Activity-Based Cost Systems

1. Activity-Based Cost Systems Chapter 4

2. Simple Cost Accounting Systems: Ericson Ice Cream Company Example • Ericson had been the low-cost producer of chocolate and vanilla ice cream, with profit margins exceeding 20% of sales • Several years ago Ericson expanded their business by extending their product line into products with premium selling prices

3. Ericson Ice Cream Company Example • Five years ago strawberry ice cream was introduced • The same basic production technology • Could be sold at a price that was 3% higher than for blue and black pens • Last year mocha-almond ice cream was added • Could be sold at a 10% price premium • The controller of Ericson was disappointed with the most recent quarter’s financial results

4. Total Profitability by Product

5. Management’s Concern • The controller wondered whether the company should continue to deemphasize the chocolate and vanilla products and keep introducing new specialty premium flavors • Ericson’s manufacturing manager commented on how the introduction of specialty flavors had changed the production environment

6. Ericson’s Indirect Cost Allocation • Because it was a small company and historically had produced only a narrow range of products, Ericson 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

7. Ericson’s Cost System • Ericson’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

8. Changes in the Production Environment • Direct labor costs have decreased and indirect expenses have increased as a result of automation • As specialty low-volume products were added, Ericson needed: • More scheduling • More setups • More quality control personnel • A computer to track orders and product specifications

9. An Outdated Cost System • Ericson operates with only a single cost center • Even if Ericson used multiple production and service department cost centers, it could still encounter severe distortions in its reported product costs

10. 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 • A complex factory has a much larger production support staff because it requires more people to:

11. Reason for Cost Distortions • Because the factory has the same physical output, it has roughly the same cost of materials • The company’s 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

12. Reason for Cost Distortions • On a per unit basis, high-volume standard flavors require about the same amount of direct labor costs (the allocation basis) as the low volume flavors • The traditional costing system would report essentially identical product costs for all products, standard and specialty, irrespective of their relative production volumes • Clearly, however, considerably more indirect and support resources are required on a per-unit basis for the low-volume specialty products than for the high-volume, standard products

13. 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

14. 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 Traditional v. ABC System

15. Traditional v. ABC System 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

16. Tracing Costs to Activities ABC at Ericson : • 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

17. Indirect Labor Activities • 50% of indirect labor was involved in what the controller called “handle production runs” • 40% of indirect labor actually performed the physical changeover from one flavor to another, an activity that she labeled “perform setups” • 10% of the time was spent on activities the controller called “support products”

18. First Steps in Design of An ABC 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

19. Computer System Expenses 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

20. Computer System Expenses (2 of 2) 80% of the computer resource was involved in the production run activity and seemed to relate well to the “handle production runs” activities

21. 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 ice cream: • The controller labeled this production activity “run machines”

22. Identifying Cost Hierarchies • The four activities for Ericson’s indirect costs represent 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

23. Benefits from first steps in an ABC System The ABC model shifts the focus from what the money was being spent on (labor, equipment, supplies) to what the resources acquired by spending are actually doing

24. From ABC to ABM Operational activity-based management (ABM) - managers use information collected by the ABC system at the activity level to identify opportunities for reducing costs in indirect and support activities

25. Activity Cost Drivers Activity cost drivers represent the quantity of activities used to produce individual products:

26. Completing the ABC Model • Once the activity cost drivers had been determined, the following quantitative information is needed: • The total quantity of each activity cost driver • The quantity of cost driver used by each product

27. Completing the ABC Model • Calculate the activity cost driver rate (ACDR) by dividing the activity expense by the total quantity of the activity cost driver • Multiply the activity cost driver rate by the quantity of each activity cost driver used by each of the four products

28. Activity Cost Drivers

29. Activity Cost Driver Rates (ACDR)

30. Activity Expenses Assigned

31. ABC Profitability Report ABC profitability report: • The results from the activity-based costing system were quite different from the results based on the traditional cost system • 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

32. Total ABC Profitability by Product

33. Using ABC to Improve Profitability • The ABC information provides managers with numerous insights about how to increase the company’s profitability: • Increase either their sales volume or prices for the specialty products • Impose minimum order sizes to eliminate short, unprofitable production runs • Increase demand for the highly profitable standard products

34. Using ABC to Improve Profitability The goal of these ABM actions is to enable the company to produce the same volume and mix of products with fewer resources

35. Problems Implementing ABC Problems may arise in practice from the approach to activity-based costing that assigns many resource expenses to activities based on interviews, surveys, and direct observation of production and support processes because these activities are time-consuming and expensive

36. Problems Implementing ABC • Inaccuracies and bias may affect the accuracy of cost driver rates derived from individuals’ subjective estimates of their past or future behavior • Companies must periodically repeat the interviewing and surveying processes if they want to keep their activity-based cost systems updated • Adding new activities to the system is also difficult, requiring re-estimates of the relative amount of resource time and effort required by the new activity

37. Problems Implementing ABC A more subtle and serious problem arises from the interview or survey process • People estimating how much time they spend on a list of activities handed to them invariably report percentages that add up to 100% • Few individuals report that a significant percentage of their time is idle or unused

38. Measuring The CostOf Resource Capacity • The calculation of activity cost driver rates are sometime based on the capacity actually used • Analysts can obtain a better estimate for the cost of resources required to handle each production run by dividing activity expenses by the practical capacity of work the resources could perform • The cost of unused capacity should not be assigned to products produced or customers served during a period

39. Cost of Unused Capacity • The cost of unused capacity remains someone’s or some department’s responsibility • Usually you can assign unused capacity after analyzing the decision that authorized the level of capacity supplied • Such an assignment is done on a lump-sum basis; it will be treated as a sustaining, not a unit-level, expense.

40. Cost of Unused Capacity • If the unused capacity relates to a particular product line then the cost of unused capacity is assigned to that product line, where the demand failed to materialize • In making assignment of unused capacity costs, trace the costs at the level in the organization where decisions are made that affect the supply of capacity resources and the demand for those resources • The lump-sum assignment of unused capacity costs provides feedback to managers on their supply and demand decisions

41. Measuring The CostOf Resource Capacity • The activity cost driver rate should reflect the underlying efficiency of the process: the cost of resources to handle each production order • This efficiency is measured better by using the capacity of the resources supplied as the denominator when calculating activity cost driver rates • The cost of unused capacity should not be ignored

42. Fixed and Variable Expenses • Most indirect expenses assigned by an ABC system are committed costs • Committed costs become variable via a two-step procedure: • demands for resources change either because of changes in the quantity of activities performed or because of changes in the efficiency of performing activities • managers must make decisions to change the supply of committed resources to meet the new level of demand for the activities performed by these resources

43. Making Committed CostsVariable • After unused capacity has been created, committed costs will vary downward if managers actively reduce the supply of unused resources • A resource cost varies downward if management acts: • To reduce the demands for the resource • To lower the spending on it

44. Activity in Excess of Capacity • If activity volumes exceed the capacity of existing resources, the result is bottlenecks, shortages, increased pace of activity, delays and poor-quality work • Facing such shortages, companies typically make committed costs variable

45. Decreased Demand for Resources • Demands for indirect and support resources also can decline • Even for many unit-level resources reduced demands for work does not immediately lead to spending decreases • The reduced demand for organizational resources lowers the cost of resources used, but this decrease is offset by an equivalent increase in the cost of unused capacity

46. Managers Make Costs Fixed • Organizations often create unused capacity through activity-based management actions • They keep existing resources in place, when demands for the activities performed by the resources have diminished • They also fail to find new activities that could be done by the unused resources already in place

47. Managers Make Costs Fixed • The organization receives no benefits from activity-based management decisions that reduce demands on their resources if capacity is not reduced or redeployed • Failure to capture benefits from activity-based management is not because their costs are “fixed” • The cost of these resources is only “fixed” if managers do not exploit the opportunities from the unused capacity they helped to create • Making decisions based solely upon resource usage may not increase profits if managers are not prepared to reduce spending to align resource supply with future lower levels of demand

48. Time-Driven ABC:An Alternative Approach • Several companies have overcome these problems by using a new approach for estimating their ABC models • Homogeneity assumption: • Most ABC systems use a large number of transactional cost drivers that assume each occurrence of the event (a production run, a customer order, a product to support) consumes the same quantity of resources

49. Time-Driven ABC: • This homogeneity assumption provides the foundation for an alternative approach to estimating cost driver rates. • The new approach requires two new estimates: • The unit cost of supplying capacity, and • The consumption of capacity (unit times) by each activity

50. Unit Cost Estimate The new procedure starts with the same information used by a traditional ABC approach: • The cost of resources that supply capacity and • The practical capacity of the resources supplied