Cost Accounting (12)

8/10/2019 Cost Accounting (12)

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Chapter 5Activity-Based Costing

and

Activity-Based Management


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Activity Based Costing System (ABC)

ABC systems follow a two-stage procedure to assign ovcosts to products.

Stage One: Identify significant activities and assign overhead costs to each ac

proportion to resources used.

Stage Two: Identify cost drivers appropriate to each activity and allocate ove

products.

Assigning Overhead to product costs is a difficult process.

Lets begin by identifying our major activities.

The first stage identifies significant activities in the production process and assigns overhead costs to

accordance with the cost of the organizations resources used by the activity. The overhead costs assi

comprise an activity cost pool.

Overhead assigned to activities are called activities cost pools.

After assigning overhead costs to activity cost pools in stage one, cost drivers appropriate for each co

stage two.Then the overhead costs are allocated from each activity cost pool to each product line in

amount of the cost driver consumed by the product line.


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ABC uses a four-level cost structure to determine how far down t

cycle costs should be pushed:

Unit-level (output-level)

Batch-level

Product-sustaining-level

Facility-sustaining-level

Cost Hierarchies


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Aerotech identified eight activity cost pools, which fall in

categories: unit level, batch level, product-sustaining lev

level.

The activity at the unit level must be applied to each uni

The activity at the batch level must be performed one tim

batch that goes into production.

The product-sustainingactivities are required to support

product line, but not needed for each unit or batch.

Facility-level activities are required in order for the entir

process to occur.


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Overhead CostsTotal budgeted cost = $3,894,000

Activity

Cost

Pools

Machinery

cost pool$1,212,600

Setup

cost pool$3,000

Engineering

cost pool$700,000

Unit

Level

Batch

Level

Product-

Sustaining

Level

F

Activity

must be

done on

each unit

produced.

Activity

performed

on each

batch

produced.

Activities needed to support

an entire product lineActivity required

for the produc

process to oc


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Machinery Cost PooTotal budgeted cost = $1,212

Maintenance

Depreciation

Computer Support

Lub

Ele

Cal

Activity

cost

pool

STAGE ONE

Various overhead

costs related

to machinery

Aerotech estimated the costs of maintenance, lubrication, depreciation, electricity, computer support

costs are added together. The sum is the machinery cost pool budgeted cost.


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Calculate

the pool

rate

Budgeted Machinery Costs $1,212,600

Budgeted Machine Hours 43,000

$28.20/hour

Cost

Assignment

STAGE TWO

=

=

Mode I:

$28.20 per hr.

1 hr. per unit

$28.20 per unit

Mode II:

$28.20

1.25

$35.25

Mode III:

$28.20 per hr.

2 hr. per unit

$56.40 per unit

Aerotech selected machine hours for

the cost driver, since a product that

uses more machine hours should

bear a larger share of machine-

related costs.

The budgeted machinery costs are

divided by the budgeted number ofmachine hours to arrive at the

machinery cost pool rate.

Then, for each circuit board, the machinery cost pool rate is multiplied by the number of machin

Di t t d P d t C t


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Can you identify a

is likely to face as a r

Mode I Mode II M

Tradition al cos tin g 209.00$ 302.00$ $

ABC cos tin g 183.44 261.81

Cos t dis tortion pe r u n it 25.56 40.19

Un its produ ce d 10,000 20,000 Total cos t dis tortion 255,600 803,800 (1

Traditional costing understates the cost of complex, low volume products

Distorted Product Costs

The cost per unit under ABC costing is deducted from the traditional costing unit cost.

This is cost distortion per unit.

The problem with cost distortion is more evident when the cost distortion per unit is multiplied by the n

produced.

The essence of the problem is that the traditional, volume-based costing system was over costing the hig

(Modes I and II) and under costing the complex, relatively low volume product line (Mode III).

The high-volume products basically subsidized the low volume line.

The activity-based costing system revealed this problem by more accurately assigning overhead costs to t

When the costs are understated, so is the selling price. See problem 1&2


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ABC vs Simple Costing

ABC is generally perceived to produce superior cost

figures due to the use of multiple drivers across multi

levels

ABC is only as good as the drivers selected, and their act

relationship to costs. Poorly chosen drivers will produinaccurate costs, even with ABC


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Conclusions

Each method is mathematically correct

Each method is acceptable

Each method yields a different cost figure, which will lea

to different Gross Margin calculations

Only Overhead is involved. Total Costs for the entire fir

remain the same they are just allocated to different coobjects within the firm

Selection of the appropriate method and drivers should b

based on experience, industry practices, as well as a cos

benefit analysis of each option under consideration


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A Cautionary Tale

A number of critical decisions can be made using this

information;

Should one product be pushedover another?

Should one product be dropped?

Accounting for overhead costs is an imprecise science.Accordingly, best efforts should be put forward to arrive

at a cost that is fair and reasonable.


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Rationale for Selecting a MoreRefined Costing System

Increase in product diversity

Increase in Indirect Costs

Advances in information technology

Competition in foreign markets

T ree gu e nes are presente or re n ng a cost ng system


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Step 1: Identify the products that are the chosen cost objects.

Step 2: Identify the direct costs of the products.

Step 3: Select the activities and cost-allocation basesto use for

allocating indirect costs to the products.

Step 4: Identify the indirect costsassociated with each cost-allocation

base (activity).

Step 5: Compute the rate per unitof each cost-allocation base

(activity) used to allocate indirect costs to the products.

Step 6: Compute the indirect costs allocatedto the products.

Step 7: Compute the total costs of the productsby adding all direct andindirect costs assigned to the products.

T ree gu e nes are presente or re n ng a cost ng system.

Direct-cost tracing.Identify as many direct costs as is

economically feasible.

Indirect-cost pools.Expand the number of cost pools so that eapool is somewhat homogeneous. Each cost in the pool has a simil

cause-and-effect relationship with a single cost driver. Cost-allocation bases.The cost driver serves as the cost allocatbase for each homogeneous indirect-cost pool.

C D i A characteristic of an event o


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Cost Drivers A characteristic of an event oin the incurrence of costs. In s

Degree of

Correlation

Cost of

Measurement

Behavioral

Effects

A cost driveris a characteristic of an

event or activity that results in the

incurrence of costs.

In activity-based costing systems, the

most significant cost drivers areidentified.

Then a database is created, which

shows how these cost drivers are

distributed across products.

Three factors are important in

selecting appropriate cost drivers.

The more activity cost pools

activity-based costing syste

the accuracy of the cost ass

more activity cost pools als

drivers, which results in gr

implementing and maintain

The first is the degree of

correlation. The concept of an

activity-based costing system is

to infer how each product line

consumes the activity by

observing how each product

line consumes the cost drive,

that is, how closely the two are

correlated.

The closer the correlation, the

more accurate the cost

assignments will be.

Designing any information

system entails cost-benefit

trade-offs.

Information systems have t

facilitate decisions but alsobehavior of decision make

This can be good or bad, de

behavioral effects.

In identifying cost drivers, a

consider the possible behav

Dysfunctional behavioral ef

COLLECTING ABC DATA


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COLLECTING ABC DATAINTERVIEWS AND PAPER TRAILS - The information for ABC systems initiacomes from interviews with employees in the support departments and a revie

each departments records.

STORYBOARDING -A procedure used to develop a detailed process flow chwhich visually represents activities and the relationships among activities.

MULTIDISCIPLINARY ABC PROJECT TEAMSTo gather information fromfacets of an organizations operations, it is essential to involve personnel from a

of functional areas. A typical ABC project team includes ACCOUNTING, FINANC

PRODUCTION, OPERATIONS, ENGINEERS, MARKETINGetc.

A storyboarding session identifies the key activities involved in each department.

These activities are written on small cards and placed on a large board in the order they

accomplished.

After several storyboarding sessions, a completed storyboard emerges, recording key ac

information vital to the ABC project.


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The use of

ABC costing information

to help

management

make decisions

Using activity-based

costing (ABC)

information tosupport

organizational

strategy, improve

operations, and

manage costsis called

activity-basedmanagement or ABM.


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Activity-based costingestablishes relationshipbetween overhead costs and activities so that

we can better allocate overhead costs.

Activity-based managementfocuseson managing activities to reduce costs.


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A method of management that used ABC as an integra

part in critical decision-making situations, including:

Pricing & product-mix decisions

Cost reduction & process improvement decisions

Design decisions

Planning & managing activities


l d


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Two-Dimensional ABC and Activity-

Based Management

Cost Objects

Activities

Resource costs

Cost Assignment View

The vertical element of

the model is the cost

assignment view of an

ABC system.

Cost assignment in an

ABC system uses a two-

stage cost allocation to

assignthe costs of

resources to the firms

cost objects.

Cost Object:A

product, serv

customer, act

or organizatio

unit to wh

costs are

assigned for

some

managementpurpose.

Two-Dimensional ABC and Activity-Based Management


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Two Dimensional ABC and Activity Based Management

Activity

Triggers

Cost Objects

Activities

Root

Causes

Process ViewActivity Analysis

Resource costs

Cost Assignment View

Performa

Measur

Activity Evalua

The horizontal element of the model is the process view of an ABC system. The emph

now is on the activities themselves, the various processes by which work is accomplis

the organization. The left-hand side is the activity analysis. This is the identification a

description of the activities conducted in the enterprise.

Activity analysis also

identifies the root causesof

activities, the events that

trigger activities, and the

linkages among activities.

The right-hand sid

the evaluation of

activities throughperformance

measures.

It is these proce

of activity analy

and evaluation

comprise activi

based managem


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Elimination of Non-Value-Added Cost

Nonvalue-added

activities

NecessaryUnnecessary

Activities

Reduce or

Eliminate

Continually Eval

and Improve

An important goal of activity-

based management is to

identify and eliminate non

value-added activities andcosts.

Non-value-added activ

operations that are eith

unnecessary and dispen

(2) necessary, but ineffi

and improvable.

Non-value-added costs, which

result from such activities, are

the costs of activities that can

be eliminated without

deterioration of product quality,

performance, or perceived

value.

U i ABM t Eli i t N V l


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Using ABM to Eliminate Non-Value-

Added Activities and Costs

1. Identify Activities.

2. Identify Non-Value-Added Activities.

3. Understand Activity Linkages, Root Causes, andTriggers.

4. Establish Performance Measures.

5. Report Non-Value-Added Costs.

Specify

parts

Select

vendor

Receive

parts

Produce

goods

Inspect

finishedgoods

Re

depr

There are a few steps that provide a strategy for eliminanon value added costs in both manufacturing and servic


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There are a few steps that provide a strategy for eliminanon value-added costs in both manufacturing and servicindustry firms.

Step one identifies all of the organizations significantactivities.

The resulting activity list should be broken down to the mfundamental level practical.

In step two, the non value-added activities are identified

Three criteria for determining whether an activity adds vare as follows:

Is the activity necessary? Is the activity efficiently performed? Is an activity sometimes value-added and sometimes non

value-added?

In identifying non value-added activities, it is critical to

understand the ways in which activities are linked togeth

The following chain of activities provides an example:


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The rework of defective units is a non-value-added activity.

The rework is triggered by the identification of defective products duringinspection.

The root cause of the rework, however, could lie in any one of a number ofpreceding activities.

Perhaps the part specifications were in error. Or an unreliable vendor was se

Maybe the wrong parts were received. Or the production activity is to blam

A set of linked activities (such as that depicted above) is called a process.

Sometimes activity analysis is referred to as process value analysis (PVA).

By continually measuring the performance of all activities, and comparingperformance with benchmarks, managements attention may be directed tounnecessary or inefficient activities.

Non-value-added costs should be highlighted in activity center cost reports.

By identifying non-value-added activities, and reporting their costs, managecan strive toward the ongoing goals of process improvement and eliminationon-value-added costs.

Using ABM to Eliminate Non Value


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Using ABM to Eliminate Non-Value-

Added Activities and Costs

Inspection time

Process time

Storage time

Move time Waiting time

One approach that cost-

management analysts find

helpful in identifying non-

value-added activities is tocategorize the ways in which

time is spent in a production

process.

In most manufacturing

operations, time is spent i

the five ways

See

pro


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Significant overhead costs allocated using one or two co

pools

Most or all overhead is considered unit-level

Products that consume different amounts of resources

Products that a firm should successfully make and s

consistently show small profits Operations staff disagreeing with accounting ov

manufacturing and marketing costs

Signals that Suggest that ABCImplementation Could Help a Firm


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Customer Profitability Analysis

Customer profitability analysis usesactivity-based costing to determine

the activities, costs, and profit associatedwith serving particular customers.

If managers hav

good understan

of which custom

are generating tgreatest profit, t

can make more-

informed decisio

about customer

service.


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Orders

small

quantities.

Ord

freque

Often

changes

orders.

Required

special

packaging.

Deman

fast

servic

costly customer

Many factors can result in

some customers being more

profitable than others.

Customers that order in small

quantities, order frequently,

often change their orders,

require special packaging or

handling, demand faster

delivery, or need special parts

or engineering design generally

are less profitable than

customers who demand less in

terms of customized services.



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Customer-Related Activities Cost Driver Base

Cost Dr

Rate

Order processing Purchase orders 1$

Sales contacts (phone calls, faxes, etc.) Contacts 1

Sales visits Visits 1,0

Shipment processing Shipments 2

Billing and collection Invoices 1Design/engineering change orders Design changes 4,0

Special packaging Units packaged

Special handling Units handled

A company may use these customer

related costs to help determine the

profitability of each customer.

Recall that ABC analysis relies on a cost hierarchy with cost levels, such as unit-

level, batch-level, product-line-level, customer-level, and facility- or general-

operations-level costs.

In this use of activity-based costing, the cost management team will focus on the

customer-related costs.

A company may then use these costs to determine the profitability of each

customer.

The first step is an activity based

costing analysis of certain

customer-related coststhat couldaffect a customers profitability.


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Customer Profitability Analy

Customer Profitability

0.0%

25.0%

50.0%

75.0%

100.0%

125.0%

1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 1CumulativeOperat

ingIncomeasa%ofTotal

OperatingIncome

75% of actual operating income



A graphical

portrayal of the

complete

customer-

profitability

analysis is

called acustomer-

profitability

profile.

It is a common

and useful way

of presenting a

customer-profitability

analysis to

management.

See

problem

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