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3. The Design and Use of Activity-Based Costing Systems 1. Joint Process Costing 2. Managing and Allocating Support-Service Costs 3. The Design and Use of Activity-Based Costing Systems

1. Joint Processes COMMON IMPUT JOINT PROCESS INTERMEDIATE PRODUCT JOINT COSTS Costs to operate joint processes COMMON IMPUT Simultaneously converts a common input into several outcomes JOINT PROCESS SPLIT-OFF POINT Point at which joint-products appear FINAL PRODUCT One that is ready for sale without further processing FINAL PRODUCT A FINAL PRODUCT B INTERMEDIATE PRODUCT A INTERMEDIATE PRODUCT B INTERMEDIATE PRODUCT A product that requires further processing before it is salable to the public

Joint Processes LOGS SAW MILL INTERMEDIATE PRODUCT JOINT COSTS Costs to operate joint processes LOGS Simultaneously converts a common input into several outcomes SAW MILL SPLIT-OFF POINT Point at which joint-products appear FINAL PRODUCT One that is ready for sale without further processing STANDARD LUMBER SPECIALTY LUMBER WOODCHIPS SAWDUST WOODCHIPS SAWDUST INTERMEDIATE PRODUCT A product that requires further processing before it is salable to the public

The Decision Challenge: Which Joint Products To Produce The objective governing production of joint products is maximizing profit

Estimating Profit From Joint Products NPW follows four steps regarding how to use their constrained mill capacity 1. Identify all alternative sets and quantities of final products possible from the joint process 2. Forecast the sales price of each product 3. Estimate the costs (if any) required to further process joint products into salable products. 4. Choose the set of products with the overall maximum profit.

Sell Intermediate Products Or Process Them Further? What is the potential additional revenue after further processing? What are the additional costs of further processing? Net realizable value (NRV) = Sales value - further processing costs after split off

Sell Intermediate Products Or Process Them Further? Net realizable value (NRV) = Sales value - further processing costs after split off Net realizable value (NRV) of SPECIALTY lumber per MBF Forecasted sales value $540.00 - Further processing costs after split off - $ 23.00 NRV = 517.00 Net realizable value (NRV) of STANDARD lumber per MBF Forecasted sales value $418.00 - Further processing costs after split off - $ 19.00 NRV = 399.00

Maximizing The Profit Of Joint Product Processes Computing the NPV of each set of products provides a comparison of each products sales revenues to cost after split-off What is RELEVANT? Revenues from selling or processing beyond the split-off and any expenditures for additional processing Allocation of the wood mill’s $800,000 joint processing costs NO YES

Profit Analysis Of Option 1 OPTION 1: SPECIALTY AND STANDARD LUMBER Main Products SELL WOOD CHIPS AT SPLIT-OFF $1,094,700 + 62,400 = 1,157,100

Profit Analysis Of Option 1 OPTION 1: SPECIALTY AND STANDARD LUMBER Main Products PROCESS WOOD CHIPS INTO PULP Monthly Processing Costs $1,094,700 + 81,500 = $1,176,200

Profit Analysis Of Option 2 OPTION 2: STANDARD LUMBER SELL WOOD CHIPS AT SPLIT-OFF $1,077,300 + 58,240 = $1,135,540

Profit Analysis Of Option 2 OPTION 2: STANDARD LUMBER PROCESS WOOD CHIPS INTO PULP Monthly Processing Cost $1,077,300 +37,400 = $1,114,700

Wyoming Mill Decision Tree Lumber decision Lumber choice Wood chip decision Wood chip choice Alternative sets of products Option 1: Specialty and standard lumber Wood chips Sell specialty, standard and wood chips Sell wood chips or process further? Process further Sell (1) Specialty and standard lumber or (2) Standard lumber only? Sell specialty, standard and process wood chips further Wood chips Sell, standard and wood chips Sell wood chips or process further? Process further Sell standard and process wood chips further Option 2: Standard lumber only

Why Allocate Joint Costs? Determing and Responding to Regulatory Rates Specifing and Resolving Contractual Interests and Obligations Organizations Allocate Joint Costs for Many Reasons Measuring Performance Estimating Casulty Losses Valuing Inventories for Financial and Tax Reporting Valuing Cost of Goods Sold for Financial and Tax Reporting

Joint Cost Allocation Methods DISTINGUISHING BETWEEN MAIN AND BY-PRODUCTS MAIN PRODUCT a joint output that generates a significant portion of of the net realizable value BY-PRODUCTS outputs from a joint process that are minor in quantity and/or NRV when compared to the main products Do not allocate joint costs to by-products

Joint Cost Allocation Methods NET REALIZABLE VALUE METHOD Is further processing required? Estimate the NRV at split-off by deducting estimated added- processing costs from sales value Allocates joint costs based on the NRV of each main product at split-off Can the main product be sold at split-off without further processing? Use market value or sales price for allocation

Joint Cost Allocation Methods NET REALIZABLE VALUE METHOD Allocation follows the proportions of net realizable values $319,200 / 1,094,700 $775,500 / 1,094,700 70.84% X $800,000 29.16% X $800,000

Joint Cost Allocation Methods NET REALIZABLE VALUE METHOD Expected gross margins at split-off The NRV method preserves the relative profitability of joint products $294,700 / $1,144,400 $208,780 / $810,000 $85,920 / $334,400

Joint Cost Allocation Methods PHYSICAL MEASURES METHOD Energy Content Example: BTU content Allocation is based on a physical measure of the joint products at split-off point Volume Example: Gallons Example: Pounds Weight

Joint Cost Allocation Methods PHYSICAL MEASURES METHOD When is the physical measures method used? Output prices are highly volatile or unpredictable Significant processing occurs between the split-off point and the first sales opportunity The market does not set product prices

Joint Cost Allocation Methods PHYSICAL MEASURES METHOD Allocation based on MBF 1,500 2,300 MBF 800 2,300MBF 65.22% X $800,000 34.78% X $800,000

Joint Cost Allocation Methods PHYSICAL MEASURES METHOD A possible disadvantage of the physical measures method is that it can distort profitability of the products, unlike the NPR method.

Joint Cost Allocation Methods CHOOSING AMONG JOINT-COST ALLOCATION METHODS Impossible to use cause-effect basis Can be arbitrary Do not base product or service production decisions on joint margins (I.e., after joint-cost allocation) unless the choice is in responses to regulatory opportunities Choose the joint-cost allocation method that maximizes regulated profits of cost reimbursements Clearly define how to allocate joint costs in contractual agreements among parties that share outputs and joint costs of joint processes

By-Product Accounting: the Basics By-products are minor products and alternative methods are not likely to have a material effect on the financial statements for either internal or external reporting Whether to sell the by-product at split-off or process them further usually depends on the highest NPR obtainable like a major product Two standard methods Consider by-product NRV as other revenue Deduct by-product NRV from costs as main product

By-Product Accounting: the Basics Method 1: The NRV of the by-product treated as other revenue Used because by-product NRVs are small and effects on income are immaterial

By-Product Accounting: the Basics Method 2: Deducted net realizable value from sale of the by- products from the cost of the main product

By-Product Accounting: the Basics Method 2: Deducted net realizable value from sale of the by- products from the cost of the main product If all the main products produced in the period have not been sold, the NRV of by-products should be prorated to the main product inventories and cost of goods sold 1,500 / 2,300 800 / 2,300 .6522 x $62,400 .3478 x $62,400

What To Do With Scrap And Waste By-Product Scrap and Waste Sales value exceeds cost of further processing Cost of further processing exceeds sales value Sold as by-product Dispose of legally at minimum cost Look for new products or

2. The Service Cost Challenge

The Service Cost Challenge ACHIEVING THE GOALS OF THE ORGANIZATION Requires the use of scarce resources and making complex trade-offs among competing uses Making resource trade-offs requires reliable quantitative and qualitative cost management information about relative costs and benefits of alternatives

Internal Or Outsourced Support Services? Factors to be Considered Sensitive Information Knowledge Base Reliable Service Providers Some organizations compete on the basis of their knowledge of technology or complex market and political situation Complex or unique organizations may have distinct procedures and cultures A less expensive, outsourced service is not cost effective if the reliability and quality of the service is low and adversely affects the organization’s ability to meet its objectives

Managing Internal Support-Service Costs Cost-based management approaches to managing internal support- service costs Charge internal customers nothing for support services and recover the costs from general revenue Charge the cost of support services provided to using departments and possibly recover the costs from these internal customers

Managing Internal Support-Service Costs Charge the cost of support services provided to using departments and possibly recover the costs from these internal customers DISADVANTAGES Cost allocations are, by nature, arbitrary and may not measure uses of resources accurately If internal customers are required to use internal services, they may spend valuable time negotiating and lobbying over fair prices which may be inefficient

Distinquishing Between Direct And Support Services Public works Provide services directly to the public Direct-service Departments Utilities Provide services to each other other and to the direct- service customers Human resources Support-service Departments Finance

Decision-Making And Cost Allocation Do employees make better decisions with or without deliberate, well designed cost allocations that reflect use of resources? PRINCIPLES OF COST ALLOCATION FOR THE CITY OF ROCK CREEK The system shall accomplish the following objectives: A. Complete recovery of service costs incurred with the exception of “general governance,” which are supported by general revenues. B. Equitable allocation of service costs to users. C. Provision of incentives for service providers to deliver products and services efficiently and effectively. D. Provision of a stable cost-allocation system to facilitate the organization’s budgeting for charges and revenues. E. Promotion of customer confidence in and acceptance of the accuracy, reasonableness, and the fairness of the charges they incur.

Other Uses Of Cost Allocation Required reporting Tax regulations External financial reporting Influencing Behavior Incentive to control use of support services Cost-based contracts Government Foundation Private industry

The Process Of Allocating Service Costs Systematically 1. IDENTIFY THE COSTS TO BE ALLOCATED TO INTERNAL CUSTOMERS 2. CHOOSE THE APPROPRIATE ALLOCATION BASE(S) 3. SELECT AND USE A COST-ALLOCATED BASE(S) 4. DETERMINE IF THE COST ALLOCATIONS ACHIEVE THE DESIRE RESULTS-IF NOT, BEGIN THE PROCESS AGAIN

The Process Of Allocating Service Costs Systematically 1. IDENTIFY THE COSTS TO BE ALLOCATED TO INTERNAL CUSTOMERS Finance COST POOLS Budgeted or actual spending amounts for distinct sets of resources Planning and Development Human resources Information technology Why use multiple cost pools? Multiple cost pools facilitate managing the different types of support services and should allow more accurate cost allocations to internal customers.

The Process Of Allocating Service Costs Systematically 1. IDENTIFY THE COSTS TO BE ALLOCATED TO INTERNAL CUSTOMERS Next year’s support- service cost are estimated by adjusting last year’s spending for an expected change in expected cost of living This should only be a first step because it ignores the expected demand for services

The Process Of Allocating Service Costs Systematically 2. CHOOSE THE APPROPRIATE ALLOCATION BASE(S) ABC Approach 2.1. Measuring each support-service department’s resource spending by level (unit, batch, customer, facility). 2.2. Identifying and measuring the activities demanded by internal customers that require support-service spending (e.g. hiring and training new employees) to obtain cost-driver basis. 2.3. Dividing support-service resource spending by appropriate cost-driver basis to derive cost-driver rates.

The Process Of Allocating Service Costs Systematically 2. CHOOSE THE APPROPRIATE ALLOCATION BASE(S) Allocation bases may be ABC cost drivers, but without careful analysis it is not possible to validate causal relationships Traditional Approach Support-Service Department Finance Human resources Information Technology Planning & development Cost-Allocation Base Size of budget before cost allocations Number of full-time equivalent employees Number of computers, including network servers Number of project applications Without ABC, choose allocation bases that seem reasonable and justifiable to internal customers

The Process Of Allocating Service Costs Systematically 3. SELECT AND USE A COST-ALLOCATION BASE(S) Direct Method Charges costs of support-service departments to internal customers without making allocations among service departments. Allocations go directly to production or direct-service departments

Example Of Direct Method Of Allocation

The Process Of Allocating Service Costs Systematically ALLOCATION USING THE DIRECT METHOD Support-service departments Direct service departments Finance department Arts department Fire department Housing and human service department Library department Municipal court department Parks and recreation department Police department Public works department Transportation department Human resource department Information technology department Planning and development department

3. SELECT AND USE A COST-ALLOCATION BASE(S) The Process Of Allocating Service Costs Systematically 3. SELECT AND USE A COST-ALLOCATION BASE(S) Step Method Recognizes that some support-service departments provide services to other support services as well as production and direct service departments Allocations begin with the service department with the largest proportion of its total allocation base in other service departments

Example Of The Step Method Allocation

The Process Of Allocating Service Costs Systematically ALLOCATION USING THE STEP METHOD Support-service departments Direct service departments Finance department Arts department Fire department Housing and human service department Library department Municipal court department Parks and recreation department Police department Public works department Transportation department Human resource department Information technology department Planning and development department

Step-order Analysis Allocate costs first from the most general department to the less general support-service departments and direct- service Most general Least general

reasonable allocations Comparison Of Methods STEP METHOD DIRECT METHOD RECIPROCAL METHOD May result in more reasonable allocations than the direct method because it recognizes that some service departments use other service departments May result in simpler allocations which do not materially differ from the direct method Recognizes services provided among multiple support-service departments

4. Step 4: Determine If The Cost Allocations Achieve The Desired Results Cost Allocation Accuracy The Direct Method does not consider interactions among service departments Least Accurate Combination The Step Method considers some interactions among service departments The Reciprocal Method is more thorough in considering interactions among service departments Most Accurate Combination ABC cost-driver bases should reflect cause-and- effect relationship between resource spending and use Traditional cost-allocation bases may be rough approximations of cause and effect

4. Step 4: Determine If The Cost Allocations Achieve The Desired Results COST ALLOCATION EFFECTS If support-service departments provide significant services to each other, the amounts of costs allocated to direct-service, production, and marketing departments probably differ under each method Significant differences can effect: Performance evaluations Contracts Decision- making

4. Step 4: Determine If The Cost Allocations Achieve The Desired Results COST ALLOCATION COSTS AND BENEFITS Complex cost-allocation systems are difficult and costly to DESIGN Complex cost-allocation systems are difficult and costly to MAINTAIN Cost-allocation systems may require revision in a continual process of improvement, which is costly but can be justified if decisions and organizational performance also continue to improve

Methods and Implementation of Activity-Based Management หลักการคิดต้นทุนตาม กฎแห่งกรรม Methods and Implementation of Activity-Based Management

Activity-Based Management (ABM) Basic ABC determines All of the organization’s major activities within the value chain The organization’s cost drivers and cost-driver rates appropriate for each activity

Activity-Based Management (ABM) adds: The customer perceived value of each activity Value-added and non-value-added activities Opportunities to enhance value-added activities and reduce or eliminate non-value-added activities

The Steps Of ABC 5. Analyze the profitability of products using ABC unit-level and full costing. 4. Use cost-driver rates to assign activity costs to products, jobs, services, and projects by multiplying the use of cost driver base(s) by the cost driver rates 3. Identify cost-driver bases and measure activity cost-driver rates 2. Measure the costs of individual activities 1. Identify and measure the different levels of resource spending

Combining ABC And Target Costing market price less return on sale Megaburger Promotional Toys

ABC-Target Costing Analysis for one year $12,391,038 -11,200,000 $1,191,038

The Importance Of Customer Value Activities Create outcomes and consume resources VALUE-ADDED ACTIVITIES enhance the value of products and services in the eyes of the customer while meeting the goals of the organization NON-VALUE-ADDED ACTIVITIES do not contribute to customer perceived value

Non-value Added Activities Why do organizations have incentives to eliminate non-value added activities? Competitors are constantly striving to create more value for customers at lower cost The organization can apply the freed- up resources to value-added activities or distribute them to the employees of the organization Competition can appear quickly

Non-Value-Added Activities Most likely sources of non- value-added activity Producing to build up inventory Waiting time for processing Time and effort to move to processing Processing itself Transportation from suppliers and to customers Producing defective products of services

Identifying Value-Added Activities The test for value added activities “Would an external customer encourage the organization to do more of the activity?” “Would the organization be more likely to reach its goal by performing that activity?” YES IF THE ANSWER IS NO TO BOTH OR EITHER IT IS NON-VALUE -ADDED IF THE ANSWER IS YES TO BOTH IT IS VALUE- ADDED YES

Value-Added And Non-Value-Added Activities Value-added and non-value-added activities can vary across organizations depending on the internal or external customers served

How Should An Organization Measure Value-Added? Rate activities on a 1 to 5 or 10 scale 5 4 3 2 1 VALUE- ADDED NON- VALUE- ADDED Necessary Activities Neither value-added nor non-value-added Technological Requirements Policy Requirements Regulatory Requirements

Who Should Perform The Measurement Activity? Use a team approach Everyone’s knowledge is limited Everyone is potentially biased in his or her response

What Tasks Does Activity-Based Management Require ? Twin objectives of ABM Identify non-value-added activities to eliminate or reduce Identify value-added activities to enhance Redesign processes to eliminate wasteful spending on non-value-added activities

Sorting Activities By Cost And Value Identify oversupplied non-value-added activities and undersupplied value-added activities Undersupplied value-added activities Oversupplied non-value-added activities

Identifying Opportunities For Process Improvement Before process improvements ASK WHY FOR EACH STEP IN THE PROCESS Elapsed Time: 100 unit Baby- care order Process activity 6.1 Trim excess plastic Why do employees need to trim excess plastic from molded products? 144 min. 6.2 Recycle trimmed plastic Why#1: Appearance and product function requires removal of the excess Why#2: Under high-injection pressure, plastic leaks from the edges of the mold Why#3: High pressure is required to mold the products properly Why#4: The design of the molds permits leakage Why#5: The molds are based on old designs 30 min. 6.3 Place good piece in box 72 min. 6.4 Log out completed order 10 min. 20 min. 6.5 Move to warehouse SOLUTION: Rework or replace old molds with improved designs to eliminate the need for trimming products and recycle trim 10 min. 6.6 Register order in inventory Total elapsed time 286 min.

Identifying Opportunities For Process Improvement Before process improvements ASK WHY FOR EACH STEP IN THE PROCESS Elapsed Time: 100 unit Baby- care order Process activity 6.1 Trim excess plastic 144 min. Why are we spending so much time on non-value-added record keeping and the correction of recording errors? 6.2 Recycle trimmed plastic 30 min. 6.3 Place good piece in box 72 min. SOLUTION: Install a bar-coding system to mark and track all orders electronically 6.4 Log out completed order 10 min. 20 min. A bar-coding system creates a unique bar code for each order and allows the company to mark and track all orders electronically 6.5 Move to warehouse 10 min. 6.6 Register order in inventory Total elapsed time 286 min.

Identifying Opportunities For Process Improvement Before process improvements After Improving or removing non-value added activities Elapsed Time: 100 unit Baby- care order Elapsed Time: 100 unit Baby- care order Process activity Process activity 6.1 Trim excess plastic 144 min. ______ ______ 6.2 Recycle trimmed plastic ______ 30 min. ______ 6.3 Place good piece in box 6.3 Place good piece in box 72 min. 72 min. 6.4 Log out completed order 10 min. 6.4 Log out completed order 10 min. 20 min. 20 min. 6.5 Move to warehouse 6.5 Move to warehouse 10 min. 10 min. 6.6 Register order in inventory 6.6 Register order in inventory Total elapsed time 286 min. Total elapsed time 122 min.

Identifying Opportunities For Process Improvement Before process improvements After Improving or removing non-value added activities Elapsed Time: 100 unit Baby- care order Elapsed Time: 100 unit Baby- care order ______ 144 min. 286/60 minutes per hour x $10 per hour = $47.67 122/60 minutes per hour x $10 per hour = $20.33 ______ 30 min. 72 min. 72 min. 10 min. 10 min. 20 min. 20 min. 10 min. 10 min. $27.34 SAVINGS Total elapsed time 286 min. Total elapsed time 122 min The problem assumes that operators of injection-molding machines, on average, earn $10 per hour (including benefits)

Implementation Of Activity-Based Costing And Management The Focus of ABC The Focus of ABM Developing improved product or service costs given current processes Identifying opportunities for improving processes Consider cost-benefits

Implementation Of Activity-Based Costing And Management What Organizations Adopt ABC and ABM? Companies facing price competition Companies producing many different, complex products from common facilities

Can You Be Sure That ABC And ABM Will Be Successful? What is the scope of the ABC or ABM project? Pilot Project Organizationwide System What is a pilot project? Why use a pilot project? Why use a pilot project? A project of limited scope that is intended to be a small-scale model or an organizational system The complexities of the organization will overwhelm the learning and development required for the implementation of the organizational wide system Anticipate the linkages across departments, groups and processes Anticipate the data gathering and reporting requirements

Can You Be Sure That ABC And ABM Will Be Successful? What Resources are Necessary? Management Commitment Personnel and Time Technology Educate top management as to cost/benefits Significant projects will require a three- to four-person, cross-functional team at least four to six months of full-time effort Begin with existing commercial software

Can You Be Sure That ABC And ABM Will Be Successful? How can you anticipate and overcome resistance to change? Education and Training Incentives that Encourage and Reward Change Prevent or Minimize Resistance by: Widespread Sponsorship and Participation Effects of Culture Be Sensitive to Differences in National Cultures

Can You Be Sure That ABC And ABM Will Be Successful? How do you gather information? ABC and ABM require information that is not normally available from an organization’s information systems This information can be generated by: Observation Survey Interview

Can You Be Sure That ABC And ABM Will Be Successful? How Should you Perform the Analysis and Make Recommendations Though Top Managers Ultimately Have the Responsibility for Authorizing and Effecting Major Changes, the Analysis Team is Best Prepared to Analyze the Data and Make Recommendations The team is ultimately familiar with the data, its strengths and weaknesses Empowering and Requiring the Team to Make Recommendations gives the Control and Accountability for the Entire Project