Chapter 5 Activity Based Costing g3r4p

Cost ing Foundations and Evolutions Kinney, Prather, Raiborn

Chapter 5 Activity-Based Management and Activity-Based Costing

Learning Objectives (1 of 2) • Identify the focus of activity-based management • Explain why non-value-added activities cause costs to increase unnecessarily • Explain why cost drivers are designated in activity-based costing

Learning Objectives (2 of 2) • Contrast activity-based costing to the traditional cost ing system • Describe the types of information provided by an activity-based costing/management system • Explain when it is appropriate to use activity-based costing

Activity-Based Management • Focuses on activities during production and performance process • Improves the value received by customers • Enhances profitability

Activity An activity is a repetitive action performed in fulfillment of a business function

Activity-Based Management

Activity analysis Cost driver analysis Activity-based costing Continuous improvement

Operational control Quality management Business process improvement Performance measurement

ABM

Activity Based Management • External Benefits – Increased customer value – Enhanced profitability

• Internal Benefits – More efficient production – More accurate cost determination – More effective performance evaluation

ABM

Activity Analysis Non-value-added activity • Increases time spent on Value-added activity product or service but does • Increases worth of not increase worth product or service to a • Unnecessary from customer customer perspective • Customer is willing to • Can be reduced, redesigned pay for it or eliminated without affecting market value or quality • Business-value-added activities are essential

Process • A process is a series of activities that, when performed together, satisfy a specific objective – – – –

Production Distribution Selling istration

ABM

Activity Analysis • Create a Process Map (detailed flowchart) for each process – Identify each step

ABM

Activity Analysis • Create a Process Map (detailed flowchart) for each process – Identify each step

• Create Value Chart – Identify stages and time spent in stages from beginning to end of process Value-Added Processing Time Service Time

Non-Value-Added Inspection Time Transfer Time Idle Time

Cycle Time Cycle Time

=

ValueAdded + Activities

NonValue-Added Activities

Eliminate or minimize activities that add the most time and cost and the least value

Manufacturing Cycle Efficiency Manufacturing Cycle Efficiency (MCE)

=

Value-Added Processing Time Total Cycle Time

Manufacturing Cycle Efficiency Manufacturing Cycle Efficiency (MCE)

=

Value-Added Processing Time Total Cycle Time

• 100% efficiency unrealistic • Reducing non-value-added activities will increase Manufacturing Cycle Efficiency • Value-added activity usually represents about 10% of total cycle time • Just-in-time (JIT) increases MCE

Non-Value-Added Activities • Attributed to following factors – Systemic – Physical – Human

• Eliminating or reducing non-value-added activities that create the most costs will – Increase product/service quality – Decrease cycle time and cost

ABM

Cost Driver Analysis • Cost drivers are factors that have a direct cause-effect relationship to a cost – Limit the number of cost drivers – Cost of measurement should not exceed benefit of using the cost driver – Easy to understand – Directly related to activity being performed – Appropriate for measurement

A Management Tool Combine • Activity analysis – What activities are non-value-added?

• Cost driver analysis – What causes costs to be incurred?

ABM

Cost Driver Analysis • Unit-level costs – direct material, direct labor

• Batch-level costs – setup, inspection

• Product/process-level costs – engineering changes, product development

• Organizational or facility costs – building depreciation, plant manager’s salary

Product Cost Behavior • Unit-level costs are variable in relation to change in production volume • Batch, product/process, and organizational level costs are variable for reasons other than changes in production volume

Product Cost Unit-Level Costs

Allocate over number of units produced

Cost per unit

Batch-Level Costs

Allocate over number of units in batch

Cost per unit in batch

Product/ProcessLevel Costs

Allocate over number of units produced in related product line

Cost per unit in product line

For each product line

Product and Company Profitability

Unit Batch Product

Total product revenue Net product margin Company profit or loss Not GAAP

ABM

Activity-Based Costing • Recognizes several levels of costs • Accumulates costs into related cost pools • Uses multiple cost drivers to assign costs to products and services

When to Use ABC Companies use ABC when • They have a wide variety of products or services • High overhead costs are not proportional to the unit volume of individual products • Automation makes it difficult to assign overhead to products using direct labor or machine hours • Profit margins are difficult to explain • Hard-to-make products show big profits and easy-tomake products show losses

Two-Step Allocation • Collect costs in general ledger and subsidiary s • Identify activity centers

Choosing an Activity Center • Geographical proximity of equipment • Centers of managerial responsibility • Magnitude of product costs Choose a manageable number of activity centers

Two-Step Allocation

• Collect costs in general ledger and subsidiary s • Identify activity centers • Accumulate costs into activity center cost pools – Identify cost drivers

ABC Cost Pools Assumptions about activity center cost pools • Costs in each cost pool are – Driven by homogenous activities – Strictly proportional to the activity

Two-Step Allocation

• Collect costs in general ledger and subsidiary s • Identify activity centers • Accumulate costs into activity center cost pools – cost drivers • Allocate costs to products and services – activity driver measures demands placed on activities, thus, the resources consumed by products/services

Activity Drivers • • • • • • •

Reports requested Job change actions Hiring actions Training hours Transactions processed Engineering changes Defects discovered

• • • • • • •

Repair hours Material requisitions Purchase requisitions Space occupied Set-ups Moves Employees

Traditional vs. ABC Costing • When ABC implemented – Cost reduced for high volume, standard products – Cost increased for low-volume, complex specialty products

Long-Term Variable Costs • Cost drivers – Product variety – number of different types of products – Product complexity – number of processes through which a product flows

ABM

ABC Costing Considerations • Number and diversity of products/services produced • Diversity and differential degree of services used for different products • Extent to which common processes are used • Effectiveness of current cost allocation methods • Rate of growth of period costs

ABM

Use ABC Costing when…. 1. 2. 3. 4.

Product Variety and Process Complexity Lack of Commonality in Overhead Costs Problems with Current Cost Allocations Changes in Business Environment

ABM

Use ABC Costing when…. 1. Product Variety and Process Complexity – Caused by mass customization • Too many choices, opportunity for errors • Pareto Principle • Commonality of parts – Reduced by • Simultaneous (or Concurrent) Engineering • Design for Manufacturability

ABM

Use ABC Costing when…. 2. Lack of Commonality in Overhead Costs - Some products/services use substantially more overhead than others

1. Problems with Current Cost Allocations - Significant changes in process with no change in cost allocations - Expense majority of period costs when incurred

ABM

Use ABC Costing when…. 4. Changes in Business Environment – Increase in competition – Change in management strategy

ABM

Continuous Improvement • Eliminates non-value-added activities to reduce cycle time • Makes products/performs services with zero defects • Reduces product costs on an ongoing basis • Simplifies products and processes ABC Costing s Continuous Improvement

Criticisms of ABC • Significant amount of time and cost to implement • Must overcome barriers to change • Does not conform to GAAP • May not promote total quality management

ABM

Advantages of ABC and ABM • Identify and monitor significant technology costs • Trace technology costs directly to products • Identify the cost drivers that create or influence cost • Identify activities that do not contribute to perceived customer value

ABM

Advantages of ABC and ABM • Illustrate the impact of new technologies on all elements of performance • Translate company goals into activity goals • Analyze the performance of activities across business functions • Analyze performance problems • Promote standards of excellence

Questions • What are the differences between activitybased costing and traditional cost ing? • What are cost drivers and activity drivers? • What are two advantages and two criticisms of activity-based costing?