Discussion module 3 MC

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Activity-Based Costing and Management

Chapter 5

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Chapter 5: Activity-Based Costing and Management

Learning Objective 5-1 – Compute product costs under a traditional, volume-based product-costing system.

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Learning Objective 5-1. Compute product costs under a traditional, volume-based product-costing system.

Traditional, Volume-Based Costing System (1 of 2)

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Traditional, volume-based product-costing systems are usually based on a single volume-based driver, such as direct labor hours, or machine hours. We will use Dronze Inc. to demonstrate how volume-based costing is accomplished. Dronze’s manufacturing plant in Denver produces three product lines of high-quality drones for recreational and light commercial use. The company manufactures three products, including: DZ-Standard (STD), DZ Deluxe (DEL), DZ-Ultimate (ULT).

This table provides the basic data upon which the company’s traditional costing system was based.

(LO 5-1)

Traditional, Volume-Based Costing System (2 of 2)

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This spreadsheet shows the calculation of the product cost for each of the product lines. Overhead is applied to the products at the rate of $24 per direct-labor hour. Notice that all of the plant’s budgeted manufacturing overhead is lumped together in one single cost-pool. This total budgeted overhead amount of $4,896,000 is then divided by the total budgeted direct labor hours of 204,000. This results in the $24.00 per direct-labor hour that will be used to allocate overhead to all of the products. Dronze’s labor-hour-based product-costing system is typical of many manufacturing companies that use a traditional volume-based costing system. (LO 5-1)

Traditional, Volume-Based Product-Costing System – Target Selling Price

With these product costs, Dronze Inc. established target selling prices (Cost × 120%).

496.00 x 1.20

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Now that Dronze Inc. has estimated the production cost per unit, the target selling price can be set.

The company’s pricing policy has been to set a target price for each drone equal to 120 percent of its full product cost.

The estimated unit cost is multiplied by 1.20 to arrive at the target selling price. (LO 5-1)

Learning Objective 5-2 - Explain how an activity-based costing system operates, including the use of a two-stage procedure for cost assignment, the identification of activity cost pools, and the selection of cost drivers.

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Learning Objective 5-2. Explain how an activity-based costing system operates, including the use of a two-stage procedure for cost assignment, the identification of activity cost pools, and the selection of cost drivers.

Activity-Based Costing System (ABC)

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

Stage One: Identify significant activities and assign overhead costs to each activity in proportion to resources used.

Stage Two: Identify cost drivers appropriate to each activity and allocate overhead to the products.

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Activity-based costing (ABC) systems follow a two-stage procedure to assign overhead costs to products.

Assigning overhead to product costs is a difficult process.

Begin by identifying the major activities. The first stage identifies significant activities in the production process and assigns overhead costs to each activity in accordance with the cost of the organization’s resources used by the activity.

After assigning overhead costs to activity cost pools in stage one, cost drivers appropriate for each cost pool are identified in stage two. Overhead assigned to activities are called “cost pools.” The overhead costs are allocated from each activity cost pool to each product line in proportion to the amount of the cost driver consumed by the product line.

This process will be demonstrated in the next set of slides. (LO 5-2)

Learning Objective 5-3 – Explain the cost hierarchy concept, including unit-level, batch-level, product-sustaining-level, and facility-level costs.

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Learning Objective 5-3. Explain the cost hierarchy concept, including unit-level, batch-level, product-sustaining-level, and facility-level costs.

Total budgeted cost = $4,896,000

Activity

Cost

Pools

Machinery

cost pool

$1,242,000

Setup

cost pool

$210,000

Engineering

cost pool

$130,000

Facility

cost pool

$2,300,000

Unit-

Level

Batch-

Level

Product-

Sustaining-

Level

Facility-

Level

Identification

of Activity

Cost Pools

Activity

must be

done on

each unit

produced.

Activity

performed

on each

batch

produced.

Activities needed to support

an entire product line

Activity required in order

for the production

process to occur.

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Overhead Costs

Dronze Inc. identified eight activity cost pools, which fall into four broad categories: unit-level, batch-level, product-sustaining-level, and facility-level (for the purposes of this exhibit, we only include one of the batch-level activities, the others are purchasing costs, material-handling costs, quality-assurance costs, and packing and shipping costs; see next slide).

The activity at the unit level must be applied to each unit produced.

The activity at the batch level must be performed one time for each batch that goes into production.

The product-sustaining activities are required to support the entire product line, but not needed for each unit or batch.

Facility-level activities are required in order for the entire production process to occur. (LO 5-3)

Purchasing

cost pool 300,000

Material-Handling

cost pool $340,000

Quality-Assurance

cost pool $110,000

Packaging/Shipping

cost pool $264,000

Machinery

cost pool

$1,242,000

Setup

cost pool

$210,000

Engineering

cost pool

$130,000

Facility

cost pool

$2,300,000

Unit-Level

Batch-Level

Product-Sustaining-

Level

Facility-

Level

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Overhead Cost Pools

For Dronze Inc., only the machinery cost pool is at the unit-level.

There are five cost pools at the batch-level: setup, purchasing, material-handling, quality assurance, and the packaging and shipping cost pool.

The engineering cost pool is at the product-sustaining-level and the facility cost pool is at the facility level. (LO 5-3)

Learning Objectives 5-4 – Compute product costs under an activity-based costing system.

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Learning Objective 5-4. Compute product costs under an activity-based costing system.

Machinery Cost Pool

Total budgeted cost = $1,242,000

Maintenance

Depreciation

Computer Support

Lubrication

Electricity

Calibration

Activity

cost

pool

Various overhead

costs related

to machinery

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Stage One – Machinery Cost Pool

Dronze Inc. estimated the costs of maintenance, lubrication, depreciation, electricity, computer support, and calibration.

These costs are added together.

The sum is the machinery cost pool budgeted cost. (LO 5-4)

Budgeted Machinery Costs $1,242,000

Budgeted Machine Hours 230,000

$5.40/hour

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Stage Two – Machinery Cost Pool

Dronze Inc. 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 of machine hours to arrive at the machinery cost pool rate of $5.40 per hour.

Then, for each drone, the machinery cost pool rate is multiplied by the number of machine hours per drone. Finally the cost for each drone type is divided by the number of units produced to arrive at an activity cost for each type. In our example, the STD drone cost per unit is $54. The DEL drone cost per unit is $64.80, and the ULT drone cost per unit is $91.80. (LO 5-4)

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ABC Pool Cost Calculations – First 4 Activities

We would then continue to follow the same process for computing the cost per set up – but this time the cost driver is the number of production runs. For example, the activity cost pool for the setups is $210,000 and the number of expected production runs is 200. This comes out to a pool rate of $1,050 per production run. This amount is applied to each type of drone. Take a moment to look at the spreadsheet and make sure you understand how to compute each activity rate, and then how to apply it to each type of drone that the company manufactures. (LO 5-4)

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ABC Pool Cost Calculations – Last 4 Activities

Here is the spreadsheet showing the computations for the last four activities of Dronze Inc. (LO 5-4)

Product Costs from ABC

These are the new product costs when ABC is used.

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Now Dronze Inc. has new product costs for each product type.

It is the sum of the costs for direct materials, direct labor, and all of the accumulated overhead costs based on our ABC analysis. Note that the direct materials and direct labor costs are NOT AFFECTED by the use of either the traditional or ABC costing method…only the manufacturing overhead will be different. (LO 5-4)

Learning Objective 5-5 – Explain why traditional, volume-based costing systems tend to distort product costs.

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Learning Objective 5-5. Explain why traditional, volume-based costing systems tend to distort product costs.

Distorted Product Costs

Both original and ABC target selling prices are based on (Cost × 120%).

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Using the existing target pricing policy, the unit cost based on ABC costing is multiplied by 1.20 to arrive at the ABC target selling price.

What has happened at Dronze? The essence of the problem is that the traditional, volume-based costing was overcosting the high-volume product lines – STD and DEL – and undercosting the complex, relatively low-volume product line – ULT. In other words, the high-volume products basically subsidized the low-volume line. The ABC costing system revealed this problem by more accurately assigning overhead to the three product lines. (LO 5-5)

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Cost Distortion

This exhibit summarizes the effects of the cost distortion under the traditional product-costing system. Dronze Inc.’s traditional system overcosted each STD drone by $9.00, for a total of $90,000 for the STD product line on a volume of 10,000 units. Each DEL drone was overcosted by $17.70, for a total of $141,600 on a volume of 8,000 units for the DEL product line. These excess costs had to come from somewhere, and that place was the ULT product line. Each ULT drone was undercosted by $115.80, for a total of $231,600 for the ULT product line on a volume of 2,000 units. Notice that the total amount by which the STD and DEL drone products were overcosted equals the total amount by which the ULT drone was undercosted. (LO 5-5)

Two Key Points

A large proportion of non-unit-level activities

A unit-level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of non-unit-level activities accurately.

Product diversity

When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

5-20

To summarize, each of the following characteristics will undermine the ability of a volume-based product-costing system to assign overhead costs accurately.

A large proportion of non-unit-level activities; and

Product diversity. When the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead costs.

When either of the above characteristics is present, a volume-based product-costing system is likely to distort product costs. (LO 5-5)

Learning Objective 5-6 – Explain three criteria for selecting cost drivers.

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Learning Objective 5-6. Explain three criteria for selecting cost drivers.

Cost Drivers

A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . .

Degree of

Correlation

Cost of

Measurement

Behavioral

Effects

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A cost driver is a characteristic of an event or activity that results in the incurrence of costs. In activity-based costing systems, the most significant cost drivers are identified. 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 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. The more activity cost pools there are in an activity-based costing system, the greater the accuracy of the cost assignments will be. However, more activity cost pools also entail more cost drivers, which results in greater costs of implementing and maintaining the system.

Information systems have the potential not only to facilitate decisions but also to influence the behavior of decision makers. This can be good or bad, depending on the behavioral effects. In identifying cost drivers, an ABC analyst should consider the possible behavioral consequences. Dysfunctional behavioral effects are also possible. (LO 5-6)

Learning Objective 5-7 – Discuss several implementation processes in activity-based costing, including data collection and storyboarding.

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Learning Objective 5-7. Discuss several implementation processes in activity-based costing, including data collection and storyboarding.

COLLECTING ABC DATA

INTERVIEWS AND PAPER TRAILS - The information for ABC systems initially comes from interviews with employees in the support departments and a review of each department’s records.

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

MULTIDISCIPLINARY ABC PROJECT TEAMS - To gather information from all facets of an organization’s operations, it is essential to involve personnel from a variety of functional areas. A typical ABC project team includes ACCOUNTING, FINANCE, PRODUCTION, OPERATIONS, ENGINEERS, MARKETING, etc.

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The information used in ABC systems initially comes from extensive interviews with key employees in each of the organization’s support departments and a careful review of each department’s records.

Storyboarding is a procedure used to develop a detailed process flowchart, which visually represents activities and the relationships among the activities.

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 are accomplished.

After several storyboarding sessions, a completed storyboard emerges, recording key activity information vital to the ABC project. (LO 5-7)

Learning Objective 5-8 – Explain the concepts of activity-based management and two-dimensional activity-based costing.

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Learning Objective 5-8. Explain the concepts of activity-based management and two-dimensional activity-based costing.

Activity-Based Management

The use of ABC costing information to help management make decisions

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Using activity-based costing (ABC) information to support organizational strategy, improve operations, and manage costs is called activity-based management or ABM. (LO 5-8)

Activity-Based Management (ABM)

Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs.

Activity-based management focuses on managing activities to reduce costs.

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Activity-based costing establishes relationships between overhead costs and activities so that we can better allocate overhead costs.

Activity-based management focuses on managing activities to reduce costs. (LO 5-8)

Two-Dimensional ABC and Activity-Based Management (1 of 2)

Activities

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One way to describe the relationship between ABC and ABM is in terms of a two-dimensional activity-based costing model.

The activities, which are the center of the model, are the focal point of ABC and ABM. (LO 5-8)

Two-Dimensional ABC and Activity-Based Management (2 of 2)

Cost Objects

Activities

Resource Costs

Cost Assignment View

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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 assign the costs of resources to the firm’s cost objects. (LO 5-8)

Two-Dimensional ABC and Activity-Based Management – Process View

Activity

Triggers

Cost Objects

Activities

Root

Causes

Process View

Activity Analysis

Resource Costs

Cost Assignment View

Performance

Measures

Activity Evaluation

5-30

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

The emphasis now is on the activities themselves, the various processes by which work is accomplished in the organization. The left-hand side is the activity analysis.

This is the identification and description of the activities conducted in the enterprise.

Activity analysis also identifies the root causes of activities, the events that trigger activities, and the linkages among activities.

The right-hand side is the evaluation of activities through performance measures.

It is these processes of activity analysis and evaluation that comprise activity-based management. (LO 5-8)

Elimination of Non-Value-Added Costs

Non-value-added activities

Necessary

Unnecessary

Activities

Reduce or Eliminate

Continually Evaluate and Improve

5-31

An important goal of activity-based management is to identify and eliminate non-value-added activities and costs.

Non-value-added activities are operations that are either (1) unnecessary and dispensable or (2) necessary, but inefficient 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. (LO 5-8)

Using ABM to Eliminate Non-Value-Added Activities and Costs (1 of 2)

Identify Activities.

Identify Non-Value-Added Activities.

Understand Activity Linkages, Root Causes, and Triggers.

Establish Performance Measures.

Report Non-Value-Added Costs.

Specify

parts

Select

vendor

Receive

parts

Produce

goods

Inspect

finished

goods

Rework

defective

products

5-32

There are five steps that provide a strategy for eliminating non-value-added costs in both manufacturing and service industry firms. Step 1 identifies all of the organization’s significant activities. The resulting activity list should be broken down to the most fundamental level practical.

In step 2, the non-value-added activities are identified. Three criteria for determining whether an activity adds value are 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 together (step 3). The following chain of activities provides an example:

The rework of defective units is a non-value-added activity. The rework is triggered by the identification of defective products during inspection. The root cause of the rework, however, could lie in any one of a number of preceding activities. Perhaps the part specifications were in error. Or an unreliable vendor was selected. Maybe the wrong parts were received. Or the production activity is to blame. 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 comparing performance with benchmarks, management’s attention may be directed to unnecessary or inefficient activities (step 4).

Non-value-added costs should be highlighted in activity center cost reports (step 5). By identifying non-value-added activities, and reporting their costs, management can strive toward the ongoing goals of process improvement and elimination of non-value-added costs. (LO 5-8)

Using ABM to Eliminate Non-Value-Added Activities and Costs (2 of 2)

Inspection time

Process time

Storage time

Move time

Waiting time

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One approach that cost-management analysts find helpful in identifying non-value-added activities is to categorize the ways in which time is spent in a production process.

In most manufacturing operations, time is spent in the five ways shown above. (LO 5-8)

Learning Objective 5-9 – Explain and execute a customer-profitability analysis.

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Learning Objective 5-9. Explain and execute a customer-profitability analysis.

Customer Profitability Analysis (1 of 2)

Customer profitability analysis uses

activity-based costing to determine

the activities, costs, and profit associated with serving particular customers.

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Customer-profitability analysis uses activity-based costing to determine the activities, costs, and profit associated with serving particular customers.

If managers have a good understanding of which customers are generating the greatest profit, they can make more informed decisions about customer service. (LO 5-9)

Customer Profitability Analysis (2 of 2)

Orders small quantities

Orders frequently

Often changes orders

Requires special packaging

Demands fast service

A costly customer

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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. (LO 5-9)

Customer Profitability Analysis (Costs)

A company may use these customer related costs to help determine the profitability of each customer.

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The first step is to produce an activity-based cost analysis of certain customer-related costs that could affect a customer’s profitability.

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. (LO 5-9)

Customer Profitability Analysis (Graph)

75% of actual operating income

50% of actual operating income

25% of actual operating income

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A graphical portrayal of the complete customer-profitability analysis is called a customer-profitability profile.

It is a common and useful way of presenting a customer-profitability analysis to management. (LO 5-9)

Learning Objective 5-10 – Understand and discuss how activity-based costing and its variant time-driven activity-based costing are used in service-industry organizations.

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Learning Objective 5-10. Understand and discuss how activity-based costing and its variant time-driven activity-based costing are used in service-industry organizations.

ABC Costing in the Service Industry

The overall objectives of ABC in service firms are no different than they are in manufacturing companies.

Identify the activities.

Create activity cost pools.

Identify activity cost drivers.

Follow similar steps discussed in chapter.

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We conclude this chapter with the important point that activity-based costing has found widespread usage in the service industry as well as in manufacturing. Some service organizations that have utilized ABC costing are Air France, American Airlines, American Express, and Bank of America, just to name a few. (LO 5-10)

End Chapter 5

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Customer-Related Activities Cost Driver Base

Cost Drive

Rate

Order processingPurchase orders150$

Sales contacts (phone calls, faxes, etc.)Contacts100

Sales visitsVisits1,000

Shipment processingShipments 200

Billing and collectionInvoices 160

Design/engineering change ordersDesign changes 4,000

Special packagingUnits packaged 40

Special handlingUnits handled 60

Sheet1


Customer-Related Activities	Cost Driver Base	Cost Drive Rate
Order processing	Purchase orders	$ 150
Sales contacts (phone calls, faxes, etc.)	Contacts	100
Sales visits	Visits	1,000
Shipment processing	Shipments	200
Billing and collection	Invoices	160
Design/engineering change orders	Design changes	4,000
Special packaging	Units packaged	40
Special handling	Units handled	60

Sheet2

Sheet3

Customer Profitability

0.0%

25.0%

50.0%

75.0%

100.0%

125.0%

1234567891011121314151617181920

Cumulative Operating Income as a % of Total

Operating Income

Chart1

0.088
0.173
0.255
0.334
0.411
0.489
0.565
0.63
0.699
0.763
0.826
0.884
0.935
0.982
1.029
1.048
1.056
1.051
1.028
1

Operating Income

Cumulative Operating Income as a % of Total Operating Income

Customer Profitability

Sheet1


Customer-Related Activities	Cost Driver Base	Cost Drive Rate	Customer	Operating Income
Order processing	Purchase orders	$ 150	1	8.8%
Sales contacts (phone calls, faxes, etc.)	Contacts	100	2	17.3%
Sales visits	Visits	1,000	3	25.5%
Shipment processing	Shipments	200	4	33.4%
Billing and collection	Invoices	160	5	41.1%
Design/engineering change orders	Design changes	4,000	6	48.9%
Special packaging	Units packaged	40	7	56.5%
Special handling	Units handled	60	8	63.0%
			9	69.9%
			10	76.3%
			11	82.6%
			12	88.4%
			13	93.5%
			14	98.2%
			15	102.9%
			16	104.8%
			17	105.6%
			18	105.1%
			19	102.8%
			20	100.0%
			1

Sheet1

0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0
0

Operating Income

Cumulative Operating Income as a % of Total Operating Income

Customer Profitability