1. 5-1 Value Chain Analysis and Activity-Based Management C hapter 5 Prepared by Douglas Cloud Pepperdine University

2. 5-2 1.Describe strategic cost management. 2.Discuss the importance of the value chain approach to analyzing decision alternatives. 3.Analyze an organization’s internal value chain, dividing it into process and activities. 4.Explain how process management can help improve organizational performance. 5.Determine the costs of individual activities and the activity costs associated with various cost objectives. ObjectivesObjectives After studying this chapter, you should be able to:

3. 5-3 Strategic Cost Management Strategic cost management is defined as making decisions concerning specific cost drivers within the context of an organization’s business strategy, its internal value chain, and its place in a larger value chain stretching from the development and use of resources to the final consumers.

4. 5-4 Elements of a Value-Chain for a Beverage-Packaging Plant First level: Business entities Timber Farm Pulp Mill Paperboard Manufacturer Paperboard Converter Beverage Company Grocery Store Final Customer to second level

5. 5-5 Second level: Processes Procurement StorageDisplay from first level Sell to customer Third level: Activities Preparing purchase order Receiving order Inspecting delivery Moving to Storage Paying invoice

6. 5-6 Usefulness of the Value Chain Perspective The goal of maximizing final customer value while minimizing final customer cost leads organizations to examine internal and external links in the value chain.

7. 5-7 The Value Chain Perspective Fosters Supplier-Buyer Partnerships Value Chain Perspective Focuses on Processes, Not Departments

8. 5-8 The Value-Chain Perspective  Comprehensive  Focused on the final customers  Strategic  Basic for partnerships between vendors and customers

9. 5-9 Structural Cost Drivers Organizational Cost Drivers Activity Cost Drivers Making fundamental choices about the size and scope of operations and technologies involved. Making choices concerning the organization of processes and activities Performing specific units of work (activities) to serve customer needs.

10. 5-10 Goals Location Scale Scope Technology Complexity Structural cost drivers include decisions affecting-- Structural Cost Drivers

11. 5-11  Organization of processes  Layout efficiency  Product configuration  Exploitation of linkages in the value chain  Work force involvement  Attitudes toward total quality management Organizational cost drivers include decisions affecting-- Structural Cost Drivers

12. 5-12 Measures of Activity Preparing purchase order Receiving delivery Inspecting delivery Moving to storage Paying invoice Number of orders Number of units in order Units in order Number of orders

13. 5-13 Generic Internal Processes Operations Inbound Logistics Outbound Logistics Marketing and Sales Service Source: The basic idea for this exhibit is based on concepts contained in Michael E. Porter, Competitive Advantage (New York: The Free Press, 1985), p. 37. Supporting Processes: Accounting, Design, Finance, Human Resources, Maintenance, and so forth.in

14. 5-14 Representative Activities Processing employee paychecks Developing budgets Determining activity costs Verifying the existence of recorded assets Accounting

15. 5-15 Developing specifications for products or services delivered to customers  Developing specifications for procedures to produce products or services Design Representative Activities

16. 5-16 Signing checks Obtaining financial resources Finance Representative Activities

17. 5-17 Human Resources Hiring employees Training employees Repairing equipment Cleaning buildings Representative Activities Maintenance

18. 5-18 Process Map It is a schematic overview of all the activities within a process.

19. 5-19 Accept shipment yes no Process Map Is there an existing order Reject shipment

20. 5-20 Process Map Activity: Placing a Purchase Order Go to file cabinet Open drawer containing blank purchase orders Remove one purchase order Close drawer Return to desk

21. 5-21 In continuous improvement, an organization’s employees constantly evaluate products, services, and processes seeking ways to do better. wa

22. 5-22 Activity-based costing (ABC) involves determining the cost of activities and tracing their costs to cost objectives on the basis of the cost objectives utilization of units of activity. Activity-Based Costing

23. 5-23 Activity-Based Costing Activity-based costing is used to develop cost information for the following (and other) purposes in which management might be interested:  The cost of processing a purchase order to assist in continuous improvement.  The cost of a product or service to determine the profitability of the product or service.  The cost of alternative long-distance telephone carriers to identify the carrier with the best combination of quality, service, and cost.

24. 5-24 Activities performed to fill customer needs consume resources that cost money. Customer Activities served by Resources consume Costs have cost money Activity-Based Costing

25. 5-25 The cost of resources consumed by activities should be assigned to cost objectives. CostsResources assigned to Activities Pools assigned to Cost Objectives Reassigned to Activity-Based Costing

26. 5-26 1.Identifying activities. 2.Assigning costs to activities. 3.Determining the basis (activity cost driver) for assigning the cost of activities to cost objectives. 4.Determining the cost per unit of activity. 5.Reassigning costs from the activity to the cost objective in the basis of the cost objective’s volume of consumption of activities. Operationalizing the two-stage model requires the following: Activity-Based Costing

27. 5-27 Detroit Metal Shop produces custom metal parts in response to customer job orders. Inbound logistics and operations for the firm is as follows: Place purchase order Receive materials Setup each job Perform activities Inbound Logistics Purchasing Department Operations Machining Department Continued

28. 5-28Polish Operations Finishing Department Pack

29. 5-29 Monthly Costs: Purchasing Dept. Placing Purchase Receiving Orders Materials Purchasing agent salaries ($4,000 x 3)$12,000 Receiving room employees ($3,000 x 5)$15,000 Supervisor: ($6,000 x.38 time with purchasing agent)2,250 ($6,000 x.63 of time with receiving agent)3,750 Other costs: ($12,000 x 0.15 purchasing space)1,800 ($12,000 x 0.85 receiving space)10,200 Total$16,050$28,950

30. 5-30 Refining into Three Activities Placing Verifying Unloading/ Purchase Purchase Unpacking Orders Orders Inspecting Purchasing agent salaries ($4,000 x 3)$12,000 Receiving room employees: ($3,000 x 5 x 0.20 verifying time)$ 3,000 ($3,000 x 5 x 0.80 unloading/ unpacking/inspect time)$12,000 ContinuedContinued

31. 5-31 Placing Verifying Unloading/ Purchase Purchase Unpacking Orders Orders Inspecting Carried forward$12,000$ 3,000$12,000 Supervisor: ($6,000 x.38 of time with purchasing agents)2,250 ($6,000 x.63 of time with receiving employees x 0.20 employees’ verifying time)750 ($6,000 x.63 of time with receiving employees x 0.80 employees’ unloading/ unpacking/inspecting time) 3,000 ContinuedContinued

32. 5-32 Carried forward$14,250$ 3,750$15,000 Other costs*: ($12,000 x 0.15 purchasing space)1,800 ($12,000 x 0.85 receiving space)10,200 Total $16,050$ 3,750$25,200 * Because the purchase order is verified before delivery trucks are unloaded, the space devoted to this activity is assumed to be insignificant. Placing Verifying Unloading/ Purchase Purchase Unpacking Orders Orders Inspecting

33. 5-33 Cost per Unit of Activity Cost per unit of activity cost driver Cost of activity Units of cost driver = Cost per unit of activity cost driver $16,050 200 = Placing Purchasing Orders Cost per unit of activity cost driver $80.25 per order =

34. 5-34 Cost per unit of activity cost driver Cost of activity Units of cost driver = Cost per unit of activity cost driver $3,750 200 = Verifying Purchasing Orders Cost per unit of activity cost driver $18.75 per order = Cost per Unit of Activity

35. 5-35 Cost per unit of activity cost driver Cost of activity Units of cost driver = Cost per unit of activity cost driver $25,200 $800,000 (direct materials) = Unloading/Unpacking/Inspecting Cost per unit of activity cost driver 0.0315 per dollar = Cost per Unit of Activity

36. 5-36 Assigning Activity Costs Purchase Purchase Order 1 Order 2 Total Direct materials costs$5,000.00$3,500.00$8,500.00 Activity costs: Placing purchase order$ 80.25$ 80.25$ 160.50 Verifying purchase order18.7518.7537.50 Unloading/unpacking/inspecting ($5,000 x 0.0315)157.50 ($3,500 x 0.0315)110.25267.75 Total256.50 209.25 465.75 Total costs assigned to cost objective$5,256.50$3,709.25$8,965.75

37. 5-37 Purchasing Department $45,000 Resource Costs Placing purchase orders $16,050 Verifying purchase orders $3,750 Unloading/ unpacking/ inspecting $25,200 $25,200 Activity Cost Pool Purchase Order 1 $5,256.50 Cost Objectives Purchase Order 2 $3,709.25 Other purchase orders $36,034.25

38. 5-38 Detroit Metal Shop Example The following activity costs were determined in the Machining and Finishing Departments: Machining Department: Setup$ 250 Conversion ($100 x 35MH)3,500 Finishing Department: Polish ($50 x 20 labor hours)1,000 Pack ($5 x 450 kilograms)2,250 Total cost assigned to cost object$7,000

39. 5-39 Machining Department Finishing Department SetupConversionPolishPack Job102 Other jobs Detroit Metal Shop Example

40. 5-40 Detroit Metal Shop Example Direct materials: Order 1$5,000.00 Order 23,500.00$ 8,500.00 Inbound logistics: Placing purchase order$ 160.50 Verifying purchase order37.50 Unloading/unpacking/inspecting 267.75465.75 Operations: Setup$ 250.00 Conversion3,500.00 Polish1,000.00 Pack2,250.00 7,000.00 Total cost assigned to Job 102$15,965.75

41. 5-41 Two-Stage Activity Based Costing Method Direct Resource Costs Costs of resources directly traceable to cost objectives To Objective 1, 2, 3, through n costs

42. 5-42 Two-Stage Activity Based Costing Method Stage 1: Indirect resources costs are assigned to activity pools. Cost of Resource 1 Cost of Resource 2 Cost of Resource 3 Cost of Resource n Activity 1 Activity 2 Activity 3 Activity 4 Activity n ContinuedContinued

43. 5-43 Stage 2: Activity costs are reassigned to cost objectives using an activity drivers. Activity 1 Activity 2 Activity 3 Activity 4 Activity n Two-Stage Activity Based Costing Method Objective nObjective 2 Objective 3 Objective 1 from Direct Resource Costs

44. 5-44 Additional Considerations Because activity-based costing is not guided by financial accounting requirements, there is wide variation in the components of ABC systems.

45. 5-45 Reducing Non-Value- Added Activities Movement Waiting Setup Inspection

46. 5-46 Continuous improvement and process reengineering seek to minimize non- value-added activities. Reducing Non-Value- Added Activities

47. 5-47 The ABC/ABM Cross Process View (ABM) Cost Assignment View (ABC) Resources (What is used to do work?) Activities (Work) Cost Objects (The object of work) Cost Drivers (Why is work done?) Performance Measures (How well is work done?)

48. 5-48C hapter 5 The End

49. 5-49