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Activity-Based Cost Management Systems

Activity-Based Cost Management Systems. General concept of Activity-based Costing (ABC). ABC COSTING MODEL. Problems With Simple Cost Accounting Systems: The Cooper Pen Company Example.

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Activity-Based Cost Management Systems

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  1. Activity-Based CostManagement Systems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  2. General concept of Activity-based Costing (ABC)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  3. ABC COSTING MODEL  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  4. Problems With Simple Cost Accounting Systems: The Cooper Pen Company Example • Cooper Pen had been the low-cost producer of blue pens and black pens, with profit margins exceeding 20% of sales • Several years ago Cooper Pen expanded their business by extending their product line into products with premium selling prices  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  5. The Cooper Pen Company Example • Five years ago red pens were introduced • The same basic production technology • Could be sold at a price that was 3% higher than for blue and black pens • Last year purple pens were added • Could be sold at a 10% price premium • The controller of Cooper Pen was disappointed with the most recent quarter’s financial results • Overall profitability for all four together had decreased • The red and purple pens, however, were more profitable than the blue and black pens  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  6. Total Profitability by Product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  7. Concern at Cooper Pen • The controller of Cooper Pen wondered whether the company should continue to deemphasize the blue and black commodity products and keep introducing new specialty colored pens • Cooper’s manufacturing manager commented on how the introduction of colored pens had changed the production environment: • Everything ran smoothly when producing just blue and black pens in long production runs • Difficulties started when the red pens were introduced and required more changeovers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  8. Changes Caused by New Pens (1 of 2) • Making black ink was simple; there was not even a need to clean out the residual blue ink from the previous run if enough black ink was dumped in to cover it up • Red required Cooper to stop production, empty the vats, clean out all remnants of the previous color, and then start the production of the red ink • Even small traces of the blue or black ink created quality problems • The ink for the purple pens also had demanding specifications, though not quite as demanding as the red ink  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  9. Changes Caused by New Pens(2 of 2) • Cooper Pens was also spending more time on purchasing and scheduling activities and keeping track of existing, backlogged, and future orders • Cooper’s manufacturing manager was concerned about rumors that new colors may be introduced in the near future • He did not think they had any more capability to handle additional confusion and complexity in the operations • Last year’s new computer system helped to reduce some of the confusion  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  10. Pen Production At Cooper’s • Pen production at the factory involved: • Preparing and mixing the ink for the different color pens • Inserting the ink into the pens in a semiautomated process • Packing and shipping the pens in a manual stage • Each product had a: • Bill of materials that identified the quantity and cost of direct materials required for the product • Routing sheet that identified the sequence of operations required for each operating step • This information was used to calculate the labor expenses for each of the four products • From this information, it was easy to calculate the direct materials costs and direct labor costs for each color pen  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  11. Cooper’s Indirect Cost Allocation • Because it was a small company and historically had produced only a narrow range of products, Cooper used a simple costing system • All the plant’s indirect expenses were aggregated at the plant level and allocated to products based on each product’s direct labor cost • Currently the cost system’s overhead burden rate was 300% of direct labor cost • Before the new specialty products were introduced, the overhead rate was only 200% of direct labor cost  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  12. Cooper Pen’s Cost System • Cooper’s management accountants designed the system years ago when: • Production operations were mostly manual • Total indirect costs were less than direct labor costs • Cooper’s two products had similar production volumes and batch sizes • Given the high cost of measuring and recording information, the accountants at the time judged correctly that a complex costing system would cost more to operate than the benefits it would provide  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  13. A Changed Production Environment • Direct labor costs have decreased and indirect expenses have increased as a result of automation • As custom low-volume products, such as red and purple pens were added, Cooper needed: • More scheduling • More setups • More quality control personnel • A computer to track orders and product specifications  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  14. An Outdated Cost System • Cooper operates with only a single cost center, the plant • Most complex companies use many cost centers for cost accumulation • Even if Cooper Pen used multiple production and service department cost centers, it could still encounter severe distortions in its reported product costs: • In an environment of high product variety, using only unit-level drivers (such as direct labor costs) to allocate overhead costs to products could lead to product cost distortion  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  15. schedule machine and production runs perform setups inspect produced items after setup move materials ship orders expedite orders rework defective items design new products improve existing products negotiate with vendors schedule materials receipts order, receive, and inspect incoming materials and parts update and maintain the much larger computer-based information system Reason for Cost Distortions (1 of 3) • A complex factory has a much larger production support staff because it requires more people to: • A complex factory generally also operates with higher levels of idle time, setup time, overtime, inventory, rework, and scrap  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  16. Reason for Cost Distortions (2 of 3) • Because the factory has the same physical output, it has roughly the same cost of materials (ignoring the slightly higher acquisition costs for smaller orders of specialty colors and other materials) • Because all pens are about the same complexity, each pen would require the same number of direct labor hours and machine hours to produce • The Cooper Pen Company factory has about the same property taxes, security costs, and heating bills as before, but it has much higher indirect and support costs because of its more varied product mix and complex production tasks  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  17. Reason for Cost Distortions(3 of 3) • On a per unit basis, high-volume standard blue and black pens require about the same amount of direct labor costs (the allocation basis) as the low volume color pens • Therefore, the traditional costing system would report essentially identical product costs for all products, standard and specialty, irrespective of their relative production volumes • This would hold true even if the cost system had multiple production and service cost centers • Clearly, however, considerably more indirect and support resources are required on a per-unit basis for the low-volume, newly designed products than for the high-volume, standard blue and black pens  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  18. Activity-Based Cost Systems • Activity-based cost systems have been developed to eliminate this major source of cost distortion • Activity-based cost (ABC) management systems use a simple two-stage approach similar to but more general than traditional cost systems • The next slide compares the essential elements of the two systems  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  19. Traditional: Uses actual departments or cost centers for accumulating and redistributing costs Asks how much of an allocation basis (usually based on volume) is used by the production department Service department expenses are allocated to a production department based on the ratio of the allocation basis used by the production department ABC: Uses activities, for accumulating costs and redistributing costs Asks what activities are being performed by the resources of the service department Resource expenses are assigned to activities based on how much of the resource is required or used to perform the activities Traditional v. ABC System  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  20. Tracing Costs to Activities • Here’s how an ABC system works, using the Cooper Pen Company as an example: • The controller started an analysis of indirect expenses, beginning with indirect labor • The controller interviewed department heads in charge of indirect labor and found that the people in these departments performed three main activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  21. Indirect Labor Activities (1 of 2) • 50% of indirect labor was involved in what the controller called “handle production runs” • Scheduling production orders • Purchasing, preparing, and releasing materials • Inspecting the first few units produced each time the process was changed to a new-colored pen • 40% of indirect labor actually performed the physical changeover from one color pen to another, an activity that she labeled “perform setups” • Change to Black pens takes 2.4 hours • Change to Red or Purple pens takes 5.6 hours  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  22. Indirect Labor Activities (2 of 2) • 10% of the time was spent on activities the controller called “support products:” maintaining records on the four products, such as: • Making up the bill of materials and routing information • Monitoring and maintaining a minimum supply of raw materials and finished goods inventory for each product • Improving the production processes • Performing engineering changes for the products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  23. First Steps in Design of An ABC System • As she conducted the interviews, the controller was performing the first two steps for designing an activity-based cost system: • Develop the activity dictionary: the list of major activities performed by both the factory’s human and physical resources • Obtain sufficient information to assign resource expenses to each activity in the activity dictionary (50% of indirect labor to “handle production runs,” 40% to “perform setups,” and 10% to “support products”)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  24. Computer System Expenses (1 of 2) • The controller next turned her attention to the $30,000 of expenses needed to operate the company’s computer system and interviewed the manager of the data center and the manager of the management information system department • 20% of computer expenses should be assigned to “support products,” an activity already defined in her activity dictionary, because it was used to keep records on the four products, including: • Production process • Associated engineering change notice information  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  25. Computer System Expenses (2 of 2) • About 80% of the computer resource was involved in the production run activity and seemed to relate well to the “handle production runs” activity already defined: • Schedule production runs in the factory • Order and pay for the materials required in each production run • Since each production run was made for a particular customer, also included in this activity was the computer time required to: • Prepare shipping documents • Invoice a customer • Collect from a customer  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  26. Other Overhead Expenses • There were three remaining categories of overhead expense: • Machine depreciation • Machine maintenance • Energy to operate the machines • These expenses were incurred to supply machine capacity to produce the pens: • A practical capability of 10,000 hours of productive time could be supplied to pen production • The controller labeled this production activity “run machines”  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  27. Identifying Cost Hierarchies • The controller noted that even though she had defined only four activities for Cooper’s indirect costs, they represented the three different levels of the manufacturing cost hierarchy: ACTIVITY COST HIERARCHY RUN MACHINES UNIT LEVEL HANDLE PRODUCTION RUNS BATCH LEVEL SETUP MACHINES BATCH LEVEL SUPPORT PRODUCTS PRODUCT SUSTAINING • Finding at least one activity for each hierarchy level gave her confidence that the complexity of the manufacturing process could be represented well enough by the activity-based cost system  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  28. Benefits from Half an ABC System • The ABC model was only half completed (costs have not yet been driven down to products), yet it had already provided some important insights: • Now the controller could see why Cooper Pens was incurring expenditures for resources instead of seeing categories of expenses • In particular she saw how expensive activities such as handling production runs and setting up machines were • The ABC model shifted the focus from what the money was being spent on (labor, equipment, supplies) to what the resources acquired by spending were actually doing  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  29. From ABC to ABM (1 of 2) • In the past, industrial engineers at Cooper Pen had studied labor and materials usage closely: • These had been the high cost resources • They were also the primary cost categories featured by Cooper’s traditional cost system • The high overhead rate on direct labor seemed to amplify any benefits from direct labor cost savings that the industrial engineers could achieve  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  30. From ABC to ABM (2 of 2) • It would be worthwhile to have industrial engineers study the way Cooper handled and scheduled production runs and how the employees set up machines to uncover new opportunities for cost reduction and process improvement projects • This is an example of operational activity-based management (ABM), where managers use information collected by the ABC system at the activity level to identify opportunities for reducing costs in indirect and support activities  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  31. Tracing Costs From Activities To Products • The controller next turned her attention to understanding the demands for these activities by the four different products • By understanding how products use activities, she would be able to relate the cost of performing activities to individual products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  32. Activity Cost Drivers • Activity cost drivers represent the quantity of activities used to produce individual products • The controller identified the following activity cost drivers for the activities in her activity dictionary:  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  33. Completing the ABC Model (1 of 2) • Once the activity cost drivers had been determined, the controller obtained quantitative information on: • The total quantity of each activity cost driver • The quantity of cost driver used by each product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  34. Completing the ABC Model (2 of 2) • The controller now had sufficient information to estimate a complete activity-based cost model for Cooper Pen’s factory • She calculated the activity cost driver rate (ACDR) by dividing the activity expense by the total quantity of the activity cost driver • She then multiplied the activity cost driver rate by the quantity of each activity cost driver used by each of the four products  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  35. Activity Cost Drivers  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  36. Activity Cost Driver Rates (ACDR)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  37. Activity Expenses Assigned  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  38. ABC Profitability Report • The controller combined the activity expense analysis for each product with their direct materials and labor costs to obtain a new ABC profitability report • The results from the activity-based costing system were quite different from the results based on the traditional cost system • The controller now understood why the profitability of Cooper Pen has deteriorated in recent years: • The two specialty products, which the previous cost system had reported as the most profitable, were in fact the most unprofitable, and losing lots of money • The company had added large quantities of overhead resources to enable these products to be designed and produced, but their incremental revenue did not cover those costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  39. Total ABC Profitability by Product  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  40. Total Profitability by Product (Traditional – Slide 6)  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  41. Using ABC to Improve Profitability (1 of 2) • The ABC information provides managers with numerous insights about how to increase the profitability of Cooper Pen: • Increase either their sales volume or prices to compensate for the large batch and product-sustaining expenses of the red and purple pens • Impose minimum order sizes to eliminate short, unprofitable production runs • Try to increase demand for the highly profitable black and blue pens, which could generate new revenues that exceed their incremental costs  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  42. Using ABC to Improve Profitability (2 of 2) • Improve processes, particularly the processes performing batch and product-sustaining activities • Manufacturing personnel can redirect their attention: • From trying to run their production equipment faster, in order to improve the performance of unit-level activities • To learning how to reduce setup times, in order to improve the performance of batch-level activities so that small batches of the specialty products would require fewer resources to produce and be less expensive • The goal of these ABM actions is to enable the company to produce the same volume and mix of products with fewer resources • This leads to lower costs for producing low-volume, specialty products, and reduces the pressure to raise prices or impose minimum order sizes on customers in order to make such products profitable  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

  43. The Past Small number of products which did not differ much in required manufacturing support. Labor was dominant element in the cost structure. The Present Numerous products with more and complicated production requirements. Labor is becoming an ever smaller part component of total production costs. ABC: Some Key Issues

  44. Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider . . . Degree of Correlation Behavioral Effects Cost of Measurement

  45. Homogeneous Activity Cost Pools A homogeneous cost pool is a grouping of overhead costs in which each cost component is consumed in roughly the same proportion by each product line. A homogeneous cost pool uses a single cost driver.

  46. Transaction Costing Transaction processing provides a readily measurable gauge of departmental activity. Usually Result In Activities Paperwork!!!

  47. Storyboarding A procedure used to develop a detailed process flow chart, which visually represents activities and the relationships among activities. Step 1 These are the steps we follow to build a memory board. Step 2 Step 3 Step 4

  48. Volume-Based Costing All production costs except direct materials and direct labor are lumped together in one overhead cost pool. Activity-Based Costing An effort is made to account for as many costs as possible as direct costs of production. Direct versus Indirect Costs Indirect Costs

  49. Indicators of Need for ABC Direct labor is a small percentage of total costs. Product-line profit margins are hard to explain. Line managers do not believe the product cost reports. Sales are increasing, but profits are declining. Some products that have reported high profit margins are not sold by competitors. Marketing does not use costs reports for pricing decisions.

  50. Selecting Activity Cost Drivers (1 of 2) • Activity cost drivers are the central innovation of activity-based cost systems • They are also the most costly to measure • Particularly the quantity of each activity cost driver used by each product • Accordingly, it is important to understand the issues involved in selecting activity cost drivers • The selection of an activity cost driver reflects a subjective trade-off between accuracy and the cost of measurement • An ABC system with 50 activity cost drivers and 2,000 products would require that 100,000 data elements be estimated  2003 Prentice Hall Business Publishing, PowerPoint supplement to Management Accounting, 4rd ed., Atkinson, Kaplan, and Young, prepared by Terry M. Lease, Ph.D., CPA, Sonoma State University

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