Activity Based Costing and Management PDF

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CHAPTER 10 System Design: Activity-Based Costing and Management

Umali, Jessa V. 15-60458

Yohanon, Kristel Marie R. 15-33281

BSAM 3103

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Table of Contents Introduction………………

Topic Background…………… Subtopic……………

3 4 5

Definition of terms………

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Review questions…………

9

Exercises………………

13

Problems……………………

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Synthesis……………

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Bibliography……………

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Introduction The most difficult task in computing accurate unit cost lies in determining the proper amount of overhead cost to assign to each job, a unit of product or service activity. Today, accountants recognize that manufacturing and providing services are related activities. Thus, they direct attention to the cost of these activities. The activity-based management system links resource consumption to the activities a company performs and costs the activities to products or customers. Activity-based management uses activity-based costing (also called transaction-based costing) to measure and control these relationships. Most organizations that use activity-based costing have two costing systems-the official costing system that is used for preparing external financial reports and the activity-based costing system that is used for internal decision making and for managing activities.

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Topic Background Activity-Based Costing Activity-based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore “fixed” costs. ABC is ordinarily used as a supplement to, rather than as a replacement for the company’s usual costing system. Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

In activity-based cost accounting, a budgeting process employing knowledge of activities and driver relationships to predict workload and resource requirements in developing a business plan. Budgets show the predicted consumption and cost of resources using forecast workload as a basis. The company can use performance to budget in evaluating success in setting and pursuing strategic goals; this activity is part of the activity-based planning process.

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Subtopic Advantages and Limitations of ABC Activity-based costing provides several benefits to the manager, namely 1. More accurate products costs 2. Better data for decision making 3. Tighter cost control ABC has also several limitations, the chief of which is the difficulty and high costs involved with gathering data relating to activity centers and cost drivers.

Design of an Activity-Based Costing System The steps or activities required in designing an ABC system are 1. 2. 3. 4.

Process Value Analysis (PVA) Identifying Activity Centers Assigning Costs to activity Centers Selecting Cost Drivers

Step 1. Process Value Analysis involves the following steps. a.) b.) c.)

Analyze activities required to make the product or perform the service. Classify each activity as value-added or non-value-added. Identify ways to either reduce or eliminate the non-valueadded activities.

Step 2. Identify activity Centers An activity center can be defined as a part of the production process for which management wants a separate reporting of the cost of the activity involved. Step 3. Assign Cost to Activity Centers Assign costs to the activity centers where they are accumulated while waiting to be applied to products. Step 4. Select Cost Drivers This involves assigning costs from the activity center to the product using appropriate cost drivers.

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Activity-Based Management Activity-based management (ABM) is a management tool that involves analyzing and costing activities with the goal of improving efficiency and effectiveness. Activity-based management (ABM) is a procedure that originated in the 1980s for analyzing the processes of a business to identify strengths and weaknesses. Specifically, activity-based management seeks out areas where a business is losing money so that those activities can be eliminated or improved to increase profitability. ABM analyzes the costs of employees, equipment, facilities, distribution, overhead and other factors in a business to determine and allocate activity costs. Activity Analysis To be competitive a firm must assess each of its activities based on its need by the product or customer, its efficiency, and its value content. A firm performs an activity because it is:   

Required to meet the specification of the product or service or satisfy customer demand Required to sustain the organization Deemed beneficial to the firm

Cost-driver analysis This technique examines, quantifies and explains the effects of the cost driver on the cost of an activity.

Performance measurement This involves the identifications of the work perform and the results achieved by an activity process, or organizational unit. Performance measure include both financial and nonfinancial. Examples of financial performance measures are the cost per unit of output, return on sales, and cost of every department’s high-value-added and low-valued-added activities. Nonfinancial performance measures evaluate operating characteristics of manufacturing process and measures of or feedbacks from customers or personnel. Examples of nonfinancial performance measures are the: a

number of customer complaints

b

customer satisfaction

c

number of defective parts or output

d

number of output unit

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e

cycle-time

f

on-time delivery rate

g

number of employee suggestion

h

scores on employee morale

Opportunity Costing Concepts

One significant factor that managers should include in their decision process information is the capacity usage of the plant and the other resources of the entity. Capacity usage information is a critical signal of the potential relevance of opportunity costs, the benefit lost when one chosen option precludes the benefits from an alternative option. When a firm has excess capacity, that is, it is able to produce the current demand as well as handle a special order or new product, no opportunity cost is present. When the plant is operating at full capacity, opportunity costs are an important consideration because the decision to produce a special order or add a new product line can cause the reduction, delay, or loss of sales of products and services currently offered.

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Definition of terms:     

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

 

Unit levels activities- which are performed each time a unit is produced Batch-level activities- which are performed each time time a batch of goods is handled or processed Product-level activities- which are performed as needed to support the production of each different type of product Facility- level activities- which simply sustain a facility’s general manufacturing process. Operational ABM- enhances operation efficiency and asset utilization and lowers cost. It focuses on doing things right and performing activities more efficiently. Among the management techniques that are applied in operational ABM are activity management, business process reengineering total quality management and performance management. Strategic ABM- on the other hand, attempts to alter demand for activities and increase profitability at the current or improved activity efficiency. It focuses on choosing the activities for the operations. Bench marking- involves the search for the best practices anywhere to identify ways to improve the operation for a task, activity, or process. Cause-and-effect diagram- maps out causes that affect an activity, process, stated problem or desire outcome. A Pareto analysis- is a histogram of the cost drivers that contribute to the total cost. Most analyses under this technique show that 20 percent of the cost drivers are responsible for 80 percent of the total cost incurred.

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REVIEW QUESTIONS AND PROBLEMS

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Questions 1

What three levels of overhead cost application are available to a company? -The three levels available are: Level 1, in which a company uses a plantwide overhead rate; Level 2, in which a company uses departmental overhead rates; and Level 3, in which a company uses activity-based costing.

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Why are new approaches to overhead cost application, such as activity based costing, needed in many companies today? -New approaches to costing are needed because events of the last few decades have made drastic changes in many organizations. Automation has greatly decreased the amount of direct labor required to manufacture products; product diversity has increased in that companies are manufacturing a wider range of products and these products differ substantially in volume, lot size, and complexity of design; and total overhead cost has increased to the point in some companies that a correlation no longer exists between it and direct labor.

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Why are departmental overhead rates sometimes not accurate in assigning overhead cost to products? -The departmental approach to assigning overhead cost to products relies solely on volume as an assignment base. Where diversity exists between products (that is, where products differ in terms of number of units produced, lot size, or complexity of production), volume alone is not adequate for overhead costing. Overhead costing based on volume will systematically overcost high-volume products and undercost low-volume products.

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When designing an activity-based costing system, why should PVA (process value analysis) always be starting point? -Process value analysis (PVA) is a systematic approach to gaining an understanding of the steps associated with a product or service. It identifies all resource-consuming activities involved in the production process and labels these activities as being either value-added or nonvalueadded. Thus, it is the beginning point in designing an activitybased costing system since management must know what activities are involved with each product before activity centers can be designated and cost drivers established. Also, PVA helps management to eliminate any 9

non-value-added activities and thereby streamline operations and minimize costs. 5

What four general levels of activity can be identified a company? -The four general levels of activities are:

    6

Unit-level activities, which are performed each time a unit is produced. Batch-level activities, which are performed each time a batch of goods is handled or processed. Product-level activities, which are performed as needed to support specific products. Facility-level activities, which simply sustain a facility’s general manufacturing process.

In what three ways does activity-based costing improve to costing system of an organization? -First, activity-based costing increases the number of cost pools used to accumulate overhead costs. Second, it changes the base used to assign overhead costs to products. And third, it changes a manager’s perception of many overhead costs in that costs that were formerly thought to be indirect (such as depreciation or machine setup) are identified with specific activities and thereby are recognized as being traceable to individual products.

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What are the two chief limitations of activity-based costing? -The two chief limitations are: First, the portion of overhead costs that relate to facility-level activities are still usually allocated to products on some arbitrary basis, such as machine-hours or direct labor-hours. Critics of activity-based costing argue that facility-level activities account for the bulk of all overhead costs in some companies. Second, high measurement costs are involved in operating an activity-based costing system. That is, the system requires the tracking of large amounts of detail and the completion of many separate computations in order to determine the cost of a unit or product.

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Can activity-based costing be used in service organizations? -Yes, activity-based costing can be used in service organizations. It has been successfully implemented, for example, in railroads, hospitals, banks and data service companies.

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What is resource driver? 10

-A resource driver is a measure of the quality of resources consumed by an activity. 10 What is an activity driver? -An activity driver is a measure of frequency and intensity of demands placed on activities by cost objects. 11.In regard to ABC, what is two stage allocation? -Two-stage allocation is a procedure that first assigns a firm’s resource costs, namely factory overhead cost, to cost pools, and then to cost objects. 12.What are two major advantages of activity-based management (ABM)? -Two major advantages of ABM are: a. ABM measures the effectiveness of the key business processes and activities, and identifies how they can be improved to reduce costs and improve the customer value. b. ABM improves the management focus by allocating resources to key value-added activities, key customers, key products, and continuous improvement methods to maintain the firm’s competitive advantage.

II. TRUE or FALSE True 1.) In activity-based costing, facility-level costs should not be included in product costs for internal management reports that are used for decision making. However, companies frequently include facility-level costs in product costs in order to meet external reporting requirements. True 2.) Batch-level activities are performed each time a batch of goods is handled or processed. False3.) When there is automation, product diversity, and little correlation between overhead cost and direct labor, a plantwide overhead rate based on direct labor is most appropriate. True 4.) In activity-based costing a separate overhead rate is computed for each activity center by dividing the estimated overhead cost in the activity center by the total expected activity for the activity center. False5.) In an activity-based costing system there is no overhead over or under applied because the costing system is much more accurate. True 6.) Activity-based costing involves a two-stage allocation in which overhead costs are first assigned to departments and then to jobs on the basis of direct labor hours.

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True 7.) When a company shifts from a traditional cost system in which overhead is applied based on direct labor-hours to an activitybased costing system in which there are batch-level and product-level costs, the unit product costs of high-volume products typically decrease whereas the unit product costs of low-volume products typically increase. True 8.) Process value analysis (PVA) consists of systematically analyzing the activities required to make a product or portion a service. PVA identifies all resource-consuming activities and labels activities as either value-added or non-value added.

III. Exercises Exercise 1

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Listed below are various activities observed in Tulip Company. Each activity has been classified as unit level, batch level, product level or facility level in nature. Activity

a. Materials are moved from the receiving dock to product flow lines by a materialhandling crew………… b. Direct labor workers assemble various products……

c. Ongoing training is provided to all employees in the company…………

d. A product is designed by a specialized design team…………

Activity Classification

Example of Cost Drivers Number of receipts; pounds handled

Batch level

Unit level

Facility level

Product level

Batch level e. Equipment setups are performed on a regular basis……… f. Numerical control machines are used to cut and shape materials…………

Example of traceable cost Labor cost; depreciation of equipment; space cost.

Unit level

Direct labor cost; indirect labor cost; labor benefits

Direct labor hours

Space cost; training costs; administratio n costs

Hours of training time; number trained

Space cost; supplies used; depreciation of design equipment Labor cost; supplies used; depreciation of equipment Power; supplies used; maintenance; depreciation

Hours of design time; number of engineering change orders Number of setups; hours or setup time Machine hours; number of units

Required: Complete the table above by listing examples of traceable costs and example of cost drivers for each activity. *Answers Exercise 2 13

Listed below are several terms relating to activity-based costing: Process value analysis Facility level High volume Activity centers Product level Volume

Plant wide overhead rate Low volume Batch level Two stage Unit level Stage

1. A single overhead rate used throughout an entire plant operation is known as a plant wide overhead rate. 2. The major problem with using direct labor-hours or machine- hours as the basis for assigning overhead cost to products is that these bases rely on volume as the sole factor in overhead cost assignment. 3. Activity-based costing involves a two stage allocation process, in which the first stage assigns overhead costs to activity centers and the second stage assigns overhead costs from activity centers to products and services. 4. Process value analysis which involves a systematic analysis of the activities required to make a product or perform service, is the beginning point in activity-based costing. 5. Unit-level activities, such as the consumption of power, are performed each time a unit is produced and arise as a result of the total volume of production going through a facility. 6. Batch-level activities, which are performed each time a batch of goods is handled or processed, include task such as placement of a purchase order. 7. Product-level activities, which are performed as needs to support the production of a particular product, include task such as maintaining parts inventories. 8. Facility-level activities just sustain a facility’s general manufacturing process and include items such as insurance or general factory management. 9. The use of activity-based costing often causes a shift in overhead costs from high-volume products to low-volume products, thereby causing the unit cost of the low-volume products to sharply increase. 10. One of the benefits of activity-based costing is that it increases the number of cost pools, or activity centers used to accumulate and assign overhead cost to products and services.

IV. Problems 14

Problem 1 Peejay Autoparts, Inc. previously used a cost system that allocated all factory overhead costs to products based on 350 percent of direct labor cost. The company has just implemented an ABC system that traces indirect costs to products based on consumption of major activities as indicated below. Compare the total annual costs of product X using both the traditional volume-based and the new ABC system.

Activity

Labor Machining Setup Production order Material handling Parts administration

Annual Cost Driver Quantity P300,000 20,000 hrs 10,000 hrs 2,000 orders 1,000 requisitions 12,000 parts
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