2. PowerPoint Authors: Susan Coomer Galbreath, Ph.D., CPA Charles W. Caldwell, D.B.A., CMA Jon A. Booker, Ph.D., CPA, CIA Cynthia J. Rooney, Ph.D., CPA Copyright © 2014 by The McGraw-Hill Companies, Inc. All rights reserved. McGraw-Hill/Irwin Chapter 4 Activity-Based Costing and Cost Management

3. 4- 3 Activity-Based Costing (ABC) Activity Based Costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require. Two-Stage Allocation Process Using ABC

4. 4- 4 Form Activity Pools and Assign Indirect Costs to Each Pool Machining and Installation (unit level) Machine Setup (batch level) Engineeringand Quality Control (product level) Assume that Toyota has grouped its production activities into three categories.

5. 4- 5 Form Activity Pools and Assign Indirect Costs to Each Pool Recall that the total manufacturing overhead cost for the Tsutsumi plant is estimated at $3,000,000 (in thousands) per year. 1n an ABC system, this indirect cost must be assigned to the three activity cost pools.

6. 4- 6 Select a Cost Driver for Each Activity Cost Pool Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the activity driver for the set-up activity. Engineering and inspection hours will be used as the driver to assign engineering and quality control costs.

7. 4- 7 Activity-Rate Method The activity-rate method is very similar to the predetermined overhead rate computed earlier. Total indirect costs assigned to the machining pool was $720,000. Total machine hours required by each Toyota model is as follows: Activity Rate = $720,000 10,000 = $72 per machine hour

8. 4- 8 Activity-Based Costing in Service Industries ABC can also be useful in service industries, particularly when different types of customers require different levels of service. Although service providers do not have manufacturing overhead, they incur many indirect costs, such as rent, supplies, supervision, advertising, and administrative expenses.

9. 4- 9 Activity-Based Management Activity-based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. The first step in any improvement program is to target areas that need improvement. What Activities Are Performed? What Activities Are Performed? How Much Does it Cost to Perform Each Activity? Does the Activity Add Value to the Customer?

10. 4- 10 Just-in-Time (JIT) Inventory In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a "demand pull" system, where materials and products are pulled through the manufacturing system based on customer demand. In a traditional manufacturing setting, products are pushed through the system and often end up sitting in inventory.

11. 4- 11 Total Quality Management Total quality management (TQM) is a management approach that aims to improve product quality by reducing and eliminating errors, streamlining activities, and continuously improving production processes: 1.Prevention costs; 2.Appraisal or inspection costs; 3.Internal failure costs; and 4.External failure costs.

12. 4- 12 Target Costing and Life Cycle Cost Management Target costing is a proactive approach to cost management that managers can use to determine what costs should be in order for the company to earn an acceptable profit across a product’s life cycle. The product life cycle represents the life of the product from its infancy (an idea), through design, development, product introduction, growth, maturity, and eventual decline.

13. 4- 13 Target Costing and Life Cycle Cost Management In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including: 1.product introduction, 2.growth, 3.maturity, and 4.eventual decline. Costs tend to be higher Most revenue earned In today’s digital and technological age, product life cycles become increasingly short.

14. 4- 14 Target Costing and Life Cycle Cost Management With target costing, the price is set by the market based on what the company believes consumers will be willing to pay for the product or service. The desired profit margin is then subtracted from the market price to determine the target cost. The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000 per unit).

15. 4- 15 Summary of ABC and ABM To gain the true benefits of activity based costing, managers must move from simply measuring costs, to find ways to manage or reduce costs. Although ABC and ABM have many potential benefits, these benefits must be weighed against the costs of obtaining the more accurate information. Implementing an ABC can be a difficult task.

16. 4- 16 End of Chapter 4