Unit-level and Higher-level Resources
a Strategic Dimension to the Traditional Activity Hierarchy
Leslie Kren and Thomas Tyson
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
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.
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.
hierarchy provides a useful framework to understand and
control the cost of activities in almost any organization.
the Traditional Activity Hierarchy
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.
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.
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.
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.
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.
following example illustrates how excess capacity and non–value-added
activities can be identified.
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.
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
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:
cost = activity rate x benchmark activity
hours) x 20,000 hours
= $8.80 x 20,000 hours
cost = plan cost – benchmark cost
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.
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).
total cost of excess capacity for logistics can be calculated
as the difference between the plan cost and the economic
cost = economic rate x plan activity
moves) x 2,170 moves
= $38.00 x 2,170 moves
capacity = plan cost – economic cost
$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.
calculate non–value-added activity, compare the economic
cost of logistics with the benchmark. To calculate the benchmark,
use the economic cost of activity:
cost = economic rate x benchmark activity
= ($95,760/2,520 moves) x 1,680 moves
= $38.00 x 1,680 moves
cost = economic cost – benchmark cost
= $82,460 – $63,840
calculations for the maintenance department would yield
a non–value-added cost of $20,250.
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.
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
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.