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Chapter 5 Activity Based Costing

1. Activity-based management focuses on improving processes and value to customers through analyzing activities, costs, and drivers. 2. Activity-based costing assigns costs to products based on their demands on activities and associated cost pools, rather than traditional methods like direct labor hours. 3. Activity-based costing is appropriate when there is high product variety or complexity, overhead costs are not proportional to volume, or current cost allocations are problematic.

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1K views

Chapter 5 Activity Based Costing

1. Activity-based management focuses on improving processes and value to customers through analyzing activities, costs, and drivers. 2. Activity-based costing assigns costs to products based on their demands on activities and associated cost pools, rather than traditional methods like direct labor hours. 3. Activity-based costing is appropriate when there is high product variety or complexity, overhead costs are not proportional to volume, or current cost allocations are problematic.

Uploaded by

Atif Saeed
Copyright
© Attribution Non-Commercial (BY-NC)
Available Formats
Download as PPT, PDF, TXT or read online on Scribd
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Cost Accounting Foundations and Evolutions

Kinney, Prather, Raiborn

Chapter 5 Activity-Based Management and Activity-Based Costing

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

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

Activity-Based Management
Focuses on activities during production and performance process Improves the value received by customers Enhances profitability

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

Activity-Based Management

Activity analysis Cost driver analysis Activity-based costing Continuous improvement

Operational control Quality management Business process improvement Performance measurement

ABM

Activity Based Management


External Benefits
Increased customer value Enhanced profitability

Internal Benefits
More efficient production More accurate cost determination More effective performance evaluation

ABM

Activity Analysis
Non-value-added activity Increases time spent on Value-added activity product or service but does Increases worth of not increase worth product or service to a Unnecessary from customer customer perspective Customer is willing to Can be reduced, redesigned pay for it or eliminated without affecting market value or quality Business-value-added activities are essential

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

ABM

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

ABM

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

Cycle Time
Cycle Time = ValueAdded + Activities NonValue-Added Activities

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

Manufacturing Cycle Efficiency


Manufacturing Cycle Efficiency (MCE)

Value-Added Processing Time Total Cycle Time

Manufacturing Cycle Efficiency


Manufacturing Cycle Efficiency (MCE)

Value-Added Processing Time Total Cycle Time

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

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

ABM

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

A Management Tool
Combine Activity analysis
What activities are non-value-added?

Cost driver analysis


What causes costs to be incurred?

ABM

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

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

Product Cost
Unit-Level Costs Batch-Level Costs Allocate over number of units produced Allocate over number of units in batch Allocate over number of units produced in related product line Cost per unit

Cost per unit in batch

Product/ProcessLevel Costs

Cost per unit in product line

For each product line

Product and Company Profitability

Unit Batch Product

Total product revenue <Total product cost> Net product margin <Organizational/facility-level costs> Company profit or loss Not GAAP

ABM

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

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-tomake products show losses

Two-Step Allocation
Collect costs in general ledger and subsidiary accounts Identify activity centers

Choosing an Activity Center


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

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

Two-Step Allocation

ABC Cost Pools


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

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

Two-Step Allocation

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

Traditional vs. ABC Costing


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

Long-Term Variable Costs


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

ABM

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

ABM

Use ABC Costing when.


1. 2. 3. 4. Product Variety and Process Complexity Lack of Commonality in Overhead Costs Problems with Current Cost Allocations Changes in Business Environment

ABM

Use ABC Costing when.


1. 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

ABM

Use ABC Costing when.


2. Lack of Commonality in Overhead Costs
- Some products/services use substantially more overhead than others

1. Problems with Current Cost Allocations


- Significant changes in process with no change in cost allocations - Expense majority of period costs when incurred

ABM

Use ABC Costing when.


4. Changes in Business Environment
Increase in competition Change in management strategy

ABM

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

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

ABM

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

ABM

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

Questions
What are the differences between activitybased costing and traditional cost accounting? What are cost drivers and activity drivers? What are two advantages and two criticisms of activity-based costing?

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