ACC3200

1. ACC3200 Activity-based Cost Management

2. Learning Objectives • Calculate cost and profit under activity-based costing. • Compare results under traditional volume based costing system and ABC • Describe approaches that can be used in activity-based management

3. 4-3 Traditional Volume-Based Cost Systems Because indirect costs cannot be directly traced to specific products or services, they must be assigned or allocated based on some other observable measure called an allocation base or cost driver. IndirectCosts$$ Cost Driveror Allocation Base IndividualProductsor Services We have used units produced or direct labor hours to assign indirect manufacturing overhead costs to specific products. Units produced and direct labor hours are examples of a volume-based allocation measure.

4. 4-4 Volume-Based Cost Systems Assume that Toyota Motor Manufacturing Kentucky (TMMK) produces three types of automobiles, with the following cost and production information: The purpose of the cost allocation method is to assign the indirect or manufacturing overhead costs to each product.

5. 4-5 Volume-Based Cost Systems The total manufacturing overhead cost for the Kentucky plant is estimated at $3,720,000 (in thousands) per year. In our example, this cost will be assigned to the three products on the basis of direct labor hours. The first step is to calculate the predetermined overhead rate. Predetermined Overhead Rate Estimated TotalManufacturing Overhead CostEstimated Units in the Allocation Base = Predetermined Overhead Rate $3,720,000$15,500 = = $240 per direct labor hour

6. 4-6 Assigning Indirect Cost to Individual Products or Services To assign manufacturing overhead costs to the individual products, we multiply the $240 overhead rate by the number of direct labor hours required for each product. The Camry receives the most total manufacturing overhead cost because it is the highest volume product and thus requires the most total direct labor hours.

7. 4-7 Calculate Total Manufacturing Cost and Profitability To compute total manufacturing cost, we need to add the manufacturing overhead cost to the direct material and direct labor cost, which were provided earlier on a per unit basis. This analysis shows that the Avalon is the most costly of the three models on a per unit basis. The Camry is the next most costly model, followed by the Camry-Hybrid.

8. 4-8 Calculate Total Manufacturing Cost and Profitability If we subtract the total manufacturing cost per unit from the unit sales price, we get the gross margin for each product. Remember that gross margin only takes into account the manufacturing cost of the product, before selling and administrative costs such as distribution fees, advertising, dealer costs and profit, and corporate administration charges have been deducted. The gross margin analysis suggests that the Camry-Hybrid is the most profitable product,

9. 4-9 Activity Based Costing (ABC) Activity Based Costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require.

10. 4-10 Stage 1: Assign Indirect Costs To Activities

11. 4-11 Form Activity Pools and Assign Indirect Costs to Each Pool TMMK has identified the following cost pools: TMMK Manufacturing Overhead Cost Pools MachiningandInstallation MachineSetup ProductEngineering and Design QualityControl

12. 4-12 Form Activity Pools and Assign Indirect Costs to Each Pool Recall that the total manufacturing overhead cost in our Toyota example was $3,720,000 (in thousands). Now we must assign this total cost to one of the four activity cost pools.

13. 4-13 Form Activity Pools and Assign Indirect Costs to Each Pool The general production engineer makes $120,000 per year. Allocation of time worked across the four activity cost pools is as follows: Since the supervisor spends 40% of his time overseeing machining and installation activities, $48,000 (40% x $120,000) should be assigned to that activity cost pool.

14. 4-14 Stage 2: Assign Activity Costs to Individual Products or Services Select an activity cost driver for each of the activity cost pools. A cost driver is a measure of the underlying activity that occurs in each activity cost pool. The goal is to identify a driver that has a cause and effect relationship with the underlying activity. ABC systems include measures that capture something other than the sheer volume of units produced or customers sold. These measures are called nonvolume-based cost drivers.

15. 4-15 Select an Activity Cost Driver for Each Cost Pool Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the activity driver for the set-up activity. Engineering hours will be used as the driver to assign engineering and design costs. Inspection time will be used to assign quality control costs.

16. 4-16 Assign Indirect Costs to Products or Services Based on Activity Demands There are two methods that can be used to assign indirect costs to individual products or services based on their activity requirements: activity rates or activity proportions. The two methods are mathematically equivalent and will provide identical results as long as there are no rounding errors in the rates or proportions. The method used will depend on the type of information provided and whether you have complete information on all product or service lines. Activity Rates Activity Proportions

17. 4-17 Activity Rate Method The activity rate method is very similar to the predetermined overhead rate computed earlier. ActivityRate Total Activity CostTotal Activity Driver Total indirect costs assigned to the machining pool was $825,000, the total machine hours required by each of the three Toyota models is as follows: = $825,00015,000 Activity Rate = = $55 per machine hour

18. 4-18 Activity Rate Method To assign the cost to the products, we multiply the activity rate by the activity requirements of each individual product. 3,000 × $55 = $165,00

19. 4-19 Activity Proportion Method Let's assign the total cost of the set-up activity ($795,000), which will be allocated based on the number of set-ups. A set-up occurs every time the company switches from producing one product to another. Once the set-up activities are complete, a production batch for that specific product is run. The batch size is the number of units produced after each set-up. 100,000 ÷ 250 = 400 400 ÷ 1,000 = 40%

20. 4-20 Activity Proportion Method The allocation of the machine set-up cost to the specific models is shown in the table below.

21. 4-21 Stage 2: Assign Activity Costs to Individual Products or Services To complete the Stage 2 ABC allocations, we need to add up the cost of all four activities for each product line. Notice that the total amount of overhead cost is the same as in the traditional costing example ($3,720,000).

22. 4-22 Stage 2: Assign Activity Costs to Individual Products or Services HOWEVER!!! Under ABC, the Camry-Hybrid receives the highest total overhead allocation, even though it is the lowest volume product. The reason is that this product is produced in small batches and requires a lot of engineering and product design, and quality inspections.

23. 4-23 Stage 2: Assign Activity Costs to Individual Products or Services To calculate the cost per unit, we need to divide the total manufacturing overhead by the number of units of each product.

24. 4-24 Comparison of Volume-Based and Activity Based Cost Systems

25. 4-25 Calculate Total Manufacturing Cost and Gross Margin The ABC analysis shows that the Toyota Camry is the most profitable product, with a 29.4% gross margin, compared to 26% for the Avalon and negative 15.2% for the Camry-Hybrid. $28,000 - $20,730 = $7,270 $5,298 ÷ $18,000 = 29.4%

26. 4-26 Activity Based Management Activity based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. The first step in any improvement program is to target areas that need improvement. What Activities Are Performed? How Much Does it Cost to Perform Each Activity? Does the Activity Add Value to the Customer?

27. 4-27 Activity Based Management In our Toyota example, the ABC analysis revealed that the Camry-Hybrid was much more costly to produce than the other models. If this had been a realistic scenario, what should Toyota managers do with this information? One possibility is for managers to rethink the pricing of the Camry-Hybrid. The price would need to be increased substantially, and it is not clear that customers would be willing to pay that kind of premium.

28. Activity-based Management • Life Cycle Cost Management • TQM • Target Costing • JIT

29. 4-29 Life Cycle Cost Management In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including product introduction, growth, maturity, and eventual decline. Costs tend to be higher. Most revenue earned. In today’s digital and technological age, product life cycles become increasingly short.

30. 4-30 Total Quality Management The second highest cost assigned to the Camry-Hybrid was due to quality control. In managing quality costs, managers must balance four types of quality costs: Prevention costs, Appraisal or inspection costs, Internal failure costs, and External failure costs.

31. 4-31 Target Costing The basic idea behind target costing is to determine what the target cost must be in order to meet the market price and still provide a profit for the company's shareholders. The target cost should reflect all of the costs that are incurred across the entire value chain. In target costing, the price is set by the market based on what consumers are willing to pay for a product or service. Let’s begin to look at target pricing at Toyota by using the following estimates:

32. 4-32 Target Costing The target cost would be computed by subtracting the target profit from the market price, as follows: Market Price $30,000 Target Profit(20% × $30,000)$6,000 TargetCost$24,000 ̶ = The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000). It is important to realize that the target cost includes more than just the manufacturing costs.

33. 4-33 Target Costing Given the target unit cost, how much can Toyota spend on the new model across its entire life cycle and still meet the target profit?

34. 4-34 Target Costing Once the target cost is set, the next step is to determine whether it is feasible to design, develop, manufacture and deliver the product at this target cost. ? Target Cost Design Product DevelopProcess EstimateCost MakeProduct Compare the estimated cost with the target cost to see if cost reduction is necessary. Cost Reduction Goals

35. 4-35 Just-in-Time (JIT) Inventory In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a "demand pull" system, where materials and products are pulled through the manufacturing system based on customer demand. In a traditional manufacturing setting where products are pushed through the system and often end up sitting in inventory. One advantage of a JIT system is that it eliminates problems in product costing associated with holding inventory.

36. 4-36 Summary of ABC and ABM To gain the true benefits of activity based costing, managers must move from simply measuring costs, to find ways to manage or reduce costs. Although ABC and ABM have many potential benefits, these benefits must be weighed against the costs of obtaining the more accurate information. Implementing an ABC can be a difficult task. It requires a great deal of time and effort from many employees across the entire organization.

37. End of Topic 6