Foundations and Evolutions Cost Accounting Foundations and Evolutions Kinney and Raiborn Seventh Edition Chapter 4 Activity-Based Management and Activity-Based Costing COPYRIGHT © 2009 South-Western, a part of Cengage Learning. South-Western is a trademark used herein under license.

Learning Objectives (1 of 2) Identify value-added versus non-value-added activities Explain how value-added and non-value-added activities effect manufacturing cycle efficiency Explain why cost drivers are designated in activity-based costing

Learning Objectives (2 of 2) Explain how costs are computed using activity-based costing Describe the types of management 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 Operational control Quality management Business process improvement Performance measurement Activity analysis Cost driver analysis Activity-based costing Continuous improvement

Activity Based Management External Benefits Increased customer value Enhanced profitability Internal Benefits More efficient production More accurate cost determination More effective performance evaluation

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

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

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

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

Two-Step Allocation Collect costs in general ledger and subsidiary accounts 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

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

Use ABC Costing for. 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

Use ABC Costing when…. Lack of Commonality in Overhead Costs - Some products/services use substantially more overhead than others Problems with Current Cost Allocations - Significant changes in process with no change in cost allocations - Expense majority of period costs when incurred

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

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 Supports Continuous Improvement

Criticisms of ABC Significant amount of time and cost to implement Must overcome barriers to change Does not conform to GAAP

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

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 activity-based costing and traditional cost accounting? What are cost drivers and activity drivers? What are two advantages and two criticisms of activity-based costing?

Potential Ethical Issues Ignoring non-value added activities Using non-value label to eliminate jobs Misclassifying activities to allocate costs away from lower volume products to justify lower selling prices Selecting an inappropriate cost driver to distort cost calculations

Potential Ethical Issues Using ABC to eliminate a vendor or customer Using ABC to eliminate funding of social or environmental causes Using ABC to transfer cost from fixed price contracts to cost-plus contracts