. College of San Mateo Accounting 131 Rosemary Nurre .
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Chapter 7

Activity Based Costing and Management Chapter Outline 1. Explain why functional-based costing approaches may produce distorted costs. 2. Explain how an activity-based costing system works for product costing. 3. Describe activity-based customer and supplier costing. 4. Explain how activity-based management can be used for cost reduction. 5. (Appendix) Explain the basics of quality cost management. 6. (Appendix) Explain the basics of environmental cost management. Lecture Notes 1. LIMITATIONS OF FUNCTIONAL-BASED COST ACCOUNTING SYSTEMS Functional-based cost accounting systems using plantwide and departmental rates can produce average costs that severely under- or overstate individual product costs. Distorted product costs can be a problem in extremely competitive environments. Plantwide and departmental rates using unit-level drivers may not assign overhead costs accu­rately if: the proportion of nonunit-level overhead costs to total overhead costs is large, and the degree of product diversity is great. A. Non-Unit-Related Overhead Costs The main problem with the traditional approach of using plantwide and departmental overhead rates is that a product’s consumption of overhead resources may not be strictly related to units produced. For example, setup costs are related to the number of setups. Activity drivers are factors that measure the consumption of activities by products. Activity drivers can be classified as: 1. unit-level activity drivers, or 2. non-unit-level activity drivers Non-unit-level activity drivers are factors, other than the number of units produced, that mea­ sure use of overhead resources. For example, setup costs are not driven by the number of units, but by the number of setups, a non-unit-level activity driver. Unit-level activity drivers are factors that cause changes in cost as the number of units produced changes. Examples of unit-level drivers include units produced, direct labor hours, and machine hours. Using only unit-level activity drivers to assign non-unit-related overhead costs can create distorted product costs. If non-unit-level overhead costs are only a small percentage of total overhead costs, the distortion of product costs would be small and the use of unit-level cost drivers might be acceptable. B. Product Diversity Product diversity occurs when products consume overhead activities in different proportions. Reasons why products might consume overhead in different proportions include: differences in product size product complexity setup time size of batches Consumption ratio is the proportion of each activity consumed by a product. Product costs can be distorted if a unit-level cost driver is used and non-unit-level overhead costs are a significant proportion of total overhead, and the consumption ratios differ between unit-level and non-unit-level input categories. Cornerstone 7-1: How to Calculate Consumption Ratios See Mowen and Hansen text for demo problems.  C. Solving the Problem of Cost Distortion The cost distortion caused by using a single plantwide overhead rate can be solved by using a separate rate for each overhead activity, such as setup and material moves. The activity-based cost reflects overhead consumption and is, therefore, more accurate. Cornerstone 7-2: How to Calculate Activity Rates See Mowen and Hansen text for demo problems.  Cornerstone 7-3: How to Calculate Activity-Based Unit Costs See Mowen and Hansen text for demo problems.  2. ACTIVITY-BASED PRODUCT COSTING An activity-based costing (ABC) system: 1. traces overhead costs to activities, and 2. then traces costs to products.                                 Stage One: Activity Pools Activity Drivers Stage Two: Costs Assigned         Functional-based costing also involves two stages; however, overhead costs are traced to departments (instead of activities), and then traced to products. Functional-based costing and activity-based costing are compared below:   Functional-Based Costing Activity-Based Costing First stage: traces costs to plant or department traces costs to activities Second stage: assigns costs to products assigns costs to products Cost tracing: usually allocation-intensive emphasizes direct tracing and driver tracing Activity drivers: unit-level unit-level and nonunit-level Activity-based cost assignment consists of the following steps: 1. Identify and define activities using interviews and surveys, then build an activity dictionary. activity name—usually consists of an action verb and an object a description of the tasks that make up the activity classification as a primary activity (activity consumed by a product or customer) or a secondary activity (activity consumed by other primary or secondary activities) activity driver—a measure of activity output 2. Assign costs to activities. Determine the cost of resources (such as materials, labor, and capital) consumed by each activity. If the resource is exclusive to the activity (such as materials), use direct tracing. If the resource is shared by several activities, use driver tracing to assign costs to the activities. The costs of secondary activities are ultimately assigned to primary activities using activity drivers. 3. Assign costs to products. After the cost of primary activities is calculated, assign the cost of these activities to products based on usage of the activity as measured by activity drivers. Costs assigned to products are calculated as follows: Cost assigned to product = Predetermined activity rate × Actual usage of activity Cornerstone 7-4: How to Assign Resource Costs Using Direct Tracing and Resource Drivers See Mowen and Hansen text for demo problems.  When do you think a firm should adopt an ABC system? There are three conditions that must be met before an ABC system is adopted. First, the non-unit-based costs should be a significant percentage of total overhead costs. Second, the consumption ratios of unit-based and non-unit-based activities must differ. Third, the benefits of an ABC system must exceed its costs. Comparison of Functional-Based Costing and Activity-Based Costing: In a functional-based cost system, the demand for overhead is assumed to be explained only by unit-level cost drivers. ABC produces more accurate product costs by more accurately tracing the consumption of overhead resources to products. 3. ACTIVITY-BASED CUSTOMER AND SUPPLIER COSTING A. Activity-Based Customer Costing Activity-based costing can be used to trace costs to specific customers. The cost of serving different customers can affect pricing decisions and profitability. Customer costing involves three steps: 1. Activities, such as order entry, shipping, and sales calls, are listed in an activity dictionary. Different levels include order level, customer level, and channel level. 2. Cost of resources used is assigned to activities. 3. Cost of the activities is assigned to customers. See the cost assignment summary below for a comparison of customer costing versus product costing:   Cornerstone 7-5: How to Calculate Activity-Based Customer Costs See Mowen and Hansen text for demo problems.  B. Activity-Based Supplier Costing Activity-based supplier costing uses activity-based costing to identify the true costs of suppliers. Activity-based costing traces costs related to purchase, quality, reliability, and delivery performance to specific suppliers. Cornerstone 7-6: How to Calculate Activity-Based Supplier Costs See Mowen and Hansen text for demo problems.  4. PROCESS-VALUE ANALYSIS Process-value analysis: focuses on cost reduction instead of cost assignment. emphasizes the maximization of system-wide performance instead of individual performance Process-value analysis is concerned with: driver analysis activity analysis activity performance measurement A. Driver Analysis: The Search for Root Causes Driver analysis is the effort expended to identify those factors that are the root causes of activity costs. Once the root cause of activity costs is known, then action can be taken to improve the activity. B. Activity Analysis: Identifying and Assessing Value Content Activity analysis is the process of identifying, describing, and evaluating the activities an orga­nization performs. Activity analysis should produce four outcomes: 1. What activities are performed? 2. How many people perform the activities? 3. The time and resources required to perform the activities. 4. Determination of the value-added portion of the activities. Value-added activities are activities that are necessary to achieve corporate objectives and remain in business. Value-added costs are costs to perform value-added activities with perfect efficiency. Non-value-added activities are unnecessary activities and are all activities other than those that are absolutely essential to remain in business. Non-value-added costs are costs caused by either: non-value-added activities, or the inefficient performance of value-added activities. Activity analysis attempts to: identify and eliminate all unnecessary activities, and increase the efficiency of necessary activities. An unnecessary activity is wasteful and should be eliminated. Managing costs may increase the efficiency of an activit y— but if the activity is unnecessary, what does it matter if it is performed efficiently? Five major categories of non-value-added activities are: Scheduling—an activity that uses time and resources to determine when different products have access to processes (or when and how many setups must be done) and how much will be produced. Moving—an activity that uses time and resources to move materials, work in process, and finished goods from one department to another. Waiting—an activity in which materials or work in process use time and resources by waiting on the next process. Inspecting—an activity where time and resources are spent on ensuring that the product meets specifications. Storing—an activity that uses time and resources while a good or raw material is held in inventory. None of the above activities adds any value for the customer. Activity management tries to manufacture the product without using any of these non-value-added activities. Activity analysis can reduce costs in four ways: 1. Activity elimination — eliminating non-value-added activities. 2. Activity selection — choosing among different sets of activities caused by competing strategies. 3. Activity reduction — decreasing the time and resources required by an activity. This approach to cost reduction should be primarily aimed at: improving the efficiency of necessary activities, or improving the non-value-added activities until they can be eliminated. Reducing setup time is an example of improving the efficiency of a necessary activity. 4. Activity sharing — increasing the efficiency of activities by using economies of scale. An example is designing a product to use components already used in other products. By using existing components, activities associated with these components, such as design and machine tooling, are not duplicated. Cornerstone 7-7: How to Assess Non-Value-Added Costs See Mowen and Hansen text for demo problems. C. Activity Performance Measurement Activity performance measures can be financial or nonfinancial. Three dimensions of activity performance measures are: Efficiency —focuses on the relationship of activity inputs and activity outputs. For example, activity efficiency is improved by producing the same activity output with less input. Quality —concerned with doing the activity right the first time it is performed. Time —longer times usually result in more resource consumption and less ability to respond to customer demands. Cycle time is the length of time it takes to produce a unit of output from start to finish. Velocity is the number of units of output that can be produced in a given period of time (units produced/time). Cornerstone 7-8: How to Calculate Cycle Time and Velocity See Mowen and Hansen text for demo problems. 5. APPENDIX: QUALITY AND ENVIRONMENTAL COSTING A. Quality Cost Management Improved quality can increase profits in two ways: 1. By increasing customer demand 2. By decreasing costs B. Quality Defined A quality product or service meets or exceeds customer expectations on the following eight dimensions: Performance —how consistent and well a product performs Aesthetics — the appearance of the product as well as the appearance of the facilities, equipment, personnel, and communication materials associated with services Serviceabilit y —ease of maintaining and/or repairing a product Features (quality of design ) —characteristics of a product that serve the same function but have different design specifications, such as the type and quality of materials used in the product (for example, 14-karat gold jewelry and gold-plated jewelry) Reliability —the probability that the product or service will perform its intended function for a specified length of time Durability —the length of time a product functions Quality of conformance — how a product meets its design specifications. Is the product manufactured as the design specifies? Fitness for use —suitability of the product for carrying out its advertised functions Providing a higher quality product than a competitor means outperforming the competitor on at least one dimension while matching performance on the remaining dimensions. A defective product does not conform to specifications. Zero defects requires that all products and services conform to specifications. The traditional vie w of conformance assumes an acceptable range on either side of a target value for each specification or quality characteristic. The robust quality vie w redefines defective units as those that do not meet the target value. C. Costs of Quality Defined Costs of quality are costs incurred because poor quality may or does exist. Quality costs are associated with two subcategories of quality-related activities: Control activitie s —activities performed by an organization to prevent or detect poor quality (because poor quality may exist). Control activities consist of prevention and appraisal activities. Control costs are the costs of performing control activities. Failure activitie s —activities performed by an organization or its customers in response to poor quality (poor quality does exist). Failure costs are the costs incurred by an organization because failure activities are performed. Four categories of quality costs include the following: 1. Prevention costs are incurred to prevent poor quality. Examples of prevention costs include: quality engineering quality training programs quality planning quality reporting supplier evaluation and selection quality audits quality circles field trials design reviews 2. Appraisal costs are incurred to determine whether products and services are conforming to requirements or customer needs. The main objective is to prevent nonconforming goods from being shipped to customers. Examples of appraisal costs include: inspecting and testing of materials packaging inspection supervising appraisal activities process acceptance (sampling goods in process to see if the process is in control and producing nondefective goods) product acceptan e (sampling finished goods to determine if the finished goods meet an acceptable quality level) measurement (inspection and test) equipment outside endorsements 3. Internal failure costs are incurred because products or services do not meet requirements and the defect is discovered before the external sale. Examples of internal failure costs include: scrap rework downtime (due to defects) reinspection retesting design changes If there are no defects, there are no internal failure costs. 4. External failure costs are incurred because products fail to meet requirements after delivery to customers. Examples include: the cost of recalling defective products lost sales because of poor product performance returns and allowances because of poor quality warranty costs repair costs product liability customer dissatisfaction lost market share complaint adjustment 6. REPORTING QUALITY COST INFORMATION The first step in a quality cost reporting system is to prepare a detailed listing of actual quality costs by category. This serves two purposes: 1. It permits managers to assess the financial impact of quality costs. 2. It reveals the relative emphasis currently placed on each category. A. Quality Cost Reports In the quality cost report, quality costs are grouped into one of four categories: prevention costs appraisal costs internal failure costs external failure costs In addition, each category of quality costs is expressed as a percentage of sales. There are two views concerning optimal quality costs: the traditional view that uses an acceptable quality level (a predetermined level of defective units are produced and sold) the robust view that uses a zero-defects approach with an optimal level of quality costs as the level where zero defects are produced. Cornerstone 7-9: Prepare a Quality Cost Report See Mowen and Hansen text for demo problems. B. Activity-Based Management and Optimal Quality Costs Activity-based management classifies activities as: value-added activities, and non-value-added activities. Internal and external failure activities and their associated costs are non-value-added and should be eliminated. Prevention activities performed efficiently are value-added. (Costs caused by inefficiency in prevention activities are non-value-added costs.) Appraisal activities may be value-added or non-value-added, depending upon the activity. For example, quality audits may serve a value-added objective. Activity-based management supports the robust zero-defect view of quality. 7. ENVIRONMENTAL COST MANAGEMENT Improving environmental quality may actually reduce environmental costs rather than increase them. A. The Benefits of Ecoefficiency Ecoefficiency is the environmental management view that organizations can produce more useful goods and services while simultaneously reducing negative environmental impacts, resource consumption, and costs. Ecoefficiency is supportive of sustainable development, the development that meets the needs of the present without compromising the ability of future generations to meet their own needs. Environmental costs can be a significant percentage of total operating costs and should be reported as a separate classification so managers can assess their impact on firm profitability. B. Environmental Quality Cost Model Environmental costs are costs incurred because poor environmental quality exist s or because poor environmental quality may exist. Four categories of environmental costs are: 1. Environmental prevention costs —costs incurred to prevent damage to the environment, such as the production of contaminants. Examples include designing processes and prod­ucts to reduce contaminants. 2. Environmental detection costs —costs incurred to detect if the firm is in compliance with environmental standards. Three types of environmental standards and procedures are: governmental regulatory laws voluntary standards developed by the International Standards Organization (ISO), and environmental policies developed by management. An example of detection activities includes measuring contamination levels. 3. Environmental internal failure costs — costs incurred after contaminants are produced but before they are introduced into the environment. Examples of internal failure costs include treating and disposing of toxic materials and recycling scrap. 4. Environmental external failure cos s —costs incurred after contaminants are introduced into the environment. Realized external failure costs are external costs the firm has to pay. Unrealized external failure costs (or societal costs) are external costs caused by the firm but paid for by society. An environmental cost report lists the environmental costs by category (prevention, detection, internal failure, and external failure) and as a percentage of operating costs. An environmental financial report lists environmental benefits (such as income from recycling) as well as environmental costs. C. Reducing Environmental Costs Environmental failure costs can be reduced by investing more in prevention and detection activities. This is consistent with the concept that prevention is cheaper than the cure. Cornerstone 7-10: Prepare an Environmental Cost Report See Mowen and Hansen text for demo problems. D. Assigning Environmental Costs Environmental product costs are the environmental costs of processes that produce, market, and deliver products and the environmental postpurchase costs caused by the use and disposal of the product. Activity-based costing facilitates environmental costing. Tracing the environmental costs to the products responsible for those costs is a fundamental requirement of a sound environmental accounting system. Cornerstone 7-11: Calculate Activity-Based Environmental Product Costs See Mowen and Hansen text for demo problems.

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