of Managerial Accounting, 5e
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Cornerstones of Managerial
Accounting, 5e
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Limitations of Functional-Based
Cost Accounting Systems
 Plant-wide and departmental rates based on direct labor hours, machine hours, or other volume-based measures are used successfully by many organizations.
 However this approach to costing is equivalent to an averaging approach and may produce distorted, or inaccurate costs.
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Limitations of Functional-Based
Cost Accounting Systems (continued)
Product cost distortions can be damaging, particularly for those firms whose business environment is characterized by :
Continuous
Improvement
Total Quality
Management
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Limitations of Functional-Based
Cost Accounting Systems (continued)
 The need for more accurate product costs has forced many companies to take a look at their costing procedures.
 Two major factors impair the ability of unit-based plant-wide and departmental rates to assign overhead costs accurately:
 The proportion of nonunit-related overhead costs to total overhead costs is large.
 The degree of product diversity is great.
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 The presence of product diversity is also necessary for product cost distortion to occur.
 Product diversity means that products consume overhead activities in systematically different proportions.
 This may occur for several reasons, including differences in:
 product size
 product complexity
 setup time
 size of batches
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Product Diversity and Product
Costing Accuracy
 For unit-level overhead rates to fail, products must consume the non-unit-level activities in proportions significantly different than the unit
 In a diverse product environment, activity-based costing promises greater accuracy.
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 Functional-based overhead costing involves two major stages:
 Overhead costs are assigned to an organizational unit
(plant or department).
 Overhead costs are then assigned to cost objects.
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 Interview-derived data is used to prepare an activity dictionary, which lists the activities in an organization along with activity attributes.
 Examples: Financial and nonfinancial information items that describe individual activities.
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 Examples include:
 types of resources consumed
 amount (percentage) of time spent on an activity by workers
 cost objects that consume the activity output (reason for performing the activity)
 measure of the activity output (activity driver)
 activity name
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 The next task is to determine how much it costs to perform each activity.
 Requires identification of the resources being consumed by each activity.
 The cost of labor, energy, materials, and capital is found in the general ledger, but the money spent on each activity is not.
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Assigning Costs to Activities (cont.)
 A work distribution matrix is developed which identifies the amount of labor consumed by each activity and is derived from the interview process
(or a written survey).
 Here is an example:
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 Activity costs are assigned to products by multiplying a predetermined activity rate by the usage of the activity, as measured by activity drivers.
 To calculate an activity rate, the practical capacity of each activity must be determined.
 To assign costs, the amount of each activity consumed by each product must also be known.
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Activity-Based Customer Costing and Activity-Based Supplier Costing
 ABC systems originally became popular for their ability to improve product-costing accuracy by tracing activity costs to the products that consume the activities.
 ABC has expanded into areas upstream (i.e., before the production section of the value chain —research and development, prototyping, etc.) and downstream (i.e., after the production section of the value chain — marketing, distribution, customer service, etc.) from production.
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Activity-Based Customer Costing and Activity-Based Supplier Costing
 ABC often is used to more accurately determine the upstream costs of suppliers and the downstream costs of customers.
 Knowing the costs of suppliers and customers can be vital information for improving a company’s profitability.
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 Process-value analysis is fundamental to activitybased management.
 Activity-based management is a system-wide, integrated approach that focuses management’s attention on activities with the objective of improving customer value and profit achieved by providing this value.
 Process value analysis focuses on cost reduction instead of cost assignment and emphasizes the maximization of system-wide performance.
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Driver Analysis:
The Search for Root Causes
 Managing activities requires an understanding of what causes activity costs. Every activity has inputs and outputs.
 Activity inputs are the resources consumed by the activity in producing its output.
 Activity output is the result or product of an activity.
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Driver Analysis: The Search for Root
Causes (cont.)
 An activity output measure is the number of times the activity is performed. It is the quantifiable measure of the output.
 Driver analysis is the effort expended to identify those factors that are the root causes of activity costs.
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Activity Analysis: Identifying and
Assessing Value Content
 The heart of process-value analysis is activity analysis.
 Activity analysis is the process of identifying, describing, and evaluating the activities that an organization performs.
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Activity Analysis: Identifying and
Assessing Value Content (cont.)
 Activity analysis produces 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, including a recommendation to select and keep only those that add value.
 Activities can be classified as value-added or nonvalue-added.
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Activity Management
Reduces Costs in Four Ways
* Activity elimination focuses on nonvalue-added activities.
* Activity selection involves choosing among different sets of activities that are caused by competing strategies.
* Activity reduction decreases the time and resources required by an activity.
* Activity sharing increases the efficiency of necessary activities by using economies of scale.
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 Activity-based management also is useful for understanding how quality costs can be managed.
 Quality costs can be substantial in size and a source of significant savings if managed effectively.
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 Improving quality can produce significant improvements in profitability and overall efficiency.
 Quality improvement can increase profitability in two ways:
 by increasing customer demand and thus sales revenues
 by decreasing costs
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 Quality-linked activities are those activities performed because poor quality may or does exist.
 The costs of performing these activities are referred to as costs of quality .
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 The definitions of quality-related activities imply four categories of quality costs:
 prevention costs
 appraisal costs
 internal failure costs
 external failure costs
 Costs of quality are associated with two subcategories of quality-related activities: control activities and failure activities .
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 Management of environmental costs is becoming a matter of high priority and a significant competitive issue.
 Environmental costs are associated with the creation, detection, remediation, and prevention of environmental degradation.
 Environmental costs are classified into the same four categories as quality costs.
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