abc vs traditional costing

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ABC vs Traditional Costing

The difference between ABC or Activity Based Costing and TCA or Traditional CostAccounting is that ABC is complex whereas TCA is simple.

The ABC system began in 1981 whereas TCA methods were designed and developedbetween 1870 to 1920. In the TCA system, the cost objects and used up resources arerequired to evaluate the cost whereas in the ABC system the cost is dependent upon theactivities used up by the cost objects.

Activity Based Costing is accurate and preferred over the TCA cost management system.The ABC method of cost management system is adopted when the overheads of thecompany are high and there are large numbers of miscellaneous products. Inaccuracy orerrors are most unwanted and undesirable because of the competitive rates set by thecompetitors in the market. Due to this heavy and stiff competition, a highly reliable andaccurate method is required for the cost management.

TCA or Traditional Cost Accounting uses a single overhead pool and is not able tocalculate the true cost. The costs of the objects are allocated randomly based upon thelabor or machine hours etc. ABC costing includes identifiable products parts or laborwhereas TCA arbitrarily accumulates expenses, salaries, depreciations etc.

Smaller targeted costs that are built upon activities are calculated with the help of theABC system. The ABC system is advantageous since it helps in simplifying the decisionmaking process and it makes management concepts become clear and target -oriented. Italso helps in evaluating performances and sets standards which can help the manager touse this information for comparison purposes.

In the Traditional Cost Accounting System, the company determines the cost ofproduction after the products havebeenproduced whereas in the target or Activity BasedAccounting System, the value or cost of the product is determined on the basis ofcustomerfeedback and pocket range. The ABC system helps the company to determinewhether to lower or raise the activities cost to grab the consumers. The ABC system alsohelps in keeping up with the competitors without sacrificing the quality and the quantityof the products.

Summary:

1. Traditional cost accounting is obsolete whereas Activity Based Accounting is usedmore by various target-oriented companies.

2. ABC methods help the company to identify the needs of keeping or eliminating certainactivities to add value to the products.

3. TCA methods focus on the structure rather than on processes whereas ABC methodsfocus on the activities or processes rather than on the structure.
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4. ABC provides accurate costs whereas TCA accumulatesvalues arbitrarily.

5. TCA is almost obsolete whereas ABC methods are largely in use since 1981.

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Management Accounting:

Concepts, Techniques & Controversial

IssuesJames R. Martin

Chapter 7Activity Based Product Costing1

MAAW's Book Main Page

CONTENTSLearning Objectives Introduction

ABC Concepts What is ABC? Problems with Traditional Systems The Causes of Product Cost Distortions

Exhibit 7-1 The Logic of ABC - Figure 7-1 Activity Volume - Exhibit 7-2 How are Activity Measures Chosen? ABC Cost Hierarchy Distinction Between Activity Drivers andActivity Measures - Exhibit 7-3

The ABC Technique Four Steps in Designing an ABC System or Sub-System Three Steps to Obtain ABC Costs

Comparing Traditional Production VolumeBased Systems and ABC Systems

CAM-I What is CAM-I? Controversial Issue: How Should ABC beUsed?

ABC and the Dichotomy of Capitalism Technology and Automation

Focused Factories and JIT Quality and Customer Responsiveness

Footnotes Questions
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0causes%20of%20product%20cost%20distortionshttp://maaw.info/Chapter7.htm#Exhibit%207-1%23Exhibit%207-1http://maaw.info/Chapter7.htm#The%20logic%20of%20ABC%23The%20logic%20of%20ABChttp://maaw.info/Chapter7.htm#Figure%207-1%23Figure%207-1http://maaw.info/Chapter7.htm#Activity%20volume%23Activity%20volumehttp://maaw.info/Chapter7.htm#Exhibit%207-2%23Exhibit%207-2http://maaw.info/Chapter7.htm#How%20are%20activity%20measures%20chosen?%23How%20are%20activity%20measures%20chosen?http://maaw.info/Chapter7.htm#ABC%20cost%20hierarchy%23ABC%20cost%20hierarchyhttp://maaw.info/Chapter7.htm#Distinction%20between%20activities,%20drivers%20and%20activitity%20measures%23Distinction%20between%20activities,%20drivers%20and%20activitity%20measureshttp://maaw.info/Chapter7.htm#Distinction%20between%20activities,%20drivers%20and%20activitity%20measures%23Distinction%20between%20activities,%20drivers%20and%20activitity%20measureshttp://maaw.info/Chapter7.htm#Exhibit%207-3%23Exhibit%207-3http://maaw.info/Chapter7.htm#The%20ABC%20technique%23The%20ABC%20techniquehttp://maaw.info/Chapter7.htm#Four%20steps%20in%20designing%20an%20ABC%20system%23Four%20steps%20in%20designing%20an%20ABC%20systemhttp://maaw.info/Chapter7.htm#Four%20steps%20in%20designing%20an%20ABC%20system%23Four%20steps%20in%20designing%20an%20ABC%20systemhttp://maaw.info/Chapter7.htm#Three%20steps%20to%20obtain%20ABC%20costs%23Three%20steps%20to%20obtain%20ABC%20costshttp://maaw.info/Chapter7.htm#Comparing%20traditional%20PVB%20and%20ABC%20systems%23Comparing%20traditional%20PVB%20and%20ABC%20systemshttp://maaw.info/Chapter7.htm#Comparing%20traditional%20PVB%20and%20ABC%20systems%23Comparing%20traditional%20PVB%20and%20ABC%20systemshttp://maaw.info/Chapter7.htm#CAM-I%23CAM-Ihttp://maaw.info/Chapter7.htm#What%20is%20CAM-I?%23What%20is%20CAM-I?http://maaw.info/Chapter7.htm#Controversial%20issue:%20How%20should%20ABC%20be%20used?%23Controversial%20issue:%20How%20should%20ABC%20be%20used?http://maaw.info/Chapter7.htm#Controversial%20issue:%20How%20should%20ABC%20be%20used?%23Controversial%20issue:%20How%20should%20ABC%20be%20used?http://maaw.info/Chapter7.htm#ABC%20and%20the%20dichotomy%20of%20capitalism%23ABC%20and%20the%20dichotomy%20of%20capitalismhttp://maaw.info/Chapter7.htm#Technology%20and%20automation%23Technology%20and%20automationhttp://maaw.info/Chapter7.htm#Focused%20factories%20and%20JIT%23Focused%20factories%20and%20JIThttp://maaw.info/Chapter7.htm#Quality%20and%20customer%20responsiveness%23Quality%20and%20customer%20responsivenesshttp://maaw.info/Chapter7.htm#Footnotes%23Footnoteshttp://maaw.info/Chapter7.htm#Questions%23Questions


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Problems Problem Solutions

Extra MC Questions

LEARNING OBJECTIVES

After you have read and studied this chapter, you should be able to:1. Explain how activity based costing (ABC) fits into an overall costaccounting system.2. Describe the two main problems that tend to occur when companies usetraditional costing.3. Discuss the causes and directions of product cost distortions that occur intraditional costing.4. Explain the logic underlying ABC.5. Discuss how the concepts of fixed and variable costs are viewed in ABC.

6. Explain the distinction between production volume and activity volume.7. Describe how activity measures are chosen when using the ABC approach.8. Describe the ABC cost hierarchy.9. Explain the conceptual distinction between activities, drivers and activitymeasures.10. Outline four steps involved in designing an activity based costing system orsub-system.2

11. Outline three additional steps required to obtain ABC product costs.12. Compute product cost in relatively simple ABC problems.13. Discuss CAM-I's involvement in developing and implementing ABC

concepts and techniques.14. Discuss a controversial issue concerning how ABC should be used.15. Discuss the connection between ABC and the dichotomy of capitalism.

INTRODUCTION

The main purpose of this chapter is to introduce the concepts and terminologyassociated with activity based costing and to discuss how activity basedconcepts are used to produce more accurate product costs than those obtainedin the traditional cost systems presented in Chapters 4, 5 and 6. This chapter

contains two relatively long sections and three fairly short sections. The firstsection places emphasis on the conceptual material underlying activity basedcosting and addresses the first nine learning objectives listed above. The secondsection outlines the steps involved in using the ABC technique and providestwo related examples that illustrate and compare ABC with traditional costing.This section covers learning objectives 10 through 12. Sections three and fourinclude a discussion of the CAM-I organization's involvement in the
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development and implementation of ABC concepts and a short discussion of acontroversial issue concerning how ABC should be used. The last sectionrelates the emergence of activity based costing to the dichotomy of capitalismframework discussed in Chapter 1.

ABC CONCEPTS

WHAT IS ABC?

This sub-section places activity based costing within the five part costaccounting system structure illustrated in Exhibit 2-1 ofChapter 2. Is ABC aninput measurement basis, an inventory valuation method, a cost accumulationmethod, a cost flow assumption, a measure relating to the timing of dataavailability, or none of the above?

Inventory Valuation Method?

From our previous discussions in Chapters 2 and 6 recall that activity basedproduct costing may be used as an alternative to the traditional inventoryvaluation methods, or as a separate stand alone, microcomputer based systemdesigned only to obtain more accurate information for management decisions.If ABC replaces traditional full absorption, or variable costing, it becomes thecompany's inventory valuation method. Then, activity based costs flow throughthe perpetual inventory accounts. However, if ABC is used as a separatemanagement decision support system where activity based product cost are

determined only once per year, then ABC is not serving as the company'sinventory valuation method.

Resource Consumption Decision Support Model?

More importantly, whether ABC is used as a replacement for traditionalinventory valuation or as a stand alone method, it provides information abouthow and why resources are consumed. Thus, according to ABC advocates, it isnot just an inventory valuation method, or just a separate product costingmethod. Activity based costing is a resource consumption model that can

provide a wealth of information to aid in decisions concerning product andprocess improvements.3 We will return to this idea in Chapter 8 under theheading of activity based management (ABM).

Cost Accumulation Method?
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Another clarification regarding how ABC fits into the overall cost accountingsystem has to do with cost accumulation. Remember that there are two basiccost accumulation methods, job order costing and process costing. Activity

based costing is not a cost accumulation method, therefore it does not replacethese methods, but instead ABC is used to enhance the accuracy of the productcosts determined in both job cost and process cost environments. Most of theillustrations of ABC in textbooks and articles are based on two to four productswhich seems to imply a process orientation. However, since there are likely to

be more product variations or differences in a job cost environment than in aprocess cost environment, it is logical to assume that the potential benefits ofusing ABC are greater for companies that produce a large number of productsto customer specifications, than for companies that have more focused

processes dedicated to a few generic products.

PROBLEMS WITH TRADITIONAL SYSTEMS

Two main problems tend to occur when traditional inventory valuation methodsare used to provide information for management decision purposes. One has todo with product cost distortions, or cross-subsidies and the other relates to theexclusiveness of traditional product costing.

Product Cost Distortions and Cross Subsidies

First, in traditional costing, only production volume related measures are usedto allocate overhead costs to products, even though many products do not

consume indirect resources (overhead) in proportion to the volume of productsproduced. Since many types of indirect resource costs are caused by, or drivenby, non-production volume related product characteristics such as size andcomplexity, traditional costing tends to distort product costs. This means thattoo much overhead cost is allocated to some products, while too little overheadcost is allocated to other products. These distortions are frequently referred toas cross-subsidies. Generally, ABC solves this problem by separating overheadcosts into different cost categories referred to as cost pools. Costs that arecaused by, or driven by, the same activity are pooled together and thenallocated, or traced, to products using an appropriate measure of the activityvolume.

Excluding Non-Manufacturing Costs

A second problem with traditional cost systems is that tracing product relatedadministrative, marketing and distribution costs to product inventories is not agenerally acceptable procedure allowable for external reporting. However,


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engineering design, marketing, distribution and customer service costs areclearly part of the costs of placing a product in the hands of the customer. Sincethese non-manufacturing costs may differ substantially from product to productand from customer to customer, ABC traces these costs to products andcustomers using additional cost pools and activity measures. Thus, the ABCapproach provides the potential for more accurate product costs formanagement decisions concerning product planning, product design andintroduction, product design changes, product pricing, make versus buy,

product distribution, product service and product discontinuance. ABC alsoprovides potential benefits to many service oriented industries such as banking,insurance, health care, and transportation.

To keep the illustrations in this chapter fairly simple, we will concentrate onmanufacturing costs, but remember that non-manufacturing costs are alsotraced to products and services using the ABC approach.

THE CAUSES OF PRODUCT COST DISTORTIONS

There are two main causes of product cost distortions in traditional costing, i.e.,where a single production volume based overhead rate is used by each productdepartment. These include product volume differences (or product volumediversity) and product differences (or product diversity).

Product Volume Diversity

Cost distortions from product volume differences occur when a companyproduces one, or more, high volume products (i.e., a relatively large number ofunits) and one, or more low volume products (i.e., a relatively small number ofunits). Generally, the low volume products will receive too little overheadwhen a single production volume based departmental rate is used and highvolume products will receive too much overhead. Conceptually, the idea is thateach type of product requires engineering, purchasing, inspection and othersupport, regardless of the number of units produced, thus these support costs donot vary in proportion to the number of units, but instead vary with otherfactors that are unrelated to production volume. If the costs of support activitiesare allocated to products on the basis of a production volume relatedmeasurement such as direct labor hours, low volume products will not receivecost allocations in proportion to their demands on these activities.

Product Diversity


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Cost distortions from product differences occur when there are variations inproduct size and product complexity. Small products tend to require lessproduction volume related input (such as direct labor time) than large products,although they do not require less support in proportion to their size. Thereforesmall products tend to be undercosted, while large products tend to beovercosted.

Product complexity generally refers to product design complexity. Productswith complex designs are likely to require more engineering work, morematerials related support (e.g., purchasing and materials movement), perhapslonger machine setups and more inspections than less complex products. Theseadditional demands on the various support activities generally cause relativelycomplex products to be undercosted and relatively simple products to beovercosted. In addition, products that require a relatively large number of parts,unique parts and relatively more, long or complex machine setups tend to beundercharged with overhead while products that require relatively few parts,common parts, relatively few setups, short or simple setups tend to beovercharged.

The generalizations in the previous paragraphs are summarized in Exhibit 7-1.The effects of product volume differences and product sized differences areillustrated in the examples below. The effects of differences in productcomplexity are illustrated in some of the problems at the end of this chapter.

EXHIBIT 7-1

SUMMARY OF COST DISTORTIONS

THAT TEND TO OCCUR IN TRADITIONAL COST SYSTEMS

TYPE OF

DIVERSITY

PRODUCT TYPE OR

CHARACTERISTIC

TYPE OF COST DISTORTION

THAT TENDS TO OCCUR IN

TRADITIONAL COST SYSTEMS

Production volume Low Volume specialty Undercost, i.e., too little overhead is

allocated to these products.

High Volume main line Overcost, i.e., too much overhead isallocated to these products.

Product Size Small Undercost


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Large Overcost

ProductComplexity

Complex design Undercost

Simple design Overcost

Product Materialsrequirements

Requires many, or uniqueparts, i.e., only used on a

single product.

Undercost

Requires few, or commonparts, i.e., same part used on

many products.

Overcost

Product Machinesetup requirements

Requires many, long orcomplex machine setups.

Undercost

Requires few, short orsimple machine setups.

Overcost

THE LOGIC OF ABC

Activity based costing is based on the following ideas. First, designing,producing and distributing products and services requires many activities to beperformed. Performing these activities requires resources to be purchased andused. Purchasing and using resources causes costs to be incurred. Restated inreverse order, the ABC logic is that resources generate costs, activitiesconsume resources and products consume activities. Thus, a company'sactivities are identified, then costs are traced to these activities (or activity cost

pools) based on the resources that they require. Then, costs are assigned, or

traced from each of these activity cost pools to the company's products (orservices) in proportion to the demands that each product (or service) places oneach activity. In ABC, a measure of the relevant activity volume is used to traceeach type of costs, rather than exclusively using measurements (or allocation

bases) related to the volume of the products or services produced. Using thislogic, ABC tends to solve the problems created by traditional cost or inventoryvaluation methods. The ABC logic is illustrated in Figure 7-1.


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There are still two stages in assigning costs to products in a manufacturingenvironment, i.e., 1) from service departments (activities) to producingdepartments, and 2) from producing department activity cost pools to products.

What About Fixed and Variable Costs In ABC?

The traditional concepts of fixed and variable costs are frequently de-emphasized in activity based costing. This is because the ABC logic looks atcosts from a long run perspective while the traditional fixed/variable cost

behavior methodology is based on a short run perspective. The ABC designer

explicitly recognizes that all costs tend to be variable in the long run.Therefore, one of the objectives of ABC is to determine the main causes ofthese long run cost variations. ABC designers attempt to answer the followingquestion. What creates the demand for the output of each of the company'smain activities?

The Rule of One


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To help managers understand the conceptual difference between the long runand short run perspectives, Cooper and Kaplan utilize an idea they refer to asthe "Rule of One". According to this rule, if a support department, or activity,uses only one unit of a particular type of resource, such as one person or onemachine, then the cost of that resource can be classified as fixed. However, ifmore than one unit of the resource is required, then classifying the resource costas fixed is not beneficial for product costing purposes. Something caused thedemand for the resource to be greater than one. Perhaps this driver can beidentified and used to trace the costs more accurately to the products or servicesthat ultimately consume the resource through activities. Although some activitycosts tend to be fixed, i.e., not respond to short run changes in activity volume,these fixed costs represent management commitments that are made to supporta past, present or expected future activity level. Generally, all costs are driven

by something, even if the driver appears to be inactive.

Can ABC Include Fixed and Variable Costs?

Does the de-emphasis on the fixed-variable cost methodology in ABC meanthat activity cost cannot be separated into short run fixed and variable costcategories? The answer is that fixed and variable activity costs can be identifiedand traced to products and services using separate activity based rates. One

potential advantage of using separate rates for fixed and variable costs is thatidle capacity (or unused resource) costs can be identified for each activity if theactivity rates are based on practical capacity rather than normal or plannedactivity volume (See the note on denominator activity levels for more on thisissue). There is another potential advantage in the area of cost control. If ABCis used as the company's inventory valuation method, it would allow varianceanalysis to be performed for each activity.

Should ABC Include Fixed and Variable Costs?

The answer to this question is controversial. Some critics argue that thefixed/variable cost methodology should be eliminated because it motivatesmanagers to add more business volume and variety in an attempt to lower thefixed costs per unit without adequately considering the long run effects.However, the additional product variety and diversity tends to cause the socalled fixed costs to increase, which defeats the original purpose. Thus, thewhole process is much like a dog chasing it's tail.4 This is an interesting issuethat we will return to in Chapter 11.

ACTIVITY VOLUME
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Activity volume refers to an input or output measurement of the quantity ofwork performed to accomplish an activity. These activity volumemeasurements may represent the frequency, duration or physical volume of anactivity.5 However, the key difference between traditional costing and activity

based costing is that ABC uses both production volume and non productionvolume activity measures to trace costs to products. Some examples ofcommon activities and representative activity measures are presented in Exhibit7-2.

EXHIBIT 7-2

EXAMPLES OF ACTIVITY COST POOLS AND ACTIVITY

MEASURES

ACTIVITY COST POOL POTENTIALLY USEFULACTIVITY MEASURES PROBABLE COSTCLASSIFICATION*

Machining parts Number of machine hours. Unit level.

Purchasing Number of purchase ordersor ordering hours.

Product or batchlevel.

Receiving and Storing Number of purchase ordersor shipments received. Product or batchlevel.

Engineering Number of engineeringwork orders or hours.

Product level.

Packing Number of shipments,number of cubic feet or

packing hours.


Shipping Number of pounds shipped. Product or batchlevel.

Machine Setup Number of setups or setup Batch level.
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time.

Materials handling Number of times handledor material handling hours.


Inventory control andmaterials planning

Number of part numbers oradministrative hours.


Inspection and quality control Number of inspections orinspections time.


* This classification scheme is discussed below.

A key idea in ABC is to find an activity measure for each activity that is closelyrelated (correlated) to the activity costs involved. As indicated in Exhibit 7-2, a

production volume related measure might be appropriate for some types ofcosts, (e.g., machine hours for machining ), but non-production volume relatedmeasures are more appropriate for other types of activity costs. For example,the number of purchase orders might be an appropriate choice as the activitymeasure for purchasing costs, while the number of engineering work ordersmight be a more appropriate basis for tracing engineering costs. The costclassification scheme referred to in the right hand column of Exhibit 7-2 isdiscussed below.

HOW ARE ACTIVITY MEASURES CHOSEN?

ABC designers normally use interviews with knowledgeable managers todefine activities, cost pools and cost driver relationships. Although thestatistical tools discussed in Chapter 3 might also be used to aid in this process,there are some serious problems that limit their usefulness for this purpose.First, analyzing short run data may produce very misleading results. This is

because performing correlation analysis with short run data is not likely toreveal the drivers of long run variable costs, i.e., the costs identified as fixedcosts in traditional costing. Another key idea in ABC is that reducing thevolume of a particular activity measurement will not necessarily have a shortrun effect on the cost of the activity. Reductions in activity requirements maysimply create idle or excess capacity. Data collected for a longer period (e.g.,two or three years) might be more useful for identifying drivers and activity


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measures for long run variable costs, but the data would have to be adjusted toremove the influence of non stationary factors such as changes in production

processes, inflation and seasonal variations. As indicated in Chapter 3, thesefactors can cause autocorrelation which tends to confuse rather than clarify therelationships involved.

There is a second potential problem when attempting to use statisticalcorrelation analysis to identify cost drivers and activity measures to representthem. The overall correlation between an activity measure and the overalldemands placed on the activity by the company's products may be fairly high,although the correlation of the activity measure with the demands of somespecific products is relatively low. For example, if ninety-eight percent of acompany's products require short machine setups, (e.g., one hour) while theother two percent require long setups, (e.g., eight hours) then, the overallcorrelation between the number of setups required and setup costs would

probably be fairly high. However, assigning setup costs to products on the basisof the number of setups would tend to undercost the products that require longsetups and overcost the products that require short setups. The main point ofthis discussion is that accurate cost tracing requires high correlation betweenthe activity measure and the demands of each specific product, not just highoverall, or average correlation.6

ABC COST HIERARCHY

A cost classification scheme, sometimes referred to as the ABC cost hierarchy,places all costs into one of the following categories:7

1. Unit level - the cost of an activity required once each time a unit ofproduct is produced.

2. Batch level - the cost of an activity required each time a batch of productsis produced.

3. Product level - the cost of an activity required to support a specific typeof product.

4. Facility level - the cost of an activity associated with maintaining thefacility or plant.

5. Customer level - the cost of an activity required to support a specificcustomer.
http://maaw.info/Chapter7.htm#Footnote%206%23Footnote%206http://maaw.info/Chapter7.htm#Footnote%207%23Footnote%207http://maaw.info/Chapter7.htm#Footnote%206%23Footnote%206http://maaw.info/Chapter7.htm#Footnote%207%23Footnote%207


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Batch and Product LevelActivities

Although it is not clear how each activity cost would be classified by aparticular company, the probable cost classifications for the activities in Exhibit7-2 are indicated in the right-hand column of the exhibit. Most of the examples

in the exhibit are either product or batch level activities. If an activity istriggered mainly by the orders, lots, or batches of products produced, then it fitsinto the batch level category. For example, if the activities associated with

purchasing, receiving and storing materials are initiated mainly by productionorders for the production of batches of products, then these are batch levelactivities. On the other hand, if these same activities are performed mainly tokeep an average inventory of raw materials available without regard forspecific batches, then they might be classified as product level activities.

Facility and Customer Level Activities

Examples of customer level activities include accounts receivable, specialpackaging, distribution or shipping requirements and certain types of non-routine customer services. Examples of facility level costs include buildingmaintenance, property taxes and insurance, plant security and the plantmanager's salary. Most of the facility level costs are common to all productsand according to one view need not be assigned to products for managementdecision purposes. Others disagree and consider full cost to be moreappropriate. We will not dwell on this controversy except to note that it is oneof the many unresolved issues in accounting.

What's the Point of the Cost Hierarchy?

The ABC cost classification scheme helps emphasize the difference betweentraditional costing and activity based costing. In assigning cost to products,traditional costing treats all manufacturing costs as unit level costs, thereforethey are referred to as production volume based (PVB), or unit basedallocations. On the other hand, ABC recognizes that many of the support costsin a company are either related to activities associated with producing batchesof products, or to other activities that are performed to support specific

products. In addition, traditional costing treats marketing, distribution andcustomer service costs as period costs, while ABC traces, or attempts to trace,these product level and customer level costs to products and customers.

DISTINCTION BETWEEN ACTIVITIES, DRIVERS AND ACTIVITY

MEASURES


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Conceptually, the three terms activity, driver and activity measure havedifferent meanings although these terms are frequently used interchangeably inaccounting literature. The purpose of this section is to clarify the conceptualdistinction between activities, drivers and activity measures.

Activities

Activities represent the types of work performed in an organization. Forexample, purchasing represents a main activity for a company. The activitieschosen in the ABC design process usually represent main activities that aremade up of many sub-activities, tasks and sub-tasks. For example, manydifferent types of work must be performed in the purchasing department, but allof this work may be conveniently classified as purchasing so that thecomplexity of the ABC design is kept to a manageable level. The differenttypes of activities, along with some examples, are summarized at the top ofExhibit 7-3.

EXHIBIT 7-3

ABC CONCEPTS AND TERMINOLOGY

Activities - A type of work or function.

Type Definition Examples

Main activitiesA major type of work,function or high levelactivity.

Purchasing raw materials.

Sub activities

A lower level type ofwork, or activity thatsupports a main activity.

Preparing purchasedorders.

TasksA minor type of work thatsupports a sub activity.

Calling vendors.

Sub tasks Part of a task.

Dialing a vendor's phone

number.

Drivers - Whatever causes the need for activities to be performed.



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Primary drivers

The initial cause of anactivity that requiresresources, i.e., whatevercreates the demand for an

activity.

Company's overallobjectives, customerdemands and productspecifications.

Secondary drivers

A resource consumingactivity that is caused bya previous activity orevent.

Purchasing raw materials,preparing purchase orders.

Activity measures - A unit of measure chosen to represent an activity volume.


Frequency measuresThe number of times anactivity is performed.

Number of purchaseorders, number ofengineering work orders.

Duration measuresThe time consumed

performing the activity.

Ordering hours,engineering hours,machine hours.

Physical measuresThe quantity of a resource

processed by an activity.Cubic feet packed, poundsshipped.

Cost and Activity Drivers

Cost drivers and activity drivers are essentially the same. A driver is anunderlying cause of a cost. Normally, whatever drives an activity also drivesthe costs of the activity. Conceptually, there are primary drivers and secondarydrivers. A primary driver represents the initial cause of an activity. A secondarydriver represents an activity or event that is caused by a previous activity orevent. For example, the primary drivers of purchasing costs may be factors

such as customer demands, product design characteristics (e.g., number of partsrequired) and the number of vendors selected. Therefore, purchasing istechnically a secondary driver of purchasing costs. This terminology issummarized in the middle section of Exhibit 7-3.

To obtain a better grasp of these concepts consider the following idea. All of acompany's functions and activities require resources that generate costs,


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therefore all activities are cost drivers. However, all functions and activities areperformed to support the company's objectives, e.g., to generate profits,increase market share etc., thus all functions and activities are technicallysubordinate to these primary drivers. Activities merely represent secondary costdrivers, although the distinction between primary and secondary is likely to beforgotten or ignored after the system is designed. It is also useful to note thatalthough activities are cost drivers, drivers do not have to be activities. Driversmay be events or other phenomena.

Activity Measures

Conceptually, an activity measure is not necessarily an activity, or a cost driveror an activity driver. An activity measure is instead a unit of measurementchosen to represent the activity volume and the primary driver. The activitymeasure provides the basis for tracing or linking the activity costs to the

products that consume the activity.

To understand the difference between the activity measure and the activitydriver, consider the following example. The number of purchase orders might

be chosen to represent the volume of work performed by the purchasingdepartment, but the number of purchase orders is driven by whatever drives the

purchasing activity. Primary, or higher level drivers are likely to be such thingsas the number of products produced, the number of raw materials and partsrequired for each product, whether the parts are common to many products orunique requirements for a single product and the number of vendors involved.Thus, to say that the number of purchase orders is the driver for purchasingcosts tends to confuse the issue. Although ordering causes costs, the number of

purchase orders is secondary. The number of purchase orders is a dependentvariable because it is caused by something else.8 However, since there may not

be a convenient measure of the primary driver, or drivers, the number ofpurchase orders often serves as a reasonably accurate substitute for tracingpurchasing cost to products.

Another example may help to clarify the point. The number of direct laborhours is frequently used in traditional cost systems as the basis for allocatingoverhead costs to products. As a result, accountants frequently say that directlabor time is the cost driver. However, the number of direct labor hoursdepends upon, or is caused by, the level of production activity which in turn isdriven by the company's objectives and customer demands. Thus, the numberof direct labor hours is simply a convenient activity measure chosen torepresent production activity.


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The lower section of Exhibit 7-3 summarizes the terminology that relates toactivity measures. There are different types of measures including frequency,duration and physical measurements. Simple frequency measures that indicatethe number of times an activity is performed are appropriate when eachoccurrence of an activity requires the same amount of time and resources, e.g.,where each purchase order requires the same amount of time to prepare on astandard form. Duration measurements and physical measurements are moreappropriate where the time or resources needed to perform an activity are notuniform.

THE ABC TECHNIQUE

FOUR STEPS IN DESIGNING AN ABC SYSTEM OR SUB-SYSTEM 9

The concepts discussed in the previous sections of this chapter can be

summarized into four steps. Designing an ABC model, system or sub-systemrequires: 1) identifying a company's main activities, 2) determining the primaryand secondary drivers for these activities, 3) aggregating activities intohomogenous cost pools and 4) selecting activity measures to represent each

pool. Homogeneous activity costs are those costs that are consumed in the sameproportions. Recognizing these relationships allows the designer to combinehomogenous costs into a single cost pool to simplify the system. Although thisconcept is somewhat vague when stated in this simple way, it should becomeclear to you after studying the examples presented below.

THREE STEPS TO OBTAIN ABC COSTS

After the system has been designed, ABC costs per unit can be calculated usinghistorical costs or budgeted costs. ABC calculations can be based on annualactivity costs obtained from historical records, or budget estimates made for asubsequent period. In either case, three steps are required to determine unitABC costs once the data is available. These steps include:

1) Calculate the activity overhead rates for each activity cost pool by dividingthe total annual cost of each cost pool by the total annual quantity of the

activity measure associated with each pool. More precisely in equation form:

Rj = Annual costs of activity j Annual quantity of activity j

where: Rj = the activity overhead rate for activity j.j = the number of the activity.


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If historical information is used to develop ABC unit costs, i.e., data from aprior period, then the annual costs and quantities in the calculation areestablished by the prior period activity levels achieved. If the ABC system isdesigned with budgeted data, then the annual cost estimates and annualquantities of the activity measures would depend on the capacity level chosen.Popular alternatives include practical capacity, normal or average capacity, and

planned volume.

2) Determine the total annual costs of each product by multiplying the activityoverhead rates by the activity quantities associated with each product asfollows,

Ci = Di + G(Rj)(Aji)

where: Ci = Total annual cost of product i.

Di = Direct cost of product i.Aji = Quantity of activity j consumed by product i.Rj = the activity overhead rate for activity j.

j = the number of the activity.i = the number of the product.

G = Greek sigma or summation sign meaning "the sum of".

3) Calculate each product's unit costs by dividing the total annual costs for eachproduct i by the number of units of product i produced.

ABC unit cost for product i = Ci Units of product i.

These three steps are illustrated in the examples provided below.

COMPARING TRADITIONAL PVB AND ABC SYSTEMS

A variety of illustrations could be provided to show how product costdistortions occur in traditional production volume based (PVB) costing andhow these distortions are eliminated when activity based costing is used. Tworelated examples are provided to show how product volume differences and

product size differences tend to affect product costs. Some other types of costdistortions appear in the problems provided at the end of this chapter. Althoughthe examples are based on manufacturing firms, similar cost distortionsfrequently occur in service organizations.

Example 7-1: Effects of Production Volume Differences


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Assume that Company A produces two products, V1 and V2 with the annualproduction volumes and product characteristics presented in Exhibit 7-4.10 Toemphasize the key issues involved without unnecessary complications, assumethat the firm has only one production department so that all service departmentcosts are allocated to this single department in stage 1 cost allocations.11 Thissimplifying assumption allows us to ignore the first stage allocations that wouldonly distract from the issue that we want to examine. To further simplify theillustrations, we will also assume that the activity costs are perfectly correlatedto the activity measures chosen. Of course this is an unrealistic assumption, butwhen there are only two products, it allows us to isolate the cost distortionscaused by production volume differences and product size differences

precisely.

EXHIBIT 7-4

ANNUAL PRODUCT DATA FOR COMPANY A

PRODUCT RELATED DATAV1 V2

Annual production quantity in unitsMaterial cost per unitDirect labor hours per unitDirect labor cost per hour

Number of purchase orders required per yearNumber of engineering work orders required

per yearNumber of machine setups required per year

100$50

1$10

14

2

1,000$50

1$10

28

4

The company's main activities have been combined into five activity cost poolsalong with appropriate activity measures based on management interviews.These five cost pools and the activity measurements associated with each cost

pool appear in Exhibit 7-5.

EXHIBIT 7-5

ANNUAL ACTIVITY COSTS FOR COMPANY A

ACTIVITYANNUAL

COSTS ACTIVITY MEASURE

Purchasing and receivingEngineeringMachine setup

$24,00018,00024,600

Number of purchase ordersNumber of engineering work

orders


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Machining, power &maintenanceMaterials planning & handlingTotal factory overhead costs

22,00011,000

$99,600======

Number of machine setupsNumber of direct labor hoursNumber of materials dollars

The way this illustration is designed, we can further simplify the problem byaggregating, or combining these five cost pools into only two homogeneouscost pools, one for non-production volume related costs and one for productionvolume related costs. This is possible because the consumption proportions forthe three non-production related costs pools (purchasing/receiving, engineeringand setups) are the same and the consumption proportions for the two

production related cost pools (machining/power/maintenance, and materialsplanning/ handling) are the same. Since each unit of V2 requires twice as muchof each type of non-production related costs as each unit of V1, these three cost

pools can be combined into a single homogeneous cost pool and traced toproducts using any one of the three activity measures, i.e., number of purchaseorders, engineering work orders or setups. Each of these measures reflects the 2to 1 consumption ratio. Since each unit of V2 requires the same amount ofdirect material and direct labor as V1, the two production volume related cost

pools can be combined and traced to products using either direct labor hours ormaterials dollars. Both of these measures reflect the 1 to 1 consumption of

production volume related resources. The activity costs and measurements aftercombining the homogeneous cost pools are presented in Exhibit 7-6.

EXHIBIT 7-6ANNUAL ACTIVITY COSTS FOR COMPANY A

COMBINED HOMOGENEOUS COST POOLS

ACTIVITY POOLANNUAL

COSTSACTIVITY MEASURE

Non-production volumerelated

Production volume relatedTotal factory overhead costs

$66,60033,000

$99,600

Number of purchase ordersNumber of direct labor hours

Calculating ABC Costs for Company A

Step 1: Calculating Activity Overhead Rates Rj = Annual costs of activity j

Annual quantity of activity j


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Activity overhead rates for the two cost categories in Example 7-1 arecalculated as follows:

1. Non-production volume related = $66,600 3* = $22,200 per purchaseorder.

* Total purchase orders = 1 for V1 and 2 for V2.

2. Production volume related = $33,000 1,100* = $30 per direct labor hour.

* Total direct labor hours = 100 for V1 and 1,000 for V2.

Steps 2 and 3: Determining Total Annual Cost Ci = Di + 3(Rj)(Aji) And

Unit Cost For Each Product

The calculations for steps 2 and 3 are presented in Exhibit 7-7. In step 2 theactivity overhead rates are multiplied by the quantities of the appropriateactivity measures to obtain the overhead costs traced to each product. Then instep 3, the unit ABC costs are determined by dividing the cost traced to each

product by the annual production quantities from Exhibit 7-4, i.e., 100 units forV1 and 1,000 units for V2. Direct material and direct labor costs are alsoincluded in the exhibit to show the total unit cost for each product. As indicatedat the bottom of Exhibit 7-7, the unit ABC costs are $312 for V1 and $134.40for V2.

Comparing ABC With Traditional PVB CostingFor Products V1 and V2

Now suppose Company A uses the traditional production volume based (PVB)costing approach where all overhead costs are allocated to products using directlabor hours as a single allocation basis. Then the total overhead rate would becalculated by dividing the total activity overhead costs in Exhibit 7-5 (orExhibit 7-6) by the total number of direct labor hours, i.e., 1,100 total unitsmultiplied by 1 hour per unit. This calculation produces a total overhead rate of$90.55 per direct labor hour ($99,600 1,100 DLHs = 90.54545). Overheadcosts for each product are $90.55 since each product requires 1 direct labor

hour. This is very different from the ABC unit overhead cost of $252 for V1and $74.40 for V2 that are calculated in Exhibit 7-7. Adding direct material anddirect labor costs of $60 provides a total unit cost of $150.55 for each product.Thus, the traditional costing approach would understate the unit cost of the lowvolume product V1 by $161.45 and overstate the unit cost of the higher volume

product V2 by $16.15.


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EXHIBIT 7-7

COMPANY A

COSTS TRACED TO PRODUCTS V1 AND V2

USING AN ACTIVITY BASED COST (ABC) SYSTEM

COST POOL OR

CATEGORY

ACTIVITY RATE

MULTIPLIED

BY QUANTITY

OF ACTIVITY

MEASURE(Rj)(Aji)

C1=COST

TRACED

TO V1

ABC

UNIT

COST

V1*

C2=COST

TRACED

TO V2

ABC

UNIT

COST

V2**

1. Non-production

volume related:

($22,200)(1 PO)

($22,200)(2 PO'S)

$22,200 $222.00

$44,400 $44.40

2. Productionvolume related:

($30)(100 DLH)($30)(1,000 DLH)

3,000 $30.0030,000 30.00

Total Overhead

$25,200 $252.00 $74,400 $74.40

3. Direct Material: ($50)(100)($50)(1,000) 5,000 50.00 50,000 50.00

4. Direct Labor: ($10)(1hr)(100)($10)(1hr)(1,000)

1,000 10.0010,000 10.00

Totals

$31,200=======

$312.00======

$134,400=======

$134.40======

* C1 = $6,000 + ($22,200)(1PO) + ($30)(100DLHs) = $31,200. ABC unit cost for V1 = $31,200 100units.** C2 = $60,000 + ($22,200)(2POs) + ($30)(1,000DLHs) = $134,400. ABC unit cost for V2 = $134,400 1,000 units.

Using Proportions Rather than Activity Rates


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A different way to solve relatively simple ABC problems is use proportions asillustrated in Figure 7-2 below. Although the non-production volume relatedcosts could be combined as above, each activity cost pool is kept separate inFigure 7-2 to provide a somewhat different view of the solution. The

proportions used are based on the data in Exhibit 7-4. For example, V1 required1 purchase order and V2 required 2 purchase orders, therefore purchasing andreceiving costs are allocated 1/3 to V1 and 2/3 to V2.

Why Traditional Production Volume Based Allocations Distort Product

Costs

To understand why the traditional production volume based (PVB) approachdistorts product costs per unit, consider the more detailed PVB unit costscalculated in Exhibit 7-8. This exhibit illustrates the cost allocations obtained ina traditional PVB system where direct labor hours are used as the allocation

basis. The separate overhead cost pools are maintained to show where thedistortions occur. Therefore separate overhead rates are needed for each pool.
http://maaw.info/Figure7-2Large.htm


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Dividing the annual costs of the non-production volume related pool ($66,600from Exhibit 7-6) by 1,100 direct labor hours generates a rate of $60.5455 perdirect labor hour. Of course the rate for the production volume related pool isstill $30 per hour, i.e., $33,000 1,100, because the activity measure for this

pool is direct labor hours in both the ABC and PVB systems.

EXHIBIT 7-8

COMPANY A

COST TRACED TO PRODUCTS V1 AND V2 USING A

TRADITIONAL PRODUCTION VOLUME BASED (PVB) COST

SYSTEM

COST POOL

OR

CATEGORY

ACTIVITY RATE

MULTIPLIED BYQUANTITY OF

ACTIVITY

MEASURE

COST

ALLOCATED

TO V1

PVBUNIT

COST

V1*

COST

ALLOCATED

TO V2

PVBUNIT

COST

V2**

1.Non-productionvolumerelated:

($60.5455)(100DLH)($60.5455)(1,000)

$6,054.55 $60.55$60,545.45 $60.55

2. Productionvolumerelated:

($30)(100 DLH)($30)(1,000)

3,000.00 $30.0030,000.00 30.00

TotalOverhead

$9,054.55 $90.55 $90,545.45 $90.55

3. DirectMaterial:

($50)(100 units)($50)(1,000)

5,000.00 50.0050,000 50.00

4. DirectLabor:

($10)(1hr)(100 units)($10)(1hr)(1,000)

1,000.00 10.0010,000 10.00


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Totals

$15,054.55========

$150.55======

$150,545.45========

$150.55======

* PVB unit cost for V1 = $15,054.55 100 units.** PVB unit cost for V2 = $150,545.45 1,000 units.

Production volume based allocations based on direct labor hour proportions areillustrated in Figure 7-3 below for each activity cost pool.

We can see from Exhibit 7-8 and Figure 7-3 that each unit of V1 and V2receive the same amount of cost in each overhead cost category. This is

because each product requires the same number of direct labor hours per unit(i.e., 1 hour each). At first, this may appear to be a fair and accurate way toallocate overhead. However, since Company A produces ten times as manyV2's as V1's, traditional PVB costing assigns ten times as much overhead coststo V2 as it assigns to V1. More specifically, V2 receives ten elevenths
http://maaw.info/Figure7-3Large.htm


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(1,000/1,100) or 90.9% of the overhead, while V1 receives only one eleventh(100/1,100) or 9.1%. This distorts the product costs per unit because V2consumes only two thirds of the non-production volume related activities , i.e.,2 out of 3 purchase orders, 8 out of 12 engineering work orders and 4 out of 6setups, while V1 consumes the other one third. The resulting unit costdistortions are summarized in Exhibit 7-9 where ABC and PVB unit costs arecompared.

EXHIBIT 7-9

COMPANY A

ABC AND PVB UNIT COST COMPARISONS

Cost Pool

or

Category

ABC

Unit

Cost V1

PVB

Unit

Cost V1

Amount V1

PVB Unit

Cost isUnderstated

ABC

Unit Cost

V2

PVB Unit

Cost V2

Amount V2

PVB Unit

Cost isOverstated

1. Non

productionvolumerelated $222 $60.55 $161.45 $44.40 $60.55 $16.15

2.Production

volumerelated 30 30.00 0 30.00 30.00 0

Totaloverhead $252 $90.55 $161.45 $74.40 $90.55 $16.15

3. Directmaterial 50 50.00 0 50.00 50.00 0

4. Directlabor 10 10.00 0 10.00 10.00 0

Totals $312

====

$150.55

======

$161.45

======

$134.40

======

$150.55

======

$16.15

=====

The unit cost comparisons in Exhibit 7-9 reveal that the high volume productV2 subsidizes the low volume product V1. Each high volume product isovercosted by $16.15 while each low volume product is undercosted by$161.45. Since Company A produces only 100 units of V1, the distortion perunit is more significant for V1 than for V2. The graphic illustration in Figure 7-


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4 shows this in a somewhat more dramatic way. The unit cost distortion thatoccurs for V1 is greater than the traditional PVB unit cost estimate.

Although the unit cost distortions are not equal, the total cost distortions arealways equal, except for small rounding errors. The approximate equality of the

distortions for Company A can be verified by multiplying the unit costdistortions by the number of units involved, i.e., (100)(161.45) isapproximately equal to (1,000)(16.15). To avoid the rounding error, we cancompare the total costs in Exhibits 7-7 and 7-8, i.e., the total understatement forV1 is 31,200 - 15,054.55 = $16,145.45, while the total overstatement for V2 is150,545.45 - 134,400 = $16,145.45.

Note from Exhibit 7-9 that the production volume related costs are not distortedby the traditional PVB approach. This reinforces the point made earlier that aproduction volume related basis may be an appropriate activity measure fortracing certain types of overhead costs to products, although it cannot be used


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as the only basis in cases where all costs are not consumed in proportion toproduction volume.

Example 7-2: Effects of Product Size Differences

Assume that Company B produces two products V2 and V3 where Product V2is the same small high volume product that Company A produces. However,V3 is a larger size, high volume product that requires more direct material anddirect labor because of it's size, but no additional support from purchasing,engineering or setups. Also assume that Company B has the same cost structureas Company A except for the differences between the two companies related to

production volume and product size. Activity costs are still perfectly correlatedto the activity measures chosen for the ABC system.

The data for Company B are presented in Exhibits 7-10 and 7-11. The sametwo aggregated cost pools used for Company A can also be used for CompanyB because the consumption proportions are the same for each of the three non-

production volume related activities. The products consume all three non-production volume related activities in the same proportions. If V3 consumed of the purchase orders, 1/3 of the engineering work orders and 1/5 of thesetups, then we would not be able to combine these costs into a singlehomogeneous pool.

EXHIBIT 7-10ANNUAL PRODUCT DATA FOR COMPANY B

PRODUCT RELATED DATAV2 V3

Annual production quantity in unitsMaterial cost per unitDirect labor hours per unitDirect labor cost per hour

Number of purchase orders requiredNumber of engineering work ordersrequired

Number of machine setups required

1,000$50

1$10

284

1,000$500

10$10

284


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EXHIBIT 7-11

ANNUAL ACTIVITY COSTS FOR COMPANY B

SEPARATE AND COMBINED HOMOGENEOUS COST POOLS

ACTIVITYANNUAL

COSTSACTIVITY MEASURE

Purchasing and receivingEngineeringMachine setup

Non-production volume related

Machining, power &maintenance

Materials planning & handlingProduction volume relatedTotal factory overhead costs

$32,00024,00032,800

$88,800

220,000110,000

330,000$418,800=======

Number of purchase ordersNumber of engineering work

ordersNumber of machine setupsNumber of purchase orders

Number of direct labor hours

Number of materials dollarsNumber of direct labor hours

Calculating ABC Costs for Company B

Step 1: Calculating Activity Overhead Rates Rj = Annual costs of activity j

Annual quantity of activity j

Activity overhead rates for the two cost categories in Example 7-2 are

calculated as follows:

1. Non-production volume related = $88,800 4* = $22,200 per purchaseorder.* Total purchase orders = 2 for V2 and 2 for V3.

2. Production volume related = $330,000 11,000* = $30 per direct labor hour.* Total direct labor hours = 1,000 for V2 and 10,000 for V3.

EXHIBIT 7-12

COMPANY B

COST TRACED TO PRODUCTS V2 AND V3

USING AN ACTIVITY BASED COST (ABC) SYSTEM


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COST POOL ORCATEGORY

ACTIVITY RATEMULTIPLIED BYQUANTITY OFACTIVITYMEASURE (Rj)(Aji)

C2=COSTTRACED

TO V2

ABCUNITCOST

V2*

C3=COSTTRACED

TO V3

ABCUNITCOSTV3**

1. Non-productionvolume related:

($22,200)(2 PO'S)($22,200)(2 PO'S)

$44,400 $44.40$44,400 $44.40

2. Productionvolume related:

($30)(1,000 DLH)($30)(10,000 DLH)

30,000 $30.00300,000 300.00

Total Overhead

$74,400 $74.40 $344,400 $344.40

3. Direct Material: ($50)(1,000 units)($500)(1,000 units)

50,000 50.00500,000 500.00

4. Direct Labor: ($10)(1hr)(1,000)($10)(10hrS)(1,000)

10,000 10.00100,000 100.00

Totals

$134,400=======

$134.40======

$944,400=======

$944.40======

* C2 = $60,000 + ($22,200)(2POs) + ($30)(1,000DLHs) = $134,400. ABC unit cost for V2 = $134,400 1,000 units.** C3 = $600,000 + (*$22,200)(2POs) + ($30)((10,000DLHs) = $944,400. ABC unit cost for V3 =$944,400 1,000.

Steps 2 and 3: Determining Total Annual Cost Ci = Di + 3(Rj)(Aji) AndUnit Cost For Each Product

The calculations for steps 2 and 3 are presented in Exhibit 7-12.

Comparing ABC With Traditional PVB CostingFor Products V1 and V2


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Exhibit 7-13 illustrates the cost allocations obtained for Company B intraditional PVB costing where direct labor hours are used as the allocation

basis. The separate overhead cost pools are maintained, as in the previousexample, to show where the distortions occur. Thus, separate overhead rates areneeded for each pool. Dividing the annual cost of the non-production volumerelated pool ($88,800 from Exhibit 7-11) by 11,000 direct labor hours generatesa rate of $8.0727 per direct labor hour. Of course the rate for the productionvolume related pool is still $30 per hour, i.e., $330,000 11,000, because directlabor hours are used as the activity measure for this pool in both the ABC andPVB calculations.

EXHIBIT 7-13

COMPANY B

COST TRACED TO PRODUCTS V2 AND V3 USING A

TRADITIONAL PRODUCTION VOLUME BASED (PVB) COST

SYSTEM

COST POOL

OR

CATEGORY

ACTIVITY RATE

MULTIPLIED BY

QUANTITY OF

ACTIVITY

MEASURE

COST

ALLOCATED

TO V2

PVB

UNIT

COST

V2*

COST

ALLOCATED

TO V3

PVB

UNIT

COST

V3**

1.Non-productionvolumerelated:

($8.0727)(1,000)($8.0727)(10,000)

$8,072.70 $8.07$80,727.00 $80.73

2. Productionvolumerelated:

($30)(1,000 DLH)($30)(10,000)

30,000.00 $30.00300,000.00 300.00

TotalOverhead

$38,072.70 $38.07 $380,727.00 $380.73

3. DirectMaterial:

($50)(1,000 units)($500)(1,000 units)

50,000.00 50.00500,000 500.00


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4. DirectLabor:

($10)(1hr)(1,000)($10)(10hrs)(1,000)

10,000.00 10.00100,000 100.00

Totals $98,072.70========

$98.07======

$980,727========

$980.73======

* PVB unit cost for V2 = $98,072.70 1,000 units.** PVB unit cost for V3 = $980,727 1,000 units.

Exhibit 7-13 shows that in PVB costing each unit of V3 receives ten times asmuch overhead costs as V2 in each overhead cost category, i.e., ten eleventhsor 90.9% for V3 as opposed to one eleventh or 9.1% for V2. This is becauseeach unit of V3 requires ten direct labor hours while each unit of V2 requiresonly one hour. The PVB approach distorts product costs because V3 consumesonly fifty percent of the non-production related support, i.e., 2 out of 4

purchase orders, 8 out of 16 engineering work orders and 4 out of 8 setups. Theresulting unit cost distortions are summarized in Exhibit 7-14 where ABC andPVB unit costs are compared. The PVB approach understates the unit cost ofthe relatively small product V2 by $36.33 and overstates the unit cost of therelatively large product V3 by $36.33. The unit cost distortions are equal

because the production volumes for V2 and V3 are equal.

EXHIBIT 7-14COMPANY B

ABC AND PVB UNIT COST COMPARISONS

Cost Pool or

Category

ABC Unit

Cost V2

PVB Unit

Cost V2

Amount V2

PVB Unit

Cost

Understated

ABC Unit

Cost V3

PVB Unit

Cost V3

Amount

V3

PVB Unit

Cost

Overstated

1. NonProductionvolumerelated

$44.40 $8.07 $36.33 $44.40 $80.73 $36.33

2. Productionvolumerelated

30.00 30.00 0 300.00 300.00 0

Totaloverhead

$74.40 $38.07 $36.33 $344.40 $380.73 $36.33


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3. Directmaterial

50.00 50.00 0 500.00 500.00 0

4. Direct labor 10.00 10.00 0 100.00 100.00 0

Totals$134.40

======

$98.07

=====

$36.33

=====

$944.40

======

$980.73

======

$36.33

=====

Comparing the Unit Cost of Product V2 in Companies A and B

The different cost assignments to product V2 in Companies A and B arecompared in Exhibit 7-15. The comparative data shows that ABC costing

produces the same unit cost of $134.40 in both companies. This preciseequality occurs because of the way the examples are designed. Remember thatwe assumed that the activity costs are perfectly correlated with the activitymeasures chosen and that the two companies have the same cost structure. Of

course these are not realistic assumptions, but they enable us to clearly see thatthe nature of the PVB cost distortion for a particular product depends on theproduct's characteristics relative to the other products the company produces. Inthe examples above, PVB costing overstates the unit cost of V2 in Company A

because it is a high volume product relative to V1. However, in Company B,the PVB approach understates the unit cost of V2 because V2 is a small productrelative to V3.

Continuation Of The V-Product Sequence

Two additional illustrations related to products V1, V2 and V3 are included inthe practice problems that appear at the end of this chapter. Problem 7-1continues this sequence of examples with a Company C that produces productsV1 and V3. Since V1 is a small, low volume product and V3 is a large, highvolume product, the direction of the resulting cost distortions is easy to predict.

Problem 7-2 provides a fourth company in this sequence. This problem extendsthe V-product sequence to a Company D that produces all three products. Inthis company, Product V2 has conflicting characteristics in terms of the biastowards over or undercosting. V2 is a small, high volume product in Company

D. In Company A, V2 is the low volume product, but size is not an issue. InCompany B, it is the small product, but production volume is not an issue.Problem 7-2 reveals that the nature of the product cost distortions becomeimpossible to predict as the number of products and product characteristicsincrease.


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EXHIBIT 7-15

COMPARING THE DISTORTIONS

FOR PRODUCT V2 IN COMPANIES A AND B

COMPANY A COMPANY B

Cost Pool or

Category

ABC Unit

Cost V2

PVB

Unit Cost

V2

Amount V2

PVB Unit

Cost is

Overstated

ABC Unit

Cost V2

PVB Unit

Cost V2

Amount V2

PVB Unit

Cost is

Understated

1. Nonproductionvolume related

$44.40 $60.55 $16.15 $44.40 $8.07 $36.33

2. Production

volume related

30.00 30.00 0 30.00 30.00 0

Total Overhead $74.40 $90.55 $16.15 $74.40 $38.07 $36.33

3. Directmaterial

50.00 50.00 0 50.00 50.00 0

4. Direct labor 10.00 10.00 0 10.00 10.00 0

Totals$134.40======

$150.55======

$16.15=====

$134.40======

$98.07=====

$36.33=====

CAM-I

CONSORTIUM FOR ADVANCED MANUFACTURING -

INTERNATIONAL12

WHAT IS CAM-I?

CAM-I is an acronym that stands for Consortium for Advanced Manufacturing- International. The consortium (pronounced, kan-sor-she-am) is made up ofindustrial organizations, government agencies, universities and professionalaccounting firms that formed in 1972 to work together in a variety of research

programs. Although most of CAM-I's research programs are related toengineering and production, one program referred to as cost managementsystems (CMS) is related to accounting and more specifically to the material

presented in this chapter.

The Cost Management Systems Program (CMS)


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The CMS program was organized in 1986 to improve management planningand control systems. To aid in the development and implementation of CMS,CAM-I published a conceptual design document in 1988 that focuses onmanaging costs through emphasis on the activities performed within acompany.13 Thus, activity based accounting provides the foundation for theCMS conceptual design. The main goals of the CMS program are to helpcompanies develop systems that are more proactive in the areas of planning,managing and reducing costs before the costs are incurred, as well as todevelop systems that more accurately trace costs to products. To accomplishthese goals, CAM-I's activity accounting system is developed around a data

base concept where data is captured only once to satisfy multiple requirements.In addition to helping companies develop pilot ABC projects, CAM-I helpscompanies change from traditional management systems (purchasing,

production and distribution) to just-in-time systems (JIT), then flexiblemanufacturing systems (FMS) and finally computer integrated manufacturing(CIM). These concepts and systems are discussed in the next chapter.

CONTROVERSIAL ISSUE: HOW SHOULD ABC BE USED?

Whether a company should use a single cost system, or multiple cost systems isone of the many controversial questions discussed in recent accountingliterature.14 For example, some accountants have argued that traditional costsystems are satisfactory for external reporting, therefore there is no compellingreason to replace traditional general ledger cost systems with more complexand more expensive ABC systems. When a separate ABC system is used formanagement purposes, ABC product costs are calculated only once per year, ormore often if changes are made in the production process, but it is notnecessary for detailed activity based costs to flow through perpetual inventoryaccounts. External users of financial statements do not need to know which

products are profitable, thus using ABC in the ledger simply overloads theaccounting system with unnecessary detail. On the other side of the issue,advocates of single systems have argued that using two separate systems will

provide two answers to every product cost related question and tend to confusemanagement. A practical solution, according to this group, is to use CAM-I's

data base concept where activity data are captured once and then used toproduce the necessary reports for both external and internal purposes. Althoughno definitive answer can be given for this question, most of the ABC systems inuse today are separate from the firms' general ledger cost systems. Therefore,the current consensus appears to support separate systems.15
http://maaw.info/Chapter7.htm#Footnote%2013%23Footnote%2013http://maaw.info/Chapter7.htm#Footnote%2014%23Footnote%2014http://maaw.info/Chapter7.htm#Footnote%2015%23Footnote%2015http://maaw.info/Chapter7.htm#Footnote%2013%23Footnote%2013http://maaw.info/Chapter7.htm#Footnote%2014%23Footnote%2014http://maaw.info/Chapter7.htm#Footnote%2015%23Footnote%2015


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ABC AND THE DICHOTOMY OF CAPITALISM

The development of activity based costing over the last ten years has beenmotivated by a number of factors and trends that are related to the competitiveframework outlined in Chapter 1.16 Some of these factors include: 1) rapid

advancements in technology and increasing automation, 2) a strategy of someglobal competitors to be more focused, combined with an emphasis on just-in-time practices, and 3) increasing demands for higher quality and customerresponsiveness.

TECHNOLOGY AND AUTOMATION

Obtaining the potential advantages of rapidly increasing technology requiresautomating manufacturing processes. However, automation generally increasesthe fixed, committed or long run variable costs, relative to the direct labor and

other short run variable costs. As a result, increasing automation tends toincrease the cost distortions produced by traditional cost systems. This trend

promotes the use of ABC to obtain more accurate product costs.

FOCUSED FACTORIES AND JIT

Many communitarian companies, (particularly Japanese) are more focused inthat they produce fewer products in a just-in-time environment. Theseorganizational characteristics allow Japanese companies to obtain lower andmore accurate product costs than companies that have a considerable amount of

product diversity. As we shall see in Chapter 8, support costs (i.e., traditionalindirect costs) are not only lower in just-in-time systems relative to traditionalmanufacturing systems, but also tend to become direct cost. Therefore,companies that produce hundreds of products and account for them in thetraditional manner cannot obtain product costs that are as accurate as the costsobtained by companies that are more focused and also apply the concepts ofJIT.

One result of these company differences is that the focused manufacturerssometimes appear to be underpricing and dumping products when they are

merely pricing products competitively based on lower and more accurateproduct costs combined with a long run emphasis on building market share.There have been cases where diversified manufacturers discontinued producinghigh volume, main line products because they appeared to be unprofitable.17ABC serves as a partial solution to this problem. At least companies withdiverse product lines can eliminate the cross subsidies introduced by traditionalcost systems. In this way ABC can help less focused companies obtain a better


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grasp of which products are profitable so that they are not tempted to dropprofitable main line, high volume products and expand the production of lessprofitable low volume specialty products.

QUALITY AND CUSTOMER RESPONSIVENESS

Companies that have embraced the communitarian concepts have not only beenmore focused than individualistic companies, they have also been able to obtainhigher quality and greater responsiveness to customer demands. Thesecompetitive advantages were obtained by following the communitarianconcepts, attitudes and practices outlined in Chapter 1. As we will see in thenext chapter, teamwork and cooperation are the building blocks of a just-in-time continuous improvement system. One aspect of the activity basedapproach that we have only alluded to thus far is the potential link betweenactivity based concepts and the just-in-time philosophy. This potentialconnection provides another motivation for developing the ABC methodology.Conceptually this takes us beyond activity based costing into the domain ofactivity based management (ABM). ABM is a broader concept than ABC andcontinues to evolve from the CMS conceptual design developed by CAM-I. Wewill examine the similarities and differences between JIT and ABM in the nextchapter.

FOOTNOTES

1 The source of the term activity based costing is attributed to John DeereCompany and appeared in a Harvard Business School Case (187-107)

published in 1987. Robin Cooper and Robert Kaplan quickly adopted the ABCterminology and the rest of the world followed their lead. An older term usedfor the ABC approach is transaction costing. Although the terminology isrelatively new, the ideas can be traced back to around 1910 in articles written

by Alexander Hamilton Church. SeeRelevance Lost, Chapter 3 for a discussionof Church's ideas and references. (Relevance Lost Main). (See MAAW's ABCtopic).

2 Technically, ABC is a sub-system if it is combined with the other componentsof a cost system. See Exhibit 2-1 to see where ABC fits into a cost system.

3 This idea is discussed in more depth by Cooper, R. and R. S. Kaplan. 1991.The Design of Cost Management Systems: Text, Readings and Cases. PrenticeHall: 275-276.
http://maaw.info/RelevanceLostMain.htmhttp://maaw.info/ABCMain.htmhttp://maaw.info/Exhibit2-1.htmhttp://maaw.info/RelevanceLostMain.htmhttp://maaw.info/ABCMain.htmhttp://maaw.info/Exhibit2-1.htm


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4 See Johnson, H. T. 1989. Professors customers and value: Bringing a globalperspective to management accounting.Proceedings of the Third AnnualManagement Accounting Symposium, (American Accounting Association): 16.(Summary).

5 These alternative types of measurements appear in Exhibit 7-3 and arediscussed later in this chapter.

6 This point is discussed by Cooper, R. 1989. The rise of activity costing - Partthree: How many cost drivers do you need, and how do you select them?

Journal of Cost Management(Winter): 34-46; and Kaplan, R. S. 1993.Research opportunities in management accounting.Journal of Management

Accounting Research (5): 1-14. (Summary).

7 For a more elaborate discussion of this cost classification scheme, see Cooper,

R. 1990. Cost classification in unit-based and activity-based manufacturing costsystems.Journal of Cost Management(Fall): 4-14.

8 For the source of this distinction, see Brimson, J. A. 1991.ActivityAccounting: An Activity-Based Approach (John Wiley & Sons): 121.

9 See footnote 2.

10 For the purpose of this example, i.e., to show the typical cost distortions thatcan occur in traditional cost systems, it does not matter if this is historical data

or budgeted data.11 Even though there is only one production department, stage 1 allocations arestill needed to accurately determine the costs of providing support services ifself services and reciprocal services are involved.

12 Although the organization has always been referred to as CAM-I, the originalname of the consortium was Computer Aided Manufacturing - International.

13 See Callie Berliner and James A. Brimson, editors. 1988. Cost Management

for Today's Advanced Manufacturing: The CAM-I Conceptual Design. HarvardBusiness School Press. (See the CAM-I Main page).

14 For example, see Martin, J. R. 1994. A controversial-issues approach toenhance management accounting education.Journal of Accounting Education(Winter): 59-75. (Summary).
http://maaw.info/ArticleSummaries/ArtSumJohnson89.htmhttp://maaw.info/Chapter7.htm#Exhibit%207-3%23Exhibit%207-3http://maaw.info/ArticleSummaries/ArtSumkaplan93.htmhttp://maaw.info/Chapter7.htm#Footnote%202%23Footnote%202http://maaw.info/CAM-IMain.htmhttp://maaw.info/ArticleSummaries/ArtSumMartin94.htmhttp://maaw.info/ArticleSummaries/ArtSumJohnson89.htmhttp://maaw.info/Chapter7.htm#Exhibit%207-3%23Exhibit%207-3http://maaw.info/ArticleSummaries/ArtSumkaplan93.htmhttp://maaw.info/Chapter7.htm#Footnote%202%23Footnote%202http://maaw.info/CAM-IMain.htmhttp://maaw.info/ArticleSummaries/ArtSumMartin94.htm


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15 See Hughes, S. B. and K. A. Paulson Gjerde. 2003. Do different cost systemsmake a difference?Management Accounting Quarterly (Fall): 22-30.(Summary). For an exception, see Mangan, T. N. 1995. Integrating an activity-

based cost system.Journal of Cost Management(Winter): 5-13. (Summary).

16 These factors and trends are discussed in the CAM-I conceptual design. Alsosee Howell, R. A. and Stephen R. Soucy, 1987. The new manufacturingenvironment: Major trends for management accounting.Management

Accounting(July): 21-27.

17 According to Johnson, this happened in the semiconductor industry. SeeJohnson, H. T. 1989. Managing costs: An outmoded philosophy.

Manufacturing Engineering(May).

QUESTIONS

(See the ABC Questions for a longer, but similar set of questions with linksto find answers.)

1. Is activity based costing an inventory valuation method or a costaccumulation method?

2. Do traditional cost systems tend to apply too much, or too little overhead

cost to high volume products in multiproduct companies assuming otherproduct characteristics are equal? Why?

3. Do traditional cost systems tend to apply too much, or too little overheadcosts to small products in multiproduct companies assuming other productcharacteristics are equal? Why?

4. Which of the following products will be overcosted in a traditional costsystem? A company produces two products. Product X is a small, high volume

product while product Y a large, low volume product.

5. How does the treatment of engineering, marketing and distribution costsdiffer between traditional cost systems and ABC systems?

6. How does the treatment of customer service costs differ in ABC systems asopposed to traditional cost systems?

7. Describe the logic underlying ABC systems.
http://maaw.info/ArticleSummaries/ArtSumHughesGjerde03.htmhttp://maaw.info/ArticleSummaries/ArtSumMangan95.htmhttp://maaw.info/ABCquestions.htmhttp://maaw.info/ArticleSummaries/ArtSumHughesGjerde03.htmhttp://maaw.info/ArticleSummaries/ArtSumMangan95.htmhttp://maaw.info/ABCquestions.htm


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8. How is the concept of fixed and variable costs viewed in an ABC system?

9. What is the "rule of one"?

10. Do the terms production volume and activit

abc vs traditional costing

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