1. Chapter 5 Activity-Based Management

2. 1. How can reasonably accurate product and service cost information be developed? 2. What are the differences among value-added, non-value-added, and business value-added activities? C5 Learning Objectives

3. 3.What might cause decreased manufacturing cycle efficiency? 4.How would the cost drivers in an activity-based costing system be developed? C5 Continuing... Learning Objectives

4. 5.What distinguishes activity-based costing from conventional overhead allocation methods? 6.When is the use of activity-based costing appropriate? 7.What are the benefits and limitations of using activity-based costing? C5 Continuing... Learning Objectives

5. Cost Distortions in a Machine- Intensive Environment Overhead costs per month, primarily machine-related $600,000 Total direct labor hours (DLHs) 800 Overhead rate per DLH ($600,000  800) $750 Total machine hours (MHs) 2,450 Overhead rate per MH ($600,000  2,400) $250

6. Continuing... Cost Distortions in a Machine-Intensive Environment Product A (10,000 units per month) Total DLHs 600 OH assigned using DLHs $450,000 OH per unit $45 Total MHs 400 OH assigned using MHs $100,000 OH per unit $10

7. Continuing... Cost Distortions in a Machine-Intensive Environment Product B (10,000 units per month) Total DLHs 200 OH assigned using DLHs $150,000 OH per unit $15 Total MHs 2,000 OH assigned using MHs $500,000 OH per unit $50

8. Activity-Based Management Managers can use activity-based management (ABM) to help enhance customer value and organizational profits by increasing organizational efficiency and effectiveness and producing more accurate costs.

9. The Activity-Based Management Umbrella Activity-Based Management Process and activity analysis Cost driver analysis Activity-based costing Strategic planning Integration with cost management system Continuous improvement Operational control Performance evaluation Business process reengineering

10. Activity-Based Management Analyze activities –Activity - a repetitive action, movement, or work sequence performed to fulfill a business function Prepare a process map –Makes it possible to identify duplication, waste, and unnecessary work –Value chart – indicates time spent in each activity and assesses value of activity

11. Value-Added Activity Increases the worth of a product or service to customers for which they are willing to pay

12. Non-Value-Added Activity Increases the time spent on a product or service but does not increase its worth to customers Inspection time, transfer time, idle time, NVA production or performance time

13. Business-Value-Added Activities Business-value-added (BVA) activities are NVA activities that are essential to business operations, but for which customers would not willingly choose to pay. Example: a publicly held company’s required audit at the end of its fiscal year.

14. Manufacturing Cycle Efficiency In a manufacturing environment, the manu- facturing cycle time efficiency at most companies is 10%. This means: Value is added to the product only 10% of the time from receipt of the parts until shipment to the customer. Ninety percent of the cycle time is waste.

15. Just-In-Time (JIT) Under JIT, inventory is manufactured or purchased only as the need for it arises or in time to be sold or used. JIT eliminates a significant portion of the idle time consumed in storage and transfer processes.

16. Activity-Based Costing Activity-based costing (ABC) is an accounting information system that identifies organizational activities and collects costs by considering the underlying nature and extent of those activities.

17. Activity-Based Costing Recognizes that various activities and cost levels exist Gathers costs into related cost pools Uses multiple cost drivers to assign costs to products and services

18. Activity-Based Costing Activity-based costing attaches costs to products and services based on the activities used to make, perform, distribute, or support products and services.

19. Level of Cost Incurrence Unit-level costs –Incurred by production or acquisition of a single unit of product or the delivery of a single unit of service Batch-level costs –Incurred when a group of similar things are made, handled, or processed at the same time Product- or process-level costs –Incurred in support of different products or processes Organizational- or facility-level costs –Incurred to support and sustain a business unit

20. Levels of Costs Classification Levels Types of Costs Necessity of Cost Unit-Level Costs Direct material Direct labor Some machine costs, if traceable Once for each unit produced

21. Levels of Costs Classification Levels Types of Costs Necessity of Cost Batch-Level Costs Purchase orders Setup Inspection Movement Scrap, if related to the batch Once for each batch produced

22. Levels of Costs Classification Levels Types of Costs Necessity of Cost Product- or Process-Level Costs Engineering change orders Equipment maintenance Product development Scrap, if related to product design Supports a product type or a process

23. Levels of Costs Classification Levels Types of Costs Necessity of Cost Organizational- or Facility-Level Costs Building depreciation Plant or division manager’s salary Organizational advertising Supports the overall production of service process

24. Two-Step Allocation Cost 1 Cost 5 Cost 2 Cost 3 Cost 4 Activity Cost Center 2 Product 1 Product 2 Product 3 Activity Cost Center 1

25. Activity Drivers Accounting Reports requested; dollars expended Personnel Job change actions; hiring actions; training hours; counseling hours Data Processing Reports requested; transactions processed; programming hours; program change requests

26. Continuing... Activity Drivers Production Engineering Hours spent in each shop; job specification changes requested; product change notices processed Quality Control Hours spent in each shop; defects discovered; samples analyzed

27. Continuing... Activity Drivers Plant Services Preventive maintenance cycles; hours spent in each shop; repair maintenance actions Material Services Dollar value of requisitions; number of transactions processed; number of personnel in direct support

28. Continuing... Activity Drivers Utilities Direct usage (metered to shop); space occupied Production Shops Fixed per-job charge; setups made; direct labor; machine hours; number of moves; material applied

29. Is ABC Information Better? Consider: The number and diversity of products or services produced or provided The diversity and differential degree of support services used for different products The extent to which common processes are used The effectiveness of current cost allocation methods The rate of growth of period costs

30. Will ABC Information Change Decisions? Consider: Management’s freedom to set prices The ratio of period costs to total costs Strategic factors The climate and culture of cost reduction in the company The frequency of analysis that is desirable or necessary

31. Product Variety Creates Overhead Costs Given differing product sets, which company would have more: Inventory carrying costs? Purchasing costs? Scheduling costs? Setup and change over costs? Expediting costs? Quality control costs? Scrap costs? Rework costs? To which products do these increased costs relate? Which product line would bear most of the costs?

32. Business Process Reengineering To find and implement radical changes in how things are made or how tasks are performed to achieve substantial cost, service, or time reductions Emphasizes continuous improvement Ignores “the way it is” Looks at “the way it should be”

33. Shortcomings of ABC Time and cost of implementing ABC –Need environment for change –Environment for change hindered by individual, organizational, and environmental barriers Does not conform with GAAP –Most companies use ABC as a supplemental system –Additional clerical costs Some people question whether it promotes total quality management and continuous improvement

34. ABC Can Help Managers To: Identify and monitor significant technology costs Trace many technology costs directly to products Promote achievement of market share through use of target costing Identify the cost drivers that create or influence cost Identify activities that do not contribute to perceived customer value

35. And To: Understand the impact of new technologies on all elements of performance Translate company goals into activity goals Analyze the performance of activities across business functions Analyze performance problems Promote standards of excellence