1. Chapter 18: Activity-Based Costing and Management
Cornerstones of
Financial and Managerial Accounting, 2e
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2. Limitations of Functional-Based Cost Accounting Systems1
Limitations of Functional-Based Cost Accounting Systems
Plantwide and departmental rates based on direct labor hours, machine hours, or other volume-based measures have been used for decades to assign overhead costs to products and continue to be used successfully by many organizations.
However, for many settings, this approach to costing is equivalent to an averaging approach and may produce distorted, or inaccurate, costs.
Plantwide and departmental rates based on direct labor hours, machine hours, or other volume-based measures have been used for decades to assign overhead costs to products and continue to be used successfully by many organizations. However, for many settings, this approach to costing is equivalent to an averaging approach and may produce distorted, or inaccurate, costs.
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3. Limitations of Functional-Based Cost Accounting Systems (continued)1
Limitations of Functional-Based Cost Accounting Systems (continued)
Product cost distortions can be damaging,
particularly for those firms whose business environment is characterized by :
Continuous Improvement
Total Quality Management
Intense worldwide competition
Sophisticated Technology
Total Customer Satisfaction
-Increasing competitive pressures
Small profit margins
Product cost distortions can be damaging, particularly for those firms whose business environment is characterized by the following:
• intense or increasing competitive pressures (often on a worldwide level)
• small profit margins
• continuous improvement
• total quality management
• total customer satisfaction
• sophisticated technology
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4. Limitations of Functional-Based Cost Accounting Systems (continued)1
Limitations of Functional-Based Cost Accounting Systems (continued)
The need for more accurate product costs has forced many companies to take a serious look at their costing procedures.
Two major factors impair the ability of unit-based plant-wide and departmental rates to assign overhead costs accurately:
The proportion of nonunit-related overhead costs to total overhead costs is large.
The degree of product diversity is great.
The need for more accurate product costs has forced many companies to take a serious look at their costing procedures.
Two major factors impair the ability of unit-based plant-wide and departmental rates to assign overhead costs accurately:
The proportion of nonunit-related overhead costs to total overhead costs is large.
The degree of product diversity is great.
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5. Categorizing Costs under ABC1
Categorizing Costs under ABC
Proponents of activity-based costing (ABC) refer to the ABC cost hierarchy that categorizes costs either as unit-level (i.e., vary with output volume), batch-level (i.e., vary with the number of groups or batches that are run), product-sustaining (i.e., vary with the diversity of the product or service line), or facility-sustaining (i.e., do not vary with any factor but are necessary in operating the plant).
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6. 1
Product Diversity
The presence of product diversity is also necessary for product cost distortion to occur.
Product diversity means that products consume overhead activities in systematically different proportions.
This may occur for several reasons, including differences in:
product size
product complexity
setup time
size of batches
The presence of product diversity is also necessary for product cost distortion to occur. Product diversity means that products consume overhead activities in systematically different proportions. This may occur for several reasons, including differences in:
product size
product complexity
setup time
size of batches
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7. Product Diversity and Product Costing Accuracy1
Product Diversity and Product Costing Accuracy
For unit-level overhead rates to fail, products must consume the non-unit-level activities in proportions significantly different than the unit-level activities.
The key message of the relationship analysis is that in a diverse product environment, activity-based costing promises greater accuracy. Given the importance of making decisions based on accurate facts, a detailed look at activity-based costing is certainly merited.
For unit-level overhead rates to fail, products must consume the non-unit-level activities in proportions significantly different than the unit-level activities.
The key message of the relationship analysis is that in a diverse product environment, activity-based costing promises greater accuracy. Given the importance of making decisions based on accurate facts, a detailed look at activity-based costing is certainly merited.
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8. Activity-Based Product Costing2
Activity-Based Product Costing
Functional-based overhead costing involves two major stages:
Overhead costs are assigned to an organizational unit (plant or department).
Overhead costs are then assigned to cost objects.
Functional-based overhead costing involves two major stages:
Overhead costs are assigned to an organizational unit (plant or department).
Overhead costs are then assigned to cost objects.
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9. Activity Dictionary 2
Interview-derived data are used to prepare an Activity dictionary, which lists the activities in an organization along with some critical activity attributes (financial and nonfinancial information items that describe individual activities). Examples include:
types of resources consumed
amount (percentage) of time spent on an activity by workers
cost objects that consume the activity output (reason for performing the activity)
measure of the activity output (activity driver)
activity name
Interview-derived data are used to prepare an activity dictionary, which lists the activities in an organization along with some critical activity attributes, like financial and nonfinancial information items that describe individual activities. Examples include:
types of resources consumed
amount (percentage) of time spent on an activity by workers
cost objects that consume the activity output (reason for performing the activity)
measure of the activity output (activity driver)
activity name
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10. Assigning Costs to Activities2
Once activities are identified and described, the next task is to determine how much it costs to perform each activity.
This determination requires identification of the resources being consumed by each activity.
The cost of labor, energy, materials, and capital is found in the general ledger, but the money spent on each activity is not revealed.
Thus, a work distribution matrix is developed which identifies the amount of labor consumed by each activity and is derived from the interview process (or a written survey). Here is an example:
Once activities are identified and described, the next task is to determine how much it costs to perform each activity. This determination requires identification of the resources being consumed by each activity. The cost of labor, energy, materials, and capital is found in the general ledger, but the money spent on each activity is not revealed.
Thus, a work distribution matrix is developed which identifies the amount of labor consumed by each activity and is derived from the interview process (or a written survey). Notice in the example, processing transactions accounts for the greatest percentage of time per activity.
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11. Assigning Costs to Products2
Assigning Costs to Products
Activity costs are assigned to products by multiplying a predetermined activity rate by the usage of the activity, as measured by activity drivers.
To calculate an activity rate, the practical capacity of each activity must be determined.
To assign costs, the amount of each activity consumed by each product must also be known.
Activity costs are assigned to products by multiplying a predetermined activity rate by the usage of the activity, as measured by activity drivers. To calculate an activity rate, the practical capacity of each activity must be determined. To assign costs, the amount of each activity consumed by each product must also be known.
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12. Activity-Based Customer Costing and Activity-Based Supplier Costing3
Activity-Based Customer Costing and Activity-Based Supplier Costing
ABC systems originally became popular for their ability to improve product-costing accuracy by tracing activity costs to the products that consume the activities.
However, since the beginning of the 21st century, the use of ABC has expanded into areas upstream (i.e., before the production section of the value chain—research and development, prototyping, etc.) and downstream (i.e., after the production section of the value chain—marketing, distribution, customer service, etc.) from production.
Specifically, ABC often is used to more accurately determine the upstream costs of suppliers and the downstream costs of customers.
Knowing the costs of suppliers and customers can be vital information for improving a company’s profitability.
ABC systems originally became popular for their ability to improve product-costing accuracy by tracing activity costs to the products that consume the activities. However, since the beginning of the 21st century, the use of ABC has expanded into areas upstream (i.e., before the production section of the value chain—research and development, prototyping, etc.) and downstream (i.e., after the production section of the value chain—marketing, distribution, customer service, etc.) from production.
Specifically, ABC often is used to more accurately determine the upstream costs of suppliers and the downstream costs of customers. Knowing the costs of suppliers and customers can be vital information for improving a company’s profitability.
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13. Process Value Analysis4
Process-value analysis is fundamental to activity-based management.
Activity-based management is a system-wide, integrated approach that focuses management’s attention on activities with the objective of improving customer value and profit achieved by providing this value.
Process value analysis focuses on cost reduction instead of cost assignment and emphasizes the maximization of system-wide performance.
Process-value analysis is fundamental to activity-based management. Activity-based management is a system-wide, integrated approach that focuses management’s attention on activities with the objective of improving customer value and profit achieved by providing this value. Process value analysis focuses on cost reduction instead of cost assignment and emphasizes the maximization of system-wide performance.
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14. Driver Analysis: The Search for Root Causes4
Managing activities requires an understanding of what causes activity costs. Every activity has inputs and outputs.
Activity inputs are the resources consumed by the activity in producing its output. Activity output is the result or product of an activity.
An activity output measure is the number of times the activity is performed. It is the quantifiable measure of the output. For example, the number of moves or distance moved are possible output measures for the material moving activity.
Driver analysis is the effort expended to identify those factors that are the root causes of activity costs.
Managing activities requires an understanding of what causes activity costs. Every activity has inputs and outputs. Activity inputs are the resources consumed by the activity in producing its output. Activity output is the result or product of an activity. An activity output measure is the number of times the activity is performed. It is the quantifiable measure of the output. For example, the number of moves or distance moved are possible output measures for the material moving activity. Driver analysis is the effort expended to identify those factors that are the root causes of activity costs.
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15. Activity Analysis: Identifying and Assessing Value Content4
The heart of process-value analysis is activity analysis.
Activity analysis is the process of identifying, describing, and evaluating the activities that an organization performs.
Activity analysis produces four outcomes:
what activities are done
how many people perform the activities
the time and resources required to perform the activities
an assessment of the value of the activities to the organization, including a recommendation to select and keep only those that add value.
Activities can be classified as value-added or nonvalue-added.
The heart of process-value analysis is activity analysis.
Activity analysis is the process of identifying, describing, and evaluating the activities that an organization performs. Activity analysis produces four outcomes:
what activities are done
how many people perform the activities
the time and resources required to perform the activities
an assessment of the value of the activities to the organization, including a recommendation to select and keep only those that add value.
Activities can be classified as value-added or nonvalue-added.
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16. Activity Management Reduces Costs in Four Ways4
* Activity elimination focuses on nonvalue-added activities.
* Activity selection involves choosing among different sets of activities that are caused by competing strategies.
* Activity reduction decreases the time and resources required by an activity.
* Activity sharing increases the efficiency of necessary activities by using economies of scale.
Activity management carries with it the objective of cost reduction. Activity management can reduce costs in four ways: (1) activity elimination; (2) activity selection; (3) activity reduction; and (4) activity sharing.
Activity elimination focuses on nonvalue-added activities.
Activity selection involves choosing among different sets of activities that are caused by competing strategies.
Activity reduction decreases the time and resources required by an activity.
Activity sharing increases the efficiency of necessary activities by using economies of scale.
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17. Quality Cost Management4
Activity-based management also is useful for understanding how quality costs can be managed.
Quality costs can be substantial in size and a source of significant savings if managed effectively.
Improving quality can produce significant improvements in profitability and overall efficiency.
Quality improvement can increase profitability in two ways:
by increasing customer demand and thus sales revenues
by decreasing costs
Activity-based management also is useful for understanding how quality costs can be managed.
Quality costs can be substantial in size and a source of significant savings if managed effectively. Improving quality can produce significant improvements in profitability and overall efficiency.
Quality improvement can increase profitability in two ways: (1) by increasing customer demand and thus sales revenues and (2) by decreasing costs
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18. Quality Related Activities4
Quality-linked activities are those activities performed because poor quality may or does exist.
The costs of performing these activities are referred to as costs of quality.
The definitions of quality-related activities imply four categories of quality costs:
prevention costs
appraisal costs
internal failure costs
external failure costs
Thus, the costs of quality are associated with two subcategories of quality-related activities: control activities and failure activities.
Quality-linked activities are those activities performed because poor quality may or does exist. The costs of performing these activities are referred to as costs of quality. The definitions of quality-related activities imply four categories of quality costs:
prevention costs
appraisal costs
internal failure costs
external failure costs
Thus, the costs of quality are associated with two subcategories of quality-related activities: control activities and failure activities.
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19. Environmental Cost Management4
For many organizations, management of environmental costs is becoming a matter of high priority and a significant competitive issue.
Environmental costs are associated with the creation, detection, remediation, and prevention of environmental degradation.
Environmental costs are classified into the same four categories as quality costs.
For many organizations, management of environmental costs is becoming a matter of high priority and a significant competitive issue. Environmental costs are associated with the creation, detection, remediation, and prevention of environmental degradation. Environmental costs are classified into the same four categories as quality costs.
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