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

Chapter SevenActivity-Based Costing and

Management

Chapter SevenActivity-Based Costing and

Management

COPYRIGHT © 2012 Nelson Education Ltd.

COPYRIGHT © 2012 Nelson Education Ltd.COPYRIGHT © 2012 Nelson Education Ltd.

Learning ObjectivesLearning Objectives

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

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

3. Describe activity-based customer and supplier costing

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

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OBJECTIVE OBJECTIVE 11

Explain why functional-based costing

approaches may produce distorted costs


Functional-Based Costing SystemsFunctional-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

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Functional-Based Costing System LimitationsFunctional-Based Costing System Limitations

1. Proportion of non-unit-related overhead costs to total overhead charge is large

2. Degree of product diversity is great

Two major factors impair their ability to assign overhead costs accurately:

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Unit and Non-Unit ActivitiesUnit and Non-Unit Activities

Activities performed each time a unit is produced

From the viewpoint of the subsequent process, transferred-in costs are a type of raw material cost

Unit-level-activities ---

Non-unit-level-activities ---

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Non-Unit-Related Overhead CostsNon-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

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Product DiversityProduct Diversity

Proportion of each activity consumed by a product

Consumption Ratio ---

Products consume overhead activities in systematically different proportions

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Example: Cornerstone 7-1Example: Cornerstone 7-1

Regular

Prime costs

Setup hours

$800

Number of moves

Total

$8,000

3 1 4

4 10

Deluxe

Activity Usage Measures

Units produced 10 100 110

$8,800

Direct labour hours 20 80 100

Machine hours 10

6

40 50

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How to Calculate Consumption Ratios


ExampleExample

Setting up equipment

Assembly

Total

Activity Cost

500

$4,000

Activity

Activity Cost Data

$1,200

Moving goods 800

Machining 1,500

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ExampleExample

Calculate the consumption ratio for each product

Overhead Activity

Setting up equipment 0.75

DeluxeActivity Driver

One of four hours was spent on the Regular model

Regular

Setup hours0.25

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Three of four hours were spent setting up the Deluxe

Model ¾ or 0.75


ExampleExample


Overhead Activity


DeluxeActivity Driver

6 of the 10 moves were for the Deluxe model, 4 of the 10 were for the Regular model

Regular

Setup hours0.25

Moving goods 0.60 0.40 # of moves

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ExampleExample


Overhead Activity


DeluxeActivity DriverRegular

Setup hours0.25


Machining 0.20 0.80 Machine hrs

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Deluxe model used 10 of the 50 machine hours, while the Regular model used 40 hours


ExampleExample


Overhead Activity



Setup hours0.25



Assembly 0.20 0.80 Direct labour hours

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Deluxe model used 20 of the 100 direct labour hours. Regular model used 80 hours


ExampleExample

Calculate the consumption ratio for each product.

Overhead Activity



Setup hours0.25



Assembly 0.20 0.80 Direct labour hours

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Deluxe model had Consumption Ratios ranging from 0.75 to 0.20


How to Calculate Activity Ratios


Activity Activity Cost

Setting up equipment

Moving goods

Machining

$1,200

1,500

500

Information:

800

Assembly

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ExampleExample

Driver Driver Quantity

Setup hours

Number of moves

Machine hours

4

50

100

Information:

10

Direct labour hours

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ExampleExample

Required: Calculate activity rates

Setup rate $1,200/4 setup hours $300 per setup hour

Materials handling rate

Machining rate

Assembly rate

$800/10 moves $80 per move

$1,500/50 machine hours

$30 per machine hour

$500/100 machine hours

$5 per direct labour hour

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Regular

Prime costs

Machine hours

$800

Direct labour hours

Activity Rate

$8,000

10 40 $ 3080 $ 5

Deluxe

Units produced per year 10 100

Setup hours 3 1 $300Number of moves 6

20

4 $ 80

Information:

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How to Calculate Activity-Based Unit Costs


ExampleExample

Required: Calculate the unit cost for deluxe and regular models

Overhead costs:

Deluxe Regular

$8,000

Setups 900

Prime costs $800

$300 per setup ×1 setup

300

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$300 per setup × 3 setups


ExampleExample


Overhead costs:

Deluxe Regular

$8,000

Setups 900

Prime costs $800

$80 per move × 4 moves

300Moving materials 480 320

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$80 per move × 6 moves


ExampleExample

Required: Calculate the unit cost for deluxe and regular models.

Overhead costs:

Deluxe Regular

$8,000

Setups 900

Prime costs $800

$30 per machine hour x 40 hours

300Moving materials 480 320Machining 300 1,200

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$30 per machine hour x 10 hours


ExampleExample


Overhead costs:

Deluxe Regular

$8,000

Setups 900

Prime costs $800

$5 per direct labour hour × 80 hours

300Moving materials 480 320Machining 300 1,200Assembly 100 400

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$5 per direct labour hour × 20 hours


ExampleExample


Overhead costs:

Deluxe Regular

$8,000

Setups 900

Prime costs $800

300Moving materials 480 320Machining 300 1,200Assembly 100 400

$2,580 $10,220Total manufacturing costs

$10,220 ÷ 100 units = $102.20 per unit 7-24

$2,580 ÷ 10 units = $258 per unit


Explain how an activity-based costing system

works for product costing


Identifying Activities and Their AttributesIdentifying 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

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Key Questions to Identify ActivitiesKey Questions to Identify Activities

1.How many employees are in your department?

2.What do they do?

3.Do customers outside your department use any equipment?

4.What resources are used by each activity?

5.What are the outputs of each activity?

6.Who or what uses the activity output?

7.How much time do workers spend on each activity? Time on each activity by equipment?

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Assigning Costs to ActivitiesAssigning 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

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Resource DriversResource Drivers

Factors that measure the consumption of resources by activity

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How to Assign Resource Costs Using Direct Tracing & Resource Drivers


Assume that each clerk is paid a salary of $30,000 ($150,000 total clerical cost for 5 clerks)

Assign the cost of labour to each of the activities in the credit department

Information:

Required:

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ExampleExample

Processing transactions $60,000

0.3 × $150,000

Preparing statements $45,000$45,000Answering questions

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0.4 × $150,0000.3 × $150,000


Assigning Costs to ProductsAssigning Costs to Products

Predetermined activity rate x

Usage of the activity (as measured by activity drivers)

To calculate this rate, the practical capacity of each activity must be

determined

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Describe activity-based customer and

supplier costing


Activity-Based Customer CostingActivity-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

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HOW TO Calculate Activity-Based Customer Costs


• 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

Information:

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ExampleExample

Data concerning Milan’s customer activity follow:Information continued:

Large Customer

Ten Smaller Customers

Units purchased 500,000 500,000

Orders placed 2 200

Number of sales calls 10 210

Manufacturing costs

Order filling costs allocated

Sales force costs allocated

$3,000,000 $3,000,000

$202,000 $202,000

$110,000 $110,0007-36


ExampleExample

Activity Rates

Assign costs to customers using an ABC approach

Required:

$404,000/202 orders = $2,000 per order

$220,000/220 calls = $1,000 per call

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Assigning Costs to Customer GroupsAssigning Costs to Customer Groups

Large Customer


Order filling costs $4,000

$2,000 × 200

$400,000

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$2,000 × 2



Large Customer


Order filling costs $4,000 $400,000Sales force costs 10,000

$1,000 × 210

210,000

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$1,000 × 10



Large Customer


Order filling costs $4,000 $400,000Sales force costs 10,000

The large customer costs much less to service that the smaller customers.

210,000

$14,000 $610,000

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Supplier Costing MethodologySupplier 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

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• 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

Information:

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How to Calculate Activity-Based Supplier Costs


ExampleExample

Activity cost information and other data needed for supplier costing follow:

Information continued:

I. Activity costs caused by suppliers

Activity Costs

Repairing Products $800,000

Expediting Products $200,000

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ExampleExample

Information continued:

Murray, Inc. Plata Assoc.II. Supplier data

$20Unit purchase price

80,000Units purchased

Part A1 Part B2 Part A1 Part B2

$52 $24 $56

40,000 10,000 10,000

Failed units

60

380 10 10

Late shipments

1,600

40 0 0

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ExampleExample

Activity Rates

Determine the cost of each supplier using ABC

Required:

$800,000/2,000 $400 per failed part

Repair rate =

Total failed units1,600 + 380 + 10 +10

=

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ExampleExample

Activity Rates

Determine the cost of each supplier using ABC

Required:

$200,000/100= = $2,000 per late delivery

Expediting rate

Total late shipments 60 + 40

$800,000/2,000 $400 per failed part

Repair rate ==

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ExampleExample

Murray, Inc.

$1,600,000Purchase costPart A1 Part B2

$2,080,000

$20 × 80,000 $52 × 40,000

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ExampleExample

Plata Associates

$240,000Purchase costPart A1 Part B2

$560,000

$24 × 10,000 $56 × 10,000

7-48


ExampleExample

Murray, Inc.


$2,080,000

$400 × 1,600 $400 × 380

640,000Reporting products 152,000

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ExampleExample

Plata Associates


$560,000

$400 × 10 $400 × 10


7-50


ExampleExample

Murray, Inc.


$2,080,000

$2,000 × 60 $2,000 × 40


120,000Expediting products 80,000

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ExampleExample

Plata Associates


$560,0004,000Reporting products 4,000

Expediting products 0 0

Plata does not deliver parts late, therefore there are no expediting costs with Plata

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ExampleExample

Murray, Inc.


$2,080,000


120,000Expediting products 80,000

$2,360,000 $2,312,000Total costs

Units ÷ 80,000 ÷ 40,000Total unit cost $29.50 $57.80

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ExampleExample

Plata Associates


$560,0004,000Reporting products 4,000

Expediting products 0 0

Plata is the better choice with the lowest total unit cost

$244,000Total costs

UnitsTotal unit cost

÷ 10,000

$564,000

÷ 10,000$24.40 $56.40

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Explain how activity-based management can be used

for cost reduction


Process-Value AnalysisProcess-Value Analysis

• Focuses on cost reduction instead of cost assignment

• Maximization of system-wide performance– Driver analysis– Activity analysis– Performance measurement

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Activity Inputs and OutputsActivity Inputs and Outputs

Activity Inputs Resources consumed by the activity in producing its output

Activity Outputs Result or product of an activity

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Driver Analysis: The Search for Root CausesDriver 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

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Activity AnalysisActivity 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

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Value-Added ActivitiesValue-Added Activities

• Activities necessary to remain in business

• Two types:– Value-added by mandate

• Necessary to comply with legal mandate

– Discretionary activities

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Discretionary Value-Added ActivitiesDiscretionary Value-Added Activities

1. Produces a change of state

2. Change of state was not achievable by preceding conditions

3. Enables other activities to be performed

Three conditions must be met simultaneously for the activity to be

classified as value added:

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Non-Value Added ActivitiesNon-Value Added Activities

All activities other than those that are absolutely essential to remain in business

Examples:Scheduling

MovingWaiting

Inspecting

Storing

Challenge of activity analysis is to find ways to produce the good without using

any of these activities7-62


Cost ReductionCost Reduction

Four Ways:

1. Activity elimination

2. Activity selection

3. Activity reduction

4. Activity sharing

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• 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

Information:Consider the following two activities:

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How to Assess Non-Value Added Costs


ExampleExample

Determine the non-value-added cost of each activity

Is the activity non value-added or value-added?

Performing warranty work is a non value-added activity

Warranty work

How much is the non value-added cost?

$120,000

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ExampleExample


Is the activity non value-added or value-added?

Competitor

Cost of the competitor is a non value-added activity

How much is the non value-added cost?

$200,000 - $110,000 = $90,000

Because the activity is not performed efficiently7-66


ExampleExample


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

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Activity Performance MeasurementActivity Performance Measurement

• Assess how well an activity was performed and the results achieved

• Measures are both financial and nonfinancial• Three dimensions:

1. Efficiency

2. Quality

3. Time

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Efficiency, Quality, & TimeEfficiency, Quality, & Time

Focuses on the relationship of activity inputs to activity outputs

Efficiency

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

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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

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How to Calculate Cycle Time and Velocity

What is the cycle time?Cycle Time = 10,000/20,000 = ½ hour


Just-in-Time SystemsJust-in-Time Systems

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• 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


Environmental Cost ManagementEnvironmental 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

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Documents

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