . . . . . . . . . . . . . . . . . . . $ 1,840
Customer Profitability Analysis—OfficeMart
Product margin (above) . . . . . . . . . . . . . . . . . . $ 1,840
Less: Customer support overhead (above) . . . . . . 1,000
Customer margin . . . . . . . . . . . . . . . . . . . . . . . $ 840
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Chapter 8: Activity-Based Costing: A Tool to Aid Decision Making 367
5. The activity analysis of the four orders for 80 filing cabinets in total is:
Action Analysis Report for Four Orders Totalling 80 Units
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $47,600
Green costs:
Direct materials . . . . . . . . . . . . . . . . . . . . . . $14,400 14,400
Green margin . . . . . . . . . . . . . . . . . . . . . . . . . . 33,200
Yellow costs:
Direct labour . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Manufacturing overhead . . . . . . . . . . . . . . . . 22,800 26,800
Yellow margin . . . . . . . . . . . . . . . . . . . . . . . . . . 6,400
Red costs:
Selling and administrative overhead . . . . . . . . 4,560 4,560
Red margin . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,840
Note: An action analysis report can also be completed for OfficeMart as a customer. The
first step would be to calculate the overhead costs for OfficeMart as follows:
Volume Order Customer
Related Related Support Total
Activity . . . . . . . . . . . . . . . . . . . . 80 units 4 orders 1 customer
Manufacturing overhead . . . . . . . . $20,000 $2,800 $ 250 $23,050
Selling and administrative overhead 2,400 2,160 750 5,310
Total cost . . . . . . . . . . . . . . . . . $22,400 $4,960 $1,000 $28,360
The action analysis report can then be easily prepared as follows:
Action Analysis Report for OfficeMart as a Customer
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $47,600
Green costs:
Direct materials . . . . . . . . . . . . . . . . . . . . . . $14,400 14,400
Green margin . . . . . . . . . . . . . . . . . . . . . . . . . . 33,200
Yellow costs:
Direct labour . . . . . . . . . . . . . . . . . . . . . . . . 4,000
Manufacturing overhead . . . . . . . . . . . . . . . . 23,050 27,050
Yellow margin . . . . . . . . . . . . . . . . . . . . . . . . . . 6,150
Red costs:
Selling and administrative overhead . . . . . . . . 5,310 5,310
Red margin . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 840
Appendix 8A: Cost Flows in an
Activity-Based Costing System
As stated in the main body of the chapter, the flow of costs through Raw Materials,
Objective 9
Work in Process, and other accounts is the same under activity-based costing as was
Record the flow of illustrated in Chapter 3. Although the flow of costs is the same, a company must com-
costs in an activity- pute several predetermined overhead rates when activity-based costing is being used
based costing system. and that complicates the journal entries and T-accounts somewhat. Our purpose in this
appendix is to provide a detailed example of cost flows in an activity-based costing
system.