Cost Accounting
Foundations and Evolutions
Kinney, Prather, Raiborn
Chapter 5
Activity-Based Management and
Activity-Based Costing
Learning Objectives (1 of 2)
• Identify the focus of activity-based
management
• Explain why non-value-added activities
cause costs to increase unnecessarily
• Explain why cost drivers are designated in
activity-based costing
Learning Objectives (2 of 2)
• Contrast activity-based costing to the
traditional cost accounting system
• Describe the types of information provided
by an activity-based costing/management
system
• Explain when it is appropriate to use
activity-based costing
Activity-Based Management
• Focuses on activities during production and
performance process
• Improves the value received by customers
• Enhances profitability
Activity
An activity is a repetitive action performed
in fulfillment of a business function
Activity-Based Management
Activity analysis
Cost driver analysis
Activity-based costing
Continuous improvement
Operational control
Quality management
Business process
improvement
Performance measurement
ABM
Activity Based Management
• External Benefits
– Increased customer value
– Enhanced profitability
• Internal Benefits
– More efficient production
– More accurate cost determination
– More effective performance evaluation
ABM
Activity Analysis
Non-value-added activity
• Increases time spent on
Value-added activity
product or service but does
• Increases worth of
not increase worth
product or service to a
• Unnecessary from customer
customer
perspective
• Customer is willing to
• Can be reduced, redesigned
pay for it
or eliminated without
affecting market value or
quality
• Business-value-added
activities are essential
Process
• A process is a series of activities that, when
performed together, satisfy a specific
objective
–
–
–
–
Production
Distribution
Selling
Administration
ABM
Activity Analysis
• Create a Process Map (detailed
flowchart) for each process
– Identify each step
ABM
Activity Analysis
• Create a Process Map (detailed
flowchart) for each process
– Identify each step
• Create Value Chart
– Identify stages and time spent in stages from
beginning to end of process
Value-Added
Processing Time
Service Time
Non-Value-Added
Inspection Time
Transfer Time
Idle Time
Cycle Time
Cycle
Time
=
ValueAdded
+
Activities
NonValue-Added
Activities
Eliminate or minimize activities that add
the most time and cost and the least value
Manufacturing Cycle Efficiency
Manufacturing
Cycle Efficiency
(MCE)
=
Value-Added
Processing Time
Total Cycle Time
Manufacturing Cycle Efficiency
Manufacturing
Cycle Efficiency
(MCE)
=
Value-Added
Processing Time
Total Cycle Time
• 100% efficiency unrealistic
• Reducing non-value-added activities will
increase Manufacturing Cycle Efficiency
• Value-added activity usually represents
about 10% of total cycle time
• Just-in-time (JIT) increases MCE
Non-Value-Added Activities
• Attributed to following factors
– Systemic
– Physical
– Human
• Eliminating or reducing non-value-added
activities that create the most costs will
– Increase product/service quality
– Decrease cycle time and cost
ABM
Cost Driver Analysis
• Cost drivers are factors that have a direct
cause-effect relationship to a cost
– Limit the number of cost drivers
– Cost of measurement should not exceed benefit
of using the cost driver
– Easy to understand
– Directly related to activity being performed
– Appropriate for measurement
A Management Tool
Combine
• Activity analysis
– What activities are non-value-added?
• Cost driver analysis
– What causes costs to be incurred?
ABM
Cost Driver Analysis
• Unit-level costs
– direct material, direct labor
• Batch-level costs
– setup, inspection
• Product/process-level costs
– engineering changes, product development
• Organizational or facility costs
– building depreciation, plant manager’s salary
Product Cost Behavior
• Unit-level costs are variable in relation to
change in production volume
• Batch, product/process, and organizational
level costs are variable for reasons other
than changes in production volume
Product Cost
Unit-Level
Costs
Allocate over number
of units produced
Cost per unit
Batch-Level
Costs
Allocate over number
of units in batch
Cost per unit
in batch
Product/ProcessLevel Costs
Allocate over number
of units produced in
related product line
Cost per unit
in product line
For each
product line
Product and Company
Profitability
Unit
Batch
Product
Total product revenue
<Total product cost>
Net product margin
<Organizational/facility-level costs>
Company profit or loss
Not
GAAP
ABM
Activity-Based Costing
• Recognizes several levels of costs
• Accumulates costs into related cost pools
• Uses multiple cost drivers to assign costs to
products and services
When to Use ABC
Companies use ABC when
• They have a wide variety of products or services
• High overhead costs are not proportional to the unit
volume of individual products
• Automation makes it difficult to assign overhead to
products using direct labor or machine hours
• Profit margins are difficult to explain
• Hard-to-make products show big profits and easy-tomake products show losses
Two-Step Allocation
• Collect costs in general ledger and subsidiary
accounts
• Identify activity centers
Choosing an Activity Center
• Geographical proximity of equipment
• Centers of managerial responsibility
• Magnitude of product costs
Choose a manageable number of
activity centers
Two-Step Allocation
• Collect costs in general ledger and subsidiary
accounts
• Identify activity centers
• Accumulate costs into activity center cost
pools
– Identify cost drivers
ABC Cost Pools
Assumptions about activity center cost pools
• Costs in each cost pool are
– Driven by homogenous activities
– Strictly proportional to the activity
Two-Step Allocation
• Collect costs in general ledger and subsidiary
accounts
• Identify activity centers
• Accumulate costs into activity center cost
pools – cost drivers
• Allocate costs to products and services
– activity driver measures demands placed on
activities, thus, the resources consumed by
products/services
Activity Drivers
•
•
•
•
•
•
•
Reports requested
Job change actions
Hiring actions
Training hours
Transactions processed
Engineering changes
Defects discovered
•
•
•
•
•
•
•
Repair hours
Material requisitions
Purchase requisitions
Space occupied
Set-ups
Moves
Employees
Traditional vs. ABC Costing
• When ABC implemented
– Cost reduced for high volume, standard
products
– Cost increased for low-volume, complex
specialty products
Long-Term Variable Costs
• Cost drivers
– Product variety – number of different types of
products
– Product complexity – number of processes
through which a product flows
ABM
ABC Costing Considerations
• Number and diversity of products/services
produced
• Diversity and differential degree of support
services used for different products
• Extent to which common processes are used
• Effectiveness of current cost allocation
methods
• Rate of growth of period costs
ABM
Use ABC Costing when….
1.
2.
3.
4.
Product Variety and Process Complexity
Lack of Commonality in Overhead Costs
Problems with Current Cost Allocations
Changes in Business Environment
ABM
Use ABC Costing when….
1. Product Variety and Process Complexity
–
Caused by mass customization
• Too many choices, opportunity for errors
• Pareto Principle
• Commonality of parts
– Reduced by
• Simultaneous (or Concurrent) Engineering
• Design for Manufacturability
ABM
Use ABC Costing when….
2. Lack of Commonality in Overhead Costs
-
Some products/services use substantially more
overhead than others
3. Problems with Current Cost Allocations
-
-
Significant changes in process with no change
in cost allocations
Expense majority of period costs when
incurred
ABM
Use ABC Costing when….
4. Changes in Business Environment
–
–
Increase in competition
Change in management strategy
ABM
Continuous Improvement
• Eliminates non-value-added activities to
reduce cycle time
• Makes products/performs services with zero
defects
• Reduces product costs on an ongoing basis
• Simplifies products and processes
ABC Costing Supports
Continuous Improvement
Criticisms of ABC
• Significant amount of time and cost to
implement
• Must overcome barriers to change
• Does not conform to GAAP
• May not promote total quality management
ABM
Advantages of ABC and ABM
• Identify and monitor significant technology
costs
• Trace technology costs directly to products
• Identify the cost drivers that create or
influence cost
• Identify activities that do not contribute to
perceived customer value
ABM
Advantages of ABC and ABM
• Illustrate the impact of new technologies on
all elements of performance
• Translate company goals into activity goals
• Analyze the performance of activities across
business functions
• Analyze performance problems
• Promote standards of excellence
Questions
• What are the differences between activitybased costing and traditional cost
accounting?
• What are cost drivers and activity drivers?
• What are two advantages and two criticisms
of activity-based costing?