Cornerstones of Managerial Accounting 2 e Chapter Seven

Cornerstones of Managerial Accounting 2 e Chapter Seven Activity-Based Costing and Management Mowen/Hansen Copyright © 2008 Thomson South-Western, a part of the Thomson Corporation. Thomson, the Star logo, and South-Western are trademarks used herein under license. 1

Functional-based Cost Systems • Functional-based systems ◦ Based on volume measures, such as ∙ ∙ ◦ Two types ∙ ∙ • Direct labor hours Machine hours Plantwide rates Departmental rates Often produce average costs that severely under- or overstate individual product costs 2

Functional-based Cost System Limitations Two major factors impair their ability to assign overhead costs accurately: 1. Proportion of non-unit-related overhead costs to total overhead costs is large 2. Degree of product diversity is great 3

Unit and Non-Unit Activities Unit-level-activities-- Activities that are performed each time a unit is produced. Non-unit-level-activities-- Activities that are not performed each time a unit of product is produced 4

Non-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 5

Product Diversity Products consume overhead activities in systematically different proportions. Consumption Ratio --- Proportion of each activity consumed by a product. 6

Calculate activity rates. Setup rate Materials handling rate $1, 200/4 setup hours $800/10 moves Machining rate $1, 500/50 machine hours Assembly rate $500/100 machine hours $300 per setup hour $80 per move $30 per machine hour $5 per direct labor hour 7

Identifying 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 8

Key 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? 9

Assigning Costs to Activities • Must determine how much it costs to perform each activity ◦ Requires identification of the resources being consumed ∙ ◦ ◦ • Labor, materials, energy, and capital Cost of resources is found in the general ledger Resources must be assigned using driver tracing Work distribution matrix ◦ Used to assign labor resources 10

Resource Drivers Factors that measure the consumption of resources by activity. 11

Assigning 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 12

Activity-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 the costs of customer service to customers is much the same as assigning manufacturing costs to products. 13

Supplier Costing Methodology • Cost of a supplier is much more than the purchase price of the components or materials acquired. • Assigning the cost to suppliers is similar to cost assignments we have seen for products and customers. 14

Process-Value Analysis • Focuses on cost reduction instead of cost assignment • Emphasizes the maximization of systemwide performance. • Concerned with: ◦ Driver analysis ◦ Activity analysis ◦ Performance measurement 15

Activity Inputs and Outputs Activity Inputs Resources consumed by the activity in producing its output Activity Outputs Result or product of an activity 16

Driver Analysis: The Search for Root Causes Activity Output Measure The number of times the activity is performed Driver Analysis The effort expended to identify those factors that are the root causes of activity costs 17

Activity Analysis • Process of identifying, describing, and evaluating the activities • It should produce four outcomes: ◦ What activities are done ◦ How many people perform the activities ◦ The time and resources required to perform the activities ◦ An assessment of the value of the activities to the organization 18

Value-Added Activities • Activities necessary to remain in business • Two types: ◦ Value-added by mandate ∙ Necessary to comply with legal mandate ◦ Discretionary activities 19

Discretionary Value-Added Activities Three conditions must be met simultaneously for the activity to be classified as valueadded: 1. Produces a change of state 2. Change of state was not achievable by preceding conditions 3. Enables other activities to be performed 20

Non-Value-Added Activities All activities other than those that are absolutely essential to remain in business Examples: Scheduling Storing Moving Waiting Inspecting Challenge of activity analysis is to find ways to produce the good without using any of these activities. 21

Cost Reduction Four Ways: 1. 2. 3. 4. Activity elimination Activity selection Activity reduction Activity sharing 22

Activity Elimination Once activities that fail to add value are identified, measures must be taken to rid the organization of these activities. 23

Activity Selection Involves choosing among different sets of activities that are caused by competing strategies. The lowestcost design strategy should be chosen. 24

Activity Reduction Decreases the time and resources required by an activity. This approach focuses on improving efficiency. 25

Activity Sharing Increases the efficiency by using economies of scale. This lowers the per-unit cost of the cost driver and the amount of cost traceable to the products that consume the activity. 26

Warranty work Is the activity non value-added or value-added? Performing warranty work is a non value-added activity Why? It is done to correct something that wasn’t done right the first time. 27

Activity Performance Measurement • Designed to assess how well an activity was performed and the results achieved. • Measures are both financial and nonfinancial • Centers on 3 dimensions: ◦ Efficiency ◦ Quality ◦ Time 28

Efficiency, Quality, & Time Efficiency Focuses on the relationship of activity inputs to activity outputs. 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. 29

Assume that a company takes 10, 000 hours to produce 20, 000 units of a product. What is the velocity? Cycle time? Velocity = 20, 000/10, 000 = 2 units per hour Velocity is the number of units of output that can be produced in a given period of time. 30

Assume that a company takes 10, 000 hours to product 20, 000 units of a product. What is the velocity? Cycle time? Cycle Time = 10, 000/20, 000 = ½ hour Cycle time is the length of time it takes to produce a unit of output from the time the raw materials are received until the good is delivered to finished goods inventory. 31