1 Activity-Based Management CHAPTER 3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use. PowerPointPresentation by PowerPoint Presentation by LuAnn Bean Professor of Accounting Florida Institute of Technology Managerial Accounting 11E Maher/Stickney/Weil

2 CHAPTER GOAL This chapter shows how ABC and ABM rest on the premise that: Products require activities and activities consume resources. For products to be competitive, managers must know  Activities for producing goods, services  Cost of activities ABC analyses ways to allocate indirect costs while ABM uses analysis to manage costs. ☼☼

3 How do ABC and ABM work?  ABC provides information about profitability in mix of activities, products  ABM encourages managers to use information to become low-cost producer or seller. LO 1

4 ABM ACTIVITY ANALYSIS  Chart, start to finish, activities used to complete product or service  Classify activities as value-added or non- value-added  Eliminate non-value-added activities  Continuously improve, reevaluate efficiency of value-added activities or replace with more efficient activities LO 1

5 Research and Development DesignProductionMarketingDistributionCustomer Service Organization Strategy and Administration Customer Value Chain EXHIBIT 3.1 LO 1

6 Research and Development DesignProductionMarketingDistributionCustomer Service Organization Strategy and Administration Customer ABM analyses and evaluates every step of the Value Chain. Value Chain EXHIBIT 3.1 & 3.2 LO 1

7 NON-VALUE-ADDED COSTS: Definition Are costs of activities that the company can eliminate without reducing product quality, performance, or value. LO 1

8 Research and Development DesignProductionMarketingDistributionCustomer Service Organization Strategy and Administration Customer ABM analyses and evaluates every step of the Value Chain. Value Chain EXHIBIT 3.1 & 3.2 LO 1 Eliminate

9 ABC ANALYSIS Potential candidates for elimination because they do not add value are  Storage  Moving: parts, materials, etc. around the factory floor  Idle time  Other production process components LO 1

10 EXAMPLE You and a friend go to dinner. You order tea ($2.50) and a salad ($8.00). Your friend orders appetizer, expensive entree, and dessert. The total bill is $60. Traditional cost allocation leads to splitting the bill, $30 apiece. What does activity analysis suggest each of you should pay? LO 2 YOU: $ tax & tip FRIEND: $ tax & tip

11 ABC COST-BENEFIT Applying ABC has a cost of information gathering. Managers must take cost-benefit into account.  Managers reject activity analysis, staying with traditional methods that are simpler.  Smaller companies don’t need sophisticated information systems  Managers use ABC because information helps them be competitive  Complex organizations facing heavy competition use ABC  Managers use ABC in special circumstances LO 2

12 COST POOLS Three major types of cost pools:  The “plant” (traditional)  Sets one indirect cost allocation rate plantwide  The department (traditional)  Sets indirect cost allocation rates for each department  The activity center (ABC)  Determines cost pool for each activity LO 2

13 ABC STEPS TO FOLLOW Accountants required to follow four steps: 1.Identify activities that consume resources; assign costs to those activities. Example: purchasing materials 2.Identify cost drivers for each activity. Cost driver for purchasing materials: # of orders 3.Compute a cost rate per cost driver unit. Cost per order 4.Assign costs to products. (Cost per order) X (number of purchase orders) LO 4

14 COST DRIVER: Definition Is a factor that causes, “drives,” an activity’s costs. LO 4

15 EXAMPLE: Cost Drivers LO 4 Machine hours Computer time Labor hours, cost Items produced, sold Pounds of material handled Clients served Pages typed Flight hours Machine setups Number of surgeries Purchase orders Scrap/rework orders Quality inspections Hours of testing time # of parts in product # of different clients Miles driven Which cost drivers listed below would a law firm use? EXHIBIT 3.3

16 EXAMPLE: Cost Drivers LO 4 Machine hours Computer time Labor hours, cost Items produced, sold Pounds of material handled Clients served Pages typed Flight hours Machine setups Number of surgeries Purchase orders Scrap/rework orders Quality inspections Hours of testing time # of parts in product # of different clients Miles driven Which cost drivers listed below would a law firm use? EXHIBIT 3.3

17 How do managers decide which cost driver to use? Typically, managers choose a cost driver that causes the cost. LO 4

18 COST RATE EQUATION LO 4 Predetermined indirect cost rate = Estimated Indirect Cost ÷ Estimated Volume of Allocation Base

19 EXAMPLE: Traditional Costing LO 4 Ciudad Juarez factory makes 2 products: mountain bikes and racing bikes. 1,000 mountain bikes and 200 racing bikes will be produced. Direct materials include  Frames: $100 per mountain bikes and $200 per racing bike  Direct labor: $30 per mountain bike and $60 per racing bike  Overhead, allocated at 5 times direct labor What would be the cost of each bike under traditional costing? Continued

20 EXAMPLE: Traditional Costing LO 4 Continued Mountain BikesRacing Bikes Direct materials$100$200 Direct Labor3060 Manufacturing overhead 1, Total cost per bike$280$ * DL 2 ($150 * 1,000 + $300 * 200) = $210,000

21 EXAMPLE: ABC Costing LO 4 Ciudad Juarez factory makes 2 products: mountain bikes and racing bikes. 1,000 mountain bikes and 200 racing bikes will be produced. Direct materials include  Frames: $100 per mountain bikes and $200 per racing bike  Direct labor: $30 per mountain bike and $60 per racing bike  Overhead, allocated by activity costs What would be the cost of each bike under ABC costing? Continued

22 EXAMPLE: ABC Costing LO 4 ActivityRateCost driver units Cost Allocated Cost driver units Cost Allocated Purchasing$20/frame1,000 frames$ 20,0001,000 frames$ 4,000 Setups$2,000/setup13 setups26,00013 setups60,000 Inspections$100/inspect hr200 hours20, hours20,000 Running machines $30/hour1,500 hrs45,0001,500 hrs15,000 Total$111,000$99,000 Mountain Bike Racing Bike Mountain Bike = $111,000 / 1,000 = $111 Racing Bike = $99,000 / 200 = $495 EXHIBIT 3.5

23 COST HIERARCHY: Definition Categorizes costs so changes in one cost can be examined for its effects on other cost categories. LO 6

24 Activity Category Example CapacitySize limitationsAircraft depreciation CustomerNeedsSpecial promotions ProductProduction needsRoute schedules Batch Fuel, baggage handling UnitVariable costsCredit card fees EXAMPLE: Hierarchy of Costs LO 6

25 RESOURCES USED: Definition Are measured by ABC. LO 7

26 UNUSED RESOURCES Knowing the difference between resources used and supplied helps managers to identify unused capacity. Finding unused capacity helps managers reduce or use it. LO 7

27 LO 7 Imprinting a hierarchy of costs on ABM statements helps managers understand what costs can be reduced or better used. EXHIBIT 3.9 Capacity-sustaining costs will have unused resources unless operating at full capacity.

28 End of CHAPTER 3