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Activity-Based Cost Management Systems. Chapter 5. Introduction. Jonathan Kellogg is the owner and CEO of Booth Motors. Booth Motors is an automobile dealership with four other lines of business. Used cars Parts Service Finance and insurance. Introduction.

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introduction
Introduction
  • Jonathan Kellogg is the owner and CEO of Booth Motors.
  • Booth Motors is an automobile dealership with four other lines of business.
  • Used cars
  • Parts
  • Service
  • Finance and insurance
introduction1
Introduction
  • Kellogg felt that as one of the largest auto dealerships in the Midwest, Booth should be earning much more than one percent pre-tax margin on sales.
  • The existing accounting system allocates operating expenses to each department based on sales.
learning objectives
Learning Objectives
  • Understand how traditional cost systems, using only unit-level drivers, distort product and customer costs.
  • Describe why factories producing a more varied and complex mix of products have higher costs than factories producing only a narrow range of products.
learning objectives1
Learning Objectives
  • Design an activity-based cost system by linking resource costs to the activities performed and then to cost objects, such as products and customers.
  • Appreciate the role for choosing appropriate activity cost drivers when tracing activity costs to products and customers.
learning objectives2
Learning Objectives
  • Use the information from a well-designed activity-based cost system to improve operations and make better decisions about products and customers.
  • Understand the importance of measuring the practical capacity of resources and the cost of unused capacity.
learning objectives3
Learning Objectives
  • Assign marketing, distribution, and selling expenses to customers.
  • Analyze customer profitability.
  • Appreciate the role for activity-based cost systems for service companies.

10Discuss the barriers for implementing activity-based cost systems and how these might be overcome.

learning objective 1
Learning Objective 1

Understand how traditional cost systems, using only unit-level drivers, distort product and customer costs.

traditional manufacturing costing systems
Traditional Manufacturing Costing Systems
  • Traditionally, job-order and process costing systems have assigned direct labor and direct materials costs to products.
  • Indirect costs were accumulated as support department expenses.
  • These expenses were allocated to production departments in a simple proportion.
traditional manufacturing costing systems1
Traditional Manufacturing Costing Systems
  • Historically, Cooper Pen had been a low cost producer of BLUE and BLACK pens.
  • Recently, these product lines have expanded into two new products.
  • The plant’s indirect expenses, about $180,000 per quarter, were aggregated at the plant level and allocated to products based on direct labor.
traditional manufacturing costing systems2
Traditional Manufacturing Costing Systems
  • The overhead burden rate was 300% of direct labor costs.
  • The controller of Cooper Pen Company wondered whether they should continue to de-emphasize their commodity products, and to keep introducing the new specialty colored pens.
traditional manufacturing costing systems3
Traditional Manufacturing Costing Systems

Production Return

Sales Volumeon Sales

Blue 50,000 13.6%

Black 40,000 13.3%

Red 9,000 14.8%

Purple 1,000 18.2%

Total 100,000 13.5%

traditional manufacturing costing systems4
Traditional Manufacturing Costing Systems
  • Traditional costing systems distort product costs.
  • They use unit level drivers, such as direct labor dollars, for allocating production center expenses to products.
learning objective 2
Learning Objective 2

Describe why factories producing a more varied and complex mix of products have higher costs than factories producing only a narrow range of products.

simple and complex factories
Simple and Complex Factories
  • A simple factory has little need for a cost system to calculate the cost of its product.
  • A complex factory requires many resources to support a highly varied product mix.
  • Complex factories require a cost accounting system to trace expenses to its various products.
simple and complex factories1
Simple and Complex Factories
  • Traditional cost systems will under-estimate the cost of resources required for specialty, low-volume products.
  • These systems will over-estimate the resource cost of high volume, standard products.
  • Activity-based cost systems have been developed to eliminate this source of cost distortion.
learning objective 3
Learning Objective 3

Design an activity-based cost system by linking resource costs to the activities performed and then to cost objects, such as products and customers.

activity based cost management systems1
Activity-Based Cost Management Systems
  • Activity-based cost-management systems trace indirect and support expenses accurately to individual products, services, and customers.
  • ABC systems use a simple two-stage approach similar to traditional cost systems.
  • However, instead of using cost centers for accumulating costs, it uses activities.
activity based cost management systems2
Activity-Based Cost Management Systems
  • What do managers do in an activity-based management?
  • Managers use information collected by the ABC system at the activity level to identify promising opportunities for reducing costs in indirect and support activities.
  • The controller of Cooper Pen Company developed an activity-based cost system.
activity based cost management systems3
Activity-Based Cost Management Systems
  • How are overhead rates determined under activity-based costing?
  • Identify the activities performed.
  • Determine the cost of performing each activity.
  • Identify a cost driver for each activity.
activity based cost management systems4
Activity-Based Cost Management Systems
  • Determine the number of units of the cost driver made available by the resources committed to each activity.
  • Divide the activity cost by the number of cost driver units made available to determine the activity overhead rate.
activity based cost management systems5
Activity-Based Cost Management Systems
  • What is an activity dictionary?
  • It is the list of the major activities performed by an organization’s resources.
tracing costs to activities
Tracing Costs to Activities
  • ABC allocation procedures trace all overhead costs to activity cost pools.

Run Machines

Setup

Machines

Handle

Production Runs

Support

Products

tracing costs to activities1
Tracing Costs to Activities
  • What are examples of production activities?

Unit-Related

Product

Sustaining

Batch-Related

Facility

Sustaining

tracing costs to activities2
Tracing Costs to Activities

Indirect Labor Computer Activity

Activity & 1/2 fringe Expense Expense

Handle

Production

Runs 50% 80% $ 66,000

Setup

Machines 40% $ 33,600

Support

Products 10% 20% $ 14,400

Total Expense $84,000 $30,000 $114,000

tracing costs to activities3
Tracing Costs to Activities

ActivityDepreciation Maintenance Energy

Run

Machines 100% 100% 100%

Total

Expense $24,000 $12,000 $6,000

learning objective 4
Learning Objective 4

Appreciate the role for choosing appropriate activity cost drivers when tracing activity costs to products and customers.

tracing costs from activities to products
Tracing Costs From Activities to Products
  • Activity cost drivers identify the linkage between activities and cost objects.
  • What are some examples of cost objects?
  • products
  • services
  • customers
tracing costs from activities to products1
Tracing Costs From Activities to Products
  • What is an activity cost driver?
  • It is a unit of measurement for the level (or quantity) of the activity performed.
  • What is a cost driver rate?
  • It is a rate obtained by dividing the activity expense by the total quantity of the activity cost driver.
tracing costs from activities to products2
Tracing Costs From Activities to Products
  • What are some examples of cost drivers?

Handle

Production Runs

Production Runs

Support Products

Number of

Products

Setup Machines

Setup Hours

Run Machines

Machine Hours

tracing costs from activities to products3
Tracing Costs From Activities to Products

Activity Activity Cost Driver

Activity Expense Driver Rate

Handle Number

Production of Runs $440

Runs $ 66,000 150

Setup Number of

Machines $ 33,600 Setup Hours $63.88

526

Support Number of

Products $ 14,400 Products $3,600

4

tracing costs from activities to products4
Tracing Costs From Activities to Products

Activity Activity Cost Driver

Activity Expense Driver Rate

Run Number of

Machines $42,000 Machine $4.20

Hours

10,000

tracing costs from activities to products5
Tracing Costs From Activities to Products

Driver Activity Cost Blue

Activity Rate Driver Quantity Total

Handle

Production $440 50 $22,000

Runs

Setup

Machines $63.88 200 $12,776

Support

Products $3,600 1 $3,600

tracing costs from activities to products6
Tracing Costs From Activities to Products

Driver Activity Cost Blue

Activity Rate Driver Quantity Total

Run

Machines $4.20 5,000 $21,000

Total Activity Expense Blue = $56,376

learning objective 5
Learning Objective 5

Use the information from a well-designed activity-based cost system to improve operations and make better decisions about products and customers.

product profitability
Product Profitability

Blue

Operating

Income

$48,624

Black

Operating

Income

$40.806

Red

Operating

Income (Loss)

($18,414)

Purple

Operating

Income (Loss)

($9,906)

product profitability1
Product Profitability
  • What is a bill of activities?
  • It is the set of activities and their costs associated with individual products.
  • What is strategic activity-based management?
  • ABM involves decisions on pricing, distribution, product design, and minimum order sizes so that loss products can become profitable.
activity based cost systems
Activity-Based Cost systems
  • Activity cost drivers are the central innovation of activity-based cost systems.
  • They are also the most costly aspects of ABC systems.
  • The selection of an activity cost driver reflects a subjective trade-off between accuracy and the cost of measurement.
activity based cost systems1
Activity-Based Cost systems
  • ABC system designers can choose from three different types of activity cost drivers.
  • Transaction
  • Duration
  • Intensity
activity based cost systems2
Activity-Based Cost systems
  • Transaction drivers count how often an activity is performed.
  • What are some examples?
  • number of setups
  • number of receipts
  • number of products supported
activity based cost systems3
Activity-Based Cost systems
  • Duration drivers represent the amount of time required to perform an activity.
  • What are some examples?
  • setup hours
  • inspection hours
  • direct labor hours
activity based cost systems4
Activity-Based Cost systems
  • Intensity drivers directly charge for the resources used each time an activity is performed.
  • What are some examples?
  • actual time
  • specific resources committed
  • Intensity drivers may be simulated with a weighted index approach.
activity based cost systems5
Activity-Based Cost systems
  • What is the goal of a properly constructed ABC system?
  • The goal is to have a cost system that balances the cost of errors made from inaccurate estimates with the cost of measurement.
learning objective 6
Learning Objective 6

Understand the importance of measuring the practical capacity of resources and the cost of unused capacity.

measuring the cost of resource capacity
Measuring the Cost of Resource Capacity
  • Practical capacity represents the maximum output that could be handled efficiently.
  • The activity cost driver rate should reflect the underlying efficiency of the process.
measuring the cost of resource capacity1
Measuring the Cost of Resource Capacity
  • How should the activity cost driver rate be computed?
  • The numerator represents the cost of supplying resource capacity to do work.
  • The denominator should match the numerator by representing the quantity of work the resources can perform.
measuring the cost of resource capacity2
Measuring the Cost of Resource Capacity
  • What is the cost of unused capacity?
  • It is the cost of capacity available but not utilized.
  • There are two ways for organizations to actively manage unused capacity.
  • Increase the volume of business.
  • Reduce the supply of unused resources.
learning objective 7
Learning Objective 7

Assign marketing, distribution, and selling expenses to customers.

marketing selling and distribution expenses
Marketing, Selling, and Distribution Expenses
  • The costs of marketing, selling, and distribution expenses have been increasing rapidly.
  • Many of these expenses do not relate to individual products or product-lines.
  • These expenses are associated with individual customers, market segments, and distribution channels.
marketing selling and distribution expenses1
Marketing, Selling, and Distribution Expenses
  • What are examples of marketing, selling, and distribution activities?

Travel to

Customers

Provide Marketing

and Technical Support

Distribute Sales

Catalog

Warehouse Inventory

for Customers

Service

Customers

marketing selling and distribution expenses2
Marketing, Selling, and Distribution Expenses
  • What are examples of activity cost drivers?

Actual Expenditures

Quantity of Inventory

and space required

Number of Mailings

Time Spent

on Customers

learning objective 8
Learning Objective 8

Analyze customer profitability.

customer profitability
Customer Profitability

More

profitable

customers

Types of Customers

Profits

Costly to serve, pay top dollar

  • Passive:
  • Product is crucial
  • Good supplier
  • match

Net ABC Margin Realized

Price-sensitive

and few

special demands

  • Aggressive:
  • Leverage their
  • buying power
  • Low price, lots of
  • customized service

Low

Cost to Serve

Hi

learning objective 9
Learning Objective 9

Appreciate the role for activity-based cost systems for service companies.

service companies
Service Companies
  • Why are service companies ideal candidates for activity-based costing?
  • The majority of their costs are indirect and appear to be fixed.
  • The variable cost is essentially zero.
service companies1
Service Companies
  • Why do service companies need to identify the differential profitability of individual customers?
  • Because the variation in demand for organizational resources is much more customer-driven than in manufacturing organizations.
learning objective 10
Learning Objective 10

Discuss the barriers for implementing activity-based cost systems and how these might be overcome.

barriers to implementing abc
Barriers to Implementing ABC
  • What are some of the barriers to implementing ABC systems?
  • Lack of clear business purpose
  • Lack of senior management commitment
  • Delegating the project to consultants
  • Poor ABC model design
  • Individual and organizational resistance to change
conclusion
Conclusion
  • Jonathan Kellogg and his controller developed an activity-based cost model of Booth Motors.
  • They identified activities for three of the product lines.
  • New Vehicle Department
  • Finance & Insurance
  • Service
conclusion1
Conclusion
  • What did the product line analysis show?
  • Profits from financing and insuring new and used cars accounted for nearly 50% of total dealer profitability.
  • The profitable car line had the lowest average days on lot.
  • Seemingly, most popular car lines were unprofitable.