Chapter 3 Activity-Based Management

2 Activity-based Costing & Management (ABCM) (Slide 1 of 4) ABCM rests on this premise: –Products and services require/consume activities and activities consume resources To understand the cost of a product or service, one must: –Identify activities required to make the product or provide the service

3 Activity-based Costing & Management(ABCM)(Slide 2 of 4) –Identify resources used to provide for those activities –Determine the cost of those resources To be competitive, managers must know both: –Activities involved in making the goods or providing the services, and –The cost of those activities

4 Activity-based Costing & Management (ABCM) (Slide 3 of 4) ABCM has 2 parts: What are they? –The costing part known as Activity-based Costing (ABC) –The management part known as Activity- Based Management (ABM)

5 Activity-based Costing & Management (ABCM) (Slide 4 of 4) ABC treats mostly indirect costs including: –Overhead costs related to the manufacture of a product or providing a service –Indirect costs of marketing a product –Indirect costs of managing a company

6 Discuss Strategic Uses of ABCM Managers use activity-based information in what 5 ways? 1.To add surcharges for particular customers 2.To “fire” some customers 3.To seek to serve more profitable customers 4.To raise or lower product prices 5.To drop products

7 What are the 4 steps of activity analysis? 1.Chart the activities used to complete the product or service 2.Classify activities as value-added or non- value-added 3.Eliminate or reduce non-value-added activities 4.Continuously improve & reevaluate efficiency of activities or replace them with more efficient activities

8 Define Cost Pools Cost pools are groups of costs List three major types of cost pools: –Plant (traditional) –Department (traditional) –Activity center (activity-based costing)

9 Product Costing Allocation Methods PRODUCTS Plantwide Overhead Rate Multiple Department Rates Activity-Based Costing Activity Department Activity Department Single Rate

10 Discuss Traditional Allocation Methods Plantwide allocation –Uses the entire plant as a cost pool –This approach is best for simple organizations with only a few departments and little variety in activities Department allocation –Uses separate cost pools with different overhead allocation rates for each department

11 Discuss Activity-Based Costing Activity-based costing (ABC) –Assigns costs first to activities –Then to products or services based on the activities used to produce the product or provide the service

12 Single Plantwide Factory Overhead Rate Total budgeted factory overhead costs Total budgeted plantwide allocation base = $80 per hour $1,600,000 20,000 direct labor hours Snowmobile: $80 x 10 direct labor hours = $800 Lawnmower: $80 x 10 direct labor hours = $800 What are the advantages of the single plantwide overhead rate method?

13 Multiple Department Factory Overhead Rate Fabrication Department Overhead Rate: = $103 per hour $1,030,000 10,000 direct labor hours Snowmobile: Fabrication: $103 x 8 dlh$824 Assembly: $57 x 2 dlh114$938 Lawnmower: Fabrication: $103 x 2 dlh$206 Assembly: $57 x 8 dlh456$662 Assembly Department Overhead Rate: = $57 per hour $570,000 10,000 direct labor hours

14 Conditions for Product Cost Distortion Fabrication Department $103 per direct labor hour $103 per direct labor hour Assembly Department Condition 1: Different department overhead rates $57 per direct labor hour $57 per direct labor hour Condition 2: Different ratios of allocation- base usage Snowmobile 8 direct2 directlabor hours Snowmobile 8 direct2 directlabor hours Lawnmower 2 direct8 directlabor hours Lawnmower 2 direct8 directlabor hours

15 What are the required steps of activity- based costing? 1.Identify activities that consume resources and assign costs to those activities 2.Identify cost drivers associated with each activity –A cost driver is a factor that causes or “drives” an activity’s costs 3.Compute a cost rate for each cost driver 4.Assign costs to products

16 Cost Rates per Cost Driver Unit Calculate predetermined cost rate for each cost driver as follows: Predetermined = Estimated indirect cost cost rate Est. volume of allocation base Multiply predetermined cost driver rate times volume of cost drivers consumed

17 Activity-Based Costing Activity AmountActivityRate Fabrication$ 530,000/ 10,000 dlh=$53 Assembly70,000/ 10,000 dlh=$7 Setup480,000/ 120 setups=$4,000 Quality control312,000/ 104 insps.=$3,000 Engineering208,000/ 16 changes=$13,000 Total$1,600,000

18 Activity-Based Costing Activity AmountActivityRate Snowmobile 8,000$53$424,000 Lawnmower 2, ,000 Total10,000$530,000 Fabrication:DL HoursRateTotal Fabrication$ 530,000/ 10,000 dlh=$53 Assembly70,000/ 10,000 dlh=$7 Setup480,000/ 120 setups=$4,000 Quality control312,000/ 104 insps.=$3,000 Engineering208,000/ 16 changes=$13,000 Total$1,600,000

19 Activity-Based Costing Snowmobile2,000$7$14,000 Lawnmower8,000756,000 Total10,000$70,000 Assembly:DL HoursRateTotal Fabrication$ 530,000/ 10,000 dlh=$53 Assembly70,000/ 10,000 dlh=$7 Setup480,000/ 120 setups=$4,000 Quality control312,000/ 104 insps.=$3,000 Engineering208,000/ 16 changes=$13,000 Total$1,600,000 Activity AmountActivityRate

20 Activity-Based Costing Snowmobile100$4,000$400,000 Lawnmower204,00080,000 Total120$480,000 Setup:SetupsRateTotal Fabrication$ 530,000/ 10,000 dlh=$53 Assembly70,000/ 10,000 dlh=$7 Setup480,000/ 120 setups=$4,000 Quality control312,000/ 104 insps.=$3,000 Engineering208,000/ 16 changes=$13,000 Total$1,600,000 Activity AmountActivityRate

21 Activity-Based Costing Snowmobile100$3,000$300,000 Lawnmower43,00012,000 Total104$312,000 Quality Control:Insps.RateTotal Fabrication$ 530,000/ 10,000 dlh=$53 Assembly70,000/ 10,000 dlh=$7 Setup480,000/ 120 setups=$4,000 Quality control312,000/ 104 insps.=$3,000 Engineering208,000/ 16 changes=$13,000 Total$1,600,000 Activity AmountActivityRate

22 Activity-Based Costing Snowmobile12$13,000$156,000 Lawnmower413,00052,000 Total16$208,000 Engineering:ChangesRateTotal Fabrication$ 530,000/ 10,000 dlh=$53 Assembly70,000/ 10,000 dlh=$7 Setup480,000/ 120 setups=$4,000 Quality control312,000/ 104 insps.=$3,000 Engineering208,000/ 16 changes=$13,000 Total$1,600,000 Activity AmountActivityRate

23 Activity-Based Costing Activity SnowmobileMowerTotal Cost Allocation Summary: Fabrication$ 424,000$106,000$ 530,000 Assembly14,00056,00070,000 Setup400,00080,000480,000 Quality control300,00012,000312,000 Engineering156,00052,000208,000 Total$1,294,000$306,000$1,600,000 Budgeted units1,000 1,000 Cost per unit$1,294 $306

24 Distortion in Product Costs Single plantwide rate$ 800$ 800 Multiple department rates Activity-based costing1, SnowmobileLawnmower Factory Overhead Cost per Unit:

25 1.Post-sale technical support 2.Order writing 3.Promotional support 4.Order entry 5.Customer return processing 6.Shipping document preparation 7.Shipping and handling 8.Field service Selling and administrative activities may include: Selling and Administrative Activities

26 Activity-Based Costing in Service Businesses PATIENTS $200 per hour Hopewell Hospital—Activity-Based Costing $120 per specimen $150 per day $320 per image $180 per admission Admitting RadiologicalTesting OperatingRoom PathologicalTesting Dietary and Laundry

27 Activity Costs Allocated to a Patient Activity-BaseActivityActivity ActivityUsageRateCost Admitting1 admission$180$ 180 Radiology testing2 images Operating room4 hours Pathological testing1 specimen Dietary and laundry7 days1501,050 Total$2,790 Patient Name: Mary Wilson

28 Cost Hierarchies Activity Category Capacity Customer Product Batch Unit Examples Plant Mgmt & Depr Mkt Research Product Specs & Testing Machine Setups Direct Materials