Activity-Based Costing

Classic Pen Company Case

Problems With Simple Cost Accounting

Systems: The Classic Pen Company
Example
Classic Pen had been the low-cost producer

of blue pens and black pens, with profit

margins exceeding 20% of sales
Several years ago Classic Pen expanded
their business by extending their product line
into products with premium selling prices

The Classic Pen Company Example

Five years ago red pens were introduced

Last year purple pens were added

The same basic production technology

Could be sold at a price that was 3% higher than for
blue and black pens
Could be sold at a 10% price premium

The controller of Classic Pen was disappointed

with the most recent quarters financial results

Overall profitability for all four together had decreased

The red and purple pens, however, were more profitable
than the blue and black pens

Total Profitability by Product

Units
Price
Sales
Material
Labor
Overhead
Total Mfg.
Expenses

Gross
Margin

G.M. %

Blue
50,000

Black
40,000

Red
9,000

Purple
1,000

$ 4.50

$ 4.50

$ 4.65

$ 4.95

$225,000 $180,000

$41,850

Total
100,000

$4,950 $451,800

75,000
30,000

60,000
24,000

14,040
5,400

1,650
600

150,690
60,000

90,000
195,000

72,000
156,000

16,200
35,640

1,800
4,050

180,000
390,690

$ 30,000 $ 24,000

$ 6,210

$ 900 $ 61,110

13.3%

13.3%

14.8%

18.2%

13.5%

Concern at Classic Pen

The controller of Classic Pen wondered whether

the company should continue to deemphasize the
blue and black commodity products and keep
introducing new specialty colored pens
Classics manufacturing manager commented on
how the introduction of colored pens had changed
the production environment:

Everything ran smoothly when producing just

blue and black pens in long production runs

Difficulties started when the red pens were

introduced and required more changeovers

Changes Caused by New Pens

(1 of 2)

Making black ink was simple; there was not even

a need to clean out the residual blue ink from
the previous run if enough black ink was
dumped in to cover it up
Red required Classic to stop production, empty
the vats, clean out all remnants of the previous
color, and then start the production of the red ink
Even small traces of the blue or black ink
created quality problems
The ink for the purple pens also had demanding
specifications, though not quite as demanding
as the red ink

Changes Caused by New Pens

(2 of 2)

Classic Pens was also spending more time on

purchasing and scheduling activities and
keeping track of existing, backlogged, and future
orders
Classics manufacturing manager was
concerned about rumors that new colors may be
introduced in the near future

He did not think they had any more capability to

handle additional confusion and complexity in the
operations

Last years new computer system helped to

reduce some of the confusion

Pen Production At Classics

Pen production at the factory involved:

Each product had a:

Preparing and mixing the ink for the different color pens
Inserting the ink into the pens in a semiautomated
process
Packing and shipping the pens in a manual stage
Bill of materials that identified the quantity and cost of
direct materials required for the product
Routing sheet that identified the sequence of operations
required for each operating step

This information was used to calculate the labor

expenses for each of the four products

From this information, it was easy to calculate the direct

materials costs and direct labor costs for each color pen

Classics Indirect Cost Allocation

Because it was a small company and historically

had produced only a narrow range of products,
Classic used a simple costing system

All the plants indirect expenses were aggregated at

the plant level and allocated to products based on
each products direct labor cost
Currently the cost systems overhead burden rate was
300% of direct labor cost
Before the new specialty products were introduced,
the overhead rate was only 200% of direct labor cost

Classic Pens Cost System

Classics management accountants designed the

system years ago when:

Production operations were mostly manual

Total indirect costs were less than direct labor costs
Classics two products had similar production volumes
and batch sizes

Given the high cost of measuring and recording

information, the accountants at the time judged
correctly that a complex costing system would cost
more to operate than the benefits it would provide

A Changed Production
Environment

Direct labor costs have decreased and indirect

expenses have increased as a result of
automation
As custom low-volume products, such as red
and purple pens were added, Classic needed:

More scheduling
More setups
More quality control personnel
A computer to track orders and product specifications

An Outdated Cost System

Classic operates with only a single cost center, the

plant

Most complex companies use many cost centers for cost

accumulation

Even if Classic Pen used multiple production and

service department cost centers, it could still
encounter severe distortions in its reported product
costs:

In an environment of high product variety, using only unitlevel drivers (such as direct labor costs) to allocate
overhead costs to products could lead to product cost
distortion

Reason for Cost Distortions (1 of 3)

A complex factory has a much larger production support
staff because it requires more people to:

schedule machine and

production runs
perform setups
inspect produced items after
setup
move materials
ship orders
expedite orders
rework defective items

design new products

improve existing products
negotiate with vendors
schedule materials receipts
order, receive, and inspect
incoming materials and parts
update and maintain the much
larger computer-based
information system

A complex factory generally also operates with higher

levels of idle time, setup time, overtime, inventory, rework,
and scrap

Reason for Cost Distortions (2 of 3)

Because the factory has the same physical

output, it has roughly the same cost of materials
(ignoring the slightly higher acquisition costs for
smaller orders of specialty colors and other
materials)
Because all pens are about the same complexity,
each pen would require the same number of
direct labor hours and machine hours to produce
The Classic Pen Company factory has about the
same property taxes, security costs, and heating
bills as before, but it has much higher indirect and
support costs because of its more varied product
mix and complex production tasks

Reason for Cost Distortions (3 of 3)

On a per unit basis, high-volume standard blue and black

pens require about the same amount of direct labor costs
(the allocation basis) as the low volume color pens
Therefore, the traditional costing system would report
essentially identical product costs for all products,
standard and specialty, irrespective of their relative
production volumes
This would hold true even if the cost system had
multiple production and service cost centers
Clearly, however, considerably more indirect and support
resources are required on a per-unit basis for the lowvolume, newly designed products than for the highvolume, standard blue and black pens

Activity-Based Cost Systems

Activity-based cost systems have been

developed to eliminate this major source of cost
distortion
Activity-based cost (ABC) management systems
use a simple two-stage approach similar to but
more general than traditional cost systems
The next slide compares the essential elements
of the two systems

Traditional v. ABC System

Traditional:

Uses actual departments or

cost centers for accumulating
and redistributing costs

Asks how much of an

allocation basis (usually
based on volume) is used by
the production department

Service department
expenses are allocated to a
production department based
on the ratio of the allocation
basis used by the production
department

ABC:

Uses activities, for

accumulating costs and
redistributing costs
Asks what activities are
being performed by the
resources of the service
department

Resource expenses are

assigned to activities based
on how much of the
resource is required or used
to perform the activities

Tracing Costs to Activities

Heres how an ABC system works, using

the Classic Pen Company as an example:

The controller started an analysis of indirect

expenses, beginning with indirect labor
The controller interviewed department heads in
charge of indirect labor and found that the
people in these departments performed three
main activities

Indirect Labor Activities (1 of 2)

50% of indirect labor was involved in what the

controller called handle production runs

Scheduling production orders

Purchasing, preparing, and releasing materials
Inspecting the first few units produced each time the
process was changed to a new-colored pen

40% of indirect labor actually performed the

physical changeover from one color pen to another,
an activity that she labeled perform setups

Change to Black pens takes 2.4 hours

Change to Red or Purple pens takes 5.6 hours

Indirect Labor Activities (2 of 2)

10% of the time was spent on activities the

controller called support products: maintaining
records on the four products, such as:

Making up the bill of materials and routing information

Monitoring and maintaining a minimum supply of raw
materials and finished goods inventory for each
product
Improving the production processes
Performing engineering changes for the products

First Step in Design of An ABC System

1)

2)

As she conducted the interviews, the controller

was performing the first two steps for designing
an activity-based cost system:
Develop the activity dictionary: the list of major
activities performed by both the factorys
human and physical resources
Obtain sufficient information to assign resource
expenses to each activity in the activity
dictionary (50% of indirect labor to handle
production runs, 40% to perform setups, and
10% to support products)

Computer System Expenses (1 of 2)

The controller next turned her attention to the

$30,000 of expenses needed to operate the
companys computer system and interviewed the
manager of the data center and the manager of
the management information system department
20% of computer expenses should be assigned
to support products, an activity already
defined in her activity dictionary, because it was
used to keep records on the four products,
including:

Production process
Associated engineering change notice information

Computer System Expenses (2 of 2)

About 80% of the computer resource was

involved in the production run activity and
seemed to relate well to the handle production
runs activity already defined:

Schedule production runs in the factory

Order and pay for the materials required in each
production run
Since each production run was made for a particular
customer, also included in this activity was the
computer time required to:
Prepare shipping documents
Invoice a customer
Collect from a customer

Other Overhead Expenses

There were three remaining categories of

overhead expense:

These expenses were incurred to supply machine

capacity to produce the pens:

Machine depreciation
Machine maintenance
Energy to operate the machines

A practical capability of 10,000 hours of productive

time could be supplied to pen production

The controller labeled this production activity run

machines

Identifying Cost Hierarchies

The controller noted that even though she had defined only
four activities for Classics indirect costs, they represented the
three different levels of the manufacturing cost hierarchy:
ACTIVITY

COST HIERARCHY

RUN MACHINES

UNIT LEVEL

HANDLE PRODUCTION RUNS

BATCH LEVEL

SETUP MACHINES

BATCH LEVEL

SUPPORT PRODUCTS

PRODUCT SUSTAINING

Finding at least one activity for each hierarchy level gave

her confidence that the complexity of the manufacturing
process could be represented well enough by the
activity-based cost system

Benefits from Half an ABC System

The ABC model was only half completed (costs

have not yet been driven down to products), yet it
had already provided some important insights:

Now the controller could see why Classic Pens was

incurring expenditures for resources instead of seeing
categories of expenses
In particular she saw how expensive activities such as
handling production runs and setting up machines were

The ABC model shifted the focus from what the

money was being spent on (labor, equipment,
supplies) to what the resources acquired by
spending were actually doing

From ABC to ABM (1 of 2)

In the past, industrial engineers at Classic Pen

had studied labor and materials usage closely:

These had been the high cost resources

They were also the primary cost categories featured by
Classics traditional cost system
The high overhead rate on direct labor seemed to
amplify any benefits from direct labor cost savings that
the industrial engineers could achieve

From ABC to ABM (2 of 2)

It would be worthwhile to have industrial engineers

study the way Classic handled and scheduled
production runs and how the employees set up
machines to uncover new opportunities for cost
reduction and process improvement projects

This is an example of operational activity-based

management (ABM), where managers use information
collected by the ABC system at the activity level to
identify opportunities for reducing costs in indirect and
support activities

Tracing Costs From Activities To

Products
The controller next turned her attention to

understanding the demands for these

activities by the four different products
By understanding how products use
activities, she would be able to relate the
cost of performing activities to individual
products

Activity Cost Drivers

Activity cost drivers represent the quantity of activities

used to produce individual products
The controller identified the following activity cost drivers
for the activities in her activity dictionary:
ACTIVITY

ACTIVITY COST DRIVER

HANDLE PRODUCTION RUNS

PRODUCTION RUNS

SET UP MACHINES

SETUP HOURS

SUPPORT PRODUCTS

NUMBER OF PRODUCTS

RUN MACHINES

MACHINE HOURS

PROVIDE FRINGE BENEFITS

LABOR DOLLARS

Completing the ABC Model (1 of 2)

Once the activity cost drivers had been

determined, the controller obtained

quantitative information on:

The total quantity of each activity cost driver

The quantity of cost driver used by each
product

Completing the ABC Model (2 of 2)

The controller now had sufficient

information to estimate a complete activitybased cost model for Classic Pens factory

She calculated the activity cost driver rate

(ACDR) by dividing the activity expense by the
total quantity of the activity cost driver
She then multiplied the activity cost driver rate
by the quantity of each activity cost driver
used by each of the four products

Activity Cost Drivers

Activity Cost
Driver

Blue

Black

Red

Purple

Total**

DL hr/unit

0.02

0.02

0.02

0.02

2,000

Mach. hr/unit

0.1

0.1

0.1

0.1

10,000

Prod. runs

70

65

50

15

200

2.4

5.6

5.6

--

Total setup hr

280

156

280

84

800

# of products

50,000

40,000

9,000

1,000

Setup time/run

**Total = per unit

X quantity

Activity Cost Driver Rates (ACDR)

Activity Activity Cost
Driver
Expense
Driver Quantity

ACDR

Handle
Production Runs

$66,000

Number of
production runs

200

$330 per

Set up machines

$33,600

Number of
setup hours

800

$42 per

Support
Products

$14,400

Number of
products

$3,600

Run Machines

$42,000

Number of
machine hours

10,000

$156,000

run

setup hr

per product

$4.20 per

machine hr

Activity Expenses Assigned

Blue

Black

Red

Purple

Total

$23,100

$21,450

$16,500

$4,950

$66,000

Set up
machines

11,760

6,552

11,760

3,528

33,600

Support
Products

3,600

3,600

3,600

3,600

14,400

Run
Machines

21,000

16,800

3,780

420

42,000

$ 48,402 $ 35,640 $ 12,498

$ 156,000

Handle
Production
Runs

Total Costs
Assigned

$ 59,460

ABC Profitability Report

The controller combined the activity expense analysis for

each product with their direct materials and labor costs
to obtain a new ABC profitability report
The results from the activity-based costing system were
quite different from the results based on the traditional
cost system
The controller now understood why the profitability of
Classic Pen has deteriorated in recent years:

The two specialty products, which the previous cost system had
reported as the most profitable, were in fact the most
unprofitable, and losing lots of money
The company had added large quantities of overhead resources
to enable these products to be designed and produced, but their
incremental revenue did not cover those costs

Total ABC Profitability by Product

Blue
Sales
Material
Labor
40%
fringe on
DL

Support
Total Mfg.
Expenses

Gross
Margin

G.M. %

Black

Red

$225,000 $180,000

$41,850

$4,950 $451,800

1,650 150,690
600 60,000
240 24,000

75,000
30,000

60,000
24,000

14,040
5,400

12,000

9,600

2,160

59,460 48,402
176,460 142,002

35,640
57,240

Purple

12,498
14,988

Total

156,000
390,690

$ 48,540 $ 37,998 $(15,390) $(10,038) $ 61,110

21.6%

21.1%

-36.8%

-202.8%

13.5%

Using ABC to Improve Profitability (1 of 2)

The ABC information provides managers

with numerous insights about how to

increase the profitability of Classic Pen:

Increase either their sales volume or prices to

compensate for the large batch and productsustaining expenses of the red and purple pens
Impose minimum order sizes to eliminate short,
unprofitable production runs
Try to increase demand for the highly profitable
black and blue pens, which could generate new
revenues that exceed their incremental costs

Using ABC to Improve Profitability (2 of 2)

Improve processes, particularly the processes

performing batch and product-sustaining activities
Manufacturing personnel can redirect their attention:

From trying to run their production equipment faster, in

order to improve the performance of unit-level activities
To learning how to reduce setup times, in order to
improve the performance of batch-level activities so that
small batches of the specialty products would require
fewer resources to produce and be less expensive

The goal of these ABM actions is to enable the company

to produce the same volume and mix of products with
fewer resources

This leads to lower costs for producing low-volume, specialty

products, and reduces the pressure to raise prices or impose
minimum order sizes on customers in order to make such
products profitable

Selecting Activity Cost Drivers (1 of 2)

Activity cost drivers are the central innovation of activitybased cost systems
They are also the most costly to measure
Particularly the quantity of each activity cost driver
used by each product
Accordingly, it is important to understand the issues
involved in selecting activity cost drivers
The selection of an activity cost driver reflects a
subjective trade-off between accuracy and the cost of
measurement
An ABC system with 50 activity cost drivers and 2,000
products would require that 100,000 data elements be
estimated

Selecting Activity Cost Drivers (2 of 2)

Because of the large number of potential activity-to-product

linkages, management accountants attempt to economize
on the number of different activity cost drivers
Activities triggered by the same event may all use the
same activity cost driver

ABC system designers choose from three different types of

activity cost drivers:

For example, preparing production orders, scheduling production

runs, performing first part inspections, and moving materials may
all use the number of production runs

Transaction
Duration
Intensity (direct charging)

The choice of a transaction, duration, or intensity cost

driver can occur for almost any activity

Transaction Drivers

Least expensive type of cost driver

Also the least accurate
They assume that the same quantity of resources is
required every time an activity is performed

For example, a transaction driver such as the number of setups

assumes that all setups take about the same time to perform

For many activities, the variation in the quantity of

resources used by each is small enough that a transaction
driver will be fine for assigning activity expenses to the cost
object

E.g., all setup times are between 30 and 35 minutes

If the amount of resources required to perform the activity

varies considerably from product to product then more
accurate and more expensive types of cost drivers should
be used

E.g., Setup times range from 30 minutes to 6 hours

Duration Drivers

Represent the amount of time required to perform an activity

Should be used when significant variations exist in the
amount of activity required for different outputs

A transaction driver such as number of setups will overcost the

resources required to set up simple products and undercost the
resources required for complex products

More expensive to implement because they require an

estimate of time needed each time an activity is performed
The choice between a duration driver and a transactional
driver is, as always, one of economics:

Balancing the benefits of increased accuracy against the costs of

increased measurement

Intensity Drivers

Directly charge for the resources used each time an activity

is performed
A duration driver, such as setup cost per hour, assumes
that all hours are equally costly but does not reflect the
higher costs that may be required on some setups:

E.g., extra personnel, more skilled personnel, more expensive

machinery

Activity costs may have to be charged directly to the

output, based on work orders or other records that
accumulate the activity expenses incurred for that output
Intensity drivers are the most accurate activity cost drivers
but the most expensive to implement
Intensity drivers should be used only when the resources
associated with performing an activity are both expensive
and variable each time an activity is performed unless the
measurements are inexpensive

Designing an ABC System (1 of 2)

Sometimes ABC system

designers get carried

away with the potential capabilities of an
activity-based cost system
For product costing and customer costing
purposes, most companies:

Limit their activity dictionary to 30 to 50 different

activities
Choose activity cost drivers that can be obtained
simply and are available within their organizations
existing information system

Designing an ABC System (2 of 2)

The goal of an ABC system should be to have

the best cost system -- not the most accurate
one
The ABC system designer should balance the
cost of errors resulting from inaccurate
estimates with the cost of measurement
Most of the benefits from a more accurate cost
system can be obtained with simple ABC
systems

Measuring The Cost

Of Resource Capacity (1 of 2)

The calculation of activity cost driver rates are

sometime based on the capacity actually used
Analysts can obtain a better estimate for the cost of
resources required to handle each production run by
dividing activity expenses by the practical capacity of
work the resources could perform
Otherwise, the activity cost driver rates overestimate
the cost of the activity provided
The cost of unused capacity should not be assigned to
products produced or customers served during a period

Measuring The Cost

Of Resource Capacity (2 of 2)

The activity cost driver rate should reflect the

underlying efficiency of the process: the cost of
resources to handle each production order
This efficiency is measured better by using the
capacity of the resources supplied as the
denominator when calculating activity cost driver
rates
Still, the cost of unused capacity should not be
ignored

Cost of Unused Capacity (1 of 2)

The cost of unused capacity remains someones or

some departments responsibility
Usually you can assign unused capacity after analyzing
the decision that authorized the level of capacity
supplied

For example, if the capacity was acquired to meet anticipated

demands from a particular customer or a particular market
segment, then the costs of unused capacity due to lower than
expected demands can be assigned to the person or
organizational unit responsible for that customer or segment

Such an assignment is done on a lump-sum basis; it will

be treated as a sustaining, not a unit-level, expense.

Cost of Unused Capacity (2 of 2)

If the unused capacity relates to a particular product line then

the cost of unused capacity is assigned to that product line,
where the demand failed to materialize
Unused capacity should not be treated as a general cost, to
be shared across all product lines
In making assignment of unused capacity costs, we trace the
costs at the level in the organization where decisions are
made that affect the supply of capacity resources and the
demand for those resources
The lump-sum assignment of unused capacity costs provides
feedback to managers on their supply and demand decisions

Fixed and Variable Expenses

Most indirect expenses assigned by an ABC

system are committed costs
Committed costs become variable via a two-step
procedure:

First, demands for resources change either because of

changes in the quantity of activities performed or
because of changes in the efficiency of performing
activities
Second, managers must make decisions to change the
supply of committed resources, either up or down, to
meet the new level of demand for the activities
performed by these resources

Activity in Excess of Capacity

If activity volumes exceed the capacity of existing

resources, the result is

Bottlenecks
Shortages
Increased pace of activity
Delays
Poor-quality work

Such shortages occur often on machines, but can also

occur in human resources who perform support activities
Facing such shortages, companies typically make
committed costs variable

They relieve the bottleneck by spending more to increase the

supply of resources to perform work
This is why many indirect costs increase over time

Decreased Demand for Resources

Demands for indirect and support resources also can

decline

Consciously through activity-based management

Inadvertently through competitive or economy-wide forces that lead
to declines in sales

Should the demands for batch and product-sustaining

resources decrease, few immediate spending reductions
will be noticed
Even for many unit-level resources, such as machines and
direct labor, reduced demands for work does not
immediately lead to spending decreases
The reduced demand for organizational resources lowers
the cost of resources used, but this decrease is offset by an
equivalent increase in the cost of unused capacity

Making Committed Costs

Variable Downward

After unused capacity has been created, committed

costs will vary downward if, and only if, managers
actively reduce the supply of unused resources
What makes a resource cost variable downward is
not inherent in the nature of the resource
It is a function of management decisions

To reduce the demands for the resource

To lower the spending on it

Managers Make Costs Fixed (1 of 2)

Organizations often create unused capacity

through activity-based management actions

Process improvement
Repricing to modify the product mix
Imposing minimum order sizes on customers

They keep existing resources in place, when

demands for the activities performed by the
resources have diminished
They also fail to find new activities that could be
done by the unused resources already in place

Managers Make Costs Fixed (2 of 2)

The organization receives no benefits from its activity-based

management decisions that reduced the demands on their
resources if capacity is not reduced or redeployed
The failure to capture benefits from activity-based
management is not because their costs are fixed

The failure occurs because managers are unwilling or unable to take

advantage of the unused capacity they have created by
Spending less on capacity resources
Increasing the volume of work processed by the capacity
resources

The cost of these resources is only fixed if managers do

not exploit the opportunities from the unused capacity they
helped to create
Making decisions based solely upon resource usage (the
ABC system) may not increase profits if managers are not
prepared to reduce spending to align resource supply with
future lower levels of demand

Problems Implementing ABC (1 of 3)

Several problems arise in practice from the

common approach to activity-based costing that
assigns many resource expenses to activities
based on interviews, surveys, and direct
observation of production and support processes

The interview and survey processes are time consuming

and costly
This front-end cost to an ABC analysis is often a
barrier to widespread ABC adoption

Problems Implementing ABC (2 of

3)
Inaccuracies and bias may affect the accuracy of cost
driver rates derived from individuals subjective
estimates of their past or future behavior
Companies must periodically repeat the interviewing
and surveying processes if they want to keep their
activity-based cost systems updated
High updating cost leads to infrequent updates of
many ABC systems and, eventually, to obsolete cost
driver estimates
Adding new activities to the system is also difficult,
requiring re-estimates of the relative amount of resource
time and effort required by the new activity

Problems Implementing ABC (3 of 3)

A more subtle and serious problem arises from the

interview or survey process
People estimating how much time they spend on a list of
activities handed to them invariably report percentages
that add up to 100%
Few individuals report that a significant percentage of
their time is idle or unused

Accordingly, the cost driver rates calculated from this

process assume that resources are working at full
capacity

But operations at capacity are more the exception

than the rule

Time-Driven ABC:
An Alternative Approach
Several companies have overcome these

problems by using a new approach for

estimating their ABC models
The insight for the new approach is simple:

Most ABC systems use a large number of

transactional cost drivers that assume each
occurrence of the event (a production run, a
customer order, a product to support) consumes
the same quantity of resources

Time-Driven ABC:
This homogeneity assumption provides

the foundation for an alternative approach

to estimating cost driver rates. The new
approach requires two new estimates:

The unit cost of supplying capacity, and

The consumption of capacity (unit times) by
each activity

Unit Cost Estimate (1 of 3)

The new procedure starts with the same

information used by a traditional ABC approach:

The cost of resources that supply capacity and

The practical capacity of the resources supplied
Practical capacity is often estimated as a
percentage (e.g., 80% or 85%) of theoretical
capacity
This estimate allows time (e.g., 15 20%) for
nonproductive time:
For personnel, time for breaks, arrival and
departure, and communication and reading
unrelated to actual work performance

Unit Cost Estimate (2 of 3)

For machines, an allowance for downtime due to

maintenance, repair, and scheduling fluctuations

With estimates of the cost of supplying capacity

and practical capacity, the analyst can calculate
the unit cost of supplying capacity:
Unit cost =
Cost of capacity supplied

Practical capacity of resources supplied

Unit Cost Estimate (3 of 3)

For example, assume that indirect labor employees

supply about 2,500 hours of labor in total each
quarter at a cost of $84,000. The practical capacity
(at 80% of theoretical) is about 2,000 hours per
quarter, leading to a unit cost (per hour) of supplying
indirect labor capacity of:

$84,000
Indirect labor cost per hour =
2000 hours
= $42 per hour

Unit Time Estimate

The second piece of new information is an estimate of time
used each time a committed resource performs a
transactional activity

Precision is not critical

Rough accuracy is sufficient
Estimates for the indirect labor from the Classic Pen
example are:

Resource
Indirect
Labor

Activity
Production Run

Unit Time
5 hours

Support Products 50 hours

Cost Driver Rate

Assume similar calculations regarding computer resources

produced estimates of $60 per hour and 2 hours per
production run
The cost driver rate for the activity, handle production
runs, can now be calculated as the costs of using indirect
labor and the computer for each production run:
Unit Cost

Unit Time

Cost Driver

Indirect Labor Resource

$42 per hour

5 hours/run

$210 per run

+ Computer Resource

$60 per hour

2 hours/run

120 per run

= Activity Cost Driver Rate

$330 per
run

Advantages of Time-Driven ABC

Managers may easily update their time-driven ABC

model to reflect changes in their operating conditions

They can incorporate the new knowledge by providing

reasonable estimates about the unit times required for
different activities for each type of product

Managers may also easily update the activity cost

driver rates

Changes in the prices of resources supplied affect the

hourly cost rate
Activity cost driver rates change when there has been a shift
in the efficiency of the activity

Tracing Marketing-Related
Costs to Customers

The costs of marketing, selling, and distribution expenses

have been increasing rapidly in recent years
Result of increased importance of customer satisfaction
and market-oriented strategies
Many of these expenses do not relate to individual
products or product lines but are associated with:
Individual customers
Market segments
Distribution channels
Companies need to understand the cost of selling to and
serving their diverse customer base

Activity-Based Pricing

Pricing is the most powerful tool a company can use

to transform unprofitable customers into profitable
ones
Activity-based pricing establishes a base price for
producing and delivering a standard quantity for each
standard product

To this base price, the company provides a menu of

options, with associated prices, for any special services
requested by the customer

Special services may be priced just to cover costs or

also to earn a margin
Activity-based pricing prices orders, not products

ABC at Service Companies (1 of 2)

Although ABC had its origins in manufacturing

companies, many service organizations today are
obtaining great benefits from this approach

In practice, the actual construction of an ABC model is

nearly identical for both types of companies
This should not be surprising since, in manufacturing
companies, the ABC system focuses on the service
component of the company

ABC at Service Companies (2 of 2)

Service companies in general are ideal

candidates for activity-based costing

Virtually all costs are indirect and appear fixed

They often do not have direct, traceable costs to
serve as convenient allocation bases
They must supply virtually all their resources in
advance to provide the capacity to perform work for
customers during each period

Implementation Issues (1 of 2)

Not all ABC systems have been sustained or contributed to

higher profitability for the company

Lack of clear business purpose

Some companies have experienced difficulties and frustrations in

building and using activity-based cost and profitability models for
some of the following reasons
The project may start in Accounting/Finance, and nobody outside the
department understands what changes need to be made and why

Lack of senior management commitment

The group (usually Accounting/Finance) that initiates the project

probably does not have the authority to make decisions about
processes, product designs, etc., without full senior management
support

Implementation Issues (2 of 2)

Delegating the project to consultants

Poor ABC model design

Consultants are usually not familiar enough with the businesss

organization and problems and may not be able to build
management consensus
The model may be too complicated to build and maintain and too
complex for managers to understand and act upon
Or the model may use arbitrary allocations that merely create
different distortions than the old system
The new data requirements may increase the workload of other
functions without increasing the benefits to them

Individual and organizational resistance to change

People may feel threatened by the suggestion that their work

might be improved
Resistance may be overt, but it may be more subtle and passive