Activity-Based Costing and Management Management Accounting: The Cornerstone for Business Decisions Copyright ©2006 by South-Western, a division of Thomson Learning. All rights reserved.

Learning Objectives 1.Explain why functional-based costing approaches may produce distorted costs. 2.Explain how an activity-based costing system works for product costing. 3.Describe activity-based customer and supplier costing.

Learning Objectives 4.Explain how activity-based management can be used for cost reduction. 5.(Appendix) Explain the basics of quality cost management. 6.(Appendix) Explain the basics of environmental cost management.

List Limitations of Functional Cost Accounting System ◙ Distorts costs in multiproduct situations ◙ Does not assign non-unit related overhead costs appropriately ◙ Companies in intensely competitive industries adopt business practices and strategies to achieve competitive excellence which are not supported by old cost accounting systems ◙ Doesn’t support product diversity

Product Costing Data for PowerPoint Cornerstones Activity Usage Measures DeluxeRegularTotal Units produced Prime costs $ 2,400 $ 24,000 $ 26,400 DLH MH Setup Hrs Number of moves

How to calculate consumption ratios. 7-1 Consumption Ratios Overhead ActivityDeluxeRegularActivity Driver Setting up equip Setup Hrs Moving goods # of moves Machining MH Assembly DLH Setup Hours for Deluxe 9 / 12 =.75; Regular 3 / 12 =.25

How to calculate activity rates. ActivityActivity CostDriver Quantity Setup equip. $3,600Setup hrs12 Moving goods 2,400# of moves30 Machining 4,500MH50 Assembly 1,500DLH 100 REQUIRED: Calculate activity rates. 7-2

Calculation: The rates are obtained by dividing the activity cost by the total cost driver quantity Setup rate$3,600 / 12 setup hrs = $300 per setup hour Mtls handling rate$2,400 / 30 moves = $80 per move Machining rate$1,500 / 150 MH = $10 per machine hour Assembly rate$1,500 / 300 DLH = $5.00 per direct labor hour How to calculate activity rates. 7-2

Illustrate Activity-Based Costing

How to calculate activity- based unit costs. Activity DeluxeRegularRate Units prod. year Prime costs $2,400 $24,000 Setup hours 9 3 $ # of moves Machine hours DLH REQUIRED: Calculate the unit cost for deluxe & regular models.

Calculation:DeluxeRegular Prime Costs $2,400 $24,000 Overhead Costs: Setups $300 x 9; $300 x 3 2, Moving Materials $80 x 18; $ 80 x 12 1, Machining $30 x 30; $30 x ,600 Assembly $5 x 60; $5 x ,200 Total manufacturing costs $7,740 $30,660 Units produced Unit cost (Total costs / Units) $ 258 $ How to calculate activity- based unit costs. 7-3

Illustrate Two Stage Assignment

How to assign resource costs using direct tracing & resource drivers. Assume each employee is paid $45,000 ($270,000 total cost for 6 employees). The work distribution is the same as exhibit 7-4. REQUIRED: Assign the cost of labor to each of the activities of the credit department. Calculation: The amount of labor cost assigned to each activity is below. The percentage is from Exhibit 7-5. Processing transaction$108,000 (0.4 x $270,000) Preparingstatements $ 81,000 (0.3 x $270,000) Answering questions $ 81,000 (0.3 x $270,000) 7-4

How to calculate activity- based customer costs. Milan company produces precision parts for 11 major buyers. Of the 11 customers one accounts for 50% of the sales, with the remaining 10 accounting for the remaining sales. The 10 smaller companies purchase approximately equal quantities of parts. Orders placed by the smaller companies are about the same size. Data pertaining to Milan’s customer activity is on the next slide. 7-5

How to calculate activity- based customer costs 7-5 Large Customers Ten Smaller Customers Units purchased 1,000,000 Orders placed Number of sales calls Manufact. costs 6,000,000 Alloc. order filling costs 404,000 Alloc. sales force costs 220,000 Currently customer driven costs are assigned based on units sold, a unit level driver.

REQUIRED: Assign cost using ABC Calculation: The appropriate drivers are orders placed and number of sales calls. The activity rates are: $808,000 / 404 = $2,000 per order $440,000 / 440 = $1,000 per call Using the information, the customer-driven costs can be assigned to each group of customers as follows: LargeTen Smaller Order filling costs: ($2,000 x 4), ($2,000 x 400) $ 8,000$ 800,000 Sales force costs: ($1,000 x 20), (1,000 x 420) $20,000$ 420,000 How to calculate activity- based customer costs. 7-5

How to calculate activity- based supplier costs. Assume that a purchasing manager uses two suppliers, Murray, Inc. and Plata Assoc., as the source of two machine parts: Part A1 and Part B2. Consider two activities repairing products (under warranty) and expediting products. Repairing products occurs because of parts failure (bought from suppliers). Expediting products occurs because suppliers are late in delivering needed parts. Activity cost information and other data needed for supplier costing follows: 7-6

How to calculate activity- based supplier costs. 1. Activity costs caused by suppliers (e.g. failed parts or late delivery) Activity Costs Repairing products$400,000 Expediting products$100, Supplier Data 7-6 Murray Inc.Plata Assoc. A1B2A1B2 Purchase price $ 20 $ 52 $ 20 $ 52 Units purchased 40,000 20,000 5,000 Failed units Late shipments

REQUIRED: Determine the cost of each supplier using ABC. Calculation: Using the previous data, the activity rates for assigning costs to suppliers are computed as follows: Repair rate = $400,000 / 1,000* = $400 per failed part *( ) Expediting rate = $200,000 / 50* = $2,000 per late delivery*( ) Using the above rates and the activity data, the total purchasing cost per unit for each component is computed: How to calculate activity- based supplier costs. 7-6

How to calculate activity- based supplier costs. 7-6 Murray Inc.Plata Assoc. A1B2A1B2 Purchase price $20 x 40,000$ 800,000 $52 x 20,000 $1,040,000 $24 x 5,000 $120,000 $56 x 5,000 $280,000

Repairing prod. $400 x ,000 $400 x ,000 $400 x 5 2,000 $400 x 5 2,000 Expediting prod. $2,000 x 30 60,000 $2,000 x , Total costs $1,180,000 $1,232,000 $122,000 $282,000 Units 40,000 20,000 5,000 Total unit cost $ $ $ $ How to calculate activity-based supplier costs.

Illustrate the Process-Value Analysis Driver Analysis Activities Performance Analysis WHY?HOW WELL? WHAT?

Match Definitions Activity Inputs Value-added Activities Activity Outputs Identifying those factors that are the root causes of activity costs Identifying, describing & evaluating the activities an organization performs Resources consumed by the activity in producing an output Activity Analysis Driver Analysis Activities necessary to stay in business The result or product of an activity

Define Non-Value Added Activities ◙ All activities other than those absolutely essential to remain in business Provide some examples ◙ Scheduling ◙ Moving ◙ Waiting ◙ Storing ◙ Inspecting

How to assess non-value added costs. Consider the following two activities: (1) Performing warranty work, cost $240,000. The warranty cost of the most efficient competitor is $20,000. (2) Purchasing components, cost $300,000 (15,000 purchase orders). A benchmarking study reveals that the most efficient level would use 5,000 purchase orders and entail a cost of $110,000. REQUIRED: Determine the non-value added cost of each activity. 7-7

Calculation: Determine the value content of each activity. Is it value added? Performing warranty work is non-value added. If done correctly the first time it is not needed. Therefore, the cost of the activity is $240,000. The cost of the competitors is also non-value added but is irrelevant. Purchasing is necessary so materials are available for production and thus is value-added. However, it is not performed as efficiently as possible as shown in the benchmarking study. The non-value added cost is $190,000 ($300,000 - $110,000). How to assess non-value added costs. 7-7