ActivityBased Management and ActivityBased Costing

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Cost Accounting Foundations and
Evolutions Kinney, Prather, Raiborn
Chapter 5 Activity-Based Management and
Activity-Based Costing
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Learning Objectives (1 of 2)

• Identify the focus of activity-based management
• Explain why non-value-added activities cause
  costs to increase unnecessarily
• Explain why cost drivers are designated in
  activity-based costing

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Learning Objectives (2 of 2)

• Contrast activity-based costing to the
  traditional cost accounting system
• Describe the types of information provided by an
  activity-based costing/management system
• Explain when it is appropriate to use
  activity-based costing

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Activity-Based Management

• Focuses on activities during production and
  performance process
• Improves the value received by customers
• Enhances profitability

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Activity

• An activity is a repetitive action performed in
  fulfillment of a business function

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Activity-Based Management
Operational control Quality management Business
process improvement Performance measurement
Activity analysis Cost driver analysis Activity-ba
sed costing Continuous improvement
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Activity Based Management

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

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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

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Process

• A process is a series of activities that, when
  performed together, satisfy a specific objective
• Production
• Distribution
• Selling
• Administration

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Activity Analysis

• Create a Process Map (detailed flowchart) for
  each process
• Identify each step

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Activity Analysis

• Create a Process Map (detailed flowchart) for
  each process
• Identify each step
• Create Value Chart
• Identify stages and time spent in stages from
  beginning to end of process

Value-Added Processing Time Service Time
Non-Value-Added Inspection Time Transfer
Time Idle Time
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Cycle Time

• Cycle Value- Non-
• Time Added Value-Added
• Activities Activities

Eliminate or minimize activities that add the
most time and cost and the least value
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Manufacturing Cycle Efficiency
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Manufacturing Cycle Efficiency

• 100 efficiency unrealistic
• Reducing non-value-added activities will increase
  Manufacturing Cycle Efficiency
• Value-added activity usually represents about 10
  of total cycle time
• Just-in-time (JIT) increases MCE

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Non-Value-Added Activities

• Attributed to following factors
• Systemic
• Physical
• Human
• Eliminating or reducing non-value-added
  activities that create the most costs will
• Increase product/service quality
• Decrease cycle time and cost

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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

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A Management Tool

• Combine
• Activity analysis
• What activities are non-value-added?
• Cost driver analysis
• What causes costs to be incurred?

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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 managers salary

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Product Cost Behavior

• Unit-level costs are variable in relation to
  change in production volume
• Batch, product/process, and organizational level
  costs are variable for reasons other than changes
  in production volume

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Product Cost
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Product and Company Profitability Total product
revenue ltTotal product costgt Net product
margin ltOrganizational/facility-level
costsgt Company profit or loss
Unit Batch Product
For each product line
Not GAAP
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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

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When to Use ABC

• Companies use ABC when
• They have a wide variety of products or services
• High overhead costs are not proportional to the
  unit volume of individual products
• Automation makes it difficult to assign overhead
  to products using direct labor or machine hours
• Profit margins are difficult to explain
• Hard-to-make products show big profits and
  easy-to-make products show losses

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Two-Step Allocation

• Collect costs in general ledger and subsidiary
  accounts
• Identify activity centers

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Choosing an Activity Center

• Geographical proximity of equipment
• Centers of managerial responsibility
• Magnitude of product costs
• Choose a manageable number of activity centers

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Two-Step Allocation

• Collect costs in general ledger and subsidiary
  accounts
• Identify activity centers
• Accumulate costs into activity center cost pools
• Identify cost drivers

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ABC Cost Pools

• Assumptions about activity center cost pools
• Costs in each cost pool are
• Driven by homogenous activities
• Strictly proportional to the activity

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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

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Activity Drivers

• Reports requested
• Job change actions
• Hiring actions
• Training hours
• Transactions processed
• Engineering changes
• Defects discovered

• Repair hours
• Material requisitions
• Purchase requisitions
• Space occupied
• Set-ups
• Moves
• Employees

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Traditional vs. ABC Costing

• When ABC implemented
• Cost reduced for high volume, standard products
• Cost increased for low-volume, complex specialty
  products

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Long-Term Variable Costs

• Cost drivers
• Product variety number of different types of
  products
• Product complexity number of processes through
  which a product flows

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ABC Costing Considerations

• Number and diversity of products/services
  produced
• Diversity and differential degree of support
  services used for different products
• Extent to which common processes are used
• Effectiveness of current cost allocation methods
• Rate of growth of period costs

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Use ABC Costing when.

• Product Variety and Process Complexity
• Lack of Commonality in Overhead Costs
• Problems with Current Cost Allocations
• Changes in Business Environment

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Use ABC Costing when.

• 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

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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

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Use ABC Costing when.

• Changes in Business Environment
• Increase in competition
• Change in management strategy

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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
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Criticisms of ABC

• Significant amount of time and cost to implement
• Must overcome barriers to change
• Does not conform to GAAP
• May not promote total quality management

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Advantages of ABC and ABM

• Identify and monitor significant technology costs
• Trace technology costs directly to products
• Identify the cost drivers that create or
  influence cost
• Identify activities that do not contribute to
  perceived customer value

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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

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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?