Chapter Seven Activity-Based Costing and Management COPYRIGHT © 2012 Nelson Education Ltd.

Learning Objectives Explain why functional-based costing approaches may produce distorted costs Explain how an activity-based costing system works for product costing Describe activity-based customer and supplier costing Explain how activity-based management can be used for cost reduction

OBJECTIVE  1 Explain why functional-based costing approaches may produce distorted costs

Functional-Based Costing Systems Functional-based systems Based on volume measures, such as Direct labour hours Machine hours Two types: Plantwide rates Departmental rates Often produce average costs that over- or understate individual product costs

Functional-Based Costing System Limitations Two major factors impair their ability to assign overhead costs accurately: Proportion of non-unit-related overhead costs to total overhead charge is large Degree of product diversity is great

Unit and Non-Unit Activities Unit-level-activities --- Activities performed each time a unit is produced Non-unit-level-activities --- From the viewpoint of the subsequent process, transferred-in costs are a type of raw material cost

Non-Unit-Related Overhead Costs What is needed for accurate cost assignment of non-unit-level activities? Non-unit-level activity drivers Factors that measure the consumption of non-unit-level activities by products and other cost objects

Product Diversity Products consume overhead activities in systematically different proportions Consumption Ratio --- Proportion of each activity consumed by a product

Example: Cornerstone 7-1 How to Calculate Consumption Ratios Activity Usage Measures Deluxe Regular Total Units produced 10 100 110 Prime costs $800 $8,000 $8,800 Direct labour hours 20 80 100 Machine hours 10 40 50 Setup hours 3 1 4 Number of moves 6 4 10

Example Activity Cost Data Activity Activity Cost Setting up equipment $1,200 Moving goods 800 Machining 1,500 Assembly 500 Total $4,000

Example Calculate the consumption ratio for each product Activity Driver Overhead Activity Deluxe Regular Setting up equipment 0.75 0.25 Setup hours Three of four hours were spent setting up the Deluxe Model ¾ or 0.75 One of four hours was spent on the Regular model

Example Calculate the consumption ratio for each product Activity Driver Overhead Activity Deluxe Regular Setting up equipment 0.75 0.25 Setup hours Moving goods 0.60 0.40 # of moves 6 of the 10 moves were for the Deluxe model, 4 of the 10 were for the Regular model

Example Calculate the consumption ratio for each product Activity Driver Overhead Activity Deluxe Regular Setting up equipment 0.75 0.25 Setup hours Moving goods 0.60 0.40 # of moves Machining 0.20 0.80 Machine hrs Deluxe model used 10 of the 50 machine hours, while the Regular model used 40 hours

Example Calculate the consumption ratio for each product Activity Driver Overhead Activity Deluxe Regular Setting up equipment 0.75 0.25 Setup hours Moving goods 0.60 0.40 # of moves Machining 0.20 0.80 Machine hrs Assembly 0.20 0.80 Direct labour hours Deluxe model used 20 of the 100 direct labour hours. Regular model used 80 hours

Deluxe model had Consumption Ratios ranging from 0.75 to 0.20 Example Calculate the consumption ratio for each product. Activity Driver Overhead Activity Deluxe Regular Setting up equipment 0.75 0.25 Setup hours Moving goods 0.60 0.40 # of moves Machining 0.20 0.80 Machine hrs Assembly 0.20 0.80 Direct labour hours Deluxe model had Consumption Ratios ranging from 0.75 to 0.20

Example: Cornerstone 7-2 How to Calculate Activity Ratios Information: Activity Activity Cost Setting up equipment $1,200 Moving goods 800 Machining 1,500 Assembly 500

Example Driver Driver Quantity Setup hours 4 Number of moves 10 Information: Driver Driver Quantity Setup hours 4 Number of moves 10 Machine hours 50 Direct labour hours 100

$5 per direct labour hour Example Required: Calculate activity rates Setup rate $1,200/4 setup hours $300 per setup hour Materials handling rate $800/10 moves $80 per move $30 per machine hour Machining rate $1,500/50 machine hours Assembly rate $500/100 machine hours $5 per direct labour hour

Example: Cornerstone 7-3 How to Calculate Activity-Based Unit Costs Information: Deluxe Regular Activity Rate Units produced per year 10 100 Prime costs $800 $8,000 Setup hours 3 1 $300 Number of moves 6 4 $ 80 Machine hours 10 40 $ 30 Direct labour hours 20 80 $ 5

Example Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups Required: Calculate the unit cost for deluxe and regular models Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups 900 300 $300 per setup × 3 setups $300 per setup ×1 setup

Example Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups Required: Calculate the unit cost for deluxe and regular models Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups 900 300 Moving materials 480 320 $80 per move × 6 moves $80 per move × 4 moves

Example Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups Required: Calculate the unit cost for deluxe and regular models. Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups 900 300 Moving materials 480 320 Machining 300 1,200 $30 per machine hour x 10 hours $30 per machine hour x 40 hours

Example Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups Required: Calculate the unit cost for deluxe and regular models Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups 900 300 Moving materials 480 320 Machining 300 1,200 Assembly 100 400 $5 per direct labour hour × 20 hours $5 per direct labour hour × 80 hours

Required: Calculate the unit cost for deluxe and regular models Example Required: Calculate the unit cost for deluxe and regular models Deluxe Regular Prime costs $800 $8,000 Overhead costs: Setups 900 300 Moving materials 480 320 Machining 300 1,200 Assembly 100 400 Total manufacturing costs $2,580 $10,220 $2,580 ÷ 10 units = $258 per unit $10,220 ÷ 100 units = $102.20 per unit

Explain how an activity-based costing system works for product costing OBJECTIVE  2 Explain how an activity-based costing system works for product costing

Identifying Activities and Their Attributes Activity Dictionary Lists the activities in an organization along with some critical activity attributes Activity Attributes Financial and nonfinancial information items that describe individual items

Key Questions to Identify Activities How many employees are in your department? What do they do? Do customers outside your department use any equipment? What resources are used by each activity? What are the outputs of each activity? Who or what uses the activity output? How much time do workers spend on each activity? Time on each activity by equipment?

Assigning Costs to Activities Must determine how much it costs to perform each activity Requires identification of resources being consumed labour, materials, energy, and capital Cost of resources is found in general ledger Resources must be assigned using driver tracing Work distribution matrix Used to assign labour resources

Factors that measure the consumption of resources by activity Resource Drivers Factors that measure the consumption of resources by activity

Example: Cornerstone 7-4 How to Assign Resource Costs Using Direct Tracing & Resource Drivers Information: Assume that each clerk is paid a salary of $30,000 ($150,000 total clerical cost for 5 clerks) Required: Assign the cost of labour to each of the activities in the credit department

Example Processing transactions $60,000 Preparing statements $45,000 Answering questions $45,000 0.4 × $150,000 0.3 × $150,000 0.3 × $150,000

Assigning Costs to Products Usage of the activity (as measured by activity drivers) Predetermined activity rate x To calculate this rate, the practical capacity of each activity must be determined

Describe activity-based customer and supplier costing OBJECTIVE  3 Describe activity-based customer and supplier costing

Activity-Based Customer Costing Customers are cost objects of fundamental interest Customer management can produce significant gains in profit Customers can consume customer-driven activities in different proportions Assigning costs of customer service to customers the same as assigning manufacturing costs to products

Example: Cornerstone 7-5 HOW TO Calculate Activity-Based Customer Costs Information: Milan Company produces precision parts for 11 major buyers One large customer Accounts for 50% of sales Ten smaller customers Account for 50% of sales Each purchases parts in roughly equal quantities Parts orders placed are similar in size

Data concerning Milan’s customer activity follow: Example Information continued: Data concerning Milan’s customer activity follow: Large Customer Ten Smaller Customers Units purchased 500,000 500,000 Orders placed 2 200 Number of sales calls 10 210 Manufacturing costs $3,000,000 $3,000,000 Order filling costs allocated $202,000 $202,000 Sales force costs allocated $110,000 $110,000

Assign costs to customers using an ABC approach Example Required: Assign costs to customers using an ABC approach Activity Rates $404,000/202 orders = $2,000 per order $220,000/220 calls = $1,000 per call

Assigning Costs to Customer Groups Large Customer Ten Smaller Customers Order filling costs $4,000 $400,000 $2,000 × 2 $2,000 × 200

Assigning Costs to Customer Groups Large Customer Ten Smaller Customers Order filling costs $4,000 $400,000 Sales force costs 10,000 210,000 $1,000 × 10 $1,000 × 210

Assigning Costs to Customer Groups Large Customer Ten Smaller Customers Order filling costs $4,000 $400,000 Sales force costs 10,000 210,000 $14,000 $610,000 The large customer costs much less to service that the smaller customers.

Supplier Costing Methodology Cost of a supplier is much more than purchase price of the components or materials acquired Assigning cost to suppliers is similar to cost assignments for products and customers

Example: Cornerstone 7-6 How to Calculate Activity-Based Supplier Costs Information: Purchasing manager uses two suppliers as sources of Part A1 and Part B2 Murray Inc. Plata Associates Consider two activities: Repairing products Because of part failure (bought from supplier) Expediting products Because supplier is late

Example Information continued: Activity cost information and other data needed for supplier costing follow: I. Activity costs caused by suppliers Activity Costs Repairing Products $800,000 Expediting Products $200,000

Example II. Supplier data Murray, Inc. Plata Assoc. Information continued: II. Supplier data Murray, Inc. Plata Assoc. Part A1 Part B2 Part A1 Part B2 Unit purchase price $20 $52 $24 $56 Units purchased 80,000 40,000 10,000 10,000 Failed units 1,600 380 10 10 Late shipments 60 40

Determine the cost of each supplier using ABC Example Required: Determine the cost of each supplier using ABC Activity Rates Repair rate = $800,000/2,000 = $400 per failed part Total failed units 1,600 + 380 + 10 +10

Determine the cost of each supplier using ABC Example Required: Determine the cost of each supplier using ABC Activity Rates Repair rate = $800,000/2,000 = $400 per failed part Expediting rate = $200,000/100 = $2,000 per late delivery Total late shipments 60 + 40

Example Murray, Inc. Purchase cost $1,600,000 $2,080,000 Part A1 Part B2 Purchase cost $1,600,000 $2,080,000 $20 × 80,000 $52 × 40,000

Example Plata Associates Purchase cost $240,000 $560,000 Part A1 Part B2 Purchase cost $240,000 $560,000 $24 × 10,000 $56 × 10,000

Example Murray, Inc. Purchase cost $1,600,000 $2,080,000 Part A1 Part B2 Purchase cost $1,600,000 $2,080,000 Reporting products 640,000 152,000 $400 × 1,600 $400 × 380

Example Plata Associates Purchase cost $240,000 $560,000 Part A1 Part B2 Purchase cost $240,000 $560,000 Reporting products 4,000 4,000 $400 × 10 $400 × 10

Example Murray, Inc. Purchase cost $1,600,000 $2,080,000 Part A1 Part B2 Purchase cost $1,600,000 $2,080,000 Reporting products 640,000 152,000 Expediting products 120,000 80,000 $2,000 × 60 $2,000 × 40

Example Plata Associates Purchase cost $240,000 $560,000 Part A1 Part B2 Purchase cost $240,000 $560,000 Reporting products 4,000 4,000 Expediting products Plata does not deliver parts late, therefore there are no expediting costs with Plata

Example Murray, Inc. Purchase cost $1,600,000 $2,080,000 Part A1 Part B2 Purchase cost $1,600,000 $2,080,000 Reporting products 640,000 152,000 Expediting products 120,000 80,000 Total costs $2,360,000 $2,312,000 Units ÷ 80,000 ÷ 40,000 Total unit cost $29.50 $57.80

Plata is the better choice with the lowest total unit cost Example Plata Associates Part A1 Part B2 Purchase cost $240,000 $560,000 Reporting products 4,000 4,000 Expediting products Total costs $244,000 $564,000 Units ÷ 10,000 ÷ 10,000 Total unit cost $24.40 $56.40 Plata is the better choice with the lowest total unit cost

Explain how activity-based management can be used for cost reduction OBJECTIVE  4 Explain how activity-based management can be used for cost reduction

Process-Value Analysis Focuses on cost reduction instead of cost assignment Maximization of system-wide performance Driver analysis Activity analysis Performance measurement

Activity Inputs and Outputs Resources consumed by the activity in producing its output Activity Outputs Result or product of an activity

Driver Analysis: The Search for Root Causes Activity Output Measure Number of times activity is performed Driver Analysis Effort expended to identify those factors that are the root causes of activity costs

Activity Analysis Process of identifying, describing, and evaluating the activities It should produce four outcomes: What activities are done How many people perform the activities Time and resources required to perform the activities Assessment of the value of the activities to the organization

Value-Added Activities Activities necessary to remain in business Two types: Value-added by mandate Necessary to comply with legal mandate Discretionary activities

Discretionary Value-Added Activities Three conditions must be met simultaneously for the activity to be classified as value added: Produces a change of state Change of state was not achievable by preceding conditions Enables other activities to be performed

Non-Value Added Activities All activities other than those that are absolutely essential to remain in business Examples: Scheduling Storing Moving Inspecting Waiting Challenge of activity analysis is to find ways to produce the good without using any of these activities

Cost Reduction Four Ways: Activity elimination Activity selection Activity reduction Activity sharing Activity Elimination: Once activities that fail to add value are identified, measures must be taken to rid the organization of these activities Activity Selection: Involves choosing among different sets of activities that are caused by competing strategies. The lowest-cost design strategy should be chosen Activity Reduction: Decreases the time and resources required by an activity. This approach focuses on improving efficiency Activity Sharing: Increases the efficiency by using economies of scale. This lowers the per-unit cost of the cost driver and the amount of cost traceable to the products that consume the activity

Example: Cornerstone 7-7 How to Assess Non-Value Added Costs Information: Consider the following two activities: Performing warranty work, cost: $120,000 Warranty cost of the most efficient competition is $20,000 Purchasing components, cost: $200,000 (10,000 purchase orders) Benchmarking study reveals that the most efficient level would use 5,000 purchase orders and entail a cost of $110,000

Example Determine the non-value-added cost of each activity Warranty work Is the activity non value-added or value-added? Performing warranty work is a non value-added activity Performing warranty work is a non value-added activity Why? It is done to correct something that wasn’t done right the first time How much is the non value-added cost? $120,000

Example Determine the non-value-added cost of each activity Competitor Is the activity non value-added or value-added? Cost of the competitor is a non value-added activity Cost of the competitor is a non value-added activity Why? It has no bearing on the analysis How much is the non value-added cost? $200,000 - $110,000 = $90,000 Because the activity is not performed efficiently

Example Determine the non-value-added cost of each activity Purchasing components is necessary (value-added) but it is not performed efficiently Actual cost – benchmark study $200,000 - $110,000 $90,000 in non-value added cost

Activity Performance Measurement Assess how well an activity was performed and the results achieved Measures are both financial and nonfinancial Three dimensions: Efficiency Quality Time

Efficiency, Quality, & Time Focuses on the relationship of activity inputs to activity outputs Quality Concerned with doing the activity right the first time Time Longer times usually mean more resource consumption and less ability to respond to customer demands

Example: Cornerstone 7-8 How to Calculate Cycle Time and Velocity Assume that a company takes 10,000 hours to produce 20,000 units of a product What is the velocity? Velocity = 20,000/10,000 = 2 units per hour Velocity is the number of units of output that can be produced in a given period of time Cycle time is the length of time it takes to produce a unit of output from the time the raw materials are received until the good is delivered to finished goods inventory What is the cycle time? Cycle Time = 10,000/20,000 = ½ hour

Just-in-Time Systems Goods pushed through system by present demand rather than on a fixed schedule based on anticipated demand Each operation produces only what is necessary to satisfy the demand of the succeeding operation Reduces all inventories to very low levels Reduces inventory carrying costs Emphasize total quality control (TQC) and continuous improvement in quality

Environmental Cost Management Environmental costs are also known as environmental quality costs Environmentally linked activities are activities performed because poor environmental quality may exist Costs are associated with two subcategories: control activities failure activities Environmental costs are classified into four analogous categories: prevention costs detection costs internal failure costs, and external failure costs