5 - 1  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost Management Systems Chapter 5

5 - 2  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Introduction u Jonathan Kellogg is the owner and CEO of Booth Motors. u Booth Motors is an automobile dealership with four other lines of business. 1 Used cars 2 Parts 3 Service 4 Finance and insurance

5 - 3  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Introduction u Kellogg felt that as one of the largest auto dealerships in the Midwest, Booth should be earning much more than one percent pre-tax margin on sales. u The existing accounting system allocates operating expenses to each department based on sales.

5 - 4  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objectives 1 Understand how traditional cost systems, using only unit-level drivers, distort product and customer costs. 2 Describe why factories producing a more varied and complex mix of products have higher costs than factories producing only a narrow range of products.

5 - 5  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objectives 3 Design an activity-based cost system by linking resource costs to the activities performed and then to cost objects, such as products and customers. 4 Appreciate the role for choosing appropriate activity cost drivers when tracing activity costs to products and customers.

5 - 6  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objectives 5 Use the information from a well-designed activity-based cost system to improve operations and make better decisions about products and customers. 6 Understand the importance of measuring the practical capacity of resources and the cost of unused capacity.

5 - 7  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objectives 7 Assign marketing, distribution, and selling expenses to customers. 8 Analyze customer profitability. 9 Appreciate the role for activity-based cost systems for service companies. 10 Discuss the barriers for implementing activity-based cost systems and how these might be overcome.

5 - 8  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 1 Understand how traditional cost systems, using only unit- level drivers, distort product and customer costs.

5 - 9  2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Traditional Manufacturing Costing Systems u Traditionally, job-order and process costing systems have assigned direct labor and direct materials costs to products. u Indirect costs were accumulated as support department expenses. u These expenses were allocated to production departments in a simple proportion.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Traditional Manufacturing Costing Systems u Historically, Cooper Pen had been a low cost producer of BLUE and BLACK pens. u Recently, these product lines have expanded into two new products. u The plant’s indirect expenses, about $180,000 per quarter, were aggregated at the plant level and allocated to products based on direct labor.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Traditional Manufacturing Costing Systems u The overhead burden rate was 300% of direct labor costs. u The controller of Cooper Pen Company wondered whether they should continue to de-emphasize their commodity products, and to keep introducing the new specialty colored pens.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Traditional Manufacturing Costing Systems Production Return Sales Volume on Sales Blue 50, % Black 40, % Red 9, % Purple 1, % Total100, %

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Traditional Manufacturing Costing Systems u Traditional costing systems distort product costs. u They use unit level drivers, such as direct labor dollars, for allocating production center expenses to products.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 2 Describe why factories producing a more varied and complex mix of products have higher costs than factories producing only a narrow range of products.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Simple and Complex Factories u A simple factory has little need for a cost system to calculate the cost of its product. u A complex factory requires many resources to support a highly varied product mix. u Complex factories require a cost accounting system to trace expenses to its various products.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Simple and Complex Factories u Traditional cost systems will under- estimate the cost of resources required for specialty, low-volume products. u These systems will over-estimate the resource cost of high volume, standard products. u Activity-based cost systems have been developed to eliminate this source of cost distortion.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 3 Design an activity-based cost system by linking resource costs to the activities performed and then to cost objects, such as products and customers.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost Management Systems u Activity-based cost-management systems trace indirect and support expenses accurately to individual products, services, and customers. u ABC systems use a simple two-stage approach similar to traditional cost systems. u However, instead of using cost centers for accumulating costs, it uses activities.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost Management Systems u What do managers do in an activity-based management? u Managers use information collected by the ABC system at the activity level to identify promising opportunities for reducing costs in indirect and support activities. u The controller of Cooper Pen Company developed an activity-based cost system.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost Management Systems u How are overhead rates determined under activity-based costing? 1 Identify the activities performed. 2 Determine the cost of performing each activity. 3 Identify a cost driver for each activity.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost Management Systems 4 Determine the number of units of the cost driver made available by the resources committed to each activity. 5 Divide the activity cost by the number of cost driver units made available to determine the activity overhead rate.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost Management Systems u What is an activity dictionary? u It is the list of the major activities performed by an organization’s resources.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Tracing Costs to Activities u ABC allocation procedures trace all overhead costs to activity cost pools. Run Machines Handle Production Runs Setup Machines Support Products

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Tracing Costs to Activities u What are examples of production activities? Unit-Related Batch-Related Product Sustaining Facility Sustaining

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Tracing Costs to Activities Indirect Labor Computer Activity Activity & 1/2 fringe Expense Expense Handle Production Runs 50% 80% $ 66,000 Setup Machines 40% $ 33,600 Support Products 10% 20% $ 14,400 Total Expense $84,000 $30,000 $114,000

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity Depreciation Maintenance Energy Run Machines 100% 100% 100% Total Expense $24,000 $12,000 $6,000 Tracing Costs to Activities

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 4 Appreciate the role for choosing appropriate activity cost drivers when tracing activity costs to products and customers.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Tracing Costs From Activities to Products u Activity cost drivers identify the linkage between activities and cost objects. u What are some examples of cost objects? – products – services – customers

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Tracing Costs From Activities to Products u What is an activity cost driver? u It is a unit of measurement for the level (or quantity) of the activity performed. u What is a cost driver rate? u It is a rate obtained by dividing the activity expense by the total quantity of the activity cost driver.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Tracing Costs From Activities to Products u What are some examples of cost drivers? Handle Production Runs Support Products Number of Products Run Machines Machine Hours Setup Machines Setup Hours

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity Activity Cost Driver Activity Expense Driver Rate Handle Number Production of Runs $440 Runs $ 66, Setup Number of Machines $ 33,600 Setup Hours $ Support Number of Products $ 14,400 Products $3,600 4 Tracing Costs From Activities to Products

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity Activity Cost Driver Activity Expense Driver Rate Run Number of Machines $42,000 Machine $4.20 Hours 10,000 Tracing Costs From Activities to Products

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Driver Activity Cost Blue Activity Rate Driver Quantity Total Handle Production $ $22,000 Runs Setup Machines $ $12,776 Support Products $3,600 1 $3,600 Tracing Costs From Activities to Products

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Driver Activity Cost Blue Activity Rate Driver Quantity Total Run Machines $4.20 5,000 $21,000 Total Activity Expense Blue = $56,376 Tracing Costs From Activities to Products

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 5 Use the information from a well-designed activity-based cost system to improve operations and make better decisions about products and customers.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Product Profitability Blue Operating Income $48,624 Black Operating Income $ Red Operating Income (Loss) ($18,414) Purple Operating Income (Loss) ($9,906)

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Product Profitability u What is a bill of activities? u It is the set of activities and their costs associated with individual products. u What is strategic activity-based management? u ABM involves decisions on pricing, distribution, product design, and minimum order sizes so that loss products can become profitable.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost systems u Activity cost drivers are the central innovation of activity-based cost systems. u They are also the most costly aspects of ABC systems. u The selection of an activity cost driver reflects a subjective trade-off between accuracy and the cost of measurement.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost systems u ABC system designers can choose from three different types of activity cost drivers. 1 Transaction 2 Duration 3 Intensity

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost systems u Transaction drivers count how often an activity is performed. u What are some examples? – number of setups – number of receipts – number of products supported

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost systems u Duration drivers represent the amount of time required to perform an activity. u What are some examples? – setup hours – inspection hours – direct labor hours

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost systems u Intensity drivers directly charge for the resources used each time an activity is performed. u What are some examples? – actual time – specific resources committed u Intensity drivers may be simulated with a weighted index approach.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Activity-Based Cost systems u What is the goal of a properly constructed ABC system? u The goal is to have a cost system that balances the cost of errors made from inaccurate estimates with the cost of measurement.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 6 Understand the importance of measuring the practical capacity of resources and the cost of unused capacity.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Measuring the Cost of Resource Capacity u Practical capacity represents the maximum output that could be handled efficiently. u The activity cost driver rate should reflect the underlying efficiency of the process.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Measuring the Cost of Resource Capacity u How should the activity cost driver rate be computed? u The numerator represents the cost of supplying resource capacity to do work. u The denominator should match the numerator by representing the quantity of work the resources can perform.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Measuring the Cost of Resource Capacity u What is the cost of unused capacity? u It is the cost of capacity available but not utilized. u There are two ways for organizations to actively manage unused capacity. 1 Increase the volume of business. 2 Reduce the supply of unused resources.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 7 Assign marketing, distribution, and selling expenses to customers.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Marketing, Selling, and Distribution Expenses u The costs of marketing, selling, and distribution expenses have been increasing rapidly. u Many of these expenses do not relate to individual products or product-lines. u These expenses are associated with individual customers, market segments, and distribution channels.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Marketing, Selling, and Distribution Expenses u What are examples of marketing, selling, and distribution activities? Travel to Customers Distribute Sales Catalog Service Customers Provide Marketing and Technical Support Warehouse Inventory for Customers

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Marketing, Selling, and Distribution Expenses u What are examples of activity cost drivers? Actual Expenditures Number of Mailings Time Spent on Customers Quantity of Inventory and space required

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 8 Analyze customer profitability.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Customer Profitability Aggressive: Leverage their buying power Low price, lots of customized service Costly to serve, pay top dollar Passive: Product is crucial Good supplier match Price-sensitive and few special demands Types of Customers More profitable customers Cost to ServeHiLow Net ABC Margin Realized Profits

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 9 Appreciate the role for activity-based cost systems for service companies.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Service Companies u Why are service companies ideal candidates for activity-based costing? u The majority of their costs are indirect and appear to be fixed. u The variable cost is essentially zero.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Service Companies u Why do service companies need to identify the differential profitability of individual customers? u Because the variation in demand for organizational resources is much more customer-driven than in manufacturing organizations.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Learning Objective 10 Discuss the barriers for implementing activity-based cost systems and how these might be overcome.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Barriers to Implementing ABC u What are some of the barriers to implementing ABC systems? u Lack of clear business purpose u Lack of senior management commitment u Delegating the project to consultants u Poor ABC model design u Individual and organizational resistance to change

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Conclusion u Jonathan Kellogg and his controller developed an activity-based cost model of Booth Motors. u They identified activities for three of the product lines. – New Vehicle Department – Finance & Insurance – Service

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young Conclusion u What did the product line analysis show? u Profits from financing and insuring new and used cars accounted for nearly 50% of total dealer profitability. u The profitable car line had the lowest average days on lot. u Seemingly, most popular car lines were unprofitable.

 2001 Prentice Hall Business Publishing Management Accounting, 3rd ed., Atkinson, Banker, Kaplan, and Young End of Chapter 5