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Chapter 4

Chapter 4. Activity-Based Cost Management Systems. 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

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Chapter 4

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  1. Chapter 4 Activity-Based Cost Management Systems

  2. 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

  3. 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 forblue 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

  4. Total Profitability by Product

  5. Concern at Cooper Pen • whether the company should continue to deemphasize the blue and black commodity products and keep introducing new specialty colored pens • 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

  6. Cooper'5 Indirect Cost Allocation • 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

  7. Cooper Pen's Cost System • 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

  8. 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

  9. 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

  10. Traditional v. ABC System 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 cost. • Asks what activities are being performed by the resources of the service department • Resource expense. ere assigned to activities based on how much of the resource i. required or used to perform the activities

  11. Tracing Costs to Activities • Here's how an ABC system works, using the Cooper Pen Company as an example: • 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

  12. Indirect Labor Activities (1of2) • 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

  13. Indirect Labor Activitie5 (2of2) • 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 or materials and routing information • Monitoring and maintaining a minimum supply or raw materials and finished goods inventory for each product • Improving the production processes • Performing engineering changes for the products

  14. 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: 1) Develop the activity dictionary: the list of major activities performed by both the factory's human and physical resources 2) 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")

  15. Computer System Expenses (1of2) • 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

  16. Computer System Expenses (2of2) • 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

  17. 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"

  18. 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: ACTIVITYCOST 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

  19. 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

  20. From ABC to ABM (1of2) • 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

  21. From ABC to ABM (2of2) • 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

  22. 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

  23. 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:

  24. Completing the ABC Model (1of2) • 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

  25. Completing the ABC Model (2of2) • 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

  26. Activity Cost Drivers

  27. Activity Cost Driver Rates (ACDR)

  28. Activity Expenses Assigned

  29. 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 or 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

  30. Total ABC Profitability by Product

  31. Using ABC to Improve Profitability (1of2) • 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

  32. Using ABC to Improve Profitability (2of2) • 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 or unit-revel activities • To reaming how to reduce setup times, in order to improve the performance or batch-Level activities so that small batches or the specialty products would require fewer resources to produce and be less expensive • The goal or 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 row-volume, specialty products, end reduces the pressure to raise prices or impose minimum order sizes on customers in order to make such products profitable

  33. Selecting Activity Cost Drivers (1of2) 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

  34. Selecting Activity Cost Drivers (2of2) • Because or the large number or potential activity-to-product linkages, management accountants attempt to economize on the number or different activity cost drivers • Activities triggered by the same event may all use the same activity cost driver • For example, preparing production orders, scheduling production runs, performing first part inspections, and moving materials may all use the number of production runs • ABC system designers choose from three different types or activity cost drivers: • Transaction • Duration • Intensity (direct charging) • The choice or a transaction, duration, or intensity cost driver can occur for almost any activity

  35. Transaction Drivers • Least expensive type of cost driver • Also the least accurate • They assume that the same quantity of resources is required every time an activity is performed • For example, a transaction driver such as the number of setups assumes that all set-ups lake about the same time to perform • For many activities. the variation in the quantity of resources used by each is small enough that a transaction driver will be fine for assigning activity expenses to the cost object • E.g., all setup times are between 30 and 35 minutes • If the amount of resources required to perform the activity varies considerably from product to product then more accurate and more expensive types of cost drivers should be used • E.g., Setup times range from 30 minutes to 6 hours

  36. Duration Drivers • Represent the amount or time required to perform an activity • Should be used when significant variations exist in the amount of activity required for different outputs • A transaction driver such as number or setups will overcost the resources required to set up simple products and undercost the resources required for complex products • More expensive to implement because they require an estimate or time needed each time an activity is performed • The choice between a duration driver and a transactional driver is, as always, one of economics: • Balancing the benefits of Increased accuracy against the costs of increased measurement

  37. Intensity Drivers • Directly charge for the resources used each time an activity is performed • A duration driver, such as setup cost per hour, assumes that all hours are equally costly but does not reflect the higher costs that may be required on some setups: • E.g., extra personnel, more skilled personnel, more expensive machinery • Activity costs may have to be charged directly to the output, based on work orders or other records that accumulate the activity expenses incurred for that output • Intensity drivers are the most accurate activity cost drivers but the most expensive to implement • Intensity drivers should be used only when the resources associated with performing an activity are both expensive and variable each time an activity is performed unless the measurements are inexpensive

  38. Designing an ABC System (1of2) • Sometimes ABC system designers get carried away with the potential capabilities of an activity-based cost system • For product costing and customer costing purposes, most companies: • Limit their activity dictionary to 30 to 50 different activities • Choose activity cost drivers that can be obtained simply and are available within their organization's existir1g information system

  39. Designing an ABC System (2of2) • The goal of an ABC system should be to have the best cost system -not the most accurate one • The ABC system designer should balance the cost of errors resulting from inaccurate estimates with the cost of measurement • Most of the benefits from a more accurate cost system can be obtained with simple ABC systems

  40. Measuring The Cost Of Resource Capacity (1of2) • 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 • Otherwise, the activity cost driver rates overestimate the cost of the activity provided • The cost of unused capacity should not be assigned to products produced or customers served during a period

  41. Measuring The Cost Of Resource Capacity (2of2) • 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 • Still, the cost of unused capacity should not be ignored

  42. Cost of Unused Capacity (1of2) • 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 lever of capacity supplied • For example, it the capacity was acquired to meet anticipated demands from a par1icular customer or a particular market segment, then the costs of unused capacity due to lower than expected demands can be assigned to the person or organizational unit responsible for that customer or segment • Such an assignment is done on a lump-sum basis; it will be treated as a sustaining, not a unit-Ievel, expense.

  43. Cost of Unused Capacity (2of2) • 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 • Unused capacity should not be treated as a general cost, to be shared across all product lines • In making assignment of unused capacity costs, we 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

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

  45. Activity in Excess of Capacity • If activity volumes exceed the capacity or existing resources, the result is • Bottlenecks • Shortages • Increased pace of activity • Delays • Poor-quality work • Such shortages occur often on machines, but can also occur in human resources who perform support activities • Facing such shortages. companies typically make committed costs variable • They relieve the bottleneck by spending more to increase the supply of resources to perform work • This is why many indirect costs increase over time

  46. Decreased Demand for Resources • Demands for indirect and support resources also can decline • Consciously through activity-based management • Inadvertently through competitive or economy-wide forces that lead to declines in sales • Should the demands for batch and product-sustaining resources decrease, few immediate spending reductions will be noticed • Even for many unit-Ievel resources, such as machines and direct labor, 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

  47. Making Committed Costs Variable Downward • After unused capacity has been created, committed costs will vary downward if, and only if, managers actively reduce the supply of unused resources • What makes a resource cost "variable" downward is not inherent in the nature of the resource • It is a function of management decisions • To reduce the demands for the resource • To lower the spending on it

  48. Managers Make Costs Fixed (1of2) • Organizations often create unused capacity through activity-based management actions • Process improvement • Repricing to modify the product mix • Imposing minimum order sizes on customers • 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

  49. Managers Make Costs Fixed (2of2) • The organization receives no benefits from its activity- based management decisions that reduced the demands on their resources if capacity is not reduced or redeployed • The failure to capture benefits from activity-based management is not because their costs are “fixed” • The failure occurs because managers are unwilling or unable to take advantage of the unused capacity they have created by • Spending less on capacity resources • Increasing the volume of work processed by the capacity resources • 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 (the ABC system) may not increase profits if managers are not prepared to reduce spending to align resource supply with future lower levels of demand

  50. Problems Implementing ABC (1of3) • Several problems arise in practice from the common approach to activity-based costing that assigns many resource expenses to activities based on interviews, surveys. and direct observation of production and support processes • The interview and survey processes are time consuming and costly • This front-end cost to an ABC analysis is often a barrier to widespread ABC adoption

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