Magazine article The CPA Journal

Distinguishing Unit-Level and Higher-Level Resources: Adding a Strategic Dimension to the Traditional Activity Hierarchy

Magazine article The CPA Journal

Distinguishing Unit-Level and Higher-Level Resources: Adding a Strategic Dimension to the Traditional Activity Hierarchy

Article excerpt

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. …

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