Activity base costing

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Activity base costing

  1. 1. Activity-based costing (ABC) is a method fordetermining accurate costs. While ABC is arelatively recent innovation in cost accounting, it israpidly being adopted by companies acrossmany industries and within government and not-for-profi t organizations. Here is a quick exampleof how it works, and why it is important Suppose youand two friends (Joe and Al) havegone out for dinner to have pizza. You each order anindividual size pizza, and Al suggests thatyou all order a plate of appetizers for the table. Youand Joe fi gure you will have a bite or twoof the appetizers, so you say OK. Dinner is great, butat the end Al is still hungry, so he ordersanother plate of appetizers and as before, eats allof it. When it is time for the check, Al suggeststhe three of you split the cost of the meal equally.Is this fair? Perhaps Al should offer topay for the two appetizer plates. The individualpizzas are direct costs for each of you so thatan equal share is fair, but while the appetizerplate was intended to be shared equally, it turnsout that Al consumed most of it.
  2. 2. There are similar examples in manufacturing.Suppose you and Joe and Al are also productmanagers at a plant that manufactures furniture.Al is in charge of sofa manufacturing, Joeof dining room tables and chairs, and you are incharge of bedroom furniture. Each of yourproduct lines has direct materials and labor coststhat are traced directly to each of you. It isyour responsibility to manage these direct costs.Also, there are indirect manufacturing costs(overhead) that cannot be traced to each product,including, the following activities: materialsacquisition, materials storage and handling,product inspection, manufacturing supervision,job scheduling, equipment maintenance, andfabric cutting. What if the company decides tocharge each of the three product managers a“fair share” of the total indirect cost using theratio of units produced in a manager’s area to thetotal units produced for all managers? Thisapproach is described in Chapter 4 and iscommonly referred to as volume-based costing .Note that whether the proportions used are basedon units of product, direct labor hours, ormachine hours, each of these is volume-based.
  3. 3. But if, as is usually the case, the usage of theseactivities is not proportional to the numberof units produced, then some managers will beovercharged and others undercharged underthe volume-based approach. For example,suppose Al insists on more frequent inspections ofhis production; then he should be fairly chargeda higher proportion of overhead (inspection)than that based on units alone. Moreover, whyshould you pay any portion of fabric cutting ifyour bedroom furniture does not require fabric?Another consideration is that the volume-basedmethod provides little incentive for themanager to control indirect costs. Unfortunately,the only way you could reduce your shareof the indirect costs is to reduce your unitsproduced (or hope that Joe and/or Al increaseproduction)—not much of an incentive. On reflection, the approach that charges indirect coststo product based on units produced does notprovide very accurate product cost for you or Joeor Al and certainly does not provide theappropriate incentives for managing the indirectcosts.
  4. 4. The solution is to use activity-based costing tocharge these indirect costs to the products,using detailed information on the activities thatmake up the indirect costs—the materialshandling, inspection, fabric cutting, andmaterials handling. This chapter shows how to doit.A good example of one of many success stories forABC is the application of ABC at theU.S. Postal Service (USPS). The ABC applicationat USPS originated from the PostmasterGeneral’s directive to develop a costing systemthat would help the USPS to become morecompetitive and to serve as a basis for comparingperformance among the various mailprocessingfacilities. The initial ABC system used 58 workactivities and nine cost objects.The cost objects included handling of letters, flats, small parcels, large parcels, priority mail,express mail, registered mail, large mailcontainers, and small mail containers. In theinitialapplication at a single mail-processing facility,there was a reduction of 13% in total cost as
  5. 5. a result of the improved understanding of costbehavior in the facility. The USPS also usedABC to determine the cost differences inprocessing payments from customers who usedcash,checks, or credit cards and from this analysisdetermined that the low-cost approach was touse credit cards. The ABC-based analyses havehelped the USPS to implement an effective,cost-competitive strategy.Volume Activity-based costing (ABC)is a costing approach that assignsresource costs to cost objectssuch as products, services, orcustomers based on activitiesperformed for the cost objects.The premise of this costing approach isthat a fi rm’s products or services arethe results ofactivities and activities use resourceswhich incur costs. Costs of resourcesare assigned to
  6. 6. activities based on the activities thatuse or consume resources (resourceconsumption drivers),and costs of activities are assigned tocost objects based on activitiesperformed for thecost objects (activity consumptiondrivers). ABC recognizes the causal ordirect relationshipsbetween resource costs, cost drivers,activities, and cost objects in assigningcosts to activitiesand then to cost objects.ABC assigns factory overhead costs tocost objects such as products orservices byidentifying the resources and activitiesas well as their costs and amountsneeded to produce
  7. 7. output. Using resource consumptioncost drivers, a fi rm determines theresource costsconsumed by activities or activitycenters (activity cost pools) andcalculates the cost ofa unit of activity. The fi rm thenassigns the cost of an activity toproducts or services bymultiplying the the cost of eachactivity by the amount of the activityconsumed by each of the cost objects..Developing an activity-based costing system entailsthree steps: (1) identifying resource costsand activities, (2) assigning resource costs toactivities, and (3) assigning activity costs to costobjects. Steps one and two constitute stage 1 fromExhibits 5.1 and 5.2 , and Step 3 is equivalentto stage 2 from these exhibits.
  8. 8. Step 1: Identify Resource Costs andActivitiesThe fi rst step in designing an ABC system is toconduct an activity analysis to identify theresource costs and activities of the fi rm. Most fi rmsrecord resource costs in specifi c accountsin the accounting system. Examples of theseaccounts include supplies, purchasing,materials handling, warehousing, offi ce expenses,furniture and fi xtures, buildings, equipment,utilities, and salaries and benefi ts. However, specialeffort most likely will be neededto determine appropriate resource costs for activity-based costing because generally severaldifferent resource costs may be recorded in a singleaccount or the costs for an activity maybe recorded in several accounts. For example, a fi rmmay use a single factory supplies accountfor all supplies in its operations that include severalmanufacturing operations. Coststo complete a purchasing order may be spread overseveral accounts including accounts forwarehousing, purchasing, and receiving.Through activity analyses a fi rm identifi es the workit performs to carry out its operations.
  9. 9. Activity analyses include gathering data fromexisting documents and records, as well ascollecting additional data using questionnaires,observations, or interviews of key personnel.Questions that ABC project team members typicallyask employees or managers in gatheringactivity data include:• What work or activities do you do?• How much time do you spend performing theseactivities?• What resources are required to perform theseactivities?• What value does the activity have for the product,service, customer, or organization?With the help of industrial engineers andmanagement accountants, the team also collectsactivity data by observing the work performed andmaking a list of all the activities involved.Levels of ActivitiesTo identify resource costs for various activities, a firm classifi es all activities according to theway in which the activities consume resources.A unit-level activity is performed on eachindividual unit of product or service of the fi rm.
  10. 10. Examples of unit-level activities include directmaterials, direct labor-hours, inserting a component,and inspecting every unit. A unit-level activity isvolume-based. The requiredactivity varies in proportion with the quantity of thecost object. The resource consumptiondriver and the activity consumption driver are mostlikely to be the same for unit levelactivities.A batch-level activity is performed for each batchor group of units of products or services.A fi rm incurs a batch-level activity for each batch orgroup of units of products or servicesscheduled to be processed together, rather than foreach individual unit of the cost object. Abatch has more than one unit of a product or service.Examples of batch-level activities aresetting up machines, placing purchase orders,scheduling production, conducting inspectionsby batch, handling materials, and expeditingproduction.A product-level activity supports the productionof a specifi c product or service. Examplesof product-sustaining activities include designingproducts, administering parts required
  11. 11. for products, and engaging in engineering changes tomodify products.A facility-level activity supports operations ingeneral. These activities are not caused byproducts or customer service needs and cannot betraced to individual units, batches, orproducts. Examples of facility sustaining activitiesinclude providing security and safety,performing maintenance of general purposemachines, managing the plant, incurring factoryproperty taxes and insurance and closing of thebooks each month. Some fi rms referto these activities as business or infrastructuresustaining activities.Note that a unit-level activity can always be tracedto a batch (one of the units in the batch),and a batch-level activity can always be traced to aproduct (one batch of this particular product),and a product-level activity can always be traced to amanufacturing facility; but, thereverse is not possible. Exhibit 5.3 illustrates activitylevel classifi cations at Siemens ElectricMotor Works.Step 2: Assign Resource Costs to Activities
  12. 12. Activity-based costing uses resource consumptioncost drivers to assign resource costs toactivities. Because activities drive the cost ofresources used in operations, a fi rm shouldchoose resource consumption cost drivers based oncause-and-effect relationships. Typicalresource consumption cost drivers include thenumber of (1) labor hours for labor intensiveactivities; (2) employees for payroll-relatedactivities; (3) setups for batch-related activities;(4) moves for materials-handling activities; (5)machine-hours for machine repair and maintenance;and (6) square feet for general maintenance andcleaning activities.Although a fi rm’s accounting system is a goodstarting point to fi nd information aboutthe cost of resources, most accounting systemsreport the costs of different resources, suchas indirect labor, electricity, equipment, andsupplies, but do not report the cost of activitiesperformed. New accounting systems are needed toobtain and track resource costs foractivities.The cost of the resources can be assigned toactivities by direct tracing or estimation. Direct
  13. 13. tracing requires measuring the actual usage ofresources by activities. For example, powerused to operate a machine can be traced directly tothat machine‘s operation by reading themeter attached to the machine.When direct tracing is not available, departmentmanagers and supervisors need to estimatethe amount or percentage of time (or effort)employees spend on each identifi ed activity.Multiple resource consumption cost drivers often areneeded to assign different resourcecosts to activity or activity center cost pools. Exhibit5.4 illustrates resources and resourcesconsumption drivers for factory overhead costs atAT&T’s New River Valley plant.Step 3: Assign Activity Costs to CostObjectsThe fi nal step is to assign costs ofactivities or activity cost pools to costobjects based on the
  14. 14. appropriate activity consumption costdrivers. Outputs are the cost objects forwhich fi rms ororganizations perform activities. Typicaloutputs for a cost system are productsand services;however, outputs also can includecustomers, projects, or business units. Forexample, theoutputs of an insurance company may beindividual insurance policies sold tocustomers,claims processed, types of policies offered,insurance agents, or divisions or subunitsof thecompany.Firms use activity consumption costdrivers to assign activity costs to costobjects. Activity
  15. 15. cost drivers should explain why the costof a cost object goes up or down. Typicalactivityconsumption cost drivers are purchaseorders, receiving reports, inspectionreports or hours,parts stored, payments, direct labor-hours, machine-hours, and setups andmanufacturingcycle time. Careful analyses should beconducted in determining proper activityconsumptioncost drivers. For example, at the Hewlett-Packard (HP)’s Surface Mount Center inBoise, theABC system has been fully operationalsince the early 1990s. This facilitymanufactures about50 electronic circuit boards for internalHP customers. The center’s accounting,production,
  16. 16. and engineering staffs jointly conductedan intense analysis of the productionprocess andcost behavior patterns to select costdrivers. This combination of accountingand engineeringanalysis helped management choose costdrivers.Benefi tsInitially, many fi rms adopt activity-based costing to reduce distortions inproduct costs oftenfound in their volume-based costingsystems. Volume-based costingsystems, generate productor service costs bearing little or norelationship to activities and resourcesconsumed in
  17. 17. operations. ABC clearly shows theeffect of differences in activities andchanges in productsor services on costs. Among the majorbenefi ts of activity-based costing thatmany fi rms haveexperienced are:Better profi tability measures. ABCprovides more accurate andinformative productcosts, leading to more accurateproduct and customer profi tabilitymeasurements and tobetter-informed strategic decisionsabout pricing, product lines, andmarket segments.Better decision making. ABC providesmore accurate measurements ofactivity-driving
  18. 18. costs, helping managers to improveproduct and process value by makingbetter productdesign decisions, better customersupport decisions, and fostering valueenhancementprojects.Process improvement. The ABCsystem provides the information toidentify areas whereprocess improvement is needed.Cost estimation. Improved productcosts lead to better estimates of jobcosts for pricingdecisions, budgeting, and planning.Cost of unused capacity. Since many firms have seasonal and cyclical fluctuations in sales
  19. 19. and production, there are times whenplant capacity is unused. This canmean that costsare incurred at the batch-, product-,and facility-level activities but are notused . Capacityis supplied but not used in productionABC systems provide betterinformation to identifythe cost of unused capacity andmaintain a separate accounting for thiscost. For example,if a particular customer’s orderrequires the addition of a certain typeof capacity in theplant, then the customer can becharged for that additional capacity.Alternatively, if a plant
  20. 20. manager decides to add capacity inexpectation of future increases in salesand production,then the cost of that additionalcapacity should not be charged tocurrent production butcharged as a lump sum in the plant’scosts. Overall, the goal is to managecapacity levels toreduce the cost of underutilization ofcapacity and to price products andservices properly.LimitationsAlthough activity-based costing providesbetter product or service costs thanvolume basedsystems, managers should be aware of itslimitations:
  21. 21. Allocations. Not all costs haveappropriate or unambiguous activity orresource consumptioncost drivers. Some costs requireallocations to departments and productsbased onarbitrary volume measures because finding the activity that causes the cost isimpractical.Examples are facility-sustaining costssuch as the costs of the informationsystem, factorymanager’s salary, factory insurance, andproperty taxes for the factory.Omission of costs. Product or servicecosts identifi ed by an ABC system arelikely to notinclude all costs associated with theproduct or service. Product or servicecosts typically
  22. 22. do not include costs for such activities asmarketing, advertising, research anddevelopment,and product engineering even thoughsome of these costs can be traced toindividualproducts or services. Product costs do notinclude these costs because generallyacceptedaccounting principles (GAAP) for financial reporting require them to betreated as periodcosts.Expense and time. An ABC system is notcost free and is time-consuming todevelop andimplement. For fi rms or organizationsthat have been using a traditionalvolume-based
  23. 23. costing system, installing a new ABCsystem is likely to be very expensive.Furthermore,like most innovative management oraccounting systems, ABC usually requiresa year orlonger for successful development andimplementation.

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