Chapter Five

Activity-Based Costing and Customer

Profitability Analysis
Blocher, Stout, Juras, Cokins: Cost Management, 7e
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McGraw-Hill Education
 Learning Objectives
• Explain the strategic role of activity-based costing
(ABC)

• Describe ABC, the steps in developing an ABC

system, and the benefits of an ABC system

• Determine product costs under both the volume-

based method and the ABC method

• Explain activity-based management (ABM)

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 Learning Objectives (continued)
• Describe how ABC/M is used organizations

• Use an activity-based approach to analyze

customer profitability

• Identify key factors for successful ABC/M

implementation

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 Strategic Role of ABC

Activity-based costing (ABC) vs. volume-based costing:

• Volume-based costing results may be distorted because
indirect costs do not always occur in proportion to output
volume
• Volume-based costing generally causes cross-
subsidization of outputs (i.e., some products will be
overcosted and others undercosted)
• Activity-based costing uses detailed information about
the activities that make up indirect costs so that outputs
are charged only for resources consumed by the activities
needed to perform them

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 Volume-Based Costing

• May be a good strategic choice for some

firms
– When the costs to be allocated are relatively small versus the
directly traceable costs
– When the activities supporting production are relatively
homogeneous across different product/service lines
• Often used by paper product
manufacturers, producers of agricultural
products, other commodity firms, and
professional service firms
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 ABC Terms

• Activity - a specific task or action of work

done, such as production set-up
• Resource - an economic element needed or
consumed in performing activities, such as
salaries and supplies
• Cost driver - either a resource consumption
cost driver or an activity consumption cost
driver

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 ABC Terms

• Resource consumption cost drivers

measure the amount of resources consumed
by an activity, such as the number of items
in a purchase or sales order
• Activity consumption cost drivers
measure the amount of activity performed
for an object, such as the number of batches
used to manufacture a product

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 Two-stage Cost Assignment
A cost assignment approach for indirect (support)
costs: resource costs such as factory overhead are
assigned to activity cost pools and then to cost
objects (jobs, clients, products, patients, etc.)
– Volume-based systems assign factory overhead to a single
plant or departmental cost pool first and then to products
or services using a volume-based rate

– ABC systems assign factory overhead costs to activities or

activity cost pools using resource consumption cost
drivers and then assign these costs to cost objects using
activity consumption cost drivers

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 ABC vs. Volume-based costing

ABC systems differ from volume-based costing

systems in two ways:
• ABC system defines cost pools as activities rather than
production plant or department cost centers
• Cost drivers
– ABC systems use drivers based on an activity or
activities performed for the cost object
– Volume-based approaches use a volume-based cost
driver that often bears little or no relationship to
the consumption of resources by the cost objects

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 Developing an ABC System

There are three steps in the development of an ABC

system:
 Identify resource costs and activities
– An activity analysis is performed to identify key activities and the way in
which the activities consume resources
 Assign resource costs to activities
– Use resource consumption cost drivers based on cause-and-effect
relationships, such as the number of labor hours, setups, moves,
machine-hours, employees, or square feet to assign resource costs
 Assign activity costs to cost objects
– Use activity consumption cost drivers, such as purchase orders,
receiving reports, parts stored, direct labor-hours, or manufacturing
cycle time to assign activity costs

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 Activity Analysis
Through activity analysis, a firm identifies the
work it performs to carry out its operations by
• Gathering data from existing documents and records
• Collecting additional data using questionnaires,
observations, or interviews of key personnel
• Sample questions include:
– What work or activities do you do?
– How much time do you spend performing these activities?
– What resources are required to perform these activities?
– What value does the activity have for the product, service,
customer, or organization?

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 Activity Analysis (continued)
To identify resource costs for various activities, a firm
classifies all activities according to the way in which the
activities consume resources
 A unit-level activity is performed on each individual unit of
product or service of the firm (e.g., direct materials)
 A batch-level activity is performed for each batch or group of
units of products or services (e.g., setting up machines or
placing purchase orders)
 A product-level activity supports the production of a specific
product or service (e.g., engineering changes to modify parts for
a product)
 A facility-level activity supports overall operations (e.g.,
property taxes and insurance)

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 Unit Level Costs

Performed for each unit of product or

service
Examples include:
• Units of production related depreciation of
factory machinery
• Energy costs for machinery used for individual
units of production (e.g., A drill press that drills
holes in pieces of metal)

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 Batch Level Costs

Performed for each batch of product or

service produced
Examples include:
• Machine setup costs
• Quality control costs
• Wages for works that move products within the
factory
• Energy costs for machinery that is used for multiple
units of product at the same time (e.g., an oven that
bakes a batch of cookies for a commercial baker)

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 Product Level Costs

Support production of a specific product

or service line
Examples include:
• Salaries for product line purchasing managers
• Quality control costs
• Product development costs
• Depreciation and maintenance for specialized
machinery dedicated to the production od a single
product or service line

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 Facility Level Costs

Support overall operations

Examples include:
• Factory depreciation
• Security costs for the factory
• Insurance and property taxes for a factory
• Salary of a plant manager

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 Remaining Steps in Developing an
ABC System
 Assign resource costs to activities
– Use resource consumption cost drivers based on
cause-and-effect relationships, such as the number
of labor hours, setups, moves, machine-hours,
employees, or square feet to assign resource costs
 Assign activity costs to cost objects
– Use activity consumption cost drivers, such as
purchase orders, receiving reports, parts stored,
direct labor-hours, or manufacturing cycle time to
assign activity costs

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 Benefits of ABC Systems

 Better profitability measures due to more accurate

costs
 Better decision making: identification of value-
added vs. non-value-added activities and
associated costs
 Information for process improvement
 Improved cost planning
 Helps identify and control the cost of unused
capacity

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 Volume-Based vs. ABC Example
Haymarket BioTech, Inc. (HBT) produces and sells two secure
communication systems, AW (Anywhere) and SZ (SecureZone).
HBT has the following operating data for the two products:

AW SZ
Production volume 5,000 20,000
Selling price $400.00 $200.00
Unit direct materials and labor $200.00 $80.00
Direct labor-hours 25,000 75,000
Direct labor-hours per unit 5 3.75

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Volume-Based vs. ABC (continued)

The traditional volume-based costing

system assigns factory overhead (OH)
based on direct labor-hours (DLH). The
firm has a total budgeted overhead of
$2,000,000. Since the firm budgeted
100,000 DLHs for the year, the overhead
rate per DLH is $20 ($2,000,000÷100,000
DLH).
Therefore......

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Volume-Based vs. ABC (continued)
The factory overhead assigned to AW is $500,000 (25,000
DLH × $20) in total and $100 ($500,000÷5,000 units) per
unit, since the firm used 25,000 direct labor hours to
manufacture 5,000 units of AW

and
The factory overhead assigned to SZ is $1,500,000
(75,000 DLH × $20) in total and $75 ($1,500,000÷20,000
units) per unit, since the firm used 75,000 direct labor
hours to manufacture 20,000 units of SZ

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 Volume-Based vs. ABC (continued)

Product profitability analysis per unit using

volume-based costing:
AW SZ
Unit selling price $400.00 $200.00
Unit-level manufacturing costs
Direct materials and labor $200.00 $80.00
Factory overhead 100.00 75.00
Cost per unit 300.00 155.00
Profit margin 100.00 45.00

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Volume-Based vs. ABC (continued)
In an attempt to use an ABC system, HBT has identified
the following activities, budgeted costs, and activity
consumption cost drivers:

Budgeted Activity Consumption Cost

Activity Cost Driver
Engineering $ 125,000 Engineering hours

Setups 300,000 Number of setups

Machine operations 1,500,000 Machine hours

Packing 75,000 Number of packing orders

Total $ 2,000,000

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Volume-Based vs. ABC (continued)

HBT also has gathered the following operating

data pertaining to each of its products:

AW SZ Total

Engineering hours 5,000 7,500 12,500

Number of setups 200 100 300

Machine hours 50,000 100,000 150,000

Number of packing orders 5,000 10,000 15,000

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Volume-Based vs. ABC (continued)
Using the operating data, the activity rate for each activity
consumption cost driver is calculated as follows:

(1) (2) (3) (4) = (2) ÷ (3)

Consumption Cost Budgeted Budgeted Activity Activity
Driver Cost Consumption Consumption Rate
Engineering hours $ 125,000 12,500 $ 10 per hour
Number of setups 300,000 300 1,000 per setup
Machine hours 1,500,000 150,000 10 per hour
Number of packing
orders 75,000 15,000 5 per order

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Volume-Based vs. ABC (continued)

Factory overhead costs for AW at 5,000 units of

production:
(1) (2) (3) (4) = (2) × (3) (5)
Activity Activity Total Overhead
Consumption Cost Driver Consumption Rate Consumption Overhead per Unit
$
Engineering hours $ 10 5,000 50,000 $ 10

Number of setups 1,000 200 200,000 40

Machine hours 10 50,000 500,000 100

Number of packing orders 5 5,000 25,000 5

Total $ 775,000 $ 155

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 Volume-Based vs. ABC (continued)

Factory overhead costs for SZ at 20,000 units of

production:
(1) (2) (3) (4)=(2)×(3) (5)
Activity
Consumption Activity Total Overhead
Consumption Cost Driver Rate Consumption Overhead per Unit
Engineering hours $ 10 7,500 $ 75,000 $ 3.75
Number of setups 1,000 100 100,000 5.00
Machine hours 10 100,000 1,000,000 50.00
Number of packing orders 5 10,000 50,000 2.50
Total $ 1,225,000 $ 61.25

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 Volume-Based vs. ABC Example
(continued)

Product profitability analysis per unit using ABC:

AW SZ
Unit selling price $ 400 $200.00
Unit-level manufacturing
costs
Direct materials and labor $ 200 $ 80.00
Engineering $ 10 3.75
Setups 40 5.00
Machine running 100 50.00
Packing 5 2.50
Factory overhead 155.00 61.25
Cost per unit 355.00 141.25
Profit margin $ 45 $ 58.75

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 Volume-Based vs. ABC (continued)
The following chart compares the results of the two costing
systems:
AW SZ
Unit overhead cost Can you guess
Volume-based $ 100 $ 75.00 which is the
Ativity-based 155 61.25
high-volume
Difference $ 55 $ 13.75
and which is
Profit margin the low-volume
Volume-based $ 100 $ 45.00 product?
Ativity-based 45 58.75
Difference $ 55 $ 13.75

Keep in mind that volume-based costing tends to undercost

low-volume products and overcost high-volume products, a
situation often referred to as product cost cross-subsidization
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 Five Steps of Strategic Decision
Making in the HBT Example
❶Determine the Strategic Issues Surrounding the
Problem: HBT competes on differentiation
❷Identify the Alternative Actions: focus on AW or SZ?
❸Obtain Information and Conduct Analyses of the
Alternatives: cost analysis based on ABC costing
❹Based on Strategy and Analysis, Choose and
Implement the Desired Alternative: do not promote
AW over SZ, but instead focus on SZ to improve overall
profitability
❺Provide an On-going Evaluation of the Effectiveness
of implementation in Step 4.
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Cost of Capacity for the HBT Example

• Suppose that instead of a budgeted activity

consumption of 12,500 hours, HBT were to use the
practical capacity of the engineering staff, which is
15,625 hours.
• Using practical capacity, the activity consumption
rate would be $8 per engineering hour
(=$125,000÷15,625). If only 12,500 hours were used, as
shown in the HBT example, then the overhead cost
charged to AW and SZ would be reduced because of
the lower rate ($8 instead of the original rate of $10).

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Cost of Capacity for the HBT Example

• Suppose that instead of a budgeted activity

consumption of 12,500 hours, HBT were to use the
practical capacity of the engineering staff, which
is 15,625 hours.
• AW overhead would be reduced by $10,000 (5,000
hours × $2) and SZ overhead would be reduced
by $15,000 (7,500 hours × $2).
• The total reduction for the two products, $25,000
(=$10,000 + $15,000) is the cost of unused
capacity.
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 Activity-Based Management (ABM)

ABM manages activities to improve the value of

products or services to customers and increase
the firm’s competitiveness and profitability:
• Focuses on the efficiency and effectiveness of
key business processes and activities
• Improves management’s focus on the firm’s
critical success factors thereby enhancing the
firm’s competitive advantage
• ABC is its major source of information

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 Activity-Based Management (ABM)
(continued)
ABM applications can be classified into two
categories:
• Operational ABM enhances operational
efficiency and asset utilization and lowers costs; it
focuses on doing things right and performing
activities more efficiently
• Strategic ABM attempts to alter the demand for
activities and increases profitability through
improved activity efficiency

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 ABC/M Tools

Some key ABC/M tools:

• In activity analysis an organization assesses each of
its activities based on its need by the product or the
customer, its efficiency, and its value content

• Value-added analyses are performed in an effort to

eliminate activities that add little or no value to the
customer; resource consumption can be reduced and
the firm can focus on activities that increase customer
satisfaction

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 ABC/M Tools (continued)

High-value-added activities:
• Increase significantly the value of the product or
service
• Are necessary to meet customer requirements
• Enhance purchased materials or components
• Contribute to customer satisfaction
• Are critical steps in a business process

In short, removal would reduce the value of the

product or service

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 ABC/M Tools (continued)

Low-value-added activities:
• Consume time, resources, or space but add
little or nothing to satisfying customer
needs
• Can be eliminated without affecting the
form/fit/function of the product or service

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 Customer Profitability Analysis

ABC/M can be used to estimate customer-related costs

and in therefore in assessing the profitability of a
specific customer or group of customers
• Customer profitability analysis identifies customer service
activities and cost drivers and determines profitability for
each customer or group; this process allows the firm to
chose its customer mix, determine an appropriate offering
of after-sale services, decide what discounts to offer, etc.

• Customer cost analysis is the first step in a customer

profitability analysis; it identifies activities and cost drivers
to service customers before and after sales
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 Customer Profitability Analysis
(continued)
Customer-related costs can be classified into the
following categories:
• Customer unit-level costs - resources consumed for each
unit sold to a customer, such as sales commissions and
shipping costs based on units sold or shipped
• Customer batch-level costs - resources consumed for each
sales transaction, such as order-processing costs or
invoicing costs
• Customer-sustaining costs -resources consumed to service
a customer regardless of the number of units or batches
sold, such as monthly statement processing costs and
collection costs for late payments
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 Customer Profitability Analysis
(continued)
Customer costs can be classified into the
following categories (continued):
• Distribution-channel costs are resources consumed in
each distribution channel the firm uses to service
customers, such as the cost of operating a regional
warehouse or centralized distribution center

• Sales-sustaining costs are resources consumed to sustain

sales and service activities that cannot be traced to an
individual unit, batch, customer, or distribution channel,
such as general corporate marketing expenditures

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 Customer Profitability Analysis
continued
• Customer Profitability Analysis combines
customer revenues and customer costs to assess
customer profitability and helps identify actions
to improve customer profitability
• Some companies quantify customer value in what
is called Customer Lifetime Value (CLV), which
is equal to the net present value (NPV) of all
estimated future profits from the customer for a
specified period of time

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 Customer Profitability Analysis
continued
Customer profitability analysis helps to assess a
customer’s value to the company:
• What is the growth potential of the customer and
the customer’s industry?
• What is its “cross-selling” potential?
• What are the possible reactions of the customer to
changes in sales terms or services?
• How important is this customer as a future sales
reference?

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 ABC/M Implementation Issues

• A successful ABC/M implementation requires close

cooperation among management accountants,
engineers, and manufacturing and operating
managers

• There are three important issues to consider in

ABC/M implementation:
– Multiple-Stage ABC
– Time-Driven ABC (TDABC)
– Resource Consumption Accounting

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 ABC/M Implementation Issues
continued
• Multiple-stage ABC takes into account that
some activities are cost objects for other activities
• Resource Consumption Accounting
emphasizes being able to attribute costs, both
fixed and proportional, to cost objects for
decision support
• Time-driven ABC (TDABC) simplifies some of
the complexity involved in large ABC systems

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Resource Consumption Accounting

• Three foundational concepts for RCA:

– The view of resources – resources are the suppliers of
capacity, meaning that capacity is a function of the
resources available.
– The quantity-based model – an operational view of the
organization based on the concept that there is a causal
relationship that can be expressed in terms of input and
output units.
– Cost behavior – the characteristics of the cost are inherent
to the underlying resource and the consumption of those
resources by value creating operations.

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 Time-Driven ABC
(TDABC)
• Is based on the idea that the common element in
the utilization of many activities is the unit of
time
• Assigns resource costs directly to cost objects
using the cost per time unit of supplying the
resource
• Requires the total activity cost be divided by the
number of minutes available to that activity to
provide a cost per unit of time

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 TDABC Example
 Assume 2 clerical workers paid $45,000 annually perform a
certain activity that is expected to require 17 minutes.
TDABC calculates the total cost as $45,000 × 2 = $90,000;
TDABC then calculates the total time available for the
activity as 180,000 minutes (assuming 30 hours per week
with two weeks vacation: 2 workers × 50 weeks × 30
hours × 60 minutes per hour = 180,000 minutes per year).

 The TDAC rate for the activity is $0.50 per minute

($90,000 ÷ 180,000). The cost of a unit of activity is
$0.50 × 17 min = $8.50.
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 Chapter Summary
Activity-based costing (ABC) is a costing approach
that assigns resource costs to cost objects such as
products, services, or customers based on activities
performed for the cost objects

Volume-based costing is often inadequate because

indirect costs do not always occur in proportion to
output volume; the use of volume-based costing can
cause costing inaccuracies and product cost cross-
subsidization

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 Chapter Summary (continued)
Among other benefits, ABC yields information
that can be used by management to guide
strategic decision-making; the use of ABC data for
decision-making purposes is referred to as ABM

ABM manages activities to improve the value of

products or services to customers and increase the
firm’s competitiveness and profitability

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 Chapter Summary (continued)
 ABC/M can be applied to customer-related costs and
therefore for conducting customer profitability
analysis; as such, ABC data become a powerful tool for
increasing customer profitability
 A successful ABC/M implementation requires close
cooperation among management accountants,
engineers, and manufacturing and operating managers
 Implementation of ABC sometimes includes recent
advances such as Multiple-Stage ABC, Time-Driven
ABC, and Resource Consumption Accounting

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