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Distinguishing unit-level and higher-level resources: adding a strategic dimension to the traditional activity hierarchy.

Activity-based costing (ABC) is a systematic method of assigning the cost of activities to products, services, customers, or any other cost object. Activity-based management (ABM) is using ABC information to control the cost of activities, such as personnel and overhead cost. The fundamental assumption of ABM is that activities cause cost. Thus, ABM focuses management attention on controlling activities, not dollars. While traditional cost systems focus on the worker, ABM focuses attention on the work.

The activity hierarchy, as shown in Exhibit 1, has proven useful for controlling activities in both service and manufacturing firms. In this hierarchy, activities are classified based on their relation to the organization's output, which is the unit-level cost driver. In Exhibit 1, the unit-level cost drivers are units of output, patient-days, and billable hours for production, hospital, and accounting firm settings. The cost of unit-level activities in the hierarchy is directly related to output. In the case of a hospital, for example, food and linen service is a unit-level activity because the cost of providing this activity varies directly with the number of patient-days.

Moving up the hierarchy, the cost of higher-level activities is essentially independent of output but related to higher-level cost drivers. Exhibit 2 highlights these differences. The cost of batch-level activities, such as setup cost in a production setting, varies more with batches of output than with the number of units produced. Similarly, hospital admissions is a batch-level activity because the cost of admissions varies less with patient-days than with a higher-level cost driver, such as the number of admissions. Product-sustaining cost is related to the range or diversity of products or services offered by an organization. Product design cost in a manufacturing firm, for example, is related more to the diversity of the firm's product lines than to units of output. Facility-level cost (i.e., the cost of being in business) is denoted as a "strategic" cost because this resource fulfills an organization's long-range commitment. Facility-level cost is not related to an operational or manageable cost driver. It can be changed only by making a long-term, strategic change in the organization. For example, occupancy cost is primarily fixed unless the organization moves its facilities or significantly alters its volume of operations. Similarly, executive manager salaries, another facility-level cost, can only be changed substantially with a strategic restructuring of the management team.


This hierarchy provides a useful framework to understand and control the cost of activities in almost any organization.

Extending the Traditional Activity Hierarchy

The activity hierarchy has extended conventional cost behavior analysis by recognizing the multidimensional nature of cost drivers in organizations. Conventional cost-behavior analysis assumes a two-dimensional world; costs are either variable or fixed. The insight of ABC is that fixed costs with respect to one cost driver, such as output, are variable with respect to other cost drivers, such as batches of output or diversity of products. Thus, cost is not uniformly variable or fixed, but its behavior depends upon the cost driver to which it is linked. The activity hierarchy can be used to organize varied activities into understandable categories which can be subsequently linked to unique cost drivers to greatly facilitate (resource) cost control.

To facilitate capacity management--specifically, to identify the cost of excess capacity--the activity hierarchy can be used to distinguish between resources acquired in advance and resources acquired as needed. Some organizational resources can be acquired as needed so that none will be wasted regardless of actual output. For example, raw materials, hospital linens, and office supplies can be acquired as needed and stored if not used immediately. Unit-level resources (activities) can typically be acquired as needed. Resources for higher-level activities shown in Exhibit 1, at the batch, product-sustaining, and facility levels, must typically be acquired in advance and must be used when available or they are wasted. For example, a design engineer can provide about 2,000 hours of engineering activity for an organization. But if only 1,500 hours of the activity are used during a year, the value of 500 hours of resource is lost, even though the entire cost of the engineering activity is incurred.

Unit-level resources have the following characteristics:

* They can be acquired as needed.

* They are variable with respect to output.

* They represent "flexible" resources, in the sense that their acquisition can be easily adjusted to meet changes in volume.

Higher-level resources (batch, product-sustaining, and facility) share the following characteristics:

* They must be acquired in advance.

* They are fixed with respect to output.

* They contain fewer flexible resources.

* They are often "committed" resources, in the sense that their acquisition cannot be easily adjusted to meet volume changes.

Distinguishing between unit-level and higher-level resources can facilitate capacity management and control of non-value-added activities. Thus, cost reduction efforts typically associated with ABM can be improved.

The following example illustrates how excess capacity and non-value-added activities can be identified.

Alpha Inc.

Except for materials, Alpha Inc.'s production cost is contained in three cost pools: labor, logistics, and maintenance. Information for 2004 is shown in Exhibit 3. Labor can be acquired as needed with direct labor hours (DLH) as the cost driver. Logistics and maintenance must be acquired in advance. Logistics and maintenance resource costs are fixed with respect to output (and DLH). Cost drivers are moves and maintenance hours.



Benchmark activity is based on analyses conducted by production staff and supported by the controller's division analysts. The cost of resources available to Alpha is the budget cost of each activity pool. This cost, however, exceeds the cost that Alpha would pay for these activities if capacity were better managed and if efficiencies approached the benchmark. Given the pressures to continually reduce costs, it would be useful to provide information to management that clearly identifies the cost of excess capacity and the cost of non-value-added activities.

In this example, labor activity can be adjusted quickly to meet output requirements, so it is classified as a unit-level activity that can be acquired as needed. Therefore, excess capacity cost does not arise in the labor activity. (Many organizations find that skilled labor cannot be acquired as needed. These organizations would treat labor as a higher-level cost.) Non-value-added cost, however, can be calculated as the difference between plan cost and benchmark cost. Benchmark cost is obtained by multiplying the plan activity rate times the benchmark activity:

Benchmark cost = activity rate X benchmark activity

= ($220,000/25,000 hours) X 20,000 hours

= $8.80 X 20,000 hours

= $176,000

Non-value-added cost = plan cost - benchmark cost

= $220,000 - $176,000

= $44,000

Logistics and maintenance are higher-level activities and must be acquired in advance. Thus, non-value-added cost and excess capacity cost can both arise. Benchmark cost cannot be obtained by multiplying the plan activity rate by the benchmark activity, because the plan activity rate includes the cost of excess capacity.

The average cost per move of the logistics resource at the plan level of activity is $44.13 ($95,760/2,170 hours). At capacity, the average cost per move falls to $38.00 ($95,760/2,520 hours). The average cost at the plan level of activity is higher than the average cost at capacity because the cost of not providing service is being spread over the service that is provided. In other words, the plan cost represents both the cost of providing service to Alpha and the cost of service that could be provided but is not needed. One could argue that $38.00 per move represents the "true" cost, because there is no excess capacity cost to burden the moves that are needed. The cost at capacity can be called the "economic" cost because it is the minimum cost at which service can be provided, given present technology (excess capacity cost has been eliminated).

The total cost of excess capacity for logistics can be calculated as the difference between the plan cost and the economic cost:

Economic cost = economic rate X plan activity

= ($95,760/2,520 moves) X 2,170 moves

= $38.00 X 2,170 moves

= $82,460

Excess capacity = plan cost - economic cost

= $95,760 - $82,460

= $13,300

Thus, $13,300 is being spent for resources (moves) that are not being used by Alpha. If the logistics department were the size to provide exactly the number of moves needed, only $82,460 would be spent on logistics.

To calculate non-value-added activity, compare the economic cost of logistics with the benchmark. To calculate the benchmark, use the economic cost of activity:

Benchmark cost = economic rate X benchmark activity

= ($95,760/2,520 moves) X 1,680 moves

= $38.00 X 1,680 moves

= $63,840

Non-value-added cost = economic cost - benchmark cost

= $82,460 - $63,840

= $18,620

Similar calculations for the maintenance department would yield a non-value-added cost of $20,250.

Reporting formats for this information can be customized to specific needs. One possible format is shown in Exhibit 4. Data can also be calculated for end-of-the-period variance reports using actual results. Exhibit 5 provides a model of the analysis described above. Resources acquired as needed (unit-level resources) are distinguished from resources acquired in advance (higher-level resources). In the case of unit-level resources, non-value-added cost represents the difference between plan cost and benchmark cost. Higher-level resources may produce both non-value-added and excess-capacity costs.

This analysis allows managers to improve their ability to differentiate between operating efficiency and capacity management. If cost exceeds the benchmark, it is useful for managers to understand how to apply their control efforts. Managers would be misguided if they attempted to improve operating efficiency when they should be managing capacity, including reducing or finding alternative uses for their department's capacity.

                                   Sample Activities
                Production           Hospital            Accounting firm
                (cost driver: units  (cost driver:       (cost driver:
                of output)           patient-days)       billable hours)

Facility-level  Plant management     Top administration  Managing
                Central accounting   Central accounting  partner
                Occupancy            Occupancy           Occupancy
Product-        Product design       Medical directors   Staff training
sustaining      Logistics            Special facilities  Office support
                Engineering          Laboratories/x-ray  Specialty
Batch-level     Setup                Nursing             Client travel
                Inspection           Admissions          Tax research
                Work scheduling                          Software
Unit-level      Power                Food, linens        Professional
                Machine              Medications         staff
                maintenance                              Office supplies


             Budget   Capacity  Benchmark  Budget Cost

Labor        $25,000    --      $20,000    $220,000
Logistics      2,170  $2,520      1,680      95,760
Maintenance    3,750   4,000      2,400      60,000


                Budget cost  Economic cost  Value added

Direct Labor    $220,000     $220,000       $176,000
Unit-level      $220,000     $220,000       $176,000
 Logistics        95,760       82,460         63,840
 Maintenance      60,000       56,250         36,000
 Incurred cost  $375,760     $358,710       $275,840
Unit cost            $38.06       $36.70         $30.07

Leslie Kren, PhD, is an associate professor of accounting at the University of Wisconsin-Milwaukee and Thomas Tyson, PhD, is a professor of accounting at St. John Fisher College, Rochester, N.Y.
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Title Annotation:Activity-Based Management; Activity-Based Costing
Author:Kren, Leslie; Tyson, Thomas
Publication:The CPA Journal
Geographic Code:1USA
Date:Aug 1, 2004
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