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 Operational control

Cost driver analysis Quality management
Business process
Activity-based costing
improvement
Continuous 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
Value-added activity • Increases time spent on
product or service but does
• Increases worth of
not increase worth
product or service to a
customer • Unnecessary from customer
perspective
• Customer is willing to
pay for it • Can be reduced, redesigned
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 Non-Value-Added
Processing Time Inspection Time
Service Time Transfer Time
Idle Time
 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
 Manufacturing Cycle Efficiency
Manufacturing Value-Added
Cycle Efficiency = Processing Time
(MCE) Total Cycle Time
 Manufacturing Cycle Efficiency
Manufacturing Value-Added
Cycle Efficiency = Processing Time
(MCE) 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 manager’s 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 Allocate over number
Cost per unit
Costs of units produced

Batch-Level Allocate over number Cost per unit

Costs of units in batch in batch

Allocate over number

Product/Process- of units produced in Cost per unit
Level Costs related product line in product line
 Unit
Product and Company Batch
For each Profitability Product
product line
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-to-
make 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
 Two-Step Allocation
• Collect costs in general ledger and subsidiary
accounts
• Identify activity centers
• Accumulate costs into activity center cost
pools
– Identify cost drivers
 ABC Cost Pools
Assumptions about activity center cost pools
• Costs in each cost pool are
– Driven by homogenous activities
– Strictly proportional to the activity
 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
 Activity Drivers
• Reports requested • Repair hours
• Job change actions • Material requisitions
• Hiring actions • Purchase requisitions
• Training hours • Space occupied
• Transactions processed • Set-ups
• Engineering changes • Moves
• Defects discovered • 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. Product Variety and Process Complexity
2. Lack of Commonality in Overhead Costs
3. Problems with Current Cost Allocations
4. 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
3. 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 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?