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Chapter Activity-Based Cost Systems for Management Questions Activity-based management is a management approach that associates the activities executed by an organization with the value customers derive from products Efficiency and effectiveness are achieved by reducing the level of activities that not create value for the customer and by improving execution of activities that create customer value Specific tools beneath the ABM umbrella include activity analysis, cost driver analysis, activity-based costing, continuous improvement, operational control, performance evaluation, and business process reengineering Value-added activities increase the worth of a product or service to the consumer Non-value-added activities increase the time spent on a product or service but not increase its worth to the consumer Performing any task required for production (adding materials, blending, molding, assembling, etc.) is an example of a value-added activity; moving partially completed units of inventory, storing those parts, inspecting for quality, and having parts waiting to be worked on are examples of non-value-added activities Value-added activities are viewed from the customer's perspective because it is the customer who is the end evaluator of the “worth” of a product or service and, therefore, the activities involved in creating that product or service Identifying non-value-added activities provides management the opportunity to minimize or eliminate such activities As nonvalue-added activities are reduced or eliminated, the costs associated with these activities can be reduced or eliminated which will allow the company to either reduce prices to consumers or to make a higher profit if selling prices are maintained 75 76 Chapter Activity-Based Cost Systems for Management In a televised football game, the value-added activities are the actual game plays Non-value-added activities consist of commercials and the time between plays Activities such as “moving the chains,” measuring to determine if a first down was made, moving the ball from the end of one play to the point where it will be put in play next are all non-valueadded activities People who believe that the commercials are informative and interesting and that the time between plays allows them an opportunity to examine the strategies of the teams and project what each team is likely to on the next play may disagree with this assessment A process map illustrates, sequentially, all of the steps associated with accomplishing a specific task By carefully studying the steps, value-added and non-value-added activities can be identified and ideas can be generated to reduce or eliminate the non-value-added activities The MCE is a measure of production efficiency It is expressed as value-added processing time divided by total cycle time The numerator refers to the actual time it takes to physically manufacture a unit Total cycle time is defined as value-added time plus all time spent on non-value-added activities (inspection time, transfer time, and idle time) In an optimized manufacturing environment, all non-value-added activities would be eliminated so the value of the MCE would be 100 percent A cost driver is an action or condition that directly influences and creates costs Cost drivers are used as bases for allocating costs to activity centers and to products Cost drivers in a production activity center may include number of setups, physical layouts, and number of defects In purchasing, cost drivers may include number of purchase orders, number of different items purchased and number of suppliers Yes, cost drivers exist in traditional accounting systems although they are called "bases for allocation." In traditional systems, a single cost driver such as direct labor hours or machine hours is commonly used rather than multiple cost drivers Also in traditional systems, volume-based cost drivers are more the norm than non-volume-based (e.g., square footage) cost drivers Finally, traditional accounting stresses finding an allocation base that demonstrates strong statistical correlation to the cost, but ABC emphasizes searching for multiple cost drivers that bear cause-and-effect relationships to the cost 10 Chapter 77 Activity-Based Cost Systems for Management Activity analysis is used to separate activities into two groups: those that add value to the product or service and those that not add value Once the non-value-adding activities are identified, managers seek to reduce or eliminate the level of the drivers of those activities If such efforts are successful, non-value-adding costs will be reduced without impairing the value of products or services to the consumer The result should be an increase in profits 11 Activity-based costing is a system that collects financial and operational data on the basis of the underlying nature and extent of business activities ABC attaches costs to products based on the activities (cost drivers) performed to produce, distribute, or support those products It differs from traditional product costing in the extent to which multiple cost drivers are used at multiple organizational levels to allocate indirect production costs Costs are more likely to be allocated to production based on the activities that cause those costs in an activity-based costing system than in a traditional costing system The result should be a more accurate reflection of product cost 12 By using a single cost pool and a single cost driver to allocate overhead, the more traditional methods of overhead assignment ignore the influence on cost of the different activities that occur to make a product In this manner, low-volume specialty products, which cause a disproportionate amount of overhead, are only assigned an average charge for overhead, thereby shifting costs to the standard product lines ABC does a better job of tracing costs to the products that caused the various costs by using multiple cost pools and multiple cost drivers 13 The organizational characteristics include: provision of a wide variety of products or services; large overhead costs not proportional to the unit volume of individual products; significant automation reducing the usefulness of direct labor as a base for allocating overhead; and difficult-to-explain product profit margins 14 Activity-based costing requires costs to be aggregated at different levels because the activities that cause costs to be generated occur at different levels Only if costs are accumulated on the same level as the activity that generates them can an allocation base be selected that represents a cause-effect relationship between the cost and the cost pool 78 15 Chapter Activity-Based Cost Systems for Management Benefits of activity-based costing include these: • Focusing on value-added and non-value-added activities to minimize those activities not adding value; • Highlighting interrelationships among areas; • Providing feedback on product design and opportunities for process improvements; • Encouraging use of nonfinancial measures of activity and performance; and • Providing a more appropriate means of charging overhead to products These benefits of ABC should result in a reduction in costs because of the improved understanding of which activities cause costs to be generated, the increased focus on controlling such activities, and the evolution of improved performance measures so that measured performance is more highly correlated with cost control 16 The view of proponents of ABC is that, in the long run, all costs are variable Costs traditionally labeled as fixed are really costs that vary with long-term cost drivers rather than short-term cost drivers Thus, ABC proponents argue that there are no fixed costs only long-term variable costs and short-term variable costs 17 Attribute-based costing extends the concept of activity-based costing by relating the company's costs to the characteristics (attributes) of a product that create value for the consumer By comparing the cost of a value-enhancing characteristic to its benefits (price the consumer is willing to pay), the company can make correct judgments about which characteristics to add to the product and which to leave out 18 All companies are not likely to benefit equally from adopting ABC The greatest benefits are likely to be gained by firms with complex production processes; firms that produce products that vary relative to cost, complexity, and volume; and firms that have a high level of overhead costs that are fixed relative to production volume 19 Implementation of ABC requires a significant commitment of time and resources Significant time is consumed identifying cost drivers and determining how to split production costs into pools that are relatively homogeneous relative to a particular cost driver Identification of these cost drivers typically requires internal surveys and interviews with company personnel Additional time is consumed evaluating, selecting, and implementing the software to manage the ABC data collection and cost assignments Chapter Activity-Based Cost Systems for Management 79 Exercises 20 a b c d e f g h i j 21 a b c d e f g h i j 10 22 a None of the items are value-added activities; products should be designed so that schedule changes should not be needed b Number of factory schedule changes is the driver c Eliminate factory schedule changes except for those asked for by a customer (in which case the customer should be charged for the cost of the change) or for critical changes necessary to realize significant quality improvements and cost reductions a Cycle time = 30 + 18 + 3,580 + 15 + 90 + 80 + 75 + 20 + 5,040 + 25 = 8,973 minutes b MCE = (90 + 80 + 75) ÷ 8,973 = 2.7% c The company could many things to improve its MCE The biggest areas to concentrate on are the time spent storing ingredients in the stock room and the time spent storing bottled dressing in the warehouse Probably the most significant improvement in MCE would come from adopting JIT management of all inventories This would allow the firm to concentrate on reducing total cycle time by not purchasing materials until they are needed and not producing finished goods until they are demanded by customers 23 10 Chapter Activity-Based Cost Systems for Management 80 24 a b c d e f g h i j 25 a b c d e f g h i j k 26 a O U B B O P U (could be product/process if left on all the time) O P P machine hours (for maintenance related to the volume of usage of machinery), average age of equipment (for obsolescence and age-related maintenance) machine hours (for machine-driven usage), outside air temperature (for weather-related usage) number of transactions processed (valid volume measure) number of product defects (volume of quality defects), pounds of scrap and waste (volume of quality defects), number of quality inspections (number of batches) pounds of material processed (volume of work processed), number of different types of material handled (complexity of material handling), number of purchase orders (volume of work processed by staff and number of suppliers used) average amount of material inventory (volume of material stored), square footage of storage area (storage capacity) amount of investment in factory machinery and buildings (total cost basis for depreciation) number of setups (volume driver), total time of setups (alternative volume measure) number of engineering changes (volume of engineering changes), number of process changes (volume of changes to the manufacturing processes), number of engineering change orders (number of requests for changes to products and processes) number of print ads (volume measure), seconds of air time (cost measure), number of new ads developed (measure of professional time) pounds of materials received (volume measure), distance of average shipment received (cost driver for commercial freight carriers) Allocation rate = Cost ÷ Allocation base Contracts rate = $200,000 ÷ 10,000 = $20 per contract page Regulation rate = $250,000 ÷ 500 = $500 per review request Court rate = $350,000 ÷ 3,000 = $117 per professional hour b 27 Chapter Activity-Based Cost Systems for Management Contracts: 1,000 × $20 $20,000 Regulation: 15 × $500 7,500 Court: 250 × $117 29,250 Total $56,750 c The rates will be used to bill other departments for the costs incurred in the legal department If the legal department operates efficiently, its billings should equal or exceed the costs it incurs The firm can hire an outside law firm to perform the legal work rather than the work internally It is difficult to determine, without more information, how this action would affect total costs However, it would tend to make the legal costs much more variable and less fixed a $400,000 ÷ 200,000 calls = $2 per call $200,000 ÷ 25,000 purchase orders = $8 per purchase order $90,000 ÷ 15,000 receiving reports = $6 per receiving report Cost assignment: 230 calls × $2 80 purchase orders × $8 25 receiving reports × $6 28 81 $ 460 640 150 $1,250 b $1,250 ÷ 332 units = $3.77 (rounded) per unit a $1,200,000 ÷ $20 per hour = 60,000 direct labor hours $4,000,000 ÷ $20 per hour = 200,000 direct labor hours Overhead = $2,210,000 + $1,612,000 = $3,822,000 Overhead rate = $3,822,000 ÷ (60,000 + 200,000) = $14.70 Revenue less: Direct materials Direct labor Overhead Profit (loss) Lawn Mowers $8,000,000 Garden Tractors Total $8,800,000 $16,000,000 (2,000,000) (1,200,000) (882,000)* $3,918,000 (1,800,000) (3,800,000) (4,000,000) (5,200,000) ** (2,940,000) (3,822,000) $ 60,000 $ 3,978,000 Number of units 50,000 Profit per unit $78.36 * $14.70 ×60,000 = $882,000 ** $14.70 × 200,000 = $2,940,000 10,000 $6 82 b Chapter Activity-Based Cost Systems for Management Overhead rate = $2,210,000 ÷ 260,000 = $8.50 per DLH Lawn Mowers Garden Tractors Total Revenue $ 8,000,000 $ 8,800,000 $16,800,000 less: Direct materials (2,000,000) (1,800,000) (3,800,000) Direct labor (1,200,000) (4,000,000) (5,200,000) * Overhead (510,000) (1,700,000)** 2,210,000) Administration (1,612,000) Profit (loss) $4,290,000 $ 1,300,000 $ 3,978,000 Per unit $85.80 $130 * ** 29 $8.50 × 60,000 = $510,000 $8.50 × 200,000 = $1,700,000 c The profit per unit in (b) provides a better picture In part (a), there was no logical basis for using direct labor hours to allocate administrative expenses Accordingly, any measure profit that relies on such an allocation is not meaningful a It is obvious that the production process in this company has a significant amount of non-value-added time built into the cycle time The most likely cause of this nonvalue-added time is one or more bottleneck processes that create long wait periods when no production is occurring and goods are simply stored or stacked until they can pass through the process A fairly simple way to determine where the bottlenecks are is to walk through the plant and see where materials or partially completed units are being stacked in sight or being brought back into the production area from a storage location Another indicator of a bottleneck is where labor is waiting for a machine to complete a process so that additional materials can be input In addition to bottlenecks, the company could be engaging in rush orders that remove regularly scheduled production from processing Always trying to catch up on backorders will create delays in processing current orders It is possible that if all backorders were filled, the current orders could be processed at a much more rapid pace Finally, defective units caused by rushing to complete orders will have to be reworked, thereby causing an even longer delay in processing time b A value chart allows a company to analyze all activities that comprise total cycle time The role of the value chart is to identify those activities that not add value in the eyes of the consumer By focusing managerial attention on reducing or eliminating such activities, total cycle time is reduced and total costs are reduced 30 31 a Chapter 83 Activity-Based Cost Systems for Management As variety in products increases, costs will also increase Thus, the shift to small special orders will increase costs in purchasing (more orders, more calls to get prices, more space required for catalogs, etc.), receiving (more orders and receipts to handle and account for), storage (different products must be grouped together and differentiated from other products for easy accessibility), accounting (more inventory to account for, potentially more suppliers to pay), customer service (new larger catalogs, possible complaints from customers receiving wrong or slightly wrong orders, more time for sales calls), production scheduling (variety in setups, increase in movement of materials depending on production run), and laboratory work (research and development tests incurred to make certain that the products meet the appropriate environmental and technical requirements) b Yes, it is very possible that management is correct in its belief because total overhead costs are typically allocated to products based on some single allocation base such as direct labor hours or machine hours These single allocation bases not reflect the actual causeand-effect relationships between cost drivers and overhead costs c The memo should suggest that management consider the use of multiple overhead allocation bases and activity-based costing This method of overhead allocation attempts to more fairly attach costs to the products and/or services that actually caused the costs to be incurred a The traditional cost system, developed to value inventory, distorts product cost information because the cost system  was designed to value inventory in the aggregate and not relate to product cost information;  uses a common departmental or factory-wide measure of activity, such as direct labor hours or dollars, now a small portion of overall production costs, to distribute manufacturing overhead to products;  deemphasizes long-term product analysis (when fixed costs become variable costs); and  causes managers, who are aware of distortions in the traditional system, to make intuitive, imprecise adjustments to the traditional cost information without understanding the complete impact 84 b c d Chapter Activity-Based Cost Systems for Management Outlined below are the purpose and several characteristics of the two noted cost systems: Inventory measurement  Meets external reporting requirements for aggregate balance sheet valuation and income determination  Provides monthly and quarterly reporting Activity-based costing  Differentiates costs between value-added and non-value-added activities  Assigns costs to products according to activities involved in the production process that cause these costs The benefits that management can expect from activity-based costing include the following:  Leads to a more competitive position by evaluating activity costs, i.e., costs associated with the complexity of the transaction rather than the production volume and the cost drivers that cause the activities  Streamlines production processes by reducing non-value-added activities, thereby creating reduced setup times, optimal plant layout, and improved quality  Provides management with a more thorough understanding of product costs and product profitability for strategies and pricing decisions  Highlights interrelationships among activities  Provides feedback for opportunities for improvements in product design and production processes  Encourages use of nonfinancial measures of activity and performance  Provides a more appropriate means of assigning overhead to products The steps that a company, using a traditional cost system, would take to implement activity-based costing include these:  Identify activity centers and cost drivers  Assign costs to activity center cost pools using appropriate first-stage cost drivers  Assign activity center cost pools to products, services, or other cost objects using appropriate second-stage cost drivers, according to level of cost (unit, batch, products, process, and organizational levels) (CMA adapted) 88 e Chapter Activity-Based Cost Systems for Management Product A Indirect labor Department ($306,000) (Total indirect LHs for A = 2,500 + 5,000 + 200 = 7,700) (Total indirect LHs for B = 2,500 + 10,000 + 200 = 12,700) Total indirect LHs = 20,400 (7,700 ÷ 20,400 = 38%) $116,280 (12,700 ÷ 20,400 = 62%) Department ($262,000) (Total indirect LHs for A = 2,500 + 1,000 + 200 = 3,700) (Total indirect LHs for B = 5,000 + 4,000 + 400 = 9,400) Total indirect LHs = 13,100 (3,700 ÷ 13,100 = 28%) (9,400 ÷ 13,100 = 72%) Product B $ 189,720 73,360 188,640 Power Total MHs in Dept = 5,000 + 10,000 = 15,000 Department $72,000 (Product A, 1/3; Product B, 2/3) 24,000 48,000 Total MHs in Dept = 5,000 + 20,000 = 25,000 Department $408,000 (Product A, 1/5; Product B, 4/5) 81,600 326,400 Machinery-related (same basis as Power) Department (1/3, 2/3) 133,333 Department (1/5, 4/5) 160,000 266,667 640,000 Building occupancy (same basis as Power) Department (1/3, 2/3) 133,333 Department (1/5, 4/5) 100,000 266,667 400,000 Purchasing Total lbs of X = 50,000 + 50,000 = 100,000 Total lbs of Y = 100,000 Material X $48,000 (Product A, 1/2; Product B, 1/2) 24,000 Material Y $72,000 (all Product B) Overhead cost $845,906 24,000 72,000 $2,422,094 f Chapter Activity-Based Cost Systems for Management Product A Raw material X (1/2, 1/2) $ 400,000 Raw material Y (all B) Direct labor - Dept (4/5, 1/5) 300,000 Direct labor - Dept (1/2, 1/2) 100,000 Overhead (from part e) 845,770 Total product costs $1,645,770 Cost per unit $164.58 89 Product B 400,000 200,000 75,000 100,000 2,422,230 $3,197,230 $319.72 $ [Adapted from Roth and Borthick, "Getting Closer to Real Product Costs," Management Accounting (May 1989), pp 28-33.] 36 a Predetermined rate using machine hours: $6,000,000 ÷ 1,000,000 MHs = $6 per MH b Cost per door: Direct material $100,000 Direct labor 300,000 Applied overhead (10,000 × $6) 60,000 Total cost $460,000 Divided by number of stores 5,000 Cost per door = $460,000 ÷ 5,000 = $92.00 c Predetermined rate per activity per unit of cost driver: Electric power: $500,000 ÷ 100,000 = $5.00 per kilowatt hour Work cells: $3,000,000 ÷ 600,000 = $5.00 per square foot Material handling: $1,000,000 ÷ 200,000 = $5.00 per material move Quality control inspections: $1,000,000 ÷ 100,000 = $10.00 per inspection Product runs: $500,000 ÷ 50,000 = $10.00 per production run Cost per door: Direct material Direct labor Applied overhead Electric power ($5.00 X 1,000) Work cells ($5.00 X 8,000) Materials handling ($5.00 X 100) Quality Control ($10.00 X 50) Product Runs ($10.00 X 25) Total costs Divided by number of doors Cost per door $100,000 300,000 $ 5,000 40,000 500 500 250 46,250 $446,250 5,000 $89.25 90 Chapter Activity-Based Cost Systems for Management d The activity-based costing method allocates the cost pools of manufacturing overhead to various cost drivers and then to products based on the amount or number or other bases that each product consumes in various cost drivers Assume that Garage Door Company's policy is to add 40% to manufacturing costs as gross profit to cover costs such as administrative expenses, selling expenses, financial expenses and research and development expenses, and the remainder will be a profit In determining the selling price of the door under both methods, add 40 % of total manufacturing costs: Present Costing System ABC System Unit costs $ 92.00 $ 89.25 Plus gross profit 40% 36.80 35.70 Selling price $128.80 $124.95 It is evident that a selling advantage results from the ABC method As illustrated in this case, the ABC method should result in a pricing decision that makes the company more competitive in the marketplace Savings in applying manufacturing overhead costs to products will enable the company to sell its products at a lower price than competitors while maintaining the same gross margin ratio [Copyright 1990 IMA (formerly NAA)] 37 a Base wages: $42,000,000 ÷ 2,100,000 = $20 per DLH Health care: $7,000,000 ÷ 1,400 = $5,000 per worker Payroll taxes: $3,360,000 ÷ $47,800,000 = $0.07 per dollar of total wages Overtime: $5,800,000 ÷ 8,000,000 = $0.725 per unit Training: $1,250,000 ÷ 200 = $6,250 per new hire Retirement: $4,600,000 ÷ 1,400 = $3,285.71 per worker Workers' comp.: $800,000 ÷ 1,400 = $571.43 per worker b Although more labor-related items are driven by the number of factory workers, the number of regular labor hours accounts for most of the labor cost, $42,000,000 c It can be inferred that the use of overtime hours minimizes some cost drivers In this example, use of overtime hours would help contain health care costs, training costs, retirement costs, and workers' compensation 38 39 a Chapter Activity-Based Cost Systems for Professional salaries: $900,000 ÷ Building costs: $450,000 ÷ 15,000 Risk management: $320,000 ÷ 1,000 91 Management 30,000 = $30 per hr = $30 per sq ft = $320 per patient b Surgery = (6,000 × $30) + (1,200 × $30) + (200 × $320) = $280,000 Housing = (20,000 × $30) + (12,000 × $30) + (500 × $320) = $1,120,000 Outpatient care = (4,000 × $30) + (1,800 × $30) + (300 × $320) = $270,000 c Surgery: professional hours (this is an activity base that would drive many costs related to surgery and would be easy to track) Housing patients: days in hospital (this activity base would be easy to follow and would account for use of time and space) Outpatient care: professional hours (this would capture service provision to outpatients); or expected patient volume (this would capture those costs that are more related to capacity to provide service) a Allocation rates: Utilities: $300,000 ÷ 60,000 = $5 per MH; assigned to products using 30,000, 10,000, and 20,000, respectively Scheduling & setup: $273,000 ÷ 780 = $350 per setup; assigned to products using 130, 380, and 270, respectively Materials handling $640,000 ÷ 1,600,000 = $0.40 per lb.; assigned to products using 500,000, 300,000, and 800,000, respectively Products A B C Direct costs $ 80,000 $ 80,000 $ 90,000 Utilities 150,000 50,000 100,000 Scheduling & setup 45,500 133,000 94,500 Material handling 200,000 120,000 320,000 Total $475,500 $383,000 $604,500 Units produced 40,000 20,000 60,000 Cost per unit $11.89 $19.15 $10.075 b Total overhead = $300,000 + $273,000 + $640,000 = $1,213,000 Total DLHs = 32,000 + 18,000 + 50,000 = 100,000 Overhead rate = $1,213,000 ÷ 100,000 = $12.13 Products A B C Direct costs $ 80,000 $ 80,000 $ 90,000 Overhead* 388,160 218,340 606,500 Total $468,160 $298,340 $696,500 Divided by units 40,000 20,000 60,000 Unit costs $11.70 $14.92 $11.61 *Assigned at 32,000, 18,000, and 50,000 respectively, times $12.13 c Product A: Product B: Product C: Conventional $11.70 × 1.20 = $14.04 $14.92 × 1.20 = $17.90 $11.61 × 1.20 = $13.92 Product A: Product B: Product C: ABC $11.89 × 1.20 = $19.15 × 1.20 = $10.08 × 1.20 = $14.27 $22.98 $12.10 The conventional approach to product costing used only one allocation base, direct labor hours This allocation base was unable to fully capture the causes of overhead cost incurrence The ABC approach developed better overhead allocation because of the superior relationship between the cost pools and the cost drivers used to allocate the overhead cost To the extent that there is error in determining costs, there will also be mispricing when prices are set based on costs as is evident in this problem Although Product A is relatively unaffected by the choice of costing system, Products B and C have substantially different costs and prices under the two systems The traditional costing system would result in underpricing Product B and overpricing Product C This would affect both sales volume and company profitability 73 Chapter Activity-Based Cost Systems for Management 93 Cases 40 a Although difficult to quantify, some costs are associated with just carrying a part number in the database Each part number must be originally set up in the system, built into the structure of a bill of materials, and maintained until it is no longer used Moreover, each part must be planned, scheduled, negotiated with vendors, purchased, received, stored, moved, and paid for Having two parts similar enough that one could be used for both applications requires unnecessary duplication of these activities and, therefore, unnecessary costs Standardizing parts results in several indirect benefits Fewer unique part numbers usually means fewer vendors and greater quality of delivered parts It also means smoother JIT production, fewer shutdowns of manufacturing lines, and greater field reliability b To appropriately influence the behavior of design and cost-reduction engineers, the MOH allocation method should assign little cost to products for each high-usage common part and more cost for each low-usage unique part, in proportion to the total usage of the parts Annual Cost to Carry = Budgeted MOH Costs Each Part Number # of Active Part Numbers MOH Rate for the Part Number = Annual Cost to Carry Each Part Number Annual Usage of a Part Number Annual Cost to Carry = $5,500,000 ÷ 8,000 = $687.50 MOH Rate for High-Usage Part = $687.50 ÷ 35,000 = $.02 MOH Rate for Low-Usage Part = $687.50 ÷ 200 = $3.44 The MOH cost for each product is based on the part numbers in its bill of materials The rate for each part number is multiplied by the number of times the part is used in the product The resulting amounts are then aggregated for all part numbers in the bill of materials The greater the number of parts in a product and the higher the percentage of unique parts, the greater the amount of allocated cost 94 c d Chapter Activity-Based Cost Systems for Management Students will discuss the appropriateness of the allocation bases they selected, the ways in which their methods would communicate accurate information to design and cost-reduction engineers concerning the indirect costs of engineering products with unique versus common parts, and the need to provide those engineers with incentives to use the information in their part selection decisions Regarding the latter point, engineers at Tektronix, are in fact evaluated on the costs of the products they design Although they are driven by emerging technologies and other considerations such as quality and customer needs, the evaluation process motivates them to seek minimum cost designs consistent with these considerations With the part number-based MOH allocation method, engineers will tend to design products differently The product costing system will tell them that engineering low-volume unique parts into products causes overhead Having the material overhead cost associated with each individual part number will help engineers to evaluate the use of a new part versus an existing part Knowing the previously hidden costs of components, the engineers can properly assess not only the tradeoffs between parts proliferation and direct labor reduction but also the cost of selecting a unique component to satisfy a specific functional requirement of a customer A MOH allocation method should provide accurate estimates of the long-run variable costs of all of the demands made on the organization's material-related overhead resources by each product in the product line To approach 100 % accuracy, the MOH cost pool would have to be decomposed into smaller homogeneous cost pools in which cost variations could be explained by a single cost driver The resulting costing system would be marginally more accurate but substantially more complex, difficult to understand, and more costly to maintain than the single-cost-pool method that was decided on in this situation Also, adding more cost drivers to the system would probably have initially created confusion and definitely would have been resisted by manufacturing, engineering, and marketing personnel Manufacturing costs are a crucial element of profitability in highly competitive markets of complex products It is therefore very important that the benefits of more accurate tracing of costs to products exceed the cost of achieving the incremental accuracy (for example, the costs of determining and measuring additional cost drivers) It would be counterproductive to implement an elaborate overhead allocation system to cost products with very high accuracy if the system would cost so much to maintain that the companies would become less, not more, competitive A single-cost-driver method may be a compromise that reflects the costs and benefits Chapter 95 Activity-Based Cost Systems for Management of achieving additional accuracy A final consideration related to accuracy is the proper interpretation of computed rates The $687.50 annual cost to carry each part number is not a short-term variable cost Most of the costs in the MOH cost pool are fixed in the short term on a unit volume basis Elimination of one part number in the database therefore will not immediately reduce the total material-related overhead cost by this amount Nor in the case of the low-usage part will using one less save $3.44 in out-of-pocket costs These rates reflect a long-term perspective; the company believes that, by supporting the manufacturing strategy, the allocation method will lead a to real cost savings over time as the next generation of products is designed with fewer different part numbers e The costs of all demands made by products on both manufacturing and non-manufacturing resources are proper elements of product costs used for management decisions, whereas inventory values for external reporting consist of manufacturing costs only The MOH cost pool includes some or all of the costs of three types of cost areas Because all such costs areas are manufacturing related, their costs are appropriately assigned to inventory, and the accurate MOH allocation method is an appropriate technique for making the assignments The company, however, decided to use the MOH rates as "management costs" only and to continue to use the old allocation method to compute "financial costs." One factor that led to this decision was the company's desire to value inventory consistently If the new method were used to compute financial costs, the reported inventory valuations would change because, among other reasons, more manufacturing support costs would be allocated to products A more compelling reason for the "two sets of costs" approach is the need to maintain flexibility in product costing The part number-based MOH allocation method was developed to modify behavior to enact the strategy of parts standardization It will cease to be an effective behavioral tool when design and cost-reduction engineers fully understand the costs of part number proliferation and naturally design products with common parts to the extent each situation allows After parts standardization becomes second nature to engineers, management will change its strategy and the accounting staff will develop a new product costing method to support the new strategy In this way, product costs can continue to be effective management tools for influencing behavior without affecting the accountants' ability to value inventory on a consistent basis [Michael A Robinson, ed Cases from Management Accounting Practice No Instructor's Manual (Montvale, NJ: National 96 Chapter Activity-Based Cost Systems for Management Association of Accountants, 1989) pp 7-11, adapted.] 41 a Advantages associated with activity-based costing systems include: * highlighting non-value-added activities so that they can be reduced or eliminated; * improving the accuracy of product costing by tightening associations between costs and their causes; * better decision making in setting prices; and * improving processes by highlighting the associations among production activities b First, determine the total cost of production for 2003: TV Board PC Board Direct material $80 × 65,000 $ 5,200,000 $140 × 40,000 $ 5,600,000 Direct labor 65,000 × 1.5 × $14 1,365,000 40,000 × × $14 $ 2,240,000 Variable overhead 65,000 × 1.5 × $4 390,000 160,000 × × $4 640,000 Machine charge 65,000 × 0.5 × $10 325,000 40,000 × 1.5 × $10 600,000 Material handling charge 65,000 × $80 × 0.10 520,000 40,000 × $140 × 0.10 560,000 Total costs $7,800,000 $9,640,000 Sales Total costs Contribution $9,750,000 $12,000,000 (7,800,000) (9,640,000) $1,950,000 $ 2,360,000 Chapter Activity-Based Cost Systems for Management 97 c TV Board PC Board Direct materials $80 × 65,000 $5,200,000 $140 × 40,000 $ 5,600,000 Material Overhead Procurement ($0.10 per part) 162,500 220,000 Prod Scheduling ($2 per board) 130,000 80,000 Pack and Ship ($4 per board) 260,000 160,000 Variable overhead Machine setup ($1.60 per setup) 208,000 192,000 Waste disposal ($3 per pound) 3,900 42,000 Quality contr.($3.50 per insp.) 227,500 280,000 General sup ($0.60 per board) 39,000 24,000 Manufacturing: Mach Ins ($0.40 per part) 624,000 560,000 Manual Ins ($4 per part) 260,000 3,200,000 Wave solder ($1.20 per board) 78,000 48,000 Total costs $7,192,900 $10,406,000 Sales Total costs Contribution d $9,750,000 $12,000,000 (7,192,900)(10,406,000) $2,557,100 $ 1,594,000 Based on the calculations made in part (a), the PC boards appear to be a much more profitable product than the TV boards Under the activity-based cost allocations, the TV boards appear to generate more contribution toward profits than the PC boards The difference is attributable to the fact that the standard cost system does not account for the cost of the complexities associated with the production of the PC board These effects are most evident with the costs of manual insertions required for the PC boards (CMA adapted) 98 42 a Chapter Activity-Based Cost Systems for Management Assignment of overhead costs: Columbus Cincinnati Dayton General Admin $153,839.79 $127,559.59 $127,600.62 Project costing 21,654.14 13,714.29 12,631.58 A/P; receiving 62,458.15 52,048.46 24,493.39 A/R 24,500.00 18,500.00 4,000.00 Payroll 10,298.51 11,641.79 8,059.70 Personnel recruit 16,000.00 8,000.00 14,000.00 Employee ins 4,805.98 5,432.83 3,761.19 Proposals 54,509.80 68,137.25 16,352.94 Sales meetings 97,104.36 74,493.53 30,402.11 Shipping 9,391.30 11,762.85 2,845.85 Ordering 19,938.46 16,246.15 11,815.38 Duplicating costs 20,000.00 18,000.00 8,000.00 Blueprinting 34,837.59 27,870.07 14,292.34 Total $529,338.08 $453,406.81 $278,255.10 Direct overhead 180,000.00 270,000.00 177,000.00 Total overhead $709,338.08 $723,406.81 $455,255.10 b Sales Direct labor Direct material Net Contribution c Contribution Overhead Contribution d 43 a Columbus $1,500,000 (382,000) (281,000) $ 837,000 Cincinnati $1,419,000 (317,000) (421,000) $ 681,000 Dayton $1,067,000 (317,000) (185,000) $ 565,000 Columbus Cincinnati Dayton 837,000.00 $ 681,000.00 $ 565,000.00 (709,338.08) (723,406.81) (455,255.10) $ 127,661.92 $ (42,406.81) $ 109,744.90 $ It is apparent that there are weaknesses in the traditional product costing system that are having a profound effect on profitability measures Relative to profit measures based on the traditional costing measures, the ABC allocations make it apparent that the Cincinnati office is much less profitable and the Dayton office is much more profitable (IMA adapted) Send/receive goods: $6,000 ÷ Store goods: $4,000 ÷ 80,000 Move goods: $5,000 ÷ 5,000 = Identify goods: $2,000 ÷ 500 Jones: 500,000 = $0.012 per lb = $.05 per cubic foot $1.00 per square foot = $4 per package (40,000 × $0.012) + (3,000 × $0.05) + + (300 × $1) + (5 × $4) = $950 Hansen: (40,000 × $0.012) + (2,000 × $0.05) + + (200 × $1) + (20 × $4) = $860 Assad: (40,000 × $0.012) + (1,000 × $0.05) + + (1,000 × $1) + (80 × $4) = $1,850 b c Chapter Activity-Based Cost Systems for Management Jones: 40,000 × $0.04 = $1,600 Hansen: 40,000 × $0.04 = $1,600 Assad: 40,000 × $0.04 = $1,600 99 Jones: $950 × 1.4 = $1,330 Hansen: $860 × 1.4 = $1,204 Assad: $1,850 × 1.4 = $2,590 d The current pricing plan captures only one dimension of cost causality, send/receive goods Accordingly, the prices charged for warehousing services are almost independent of the causes of the costs As indicated in a comparison of the answers to parts (b) and (c), the existing pricing plan generates the same price for the three customers whereas an ABC-based price results in very different prices to be charged to the three customers [Adapted from Harold P Roth and Linda T Sims, "Costing for Warehousing and Distribution," Management Accounting, (August 1991) pp 42-45 Published by Institute of Management Accountants, Montvale, NJ.] Reality Check 44 a In the modern competitive environment, firms must be willing to relinquish unprofitable customers so that the highest quality of service is provided to the most profitable customers Small customers are not able to provide the same economy of operations that are available from larger customers b There are ethical obligations in ending all business relationships This is particularly true for firms that are sole suppliers of parts or materials that are critical to their customers At a minimum, an ethical "firing" of a customer should  involve an explanation as to why service is being discontinued;  be announced well in advance of discontinuing services to the customer;  be accompanied by suggestions of alternative sources of supply; and  be sensitive to all negative effects that will be suffered by the customer when service is ended 100 c 45 Chapter Activity-Based Cost Systems for Management Activity-based costing is a financial management tool It is not a tool for ethical management of a firm, nor is it a tool that can expressly impound nonfinancial, qualitative information To the extent that factors such as customer goodwill and market reputation are involved in decisions driven by ABC prescriptions, those factors will be ignored by activity-based management However, it is important to acknowledge that these qualitative factors should not be ignored and, in fact, may be important enough to overturn the activity-based prescriptions a In particular, the other initiatives would include management methods to improve quality For example, an adoption of the TQM philosophy would be one of the initiatives; others could include adoption of ABC, employee empowerment, formation of quality circles, JIT inventory management, decentralization of decision making, and use of kaizen costing techniques b These tools help orient the firm to managing based on a customer’s perspective of value World class competition is based on satisfying the customer If a firm concentrates on accentuating those activities that are highly valued by customers and diminishing those activities that are not perceived as value-adding by customers, it should be successful in both managing costs and maintaining market share c Yes Activity-based costing is most useful if managers are willing to act based on the information provided by the ABC system For example, activity-based costing could lead to changes in product mix and product pricing Top management must support the ABC prescriptions for the costing system to lead to operational improvements d Preferably, both would be adopted Without adopting ABC, the ABM prescriptions may not be understood by managers But, without ABM, there may be reduced opportunity to identify and eliminate NVA activities ABC would require a separate information system to generate activity-based information This would not necessarily be the system that managers would attend to; rather, they would continue to use the firm’s traditional and formal information systems The two sources of information would inevitably give some conflicting signals and confuse managers By using both an ABC system and ABM, actions taken by managers will be consistent with the information provided by the firms’ formal information systems 46 a Chapter 101 Activity-Based Cost Systems for Management This problem indicates that ABC and ABM can cause conflict among the various stakeholders in a business The equipment installation would likely be viewed with favor by the stockholders Analysis indicating that the equipment would be value-adding obviously underlies the decision to make the installation Employees would be strongly against any move that would result in displacement of 60 percent of the workforce Such an action would demoralize both those workers who were fired and those who remained The customers would likely have both short-term and long-term concerns Short-term customers would be very concerned about the impact on quality of laying off 60 percent of the workers However, customers may have a favorable long-term view of the move because of the potential to improve the quality and reduce the costs of products b No matter how articulate the explanation given, it is difficult to visualize acceptance of the explanation by workers who may have dedicated much of their lives to learning skills required for their current positions One approach, however, would be to discuss what customers value in the products currently produced by the business; then, explain how each internal area in the business contributes (or fails to contribute) to customer value This explanation would need to clearly show that the function performed by the displaced workers is no longer value-adding in the eyes of the customer Also, it would be important to explain to the employees that this conclusion holds no matter how well the employees perform the functions c Cycle time is reduced/eliminated largely by reducing nonvalue-added activities When non-value-added activities are reduced, work is no longer required of the employees who performed those activities Only if the employees can be redeployed to other operational areas that are value-adding can employee layoffs be totally avoided However, to the extent possible, the company could aggressively implement training programs to qualify displaced workers for other positions Secondly, the company could seek market opportunities to expand the business so that growth would create an internal demand for those workers’ services in other areas of the business Third, the company could provide employee counseling services to workers and help retrain them for work in other businesses 102 Chapter Activity-Based Cost Systems for Management ... Chapter Activity- Based Cost Systems for Management d The activity- based costing method allocates the cost pools of manufacturing overhead to various cost drivers and then to products based on... correlation to the cost, but ABC emphasizes searching for multiple cost drivers that bear cause -and- effect relationships to the cost 10 Chapter 77 Activity- Based Cost Systems for Management Activity analysis... consistent with the information provided by the firms’ formal information systems 46 a Chapter 101 Activity- Based Cost Systems for Management This problem indicates that ABC and ABM can cause conflict
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