University of Luzon
COLLEGE OF ACCOUNTANCY
2NDSemester 2022 – 2023
Management II
Activity-based Costing Method
ACC206
Cost
Accounting
and
ACTIVITY BASED MANAGEMENT AND
ACTIVITY BASED COSTING
Lecture Outline
A. Activity Based Management
1. Activity-Based Management.
a. Product cost determination, although specifically designated as an accounting function,
is a major concern of all managers.
b. Activity-Based Management focuses on controlling the activities incurred during the
production or performance process to improve customer value and enhance profitability.
c. Activity analysis is the process of studying activities to classify them as value-added or
non-value-added and to devise ways of minimizing or eliminating non-value-added
activities.
2. Value-Added versus Non-Value-Added Activities.
a. Activities may be designated as value-added and non-value-added:
i. An activity is a repetitive action performed in fulfillment of business functions.
ii. A value-added activity (VA) is an activity that increases the worth of a product or
service to the consumer and for which the customer is willing to pay.
iii. A non-value-added activity (NVA) is an activity that increases the time spent on a
product or service but does not increase its worth.
b. A business-value-added activity is an activity that is necessary for the operation of a
business but for which a customer would not want to pay.
c. A process is a series of activities that, when performed together, satisfy a specific
objective.
d. A process map is a detailed flowchart that indicates every step that goes into making a
product or providing a service.
e. A value chart is a visual representation that identifies the stages and the time spent in
those stages from the beginning to the end of a process.
f. There are four types of time that compose the entire processing time of an entity.
i. Processing (or service) time is the actual time it takes to perform the functions
necessary to manufacture a product or perform a service; this quantity of time is
value-added.
ii. Inspection time is the time taken to perform quality control activities. Such time is
non-value-added time.
iii. Transfer time is the time consumed moving products or components from one place
to another. Such time is non-value-added time.
iv. Idle time is the amount of time spent in storing inventory or waiting at a production
operation for processing. Such time is non-value-added time.
g. Inspection time, idle time, and transfer time all add no value. Therefore, cycle (lead)
time is equal to value-added processing time plus non-value-added time.
3. Manufacturing cycle efficiency (MCE) is a ratio resulting from dividing the value-added
processing time by total cycle time. The longer the cycle time, the longer time the product has
to “pull” costs to it.
a. A JIT manufacturing process may achieve higher efficiency, eliminating idle time for
storage and thus increasing MCE.
b. A service company would compute service cycle efficiency is a ratio resulting from
dividing the actual service time by total cycle time.
c. Cycle time for a service company refers to the time between the service order and service
completion. All time spent on activities that are not actual service performance are
considered non-value-added for that job.
d. Cycle time in a retail environment is the time from ordering an item to the sale of that
item to a customer. Non-value-added activities include shipping time from the supplier,
receiving delays for counting merchandise, and any storage time between receipt and
sale.
e. Non-value-added activities can be attributed to systematic, physical, and human factors.
f. The NVA activities that create the most cost should be the ones management focuses its
efforts on diminishing or eliminating.
g. The concentration of attention on the elimination of NVA activities should cause product
quality to increase and cycle time and cost to decrease.
Illustration 1
University of Luzon
COLLEGE OF ACCOUNTANCY
Activity-based Costing Method
ACC206
Cost
Accounting
and
2NDSemester 2022 – 2023
Management II
Magic Company manufactures hand-made pine storage boxes for a variety of clients. As
production manager, you have developed the following value chart:
Operation
Receiving materials
Storing materials
Handling materials
Cutting/measuring materials
Assembling materials
Building boxes
Attaching hinges
Inspection
a.
b.
c.
Average Number of Days
1
2
3
6
4
7
2
1
Determine the value-added activities and their total time.
Determine the non-value-added activities and their total time.
Calculate the manufacturing cycle efficiency.
ANSWER:
a.
Value-added activities
Cutting/measuring materials
Assembling materials
Building boxes
Attaching hinges
Total production time (days)
Time
6
4
7
2
19
b.
Non-value-added activities
Receiving
Storing
Handling
Inspection
Total nonproduction time (days)
Time
1
2
3
1
7
c.
Total lead time = 19 + 7 = 26 days
MCE = 19/26 = 73.1%
B. Cost Driver Analysis
1. All activities have cost drivers that consume resources and cause costs to be incurred.
a. A greater number of cost drivers can normally be identified than should be used for cost
allocation or activity elimination. Management should, therefore, restrict the cost drivers
chosen to a reasonable number and determine that the cost of measuring each cost driver
does not exceed the benefit of using it.
b. Costs have traditionally been accumulated into one or two cost pools —total factory
overhead or variable and fixed factory overhead.
i. One or two cost drivers—direct labor hours and/or machine hours—have been used
to assign costs to products.
ii. The use of single cost pools and single cost drivers may produce illogical product or
service costs in complex production (or service) environments.
2. Cost Driver Analysis is the process of investigating, quantifying, and explaining the
relationships of cost drivers and their related costs.
a. Cost driver analysis identifies the activities causing the costs to be incurred.
b. Activity analysis highlights the activities that do not add value and can be targeted for
reduction or elimination to reduce costs and increase profitability.
c. Cost drivers are the factors having direct cause-effect relationships with costs.
3. The accounting system, to reflect more complex environments, must first recognize that costs
are created and incurred because their drivers occur at different levels.
a. A unit-level cost is a cost that is caused by the production or acquisition of a single unit
of product or the delivery of a single unit of service.
b. A batch-level cost is a cost that is caused by a group of things made, handled, or
processed at a single time.
University of Luzon
COLLEGE OF ACCOUNTANCY
2NDSemester 2022 – 2023
Activity-based Costing Method
ACC206
Cost
Accounting
and
Management II
c. A product-level (or process-level) cost is a cost that is caused by the development,
production, or acquisition of different items.
d. An organizational-level cost is a cost incurred to support the ongoing facility
operations.
C. Activity Based Costing
1. Activity-based costing (ABC) is a cost accounting system that focuses on the various
activities performed in an organization and collects costs on the basis of the underlying
nature and extent of those activities.
a. ABC focuses on attaching costs to products and services based on the activities performed
to produce, perform, distribute, or support those products and services.
b. ABC is useful in companies having the following characteristics:
i. The production or performance of a wide variety of products or services;
ii. High overhead costs that are not proportional to the unit volume of individual
products;
iii. Significant automation that has made it increasingly more difficult to assign overhead
to products using the traditional direct labor or machine hour bases;
iv. Profit margins that are difficult to explain; and
v. Hard-to-make products that show big profits and easy-to-make products that show
losses.
2. A two-step allocation of costs must be accomplished.
a. Costs, after being initially recorded, are accumulated in activity center cost pools using
first-step cost drivers that reflect the appropriate level of cost incurrence (unit, batch, or
product/process).
b. Costs, after accumulation, are allocated out of the activity center cost pools and applied
to products and services using a second-step cost driver.
c. An activity center is a segment of the production or service process for which
management wants to separately report the costs of the activities performed.
d. An activity driver is a measure of the demands placed on activities and, thus, the
resources consumed by products and services; it often indicates an activity’s output.
3. Short-term and Long-term Variable Costs
a. Activity-based costing systems do not use the traditional definitions of variable and fixed
costs. Instead, costs are referred to as being short-term variable and long-term variable
costs.
b. A short-term variable cost increases or decreases in direct relation to changes in the
volume of activity.
c. A long-term variable cost is a cost that has traditionally been viewed a fixed cost, and
for which the appropriate cost drivers simply need to be identified.
d. Product variety refers to the number of different types of products made.
e. Product complexity refers to the number of components included in a product or the
number of processes through which a product flows.
f. Process complexity refers to the number of processes through which a product flows.
Illustration 2
Cornerstone Company would like to institute an activity-based costing system to price
products. The company's Purchasing Department incurs costs of P550,000 per year and has
six employees. Purchasing has determined the three major activities that occur during the
year.
Allocation
# of
Total
Activity
Measure
People
Cost
Issuing purchase orders
# of purchase orders
1
P150,000
Reviewing receiving reports
# of receiving reports
2
P175,000
Making phone calls
# of phone calls
3
P225,000
During the year, 50,000 phone calls were made in the department; 15,000 purchase orders
were issued; and 10,000 shipments were received. Product A required 200 phone calls, 150
receiving reports, and 50 purchase orders. Product B required 350 phone calls, 400
receiving reports, and 100 purchase orders.
a.
Determine the amount of purchasing department cost that should be assigned to each of these
products.
University of Luzon
COLLEGE OF ACCOUNTANCY
2NDSemester 2022 – 2023
Activity-based Costing Method
ACC206
Cost
Accounting
and
Management II
b.
Determine purchasing department cost per unit if 1,500 units of Product A and 3,000 units of
Product B were manufactured during the year.
ANS:
a.
P150,000/15,000 = P10 per purchase order
P175,000/10,000 = P17.50 per receiving report
P225,000/50,000 = P4.50 per phone call
50 purchase ordersxP10
100 purchase ordersxP10
150 receiving reportsxP17.50
400 receiving reportsxP17.50
200 phone callsxP4.50
350 phone callsxP4.50
Total cost
b.
Product A
P 500
2,625
900
P4,025
Product B
P1,000
7,000
1,575
P9,575
Product A= P4,025/1,500 = P2.68 per unit
Product B= P9,575/3,000 = P3.19 per unit
D. Determining Whether ABC is Appropriate
1. ABC allows managers to recognize the horizontal flow of products, services, and activities
through an organization.
a. The process focuses on the numerous cost impacts created by making a product or
performing a service.
b. A vital loss of information may occur in an accounting system that ignores activity and
cost relationships.
c. There are some general operating activity clues that may alert managers to the need to
review the cost data being provided by their conventional accounting system.
i. Number and diversity of products or services produced.
ii. Diversity and differential degree of support services used for different products.
iii. Extent to which common processes are used.
iv. Effectiveness of current cost allocation methods.
v. Rate of growth of period costs.
d. New information will change management decisions only if:
i. Management is free to set product/service prices;
ii. There are no strategic constraints in the company; and
iii. There is a climate and culture of cost reduction in the company.
2. Product variety and product complexity.
a. Two underlying assumptions that companies must consider before adopting ABC are:
i. Product variety; and
ii. Product complexity.
b. If these assumptions are met, this could indicate the need to consider using ABC.
c. Mass customization refers to the relatively low-cost mass production of products to the
unique specifications of individual customers; it requires the use of flexible
manufacturing systems.
d. The Pareto principle is a rule stating that the greatest effects in human endeavors are
traceable to a small number of causes (the vital few), while the majority of causes (the
trivial many) collectively yield only a small impact; this relationship is often referred to
as the 20:80 rule and is named after the Italian economist Vilfredo Pareto.
e. Simultaneous (or concurrent) engineering refers to a continuous involvement of all
primary functions and personnel contributing to a product’s origination and production
from the beginning of a project.
i. Design for manufacturability involves multifunctional design teams that design
products by considering customer expectations, vendor capabilities, parts
commonality, and production process compatibility.
3. With lack of commonality in overhead costs.
a. Certain products and services create considerably more overhead costs than others.
i. While some of the additional costs may be caused by product variety or product
complexity, others may be related to a variety of support services.
University of Luzon
COLLEGE OF ACCOUNTANCY
2NDSemester 2022 – 2023
Management II
Activity-based Costing Method
ACC206
Cost
Accounting
and
ii. Some products require high levels of advertising, some use high-cost distribution
channels, and some require high technology machinery.
iii. Overhead related to specific products will be spread over all products if only one or
two overhead cost pools are used.
iv. The result is increased costs for some products that should be costed lower and lower
costs for some products that should be costed higher.
b. With problems in current cost allocations.
i. Managers and accountants need to ascertain whether the existing cost system still
provides a reasonable estimate of product or service cost if a company’s process or
product/service line has undergone one or more significant changes.
ii. Many companies with automated production processes have experienced large
increases in overhead costs and large decreases in labor. In such firms, the use of
direct labor as an overhead allocation base produces extremely high application
rates.
4. With changes in business environment.
a. A change in the competitive environment in which a company operates may also mean a
need for better cost information. Increased competition may occur for several reasons:
i. Other companies have recognized the profit potential of a particular product or
service;
ii. The product or service has become cost-feasible to make or perform; or
iii. An industry has been deregulated.
b. Changes in management strategy can also signal a need for a new cost system.
c. Continuous improvement is an ongoing process of enhancing employee task
performance, level of product quality, and level of company service through eliminating
non-value-added activities to reduce lead time, making products (performing services)
with zero defects, reducing product costs on an ongoing basis, and simplifying products
and processes.
d. The benefits from ABC are two-dimensional in that ABC improves product costs for
managerial decision making and improves the performance measurement process.
e. Traditional accounting systems focus attention on controlling cost incurrence, while ABC
concentrates on controlling the causes (activities) of the cost incurrence.
f. ABC systems disclose that significant resources are consumed by low-volume products
and complex production operations.
E. Criticisms of Activity-Based Costing
1. ABC implementation necessitates a considerable amount of time and cost. Significant support
is needed throughout the firm for the implementation process to be successful.
2. ABC does not specifically comply with generally accepted accounting principles.
3. Companies desiring to implement ABC systems must be aware that, while more accurate
costing may be provided, ABC systems are not always appropriate.
4. Another criticism that has been charged is that ABC does not, in and of itself, promote total
quality management and continuous improvement. However, companies can implement ABC
and its related management techniques in support of and in conjunction with TQM, JIT, and
any other world-class methodologies.