Chapter 5 Activity-Based Systems: Activity-Based Management and Just-in-Time

Activity-Based Systems To create value and to satisfy customer needs for quality, reasonable price, and timely delivery, managers must:

Activity-Based Systems Work with suppliers and customers. View the organization as a collection of value-adding activities. Use resources for value-adding activities Reduce or eliminate nonvalue-adding activities. Know the total cost of creating value for a customer.

Managers work with suppliers and customers: To improve quality To reduce costs To improve delivery time

Activity-Based Systems Managers need to know the full product cost. Managers use resources efficiently by matching resources to activities that add value. Full product cost includes not direct materials and direct labor, but all production and non-production activities Activity-based systems are information systems that provide quantitative information

Using Activity-Based Systems in the Management Cycle Product costing information helps improve operating processes and make better pricing decisions.

Activity-Based Systems and the Management Cycle

Activity-Based Management Activity-based management (ABM) is an approach to management that includes: Identifying all major operating activities. Determining what resources are consumed by each activity. Categorizing the activities as either adding value to a product or service or not adding value.

Activity-Based Management Focuses on the reduction or elimination of nonvalue-adding activities. ABM provides financial and operational performance information at the activity level that: Useful for deciding on product lines, market segments and customer groups Eliminates waste and inefficiencies

Activity-Based Costing ABC is the tool used in an ABM environment to assist in assigning activity costs to cost objects for product costing and decision making. Improves pricing and profitability decisions and inventory valuations.

Supply Networks and Value Chains Two tools of ABM are supply chains analysis and value chain analysis They help managers better understand their organization’s external and internal operations.

Supply Network A supply network is an interdependent web of organizations that supply materials, products, or services to a customer. A supply network includes suppliers and suppliers’ suppliers as well as customers and customers’ customers. It moves from materials through production, distribution and retailing to the final customer.

Value Chain A value chain is a related sequence of value-creating activities within an organization. It helps managers better understand the interdependencies of those activities. A company’s value chain is part of its supply chain. It includes the value chains of suppliers and customers.

Supply Network and Value Chain for a Manufacturing Company

Value Chain When organizations work cooperatively with others in their supply chain or larger value chain, new processes can be introduced to reduce the total cost of products or services, and enhance quality

ABM in a Service Organization The supply network includes the suppliers of goods and services, the organization itself, its customers and the customers’ customers. The value chain includes marketing, market research, purchasing supplies, processing orders, providing services and customer relations.

Supply Network and Value Chain for a Service Organization

Value-Adding Activities A value-adding activity is an activity that adds value to a product or service as perceived by the customer. Examples include: Designing a car. Assembling a car. Painting a car. Installing brakes on a car.

Nonvalue-Adding Activities A nonvalue-adding activity is an activity that adds cost to a product or service but does not increase its market value. Examples include: Moving materials. Storing materials.

Process Value Analysis Process value analysis (PVA) is an analytical method of identifying all activities and relating them to events that cause or drive the need for the activities and the resources consumed.

Costs and Resources By identifying nonvalue-adding activities, organizations can reduce costs and redirect resources to value-adding activities. To manage the cost of an activity, the frequency of the activity can be reduced or it can be eliminated. Outsourcing may also reduce costs.

Value-Adding Activities in a Service Organization Western Data Services, Inc. Value-Adding Activities for the Classic Letter Value-Adding Activities How the Activity Adds Value Design the letter Enhances the effectiveness of the communication Create a database of customer Increases the probability that the client names and addresses sorted in will efficiently and effectively reach the ZIP code order targeted customer group Verify the conformity of mailing Ensures that the client’s mailing will information with USPS receive the best postal rate requirements Process the job Creates the client mailing Deliver the letters to the post office Begins the delivery process

Nonvalue Adding Activities in a Service Organization Prepare a job order form and schedule the job. Order, receive, inspect and store paper, envelopes and supplies. Set up machines to process a specific letter size. Log the total number of items processed in a batch. Bill the client and record and deposit payments.

To implement ABC, managers: 1. Identify and classify each activity. 2. Estimate the cost of resources for each activity. 3. Identify a cost driver for each activity and estimate the quantity of each cost driver. 4. Calculate an activity cost rate. 5. Assign costs to cost objects based on the level of activity required to make the product or provide the service.

Cost Hierarchy Many companies use a cost hierarchy to manage the assignment of activity-based costs to the level at which costs are incurred. A cost hierarchy for a manufacturer typically has four levels: Unit level. Batch level. Product level. Facility level.

Unit-Level Activities Unit-level activities are performed each time a unit is produced. These activities vary with the number of units produced. Insertion of a component during assembly. Examples: assembling engine subassemblies, connecting engines to car frames

Batch-Level Activities Batch-level activities are performed each time a batch of goods is produced. These activities vary with the number of batches prepared. Examples: setup, scheduling, and materials handling.

Product-Level Activities Product-level activities are performed to support the diversity of products in a manufacturing plant. Examples: implementing engineering change notices, redesigning the installation process.

Facility-Level Activities Facility-level activities are performed to support a facility’s general manufacturing process. Examples: lighting the manufacturing plant, securing the manufacturing plant, insuring the manufacturing plant.

The cost hierarchy includes both value-adding and nonvalue-adding activities. Service organizations also use a cost hierarchy.

Sample Activities in Cost Hierarchies Direct Mail Service: Car Manufacturer: Preparing Bank Activity Level Engine Installation Customer Mailing Unit level Install engine Print and fold letter Test engine Insert letter and other information into envelope Seal and meter envelope Batch level Set up installation process Retool machines Move engines Verify correct postage Inspect engines Bill client Product or Redesign installation Train employees service level process Develop and maintain computer systems and databases Facility or Provide facility management, Provide facility operations level maintenance, lighting, management, security, and space maintenance, lighting, security, and space

Bill of Activities A bill of activities is a list of activities and related costs that is used to compute the costs assigned to activities and the product unit cost.

Bill of Activities More complex bills of activities include cost pool rates and cost driver levels used to assign costs to cost objects. A bill of activities may be used as the primary document or a supporting schedule to calculate the product unit cost in job order or process costing for manufacturing and service organizations.

Activity-Based Costing for Selling and Administrative Activities ABC can be used to group S&A activities and assign the costs of those activities to cost objects such as sales territories or customer groups. S&A cost pools include salaries, depreciation, sales commissions and utilities. Cost drivers may include number of sales calls, sales orders, invoices or billings.

Traditional Operating Environment In a traditional operating environment, a company usually: Maintains large amounts of inventory. Uses push-through production methods. Purchases materials in larger lot sizes with fewer deliveries. Performs infrequent setups (long production runs). Manufactures products in batches. Uses a work force skilled in only one area.

The New Environment The new manufacturing environment emphasizes streamlined and improved manufacturing. Waste in materials, inventory, labor, space, and production time are reduced. Recordkeeping is reduced. The number of nonvalue-adding activities can be reduced. The sources of poor quality products, services or materials can be pinpointed and eliminated.

JIT: Basic Concepts Underlying the new methods are several basic concepts. Simple is better. The quality of the product or service is critical. The work environment must emphasize continuous improvement. Maintaining inventories wastes resources and may hide poor work. Any activity or function that does not add value should be reduced. Goods should be produced only when needed. Workers must be multiskilled and participate in improving efficiency and quality.

JIT Operating Environment The elements of a JIT operating environment are: Maintain minimum inventory levels. Develop pull-through production planning and scheduling. Purchase materials and produce as needed, in smaller lot sizes. Perform quick, inexpensive machine setups.

JIT Operating Environment 5. Create flexible manufacturing work cells. 6. Develop a multiskilled work force. 7. Maintain high levels of product quality. 8. Enforce a system of effective preventive maintenance. 9. Encourage continuous improvement of the work environment.

Traditional Operating Environment The traditional operating environment divides the production into five parts: Processing time. Inspection time. Moving time. Queue time. Storage time.

JIT Operating Environment In product costing under JIT, costs associated with processing time are grouped as either materials costs or conversion costs. Conversion costs include the total of direct labor costs and manufacturing overhead costs incurred by a production department, JIT work cell, or other work center.

JIT Operating Environments Costs of Inspection Moving Queue time Storage time should be reduced or eliminated because these are nonvalue-added activities.

Throughput Time The key measure in a JIT operating environment is throughput time. Throughput time is the time it takes to move a product through the entire production process.

Changes Caused by JIT: Direct Versus Indirect Costs Traditional JIT Environment Environment Direct Materials and parts Direct Direct Direct labor Direct Indirect Repairs and maintenance Direct to work cell Indirect Materials handling Direct to work cell Indirect Operating supplies Direct to work cell Indirect Utility costs Direct to work cell Indirect Supervision Direct to work cell Indirect Depreciation Direct to work cell Indirect Supporting service functions Mostly direct to work cells Indirect Building occupancy Indirect Indirect Insurance and taxes Indirect

Assigning Costs In the JIT operating environment, indirect costs have little correlation with direct labor hours. Since automation has replaced direct labor hours with machine hours, machine hours become more important with JIT. Depreciation costs are based on output units (not time), so are charged directly to work cells.

Indirect Costs Several costs that were treated as indirect costs in a traditional production environment are directly traceable to a JIT production cell such as materials handling, utilities, supplies and supervision. Only costs associated with building occupancy, insurance, and property taxes remain indirect costs of work cells.

JIT Operating Environment In a JIT operating environment, the cost flows through the accounting system are simplified. Backflush costing involves initially accumulating all product costs in Cost of Goods Sold. At period end, work costs backward to determine the proper inventory account balances. Recording time is reduced.

JIT Operating Environment Since labor costs are reduced, the accounting system combines direct labor costs and manufacturing overhead costs into a single category: conversion costs.

Comparison of Cost Flows in Traditional and Back-flush Costing

Cost Flows through T Accounts in Traditional and Back-flush Costing

Similarities of ABM and JIT Both ABM and JIT analyze processes and identify value-adding and nonvalue-adding activities. They both seek to: eliminate or reduce nonvalue-adding activities. improve the allocation of resources. improve quality, efficiency and productivity. improve information quality for decision-making.

System Differences The two systems differ in their primary goals. The primary goal of ABM is to calculate the most accurate product cost by using activity-based costing (ABC). ABC is an accounting method. The primary goal of JIT is to simplify and standardize production and purchasing activities.

Comparison of ABM and JIT Approaches to Activity-Based Systems ABM JIT Purpose Reduce or eliminate Reduce or eliminate waste. nonvalue-adding activities Cost Use ABC to assign Reorganize service activities so assignment manufacturing over- that they are performed within head costs to the work cells and manufacturing product cost by overhead costs incurred in the using appropriate work cell become direct costs of cost drivers the products made in the work cell Costing Integrate ABC with Use backflush costing to calculate method either job order or product costs when the products process costing to are completed calculate product costs