Cost-Volume-Profit Analysis

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costing is a costing method that is designed to provide managers with cost
information for strategic and other decisions that potentially affect capacity
and therefore “fixed” costs. Activity-based costing is ordinarily used as a
supplement to, rather than as a replacement for, the company’s usual costing

Cost system has recently gained popularity. It is based on a simple idea: in an
enterprise, overhead (or operating) expenses are generated by a number of activities
needed to successfully perform manufacturing and business processes. Since activities
consume overhead resources, and products (or projects or processes) demand
activities, the cost of products is related to the cost of resources. By
design, ABC provides not only relatively accurate cost data, but also
information about the origin of the cost. ABC has been implemented in numerous
companies, and managers familiar with the ABC method were able to manage costs more
successfully. Costs were kept in-line through the removal of non-value-added
activities, process improvement, or outsourcing. Even the most impressive cost
reductions, however, do not automatically imply an improvement in value creation;
often the shareholder value remained unchanged or was reduced. This results
from the fact that the ABC method, however sufficient in the calculation of
operating costs, is deficient in the handling of full capital costs.

Why Activity-Based
Cost Systems:

Activity-Based Costing (ABC) arose in the 1980s from the
increasing lack of relevance of traditional cost accounting methods. The
traditional cost accounting methods were designed around 1870 – 1920 and in
those days industry was labor intensive, there was no automation, the product
variety was small and the overhead costs in companies were generally very low
compared to today. However, from the 1960s – particularly 1980s – this changed
rapidly. For these reasons, and more, traditional cost accounting has been
called everything from ‘number 1 enemy of production’ and questions whether it
is ‘an asset or a liability’ have been raised.

The question of course is whether ABC has overcome these
deficiencies or not?  It has. In fact, ABC has been called one of the most
important management innovations the last hundred years.

So what is really the difference between ABC and traditional cost
accounting methods? Despite the enormous difference in performance, there are
some major differences:

  1. In
    traditional cost accounting it is assumed that cost objects consume
    resources whereas in ABC it is assumed that cost objects consume
  2. Traditional
    cost accounting mostly utilizes volume related allocation bases while ABC
    uses drivers at various levels.
  3. Traditional
    cost accounting is structure-oriented whereas ABC is process-oriented.
  4. The
    allocation bases often differ from those used in traditional costing
  5. Some
    manufacturing costs may be excluded from product costs.

ABC versus
Traditional Costing

causes costs to be incurred. Traditional costing uses broad cost drivers that
do not reflect cause and effect.

1 hour of activity A has different
costs than 1 hour of activity B

traditional cost accounting, predetermined overhead rated are computed by
dividing budgeted overhead costs by a measure of budgeted activity such as
budgeted direct labor-hours this practice results in applying the costs of
unused, or idle, capacity to products, and it results in unstable unit product
costs. If budgeted activity falls, the overhead rate increases because the
fixed components of overhead are spread over a smaller base, resulting in
increased unit product costs.

contrast to traditional cost accounting, in activity-based costing, products
are charged for the costs of capacity they use- not for the costs of capacity
they don’t use. In other words, the costs of idle capacity are not charged to
products. This results in more stable unit costs and is consistent with the
objective of assigning only those costs of idle capacity to products, in
activity-based costing these costs are considered to be period costs that flow
through to the income statement as an expense of the current period this
treatment highlights the cost of idle capacity rather than burying it in
inventory and cost of goods sold.

under traditional costing, cost targets (products, jobs, customers) involving
complex (costly) activity tends to be under-costed while products involving
simple (less costly) activities tend to be over-costed.

The direction of the arrows are different because ABC brings
detailed information from the processes up to assess costs and manage capacity
on many levels whereas traditional cost accounting methods simply allocate
costs, or capacity to be correct, down onto the cost objects without
considering any ’cause and effect’ relations.

Consumption of resources versus consumption of activities

ABC acknowledges that costs cannot be managed, the only thing
that can be managed is what is being done and then costs will change as a
consequence. In traditional cost accounting, however, the underlying
assumption is that costs can be managed, but as most managers have found out
the hard way – managing costs is almost impossible.

The benefit of the ABC mindset is that it opens up for a much
wider array of measures when it comes to improving productivity. By
investigating systematically what is being done, i.e. the activities, one
will not only be able to identify surplus capacity if it occurs, but also
lack of capacity and misallocation of capacity. A result of this might be
that costs are cut the traditional way, but it might as well lead to a
reallocation of capacity to where it is most needed which will yield high
productivity more effectively than the traditional way.

Volume related allocation bases versus drivers at many levels

Due to the historic background of traditional cost accounting
methods, they tend to use direct labor – or other volume related allocation
bases – for cost assignment purposes. But as overhead has grown and new
technologies have come, it goes without saying that assigning costs based on
only 5 – 15% (in most companies) of total costs is highly risky. In fact, the
incurred errors are up to several hundred percent!

In ABC, however, costs are assigned according to the ‘cause and effect’ relationship between
activities (the actual process) and cost objects, which is captured using
drivers. The drivers are therefore not allocation bases in the traditional
sense, although they work the same way mathematically – drivers are estimates
of actual cost behavior and can therefore also be used to identify, or they
are themselves, the critical cost factors. Because the drivers are related to
the actual processes, they occur on several levels. The four most common
levels are;

  1. Unit level.
    Unit level drivers are triggered for every unit that is being produced.
    For example, for a man and a machine that produces one unit at a time,
    the associated direct labor will be a unit level cost driver. This is
    therefore a volume related driver similar to the traditional allocation
  2. Batch level.
    Batch level drivers are triggered for every batch produced. A good
    example of that is production planning, because the planning is done for
    each and every batch regardless of the size of the batch. Here, number
    of batches can be a good driver.
  3. Product level.
    Product level drivers are triggered for every product regardless of the
    number of units and batches produced. These drivers occur by the sole
    existence of a product. A good example of a driver is the number of
    product development hours per product so that the more product
    development hours a product triggers the more product development costs
    should be assigned to that product.
  4. Facility level.
    Facility level driver are drivers that are not related to the products
    at all. Costs that are traced by such drivers will therefore be
    allocated to products and not traced. The difference between allocation
    and tracing is that allocation is quite arbitrary whereas tracing is
    based on ’cause and effect’ relations.

Hence, it can be seen that the traditional usage of fixed and
variable costs is totally meaningless. In ABC, all costs are included.
However, ABC employs a different usage and definition of fixed and variable
costs.  A fixed activity cost is a cost that exists due to the
very existence of the activity whereas a variable activity cost
changes as the output of the activity changes.  This distinction is very
helpful in various improvement efforts.

In ABC there are two types of drivers:

  1. Activity
    Cost Drivers:

 That keep track of how cost object behavior
influences activity levels, i.e., the level of activity for each

©  Selecting activity cost drivers

cost drivers are the central innovation of activity-based cost systems. They
are also the most costly to measure, particularly the quantity of each
activity cost driver used by each product. The selection of an activity cost
driver reflects a subjective trade-off between accuracy and the cost of
measurement. An ABC system, with 50 activity cost drivers and 2000 products
would require 100,000 data elements to be estimated (the quantity of each
activity cost driver used by each product). Because of the large number of
potential activity-to-product linkages, management accountants attempt to
economize the number of different activity cost driver.

system designers can choose from three types of activity cost drivers:


drivers are the least expensive type of cost driver but are also the least
accurate because they assume that the same quantity of resources is required
every time an activity is performed. For example, a transaction driver such
as the number of setups assumes that all setups take about the same time to
perform. For many activities, the variation in the quantity of resources used
by each is small enough that a transaction driver will be fine for assigning
activity expenses to the cost object. If however, the amount of resources
required to perform the activity varies considerably from product to product,
more accurate and more expensive types of cost drivers should be used.

Duration Drivers:

drivers represent the amount of time required to perform an activity.
Duration drivers should be used when significant variation exists in the
amount of activity required for different outputs. Examples of duration
drivers include inspection hours and direct labor hours. In general, duration
drivers are more accurate than transaction drivers, but duration drivers are
more expensive to implement because they require an estimate of the time
required each time an activity is performed.


drivers charge directly for the resources used each time an activity is
performed. Intensity cost drivers are the most accurate activity cost drivers
but the most expensive to implement; in effect, they require a job order
costing system to track all the resources used and their cost each time an
activity is performed. Unless such measurement is inexpensive, intensity
drivers should be used only when the resources associated with performing an
activity are both expensive and variable each time an activity is performed.

2. Resource Cost Drivers:

Resource cost drivers are drivers that keep track of how the
subsequent activity level affects the resource consumption.

In early terminology activity drivers were referred to as
‘second stage cost drivers’ whereas resource drivers were denoted ‘first
stage cost drivers’.  But it is evident that the word ‘cost driver’ is
misleading in this context because activity- and resource drivers do not tell
what drives costs in the general case.

Therefore, in Activity-Based Management (ABM) a third
type of drivers is employed in addition to the two aforementioned drivers.
This type of drivers is called cost drivers and they are the
underlying causes of costs of activities and measured by non-financial
performance measures. Today, the most important of these measures can be
presented in Balanced Scorecard and they represent the process view in ABM.
These are possibly the most difficult drivers to identify.

Structure-orientation versus process-orientation

Traditional costing systems are more concerned about the
organizational charts than the actual process. Traditional cost accounting
systems are therefore structurally oriented and the process view is
completely missing. The result is that one cannot ask ‘what needs to be
done?’, because the process is unknown. The only questions such costing
systems can give answers to, although often off the mark, is ‘what do we have
at our disposal to do the job?’

The latter question is a question of capacity, that is, how
capacity is managed. Capacity is measured as an expense and found easily in
the accounting system. The first question is a question of resource
management, because resources is what you need in order to do a job and
measured as a cost, but the resource measures can only be found by
investigating the processes.

Thus, because ABC is process-oriented and gathers information
from the processes it can be used to identify both ‘what needs to be done?’
and how to allocate resources most productively. ABC can therefore give
managers the ability to match the resource needs with the available capacity
as closely as possible and hence improving productivity. From this we
understand that the structure oriented approach of traditional costing
systems gives no decision support in allocating capacity to match resource
needs. Over time this leads to cost inefficient organizations and poor

There is also another aspect to process-orientation; how ABC is
used and implemented. Because ABC can direct attention towards the causes of
costs (critical success factors) related to both cost objects and processes
and not to mention the cost of quality, ABC is viewed as more than a method
for cost accounting – it invites to a whole new way of management, such as;


The identification of critical
success factors that enables continuous improvement of product- and process


The link between cost information
and other information enables a much wider array of improvement strategies
than traditionally acknowledged.


The identification of the cost of
quality and the process-orientation in ABC open up for a very powerful link
to various quality management methods.

From the above discussion it should be evident that not only is
ABC useful and powerful to any organization, but a need for companies that
want to excel, and efficiently and effectively increase their Sustainable
Competitive Advantage (SCA).

Two stage ABC systems

two stage ABC system is used. The first stage cost drivers are used to allocate
indirect resource costs to activities that require the resources. The cost
drivers are usually expressed as percentages.

for the second-stage allocation, the cost driver for the production-support
activity costs might be “number of customer-generated engineering changes” or
“number of distinct parts,” whichever is a better measure of the consumption of
production-support activity.

How costs are
treated under Activity-based Costing

costs and activity-based costing:

traditional cost accounting, only manufacturing costs are assigned to products.
Selling, general, and administrative expenses are treated as period expenses
and are not assigned to products. However man of these nonmanufacturing costs
are also part of the costs of producing, selling, distributing, and servicing
products in activity-based costing, products are assigned all of the overhead
costs- nonmanufacturing as well as manufacturing-that they can reasonably be
supposed to have caused.

costs and Activity-Based costing:

traditional cost accounting, all manufacturing costs are assigned to
products—even manufacturing costs that are not caused by the products. For
example, a portion of the factory security guard’s wages would be allocated to
each product even though the guard’s wages are totally unaffected b which
products are made or not made during a period. In activity-based costing, a
cost is assigned to a product only if there is good reason to believe that the
cost would be affected by decisions concerning the product.

Plant wide Overhead

an economy wide basis, direct labor and overhead costs has been moving in
opposite directions for a long time as a percentage of total cost, direct labor
has been declining, whereas overhead has been increasing many tasks that used
to be done b hand are now done with largely automated equipment-a component of
overhead. Further more, product diversity has increased companied are creating
new products and services at an ever-accelerating rate that differ in volume,
batch size, and complexity managing and sustaining this product diversity
requires many more overhead resources such as production schedulers and product
design engineers, and many of these overhead resources have no obvious
connection with direct labor. Finally computers, bar code readers, and other
technology have dramatically reduced the costs of collecting and manipulating
data- making more complex (and accurate) costing systems such as activity-based
costing much less expensive to build and maintain.

direct labor remains a viable base for applying overhead to products in some
companies-particularly for external reports. Direct labor is an appropriate
allocation base for overhead when overhead costs and direct labor are highly
correlated and indeed, most companies throughout the world continue to base
overhead allocations on direct labor or machine-hours.

Departmental Overhead

than using a plant wide overhead rate, many companied have a system in which
each department has its own overhead rate. The nature of the work performed in a
department will determine the department’s allocation base. For example,
overhead costs in a machining department may be allocated on the basis of the
machine-hours incurred in that department. In contrast, the overhead costs in
an assembly department may be allocated on the basis of direct labor-hours
incurred in that department.

even departmental overhead rates will not correctly assign overhead costs in
situations where a company has a range of products that differ in volume,
batch, size, or complexity of production. The reason is that the departmental
approach usually relied on volume as the factor in allocating overhead cost to
products. However, the department’s overhead costs are probably more complex
than this and are caused by a variety of factors, including the range of
products processed in the department, the number of batch setups that are
required, the complexity of the products, and so on. Activity-based costing is
a technique that is designed to reflect these diverse factors more accurately
when costing products. It attempts to accomplish this goal by identifying the
major activities such as batch setups, purchase order processing and so on,
that consumes overhead resources and thus cause costs.

Fixed Costs and
Variable costs in activity-based cost systems:

ABC system assigns most indirect costs to products, but this system does not
assume that such costs will vary based on short-term changes in activity
volumes. In fact, most indirect expenses assigned by an ABC system are
committed costs. Committed costs become variable via a two step procedure.


First Demands for resources change either
because of changes in the quantity of activities performed or because of
changes in the efficiency of performing activities.


Second  Managers must make decisions to change the
supply of committed resources, either up or down, to meet the new level of
demand for the activities performed by these resources.

activity volumes exceed the capacity of existing resources, the result is
bottlenecks, shortages, increased pace of activity, delays or poor-quality
work. Such shortages occur often on machines, but the ABC approach makes clear
that shortages can also occur for human resources who perform support
activities, such as designing, scheduling, ordering, purchasing, maintaining
and handling products and customers. Companies facing such shortages typically
make committed costs variable. They relieve the bottleneck by spending more to
increase the supply of resources to perform work, which is why many indirect
costs increase over time.

for indirect and support resources also can decline, either intentionally
through activity-based management or inadvertently through competitive or
economy wide forces that lead to declines in sales. For many unit level
resources such as machines and direct labor, reduced demands for work do not
immediately lead to spending decreases. People have been hired, space has been
rented, and computers, telephones and furniture have been acquired. The
expenses for these resources continue even though there is less work for the
resources to perform. The reduced demand for organizational resources does
lower the cost of resources used by products, services and customers. But this
decrease is offset by an equivalent increase in the cost of unused capacity.

unused capacity has been created, committed costs will vary downward if, and
only if, managers actively reduce the supply of unused resources. Organizations
often create unused capacity through activity-based management actions, such as
process improvement, repricing to modify the product mix, and imposing minimum
order sizes on customers. They keep existing resources in place, however, even
though the demands for the activities performed by the resources have
diminished substantially. They also fail to find new activities that could be
done by the resources already in place but not being used. In this case, the
organization receives no benefits from its activity-based management decisions
that reduced the demands on its resources. The failure occurs because managers
are unwilling or unable to take advantage of the unused capacity they have
created, such as by spending less on capacity resources or increasing the
volume of work processed by the capacity resources. The costs of these
resources are only fixed if managers do not exploit the opportunities from the
unused capacity they helped to create.


is the most powerful tool a company can use to transform unprofitable customers
into profitable ones. Activity-based pricing establishes a base price for producing
and delivering a standard quantity for each standard product. In addition to
this base price, the company provides a menu of options, with associated
prices, for any special services requested by the customer. The prices for
special services on the menu can be set simply to recover the activity-based
cost-to-serve, allowing the customer to choose from the menu the features and
services it wishes while also allowing the company to recover its cost of
providing those features and services to that customer. Alternatively, the
company may choose to earn a margin on special services by pricing such
services above the costs of providing the service. Price surcharges could be
imposed when designing and producing special variants for a customer’s
particular needs. Discounts would be offered when a customer’s ordering pattern
lowers the company’s cost of supplying it.

pricing, therefore, prices orders, not products. When managers base prices on
valid cost information, customers shift their ordering, shipping, and
distribution patterns in ways that lower total supply-chain costs to the
benefit of both suppliers and customers.

Management: A cost management system tool

systems not only develop more accurate costs, they also aid control of costs.
Activity based management is using the output of an activity based cost
accounting system to aid strategic decision making and to improve operational
control of an organization. In the broadest terms, activity-based management
aims to improve the value received by customers and to improve profits by
identifying opportunities for improvements in strategy and operations.

Value-added cost

added cost is the cost of an activity that a company cannot eliminate without
affecting a product’s value to the customer. Value-added costs are necessary s
long as the activity that drives such costs is performed efficiently.

©  Non-value-added cost

try to minimize non-value-added costs in contrast to value-added costs.
Non-value-added costs mean costs that a company can eliminate without affecting
a product’s value to the customer. Activities such as storing and handling
inventories, transporting partly finished products from one part of the plant
to another, and changing the setup of production-line operations to produce a
different model of the product are all non-value-adding activities. A company
can rescue, if not eliminate, them by careful redesign of the plant layout and
the production process.

©  Benchmarking

ABC related technique that has gained popularity is benchmarking, the
continuous process of comparing products, services, and activities to the best
industry standards. Benchmarking is a tool to help an organization measure its
competitive posture. Benchmarks can come from within the organization, from
competing organizations, or from other organizations having similar processes.

must exercise caution when benchmarking, especially when using financial

Benefits of
activity-based costing and activity-based management

costing systems are more complex and costly than traditional systems. So
companies that have relatively simple operating systems may not realize
sufficient benefits and thus may not want to use ABC systems. But more and more
organizations in both manufacturing and non-manufacturing industries are
adopting activity-based costing systems for a variety of reasons:

Fierce competitive pressure has resulted in shrinking profit margins. Companies
may know their overall margin, but they often do not have confidence in the
accuracy of the margins for individual products or services. Some are winners
and some are losers. Accurate costs are essential for these purposes.

Greater diversity in the types of products and services as well as customer
classes results in greater business operating complexity. Therefore, the
consumption of a company’s shared resources also varies substantially across
products and customers.

3. New
production techniques have increased the proportion of indirect costs. That is
indirect costs are far more important in today’s world-class manufacturing
environment than they have been in the past. In many industries automated
equipment is replacing direct labor. Indirect costs are sometimes more than 50%
of total cost.

4. The
rapid pace of technological change has shortened product life cycles. Hence,
companies do not have time to make price or cost adjustments once they discover
costing errors.

5. The
rapid pace of technological change has shortened product life cycles. Hence,
companies do not have time to make price or cost adjustments once they discover
costing errors.

6. The
cost, associated with bad decisions that result from inaccurate cost
determinations are substantial. Examples include bids lost due to overcosted
products, hidden losses from undercosted products, and failure to detect
activities that are not cost effective companies with accurate costs have a
huge advantage over those with inaccurate costs

Computer technology has reduced the costs of developing and operating ABC

An Activity-Based
Costing Model:

Like most other ABC
implementations, the new ABC system would supplement, rather than replace, the
existing cost accounting system, which would continue to be used for external
financial reports. The new ABC system would be used to prepare special reports
for management decisions such as bidding on new business.

In the above chart the accounting
managers have shown the general model of ABC system. Cost objects such as
products generate activities. For example, a customer order for a brass cup
holder requires the activity of preparing a production order. Such an activity
consumes resources. A production order uses a sheet of paper and takes time to
fill out. And consumption of resources causes costs. The greater the number of
sheets used to fill out production orders and the greater the amount of time
devoted to filling out such orders, the greater the cost. Activity-based
costing attempts to trace through these relationships to identify how products and
customers affect costs.

Design of an
Activity-based cost accounting system

How do managers actually design
ABC systems? A team of managers from the billing department and regional
controller used the following four-step procedure to design their new cost
accounting system:

Step 1: Determine the
Key Components of the Activity-Based Cost Accounting System:

They key components of an
activity- based cost accounting system are cost objectives, key activities,
resources, and related cost drivers. These components, together with the
purpose of the new system, determine the scope of the ABC system. The system is

a. Determine the billing department cost per account for each customer
class in order to support the strategic decision regarding outsourcing accounts
to the local service bureau, and

b. Enhance the managers’ understanding of key billing department
activities to support operational cost control. Because the bid from the local
service bureau includes performing all the activities of the department, the
ABC system must include all department cost. Further, because management wants
to understand the key activities and related costs, the team designed an
activity-based system.

Step 2: Determine the
relationships among cost objectives, activities, and resources:

An important phase of any
activity-based analysis is identifying the relationships among key activities
and the resources consumed. The management team does this by interviewing
personnel and analyzing various internal data.

Implementing an ABC system
requires a careful study of operations. As a result, managers often discover
that they can trace directly to cost objectives some previously indirect or
even unallocated costs, thus improving the accuracy of product or service

Process maps:

A process map is a schematic
diagram with symbols that captures the inter-relationships between cost
objects, activities, and resources. These maps can be efficient method to
enhance managers’ understanding of operations. Many ABC teams find it useful to
develop a process map.

There are two examples following,
which contain the basic concepts of drawing process maps.

Let us assume that there is no
way to physically trace the costs of resource A to activities 1 and 2, so we
must use a cost driver to allocate the costs, making them indirect costs.

Similarly we must use cost
drivers for the allocation of the costs of activities 2 and 3 to the products.
In contrast, any resource cost that is used by only one activity (as for
resources B and C) is direct with respect the activity cost that is required by
only one product (as for activities 1 and 4). There is no ambiguity about which
cost objective is responsible for these direct costs.

A process map depicts in a
concise manner the same information that was gathered from interviews. Process
maps can be a key tool for managers to gain an understanding of operations.

Step 3: Collect
relevant data concerning costs and the physical flow of the cost-driver units
among resources and activities:

Using the process map as a guide,
the managers can collect the required cost and operational data by further
interviews with relevant personnel. Sources of data may include the accounting
records, special studies and sometimes best estimates of managers. They can collect
resource cost information from the general ledger and data on the flow of cost
drivers from various operational reports.

Step 4: Calculate and
Interpret the New Activity-Based Cost Information:

After collecting all required
financial and operational data, we can calculate the new activity-based
information. Traditional systems generally overcost high- volume cost objects
with simple processes. Which system makes more sense- the traditional
allocation system that “spreads” all support costs to customer classes based
solely on the number of inquiries, or the activity-based costing system that
identifies key activities and assign costs based on the consumption of units of
cost drivers for each key activity can be measured from ABC systems.

Steps for Implementing
Activity-Based Costing:

1: Identify and difine activities and activity cost pools:

The first major
step in imolementing an ABC system is to identify the activities that will form
the foundation for the system. A common procedure is for the individuals on the
ABC imolementation team to interview people who work in overhead departments
and ask themto describe their major activities.

A useful way to
think about activities and how to combine them is to organize them into five
general levels:

1. Unit level activities:

These are
performed each time a unit is produces. The costs of unit-level activities
should be proportional to the number of units produced. For example, providing
power to run processing equipment would be a unit-level activity since power
tends to be consumed in proportion to the number of units produced.

2. Batch-level activities:

These are
performed each time a batch is handled or processed, regardless of how many
units are in the batch. For example, tasks such as placing purchase orders,
setting up equipment and arranging for shipments ot customers are batch-level
activities. They are incurred once for each batch (or customer order). Costs at
the batch level
depend on the number of batches processed rather than on the number of units
produced, the number of units sold, or other measures of volume. For example,
the cost of setting up a machine for batch processing is the same regardless of
whether the batch contains one or thousands of items.

3. Product-level activities:

These are related to specific
products and typically must be carried out regardless of how many batches are
run or units of product are produced or sold. For example, activities such as
designing a product, advertising a product, and maintaining a product manager
and staff are all product-level activities.

4. Customer-level activities:

These are related to specific
customers and include activities such as sales calls, catalog mailings, and
general technical support that are not tied to any specific product.

5. Organization-sustaining activities:

These are carried out regardless
of which customers are served, which products are produced, how many batches
are run, or how many units are made. This category includes activities such as
heating the factory, cleaning executive offices, providing a computer network,
arranging for loans, preparing annual reports to shareholders and so on.

System of combining activities to ABC:

Activities should be grouped
together at the appropriate level while combining activities in an ABC system.
Batch-level activities should not be combined with unit-level activities or
product-level activities with batch-level activities and so on. In general, it
is best to combine only those activities that are highly correlated with each
other within a level. And it can only be possible when they tend to move in

Activity Cost Pool:

It is a bucket in which costs are
accumulated that relate to a single activity measure in the ABC system.

© The Product Design Cost Pool:

The product design cost pool will
be assigned all costs of resources consumed by designing products. The activity
measure for this cost pool is the number of products designed. This is a
product-level activity, since the amount of design work on a new product does
not depend on the number of units ultimately.

©  Order Size Cost Pool:

The order size cost pool will be
assigned all costs of resources consumed as a consequence of the number of
units produced, including the costs of miscellaneous factory supplies, power to
run machines, and some equipment depreciation. This is unit-level activity
since each unit requires some of these resources.

©  Customer Relations cost pool:

The customer relations cost pool
will be assigned all costs associated with maintaining relations with
customers, including the costs of sales calls and the costs of entertaining

©  Other cost pool:

The other cost pool will be
assigned all overhead costs that are not associated with customer orders,
product design, the size of the orders, or customer relations. These costs
mainly consist of organization-sustaining costs and the costs of unused, idle

Step 2: Whenever
possible, directly trace overhead costs to activities and cost objects:

The second step in implementing
an ABC system is to directly trace as many overhead costs as possible to the
ultimate cost objects. Let us assume, a company’s cost objects are products,
customer orders and customers. In the ABC system at this company, all the
annual manufacturing overhead and selling, general and administrative costs are
considered to be overhead and will be assigned to cost objects where

Step 3: Assign costs
to activity cost pools:

For example, if the ABC system
has an activity called purchase order processing, then all of the costs of the
purchasing department could probably be traced to that activity. To the extent
possible, costs should be traced directly to be activity cost pools. But it is
quite common for an overhead department to be involved in several of the
activities that are tracked in the ABC system. In such situations, the costs of
the department are divided among the activity cost pools via an allocation
process called first-stage allocation. It is the process by which overhead
costs are assigned to activity cost pools.

The immediate problem is to
figure out how to divide. The point of activity-based costing is to determine
the resources consumed by cost objects. Soften, the best way to get this kind
of information is to ask the people who are directly involved. Members of the
ABC team may interview the workers related to the resources. Those who are
interviewed must thoroughly understand what the activities encompass and what
is expected of them in the interview.

Step 4: Calculate
Activity Rates

The next step is to calculate activity
rates that will be used for assigning overhead costs to products and customers.
The activity rates are computed by dividing the total cost for each activity by
its total activity. But the activity rates will not be computed for the other
category of costs. This is because the other cost pool consists of
organization-sustaining costs and costs of idle capacity that are not allocated
to products and customers.

Step 5: Assign costs
to cost objects:

The fifth step in the
implementation of activity-based costing is called second-stage allocation. In
the second-stage allocation, activity rates are used to apply cots to products
and customers.

Step 6: Prepare
Management Reports:

And the last step for
implementing ABC system is to prepare a report showing activity-based costing
margins from an activity view. Such customer analyses can be easily
accomplished by adding together the product margins for each of the products a
customer has ordered and then subtracting the average charge for customer


can transform unprofitable customers into profitable ones by persuading such
customers to use a greater scope of the company’s products and services. The
margins from increased purchases contribute to covering customer-sustaining
costs. Let us consider a commercial bank with a basic entry-level product:
commercial loans. The interest spread on such loans-the difference between the
bank’s effective borrowing rate and the rate it charges the customers-may be
insufficient to cover the bank’s cost of making and sustaining the loan because
of intense competition and the customer’s low use of the lending relationship.
However, the bank may make enough profit on other services that the customer
uses- for example, investment banking services and corporate money
management-that in aggregate the customer is a highly profitable one.
Alternatively, however, a small borrower who uses no other commercial banking
or investment banking services may be quite unprofitable. In this case, the bank
would ask the customer to expand its use of the loan facility, such as to
borrow more, and use other and more profitable services offered by the bank’s
services. If these efforts fail, the bank may then contemplate “firing” the
customer by encouraging it to take its demands for a commercial loan to another


activity-based costing has provided managers in many companies with valuable
information about the cost of their activities, processes, products, services
and customers, not all ABC systems have been sustained or have contributed to
higher profitability for the company. Companies have experienced difficulties
and frustrations in building and using activity-based cost and profitability
models. Here are some pitfalls that have occurred and suggest ways to avoid

Lack of clear
Business Purpose:

the ABC project is initiated out of the finance or accounting department and is
touted as “a more accurate cost system”. The project team gets resources for
the project, builds an initial ABC model, and then becomes disappointed and
disillusioned when no one else looks at or acts upon the new ABC cost and
profitability information.

To avoid
these problems, all ABC projects should be launched with a specific business
purpose in mind, the purpose could be to redesign or improve processes, to
influence product design decisions, to rationalize the product mix, or to
better manage customer relationships. By defining the business purpose at the
start, the team will identify the line manager or department whose behavior and
decisions are expected to change as a consequence of the information. The
decision maker could be the manufacturing or operations manager (for process
improvement), the engineering manager (for product design decisions), the sales
organization (for managing customer relationships), or the marketing department
(for decisions about pricing and product mix).

ABC projects were aborted when they did not provide operating managers with
frequent feedback on the costs and expenses under their responsibility. These
operating managers needed a feedback system, in addition to the ABC system,
that could be specifically designed for the purpose of providing operational
feedback on process efficiencies. Some projects foundered because the company
expected its new ABC system model to also be the basis for costing inventory
for financial reporting. Such companies failed to realize that their
traditional costing system already worked fine for external reporting and did
not need to be replaced right away with the ABC system. Companies should allow
some experimentation and flexibility with their first ABC system, customizing
its design for maximum managerial benefits, before imposing the additional
burden of also satisfying external, regulatory reporting.

decisions about pricing, customer relationships and product mix, the ABC model
should be simpler, using fewer than 50 activities and with data readily
available for all the important activity cost drivers. A model intended for
product designers and engineers should use activity cost drivers that would be
meaningful to them. Drivers such as number of parts placements, number of
unique parts and number of unique vendors are understandable and actionable to
product designers.

Lack of senior
management commitment:

most successful ABC projects occur when clear business purpose exists for
building the ABC model and this purpose is led, or at least understood and
fully supported by, senior line managers in the organization. A steering
committee of senior managers from various functional groups and business units
provides guidance and oversight, meeting monthly to review project progress,
make suggestions on how to enhance the model, and prepare for the decisions that
will be made once the model has been completed.

when the ABC project is initiated from the finance group, a multifunctional
project team should be formed. The team should include, in addition to a
management accountant or other finance group representative, members from
operations, marketing/sales, engineering, and systems. In this way, the
expertise from diverse groups can be incorporated into the model design and
each team member can build support for the project within his or her department
and group.

Delegating the
project to consultants:

Some projects
may fail when they were outsourced to an external consulting company. Constants
may have considerable experience with ABC but not the needed familiarity with a
company’s operations and business problems. Nor can they build management
consensus and support within the organization either to make decisions with the
ABC information or to maintain and update the model.

companies may use the software but it cannot provide the thinking required to
build a cost effective ABC model.

consultants and ABC software can play valuable roles for many companies, but
they are not substitutes for leadership and sponsorship and a dedicated,
multifunctional internal project team. These functions cannot be bypassed just
because external consultants and prepackaged software have also been purchased.

Poor ABC Model

even with strong management support and sponsorship, the project team gets lost
in the details and develops an ABC model that is both too complicated to build
and maintain and too complex for managers to understand and act upon. ABC model
design should be like any design or engineering project. It should be regularly
evaluated, with continual appropriate trade-offs to enable the essential
function of the system to be accomplished at minimal additional cost. If the
ABC project team keeps end-users clearly in mind and gets good advice from its
senior management steering committee, it should make good cost-effective design
decisions along the way. These decisions can help avoid the problem of having
an over complex system or misidentified casual relationships between cost
objects (products and customers), activities and resources.

Individual and
organizational resistance to change:

all managers welcome technically superior solutions. Individuals often resist
new ideas and change and organizations have great inertia. The resistance to a
new ABC model may not be overt. Managers can politely sit though an ABC
presentation about product and customer profitability but continue to behave
just as they have in the past. Or they will ask the project team to re-estimate
the model, using a more recent period or at another company site. Sometimes,
however, the resistance is more overt. Managers may exclaim the company has
been successful in the past with its existing cost system. Or, if it has been a
finance-led project, they may accuse the finance people of not understanding
the complexity of the business or wanting to run the company.

Activity Based
Costing – Pros & Cons:


Identifies Non-Value Added

Identifies cost savings
opportunities (untraceable costs)

Provides very detailed
cost/profitability information

complex versus simple processes

More data can
lead to more information = better decisions


Very costly to implement and

Historical in nature
(same as traditional absorption costing)

Detail versus Accuracy

Discourages novel
approach’s to processes

Encourages activity

equal and proportionate benefits result from common activity


systems drive the cost of indirect and support resources-manufacturing
resources in factories and marketing, selling, distribution and administrative
resources-to the activities they perform and then to the cost objects-the
products, services and customers- that generate the demand for the activities.

develop an ABC model, management accountants should estimate activity cost
driver rates using the practical capacity of the resources supplied. They
should also make appropriate trade-offs in the design of the model, balancing
the cost of more accurate measurement for more complex models, with the
benefits from the greater accuracy. Managers use the information on activity
costs to improve profitability. They can identify high-cost and inefficient
processes that are prime candidates for operational improvements projects. By
driving activity costs down to cost objects, managers identify profitable and
unprofitable products, services and customer. They can make better decisions on
pricing, product mix, product design, customer and supplier relationships and
technology that transforms unprofitable products and customers into profitable
ones. These are examples of activity-based management in action.

the apparent attraction of increased accuracy and managerial relevance from
activity-based costing, individual and organizational resistance can arise to
block the effective use of these systems. Management accountants must be
sensitive to the conditions that cause such resistance to arise and devise good
countermeasures to overcome them.