A major component of activity-based management is activity analysis, which is the process of examining activities to classify them and devise ways to reduce or eliminate non-value-added activities. Taking a black and white perspective, activities are either value-added or non-value-added. Alternatively, a non-value-added activity (NVA) increases the time spent on a product or service but does not increase its value.
Activities that do not add value are unnecessary from the customer's perspective. Thus, the cycle time (or lead time) from the receipt of an order to the completion of a product or the performance of a service is equal to the value-added processing time plus the non-value-added time. People can also be responsible for activities that do not add value due to improper skills or training or the need to be social.
Focusing attention on eliminating non-value-added activities should increase product/service quality and decrease cycle time and costs.
Two-Step Allocation
Companies that have the above characteristics may want to reevaluate their costing systems and implement activity-based costing. In defining these centers, management must consider the following issues: geographic proximity of equipment, defined centers of management responsibility, scope of product costs, and a need to keep the number of activity centers manageable. After accumulation, costs are allocated from the activity center's cost pools and allocated to products and services using a second driver.
An activity driver measures the demands placed on activities and thus the resources consumed by products and services. Exhibit 4-7 illustrates this two-step process of tracking costs for products and services in an ABC system. The cost allocated to Product Z with the activity-based costing system is 132 percent higher than the cost allocated with the traditional allocation system ($1,564 vs. $0.675).
Activity-based costing systems indicate that significant resources are consumed by low-volume products and complex production operations. Studies have shown that, after implementing activity-based costing, the costs of high-volume, standard products were often too high and, with the help of ABC, dropped anywhere from 10 to 30 percent. Low-volume, complex specialty product costs tend to increase from 100 to 500 percent, although in some cases these costs have increased by 1,000 to 5,000 percent!7 Thus, activity-based costing typically.
The ABC costs of moderate products and services (those that are not extremely simple or complex, nor are they produced in extremely low or high volumes) generally remain approximately the same as those calculated using traditional costing methods. Although the preceding discussion concerns costs normally considered product costs, activity-based costing applies equally well to service department costs. Many companies use an activity-based costing system to allocate business overhead costs to their revenue-generating units based on the number of reports, documents, customers, or other reasonable measures of activity.
Short-Term and Long-Term Variable Costs
Two important cost drivers that cause long-run variable costs to change, but which have traditionally been ignored, are product variety and product complexity. These items create additional overhead (such as warehousing, purchasing, setup, and inspections), so long-run variable costs tend to increase as the number and types of products increase.
Attribute-Based Costing
Estrin, Jeffrey Kantor, and David Albers, "Is ABC Right for Your Business?" Management Accounting (April 1994), pp DECIDING WHETHER ABC IS APPROPRIATE A significant loss of information can occur in an accounting system that ignores asset-. Not all accounting systems that use direct labor or machine hours as a cost driver provide insufficient or inaccurate cost information.
However, some general clues can alert managers to the need to review the cost data provided by a conventional accounting system. For a given organization, it is likely that ABC will produce costs that are significantly different from those generated by conventional accounting, and it seems likely that these costs will be "better". If information deemed to be "better" is generated by ABC, the new information will change the dependent decisions made by management.
Two primary underlying assumptions that companies must consider before adopting ABC are that the costs in each cost pool are (1) driven by homogeneous activities and (2) strictly proportional to the activity.12 If these assumptions are met, the following circumstances can be ' indicate a need to consider using activity-based costing.
With Product Variety and Product Complexity
And third, most companies have found that, given the wide range of choices, customers tend to choose from a fairly small percentage of the total. At Toyota, a purchase investigation showed that 20 percent of different products accounted for 80 percent of sales.15 This ratio of 20:80 is quite common and is called the Pareto principle, after the Italian economist Vilfredo Pareto.16 . Management may want to review the design of the company's products and processes to standardize them and reduce the number of different components, tools, and processes required.
Products should be designed to take into account the Pareto principle and take advantage of the commonality of parts. An ingredient analysis will generally reveal that 20 percent of the ingredients are used in 80 percent of the products. If not, can the products be sold for a premium price to cover the costs associated with using low volume components.
However, would customers be as satisfied if more common parts were used and the product price was reduced? The complexity of processes reflects many activities that do not add value and therefore causes delays and cost increases. Simultaneous (or simultaneous) engineering refers to the continuous involvement of all primary functions and personnel that contribute to the origination and production of a product from the beginning of a project.
Simultaneous engineering helps companies shorten the time-to-market for new products and minimize complexity and costs. 16Pareto found that about 85 percent of Milan's wealth was owned by about 15 percent of the population. Juran found that a high proportion of such problems were caused by a small number of process characteristics (the vital few), whereas the majority of process characteristics (the trivial many) accounted for only a small portion of the quality problems.
With Lack of Commonality in Overhead Costs
With Problems in Current Cost Allocations
With Changes in Business Environment
By promoting an understanding of cost drivers, Activity Based Costing makes it possible to identify activities that do not add value and eliminate or reduce their causes. Activity-based costing differs from conventional costing in that it uses cost drivers to allocate costs. The first shock comes when customers or products previously thought to be profitable consume more resources than the revenue they generate.
Not surprisingly, many small items generated costs that do not fit well with the accounting system and the Christmas holiday was used to reprice the items in the warehouse and on its shelves. SOURCE: Michael Gering, "Activity-Based Costing and the Customer," Management Accounting (London) (April 1999), pp. Activity-based costing, although it typically provides better information than that generated under the traditional overhead allocation process, is not a panacea for all management issues.
Assuming that top management supports the changes in the internal accounting system and that employees are educated about the system, additional time will be needed to analyze the activities that occur in the activity centers, trace costs to those activities, and determine the cost drivers . One final criticism leveled at activity-based costing is that it does not promote total quality management (TQM) and continuous improvement. Activity-based prescriptions for improved competitiveness usually involve steps that lead to more being sold or done less of what should not be sold or done in the first place.
Indeed, activity-based costing information does nothing to change the old remote, top-down management behavior. No cost information, not even activity-based cost management information, will do this.19 Companies trying to implement ABC as a cure for product failures, volume declines, or financial losses will quickly realize that Professor Johnson is right. . Activity-based costing and activity-based management are effective in supporting continuous improvement, short lead times, and flexible production by helping managers.
REVISITING
ABC assigns costs to products based on the types and quantities of activities that must be performed to create those products. Determine whether each of the following costs is unit level (U), group level (B), product/process level (P), or organizational level (O). Cost Drivers) For each of the following costs important in manufacturing companies, identify a cost driver and explain why it is appropriate.
Because finding the best supplier requires the most effort in the department, most of the costs are allocated to this area. If 300 units of the product are produced during the year, what is the purchasing department's cost per unit. Give your answer in part (a) or part (b) the better representation of the profit contributed by each product.
At the president's request, the production manager provided the following data regarding expected activity in 2001 for the cost drivers of the previously budgeted overhead costs. Below are some of the potential cost drivers the company has identified for labor-related costs, along with their 2001 volume levels. For each cost pool, you must determine the price per unit for the activity driver using the activity driver that you believe has the closest relationship to the cost pool.
Explain how using the method developed in part (b) would support the parts standardization strategy. Kendall Corporation manufactures several different types of printed circuit boards; however, two of the boards account for the majority of the company's sales. Management decided that applying overhead based on activity-based costing and direct tracking, where possible, should provide a more accurate picture of each branch's profitability.
In the past two years, Lutz has become dissatisfied with the profitability of warehouse operations. Recently, Lutz approached his accountant, Jill Green, about using activity-based costing to improve his understanding of the causes of costs and revise the pricing formula.
