1. Activity-based Cost Management
ACC3200
Chapter 2: Job Order Costing
Activity-based Cost Management

2. Learning Objectives
Calculate cost and profit under activity-based costing.
Compare results under traditional volume based costing system and ABC
Describe approaches that can be used in activity-based management

3. Traditional Volume-Based Cost Systems
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Traditional Volume-Based Cost Systems
Because indirect costs cannot be directly traced to specific products or services, they must be assigned or allocated based on some other observable measure called an allocation base or cost driver.
Indirect Costs $$
Cost Driver or
Allocation Base
Individual Products or Services
Because indirect costs cannot be directly traced to specific products or services, they must be assigned or allocated based on some other observable measure called an allocation base or cost driver. The cost driver or allocation base can be a simple measure such as the number of units produced or direct labor hours, or can include multiple measures that capture the cause and effect relationship between activities and costs.
We have used units produced or direct labor hours to assign indirect manufacturing overhead costs to specific products. Units produced and direct labor hours are examples of a volume-based allocation measure. A volume-based allocation measure is directly related to the number of units produced or the number of customers served.
We have used units produced or direct labor hours to assign indirect manufacturing overhead costs to specific products. Units produced and direct labor hours are examples of a volume-based allocation measure.

4. Volume-Based Cost Systems
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Volume-Based Cost Systems
Assume that Toyota Motor Manufacturing Kentucky (TMMK) produces three types of automobiles, with the following cost and production information:
Assume that Toyota Motor Manufacturing Kentucky (TMMK) produces three types of automobiles, with the cost and production shown in the table on this slide. Direct materials and direct labor are traced directly to the product. The purpose of the cost allocation method is to assign the indirect or manufacturing overhead costs to each product.
The purpose of the cost allocation method is to assign the indirect or manufacturing overhead costs to each product.

5. Volume-Based Cost Systems
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Volume-Based Cost Systems
The total manufacturing overhead cost for the Kentucky plant is estimated at $3,720,000 (in thousands) per year. In our example, this cost will be assigned to the three products on the basis of direct labor hours. The first step is to calculate the predetermined overhead rate.
Predetermined
Overhead
Rate
Estimated Total Manufacturing Overhead Cost Estimated Units in the Allocation Base =
Part I
The total manufacturing overhead cost for the Kentucky plant is estimated at $3,720,000 (in thousands) per year. In our example, this cost will be assigned to the three products on the basis of direct labor hours. The first step is to calculate the predetermined overhead rate.
Part II
Recall that the predetermined overhead rate is equal to the estimated total manufacturing overhead cost for the period divided by the estimated units in the allocation base.
Part III
The predetermined overhead rate for TMMK is $240 per direct labor hour.
Predetermined
Overhead
Rate =
$3,720,000 $15,500
$240 per direct labor hour

6. Assigning Indirect Cost to Individual Products or Services
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Assigning Indirect Cost to Individual Products or Services
To assign manufacturing overhead costs to the individual products, we multiply the $240 overhead rate by the number of direct labor hours required for each product.
To assign manufacturing overhead costs to the individual products, we multiply the $240 overhead rate by the number of direct labor hours required for each product. The Camry receives the most total manufacturing overhead cost because it is the highest volume product and thus requires the most total direct labor hours.
The Camry receives the most total manufacturing overhead cost because it is the highest volume product and thus requires the most total direct labor hours.

7. Calculate Total Manufacturing Cost and Profitability
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Calculate Total Manufacturing Cost and Profitability
To compute total manufacturing cost, we need to add the manufacturing overhead cost to the direct material and direct labor cost, which were provided earlier on a per unit basis.
To compute total manufacturing cost, we need to add the manufacturing overhead cost to the direct material and direct labor cost, which were provided earlier on a per unit basis. This analysis shows that the Avalon is the most costly of the three models on a per unit basis. The Camry is the next most costly model, followed by the Camry-Hybrid.    
This analysis shows that the Avalon is the most costly of the three models on a per unit basis. The Camry is the next most costly model, followed by the Camry-Hybrid.

8. Calculate Total Manufacturing Cost and Profitability
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Calculate Total Manufacturing Cost and Profitability
If we subtract the total manufacturing cost per unit from the unit sales price, we get the gross margin for each product. Remember that gross margin only takes into account the manufacturing cost of the product, before selling and administrative costs such as distribution fees, advertising, dealer costs and profit, and corporate administration charges have been deducted.
If we subtract the total manufacturing cost per unit from the unit sales price, we get the gross margin for each product. Remember that gross margin only takes into account the manufacturing cost of the product, before selling and administrative costs such as distribution fees, advertising, dealer costs and profit, and corporate administration charges have been deducted. The gross margin analysis suggests that the Camry-Hybrid is the most profitable product, with a 54% gross margin, compared to 31% for the Avalon and 8% for the Toyota Camry. But do these profitability numbers represent the true cost of producing each model?
The gross margin analysis suggests that the Camry-Hybrid is the most profitable product,

9. Activity Based Costing (ABC)
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Activity Based Costing (ABC)
Activity Based Costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require.
Activity Based Costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require. ABC uses a two-stage process in which indirect costs are first assigned to activities, and then assigned to individual products and services based on their activities requirements

10. Stage 1: Assign Indirect Costs To Activities
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Stage 1: Assign Indirect Costs To Activities
The first stage in activity based costing is to identify all the activities that must occur to make a product or provide a service and then classify them into one of the following categories:
Facility-Level Activities are performed for the overall company, to benefit multiple customers and product lines.
Customer-Level Activities are performed for a specific customer.
Product-Level Activities are performed to support a specific product line.
Batch-Level Activities are performed all at once for a group of units or customers.
Unit-Level Activities are performed one at a time for each unit or customer.
The table on your screen shows how sample activities are categorized at TMMK.

11. Form Activity Pools and Assign Indirect Costs to Each Pool
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Form Activity Pools and Assign Indirect Costs to Each Pool
TMMK has identified the following cost pools:
TMMK Manufacturing Overhead Cost Pools
Machining and Installation
Machine Setup
Product Engineering
and Design
Quality Control
Once the activities are identified and classified, the next step is to combine similar activities together into activity cost pools. You can imagine that a company as large as Toyota has employees performing hundreds if not thousands of activities. To keep the cost system manageable, we must simplify the number of activities by grouping like or similar activities together. The goal is to create as few cost pools as possible, while still capturing the major activities identified in the previous step.
Toyota Motor Manufacturing Kentucky (TMMK) has determined that the following four activities are required to produce its product:
Machining and Installation
Machine Set-Up
Product Engineering and Design
Quality Control

12. Form Activity Pools and Assign Indirect Costs to Each Pool
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Form Activity Pools and Assign Indirect Costs to Each Pool
Recall that the total manufacturing overhead cost in our Toyota example was $3,720,000 (in thousands). Now we must assign this total cost to one of the four activity cost pools.
Recall that the total manufacturing overhead cost in our Toyota example was $3,720,000 (in thousands). Now we must assign this total cost to one of the four activity cost pools. Notice that $825,000 of the $3,720,000 is assigned to the machining and installation activity cost pool. This activity pool will include all indirect costs related to machining and installation of components, such as the depreciation on all of the robots that produce the automobiles.
The machine set-up pool will include all indirect costs related to setting up for production, including the salaries of workers who perform set-up activities, indirect materials used during the set-up process, etc. The engineering and design activity cost pool will include the salaries of product development and design engineers, the cost of developing prototype models, etc. The quality control activity pool will include the salaries of quality control engineers, depreciation on testing equipment, and the like.

13. Form Activity Pools and Assign Indirect Costs to Each Pool
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Form Activity Pools and Assign Indirect Costs to Each Pool
The general production engineer makes $120,000 per year. Allocation of time worked across the four activity cost pools
is as follows:
The general production engineer must keep track of time spent dealing with each of the four activities. The production manager makes $120,000 per year and allocation of his time across the four activity cost pools is as shown on your screen. Since the supervisor spends 40% of his time overseeing machining and installation activities, $48,000 (40% x $120,000) should be assigned to that activity cost pool.
Since the supervisor spends 40% of his time overseeing machining and installation activities, $48,000 (40% x $120,000) should be assigned to that activity cost pool.

14. Stage 2: Assign Activity Costs to Individual Products or Services
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Stage 2: Assign Activity Costs to Individual Products or Services
Select an activity cost driver for each of the activity cost pools. A cost driver is a measure of the underlying activity that occurs in each activity cost pool. The goal is to identify a driver that has a cause and effect relationship with the underlying activity. ABC systems include measures that capture something other than the sheer volume of units produced or customers sold. These measures are called nonvolume-based cost drivers.
In Stage 2 we assign activity costs to individual products or services. We begin by selecting an activity cost driver for each of the activity cost pools. A cost driver is a measure of the underlying activity that occurs in each activity cost pool. The goal is to identify a driver that has a cause and effect relationship with the underlying activity. ABC systems include measures that capture something other than the sheer volume of units produced or customers sold. These measures are called nonvolume-based cost drivers.

15. Select an Activity Cost Driver for Each Cost Pool
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Select an Activity Cost Driver for Each Cost Pool
Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the activity driver for the set-up activity. Engineering hours will be used as the driver to assign engineering and design costs. Inspection time will be used to assign quality control costs.
By incorporating activity drivers that capture other aspects of the production process besides volume, ABC can assign more indirect cost to products that require more setup time, more complex processing, more quality control, or more engineering and design. Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the activity driver for the set-up activity. Engineering hours will be used as the driver to assign engineering and design costs. Inspection time will be used to assign quality control costs.

16. 4-16
Assign Indirect Costs to Products or Services Based on Activity Demands
There are two methods that can be used to assign indirect costs to individual products or services based on their activity requirements: activity rates or activity proportions. The two methods are mathematically equivalent and will provide identical results as long as there are no rounding errors in the rates or proportions. The method used will depend on the type of information provided and whether you have complete information on all product or service lines.
There are two methods that can be used to assign indirect costs to individual products or services based on their activity requirements: activity rates or activity proportions. The two methods are mathematically equivalent and will provide identical results as long as there are no rounding errors in the rates or proportions. The method used will depend on the type of information provided and whether you have complete information on all product or service lines.
Activity Rates
Activity Proportions

17. Total Activity Cost Total Activity Driver
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Activity Rate Method
The activity rate method is very similar to the predetermined overhead rate computed earlier.
Activity Rate
Total Activity Cost Total Activity Driver =
Total indirect costs assigned to the machining pool was $825,000, the total machine hours required by each of the three Toyota models is as follows:
Part I
The first method involves computing an activity rate that is very similar to the predetermined overhead rate computed earlier. The only difference is that we will now have an activity rate for each activity cost pool.
Part II
Total indirect costs assigned to the machining pool was $825,000, the total machine hours required for the Avalon is 3,000, for the Camry 10,500, and for the Camry Hybrid 1,500, for a total of 15,000 machine hours during the period.
Part III
The activity rate for machining and installation is $55 per machine hour.
Activity Rate =
$825,000 15,000
= $55 per machine hour

18. 4-18
Activity Rate Method
To assign the cost to the products, we multiply the activity rate by the activity requirements of each individual product.
To assign the cost to the products, we multiply the activity rate by the activity requirements of each individual product. So, the total machine related indirect costs of $825,000, will be assigned to each of the three models.
3,000 × $55 = $165,00

19. Activity Proportion Method
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Activity Proportion Method
Let's assign the total cost of the set-up activity ($795,000), which will be allocated based on the number of set-ups. A set-up occurs every time the company switches from producing one product to another. Once the set-up activities are complete, a production batch for that specific product is run. The batch size is the number of units produced after each set-up.
Let's assign the total cost of the set-up activity ($795,000), which will be allocated based on the number of set-ups. A set-up occurs every time the company switches from producing one product to another. Once the set-up activities are complete, a production batch for that specific product is run. The batch size is the number of units produced after each set-up. The activity proportions suggest that 40% of all set-ups are for the Avalon. The proportion of set-ups for the Camry is 35% (350 divided by 1,000) and 25% (250 divided by 1,000) for the Camry-Hybrid. We can assign the total set-up related cost of $795,000 by multiplying by the activity proportions for each product. Let’s do that now.
100,000 ÷ 250 = 400
400 ÷ 1,000 = 40%

20. Activity Proportion Method
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Activity Proportion Method
The allocation of the machine set-up cost to the specific models is shown in the table below.
The allocation of the machine set-up cost to the specific models is shown in the table on your screen. We multiply the total machine set-up costs times the activity proportion for each model. The Avalon is allocated $318,000 ($795,000 times 40%).

21. Stage 2: Assign Activity Costs to Individual Products or Services
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Stage 2: Assign Activity Costs to Individual Products or Services
To complete the Stage 2 ABC allocations, we need to add up the cost of all four activities for each product line.
To complete the Stage 2 ABC allocations, we need to add up the cost of all four activities for each product line. Notice that the total amount of overhead cost is the same as in the traditional costing example ($3,720,000).
Notice that the total amount of overhead cost is the same as in the traditional costing example ($3,720,000).

22. Stage 2: Assign Activity Costs to Individual Products or Services
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Stage 2: Assign Activity Costs to Individual Products or Services
HOWEVER!!! Under ABC, the Camry-Hybrid receives the highest total overhead allocation, even though it is the lowest volume product. The reason is that this product is produced in small batches and requires a lot of engineering and product design, and quality inspections.
Under ABC, the Camry-Hybrid receives the highest total overhead allocation, even though it is the lowest volume product. The reason is that this product is produced in small batches and requires a lot of engineering and product design, and quality inspections.

23. Stage 2: Assign Activity Costs to Individual Products or Services
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Stage 2: Assign Activity Costs to Individual Products or Services
To calculate the cost per unit, we need to divide the total manufacturing overhead by the number of units of each product.
To calculate the cost per unit, we need to divide the total manufacturing overhead by the number of units of each product. Notice the differences in the manufacturing overhead cost allocated to the individual products under the ABC method as opposed to the volume-based approach.

24. Comparison of Volume-Based and Activity Based Cost Systems
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Comparison of Volume-Based and Activity Based Cost Systems
The differences between the traditional cost system and the ABC system relate to the volume and complexity of the three models, and how these issues are accounted for in the costing system.
Recall that the Camry received the most total manufacturing overhead under the volume-based cost system because it required the most total direct labor hours. Although the Camry model is high-volume, it is also the most basic or standard model produced at the Kentucky plant. The Avalon is a premium version of the Camry, while the Camry-Hybrid uses more innovative technology than the Camry.
The largest distortion occurs with the Camry-Hybrid. Although this is a low-volume product, it is produced in smaller batches and requires a disproportionate share of the set-ups, engineering and product design and quality inspections. The result is that the Camry-Hybrid is dramatically under-costed under the volume-based cost system compared to ABC.

25. Calculate Total Manufacturing Cost and Gross Margin
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Calculate Total Manufacturing Cost and Gross Margin
The ABC analysis shows that the Toyota Camry is the most profitable product, with a 29.4% gross margin, compared to 26% for the Avalon and negative 15.2% for the Camry-Hybrid.
The ABC analysis shows that the Toyota Camry is the most profitable product, with a 29.4% gross margin, compared to 26% for the Avalon and negative 15.2% for the Camry-Hybrid. Gross margin is the profit before any non-manufacturing costs such as selling, distribution, dealerships and corporate administration costs have been taken into account. Although this example is not intended to reflect the realities of Toyota's production process, it does illustrate a common problem with volume-based cost systems.
$28,000 - $20,730 = $7,270
$5,298 ÷ $18,000 = 29.4%

26. Activity Based Management
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Activity Based Management
Activity based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. The first step in any improvement program is to target areas that need improvement.
What Activities
Are Performed?
How Much Does it Cost to Perform Each Activity?
Does the Activity Add Value to the Customer?
Activity based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. To get benefits of ABC, managers must use it to manage the underlying activities and identify activities that would benefit from process improvements.
What activities are preformed? This question focuses managers’ attention on activities as the driver of cost within the organization.
How much does it cost to perform each activity? This question helps focus managers’ attention on those activities that have the most potential for improvement. The activity rates in the ABC system provide insight into how much it costs to perform key activities.
Does the activity add value to the customer? This is one of the most important questions in activity based management. A value-added activity is one that enhances the perceived value of the product or service to the customer. A non-value-added activity is one that, if eliminated, would not reduce the value of the product or service in the eyes of the customer. To the extent possible, managers should attempt to reduce or eliminate non-value-added activities.

27. Activity Based Management
4-27
Activity Based Management
In our Toyota example, the ABC analysis revealed that the Camry-Hybrid was much more costly to produce than the other models. If this had been a realistic scenario, what should Toyota managers do with this information?
One possibility is for managers to rethink the pricing of the Camry-Hybrid. The price would need to be increased substantially, and it is not clear that customers would be willing to pay that kind of premium.
In our Toyota example, the ABC analysis revealed that the Camry-Hybrid was much more costly to produce than the other models. If this had been a realistic scenario, what should Toyota managers do with this information?
One possibility is for managers to rethink the pricing of the Camry-Hybrid. The price would need to be increased substantially, and it is not clear that customers would be willing to pay that kind of premium. Another option managers may consider is eliminating products that do not appear profitable. Although this course of action may eventually need to be considered, managers should first try to make the product profitable.

28. Activity-based Management
Life Cycle Cost Management
TQM
Target Costing
JIT

29. Life Cycle Cost Management
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Life Cycle Cost Management
In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including
product introduction,
growth,
maturity, and
eventual decline.
In today’s digital and technological age, product life cycles become increasingly short.
Costs tend to be higher.
Most revenue earned.
Part I
In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including
product introduction,
growth,
maturity, and
eventual decline.
Cost tends to be higher in the early stages of the product life cycle (as in the case of hybrid cars).
Part II
Most of the revenues are earned in the growth and maturity stages of the life cycle.
Part III
In today's digital age, product life cycles are becoming increasingly short (only a few years in the case of technology products), so managers must be able to estimate life-cycle costs accurately to make good product introduction decisions.

30. Total Quality Management
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Total Quality Management
The second highest cost assigned to the Camry-Hybrid was due to quality control. In managing quality costs, managers must balance four types of quality costs:
Prevention costs,
Appraisal or inspection costs,
Internal failure costs, and
External failure costs.
The second highest cost assigned to the Camry-Hybrid was due to quality control. In managing quality costs, managers must balance four types of quality costs:
Prevention costs,
Appraisal or inspection costs,
Internal failure costs, and
External failure costs.
Prevention costs are incurred to prevent quality problems from occurring in the first place. Appraisal or inspection costs are incurred to identify defective products before products are shipped to customer. Internal failure costs result from defects that are caught BEFORE the product is shipped to the customer. External failure costs occur when a defective product makes its way into the hands of the customer.

31. 4-31
Target Costing
The basic idea behind target costing is to determine what the target cost must be in order to meet the market price and still provide a profit for the company's shareholders. The target cost should reflect all of the costs that are incurred across the entire value chain. In target costing, the price is set by the market based on what consumers are willing to pay for a product or service. Let’s begin to look at target pricing at Toyota by using the following estimates:
The basic idea behind target costing is to determine what the target cost must be in order to meet the market price and still provide a profit for the company's shareholders. The target cost should reflect all of the costs that are incurred across the entire value chain. In target costing, the price is set by the market based on what consumers are willing to pay for a product or service. Let’s begin to look at target pricing at Toyota assuming an estimated market price of $30,000, an annual demand in units of 20,000, a product life cycle of 3 years, and a target profit or return on sales of 20%. Let’s see how we determine the target cost for this product.

32. 4-32
Target Costing
The target cost would be computed by subtracting the target profit from the market price, as follows:
Market Price $30,000
Target Profit (20% × $30,000) $6,000
Target Cost $24,000 ̶ =
The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000). It is important to realize that the target cost includes more than just the manufacturing costs.
The target cost would be computed by subtracting the target profit from the market price. Using our estimates we would calculate the target profit of $6,000 (20% times $30,000 estimated market price). Subtract the $6,000 target profit from the market price of $30,000, and get the target cost of $24,000. The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000). It is important to realize that the target cost includes more than just the manufacturing costs.

33. 4-33
Target Costing
Given the target unit cost, how much can Toyota spend on the new model across its entire life cycle and still meet the target profit?
Part I
Given the target unit cost, how much can Toyota spend on the new model across its entire life cycle and still meet the target profit?
Part II
Now that we know the total estimated target cost over the product life cycle, we must determine if we can design and produce the model for $1,440,000,000 or less.

34. 4-34
Target Costing
Once the target cost is set, the next step is to determine whether it is feasible to design, develop, manufacture and deliver the product at this target cost.
Make Product ?
Target Cost
Design Product
Develop Process
Estimate Cost
Cost Reduction Goals
Once the target cost is set, the next step is to determine whether it is feasible to design, develop, manufacture and deliver the product at this target cost. If the estimated cost exceeds the target cost, further cost reduction is necessary, either by redesigning the product or re-engineering the process (or both). To achieve the cost reduction goals, managers from all areas (design, development, manufacturing, and accounting) must work together to find creative ways to achieve the target cost, without affecting the end value to the consumer.
Compare the estimated cost with the target cost to see if cost reduction is necessary.

35. Just-in-Time (JIT) Inventory
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Just-in-Time (JIT) Inventory
In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a "demand pull" system, where materials and products are pulled through the manufacturing system based on customer demand.
In a traditional manufacturing setting where products are pushed through the system and often end up sitting in inventory. One advantage of a JIT system is that it eliminates problems in product costing associated with holding inventory.
In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a "demand pull" system, where materials and products are pulled through the manufacturing system based on customer demand, as opposed to a traditional manufacturing setting where products are pushed through the system and often end up sitting in inventory. An advantage of using a JIT system is that it eliminates many of the problems in product costing associated with holding inventory.

36. 4-36
Summary of ABC and ABM
To gain the true benefits of activity based costing, managers must move from simply measuring costs, to find ways to manage or reduce costs. Although ABC and ABM have many potential benefits, these benefits must be weighed against the costs of obtaining the more accurate information. Implementing an ABC can be a difficult task. It requires a great deal of time and effort from many employees across the entire organization.
To gain the true benefits of activity based costing, managers must move from simply measuring costs, to find ways to manage or reduce costs. Although ABC and ABM have many potential benefits, these benefits must be weighed against the costs of obtaining the more accurate information. Implementing an ABC is not a trivial task. It requires a great deal of time and effort from many employees across the entire organization (not just accountants), as well support of upper management.

37. End of Topic 6