Activity--Based Activity -Based Costing
Classic Pen Company Case
Problems With Simple Cost Accounting Systems: Sys tems: The Classic Pen Company Example Classic Pen had been the lowlow -cost -cost producer of blue pens and black pens, with profit margins exceeding 20% of sales years ago Classic Pen expanded Several years their business by extending their product line into products with premium selling prices
Problems With Simple Cost Accounting Systems: Sys tems: The Classic Pen Company Example Classic Pen had been the lowlow -cost -cost producer of blue pens and black pens, with profit margins exceeding 20% of sales years ago Classic Pen expanded Several years their business by extending their product line into products with premium selling prices
The Classic Pen Company Example
Five years ago red pens were introduced
Last year purple pens were added
The same basic production technology Could be sold at a price that was 3% higher than for blue and black pens Could be sold at a 10% price premium
The controller of Classic Pen P en 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
Total Profitability by Product Blue
Black
Red
Purple
Total
Units
50,000
40,000
9,000
1,000
100,000
Price
$ 4.50
$ 4.50
$ 4.65
$ 4.95
$225,000
$180,000
$41,850
$4,950
$451,800
75,000
60,000
14,040
1,650
150,690
Labor Labor
30,000
24,000
5,400
600
60,000
Overhead
90,000
72,000
16,200
1,800
180,000
Total Mfg. Expenses
195,000
156,000
35,640
4,050
390,690
$ 30,000 $ 24,000
$ 6,210
$ 900 $ 61,110
Sales Material
Gross Margin
G.M. %
13.3%
13.3%
14.8%
18.2%
13.5%
Concern at Classic Pen
The controller of Classic Pen wondered whether the company should continue to deemphasize the blue and black commodity products and keep introducing new specialty colored pens Classic¶s manufacturing manager commented on 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
Changes Caused by New Pens
(1 of 2)
Making black ink was simple; there was not even a need to clean out the residual blue ink from the previous run if enough black ink was dumped in to cover it up Red required Classic to stop production, empty the vats, clean out all remnants of the previous color, and then start the production of the red ink Even small traces of the blue or black ink created quality problems The ink for the purple pens also had demanding specifications, though not quite as demanding as the red ink
Changes Caused by New Pens
(2 of 2)
Classic Pens was also spending more time on purchasing and scheduling activities and keeping track of existing, backlogged, and future orders Classic¶s manufacturing manager was concerned about rumors that new colors may be introduced in the near future
He did not think they had any more capability to handle additional confusion and complexity in the operations
Last year¶s new computer system helped to reduce some of the confusion
Pen Production At Classic¶s
Pen production at the factory involved:
Each product had a:
Preparing and mixing the ink for the different color pens Inserting the ink into the pens in a semiautomated process Packing and shipping the pens in a manual stage Bill of materials that identified the quantity and cost of direct materials required for the product Routing sheet that identified the sequence of operations required for each operating step
This information was used to calculate the labor expenses for each of the four products
From this information, it was easy to calculate the direct materials costs and direct labor costs for each color pen
Classic¶s Indirect Cost Allocation
Because it was a small company and historically had produced only a narrow range of products, Classic 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
Classic Pen¶s Cost System
Classic¶s management accountants designed the system years ago when:
Production operations were mostly manual Total indirect costs were less than direct labor costs Classic¶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
A Changed Production Environment Direct labor costs have decreased and indirect expenses have increased as a result of automation As custom lowlow-volume products, such as red and purple pens were added, Classic needed:
More scheduling More setups More quality control personnel A computer to track orders and product specifications
An Outdated Cost System
Classic operates with only a single cost center, the plant
Most complex companies use many cost centers for cost accumulation
Even if Classic Pen used multiple production and service department cost centers, it could still encounter severe distortions in its reported product costs:
In an environment of high product variety, using only unit--level drivers (such as direct labor costs) to unit allocate overhead costs to products could lead to product cost distortion
Reason for Cost Distortions (1 of 3) A complex factory has a much larger production support staff because it requires more people to:
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 computercomputer -based information system
A complex factory generally also operates with higher levels of idle time, setup time, overtime, inventory, rework, and scrap
Reason for Cost Distortions (2 of 3)
Because the factory has the same physical output, it has roughly the same cost of materials (ignoring the slightly higher acquisition costs for smaller orders of specialty colors and other materials) Because all pens are about the same complexity, each pen would require the same number of direct labor hours and machine hours to produce The Classic Pen Company 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
Reason for Cost Distortions (3 of 3)
On a per unit basis, highhigh-volume standard blue and black pens require about the same amount of direct labor costs (the allocation basis) as the low volume color pens Therefore, the traditional costing system would report essentially identical product costs for all products, standard and specialty, irrespective of their relative production volumes This would hold true even if the cost system had multiple production and service cost centers Clearly, however, considerably more indirect and support resources are required on a per per- -unit unit basis for the lowlowvolume, newly designed products than for the highhighvolume, standard blue and black pens
Activity--Based Cost Systems Activity Activity-based cost systems have been Activitydeveloped to eliminate this major source of cost distortion Activity Activity--based cost (ABC) management systems use a simple two two--stage approach similar to but more general than traditional cost systems The next slide compares the essential elements of the two systems
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 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
Tracing Costs to Activities
Here¶s how an ABC system works, using the Classic Pen Company as an example:
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
Indirect Labor Activities (1 of 2)
50% of indirect labor was involved in what the controller called ³ 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 new--colored pen
40% of indirect labor actually performed the physical changeover from one color pen to another, an activity that she labeled ³ perform setups
´
Change to Black pens takes 2.4 hours Change to Red or Purple pens takes 5.6 hours
Indirect Labor Activities (2 of 2)
10% of the time was spent on activities the controller called ³ support products: maintaining records on the four products, such as: ´
Making up the bill of materials and routing information Monitoring and maintaining a minimum supply of raw materials and finished goods inventory for each product Improving the production processes Performing engineering changes for the products
First Step in Design of An ABC System
1)
2)
As she conducted the interviews, the controller was performing the first two steps for designing an activityactivity-based cost 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 (50% of indirect labor to ³handle production runs, 40% to ³perform setups, and 10% to ³support products ) ´
´
´
Computer System Expenses (1 of 2)
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 ³support 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
Computer System Expenses (2 of 2)
About 80% of the computer resource was involved in the production run activity and seemed to relate well to the ³ 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
Other Overhead Expenses
There were three remaining categories of overhead expense:
These expenses were incurred to supply machine capacity to produce the pens:
Machine depreciation Machine maintenance Energy to operate the machines
A practical capability of 10,000 hours of productive time could be supplied to pen production
The controller labeled this production activity ³run mac hines ´
Identifying Cost Hierarchies
The controller noted that even though she had defined only four activities for Classic¶s indirect costs, they represented 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
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
Benefits from Half an ABC System
The ABC model was only half completed c ompleted (costs have not yet been driven down to products), yet it had already provided some important insights:
Now the controller could see why Classic Pens was incurring expenditures 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
From ABC to ABM (1 of 2)
In the past, industrial engineers engineers at Classic Pen had studied labor and materials usage closely:
These had been the high cost c ost resources They were also the primary cost categories featured by Classic¶s traditional 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
From ABC to ABM (2 of 2)
It would be worthwhile to have industrial engineers study the way Classic handled and scheduled production runs and how the employees set up machines to uncover new opportunities for cost reduction and process improvement projects
activity- -based based This is an example of operational activity 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
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
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:
ACTIVITY
ACTIVITY COST DRIVER
HANDLE PRODUCTION RUNS
PRODUCTION RUNS
SET UP MACHINES
SETUP HOURS
SUPPORT PRODUCTS
NUMBER OF PRODUCTS
RUN MACHINES
MACHINE HOURS
PROVIDE FRINGE BENEFITS
LABOR DOLLARS
Completing the ABC Model (1 of 2)
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
Completing the ABC Model (2 of 2)
The controller now had sufficient information to estimate a complete activityactivitybased cost model for Classic 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
Activity Cost Drivers Activity Cost
Driver
Blue
Black
Red
Purple
Total**
DL hr/unit
0.02
0.02
0.02
0.02
2,000
0.1
0.1
0.1
0.1
10,000
70
65
50
15
200
Setup time/run
4
2.4
5.6
5.6
--
Total setup hr
280
156
280
84
800
1
1
1
1
4
50,000
40,000
9,000
1,000
Mach. hr/unit
Prod. runs
# of products
**Total = per unit X quantity
Activity Cost Driver Rates ( ACDR) ACDR) Activity Activity Cost Driver Expense Driver Quantity Handle
Production Runs Set up machines
$66,000 $33,600
Support Products
$14,400
Run Machines
$42,000 $156,000
Number of production runs
200
Number of setup hours
800
Number of products
4
Number of machine hours
10,000
ACDR $330 per run
$42 per setup hr
$3,600 per product
$4.20 per machine hr
Activity Expenses Assigned Blue
Black
Red
Purple
Total
$23,100
$21,450
$16,500
$4,950
$66,000
Set up machines
11,760
6,552
11,760
3,528
33,600
Support Products
3,600
3,600
3,600
3,600
14,400
21,000
16,800
3,780
420
42,000
$ 48,402 $ 35,640 $ 12,498
$ 156,000
Handle
Production Runs
Run Machines
Total Costs Assigned
$ 59,460
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 activityactivity-based costing system were quite different from the results based on the traditional cost system The controller now understood why the profitability of Classic 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
Total ABC Profitability by Product Blue
Sales
Black
Red
Purple
Total
$225,000 $180,000
$41,850
$4,950 $451,800
1,650 150,690
Material
75,000
60,000
14,040
Labor
30,000 12,000
24,000 9,600
5,400 2,160
59,460
48,402
35,640
12,498 156,000
176,460 142,002
57,240
14,988 390,690
40% fringe on DL
Support Total Mfg. Expenses
Gross Margin
G.M. %
600 240
60,000 24,000
$ 48,540 $ 37,998 $(15,390) $(10,038) $ 61,110 21.6%
21.1%
-36.8%
-202.8%
13.5%
Using ABC to Improve Profitability (1 of 2)
The ABC information provides managers with numerous insights about how to increase the profitability of Classic Pen:
Increase either their sales volume or prices to compensate for the large batch and productproduct 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
Using ABC to Improve Profitability (2 of 2)
Improve processes, particularly the processes performing batch and productproduct-sustaining activities Manufacturing personnel can redirect their attention: From trying to run their production equipment faster, in order to improve the performance of unitunit-level activities To learning how to reduce setup times, in order to improve the performance of batchbatch-level activities so that small batches of the specialty products would require fewer resources to produce and be less expensive
The goal of 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 lowlow-volume, specialty products, and reduces the pressure to raise prices or impose minimum order sizes on customers in order to make such products profitable
Selecting Activity Cost Drivers (1 of 2) Activity cost drivers are the central innovation of activityactivitybased 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 tradetrade-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
Selecting Activity Cost Drivers (2 of 2) Because of the large number of potential activityactivity-to to--product linkages, management accountants attempt to economize on the number of different activity cost drivers Activities triggered by the same event may all use the same activity cost driver
ABC system designers choose from three different types of activity cost drivers:
For example, preparing production orders, scheduling production runs, performing first part inspections, and moving materials may all use the number of production runs
Transaction Duration Intensity (direct charging)
The choice of a transaction, duration, or intensity cost driver can occur for almost any activity
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 take 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
Duration Drivers
Represent the amount of 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 of 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 of 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
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
Designing an ABC System (1 of 2) Sometimes ABC system designers get carried away with the potential capabilities of an activityactivity-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 existing information system
Designing an ABC System (2 of 2)
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
Measuring The Cost Of Resource Capacity (1 of 2) 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
Measuring The Cost Of Resource Capacity (2 of 2)
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
Cost of Unused Capacity (1 of 2)
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
For example, if the capacity was acquired to meet anticipated demands from a particular 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 lumplump -sum basis; it will be treated as a sustaining, not a unit--level, expense. unit
Cost of Unused Capacity (2 of 2)
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 lumplump-sum assignment of unused capacity costs provides feedback to managers on their supply and demand decisions
Fixed and Variable Expenses
Most indirect expenses assigned by an ABC system are committed costs Committed costs become variable via a twotwo-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
Activity in Excess of Capacity
If activity volumes exceed the capacity of existing resources, the result is
Bottlenecks Shortages Increased pace of activity Delays Poor--quality work Poor
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
Decreased Demand for Resources
Demands for indirect and support resources also can decline
Consciously through activityactivity-based management Inadvertently through competitive or economyeconomy-wide forces that lead to declines in sales
Should the demands for batch and product product--sustaining resources decrease, few immediate spending reductions will be noticed Even for many unitunit-level 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
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 ³variable 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
Managers Make Costs Fixed (1 of 2)
Organizations often create unused capacity through activityactivity-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
Managers Make Costs Fixed (2 of 2)
The organization receives no benefits from its activityactivitybased management decisions that reduced the demands on their resources if capacity is not reduced or redeployed The failure to capture benefits from activity activity--based management is not because their costs are ³fixed ´
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 ³fixed 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
´
Problems Implementing ABC (1 of 3)
Several problems arise in practice from the common approach to activity 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 frontfront-end cost to an ABC analysis is often a barrier to widespread ABC adoption
Problems Implementing ABC (2 of
3) 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 activity High updating cost leads to infrequent updates of many ABC systems and, eventually, to obsolete cost driver estimates Adding new activities to the system is also difficult, requiring rere-estimates of the relative amount of resource time and effort required by the new activity
Problems Implementing ABC (3 of 3)
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 Accordingly, the cost driver rates calculated from this process assume that resources are working at full capacity But operations at capacity are more the exception than the rule
Time-Driven ABC: Time An Alternative Approach Several companies have overcome these problems by using a new approach for estimating their ABC models The insight for the new approach is simple:
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
Time--Driven ABC: Time
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
Unit Cost Estimate (1 of 3)
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 Practical capacity is often estimated as a percentage (e.g., 80% or 85%) of theoretical capacity This estimate allows time (e.g., 15 ± ± 20%) for nonproductive time: For personnel, time for breaks, arrival and departure, and communication and reading unrelated to actual work performance
Unit Cost Estimate (2 of 3)
For machines, an allowance for downtime due to maintenance, repair, and scheduling fluctuations
With estimates of the cost of supplying capacity and practical capacity, the analyst can calculate the unit cost of supplying capacity: Unit cost = Cost of capacity supplied Practical capacity of resources supplied
Unit Cost Estimate (3 of 3)
For example, assume that indirect labor employees supply about 2,500 hours of labor in total each quarter at a cost of $84,000. The practical capacity (at 80% of theoretical) is about 2,000 hours per quarter, leading to a unit cost (per hour) of supplying indirect labor capacity of: $84,000 Indirect labor cost per hour = 2000 hours = $42 per hour
Unit Time Estimate
The second piece of new information is an estimate of time used each time a committed resource performs a transactional activity Precision is not critical Rough accuracy is sufficient Estimates for the indirect labor from the Classic Pen example are:
Resource
Activity
Indirect Labor Labor Production Run
Unit Time
5 hours
Support Products 50 hours
Cost Driver Rate Assume similar calculations regarding computer resources produced estimates of $60 per hour and 2 hours per production run The cost driver rate for the activity, handle production runs, can now be calculated as the costs of using indirect labor and the computer for each production run:
Unit
Cost
Unit Time
Cost Driver Driver
Indirect Labor Resource
$42 per hour
5 hours/run
$210 per run
+ Computer Resource
$60 per hour
2 hours/run
120 per run
= Activity Cost Driver Rate
$330 per run
Advantages of TimeTime-Driven ABC
Managers may easily update their timetime -driven ABC model to reflect changes in their operating conditions
They can incorporate the new knowledge by providing reasonable estimates about the unit times required for different activities for each type of product
Managers may also easily update the activity cost driver rates
Changes in the prices of resources supplied affect the hourly cost rate Activity cost driver rates change when there has been a shift in the efficiency of the activity
Tracing MarketingMarketing-Related Costs to Customers
The costs of marketing, selling, and distribution expenses have been increasing rapidly in recent years Result of increased importance of customer satisfaction and market market--oriented strategies Many of these expenses do not relate to individual products or product lines but are associated with: Individual customers Market segments Distribution channels Companies need to understand the cost of selling to and serving their diverse customer base
Activity--Based Pricing Activity Pricing is the most powerful tool a company can use to transform unprofitable customers into profitable ones Activity--based pricing establishes a base price Activity for producing and delivering a standard quantity for each standard product
To this base price, the company provides a menu of options, with associated prices, for any special services requested by the customer
Special services may be priced just to cover costs or also to earn a margin Activity--based pricing prices orders, not products Activity
ABC at Service Companies (1 of 2)
Although ABC had its origins in manufacturing companies, many service organizations today are obtaining great benefits from this approach
In practice, the actual construction of an ABC model is nearly identical for both types of companies This should not be surprising since, in manufacturing companies, the ABC system focuses on the ³service component of the company ´
ABC at Service Companies (2 of 2)
Service companies in general are ideal candidates for activityactivity-based costing
Virtually all costs are indirect and appear fixed They often do not have direct, traceable costs to serve as convenient allocation bases They must supply virtually all their resources in advance to provide the capacity to perform work for customers during each period
Implementation Issues (1 of 2)
Not all ABC systems have been sustained or contributed to higher profitability for the company
Lack of clear business purpose
Some companies have experienced difficulties and frustrations in building and using activity activity--based cost and profitability models for some of the following reasons The project may start in Accounting/Finance, and nobody outside the department understands what changes need to be made and why
Lack of senior management commitment
The group (usually Accounting/Finance) that initiates the project probably does not have the authority to make decisions about processes, product designs, etc., without full senior management support
