those factors that are the root causes of activity costs. For instance, an analysis may reveal that the root cause of the cost of moving materials is plant layout. Once the root cause is known, then action can be taken to improve the activity. Specifically, reorganizing plant layout can reduce the cost of moving materials.
Often the root cause of the cost of an activity is also the root cause of other related activities. For example, poor supplier quality may be the root cause of both the costs of inspecting purchased parts (output measure number of inspection hours) and reordering (output measure number of reorders). By implementing total quality management and a supplier evaluation program, both activities and the procurement process itself may be improved.
Activity Analysis: Identifying and Assessing Value Content
The heart of process value analysis is activity analysis. Activity analysisis the process of identifying, describing, and evaluating the activities an organization per- forms. Activity analysis should produce four outcomes: (1) what activities are done, (2) how many people perform the activities, (3) the time and resources required to perform the activities, and (4) an assessment of the value of the activities to the organization, including a recommendation to select and keep only those that add value. Steps 1–3 have been described in Chapter 4. Those steps were critical for assigning costs. Step 4, determining the value-added content of activities, is con- cerned with cost reduction rather than cost assignment. Therefore, some feel that this is the most important part of activity analysis. Activities can be classified as value-addedornon-value-added.
Value-Added Activities
Those activities necessary to remain in business are calledvalue-added activities. Some activities—required activities—are necessary to comply with legal mandates. For example, RTP, Inc., is a public company. All the activities that RTP must do to comply with the reporting requirements of the Securi- ties and Exchange Commission and the filing requirements of the Internal Revenue Service are examples of mandated activities. These activities are value-added by man- date.The remaining activities in the firm are discretionary.A discretionary activity is classified as value-added provided it simultaneously satisfies three conditions: (1) the activity produces a change of state, (2) the change of state was not achievable by preceding activities, and (3) the activity enables other activities to be performed.For example, recall that RTP, Inc., manufactures hydraulic cylinders. The first activity, cutting rods, cuts long rods into the correct lengths for the cylinders. Next, the cut rods are welded to cut plates. The cutting-rod activity is value-added because (1) it causes a change of state—uncut rods become cut rods, (2) no prior activity was supposed to create this change of state, and (3) it enables the welding activity to be performed. Though the value-added properties are easy to see for an operational activity like cutting rods, what about a more general activity like supervising produc- tion workers? A managerial activity is specifically designed to manage other value- added activities—to ensure that they are performed in an efficient and timely man- ner. Supervision certainly satisfies the enabling condition. Is there a change in state?
There are two ways of answering in the affirmative. First, supervising can be viewed as an enabling resource that is consumed by the operational activities that do pro- duce a change of state. Thus, supervising is a secondary activity that serves as an input that is needed to help bring about the change of state expected for value- added primary activities. Second, it could be argued that the supervision brings order by changing the state from uncoordinated activities to coordinated activities.
Once value-added activities are identified, we can define value-added costs. Value- added costsare the costs to perform value-added activities with perfect efficiency.
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Non-Value-Added Activities
All activities other than those that are absolutely essential to remain in business, and therefore considered unnecessary, are referred to asnon-value-added activities.Anon-value-added activitycan be identified by its fail- ure to satisfy any one of the three previous defining conditions. Violation of the first two is the usual case for non-value-added activities. Inspecting cut rods (for correct length), for example, is a non-value-added activity. Inspection is a state-detection activity, not a state-changing activity (it tells us the state of the cut rod—whether it is the right length or not). For this reason, it fails the first condition. Consider the activity of reworking goods or subassemblies. Rework is designed to bring a good from a nonconforming state to a conforming state. In other words, a change of state occurs. Yet, the activity is non-value-added because it repeats work; it is doing some- thing that should have been done by preceding activities (Condition 2 is violated).Non-value-added costsare costs that are caused either by non-value-added activi- ties or the inefficient performance of valued-added activities. Due to increased com- petition, many firms are attempting to eliminate non-value-added activities because they add unnecessary cost and impede performance; firms are also striving to opti- mize value-added activities. Thus, activity analysis attempts to identify and eventu- ally eliminate all unnecessary activities and, simultaneously, increase the efficiency of necessary activities.
The theme of activity analysis is waste elimination. As waste is eliminated, costs are reduced. The cost reduction followsthe elimination of waste. Note the value of managing the causesof the costs rather than the costs themselves. Though managing costs may increase the efficiency of an activity, if the activity is unnecessary, what does it matter if it is performed efficiently? An unnecessary activity is wasteful and should be eliminated. For example, moving materials and partially finished goods is often cited as a non-value-added activity. Installing an automated material-handling system may increase the efficiency of this activity, but changing to cellular manufac- turing with on-site, just-in-time delivery of materials could virtually eliminate the activity. It is easy to see which is preferable.
Examples of Non-Value-Added Activities
Reordering parts, expediting pro- duction, and rework because of defective parts are examples of non-value-added activities. Other examples include warranty work, handling customer complaints, and reporting defects. Non-value-added activities can exist anywhere in the organiza- tion. In the manufacturing operation, five major activities are often cited as wasteful and unnecessary:1. Scheduling.An activity that uses time and resources to determine when different products have access to processes (or when and how many setups must be done) and how much will be produced.
2. Moving.An activity that uses time and resources to move materials, work in process, and finished goods from one department to another.
3. Waiting.An activity in which materials or work in process use time and resources by waiting on the next process.
4. Inspecting.An activity in which time and resources are spent ensuring that the product meets specifications.
5. Storing.An activity that uses time and resources while a good or material is held in inventory.
None of these activities adds any value for the customer. (Note that inspection would not be necessary if the product were produced correctly the first time; it therefore adds no value for the customer.) The challenge of activity analysis is to find ways to produce the good without using any of these activities.
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Cost Reduction
Continuous improvement carries with it the objective of cost reduction. Efforts to reduce costs of existing products and processes is referred to as kaizen costing. Competitive conditions dictate that companies must deliver prod- ucts the customers want, on time, and at the lowest possible cost. This means that an organization must continually strive for cost improvement. Kaizen costing is characterized by constant, incremental improvements to existing processes and prod- ucts. Activity analysis is a key element of kaizen costing. Activity analysis can reduce costs in four ways:61. Activity elimination 2. Activity selection 3. Activity reduction 4. Activity sharing
Activity eliminationfocuses on non-value-added activities. Once activities that fail to add value are identified, measures must be taken to rid the organization of these activities. For example, the activity of inspecting incoming parts seems neces- sary to ensure that the product using the parts functions according to specifications.
Use of a bad part can produce a bad final product. Yet, this activity is necessary only because of the poor-quality performance of the supplying firms. Selecting suppliers who are able to supply high-quality parts or who are willing to improve their quality performance to achieve this objective will eventually allow the elimination of incoming inspection. Cost reduction then follows.
Activity selectioninvolves choosing among different sets of activities that are caused by competing strategies. Different strategies cause different activities. Differ- ent product design strategies, for example, can require significantly different activi- ties. Activities, in turn, cause costs. Each product design strategy has its own set of activities and associated costs. All other things being equal, the lowest-cost design strategy should be chosen. In a kaizen cost framework, redesign of existing products and processes can lead to a different, cheaper set of activities. Thus, activity selection can have a significant effect on cost reduction.
Activity reductiondecreases the time and resources required by an activity. This approach to cost reduction should be primarily aimed at improving the efficiency of necessary activities or be a short-term strategy for improving non-value-added activi- ties until they can be eliminated. Setup activity is a necessary activity that is often cited as an example for which less time and fewer resources need to be used. Find- ing ways to reduce setup time—and thereby lower the cost of setups—is another example of the kaizen costing concept.
Activity sharingincreases the efficiency of necessary activities by using economies of scale. Specifically, the quantity of the cost driver is increased without increasing the total cost of the activity itself. This lowers the per-unit cost of the cost driver and the amount of cost traceable to the products that consume the activity. For example, a new product can be designed to use components already being used by other prod- ucts. By using existing components, the activities associated with these components already exist, and the company avoids the creation of a whole new set of activities.
Activity Performance Measurement
Assessing how well activities (and processes) are performed is fundamental to man- agement’s efforts to improve profitability. Activity performance measures exist in both financial and nonfinancial forms. These measures are designed to assess how well an activity was performed and the results achieved. They are also designed to 178 P a r t 2 / A c t i v i t y - B a s e d A c c o u n t i n g
6 Peter B. B. Turney, “How Activity-Based Costing Helps Reduce Cost,” Journal of Cost Management(Winter 1991): pp. 29–35.
reveal if constant improvement is being realized. Measures of activity performance center on three major dimensions: (1) efficiency, (2) quality, and (3) time.
Efficiencyfocuses on the relationship of activity inputs to activity outputs. For example, one way to improve activity efficiency is to produce the same activity out- put with lower cost for the inputs used. Qualityis concerned with doing the activity right the first time it is performed. If the activity output is defective, then the activity may need to be repeated, causing unnecessary cost and reduction in efficiency. The timerequired to perform an activity is also critical. Longer times usually mean more resource consumption and less ability to respond to customer demands. Time meas- ures of performance tend to be nonfinancial, whereas efficiency and quality meas- ures are both financial and nonfinancial.