1. Activity Based Cost Management
Chapter 4
Chapter 4: Activity Based Cost Management
Activity Based Cost Management
PowerPoint Authors:
Jon A. Booker, Ph.D., CPA, CIA
Charles W. Caldwell, D.B.A., CMA
Susan Coomer Galbreath, Ph.D., CPA
McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.

2. Traditional Volume-Based Cost Systems
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Traditional Volume-Based Cost Systems
Because indirect costs cannot be directly traced to specific products or services, they must be assigned or allocated based on some other observable measure called an allocation base or cost driver.
Indirect Costs $$
Cost Driver or
Allocation Base
Individual Products or Services
Because indirect costs cannot be directly traced to specific products or services, they must be assigned or allocated based on some other observable measure called an allocation base or cost driver. The cost driver or allocation base can be a simple measure such as the number of units produced or direct labor hours, or can include multiple measures that capture the cause and effect relationship between activities and costs.
We have used units produced or direct labor hours to assign indirect manufacturing overhead costs to specific products. Units produced and direct labor hours are examples of a volume-based allocation measure. A volume-based allocation measure is directly related to the number of units produced or the number of customers served.
We have used units produced or direct labor hours to assign indirect manufacturing overhead costs to specific products. Units produced and direct labor hours are examples of a volume-based allocation measure.

3. Activity Based Costing (ABC)
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Activity Based Costing (ABC)
Activity Based Costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require.
Activity Based Costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require. ABC uses a two-stage process in which indirect costs are first assigned to activities, and then assigned to individual products and services based on their activities requirements

4. Stage 1: Assign Indirect Costs To Activities
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Stage 1: Assign Indirect Costs To Activities
The first stage in activity-based costing is to identify all the activities that must occur to make a product or provide a service and then classify them into one of the following categories:
Facility-Level Activities are performed for the overall company, to benefit multiple customers and product lines.
Customer-Level Activities are performed for a specific customer.
Product-Level Activities are performed to support a specific product line.
Batch-Level Activities are performed all at once for a group of units or customers.
Unit-Level Activities are performed one at a time for each unit or customer.
The table on your screen shows how sample activities are categorized at TMMK.

5. Form Activity Pools and Assign Indirect Costs to Each Pool
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Form Activity Pools and Assign Indirect Costs to Each Pool
TMMK has identified the following cost pools:
TMMK Manufacturing Overhead Cost Pools
Machining and Installation
Machine Setup
Product Engineering
and Design
Quality Control
Once the activities are identified and classified, the next step is to combine similar activities together into activity cost pools. You can imagine that a company as large as Toyota has employees performing hundreds if not thousands of activities. To keep the cost system manageable, we must simplify the number of activities by grouping like or similar activities together. The goal is to create as few cost pools as possible, while still capturing the major activities identified in the previous step.
Toyota Motor Manufacturing Kentucky (TMMK) has determined that the following four activities are required to produce its product:
Machining and Installation
Machine Set-Up
Product Engineering and Design
Quality Control

6. Form Activity Pools and Assign Indirect Costs to Each Pool
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Form Activity Pools and Assign Indirect Costs to Each Pool
Recall that the total manufacturing overhead cost in our Toyota example was $3,720,000 (in thousands). Now we must assign this total cost to one of the four activity cost pools.
Recall that the total manufacturing overhead cost in our Toyota example was $3,720,000 (in thousands). Now we must assign this total cost to one of the four activity cost pools. Notice that $825,000 of the $3,720,000 is assigned to the machining and installation activity cost pool. This activity pool will include all indirect costs related to machining and installation of components, such as the depreciation on all of the robots that produce the automobiles.
The machine set-up pool will include all indirect costs related to setting up for production, including the salaries of workers who perform set-up activities, indirect materials used during the set-up process, etc. The engineering and design activity cost pool will include the salaries of product development and design engineers, the cost of developing prototype models, etc. The quality control activity pool will include the salaries of quality control engineers, depreciation on testing equipment, and the like.

7. Select an Activity Cost Driver for Each Cost Pool
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Select an Activity Cost Driver for Each Cost Pool
Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the activity driver for the set-up activity. Engineering hours will be used as the driver to assign engineering and design costs. Inspection time will be used to assign quality control costs.
By incorporating activity drivers that capture other aspects of the production process besides volume, ABC can assign more indirect cost to products that require more setup time, more complex processing, more quality control, or more engineering and design. Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the activity driver for the set-up activity. Engineering hours will be used as the driver to assign engineering and design costs. Inspection time will be used to assign quality control costs.

8. Total Activity Cost Total Activity Driver
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Activity Rate Method
The activity rate method is very similar to the predetermined overhead rate computed earlier.
Activity Rate
Total Activity Cost Total Activity Driver =
Total indirect costs assigned to the machining pool was $825,000, the total machine hours required by each of the three Toyota models is as follows:
Part I
The first method involves computing an activity rate that is very similar to the predetermined overhead rate computed earlier. The only difference is that we will now have an activity rate for each activity cost pool.
Part II
Total indirect costs assigned to the machining pool was $825,000, the total machine hours required for the Avalon is 3,000, for the Camry 10,500, and for the Camry Hybrid 1,500, for a total of 15,000 machine hours during the period.
Part III
The activity rate for machining and installation is $55 per machine hour.
Activity Rate =
$825,000 15,000
= $55 per machine hour

9. Activity Based Management
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Activity Based Management
Activity based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. The first step in any improvement program is to target areas that need improvement.
What Activities
Are Performed?
How Much Does it Cost to Perform Each Activity?
Does the Activity Add Value to the Customer?
Activity based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. To get benefits of ABC, managers must use it to manage the underlying activities and identify activities that would benefit from process improvements.
What activities are preformed? This question focuses managers’ attention on activities as the driver of cost within the organization.
How much does it cost to perform each activity? This question helps focus managers’ attention on those activities that have the most potential for improvement. The activity rates in the ABC system provide insight into how much it costs to perform key activities.
Does the activity add value to the customer? This is one of the most important questions in activity based management. A value-added activity is one that enhances the perceived value of the product or service to the customer. A non-value-added activity is one that, if eliminated, would not reduce the value of the product or service in the eyes of the customer. To the extent possible, managers should attempt to reduce or eliminate non-value-added activities.

10. Life Cycle Cost Management
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Life Cycle Cost Management
In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including
product introduction,
growth,
maturity, and
eventual decline.
In today’s digital and technological age, product life cycles become increasingly short.
Costs tend to be higher.
Most revenue earned.
Part I
In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including
product introduction,
growth,
maturity, and
eventual decline.
Cost tends to be higher in the early stages of the product life cycle (as in the case of hybrid cars).
Part II
Most of the revenues are earned in the growth and maturity stages of the life cycle.
Part III
In today's digital age, product life cycles are becoming increasingly short (only a few years in the case of technology products), so managers must be able to estimate life-cycle costs accurately to make good product introduction decisions.

11. Total Quality Management
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Total Quality Management
The second highest cost assigned to the Camry-Hybrid was due to quality control. In managing quality costs, managers must balance four types of quality costs:
Prevention costs,
Appraisal or inspection costs,
Internal failure costs, and
External failure costs.
The second highest cost assigned to the Camry-Hybrid was due to quality control. In managing quality costs, managers must balance four types of quality costs:
Prevention costs,
Appraisal or inspection costs,
Internal failure costs, and
External failure costs.
Prevention costs are incurred to prevent quality problems from occurring in the first place. Appraisal or inspection costs are incurred to identify defective products before products are shipped to customer. Internal failure costs result from defects that are caught BEFORE the product is shipped to the customer. External failure costs occur when a defective product makes its way into the hands of the customer.

12. 4-12
Target Costing
The target cost would be computed by subtracting the target profit from the market price, as follows:
Market Price $30,000
Target Profit (20% × $30,000) $6,000
Target Cost $24,000 ̶ =
The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000). It is important to realize that the target cost includes more than just the manufacturing costs.
The target cost would be computed by subtracting the target profit from the market price. Using our estimates we would calculate the target profit of $6,000 (20% times $30,000 estimated market price). Subtract the $6,000 target profit from the market price of $30,000, and get the target cost of $24,000. The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000). It is important to realize that the target cost includes more than just the manufacturing costs.

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Target Costing
Once the target cost is set, the next step is to determine whether it is feasible to design, develop, manufacture and deliver the product at this target cost.
Make Product ?
Target Cost
Design Product
Develop Process
Estimate Cost
Cost Reduction Goals
Once the target cost is set, the next step is to determine whether it is feasible to design, develop, manufacture and deliver the product at this target cost. If the estimated cost exceeds the target cost, further cost reduction is necessary, either by redesigning the product or re-engineering the process (or both). To achieve the cost reduction goals, managers from all areas (design, development, manufacturing, and accounting) must work together to find creative ways to achieve the target cost, without affecting the end value to the consumer.
Compare the estimated cost with the target cost to see if cost reduction is necessary.

14. Just-in-Time (JIT) Inventory
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Just-in-Time (JIT) Inventory
In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a "demand pull" system, where materials and products are pulled through the manufacturing system based on customer demand.
In a traditional manufacturing setting where products are pushed through the system and often end up sitting in inventory. One advantage of a JIT system is that it eliminates problems in product costing associated with holding inventory.
In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a "demand pull" system, where materials and products are pulled through the manufacturing system based on customer demand, as opposed to a traditional manufacturing setting where products are pushed through the system and often end up sitting in inventory. An advantage of using a JIT system is that it eliminates many of the problems in product costing associated with holding inventory.

15. End of Chapter 4 End of chapter 4. McGraw-Hill/Irwin
Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.