Activity-based costing is an exciting approach to product costing.

It provides cost system designers with

new ways to cost products, focus managerial attention, and modify behavior. This article, part four in a
series, explains how activity based cost systems take advantage of the two-stage cost tracing procedure.
It then describes five activity-based cost systems that demonstrate the range of design alternatives
available. The first two systems are quite simple and use only a few cost drivers The third system uses
seven cost drivers, and the two systems utilize many more .

This article is the fourth part of a series on activity-based costing and describes the activity-based
costing and describes the activity-based cost system‘s implemented by five different companies. The
first two systems are simple, the next somewhat more complex, and the final two quite complex. The
aim of this article is to describe the range of design alternatives available for activity-based cost systems
and to explore some practical design issues.

To help put this article in perspective, a look back at the first three parts of this series may be in order.
Part one of the series introduced the concept of activity based costing. It demonstrated that if the
product mix produced in a facility is diverse, an activity-based system will report more accurate product
costs than a traditional volume-based cost system.

Part two of the series continued the discussion of activity-based costing. It pointed out that firms that
face intense competition and have both high product diversity and low measurement costs are best
suited to take advantage of the increased accuracy offered by an activity-based costing system.

Part three discussed the factors that should be considered when designing an activity-based cost
system. In particular, it explored how many cost drivers should be used to trace the cost of resources
consumed to the products produced in addition to what types of cost drivers to use.

TWO CLASSES OF COST DRIVERS

Activity-based cost systems achieve their improved accuracy over traditional volume-based cost systems
by using two different classes of cost drivers. The underlying assumption for the first class of cost driven-
those related to the volume of production-(slit resources are consumed in direct proportion to the
timber of units produced. The underlying assumption for the second class of cost drivers-those
unrelated to the volume of production-is that no direct relationship exists between resources consumed
and the number of units produced.

Given the increased attention that activity-based cost systems have recently been attracting, a natural
question to ask Is, ”What do activity-based systems look like?” Although it is still too soon to be certain
(since only a few activity-based systems have been documented), they all appear to rely on a two-stage
allocation procedure that indirectly traces the costs of resources consumed to products. This procedure
can be illustrated by a simple diagram. (See Figure 1.)
FIVE. DESIGN CHOICES

In an activity-based cost system, five design choices have to be made:

1. Aggregating actions into activities;

2. Reporting the cost of activities;

3. Selecting the first-stage allocation bases; .

4. Identifying the activity centers; and

5. Selecting second-stage cost drivers.

To reduce the cost of measurement, the level of aggregation of actions into activities has to be
determined. For example, every time a machine is set up, new tools have to be drawn from the tool
room, inserted, and qualified. The feeds and speeds of the machine must be altered, parts moved from
inventory storage to the shop floor, the first part has to be inspected, the batch scheduled, and so on.

Aggregation. Aggregation, the first design choice, is necessary because tracing the consumption of
resources by each action to the products would be prohibitely expensive Treating collections of actions
as activities removes the need to measure and track the performance (if individual actions. For example,
all of the actions associated with setups can be treated as the activity ”setup.”

Identifying activities is important because the costs of resources consumed by each activity are traced to
products (in the second stage) using a single cost driver. As more actions are aggregated into an activity,
the ability of this single cost driver to accurately trace the consumption of resources by actions-farad~
therefore products-decreases.

For example, if the actions ”material movement” and ”setup” are treated as a single activity and traced
to products using the cost driver ”setup hours," the sys~ tem assumes that the distance moved is
directly proportional to the duration of the setup On the other hand, if the driver ”number of setups” is
used, the system assumes that the distance moved 15 the same for each setup.

If instead No distinct activities-’ ’”setup and ”material movement” --are created and to separate drivers-
for example, ”setup hours” and ”distance moved"--are used to trace the cost of these actions to the
products, the activityhas-ed system does not assume any relationship between setup duration and
distance moved This two-activity system can therefore report more accurate product costs than its one-
activity counterpart. Its cost of measurement will be higher, however er, because two sets of
measurements must be made per product (setup hours consumed and distance moved) instead of only
one (e.g., setup hours consumed).h

REPORTING THE COST OF ACTIVITIES

Once the activities have been selected, how to report the resources consumed by those activities can be
determined. The second design choice, then, is the level of aggregation in reporting the resources
consumed by each activity.

For example, the cost of the resources consumed by the activity’ ’"setup can be reported separately or
collectively. It is therefore possible to aggregate actions into activities but report the cost of those
actions separately. Reported product costs are not affected by this design choice-only the level of
reporting detail. For example, the system might report “setup" costs for product A of $6 or,
alternatively, a “machine setup" cost of S4 and a ”material movement” cost of $2.

SELECTING THE FIRST-STAGE ALLOCATION BASES

The third design choice is the way the cost system traces the cost of resources com summed by an
activity to the different kinds of activities. The costs of each kind of activity are traced to separate cost
pools. Each activity cost pool contains the

total costs of performing that kind of activity on all of the products. For example, the activity ”setup"
might be performed on two different classes

of machine. One class might require 10 1ger and more complex setups than the other. The cost system
can ignore the differences between the two machine classes

and identify only one kind of setup, or it can differentiate between the two types of machine and
identify two kinds of setup. If two different kinds of setup are

identified, the system designer has to choose how to trace the costs consumed by
the activity ”setup” to the two different machine classes. The resources consumed in setting up the two
machine classes can be mea

sure directly or estimated indirectly. If they are measured directly, then the cost system (disregarding
measurement error) will not introduce any distortion into reported product costs. If they are indirectly
estimated, then distortion can be introduced by the estimation process per part. Under this scheme,
high-usage parts have a low cost per part, while low-usage parts have a high cost per part. (See Exhibit 1
for an example of how this cost driver is calculated.)

Management selected this driver to reduce the number of low-volume parts used in the facility.
Management believed its use would increase the product designers awareness of the costs associated
with part-number proliferation and in particular the high cost associated with designing products that
relied heavily on low-usage parts. In addition, management believed that this awareness would provide
incentives to the engineers to design products that contained more high-usage parts and fewer low-
usage parts. Finally, management felt that although reducing the number of part numbers would not
reduce overhead costs immediately or in direct proportion to the reduction of part numbers, it wand
eventually result in real cost savings.

The search for simplicity. The activity-based cost system at Tektmnix was kept relatively simple because
management considered reducing the number of part numbers to be vital.

Management believed that having only two cost drivers was beneficial because it allowed the cost
system to send clear messages to the designers about what was strategically important-the reduction in
the number of different part numbers used at the facility. Management was concerned that if multiple
drivers were used, the pressure to achieve this strategic goal would be diluted or lost. Given this
orientation, management was less concerned about the accuracy of the cost system than they were
with the behavior it induced.

SIEMENS ELECTRIC MOTOR WORKS

Siemens Electric Motor Works (BMW) produces low wattage alternating current electric motors. It had
recently implemented a new strategy of selling low volumes of customized motors. This strategy was
designed to offset the lower labor rates of the Eastern Bloc countries with whom BMW competed. This
new strategy requires BMW to manufacture products in lots that vary in size from one to over 100 units.

Previously, BMW had manufactured only standard motors in large 1013. This change in strategy and
therefore its manufacturing policy had made its existing cost accounting system obsolete. in particular,
its existing cost system traced inch hint costs to the small lots and excessive costs to the large ones.

The firm's existing cost system used four (on drivers: (1) “outer-in dollars. . (2} ”direct labor hours," (3)
“machine hours.” and (4) “reported cost to date.“ Due to its volumee based orientation, this system
traced appmximatel' 100 times as much ,

. . . tor. overhead to lots containing 100 motors as it did to lots containing only one minion This system
treated each of the trim’s 600 machine types as a separate produce cost center."“’

A Special study by the company showed that about 7 percent of total costs were related to activities
associated with shop floor orders and to the management of the production of the Special components
required by custom motor Sat least part of each of the following departments’ costs were considered
driven by these activities:

° Costs Related to Order Processing --Billing --Order receiving *Product costing and bidding --Shipping‘ 0
Costs ‘related to special components ‘--Inventory handling --Product costing and bidding ----Product
development --Purchasing -Receiving --Schedu1ing and production control

Technical examination of incoming orders

Order-related costs were found to be approximately the same for each lot, regardless of its size. Special
component costs, on the other hand, were found to be dependent on the number of different special
components used by the motor in the lot.
Additional cost drivers for greater accuracy. To report more accurate product costs, management
implemented a new cost system that, in addition to the original four cost drivers, used two new ones:
”number of shop floor orders” and ”number of different special components used per lot. ”

This new cost system adopted by BMW is shown in Figure 3. The driver 1’number of shop floor orders”
charges a flat fee for each order, and the driver ”number of special-components" charges a flat fee per
different special component. Thus, a lot of one motor that contains N special components is charged the
same order and special component overhead as a lot of 10 motors, where each motor contains N special
components.

The advantage of this new cost system is that it traces costs in ways that better approximate their
consumption by products. Exhibit 2 shows the reported product cost for a lot of one motor, and Exhibit
3 the reported unit cost of the same motor if it were manufactured in a lot containing 100 units. BMW’s
activity-based cost system reports high costs for the low-volume motors and relatively low costs for the
high-volume motors. In contrast, the traditional system would have reported unit costs of about $310,
irrespective of the lot size.

The activity-based cost system at BMW was also kept simple, because management felt that the two
additional drivers corrected enough of the distortion in the existing system for their current needs.
Management had experimented with additional cost drivers, but found that they had little effect on
reported product costs. This suggests that the products manufactured in the facility are sufficiently
similar enough that the simple activity-based cost system can capture most of t e effects of product
diversity.

A MEDIUM COMPLEX ACTIVITY-BASED COST SYSTEM

John Deere Components Works (JDCW)11 produces screw machine parts. It had recently ceased to be a
captive supplier to its parent, John Deere, and was now competing for business on the outside.

The manufacturing facility was designed to produce high-volume parts. Its existing cost system was
quite sophisticated, and used three volume-related drivers to trace costs to products:

Direct labor hours; ' Machine hours; and 0 Material dollars.

Due to its volume-based orientation, this system systematically undercoated low volume and
overcastted high-volume production products. This distortion became apparent when the firm bid on
several hundred parts and won only 20 percent of them, many of which were low-volume parts.
Reacting to the outcome of these failed bids, management designed a new cost system. The new system
contained the original three volume-related drivers and four drive errs that were not related to volume:

”Setup hours” ; c ”Number of production orders"; . ”Part numbers”; and

0 ”Number of production loads.”

General and administrative costs were allocated using the value added in production. This cost system is
shown in Figure 4.

The cost driver "setup hours” was used to allocate setup-related costs to the products. The cost driver
”number of production orders” is identical to the equivalent driver used at BMW. At IDCW, however, it
is used to trace only production~ order related costs to products.

' The driver ”part numbers” creates a constant charge for each part number. This charge includes the
cost of establishing and maintaining records and system documentation plus a share of salaries in
process engineering, industrial engineering, supervision, and materials control. The principle behind this
driver is identical to the one behind the ”number of part numbers” driver in PID’s system.

The driver ”number of loads" is used to allocate the cost 'of material handling. These costs include
moving bar stock to the machines, moving the parts to the next operation, inspecting the parts, and a
share of defective material costs. The computation of the driver ”number of loads” shows an interesting
twist on the real-' township between volume-related and unrelated cost drivers. The firm moves
products in loads of a maximum size. Consequently, as the lot size increases, the number of lots that
have to be moved also increases, but in discrete steps. The cost driver ”number of loads” is therefore
only partially proportional to lot size. The

computation of the cost driver ”number of loads” was designed to handle this semi proportionality. (See
Exhibit 4.)
The change from traditional cost accounting system to an activity-based cost system had a pronounced
effect on reported product costs. The reported overhead costs of low-volume products approximately
doubled, and the overhead cost of high volume products decreased by about 10 percent. The costs
reported by the activity-based system better fit management’s intuitions about product costs. This
”better fit” increased management’s confidence that the new system was reporting more accurate
product costs.

TWO COMPLEX ACT IVITY-BASED COST SYSTEMS

Hewlett-Packard's Roseville Networks Division (RND)12 produces electronic circuit boards that allow
computers to communicate with other computers and peripheral devices.

The rapid change of technology in the last few years has reduced the life expectancy of RND's products
dramatically while simultaneously increasing the number of products produced. In recent years, the
company has introduced a new product every month. This rapid rate of product. introduction requires
an

J improved understanding of the economics of product design. The existing cost system was not
designed to provide the required cost / design insights and consequently became obsolete. _

The design engineers-reacting to the obsolescence of the existing system-54 designed their own prix ate
cost system and used the product costs it reported ‘to ” make design decisions When the accounting
department learned about this private system, they used it as the basis for their new activity-based cost
system. Over the next few years, management arid engineering continuously added new cost drivers to
the system as their understanding of the economics of design improved. By mid-1988, the system used
approximately nine drivers:

0 "Number of axial insertions”;

”N umber of radial insertions";

0 ”Number of DIP insertions"; ' 0 ”Number. of test hours";

0 ”Number of boards”; I

0 ”Number of solder joints";

. ”Number of parts";

0 ”Number of manual insertions"; and c "Number of slots.”

Additional drivers were added as management and the engineers became aware that the cost system
was not adequate for their needs.

For example, one designer designed a product that required many axial but few DIP maser tins. The cost
5} stern suggested that this product was expensive to manufacture. The engineer '5 intuition, however,
was that the product was actually inexpensive to manufacture. A subsequent study shows that axial
insertions were about one third the cost of DIP insertions. The cost system was therefore modified to
differentiate between the two types of insertion. The complexity of the activity based cost system thus
reflects the complexity of the behavior it was designed to modify: The design of products. . ,

from over 20,000 distinct components. These components were manful lots of varying sizes, from under
100 lots to over 1,000. “mt-.951 m

The facility's existing cost system traced overhead to products using aim“ labor hours. It contained five
manufacturing cost centers. support-related over head accounted for approximately 50 percent of all
overhead and 25 Percent oil ‘ total cost. Management decided to retain the existing system for
manufacture’s overhead costs, but to develop an activity-based cost system for Support Casts g

The support functions were treated as eight separate activity Centers; .

0 Raw material inventory; -W0rl<-in-process inventory; 0 Finish goods inventory; ,0 Production control;
0 Purchasing; . Setup; 0 Quality control; and 0 Manufacturing engineering. The activity-based cost
system designed for this facility contained the following cost drivers:

0 Setup hours; 0 Number of setups; 0 Average dollar value of work in process; 0 Number of direct labor
reports; 0 Sales dollars; 0 Sales units; « 0 Direct labor hours; 0 Cost of goods sold;

0 Number of incoming shipments-purchased parts; 0 Number of incoming shipments-raw material; 0

Number of outgoing shipments; 0 Number of parts purchased; 0 Number of parts produced; ' Number of
customer orders; 0 Number of purchase orders cut; 0 N . beer of supplies orders; and

* ‘ umber of purchase received.

an. r I. . . -L ‘LA‘ LA

The costs of the different activities performed in each center were traced to the cost pools using the
work effort required to perform them. These costs were then traced to the products using the number
of transactions or effort required to perform the activity for each product.

For example, the cost of the activities performed in the raw material inventory department were traced
to cost pools using the percentage of work load performed by the people in that department. The costs
were traced from the cost pools to the products by using the number of transactions generated by each
activity. For exam» plea, the number of incoming purchased parts shipments was traced using the
number of shipments. The complete structure of the activity-based cost system for this department is
shown in Figure 5.

The activity-based cost system reported product costs that were significantly different from those
reported by the traditional system. The overhead traced to products manufactured in low volumes was
up to ten times the amount previously
reported. The activity-based system at SB is complex, in part because the product mix is diverse. The
facility produces several major product lines, each of which contains hundreds of very different
products. This diversity requires a large num‘ beer of drivers to capture accurately the economics of
production.

CONCLUSION

The objective of this four-part series was to introduce and explore the concept of

activity-based costing. Part one of the series illustrated the need for activity-based

cost systems by demonstrating that traditional, volume-based cost systems can

report seriously distorted product costs when the products manufactured are

diverse. In particular, it demonstrated the effect of size and volume diversity on the

accuracy of reported product costs. In addition, Part one demonstrated that, by

contrast, activity-based cost systems can remove or reduce the distortion caused by product diversity.

Part two explained which firms were most likely to benefit from the additional

accuracy provided by activity-based cost systems. It identified the factors that support implementing an
activity-based cost system as the following:

0 Low cost of measurement for the additional data required by the activity-based cost system;
0 High levels of competition; and 0 A very diverse product mix. _

Part three explored the factors that affect the choice of the number of cost drivers to use and what kind
of cost drivers to use to achieve a desired level of accuracy. ‘ '

Part three identified several factors that affect the number of drivers required, including:

'0 The desired level of accuracy of reported product costs; . The degree of product diversity; . The
relative cost of different activities;

reported. The activity-based system at SB is complex, in part because the product mix is diverse. The
facility produces several major product lines, each of which contains hundreds of very different
products. This diversity requires a large num‘ beer of drivers to capture accurately the economics of
production.

CONCLUSION

The objective of this four-part series was to introduce and explore the concept of

activity-based costing. Part one of the series illustrated the need for activity-based

cost systems by demonstrating that traditional, volume-based cost systems can

report seriously distorted product costs when the products manufactured are

diverse. In particular, it demonstrated the effect of size and volume diversity on the
accuracy of reported product costs. In addition, Part one demonstrated that, by

contrast, activity-based cost systems can remove or reduce the distortion caused by product diversity.

Part two explained which firms were most likely to benefit from the additional

accuracy provided by activity-based cost systems. It identified the factors that support implementing an
activity-based cost system as the following:

0 Low cost of measurement for the additional data required by the activity-based cost system;

0 High levels of competition; and 0 A very diverse product mix. _

Part three explored the factors that affect the choice of the number of cost drivers to use and what kind
of cost drivers to use to achieve a desired level of accuracy. ‘ '

Part three identified several factors that affect the number of drivers required, including:

'0 The desired level of accuracy of reported product costs; . The degree of product diversity; . The
relative cost of different activities;

o The degree of volume diversity; and o The use of imperfectly correlated cost drivers.

The factors affecting what kind of cost drivers to use include: o The cost of measuring the quantities
associated with each driver;
'3 The correlation of the selected driver to the actual consumption of the activity by the products; and

0 The behavior induced by the use of a cost driver.

One major finding in Part three was that, in most environments, volume diversity is likely to be the
dominant source of distortion in reported product costs. This article, the fourth part of the series,
explains how activity-based cost systems take advantage of the two-stage cost tracing procedure. It then
described five activity-based cost systems that were selected to demonstrate the range of design
alternatives available. The first two systems discussed were simple and had

only a few cost drivers. The third system used seven cost drivers, and the last two systems utilized even
more. '

Competitive pressures. All of the activity-based cost systems described in this article were introduced by
firms that faced intense competitive pressure. PID was reacting to the entry of the Japanese companies
to their marketplace, BMW to the low labor rates of the Eastern Bloc, IDWC reacted to ceasing to be a
captive supplier, $8 to a loss in profitability, and RND to changing technology.

The complexity of the design of activity-based cost systems appears -' to be driven by a multitude of
factors, including the objectives that management has in mind when designing the cost system. If a
single objective dominates, as in the case of PID, then only a few cost drivers may be required to achieve
the desired objective. As the design objectives, however become more complex, as they did at RND,
then multiple drivers may be required.

In addition, the complexity of a system appears to be driven by the diversity of the product mix. BMW,
whose product mix has a relatively low product diversity, requires only a few cost drivers to achieve the
desired level of accuracy;

RND and SB, on the other hand, which have high product diversity, require many drivers.
Cost drivers that adjust for volume diversity. Every activity-based cost system described in this article
contained at least one cost driver designed to adjust for volume diversity. What is particularly
interesting is the way the drivers were designed to handle different kinds of volume diversity. In PID, the
driver adjusted for the volume diversity allocated with the volume of parts used in the facility. It was
used to trace 50 percent of all overhead costs to products. In RND, a similar driver was used, but it
traced only a small portion of overhead. In the Other companies, several volume-diversity drivers were
used. These adjusted for activities that are performed simultaneously on multiple product units (such as
”cutting production orders” and “setting up machine"). The ”number of loads" driver utilized at JDCW
was interesting because it demonstrated how cost drivers can be designed to handle activities that are
only partly pr0portional to the size of the batch.15 ' Activity-based costing is a relatively new concept:
The oldest known system has been in use for only a few years. Despite the newness of these systems
and their rarity, they have recently attracted a lot of attention. Activity-based costing is an exciting
approach to product costing that provides cost system designers with new ways to cost products, focus
managerial attention, and modify behavior.