Activity-Based Management and

Activity-Based Costing

Dr Maha Rabei
 Learning Objectives
• Identify the focus of activity-based
management
• Explain why non-value-added activities
cause costs to increase unnecessarily
• Explain why cost drivers are designated in
activity-based costing
 Learning Objectives
• Contrast activity-based costing to the
traditional cost accounting system
• Describe the types of information provided
by an activity-based costing/management
system
• Explain when it is appropriate to use
activity-based costing
 Activity-Based Management
• Activity-based management (ABM) is an approach to
management that includes:
• Focuses on activities during production and performance
process
• Identifying all major operating activities.
• Determining what resources are consumed by each
activity.
• Categorizing the activities as either adding value to a
product or service or not adding value.
• Improves the value received by customers
• Enhances profitability
ABM provides financial and operational
performance information at the activity level
that:
Is helpful for making decisions about business
segments.
Helps managers eliminate waste and
inefficiencies and redirect resources to activities
that add value to the product or service.
 Activity
An activity is a repetitive action performed
in fulfillment of a business function
 Activity-Based Management

Activity analysis Operational control

Cost driver analysis Quality management
Activity-based costing Process improvement
Performance measuremen
Continuous improvement
ABM

Activity Based Management

• External Benefits
– Increased customer value
– Enhanced profitability
• Internal Benefits
– More efficient production
– More accurate cost determination
– More effective performance evaluation
 ABM

Activity Analysis
Non-value-added activity
Value-added activity • Increases time spent on
product or service but does
• Increases worth of
not increase worth
product or service to a
customer • Unnecessary from customer
perspective
• Customer is willing to
pay for it • Can be reduced, redesigned
or eliminated without
affecting market value or
quality
 Cost Driver Analysis: Cost Hierarchy

 A cost hierarchy is a framework for classifying activities

according to the level at which their costs are incurred.
 The cost hierarchy typically has four levels:
 Unit-level activities are performed each time a unit is
produced and are generally considered variable costs.
 Batch-level activities are performed each time a batch or
production run of goods is produced.
 Product-level activities are performed to support a
particular product line.
 Facility-level activities are performed to support a facility’s
general manufacturing process and are generally fixed costs.
 ABM
Cost Driver Analysis
• Unit-level costs
– direct material, direct labor
• Batch-level costs
– setup, inspection
• Product/process-level costs
– engineering changes, product development
• Organizational or facility costs
– building depreciation, plant manager’s salary
 Bill of Activities
• A bill of activities is a list of activities and related
costs that is used to compute the costs assigned to
activities and the product unit cost.
– A bill of activities may be used as the primary
document or as a supporting schedule to calculate the
product unit cost in both job order and process costing
systems and in both manufacturing and service
businesses.
– A bill of activities for a furniture manufacturer
completing an order for 100 chairs is shown on the next
slide.
Bill of Activities
 Activity-Based Costing

Activity-Based Costing
(ABC) is a costing
approach that assigns
costs to a cost object
based on activities
performed for the cost
object

1-14
ABM
Activity-Based Costing

• Recognizes several levels of costs

• Accumulates costs into related cost pools
• Uses multiple cost drivers to assign costs to
products and services
 Steps in Designing an
Activity-Based Costing System

 Identify resource costs and

activities
 Assign resource costs to activities
 Assign activity costs to cost objects

1-16
 ABC : How it works..?
• Identify all the activities required to create the product.
• Divide the activities into cost pools, which includes all the
individual costs related to an activity—such as manufacturing.
• Calculate the total overhead of each cost pool.
• Assign each cost pool activity cost drivers, such as hours or
units.
• Calculate the cost driver rate by dividing the total overhead in
each cost pool by the total cost drivers.
• Divide the total overhead of each cost pool by the total cost
drivers to get the cost driver rate.
• Multiply the cost driver rate by the number of cost drivers.
 Traditional costing systems:

Product A Direct Costs

Indirect
Product B Direct Costs
Costs

Product C Direct Costs

Indirect costs are The Direct costs

grouped into one (or a individual are traced to
small number) of cost products are the individual
pools; a cost allocation the final cost products.
base assigns costs to objects.
the individual products
 Activity-based costing systems:

Activity 1
Product A Direct Costs

Indirect
Activity 2 Product B Direct Costs
Costs

Product C Direct Costs

Activity 3

Indirect costs are The individual

assigned (traced & Activity costs products are the final
allocated) to are allocated to cost objects & direct
various pools of products costs are traced to
activity costs. the individual
products.
 ABM

Use ABC Costing when….

1. Product Variety and Process Complexity
2. Lack of Commonality in Overhead Costs
- Some products/services use more overhead than
others
3. Problems with Current Cost Allocations
- Significant changes in process with no change
in cost allocationsChanges in Business
Environment
4. Increase in competition
- Change in management strategy
 ABM

Continuous Improvement
• Eliminates non-value-added activities to
reduce cycle time
• Makes products/performs services with zero
defects
• Reduces product costs on an ongoing basis
• Simplifies products and processes
ABC Costing Supports
Continuous Improvement
 ABM

Advantages of ABC and ABM

• Identify and monitor significant technology
costs
• Trace technology costs directly to products
• Identify the cost drivers that create or
influence cost
• Identify activities that do not contribute to
perceived customer value
 ABM

Advantages of ABC and ABM

• Illustrate the impact of new technologies on
all elements of performance
• Translate company goals into activity goals
• Analyze the performance of activities across
business functions
• Analyze performance problems
• Promote standards of excellence
 Activity Based Costing, Time-Driven Activity
Based Costing and Lean Accounting

In the past, before 1980, accounting systems had a

completely different approach.
Those systems could not support management,
planning and decision making as they were not fit
for recent ever changing competitive environment.
 Development of Recent accounting systems
• At that time, in order to deal with new challenges some
companies approached Activity Based Costing
introduced by Cooper and Kaplan in 1987 and some
others applied the lean manufacturing concept founded
on the constant elimination of waste.

• Lean accounting, based on lean thinking refers to efforts

to develop financial management based on lean
principles.
• In 2004, Kaplan "father of Activity Based Costing"
reviewed his method and accepted the criticism that ABC
requires too much work and that it is difficult for a
company to maintain it over time. Therefore, Kaplan
introduced Time-Driven ABC as a new solution, referring
to problems recognized in the ABC method.
• On the other hand, in 2005, leaders in Lean Accounting
reached an agreement on a document called "The
Principles, Practices, and Tools of Lean Accounting" in
order to develop a single and clear definition for Lean
Accounting.
 ABC
• ABC Methods were concerned with what was done in terms of
activities instead of what was spent. A number of cost pools and
a variety of cost drivers are the key differences of ABC and
traditional costing. Actually the activity cost pool is the overall
cost associated with an activity.
• In addition, the cost driver, which justifies changing the costs in
an activity cost pool over time, is a feature that affects the cost
and performance of the activity.
• It is assigning indirect costs first on activities and then on cost
objectives (product, service or costumer) what makes requests
for these indirect costs.
• The expenses of indirect resources are allocated to the
different activities via resource drivers. Besides, activity
drivers represent the consumption of activities by the
different cost objects.

• It can be said that ABC models the causal relationships

between products and the resources used in their
production and traces the cost of products according to the
activities through the use of appropriate cost drivers.
 Time-Driven Activity Based Costing
(TD-ABC)
• This method identifies the capacity of each department or
process and allocates the cost of this capacity of resource groups
over the cost object based on the time required to perform an
activity.
• If the demand for work in these departments or processes
declines, TD ABC can estimate the quantity of resources
released.
• TD-ABC captures the different characteristic of an activity by
time equations in which the time consumed by an activity is a
function of different characteristics. This equation assigns the
time and the cost of the activity to the cost object based on
characteristics of each object.
• The unit cost of used resources and time required to
perform an activity are two parameters for this method.
The time-driven approach consists of six steps:
1. Identifying cost pools and the activities for which they
are used.
2. Defining the costs of each pool
3. Estimating the practical capacity of each pool
4. Calculating cost per time unit
5. Determining the required time units for each activity
6. Calculating cost per transaction
 Lean Accounting
• The lean concept is a philosophy that non-value-adding activities
are being recognized and eliminated in lean manufacturing
systems.
• It contains a set of principles and practices aimed to reduce cost
over removal of waste and done with simplification of all
manufacturing processes.
• Then, not only non-value-adding activities in accounting
processes as well as other processes have to be removed but also
the accounting system itself should interpret the results of efforts
in lean manufacturing.
• Lean Accounting methods and tools support three key aspects of
a lean organization: visual management, value stream
management, and continuous improvement.
• The purpose of Lean Accounting includes
accounting, control, measurements, and decision-
making processes that actively support their lean
strategy.
• Also to remove the harmful impact of traditional
accounting.
• Lean accounting also eliminates waste within
the accounting processes by stripping them down
to the minimum amount of work.
 How it works?
1. Working by Value Streams.
• We focus our financial and operational reporting
around the whole value stream. We are not so
much interested in the efficiency of individual
departments, processes, or products, but we are
very interested in the productivity of value stream
as a whole.
• Ideally, a value stream starts from a sales process
and goes all the way through to purchasing,
production, and shipping.
2. Timely, Plain English Financial Reports.
The financial and operational reporting is at a value stream
level and is usually available weekly.
• Instead of the traditional, complicated financial reports,
we create “plain English” income statements that everyone
in the company can readily understand and use.
• If you have timely and understandable financial
information, the value stream leaders can quickly see
what’s happening in their business, make better decisions
leading to growth, productivity, and profits
3. Customer Value.
• The value stream team members have a clear focus
on the value created for the customers. When we
know what the customers truly value, and when we
have full control over the processes that create this
value – then we can work step-by-step to increase
the value while at the same time reducing the costs.
• Increasing value for the customers leads to
customer loyalty, unprecedented growth, and
profits.
4. Decision-Making and the Box Score
• Lean Accounting uses a “box score” which is a single page
report showing the three aspects of a value stream that determine
the operational and financial results i.e. the operational
performance measurements, the capacity usage, and a summary of
the income statement.
• he Box Score is the primary decision-making method for lean
companies.
• All routine decisions no longer use product cost information.
When decisions are made the information is entered into the box
score so as to understand the true impact of the decision on the
value stream as a whole.
• The box score shows how the decision
impacts the operational measures, the use of
people’s capacity, and the value stream
profitability. The box score financial
numbers are real. They show how much
money will go into the bank as a result of the
decisions being made.
• 5. Lean Accounting is a Lot Less Work.
• An important purpose of Lean Accounting
is to reduce the work required for the
routine accounting, control, and
measurement system so as to free up the
time of the accountants (and others) so as to
give them time to work on more strategic
activities that drive the company forwards.
 Decision making and planning

• There are many management decisions made on the

basis of information gained from ABC, Lean accounting
, and TD-ABC. Companies began to regulate their
decisions and strategy according to what they had
learned from ABC, Lean accounting , and TD-ABC.
 ABC and decision making
As an example; the greater range of demand, the greater
the variation of lot sizes of products for manufacturing
and shipping. This caused a complex management
environment and complexity required more costs to be
managed
• Based on the ABC model overhead is not just a certain
cost that has to be allocated regardless of the
complexity involved. All costs of performing an
activity are correspondingly allocated to cost objects
based on the activity cost driver.
• Consequently a more realistic view of products was
provided to support decision making.
• ABC systems enabled managers to recognize
marginal, low-volume, complex products and
any other elements that could charge the
companies with additional cost on products.
• Under this recognition they could make the
decision to stop producing these types of
products.
• Manager may recognize that they are more competitive on high-
volume and low complex products than they had thought before.
• There are many other management decisions made on the basis
of information gained from ABC.
• The new and accurate information on each product cost enables
companies to remove products involving extra activities that
cause supplementary costs if their price did not cover the
additional costs required by these activities.
• All the abovementioned examples indicate that ABC enables
the decision making process to take place at the product
level.
 Lean Accounting and decsison
making
• Lean Accounting based on lean thinking relies on
management of the overall system. In other
words: it collects costs and provides accounting
information over the value stream, which is
defined as all the activities for taking products or
services from conception to the costumer.
• Total cost of all labor, machinery and facilities,
materials and support services is counted within
the value stream.
• In Lean Accounting system, although product
cost might be calculated in some special cases,
generally the foundation for decision making
are value stream costing which collect the
required information over the value stream
 Time-Driven ABC and decision making
• A Time-Driven ABC model identifies the
capacity of each department or process and
assigns the cost of this capacity on the required
work done in the process.
• This is similar to the cost collection in the value
stream in Lean Accounting.
• Besides that, throughout the process or product,
the used and unused capacity of processes are
being calculated, which is comparable to
“productive capacity", "non-productive capacity"
• Therefore, if the demands for work in these
departments decrease because of process
optimization or any other reasons, the capacities
of resources released are being estimated.
Therefore managers would be able to manage
the free resources in the flow.
• Example; in the case of new market development,
new product introductions or rising product and
customer demands that managers might be
involved with capacity shortage, they come to
decisions on how much they will require for
handling increasing demands.
• So, decision making in TD ABC takes place on
both production and process level whereas
traditional ABC is based on actual utilization and
does not identify the idle capacity.