Activity Based Costing and Management Systems ABC systems focus on the activities and the business...
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Transcript of Activity Based Costing and Management Systems ABC systems focus on the activities and the business...
Activity Based Costing and Activity Based Costing and Management SystemsManagement Systems
• ABC systems focus on the activities and the ABC systems focus on the activities and the business processes as the foundation for business processes as the foundation for determining the cost of goods, services, processes, determining the cost of goods, services, processes, or any cost objector any cost object
• ABC systems attempt to address the problems ABC systems attempt to address the problems found with traditional costing systems, such as found with traditional costing systems, such as ignoring volume differences, diversity, and ignoring volume differences, diversity, and resource demands of different cost objectsresource demands of different cost objects
ABC BasicsABC Basics• ABC systems use a cost hierarchy: unit level, ABC systems use a cost hierarchy: unit level,
batch level, product sustaining level, and facility batch level, product sustaining level, and facility sustaining levelsustaining level
• ABC systems, as part of identifying the relevant ABC systems, as part of identifying the relevant activities, also classify these activities into value-activities, also classify these activities into value-added and non-value added activities, so it added and non-value added activities, so it becomes a management toolbecomes a management tool
• ABC systems recognize not only economies of ABC systems recognize not only economies of scale but economies of scopescale but economies of scope
• At the heart of ABC is a two stage allocation At the heart of ABC is a two stage allocation processprocess
The Two Stage Process in ABCThe Two Stage Process in ABC
• Stage 1: Create homogeneous cost pools based on Stage 1: Create homogeneous cost pools based on activities and/or processes; e.g., group all purchasing costs activities and/or processes; e.g., group all purchasing costs together, all set-up costs together, all delivery costs together, all set-up costs together, all delivery costs together. This may take some work since most accounting together. This may take some work since most accounting systems gather cost by account categories such as salaries, systems gather cost by account categories such as salaries, depreciation, supplies, etc. and these accounts have to be depreciation, supplies, etc. and these accounts have to be studied in order to break them down into homogeneous studied in order to break them down into homogeneous costs poolscosts pools
• Stage 2: Allocate from the cost pools to the cost object Stage 2: Allocate from the cost pools to the cost object (usually a product) using second stage cost drivers; e.g., (usually a product) using second stage cost drivers; e.g., number of deliveries, number of setupsnumber of deliveries, number of setups
Mapping Resource Expenses to Activities: Stage OneMapping Resource Expenses to Activities: Stage One
Salaries and Fringes$313,000
Occupancy$111,000
Equipment and Technology
$146,000
Materials and Supplies$30,000
Activity
Salaries andFringes Occupancy
Equipment andTechnology
Materials and Aupplies Total
Process Customer Orders 31,000$ 5,300$ 12,600$ 800$ 49,700$ Purchase Materials 34,000 6,900 8,800 1,500 51,200Schedule Production Orders 22,000 1,200 18,400 300 41,900Move Materials 13,000 2,100 22,300 3,600 41,000Set-up Machines 42,000 700 4,800 200 47,700Inspect Items 19,000 13,000 19,700 800 52,500Maintain Product Info 36,000 2,800 14,500 400 53,700Perform Engineering Changes 49,000 32,000 26,900 2,400 110,300Expedite Orders 14,000 900 700 500 16,100Introduce New products 35,000 44,000 16,100 18,700 113,800Resolve Quality Problems 18,000 2,100 1,200 800 22,100Total 313,000$ 111,000$ 146,000$ 30,000$ 600,000$
Total$600,000
An ABC ExampleAn ABC Example
Supermarkets Drugstores MA and Pa Total
Average Revenue per delivery $30,900 $10,500 $1,980
Average CGS per delivery 30,000 10,000 1,800
Gross Margin per delivery 900 500 180
Number of Deliveries 120 300 1,000 1,420
Total Gross margin $108,000 $150,000 $180,000 $438,000
Gross Margin % 2.9% 4.8% 9.1%
Other operating Costs 301,080
Operating Profit 136,920
Allocation of Other Costs 74,239 103,110 123,731 301,080
Distribution Line Profit 33,761 46,890 56,269 136,920
Profit Margin 0.9% 1.5% 2.8%
Other Costs are allocated in proportion to Gross Margin
301,080/438,000 = 68.7%; Ma and Pa = 68.7% * 180,000 = 123,731
An ABC Example, 2An ABC Example, 2
The manager of this pharmaceutical distribution company heard about ABC and thought it may be useful for his operations. He identified 5 key activities, and their corresponding cost drivers.
Activity Cost Driver
Order Processing Number of Orders
Line Item Ordering Number of Line Items
Store Delivery Number of Store Deliveries
Cartons Shipped to Stores Number of Cartons shipped/delivery
Shelf Stacking at Store Number of hours of shelf stacking
An ABC Example, 3An ABC Example, 3
Each order consists of one or more line items. A line item represents a single product (such as Extra Strength Tylenol. Each Store delivery entails delivery of one or more cartons of products. Each product is delivered in one or more separate cartons. The delivery staff stock cartons directly onto display shelves in a store. Currently there is no charge for this service, and not all customers use this service.
An ABC Example, 4An ABC Example, 4
The firm has finished Stage 1 and has assigned the following costs to each of the five activity areas
Activity Area Total Costs Total Units of Cost Driver
Order Processing $80,000 2,000 orders
Line Item Ordering 63,840 21,280 line items
Store Deliveries 71,000 1,420 store deliveries
Carton Deliveries 76,000 76,000 cartons
Shelf Stacking 10,240 640 hours
An ABC Example, 5An ABC Example, 5
Other useful data by distribution line
Supermarkets Drugstores Ma and Pa
1. Total number of orders 140 360 1,500
2. Average number of line
items per order 14 12 10
3. Total number of store
deliveries 120 300 1,000
4. Average number of
cartons shipped per delivery 300 80 16
5. Average number of hours
of shelf stacking per delivery 3 0.6 0.1
An ABC Example, 6An ABC Example, 6
First, calculate the cost driver rate for each cost pool.
Activity Area Total Costs Total Units of Cost Driver Cost Driver Rate
Order Processing $80,000 2,000 orders $40/order
Line Item Ordering 63,840 21,280 line items 3/line item
Store Deliveries 71,000 1,420 store deliveries 50/store delivery
Carton Deliveries 76,000 76,000 cartons 1/carton
Shelf Stacking 10,240 640 hours 16/hour
An ABC Example, 7An ABC Example, 7
Next, allocate these costs to each distribution channel
Supermarkets Drugstores Ma and Pa
1. Orders 140*40=5,600 360*40=14,400 1,500*40=60,000
2. Average line items 14 12 10
2a. Total line items 1,960*3=5,880 4,320*3=12,960 15,000*3=45,000
3. Deliveries 120*50=6,000 300*50=15,000 1,000*50=50,000
4. Average # of cartons 300 80 16
4a. Total cartons 36,000*1=36,000 24,000*1=24,000 16,000*1=16,000
5. Average stacking hours 3 0.6 0.1
5a. Total Stacking hours 360*16=5,760 180*16=2,880 100*16=1,600
Totals (= 301,080) 59,240 69,240 172,600
An ABC Example, 8An ABC Example, 8
Comparing ABC to Traditional Costing Profit: Supermarket
Traditional ABC
Average Revenue per delivery $30,900 $30,900
Average CGS per delivery 30,000 30,000
Gross Margin per delivery 900 900
Number of Deliveries 120 120
Total Gross margin $108,000 $108,000
Allocation of Other Costs 74,239 59,240
Distribution Line Profit 33,761 48,760
Profit Margin 0.9% 1.3%
An ABC Example, 9An ABC Example, 9
Comparing ABC to Traditional Costing Profit: Drugstores
Traditional ABC
Average Revenue per delivery $10,500 $10,500
Average CGS per delivery 10,000 10,000
Gross Margin per delivery 500 500
Number of Deliveries 300 300
Total Gross margin $150,000 $150,000
Allocation of Other Costs 103,110 69,240
Distribution Line Profit 46,890 80,760
Profit Margin 1.5% 2.6%
An ABC Example, 10An ABC Example, 10
Comparing ABC to Traditional Costing Profit: Ma and Pa
Traditional ABCAverage Revenue per delivery $1,980 $1,980
Average CGS per delivery 1,800 1,800
Gross Margin per delivery 180 180
Number of Deliveries 1,000 1,000
Total Gross margin $180,000 $180,000
Allocation of Other Costs 123,731 172,600
Distribution Line Profit 56,269 7,400
Profit Margin 2.8% 0.4%
An ABC Example, 10An ABC Example, 10
Summary Profit Comparison of Traditional vs. ABC
Traditional ABC
Supermarket 33,761 (0.9%) 48,760 (1.3%)
Drugstores 46,890 (1.5%) 80,760 (2.6%)
Ma and Pa 56,269 (2.8%) 7,400 (0.4%)
Total 136,920 136,920
An ABC Example, 11An ABC Example, 11
• Note that the total profit for the firm has not Note that the total profit for the firm has not changed at all as a result of using ABC vs. changed at all as a result of using ABC vs. traditional costing techniquestraditional costing techniques
• So what’s the big deal??So what’s the big deal??• Some people argue that for many firms using ABC Some people argue that for many firms using ABC
is analogous to re-arranging the chairs on the deck is analogous to re-arranging the chairs on the deck of the Titanic - it really doesn’t stop a firm from of the Titanic - it really doesn’t stop a firm from failingfailing
• also, ABC is not GAAPalso, ABC is not GAAP– also, implementing ABC is a significant taskalso, implementing ABC is a significant task
• This is true if figuring out new product costs is the This is true if figuring out new product costs is the only thing ABC is used foronly thing ABC is used for
So What is the Value of ABCSo What is the Value of ABC• Like any accounting system, ABC is an Like any accounting system, ABC is an
INFORMATION system - it provides info to INFORMATION system - it provides info to assist decision makers, but in and of itself this info assist decision makers, but in and of itself this info DOES NOTHING, unless management acts upon DOES NOTHING, unless management acts upon itit
• ABC provides insights into your business that ABC provides insights into your business that management was probably not aware of beforemanagement was probably not aware of before
• The old system simply charged each line 68.7% of The old system simply charged each line 68.7% of its gross margin to arrive at product line its gross margin to arrive at product line profitability - peanut butter costingprofitability - peanut butter costing
So What is the Value of ABC, 2So What is the Value of ABC, 2
• The ABC system reveals however that the MA and PA The ABC system reveals however that the MA and PA stores actually consume 95.9% of its gross margin with stores actually consume 95.9% of its gross margin with other operating expensesother operating expenses
• This is because the MA and PA stores are more activity This is because the MA and PA stores are more activity intense, and thus more cost intensiveintense, and thus more cost intensive
• Under the old system, MA and PA stores were charged Under the old system, MA and PA stores were charged 41.1% (180,000/438,000) of overhead, since this was their 41.1% (180,000/438,000) of overhead, since this was their share of gross marginshare of gross margin
• However, if you look at the activities, you can see that MA However, if you look at the activities, you can see that MA and PA stores account for well over 41.1% of the activities and PA stores account for well over 41.1% of the activities (75% of the orders, 70% of the deliveries, etc)(75% of the orders, 70% of the deliveries, etc)
How can managers act on this infoHow can managers act on this info
• Now that managers know the cost of these Now that managers know the cost of these activities, they can work to try and reduce those activities, they can work to try and reduce those costscosts
• Also, they can see why Ma and Pa stores are so Also, they can see why Ma and Pa stores are so expensive (they order more often, they have more expensive (they order more often, they have more deliveries, etc.) and they work with these stores to deliveries, etc.) and they work with these stores to try and reduce those activities; i.e., less frequent try and reduce those activities; i.e., less frequent ordering, less frequent deliveriesordering, less frequent deliveries
• Also, since part of ABC is activity identification Also, since part of ABC is activity identification and classification as VA or NVA, managers can and classification as VA or NVA, managers can attempt to eliminate or minimize NVAattempt to eliminate or minimize NVA
When Would ABC not be UsefulWhen Would ABC not be Useful(at least from a product costing view)(at least from a product costing view)
• If the company only has one productIf the company only has one product• If all products use all resources in the same If all products use all resources in the same
proportions, which is the same proportion used to proportions, which is the same proportion used to allocate costs in a traditional system (little allocate costs in a traditional system (little diversity)diversity)
• Cost control is not critical at this stage for the Cost control is not critical at this stage for the company (growth stage companies)company (growth stage companies)
When Would ABC be most UsefulWhen Would ABC be most Useful
• The Willie Sutton ruleThe Willie Sutton rule– large expenses in indirect and support resourceslarge expenses in indirect and support resources
• High diversity (products, customers, processes)High diversity (products, customers, processes)• When a firm wants to better understand its When a firm wants to better understand its
activities and the costs of those activities, even if activities and the costs of those activities, even if the firm only makes one productthe firm only makes one product
Developing an ABC System, 1Developing an ABC System, 1
• There are four sequential steps a firm would go There are four sequential steps a firm would go through o develop an ABC systemthrough o develop an ABC system– Develop the activity dictionaryDevelop the activity dictionary
– determine how much the organization is spending on determine how much the organization is spending on each of its activitieseach of its activities
– identify the organization’s products, services, and identify the organization’s products, services, and customerscustomers
– select activity cost drivers that link activity costs to the select activity cost drivers that link activity costs to the organization’s products, services, and customersorganization’s products, services, and customers
• transaction, duration, and intensitytransaction, duration, and intensity
Developing an ABC System, 2Developing an ABC System, 2
• The goal of an ABC system should not be to The goal of an ABC system should not be to develop the most accurate, but one that balances develop the most accurate, but one that balances the cost of errors made from inaccurate estimates the cost of errors made from inaccurate estimates with the cost of measurementwith the cost of measurement
• Activity cost drivers are the central innovation of Activity cost drivers are the central innovation of ABC systems, but they are also the most costlyABC systems, but they are also the most costly