Chapter 5

Activity

a specific task or action of work done

ABC is a method for improving the

accuracy of cost determination .

Ideally, the cost of resources is directly

traced or assigned to activities, which requires measuring the actual usage of resources by . an activity -when not available, department managers and supervisors need to estimate the amount or percentage of time employees spend on each identified activity

Typical resource consumption cost drivers include

# of labor hours for labor intensive activities # of employees for payroll-related activities # setups for batch related activities # of moves for materials-handling activities # of machine hours for machine repair and maintenance # square feet for general maintenance and cleaning activities

Step 2 in developing an ABC system--> Assign Resource Costs to Activities

-Activities drive the consumption of resources, so the next step is to use resource consumption drivers to assign resource costs to activities -cost drivers should be based on cause and effect relationshops

Step 3 in developing an ABC system--> Assign Activity Costs to Cost Objects

-assign costs of activities to items of interest (cost objects) based on the appropriate activity consumption cost drivers --cost objects are usually products or services

Benefits of ABC

-clearly shows the effect of difference in activities and changes in products or service on costs -accurate costs -will give us most accurate cost informaiton --needed for pricing decisions --important for profitability --better for cost control--> helps minimize costs

Categories of customer costs

-customer unit-level cost -customer batch-level cost -customer sustaining costs -distribution channel cost -sales-sustaining cost

Step 1 in developing an ABC system--> Identify Resource Costs and Activities

-determine which of the resources in each of the accounts is consumed by the identified activities

Examples of customer specific activities include

-order processing costs -billing, collection and payment processing costs -accounts receivable and carrying costs -customer service costs -selling and marketing costs

The ABC Two Stage Cost Assignment is likely to

-provide more accurate measures of product or service costs for the cost of activities that are not proportional to the volume of outputs produced -define cost pools as activities rather than product plant or departmental cost centers -cost drivers are based on an activity performed for the cost object

Customer-sustaining costs

-resources consumed to service a customer regardless of the number of units or batches sold, such as monthly statement processing costs and collection costs for late payments and salespersons' travel costs to visit customers

ABC Hierarchy of Activities (Level of Activities)

-to identify resource costs for various activities, a firm classifies all activities according to the . way in which the activities consume resources -unit level -batch . level -Product level -facility level

Steps in developing and Activity Based Costing System

1.) Identifying resource costs and activities 2.) Assigning resource costs to activities 3.) Assigning activity costs to cost objects

Major Benefits of ABC

1.)Better, profitability measures→ leads to more accurate product and customer profitability measurements 2.)Better decision making→ ABC provides more accurate measurements of activity-driving costs helping managers to improve product and process value through decision making 3.)Process Improvement→ provides the information to identify areas where process improvement is needed 4.)Improved Planning→ improved product costs lead to better estimates of costs for budgeting and planning 5.)Cost of unused capacity→ since many firms have seasonal and cyclical fluctuations in sales and production, there are times when plant capacity is supplied but not used ---Costs are incurred at batch-, product-, and facility-level activities but are not used ---Provide better information to identify the cost of unused capacity and maintain a separate accounting for this cost ---The goal is to manage capacity levels to reduce the cost of underutilization of capacity and to price products and services properly

resource consumption accounting

A comprehensive and fully integrated management accounting approach that provides managers with decision support information based on operational view of the organization

Customer Level Activities

Activities performed to appease the customer -customer is the cost driver -can help see what customers are profitable and worth the cost

Two Stage Cost Assignment- Activity Based Costing

-Differs from volume based costing systems by linking uses of resources to activities and linking activity costs to products, services or customers First Stage--assigns factory overhead costs to activities by using appropriate resource consumption cost drivers Second Stage--assigns the costs of activities to cost objects using appropriate activity consumption cost drivers that measure the demands cost objects for the activities

Set-Ups

-a batch level cost activity -will have to switch between different set-ups to produce slightly different products -these costs are fixed in the short run--> they will be . the same for small batches as large batches -Wedding Invitations--> even if you order 10, the set up cost will be same as if you ordered 100

Activity Based Costing

A costing approach that assigns resource costs to cost objects based on activities performed for the cost objects

Two-Stage Cost Assignment

A procedure that assigns a . firm's resource costs to cost pools and then to cost objects

Batch-Level Activity

An activity performed for each batch of products or services performed for each batch or group of units of products or services -setting up machines, placing purchase orders, scheduling production, conducting inspections by batch, handling materials and expediting production -can always be traced to a product -quality testing is batch level--> chemical plants produce products in large batches

Unit-Level Activity

An activity performed for each unit of the cost object -required for each unit produced, so the activity level varies in direct proportion to the quantity of the cost object produced --said to be volume based and can always be traced to a batch -As volume increases, so does output activity

Facility-level activities

An activity performed to support operations of products in general - providing security for the plant, performing maintenance of general purpose machines and incurring factory property taxes and insurance -Assigning costs is difficult -some companies don't assign these costs, some do but know the allocation has flaw

Product-Level Activity

An activity performed to support the production of a specific product or service -designing products, purchasing parts required for products and engaging in engineering changes to modify products -can usually be traced to a manufacturing facility Activity performed for different products to develop and sustain marketability -redesigning cars, computers and phones--> Apple makes a slightly different version of the iPhone every few years -Assigning the engineering costs

Two Stage Cost Assignment--Volume Based Costing

First Stage--> the factory overhead costs are combined into a single plant cost pool or several departmental cost pools Second Stage--> a volume based rate is then used to apply overhead to each fo the cost objects

Activity Consumption Cost Driver

Measures how much of an activity a cost object uses -are the number of machine hours in the manufacturing of product X, or the number of batches used to manufacture product Y

High-Value Added Activity

Something that, in the eyes of the consumer, adds value to a product or service

Multistage ABC

The assignment of resource costs to certain activities which in turn are assigned to other activities before assigned to the final cost objects

Cost Driver

a factor that causes or relates to a change in the cost of an activity

The solution to VBC is to use ABC to

charge these indirect costs to the products using detailed information on the activities that make up the indirect costs inspection

Volume Based Costing can be a good strategic choice for some firm and is appropriate when

common costs are relatively small or when activities supporting the production of the product or service are relatively homogenous across different product lines

Low-Value-Added Activity

consumes time, resources or space but adds little to satisfying customer needs

Customer Profitability Analysis combines

customer revenues and customer costa analyses to asses customer profitability and helps identify . actions to improve customer profitability

ABC is best known for its application in computing product costs, but firms also fin it useful in

determining the cost of serving customers and as a basis fore evaluating the profitability of a specific customer or group of customers --> most managers agree that 80% of their profits come from the top 20% of their customers and the bottom 20% of their customers are unprofitable

Customer Cost Analysis

identifies cost activities and cost drivers related to servicing customers --these costs are hidden in the customer support, marketing and sales function

If a company decides to charge three product managers a "fair-share" of the total indirect costs using the proportion of units produced in a manager's area relative to the total units produced, it is using

the Volume Based Approach -Will result in some managers being overcharged and others undercharged

Time-Driven Activity-Based Costing

the assignment of resource costs directly to cost objects using the cost per time unit of supplying the resource, rather than first assigning costs to activities and then from activities to cost objects

Customer Lifetime Value

the net present value of all estimated future profits from a given customer

The Two Stage Cost Assignment Procedure assigns resource costs such as factory overhead costs to activity cost pools and then

to cost object to determine the amount of resource costs for the cost objects

Customer Profitability analysis provides

valuable information to the assessment of customer value

In customer profitability analysis, firms must

weigh other relevant factors before determining the actions appropriate for each customer --Growth potential of the customer, the customer's industry and its cross-selling potential --Possible reactions of the customer to changes in sales terms or services --Importance of having the firm as a customer for future sales references, especially when the customer could play a pivotal role in bringing in additional business

The VBC Two Stage Cost Assignment is likely to distort product or service costs because

all products or services do not usually consume factory overhead resources in proportion to the volume-based measure the firm uses to assign factory overhead costs -often leads to inaccurate measures for the costs of support activities in its operation

resource consumption cost driver

an activity or characteristic that consumes resources -number of items in a purchase or sales order, changes in product design and square feet to occupied space

Resource

an economic element applied or used to perform activities

In ABC, costs of resources are assigned to activities based on the activities

that use or consume resources and costs of activities are assigned to cost objects based on activities performed for the cost objects

Customer Profitability Analysis

identifies customer service activities, cost drivers and the profitability of individual customers or customer groups -customer service includes all activities to complete the sale and satisfy the customer -allows managers to --identify most profitable customers --manage each customer's costs-to-serve --introduce profitable new products and services --discontinue unprofitable products, services or customers --shift a customer's purchase mix toward higher-margin products and service lines --offer discounts to gain more volume with low costs-to-serve customers --choose types of after-sale service to provide

ABC is a costing system that

identifies which activities that consume resources and assigns resource costs to cost objects such as products, services or intermediate cost pools based on activities performed for the cost objects

ABC assigns factory overhead costs to cost objects such as products or service by

identifying the resources anc activities as well as their costs and amounts needed to produce output

The Volume Based method provides

little incentive for the manager to control indirect costs

Customer batch-level costs

resources consumed for each sales transaction, such as order-processing costs or invoicing costs

Customer unit-level costs

resources consumed for each unit sold to a customer, such as sales commissions and shipping costs based on units sold or shipped

Distribution channel costs .

resources consumed in each distribution channel the firm uses to service customers, such as the cost of operating a regional warehouse or centralized distribution center

Sales-sustaining costs

resources consumed to sustain sales and service activities that cannot be traced to an individual unit, batch, customer, or distribution channel, such as general corporate marketing expenditures and the salary, fringe benefits and bonus of general sales managers