CHAPTER 5 ACTIVITY- BASED MANAGEMENT QUESTIONS FOR WRITING AND DISCUSSION 1. The two dimensions are the cost dimension and the process dimension. The cost dimension is concerned with accurate assignment of costs to cost objects, such as products and customers. Activity-based costing is the focus of this dimension. The second dimension — the process dimension — provides information about why work is done and how well it is done. It is concerned with cost driver analysis, activity analysis, and performance measurement. This dimension offers the connection to the continuous improvement world found in the advanced manufacturing environment. 2.
5. Activity inputs are the resources consumed by an activity in producing its output. Activity output is the result or product of an activity. Activity output measurement simply means the number of times the activity is performed. 6. Activity analysis is concerned with identifying activities performed by an organization, assessing their value to the organization, and selecting and keeping only those that are value adding. Selecting and keeping value-adding activities brings about cost reduction and greater operating efficiency, thus providing support for the objective of continuous improvement.
A functional-based responsibility accounting system is characterized by four elements: (1) a responsibility center, where responsibility is assigned to an individual in charge (responsibility is usually defined in financial terms); (2) the setting of budgets and standards to serve as benchmarks for performance measurement; (3) measurement of performance by comparing actual outcomes with budgeted outcomes; and (4) individuals being rewarded or penalized according to management policies.
7. Value-added activities are necessary activities. Activities are necessary if they are mandated or if they are not mandated and satisfy three conditions: (1) they cause a change of state, (2) the change of state is not achievable by preceding activities, and (3) they enable other activities to be performed. Value-added costs are costs caused by activities that are necessary and efficiently executed. 8. Nonvalue-added activities are unnecessary activities or those that are necessary but inefficient and improvable. An example is moving goods. Nonvalue-added costs are those costs caused by nonvalue-added activities. An example is the cost of materials handling.
3. In an activity-based responsibility accounting system, the focus of control shifts from responsibility centers to processes and teams. Management is concerned with how work is done, not with where it is done. Process improvement and process innovation are emphasized. Standards tend to be optimal, dynamic, and process oriented. Performance measurement focuses on processes and activities that define the processes. Finally, there tends to be more emphasis on group rewards than on individual rewards. 4. Driver analysis is concerned with identifying the root causes of activity costs. Knowing the root causes of activity costs is the key to improvement and innovation. Once a manager understands why costs are being incurred, then efforts can be taken to improve cost efficiency.
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9.
(1) Activity elimination — the identification and elimination of activities that fail to add value. (2) Activity selection — the process of choosing among different sets of activities caused by competing strategies. (3) Activity reduction — the process of decreasing the time and resources required by an activity. (4) Activity sharing — increasing the efficiency of necessary activities using economies of scale.
10.
Value-added standards represent the absolute levels of efficiency for activities. The costs that should be incurred for these abso-
lute levels are value-added costs. Any difference between the actual costs incurred and the ideal costs are nonvalue-added costs. 11.
Trend reports will reveal the progress made over time in reducing nonvalue-added costs.
12.
A kaizen standard is the planned improvement for the coming period. The kaizen subcycle implements the improvement, checks it, and locks it in and then begins a search for additional improvements. The maintenance subcycle sets a standard based on prior improvements, executes, and checks the results to make sure that performance conforms to the new results. If not, then corrective action is taken.
13.
Benchmarking identifies the best practices of comparable internal and external units. For internal units, information can be gathered that reveals how the best unit achieves its results; these procedures can then be adopted by other comparable units. For external units, the performance standard provides an incentive to find ways to match the performance (it may sometimes be possible to determine the ways the performance is achieved).
14.
If individuals are asked to reduce costs and are told what the activity driver is, they may decrease the level of the driver below that which is optimal. Thus, it may be necessary to also identify the optimal level of the cost driver so that only nonvalue-added costs are eliminated.
15.
The activity volume variance is a measure of the nonvalue-added costs. The unused capacity variance tells how much of the committed resources are not being used. This information is particularly important because it helps managers know when they can take actions to reduce nonvalue-added costs.
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16. Activity-based customer costing can identify what it is costing to service different customers. Once known, a firm can then devise a strategy to increase its profitability by focusing more on profitable customers, converting unprofitable customers to profitable ones where possible, and “firing” customers that cannot be made profitable. 17.
Activity-based supplier costing traces all supplier-caused activity costs to suppliers. This new total cost may prove to be lower than what is signaled simply by purchase price.
EXERCISES 5–1 1.
Plantwide rate = ($1,200,000 + $1,800,000+ $600,000)/60,000 = $60 per Machine hour Unit overhead cost = $60 × 50,000/100,000 = $30 Activity rates: Machine rate = $1,800,000/60,000 = $30 per machine hour Testing rate = $1,200,000/40,000 = $30 per testing hour Rework rate = $600,000/20,000 = $30 per rework hour Total overhead cost = ($30 × 50,000) + ($30 × = $2,250,000
20,000) + ($30 × 5,000)
Unit overhead cost = $2,250,000/100,000 = $22.50 Improving the accuracy reduced the cost by $7.50, which is still less than the $10 reduction needed. What this means is that although accuracy has a positive effect on the price, it is not the only problem. It appears that competitors may be more efficient than Timesaver. This outcome then signals the need to reduce costs. 2.
Since testing and rework costs and setup and rework time are both reduced by 50%, the activity rates remain the same, although the amount of cost assigned to the regular microwave will change: Total overhead cost = ($30 × 50,000) + ($30 × 10,000) + ($30 × 2,500) = $1,875,000 Unit cost = $1,875,000/100,000 = $18.75 This cost now is $11.25 less than the original allows management to reduce the price by $10, increasing the competitive position of the regular model. ABC is concerned with how costs are assigned, whereas ABM is not only concerned with how they are assigned but also with how costs can be reduced. Cost accuracy and cost reduction are the dual themes of ABM.
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5–2 Classification: Situation 1 2 3 4 5 6 7
Activity-Based A A A B B B A
Functional-Based B B B A A A B
Comments: Situation 1: In a functional-based system, individuals are held responsible for the efficiency of organizational units, such as the Grinding Department. In an activitybased system, processes are the control points because they are the units of change; they represent the way things are done in an organization. Improvement and innovation mean changing the way things are done, or in other words, changing processes. Since processes, such as procurement, cut across functional boundaries, teams are the natural outcome of process management. It is only natural that the managers of purchasing, receiving, and accounts payable be part of a team looking for ways to improve procurement. Situation 2: In a functional-based responsibility system, individuals in charge of responsibility centers are rewarded based on their ability to achieve the financial goals of the responsibility center. Thus, meeting budget promises the “fat” bonus. In a continuous improvement environment, process improvement is dependent on team performance, so rewards tend to be group based, and gainsharing is often used. Furthermore, there are many facets to process performance other than cost, so the performance measures tend to be multidimensional (e.g., quality and delivery time).
112
5–2
Concluded
Situation 3: In a functional-based system, efforts are made to encourage individuals to maximize the performance of the subunit over which they have responsibility. The concern of activity-based responsibility accounting is overall organizational performance. The focus is systemwide. It recognizes that maximizing individual performance may not produce firmwide efficiency. Situation 4: In a functional-based system, performance of subunits is usually financial-based and is measured by comparing actual with budgeted outcomes. In an activity-based system, process performance is emphasized. The objective is to provide low-cost, high-quality products, delivered on a timely basis. Thus, both financial and nonfinancial measures are needed. Situation 5: In a functional-based system, budgets and standards are used to control costs. In an activity-based responsibility system, the focus is on activities because activities are the cause of costs. Driver analysis and activity analysis are fundamental to the control process. Driver analysis recognizes that controlling costs requires managers to understand the root causes. Activity analysis is the effort expended to identify, classify, and assess the value content of all activities. Once the value content is known, then costs can be controlled through such means as activity reduction, activity elimination, activity sharing, and activity selection. Situation 6: A functional-based system uses currently attainable standards that allow for a certain amount of inefficiency. Achieving the standard is the emphasis, and there is no effort to improve on the standards themselves. An activitybased approach strives for the ideal, and so the standard is the ideal. Progress is measured over time with the expectation that performance should be continually improving. Efforts are made to find new ways of doing things and, thus, to find new optimal standards. The objective is to always provide incentives for positive changes. Situation 7: The functional-based system tends to ignore a firm’s activities and the linkages of those activities with suppliers and customers. It is internally focused. An activity-based system builds in explicit recognition of those linkages and emphasizes the importance of the value chain. Furthermore, the assessment of the value content of activities is explicitly related to customers. What goes on outside the firm cannot be ignored.
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5–3 The ABM implementation is taking too long and is not producing the expected results. It also appears to not be integrated with the division’s official accounting system, thus encouraging managers to continue relying on the old system (as evidenced by the continued reliance on traditional materials and labor efficiency variances). The fact that the ABC product costs are not significantly different in many cases could be due to a lack of product diversity or perhaps due to poor choices of pools and drivers. The lack of a competitive cost state suggests the presence of significant nonvalue-added costs. The emphasis on the absence of product cost differences, lack of cost reductions, and the attitude about activity detail and the value content of inspection all reveal that plant managers have a very limited understanding about ABM and what it can do. There clearly needs to be a major effort to train managers to understand and use activity data. At this point, there is no organizational culture that emphasizes the need for continuous improvement. This need and the role ABM plays in continuous improvement needs to be taught. The new ABM system also needs to be integrated to maximize its chances for success.
5–4 1.
David was concerned about meeting the schedule and staying within the 5 percent variance guideline. The first week’s production exceeded the guideline for both materials and labor, and he expected the same outcome for the second week. By stopping inspections, no materials waste would be observed and recorded for the second week, moving the usage variance back within the 5 percent tolerance level. Accepting all units produced also will reduce the total labor time reported. Finally, using inspectors as production labor and counting their time as inspection labor provides some “free” direct labor time, which would also contribute to the reduction or elimination of an unfavorable labor efficiency variance. David’s behavior is unethical. David (and perhaps others) is deliberately subverting the organization’s legitimate and ethical objective of providing a high-quality product used in the manufacture of an airplane—in exchange for a favorable performance rating and, presumably, a good salary increase or bonus. Although no explicit information is provided, the stress test seems to imply an important safety role for the bolts in the airplane structure. If true, then David’s actions become even more questionable.
114
5–4 2.
Concluded There appears to be an overreliance on standards and variances. There also appears to be a strong internal focus—David did not give much consideration to the effect of his decision on the company’s customers. The reward structure seems to be tied to the ability of David to meet or beat standards, and this provides some incentive to engage in perverse and even unethical behavior. The system certainly works against the goal of zero defects and total quality. An activity-based system would tend to mitigate the problem because it encourages a multidimensional performance measurement. For example, quality measures are important. Failure to meet measures on one dimension may be offset to some extent by good performance on other dimensions. A strategic-based approach would mitigate the behavior even more, as it adopts a customer focus, and performance measures relating to such things as customer satisfaction are introduced. Furthermore, more effort is made to link the performance measures with the company’s mission and strategy. Finally, by communicating the strategy through the use of performance measures of various perspectives, a strategic-based approach tends to align individual goals with those of the organization. However, it should be mentioned that designing a system with perfect incentives is difficult. Ultimately, the firm must rely on the character of its employees to carry out its objectives.
3.
The first week’s experience indicates a fairly high defect rate—between 7 and 8 percent—which was expected to continue for the second week. Apparently, item-by-item inspection is the company’s way of ensuring reliable bolt performance. Abandoning the inspection process for a week simply to meet internal reporting standards seems like a weak excuse, even if a return to normal practices is expected. All too often, this sort of rationalization leads to repeated violations of norms to meet short-term goals, and it becomes part of the culture—to the point where it doesn’t appear to be wrong anymore. Fundamentally, the need for inspection and the high reject rate suggests that the company needs to think about ways of improving its manufacturing process to reduce the number of defective units. This is why an activity- or strategicbased approach may be more suitable because they both have a process focus that emphasizes quality and efficiency. Production of defective units would not be encouraged.
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5–5 The following are possible sets of questions and answers (provided as examples of what students could suggest): Cleaning oil: Question: Answer:
Why is the oil puddle cleaned daily? Because the production equipment leaks oil every day.
Question: Answer:
Why does the production equipment leak oil? Because a seal is damaged (root cause).
Question: Answer:
How do we repair the damaged seal? By replacing it.
Providing sales allowances: Question: Answer:
Why are we giving sales allowances? Because the product is not working as it should.
Question: Answer:
Why is the product not working as it should? Usually because it has a defective component.
Question: Answer:
Why does it have a defective component? Because our subassembly processes occasionally produce bad components.
Question: Answer:
Why do our subassembly processes produce bad components? Because our workers are not as well trained as they should be (root cause).
Question: Answer:
How do we improve the skills of our workers? By ensuring that they all pass a rigorous training course.
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5–6 Nonvalue-added: Comparing documents Resolving discrepancies
(state detection) $90,000 (0.15 × $600,000) (rework) $420,000 (0.70 × $600,000)
Value-added: Preparing checks $60,000 (0.10 × $600,000) Mailing checks $30,000 (0.05 × $600,000)
5–7 Questions 2–6 represent a possible sequence for the activity of comparing documents, and Questions 1 and 3–6 represent a possible sequence for resolving discrepancies. The two activities have a common root cause. Question 1: Why are we resolving discrepancies? Answer: Because the purchase order, receiving order, and invoice have been compared and found to be in disagreement. Question 2: Why are documents being compared? Answer: Because they may not agree. Question 3: Why would the documents not agree? Answer: Because one or more may be wrong. Question 4: Why would a document be wrong? Answer: Because the amount received from the supplier may not correspond to the amount ordered or because the amount billed may not correspond to the amount received or both. Question 5: Why are the amounts different? Answer: Because of clerical error—either by us or by the supplier. Question 6: How can we avoid clerical error? Answer: Training for our clerks will reduce the number of discrepancies; for suppliers, extra training and care can be suggested where there is evidence of a problem.
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5–8 1.
A process is a collection of activities with a common objective. The common objective of procurement is to supply bought and paid for materials to operations (e.g., the manufacturing process). The common objective of purchasing is to produce a request for materials from suppliers; the common objective of receiving is to process materials from suppliers and move them to the operations area (e.g., stores or manufacturing); the common objective of paying bills is to pay for the materials received from suppliers.
2.
The effect is to reduce the demand for the activity of resolving discrepancies by 30 percent. By so doing, Whitley will save 21 percent (0.30 × 0.70) of its clerical time. Thus, about four clerks can be eliminated (21% * 20 clerks = 4 clerks eliminated) by reassigning them to other areas or simply laying them off. This will produce savings of about $120,000 per year (4 clerks * $30,000 salary). This is an example of process improvement—an incremental increase in process efficiency resulting in a cost reduction.
5–9 EDI eliminates the demand for virtually all the activities within the bill-paying process. Some demand may be left for payment activities relative to the acquisition of nonproductive supplies. Assuming conservatively that 90 percent of the demand is gone, then there would be a need for perhaps two clerks (10% * 20 clerks = 2 remaining clerks). This would save the company $540,000 (18 clerks * $30,000 salary) per year for this subprocess alone. Additional savings would be realized from reduction of demands for purchasing and receiving activities. Switching to an EDI procurement structure is an example of process innovation.
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5–10 Case A B C D E F
Nonvalue-Added Cost
Root Cause
Cost Reduction
$9 per unit1 $300 per setup2 $120 per unit3 $400,000 per year4 $250 per unit5 $900,000 per year6
Process design Product design Plant layout Multiple* Suppliers Product design
Activity selection Activity reduction Activity elimination Activity selection Activity elimination Activity sharing
1
(0.5)$12 – (0.25)$8 + (8 – 7.5)$10 (8 – 2)$50 3 (6 – 0)$20 4 $320,000 + (16,000)$5 5 (6.5 – 6)$500 6 As given 2
*For example, process design, product design, and quality approach or philosophy.
5–11 Fixed activity rate = SP = $252,000/28,800 = $8.75 per order Cost of unused capacity: SP × SQ $8.75 × 14,400
SP × AQ $8.75 × 28,800
$126,000 U Activity Volume Variance
SP × AU $8.75 × 27,600
$10,500 F Unused Capacity Variance
The activity volume variance measures the nonvalue-added cost. The unused capacity variance is a measure of the potential to reduce the spending on an activity and, thus, reduce the nonvalue-added costs.
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5–11 2.
Concluded
Value-added costs = $8.75 × 14,400 = $126,000 Nonvalue-added costs = $8.75 × 14,400 = $126,000 Note: For fixed activity costs, the practical capacity is currently 28,800 orders; thus, 14,400 orders are unnecessary. A value-added cost report would be as follows:
Purchasing
Value-Added Costs $126,000
Nonvalue-Added Costs $126,000
Actual Costs $252,000
Highlighting nonvalue-added costs shows managers where savings are possible and emphasizes the need for improvement. In this case, reducing orders processed to 14,400 will create unused capacity of 14,400 orders, allowing the company to save $126,000 in salaries. 3.
First, the value-added standard is nonzero. Second, purchasing enables other activities to be performed. Third, there is a change of state—from a state of no materials requested to a state of materials requested. Fourth, the purchase state could not have been achieved by a prior activity. Fifth, it is a necessary activity—one essential for the firm to remain in business. Possible reasons for exceeding the value-added standard: suboptimal inventory management policies, reorders due to bad parts being delivered by suppliers, extra orders due to rework requirements, and additional orders because the wrong types and quantities of materials were ordered.
4.
By reducing the demand by another 6,000 units, the unused capacity will now equal 7,200 orders—an amount equivalent to 1.5 purchasing agents. Thus, the number of purchasing agents can be reduced from 6 to 5, saving $42,000.
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5–12 1.
Willson Company Value- and Nonvalue-Added Cost Report For the Year Ended December 31, 2005 Value-Added Costs Purchasing parts $ 450,000 Assembling parts 2,160,000 Administering parts 1,980,000 Inspecting parts 0 Total $4,590,000
2.
Nonvalue-Added Costs $ 180,000 234,000 858,000 1,125,000 $2,397,000
Actual Costs $ 630,000 2,394,000 2,838,000 1,125,000 $6,987,000
Inspecting parts is nonvalue-added (SQ = 0 is a necessary condition for a nonvalue-added activity). Inspection is nonvalue-added because it is a statedetection activity, not a state-changing activity. It also is not essential to enable other activities to be performed. Value-added activities can engender nonvalue-added costs if they are not performed efficiently.
5–13 1.
Willson Company Nonvalue-Added Cost Trend Report For the Year Ended December 31, 2006 Purchasing parts Assembling parts Administering parts Inspecting parts Total
2005 $ 180,000 234,000 858,000 1,125,000 $2,397,000
2006 90,000 72,000 660,000 675,000 $1,497,000 $
Change $ 90,000 F 162,000 F 198,000 F 450,000 F $900,000 F
Note: The above amounts were computed for each year, using the following formula: (AQ – SQ)SP. 2.
A trend report allows managers to assess the effectiveness of activity management. It is a critical document that reveals the success of continuous improvement efforts. It also provides some information about additional opportunity for improvement. In 2006, activity management reduced the nonvalue-added costs by $900,000, signaling that the actions taken were good. It also shows that additional opportunity for reduction exists—more effort is needed to reduce the $1,497,000 of remaining nonvalue-added costs.
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5–14 1.
Activity and driver analysis: Setting up equipment: This is a value-added activity because (1) it causes a change in the state of nature: improperly configured equipment to properly configured equipment, (2) there is no prior activity that could have caused the state change, and (3) it is necessary to enable other activities to be performed. However, setting up equipment often takes more time than needed and so this activity has a nonvalue-added component. Most companies strive for zero setup time. Thus, the time and associated cost are nonvalue-added because the activity is performed inefficiently. Means should be explored to reduce the time of this activity so that it consumes fewer resources. Possible root causes include such factors as product design, process design, and equipment design. Knowing the root causes can lead to an improvement in activity efficiency. Moving from a departmental manufacturing structure to a cellular manufacturing structure in some cases may eliminate the need for setups, thus eliminating the activity, or flexible manufacturing equipment might be purchased that provides an almost instantaneous setup capability (a change in process technology—and certainly a change in equipment design). In other cases, the activity may be improved by redesigning the product so that a less complicated setup is required. Creating scrap: This is generally viewed as a nonvalue-added activity and should be eliminated. It is nonvalue-added because it causes a nondesired change of state and because it does not enable other value-added activities to be performed. Efforts should be made to find ways of producing that eliminate scrap. Possible root causes include poor vendor quality, quality management approach, and manufacturing process used. Knowing the root causes may lead to a supplier valuation program that improves the quality of the parts and materials purchased externally, adoption of a total quality management program, and perhaps the use of automated equipment to cut down on material waste (because of greater precision). Welding subassemblies: This is a value-added activity. It causes a desired state change that could not have been done by preceding activities and enables other activities to be performed. If inefficient, then means should be sought to improve efficiency. The goal is to optimize value-added activity performance. Possible root causes include product design, process design, and production technology. Changing either of the two designs could decrease the demand for the welding activity while producing the same or more output. A change in technology—buying more advanced technology, for example— may also increase the efficiency of the activity.
122
5–14
Continued
Materials handling: This is a nonvalue-added activity. Moving materials and subassemblies from one point in the plant changes location but not the state. But it does enable other activities to be performed, and it is not a repeated action. If you argue that changing location is a change in state, then moving materials is value-added but with the potential of significant increases in efficiency (as with setups, the goal is to minimize the amount of activity performance). Possible root causes include plant layout, manufacturing processes, and vendor arrangements. Moving from a departmental to a cellular structure, adopting computer-aided manufacturing, and entering into contracts with suppliers that require just-in-time delivery to the point of production are examples of how knowledge of root causes can be exploited to reduce and eliminate nonvalueadded activities. Inspecting parts: Inspection is a nonvalue-added activity. It is a statedetection activity and is not necessary to enable other activities to be performed. This activity should be reduced and eventually eliminated. A possible root cause of inspection is the possibility of poor quality of parts and materials. The company should work with suppliers to ensure high quality (zerodefect parts). 2.
Behavioral analysis: Setting up equipment: Using the number of setups as a driver may cause a buildup of inventories. Since reducing the number of setups will reduce setup costs, there will be an incentive to have fewer setups. Reducing the number of setups will result in larger lots and could create finished goods inventory. This is in opposition to the goal of zero inventories. On the other hand, if setup time is used as the driver, managers will have an incentive to reduce setup time. Reducing setup time allows managers to produce on demand rather than for inventory.
123
5–14
Concluded
Creating scrap: Using the number of defective units as a driver should encourage managers to reduce defective units. Assuming that defective units are the source of scrap, this should reduce scrap costs. Similarly, using pounds of scrap should encourage managers to find ways to reduce scrap. In both cases, the behavioral consequences could be two-edged. If the reduction of scrap (defective units) is achieved by increasing quality/productive efficiency, the effect is compatible with the objective of creating a competitive advantage. If the reduction is achieved by allowing defective units to flow through to finished goods, then the effect will be to alienate customers, not win their favor (customer realization decreases). Neither driver appears to dominate. One solution is to report the trend in warranty activity with the trend in scrap activity. This may discourage any kind of pass-on behavior. Welding subassemblies: Using welding hours should encourage management to find ways of reducing the welding hours required per product. This would be more likely to induce managers to look at possible root causes such as product design and process design rather than number of welded subassemblies. There is some value in looking for ways to reduce the number of welded subassemblies, perhaps redesigning the product to eliminate welding. Materials handling: Both drivers seem to have positive incentives. Seeking ways to reduce the number of moves or distance moved should lead managers to look at root causes. Reorganizing the plant layout, for example, should reduce either the number of moves or the distance moved. Hopefully, the activity drivers will lead to the identification of executional drivers that can be managed so that the activity can be reduced and eventually eliminated. Inspecting parts: Hours of inspection can be reduced by working with suppliers so that greater incoming quality is ensured. Similarly, the number of defective parts can be reduced by working with suppliers so that incoming quality is increased. Hours of inspection, however, can be reduced without increasing quality. This is not true for the number of defective parts. Using the number of defective parts appears to be a better choice.
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5–15 1.
First quarter: Setup time standard = 10 hours (based on the planned improvement: 15 hours – 5 hours) Second quarter: Setup time standard = 8 hours (based on the planned improvement: 9 hours – 1 hour)
2.
Kaizen subcycle: • Plan (five-hour reduction from process redesign) • Do (try out setup with new design) • Check (time required was nine hours, a six-hour reduction) • Act (lock in six-hour improvement by setting new standard of nine hours and using same procedures as used to give the nine-hour outcome; and, simultaneously, search for new improvement opportunity; in this case, the suggested changes of the production workers.) Repeat kaizen subcycle: • Plan (one-hour reduction from setup procedure changes) • Do (train and then implement procedures) • Check (actual time required was 6.5 hours, a 2.5-hour reduction) • Act (lock in improvement by setting standard of 6.5 hours and begin search for new improvement)
3.
Maintenance subcycle: First quarter (end of): • Establish standard (nine hours based on improved process design) • Do (implement repetitively the improved standard) • Check (see if the nine-hour time is maintained) • Act (if the nine-hour time deteriorates, find out why and take corrective action to restore to seven hours.) Second quarter: Same cycle using 6.5 hours as the new standard to maintain Note: The maintenance cycle described begins after observing the actual improvement. The actual improvement is locked in. The maintenance standard at the beginning of the first quarter is 15 hours.
125
5–15
Concluded
4.
Nonvalue-added cost saved (eliminated): $100 × 8.5 = $850 per setup.
5.
Standard costing basically uses only a maintenance subcycle. Standards are set and maintained. The principal difference is the emphasis on constantly searching for improvements with the standard changing with each improvement. This search involves all employees (e.g., engineers and production workers). Thus, kaizen costing is dynamic, whereas traditional (functionalbased) standard costing is static.
5–16 1.
Salesa Allocationb
JIT $25,000,000 1,500,000
Non-JIT $25,000,000 1,500,000
a
$125 × 200,000, where $125 = $100 cost + ($100 × 0.25) markup on cost, and 200,000 is the average order size times the number of orders JIT : 400 orders * 500 average order size = 200,000 Non-JIT: 40 orders * 5,000 average order size = 200,000
b
2.
0.50 × $3,000,000
Activity rates: Ordering rate = $1,760,000/440= $4,000 per sales order Selling rate = $640,000/80 = $8,000 per sales call Service rate = $600,000/300 = $2,000 per service call
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5–16
Concluded JIT
Ordering costs: $4,000 × 400 $4,000 × 40 Selling costs: $8,000 × 40 $8,000 × 40 Service costs: $2,000 × 200 $2,000 × 100 Total
Non-JIT
$ 1,600,000 $ 160,000 320,000 320,000 400,000 $ 2,320,000
200,000 $ 680,000
For the non-JIT customers, the customer costs amount to $1,500,000/40 = $37,500 per order under the original allocation. Using activity assignments, this drops to $680,000/40 = $17,000 per order, a difference of $20,500 per order. For an order of 5,000 units, the order price can be decreased by $4.10 per unit without affecting customer profitability. Overall profitability will decrease, however, unless the price for orders is increased to JIT customers. 3.
It sounds like the JIT buyers are switching their inventory carrying costs to Carbon without any significant benefit to Carbon. Carbon needs to increase prices to reflect the additional demands on customer-support activities. Furthermore, additional price increases may be needed to reflect the increased number of setups, purchases, and so on, that are likely occurring inside the plant. Carbon should also immediately initiate discussions with its JIT customers to begin negotiations for achieving some of the benefits that a JIT supplier should have, such as long-term contracts. The benefits of long-term contracting may offset most or all of the increased costs from the additional demands made on other activities.
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5–17 1.
Supplier cost: First, calculate the activity rates for assigning costs to suppliers: Inspecting components: $240,000/2,000 = $120 per sampling hour Reworking products: $760,500/1,500 = $507 per rework hour Warranty work: $4,800,000/8,000 = $600 per warranty hour Next, calculate the cost per component by supplier: Supplier cost: Vance Purchase cost: $23.50 × 400,000 $21.50 × 1,600,000
Foy
$ 9,400,000 $ 34,400,000
Inspecting components: $120 × 40 $120 × 1,960
4,800 235,200
Reworking products: $507 × 90 $507 × 1,410
45,630 714,870
Warranty work: $600 × 400 $600 × 7,600 Total supplier cost Units supplied Unit cost
240,000 $ 9,690,430 ÷ 400,000 $ 24.23*
4,560,000 $ 39,910,070 ÷ 1,600,000 $ 24.94*
*Rounded The difference is in favor of Vance; however, when the price concession is considered, the cost of Vance is $23.23, which is less than Foy’s component. Lumus should accept the contractual offer made by Vance.
128
5–17 2.
Concluded
Warranty hours would act as the best driver of the three choices. Using this driver, the rate is $1,000,000/8,000 = $125 per warranty hour. The cost assigned to each component would be: Vance Lost sales: $125 × 400 $125 × 7,600
Foy
$ 50,000 $ 50,000 ÷ 400,000 $ 0.13*
Units supplied Increase in unit cost *Rounded
129
$ 950,000 $ 950,000 ÷ 1,600,000 $ 0.59*
PROBLEMS 5–18 1.
An activity driver measures the amount of an activity consumed by a cost object. It is a measure of activity output. Activity drivers are used to assign activity costs to cost objects. On the other hand, a cost driver is the root cause of the activity and explains why the activity is performed. Cost drivers are useful for identifying how costs can be reduced (rather than assigned).
2.
Value content and driver analysis: Setting up equipment: At first glance, this appears to be a value-added activity because: (1) it causes a change in the state of nature: improperly configured equipment to properly configured equipment, (2) there is no prior activity that should have caused the state change, and (3) it is necessary to enable other activities to be performed. However, setting up equipment often takes more time than needed and so has a nonvalue-added component. Most companies strive for zero setup time, suggesting that the time and associated cost are nonvalue-added because the activity is performed inefficiently. (A zero setup time suggests a nonvalue-added activity.) Means should be explored to reduce the time of this activity so that it consumes fewer resources. Possible root causes include such factors as product design, process design, and equipment design. Knowing the root causes can lead to an improvement in activity efficiency. Moving from a departmental manufacturing structure to a cellular manufacturing structure in some cases may eliminate the need for setups, thus eliminating the activity. Or flexible manufacturing equipment might be purchased that provides an almost instantaneous setup capability (a change in process technology—and certainly a change in equipment design). In other cases, the activity may be improved by redesigning the product so that a less complicated setup is required. Performing warranty work: This is generally viewed as a nonvalue-added activity and should be eliminated. It is nonvalue-added because it represents a type of rework—repairs on products that are caused by faulty production. Possible root causes include poor vendor quality, poor product design, quality management approach, and manufacturing process used. Knowing the root causes may lead to a supplier valuation program that improves the quality of the parts and materials purchased externally, adoption of a total quality management program, product redesign, process redesign, and perhaps the use of automated equipment to cut down on faulty products.
130
5–18
Continued
Welding subassemblies: This is a value-added activity. It causes a desired state change that could not have been done by preceding activities and enables other activities to be performed. If inefficient, then means should be sought to improve efficiency. The goal is to optimize value-added activity performance. Possible root causes of inefficiency include product design, process design, and production technology. Changing either product or process design could decrease the demand for the welding activity while producing the same or more output. A change in technology—buying more advanced technology, for example—may also increase the efficiency of the activity. Moving materials: This is usually viewed as a nonvalue-added activity. Moving materials and subassemblies from one point in the plant changes location but not the state. But it does enable other activities to be performed, and it is not a repeated action. If it is argued that changing location is a change in state, then you could respond by noting that it is an unnecessary change of state. Possible root causes include plant layout, manufacturing processes, and vendor arrangements. Moving from a departmental to a cellular structure, adopting computer-aided manufacturing, and entering into contracts with suppliers that require just-in-time delivery to the point of production are examples of how knowledge of root causes can be exploited to reduce and eliminate material handling cost. Inspecting components: Inspection is a nonvalue-added activity. It is a statedetection activity and is not necessary to enable other activities to be performed. This activity should be reduced and eventually eliminated. A possible root cause of inspection is the possibility of poor quality of parts and materials. The company should work with suppliers to ensure high quality (zerodefect parts).
131
5–18 3.
Concluded
Behavioral analysis: Setting up equipment: Using the number of setups as a driver may cause a buildup of inventories. Since reducing the number of setups will reduce setup costs, there will be an incentive to have fewer setups. Reducing the number of setups will result in larger lots and could create finished goods inventory. This is in opposition to the goal of zero inventories. On the other hand, if setup time is used as the driver, managers will have an incentive to reduce setup time. Reducing setup time allows managers to produce on demand rather than for inventory. Performing warranty work: Using the number of defective units as a driver should encourage managers to reduce defective units. Assuming that defective units are the source of warranty work, this should reduce warranty costs. Similarly, using warranty hours could encourage managers to find ways to reduce warranty work by decreasing its causes. Alternatively, it may cause them to look for more efficient means of performing warranty work. Increasing the efficiency of a nonvalue-added activity has some short-run merit but it should not be the focus. Of the two drivers, defective units is the most compatible with eventual elimination of the nonvalue-added activity. Welding subassemblies: Using welding hours should encourage management to find ways of reducing the welding hours required per product. This would more likely induce managers to look at possible root causes such as product design and process design than would number of welded subassemblies. There is some value in looking for ways to reduce the number of welded subassemblies, perhaps redesigning the product to eliminate welding. Moving materials: Both drivers seem to have positive incentives. Seeking ways to reduce the number of moves or distance moved should lead managers to look at root causes. Reorganizing the plant layout, for example, should reduce either the number of moves or the distance moved. Hopefully, the activity drivers will lead to the identification of executional drivers that can be managed so that the activity can be reduced and eventually eliminated. Inspecting components: Hours of inspection can be reduced by working with suppliers so that greater incoming quality is ensured. Similarly, the number of defective parts can be reduced by working with suppliers so that incoming quality is increased. Hours of inspection, however, can be reduced without increasing quality. This is not true for the number of defective parts. Using the number of defective parts appears to be a better choice.
132
5–19 1.
Activity-based management is a systemwide, integrated approach that focuses management’s attention on activities. It involves two dimensions: a cost dimension and a process dimension. A key element in activity management is identifying activities, assessing their value, and retaining only value-adding activities. The consultant identified the activities but did not formally classify the activities as value-added or nonvalue-added. Nor did the consultant offer any suggestions for increasing efficiency—at least not formally. The consultant apparently had tentatively identified savings possible by eliminating nonvalue-added activities. Management must still decide how to reduce, eliminate, share, and select activities to achieve cost reductions.
2.
Setup Materials handling Inspection Customer complaints Warranties Storing Expediting Total
$125,000 180,000 122,000 100,000 170,000 80,000 75,000 $852,000
Units produced and sold
÷120,000*
Potential unit cost reduction
$
7.10
*$1,920,000/$16 (total cost divided by unit cost) The consultant’s estimate of cost reduction was on target. Per-unit costs can be reduced by at least $7, and further reductions may be possible if improvements in value-added activities are possible. 3.
Total potential reduction: $ 852,000 (from Requirement 2) 150,000 (by automating) $1,002,000 Units ÷ 120,000 Unit savings $ 8.35 Costs can be reduced by at least $7, enabling the company to maintain current market share. Further, if all the nonvalue-added costs are eliminated, then the cost reduction needed to increase market share is also possible. Activity selection is the form of activity management used here.
133
4.
Current: Sales Costs Income
$ 2,160,000 ($18 × 120,000 units) (1,920,000) $ 240,000
$14 price (assumes that current market share is maintained): Sales Costs Income
$1,680,000 ($14 × 120,000 units) (918,000) ($7.65* × 120,000 units) $ 762,000
$12 price: Sales Costs Income
$ 2,160,000 ($12 × 180,000 units) (1,377,000) ($7.65* × 180,000 units) $ 783,000
*$16 – $8.35 = $7.65 The $12 price produces the greatest benefit.
134
5–20 1.
Nonvalue-added usage and costs, 2008: Nonvalue-AddedNonvalue-Added Cost Usage
Materials Engineering
AQ* 600,000 48,000
SQ** 480,000 27,840
AQ – SQ 120,000 20,160
(AQ – SQ)SP $ 600,000 604,800 $1,204,800
*1.25 × 6 × 80,000; (4 × 6,000) + (10 × 2,400) (AQ for engineering represents the actual practical capacity acquired.) **6 × 80,000; (0.58 × 24,000) + (0.58 × 24,000) Note: SP for materials is $5; SP for engineering is $30 ($1,440,000/48,000). There are no price variances because SP = AP. Unused capacity for engineering: SP × AQ
SP × AU
$30 × 48,000
$30 × 46,000 $60,000 F
Unused Capacity Variance 2.
Kaizen standards for the coming year (2009): Materials: Engineering:
SQ = 480,000 + 0.6(120,000) = 552,000 pounds SQ = 27,840 + 0.6(20,160) = 39,936 engineering hours
135
5–20
Concluded
3. Materials Engineering
AQ* 584,800 35,400
SQ 552,000 39,936
AQ – SQ 32,800 (4,536)
SP(AQ – SQ) $164,000 U 136,080 F
*For engineering, the kaizen standard is a measure of how much resource usage is needed (this year), and so progress is measured by comparing SQ with actual usage, AU, not AQ, activity availability. The formula AQ – AU, on the other hand, will measure the unused capacity, a useful number, as is discussed below. The company failed to meet the materials kaizen standard but beat the engineering standard. The engineering outcome is of particular interest. The actual usage of the engineering resource is 35,400 hours, and activity availability is 48,000. Thus, the company has created 12,600 hours of unused engineering capacity. Each engineer brings a capacity of 2,000 hours. Since engineers come in whole units, the company now has six too many! Thus, to realize the savings for the engineering activity, the company must decide how to best use these available resources. One possibility is to simply lay off six engineers, thereby increasing total profits by the salaries saved ($360,000). Other possibilities include reassignment to activities that have insufficient resources (assuming they could use engineers, e.g., perhaps new product development could use six engineers). The critical point is that resource usage reductions must be converted into reductions in resource spending, or the efforts have been in vain.
136
5–21 1.
Nonvalue-added costs: Materials (400,000 – 380,000)$21 Labor (96,000 – 91,200)$12.50 Setups (6,400 – 0)$75 Materials handling (16,000 – 0)$70 Warranties (16,000 – 0)$100 Total Units produced and sold Unit nonvalue-added cost
$
420,000 60,000 480,000 1,120,000 1,600,000 $ 3,680,000 ÷ 20,000 $ 184
Current cost less nonvalue-added cost: $640 – $184 = $456 This is much less than the Santa Clara plant’s cost of $560. Thus, matching the Santa Clara cost is possible and so is the target cost for expanding market share. How quickly the cost reductions can be achieved is another matter. Since the Santa Clara plant has experience in achieving reductions, it may be possible to achieve at least a cost of $560 within a reasonably short time. As plant manager, I would borrow heavily from the Santa Clara plant experience and attempt to reduce the nonvalue-added costs quickly. I would also lower the price to $624 and seek to take advantage of the increased market share— even if it meant a short-term reduction in profits. 2.
Benchmarking played a major role. The Santa Clara plant set the standard and offered to share information on how it achieved the cost reductions that enabled it to lower its selling price. The Lincoln plant responded by accepting the offer of help and taking actions to achieve the same or greater cost reductions.
137
5–22 1.
First quarter:
Setup time standard = 8 hours (based on the planned improvement: 12 hours – 4 hours of reduced time) Second quarter: Setup time standard = 4 hours (based on the planned improvement: 9 hours – 5 hours)
2.
Kaizen subcycle: • • • •
Plan (4-hour reduction from process redesign.) Do (Try out setup with new design.) Check (Time required was 9 hours, a 3-hour reduction.) Act (Lock in 3-hour improvement by setting new standard of 9 hours and using same procedures as used to give the 9-hour outcome; simultaneously, search for new improvement opportunity—in this case, the suggested changes of the production workers.)
Repeat Kaizen subcycle: • • • •
3.
Plan (5-hours reduction from setup procedure changes.) Do (Train and then implement procedures.) Check (Actual time required was 3 hours, a 6-hour reduction.) Act (Lock in improvement by setting standard of 3 hours and begin search for new improvement.)
Maintenance subcycle: First quarter: • • • •
Establish standard (9 hours based on improved process design.) Do (Implement repetitively the improved standard.) Check (See if the 9-hour time is maintained.) Act (If the 9-hour time deteriorates, find out why and take corrective action to restore to 9 hours.)
Second quarter: Same cycle using 3 hours as the new standard to maintain. Note: The maintenance cycle begins after observing the actual improvement. The actual improvement is locked in.
138
5–22
Concluded
4.
Nonvalue-added cost saved (eliminated): $300 × 6 hours savings = $1,800 per setup. Kaizen costing is concerned with improving activity performance and uses root causes to help identify initiatives for improvement. Thus, kaizen is a tool or means for implementing ABM concepts.
5.
Kaizen costing emphasizes constantly searching for process improvements with the standard changing with each improvement. This search involves all employees (e.g., engineers and production workers). Thus, kaizen costing focuses on processes and uses dynamic standards, which are characteristics of activity-based responsibility accounting. Standard costing uses only the maintenance subcycle. Standards are set and maintained—they are static in nature and thus consistent with the financial-based responsibility accounting model.
5–23 1.
Cost per account = $4,070,000/50,000 = $81.40 Average fee per month = $81.40/12 = $6.78* *Rounded
2.
Activity rates: Opening and closing accounts: $200,000/20,000 = $10 per account Issuing monthly statements: $300,000/600,000 = $0.50 per statement Processing transactions: $2,050,000/20,500,000 = $0.10 per transaction Customer inquiries: $400,000/2,000,000 = $0.20 per minute Providing ATM services: $1,120,000/1,600,000 = $0.70 per transaction
139
5–23 3.
Continued
Costs assigned: Low Opening and closing: $10 × 15,000 $10 × 3,000 $10 × 2,000 Issuing monthly statements: $0.50 × 450,000 $0.50 × 100,000 $0.50 × 50,000 Processing transactions: $0.10 × 18,000,000 $0.10 × 2,000,000 $0.10 × 500,000 Customer inquiries: $0.20 × 1,000,000 $0.20 × 600,000 $0.20 × 400,000 Providing ATM services: $0.70 × 1,350,000 $0.70 × 200,000 $0.70 × 50,000 Total cost Number of accounts Cost per account
Medium
High
$ 150,000 $ 30,000 $ 20,000 225,000 50,000 25,000 1,800,000 200,000 50,000 200,000 120,000 80,000 945,000 140,000 $ 3,320,000 ÷ 38,000 $ 87.37
$540,000 ÷ 8,000 $ 67.50
Average profit per account: $90.00 – $81.40 = $8.60 ABC profit measure: Low-balance customers: $80 – $87.37 = $(7.37) Medium-balance customers: $100 – $67.50 = $32.50 High-balance customers: $165 – $52.50 = $112.50
140
35,000 $210,000 ÷ 4,000 $ 52.50
5–23 4.
Concluded
First, calculate the profits from loans, credit cards, and other products by customer category (using ABC data). Next, compare 50 percent of the cross sales profits from low-balance customers with the total loss from the lowbalance checking accounts. If the cross sales profits are greater than the loss, the president’s argument has merit.
5–24 1.
GAAP mandates that all nonmanufacturing costs be expensed during the period in which they are incurred. GAAP are the most likely cause of the practice. The limitations of GAAP-produced information for cost management should be emphasized.
2.
The total product consists of all benefits, both tangible and intangible, that a customer receives. One of the benefits is the order-filling service provided by Sorensen. Thus, it can be argued that these costs should be product costs and not assigning them to products undercosts all products. From the information given, there are more small orders than large (50,000 orders averaging 600 units per order); thus, these small orders consume more of the orderfilling resources. They should, therefore, receive more of the order-filling costs. The average order-filling cost per unit produced is computed as follows:
1
$4,500,000/90,000,0001 units = $0.05 per unit (50,000 orders * 600 units per order) + (30,000 orders * 1,000 units per order) + (20,000 orders * 1,500 units per order) = 90,000,000 units Thus, order-filling costs are about 6 to 10 percent of the selling price, clearly not a trivial amount. Furthermore, the per-unit cost for individual product families can be computed using the number of orders as the activity driver: Activity rate = $4,500,000/100,000 orders = $45 per order The per-unit ordering cost for each product family can now be calculated: Category I: $45/600 = $0.075 per unit Category II: $45/1,000 = $0.045 per unit Category III: $45/1,500 = $0.03 per unit Category I, which has the smallest batches, is the most undercosted of the three categories. Furthermore, the unit ordering cost is quite high relative to
5-24
Concluded 141
Category I’s selling price (9 to 15 percent of the selling price). This suggests that something should be done to reduce the order-filling costs. 3.
With the pricing incentive feature, the average order size has been increased to 2,000 units for all three product families. The number of orders now processed can be calculated as follows: Orders = [(600 × 50,000) + (1,000 × 30,000) + (1,500 × 20,000)]/2,000 = 45,000 Reduction in orders = 100,000 – 45,000 = 55,000 Steps that can be reduced = 55,000/2,000 = 27 (rounding down to nearest whole number) There were initially 50 steps: 100,000/2,000 Reduction in resource spending: Step-fixed costs: Variable activity costs:
$50,000 × 27 = $20 × 55,000 =
$1,350,000 1,100,000 $2,450,000
Customers were placing smaller and more frequent orders than necessary. They were receiving a benefit without being charged for it. By charging for the benefit and allowing customers to decide whether the benefit is worth the cost of providing it, Sorensen was able to reduce its costs (potentially by shifting the cost of the service to the customers). The customers, however, apparently did not feel that the benefit was worth paying for and so increased order size. By increasing order size, the number of orders decreased, decreasing the demand for the order-filling activity, allowing Sorensen to reduce its order-filling costs. Other benefits may also be realized. The order size affects activities such as scheduling, setups, and material handling. Larger orders should also decrease the demand for these activities, and costs can be reduced even more. Competitive advantage is created by providing the same customer value for less cost or better value for the same or less cost. By reducing the cost, Sorensen can increase customer value by providing a lower price (decreasing customer sacrifice) or by providing some extra product features without increasing the price (increasing customer realization, holding customer sacrifice constant). This is made possible by the decreased cost of producing and selling the bolts.
142
5–25 1.
Supplier cost: First, calculate the activity rates for assigning costs to suppliers: Replacing engines: $3,200,000/4,000 = $800 per engine Expediting orders: $4,000,000/400 = $10,000 per late shipment Repairing engines: $7,200,000/5,000 = $1,440 per engine Next, calculate the cost per engine by supplier: Supplier cost: Watson Purchase cost: $900 × 72,000 $1,000 × 16,000
$64,800,000 $16,000,000
Replacing engines: $800 × 3,960 $800 × 40
3,168,000
Expediting orders: $10,000 × 396 $10,000 × 4
3,960,000
Repairing engines: $1,440 × 4,880 $1,440 × 120 Total supplier cost Units supplied Unit cost
Johnson
32,000
40,000 7,027,200 $ 78,955,200 ÷ 72,000 $ 1,096.60
172,800 $16,244,800 ÷ 16,000 $ 1,015.30
The Johnson engine costs less when the full supplier effects are considered. This is a better assessment of cost because it considers the costs that are caused by the supplier due to poor quality, poor reliability, and poor delivery performance. 2.
In the short run, buy 40,000 from Johnson and 48,000 from Watson. In the long run, one possibility is to encourage Johnson to expand its capacity; another possibility is to encourage Watson to increase its quality and maintain purchases from both sources.
143
MANAGERIAL DECISION CASE 5–26 1.
Tim and Jimmy have been friends for a long time. The one-time nature of the request and the alleged effect a redesign would have on Jimmy’s career opportunity both create strong pressure for Tim to provide the requested cooperation. Of course, even without any specific ethical standards, it is fairly easy to see that falsification of reports to help ensure a promotion is not the right thing to do. Tim should turn down the request and make every effort to help Jimmy find a solution that will benefit him and the company. For example, Tim might be able to use his influence to obtain extra development capital, including a sufficient amount to expedite the development so that the production dates can still be met.
2.
If Tim cooperates, he will violate (at least) the following ethical standards (see Chapter 1): competence standard I-3 (Provide decision support information and recommendations that are accurate, clear, concise, and timely); integrity standards III-1 and III-2: and credibility standards IV-1 and IV-2.
3.
Tim should follow any relevant organizational policies bearing on matters such as these. If these policies do not apply, then he should discuss the problem with his supervisor (the divisional manager). If satisfactory resolution is not obtained here, then the issues should be submitted to the next higher management level. Certainly, the actions described here would place Tim in an awkward position. Even though he has not willingly cooperated, a passive reaction could later be construed as implicit involvement. Thus, some action such as that outlined is strongly recommended.
RESEARCH ASSIGNMENT 5–27 Answers will vary.
144
