Activity-Based Costing and Management

Activity-Based Costing and Management
Chapter 5 Activity-Based Costing and Management Chapter 5: Activity-Based Costing and Management MBA 631 Dr. Luchs Ball State University

Learning Objective 1 Learning Objective 1. Compute product costs under a traditional, volume-based product-costing system. 5-2

Traditional, Volume-Based Product-Costing System
Aerotech produces three complex printed circuit boards referred to as Mode I, Mode II, and Mode III. The following information is obtained from company records: Aerotech produces three circuit boards referred to as Mode I, Mode II and Mode III. 10,000 units of Mode I are produced in 1 run. 20,000 units of Mode II are produced in 4 runs of 5,000 units. And 4,000 units of Mode III are produced in 10 runs o f400 units. (LO1) 5-3

Additional information includes: In a traditional, job-order product-costing system, the cost of each product is the sum of its actual direct-material cost, actual direct-labor cost, and applied manufacturing overhead. The unit cost for Mode I is $209 which is $50 direct materials cost, $60 direct labor cost and $99 overhead cost. Mode II unit cost is $302 which is $90 for direct materials, $80 for direct labor and $132 for overhead. Mode III has a unit cost of $126 which is $20 direct materials cost, $40 direct labor cost and $66 overhead cost. (LO1) Manufacturing overhead is determined as follows 5-4

Budgeted manufacturing overhead $3,894,000 Budgeted direct-labor hours ,000 = $33 per hour Aerotech applies manufacturing overhead using a predetermined overhead rate based on direct-labor hours. The total direct labor hours was estimated to be 118,000. The budgeted manufacturing overhead cost was estimated at $3,894,000. The estimated cost is divided by the estimated hours resulting in a predetermined overhead rate of $33 per hour. The overhead per unit is calculated by multiplying the direct labor hours per unit times the predetermined overhead rate per hour. (LO1) 5-5

With these product costs, Aerotech established target selling prices (Cost × 125%). Now that Aerotech is estimated the production cost per unit, the target selling price can be set. The company’s pricing policy has been to set a target price for each grill equal to 125 percent of the full product cost. The estimated unit cost is multiplied by 1.25 to arrive at the target selling price. (LO1) x 1.25 5-6

Learning Objective 2 Learning Objective 2. Explain how an activity-based costing system operates, including the use of a two-stage procedure for cost assignment, the identification of activity cost pools, and the selection of cost drivers. 5-7

Activity Based Costing System (ABC)
ABC systems follow a two-stage procedure to assign overhead costs to products. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used. Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products. Activity-based costing (ABC) systems follow a two-stage procedure to assign overhead costs to products. (LO2) Assigning Overhead to product costs is a difficult process. Lets begin by identifying our major activities. The first stage identifies significant activities in the production process and assigns overhead costs to each activity in accordance with the cost of the organization’s resources used by the activity. The overhead costs assigned to each activity comprise an activity cost pool. (LO2) Overhead assigned to activities are called “activities cost pools.” After assigning overhead costs to activity cost pools in stage one, cost drivers appropriate for each cost pool are identified in stage two. Then the overhead costs are allocated from each activity cost pool to each product line in proportion to the amount of the cost driver consumed by the product line. 5-8

Learning Objective 3 Learning Objective 3. Explain the concept of cost levels, including unit-level, batch-level, product-sustaining-level, and facility-level costs. 5-9

Product- Sustaining Level Unit Level Batch Level Facility Level
Overhead Costs Total budgeted cost = $3,894,000 Identification of Activity Cost Pools Activity must be done on each unit produced. Activity Cost Pools Product- Sustaining Level Unit Level Batch Level Facility Level Activities needed to support an entire product line Activity performed on each batch produced. Activity required in order for the production process to occur. Machinery cost pool $1,212,600 Setup cost pool $3,000 Engineering cost pool $700,000 Facility cost pool $507,400 Aerotech identified eight activity cost pools, which fall into four broad categories: unit level, batch level, product-sustaining level and facility level. The activity at the unit level must be applied to each unit produced. The activity at the batch level must be performed one time for each batch that goes into production. The product-sustaining activities are required to support the entire product line, but not needed for each unit or batch. Facility-level activities are required in order for the entire production process to occur. (LO3) 5-10

Receiving/Inspection
Product- Sustaining Level Unit Level Batch Level Facility Level Machinery cost pool $1,212,600 Setup cost pool $3,000 Engineering cost pool $700,000 Facility cost pool $507,400 Receiving/Inspection cost pool $200,000 Material-Handling cost pool $600,000 For Aerotech, only the machinery cost pool is at the unit level. There are five cost pools at the batch level: setup, receiving and inspection, material-handling, quality assurance and the packaging and shipping cost pool. The engineering cost pool is at the product-sustaining level and the facility cost pool is at the facility level. (LO3) Quality-Assurance cost pool $421,000 Packaging/Shipping cost pool $250,000 5-11

Learning Objectives 3 & 4 Learning Objectives 3 & 4. Explain the concept of cost levels, including unit-level, batch-level, product-sustaining-level, and facility-level costs. Compute product costs under an activity-based costing system. 5-12

STAGE ONE Machinery Cost Pool Various overhead costs related
to machinery Maintenance Depreciation Computer Support Lubrication Electricity Calibration Activity cost pool Aerotech estimated the costs of maintenance, lubrication, depreciation, electricity, computer support and calibration. These costs are added together. The sum is the machinery cost pool budgeted cost. (LO3) Machinery Cost Pool Total budgeted cost = $1,212,600 5-13

STAGE TWO Calculate the pool rate Cost Assignment
Budgeted Machinery Costs $1,212,600 Budgeted Machine Hours ,000 $28.20/hour = = Cost Assignment Aerotech selected machine hours for the cost driver, since a product that uses more machine hours should bear a larger share of machine-related costs. The budgeted machinery costs are divided by the budgeted number of machine hours to arrive at the machinery cost pool rate. Then, for each circuit board, the machinery cost pool rate is multiplied by the number of machine hours per board. (LO4) 5-14

STAGE ONE Setup Cost Pool Calculation of total setup cost Activity
The budgeted cost for the setup cost pool is determined by multiplying the setup cost per hour by the number of hours required per setup then multiplying that by the number of production runs. (LO3) Setup Cost Pool Total budgeted cost = $3,000 5-15

Budgeted Setup Costs $3,000 Planned Production Runs runs $200 per run = = Cost Assignment The budgeted setup costs are divided by the planned production runs to arrive at the setup cost pool rate. Then, for each circuit board, the setup cost pool rate is divided by the number of units per run to arrive at the setup cost per unit. (LO4) 5-16

STAGE ONE Engineering Cost Pool Various overhead costs related
to engineering Engineering salaries Engineering software Engineering supplies Depreciation Activity cost pool Engineering Cost Pool Total budgeted cost = $700,000 Aerotech estimated the costs of engineering salaries, supplies, software and depreciation. These costs are added together. The sum is the engineering cost pool budgeted cost. (LO3) 5-17

STAGE TWO Engineering Cost Pool Allocate based on engineering
Total budgeted cost = $700,000 Allocate based on engineering transactions Cost Assignment The engineering department has estimated that 25% of its time is spent on Mode I, 45% on Mode II and 30% spent on Mode III. For each board, the percentage of engineering time is multiplied by the budgeted engineering cost then divided by the number of units to be produced. The result is the engineering cost per unit. (LO4) 5-18

STAGE ONE Facility Cost Pool Total budgeted cost = $507,400
Various overhead costs related to general operations Plant depr. Property taxes Plant mgmt. Insurance Plant maint. Security Activity cost pool Facility Cost Pool Total budgeted cost = $507,400 Aerotech estimated the costs of plant depreciation, management salaries, maintenance, property taxes, insurance and security. These costs are added together. The sum is the facility cost pool budgeted cost. (LO3) 5-19

Budgeted Facilities Cost $507,400 Budgeted Direct-Labor Hours ,000 $4.30/hour = = Cost Assignment Aerotech has selected to use direct labor hours as the cost driver for facilities cost. The budgeted facilities cost is divided by the budgeted direct labor hours to arrive at the facilities cost per hour. The facilities cost per unit is calculated by multiplying the facilities cost per hour by the number of direct labor hours required per board. (LO4) 5-20

Other Overhead Costs Aerotech has four other batch level cost pools: receiving and inspection, material handling, quality assurance, and packaging and shipping. Each of these departments has estimated the costs and the percentage of time spent on each of the three circuit boards. The budgeted costs are multiplied by the percentage to determine the cost per unit for each board. (LO4) 5-21

Other Overhead Costs $14.82 The cost per unit for each of these batch level costs is added together for each board. (LO4) 5-22

These are the new product costs when Aerotech uses ABC.
Product Cost from ABC These are the new product costs when Aerotech uses ABC. Now Aerotech has new product costs for each board. It is the sum of the costs for direct materials, direct labor, machinery, setup, engineering, facilities and costs accumulated as other costs. (LO4) 5-23

Learning Objective 5 Learning Objective 5. Explain why traditional, volume-based costing systems tend to distort product costs. 5-24

Distorted Product Costs
Both original and ABC target selling prices are based on (Cost × 125%). Using the existing target pricing policy, the unit cost based on ABC costing is multiplied by 1.25 to arrive at the ABC target selling price. Under ABC costing, the selling price for Mode I and Mode II boards has decreased, but the selling price for the Mode III board has increased significantly. (LO5) The selling price of Mode I and II are reduced and the selling price for Mode III is increased. [$ × 1.25] [$ × 1.25] 5-25

Distorted Product Costs
Can you identify any problems Aerotech is likely to face as a result of this distortion? The cost per unit under ABC costing is deducted from the traditional costing unit cost. This is cost distortion per unit. The problem with cost distortion is more evident when the cost distortion per unit is multiplied by the number of units produced. The essence of the problem is that the traditional, volume-based costing system was over costing the high-volume product lines (Modes I and II) and under costing the complex, relatively low volume product line (Mode III). The high-volume products basically subsidized the low volume line. The activity-based costing system revealed this problem by more accurately assigning overhead costs to the three product lines. When the costs are understated, so is the selling price. (LO5) Traditional costing understates the cost of complex, low volume products. 5-26

Two Key Points Product diversity
A large proportion of non-unit-level activities A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately. Product diversity When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs. To summarize, each of the following characteristics will undermine the ability of a volume-based product-costing system to assign overhead costs accurately. 1. A large proportion of non-unit-level activities and 2. Product diversity. When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs. When either of these characteristics is present, a volume-based product- costing system is likely to distort product costs. (LO5) 5-27

Learning Objective 6 Learning Objective 6. Explain three criteria for selecting cost drivers. 5-28

Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . . Degree of Correlation Behavioral Effects A cost driver is a characteristic of an event or activity that results in the incurrence of costs. In activity-based costing systems, the most significant cost drivers are identified. Then a database is created, which shows how these cost drivers are distributed across products. Three factors are important in selecting appropriate cost drivers. (LO6) The first is the degree of correlation. The concept of an activity-based costing system is to infer how each product line consumes the activity by observing how each product line consumes the cost drive, that is, how closely the two are correlated. The closer the correlation, the more accurate the cost assignments will be. (LO6) Designing any information system entails cost-benefit trade-offs. The more activity cost pools there are in an activity-based costing system, the greater will be the accuracy of the cost assignments. However, more activity cost pools also entail more cost drivers, which results in greater costs of implementing and maintaining the system. (LO6) Information systems have the potential not only to facilitate decisions but also to influence the behavior of decision makers. This can be good or bad, depending on the behavioral effects. In identifying cost drivers, an ABC analyst should consider the possible behavioral consequences. Dysfunctional behavioral effects are also possible. (LO6) Cost of Measurement 5-29

Learning Objective 7 Learning Objective 7. Discuss several key issues in activity-based costing, including data collection and storyboarding. 5-30

COLLECTING ABC DATA INTERVIEWS AND PAPER TRAILS - The information for ABC systems initially comes from interviews with employees in the support departments and a review of each department’s records. STORYBOARDING - A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities. The information used in ABC systems initially come from extensive interviews with key employees in each of the organization’s support departments and a careful review of each department’s records. (LO7) Storyboarding is a procedure used to develop a detailed process flowchart, which visually represents activities and the relationships among the activities. A storyboarding session identifies the key activities involved in each department. These activities are written on small cards and placed on a large board in the order they are accomplished. After several storyboarding sessions, a completed storyboard emerges, recording key activity information vital to the ABC project. (LO7) MULTIDISCIPLINARY ABC PROJECT TEAMS – To gather information from all facets of an organizations operations, it is essential to involve personnel from a variety of functional areas. A typical ABC project team includes ACCOUNTING, FINANCE, PRODUCTION, OPERATIONS, ENGINEERS, MARKETING etc. 5-31

Learning Objective 8 Learning Objective 8. Explain the concepts of activity-based management and two-dimensional ABC. 5-32

Activity-Based Management
The use of ABC costing information to help management make decisions Using activity-based costing (ABC) information to support organizational strategy, improve operations, and manage costs is called activity-based management or ABM. (LO8) 5-33

Activity-Based Management
Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs. Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs. Activity-based management focuses on managing activities to reduce costs. (LO8) 5-34

Two-Dimensional ABC and Activity-Based Management
Activities One way to describe the relationship between ABC and ABM is in terms of a two-dimensional activity-based costing model. The activities, which are the center of the model, are the focal point of ABC and ABM. (LO8) 5-35

Resource costs Cost Assignment View Activities The vertical element of the model is the cost assignment view of an ABC system. Cost assignment in an ABC system uses a two-stage cost allocation to assign the costs of resources to the firm’s cost objects. (LO8) Cost Objects 5-36

Resource costs Cost Assignment View Root Causes Process View Activity Analysis Performance Measures Activity Evaluation Activities Activity Triggers The horizontal element of the model is the process view of an ABC system. The emphasis now is on the activities themselves, the various processes by which work is accomplished in the organization. The left-hand side is the activity analysis. This is the identification and description of the activities conducted in the enterprise. Activity analysis also identifies the root causes of activities, the events that trigger activities, and the linkages among activities. The right-hand side is the evaluation of activities through performance measures. It is these processes of activity analysis and evaluation that comprise activity-based management. (LO8) Cost Objects 5-37

Elimination of Non-Value-Added Costs
Activities Nonvalue-added activities An important goal of activity-based management is to identify and eliminate nonvalue-added activities and costs. Non-value-added activities are operations that are either (1) unnecessary and dispensable or (2) necessary, but inefficient and improvable. Non-value-added costs, which result from such activities, are the costs of activities that can be eliminated without deterioration of product quality, performance, or perceived value. (LO8) Unnecessary Necessary Reduce or Eliminate Continually Evaluate and Improve 5-38

Using ABM to Eliminate Non-Value-Added Activities and Costs
Identify Activities. Identify Non-Value-Added Activities. Understand Activity Linkages, Root Causes, and Triggers. Establish Performance Measures. Report Non-Value-Added Costs. Specify parts Select vendor Receive parts Produce goods Inspect finished goods Rework defective products There are five steps that provide a strategy for eliminating nonvalue-added costs in both manufacturing and service industry firms. Step one identifies all of the organization’s significant activities. The resulting activity list should be broken down to the most fundamental level practical. (LO8) In step two, the nonvalue-added activities are identified. Three criteria for determining whether an activity adds value are as follows: • Is the activity necessary? • Is the activity efficiently performed? • Is an activity sometimes value-added and sometimes non-value-added? (LO8) In identifying nonvalue-added activities, it is critical to understand the ways in which activities are linked together. The following chain of activities provides an example: The rework of defective units is a non-value-added activity. The rework is triggered by the identification of defective products during inspection. The root cause of the rework, however, could lie in any one of a number of preceding activities. Perhaps the part specifications were in error. Or an unreliable vendor was selected. Maybe the wrong parts were received. Or the production activity is to blame. A set of linked activities (such as that depicted above) is called a process. Sometimes activity analysis is referred to as process value analysis (PVA). (LO8) By continually measuring the performance of all activities, and comparing performance with benchmarks, management’s attention may be directed to unnecessary or inefficient activities. (LO8) Non-value-added costs should be highlighted in activity center cost reports. By identifying non-value-added activities, and reporting their costs, management can strive toward the ongoing goals of process improvement and elimination of non-value-added costs. (LO8) 5-39

Using ABM to Eliminate Non-Value-Added Activities and Costs
Process time Inspection time Storage time One approach that cost-management analysts find helpful in identifying nonvalue-added activities is to categorize the ways in which time is spent in a production process. In most manufacturing operations, time is spent in the five ways (LO8) Move time Waiting time 5-40

Learning Objective 9 Learning Objective 9. Explain and execute a customer-profitability analysis. 5-41

Customer Profitability Analysis
Customer profitability analysis uses activity-based costing to determine the activities, costs, and profit associated with serving particular customers. Customer-profitability analysis uses activity-based costing to determine the activities, costs, and profit associated with serving particular customers. If managers have a good understanding of which customers are generating the greatest profit, they can make more-informed decisions about customer service. (LO9) 5-42

Required special packaging. Orders small quantities. Demand fast service. Often changes orders. Orders frequently. Many factors can result in some customers being more profitable than others. Customers that order in small quantities, order frequently, often change their orders, require special packaging or handling, demand faster delivery, or need special parts or engineering design generally are less profitable than customers who demand less in terms of customized services. (LO9) A costly customer 5-43

The first step is an activity based costing analysis of certain customer-related costs that could affect a customer’s profitability. Recall that ABC analysis relies on a cost hierarchy with cost levels, such as unit- level, batch-level, product-line-level, customer-level, and facility- or general-operations-level costs. In this use of activity-based costing, the cost management team will focus on the customer-related costs. A company may then use these costs to determine the profitability of each customer. (LO9) A company may use these customer related costs to help determine the profitability of each customer. 5-44

75% of actual operating income 50% of actual operating income A graphical portrayal of the complete customer-profitability analysis is called a customer-profitability profile. It is a common and useful way of presenting a customer-profitability analysis to management. (LO9) 25% of actual operating income 5-45

Learning Objective 10 Learning Objective 10. Understand and discuss how activity-based costing is used in service-industry organizations. 5-46

Activity-Based Management in the Service Industry
Customer Profitability Analysis Activity Analysis Many service-industry companies have benefited from significant use of activity-based management and other cost management tools. Many well-known service companies have used cost management tools to understand the profitability of their key customer relationships, eliminate non-value-added activities, and improve the overall cost effectiveness of their operations. FedEx has used activity analysis to analyze and map every step in the company’s logistical. Non-value-added activities and inefficiencies have been squeezed out of the system. Standards have been set for key aspects of operations. FedEx has also used ABC data and ABM to analyze the profitability of its key customer relationships. (L1O) 5-47

Learning Objective 11 Learning Objective 11. List and explain eight important features of just-in-time inventory and production management systems (Appendix). 5-48

Just-in-Time Inventory and Production Management
No materials are purchased and no products are manufactured until they are needed. The primary goal of a JIT production system is to reduce or eliminate inventories at every stage of production. A just-in-time (JIT) inventory and production management system is a comprehensive inventory and manufacturing control system in which no materials are purchased and no products are manufactured until they are needed. For example, raw materials and parts are purchased only as they are needed in some phase of the production process. A primary goal of a JIT production system is to reduce or eliminate inventories at every stage of production, from raw materials to finished goods. Tremendous cost savings have been realized by many companies that have adopted the JIT approach. (L11) 5-49

Key Features of the JIT Approach
Smooth, uniform production rate Pull method of production Purchase is small lot sizes Quick, inexpensive setups High quality materials The key features of JIT include a smooth, uniform production rate, a pull method of coordinating steps in the production process, purchase of materials and manufacture of subassemblies and products in small lot sizes, quick and inexpensive setups of production machinery, high quality levels for raw material and finished products, effective preventive maintenance of equipment, an atmosphere of teamwork to improve the production system, multiskilled workers and flexible facilities. (L11) Effective preventive maintenance Teamwork Multiskilled workers 5-50

JIT Purchasing Long-term contracts with suppliers. Only a few
Parts delivered in small lots. Along with a JIT production approach, many companies implement JIT purchasing. Under this approach, materials and parts are purchased from outside vendors only as they are needed. This avoids the costly and wasteful buildup of raw-material inventories. There are five key features of JIT purchasing. Only a few suppliers. Long-term contracts negotiated with suppliers. Materials and parts delivered in small lot sizes immediately before they are needed. Only minimal inspection of delivered materials and parts. Grouped payments to each vendor. (L11) Grouped payments to vendor. Minimal inspection of materials. 5-51

End of Chapter 5 This is my kind of cost pool! Practice Problems
5-52

Activity-Based Costing and Management

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