Preliminary stage cost drivers definition

4 Activity-Based Costing and Just-In-Time Costing

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Learning Objectives

After studying Chapter 4, you will be able to:

• Explain the interrelationships among cost drivers, activities, and products in an activity-based cost system, and describe the system’s key components and cost flows.

• Distinguish between the two stages of cost allocation in an activity-based cost system, and apply activity- based costing in a manufacturing setting.

• Understand how activity-based costing is extended to nonmanufacturing settings.

• Relate activity-based management to activity-based costing.

• Describe the key elements of a just-in-time cost system.

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Chapter Outline

4.1 Activity-Based Costing Issues Influencing Cost Management Systems Design Definition of Activity-Based Costing Flow of Costs Under Activity-Based Costing Influence of Production Complexity

4.2 A Comprehensive Activity-Based Costing Example Preliminary Stage Allocation Primary Stage Allocation Comparing ABC to Traditional Volume-Based Costing

4.3 ABC and Nonmanufacturing Activities

4.4 Activity-Based Management

4.5 JIT Costing

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Testing . . . Testing

Cortell Laboratories was formed in 1993 and began its operations in testing various electrical characteristics of integrated circuits sent to it by manufacturers on the west coast. Cortell focused on a strategy of providing quicker turnaround times than had been offered by manufacturers’ labs or other outside labs. The strategy was successful and was marketed well. Within 10 years, Cortell had annual revenues of over $30 million. Profit and cash flow, also highly positive, allowed Cortell to self-fund all expansion.

In 2010, Cortell began offering tests for transformers. Within one year, transformer testing was so successful that the lab was now running on three full shifts. In the midst of all this success, Harriet Cortell, the company president, is now faced with a dilemma. The marketing manager, Kitty Cohen, has come to her and argued that testing transformers is much more profitable than testing integrated circuits, and therefore, the lab should concentrate more of its resources on marketing and performing transformer tests. To support her argument, Cohen compiled costs and profit margins for each testing service. These figures showed that transformer testing was over 40% more profitable than testing integrated circuits. Cortell looked at the overhead allocated to the two types of tests and could hardly believe that each test was assigned the same amount of overhead per test. She knew that testing transformers involved more job orders and required more setups than testing integrated circuits. “Our costing system is not reflecting the complexity of these tests,” claimed Cortell.

Several months earlier, Cortell had heard about an activity-based cost approach for assigning overhead costs. She immediately contacted the controller, Charlie Kaplan, and asked him to do an activity-based cost analysis.

Two major forces have combined to put great pressure on managerial accountants like Char- lie Kaplan to provide improved cost information about their firms’ products and services. These are global competition and automation in the workplace.

1. Global competitiveness. Most companies in nearly every industry face increased competition from direct competitors, whether from across the street or halfway around the world. Whether the technology is old (making iron and steel) or new (making smart televisions), the needs for accurate and relevant product cost data have grown dramatically. Competitiveness also means knowing the costs of product quality, reliable delivery, and waste (unproductive effort). Cost control takes on new meaning if a competitor can sell an item at a price that is 10% lower than another company’s production cost and still make money on the sale. Increasingly, com- panies are realizing that traditional volume-based cost systems are not using the “right” variables or collecting cost data in enough detail.

2. Automation of the workplace. Dramatic changes in production have also taken place. Another “industrial revolution” is what some people have called it. Computer power has introduced concepts like computer-aided design (CAD), computer-aided manufacturing (CAM), flexible manufacturing systems (FMS), and robotics. Computer power has allowed precise tasks to be programmed and machines to be designed to do those tasks. Likewise, computer power has enabled production managers to

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Section 4.1 Activity-Based Costing

coordinate thousands of events, transactions, and possible courses of action. One outcome is a shift from heavy dependence on labor to technology. Direct labor costs were often a major product cost, and labor activity often reflected general activity in the plant. Now, in many companies, direct labor is a minor portion of a product’s total cost. Other production costs have grown tremendously because of equipment costs and support personnel needed to coordinate production. New activity measures are needed to link resources used with production activities. The traditional approach of allocating overhead costs using direct labor hours or direct labor cost is no longer relevant in companies that are highly automated.

Competition and automation have focused attention on getting more accurate, timely, and relevant costs for products and services. The concepts are simple and have always been at the heart of cost accounting: Link the cost of resources used to the activity using the resources, and link the activity to the product being produced. Traditionally, the activity measure used most often has been a volume measure: direct labor hours (or dollars). In recent years, there has been a recognition that the complexity of production, rather than volume, is the most important determinant of overhead costs. Cost systems known as activity-based costing reflect this new orientation.

Consider the following example of a company that manufactures ball-point pens in two dif- ferent plants. In one plant, plant A, 30,000 identical pens are produced—all with black ink and black casings. In the other plant, plant B, 30,000 similar pens are also produced, but 10,000 have black ink, another 10,000 have blue ink, and the remaining 10,000 contain red ink. Likewise, those in plant B have a variety of casing colors: 8,000 are black, 12,000 are gold, and 10,000 are silver. Since each plant manufactures 30,000 pens, the amount of direct labor hours worked would be expected to be virtually the same in each plant. Therefore, using direct labor to allocate overhead costs to the two plants would result in the same amount of overhead costs assigned to each plant. Yet, plant B clearly consumes more overhead costs such as indirect labor costs relating to more machine changeovers, time spent on purchas- ing materials, and inventory management time. In other words, plant B manufactures more complex products (i.e., products that involve extra processes), but traditional costing that uses direct labor to allocate overhead costs ignores this complexity. Activity-based costing not only considers volume when assigning overhead costs, but does so in ways that reflect the complexity of the various products.

This chapter presents the conceptual foundation for activity-based costing as a means of improving the accuracy of assigning costs to cost objectives—primarily to products and ser- vices. Many companies that have adopted activity-based cost systems have also instituted just-in-time inventory systems. Later in the chapter, we discuss how adoption of just-in-time inventory systems has affected product costing.

4.1 Activity-Based Costing Activity-based costing focuses on finding the cost of producing a product or service. In Chap- ter 1, we introduced cost of goods manufactured and the three traditional groups of costs: direct materials, direct labor, and factory overhead. In past years, direct materials and direct labor were linked with products because of their obvious direct relationships; all other

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Section 4.1 Activity-Based Costing

manufacturing costs were traditionally grouped together in a cost pool as overhead. One activity measure, often direct labor, was used to attach all overhead costs to products. Many different overhead costs were combined and included:

1. Plant supervision and other indirect labor salaries 2. Materials handling costs 3. Plant engineering costs 4. Setup or changeover costs 5. Supplies and indirect materials 6. Depreciation, taxes, and insurance on equipment 7. Energy and other utility costs 8. Repair and maintenance costs

Ideally, every overhead cost item could be traced directly to specific products. This is just not possible. If we produce a million units of different types and sizes of batteries in a factory, can the manager’s $100,000 salary be traced to the different batteries? No. Can we link the manager’s salary to certain factory activities, then link the activity costs to the different bat- teries? Yes, but only with careful analysis and application. Activity-based costing focuses on distributing costs that managers are unable to clearly identify with specific jobs or products (i.e., indirect costs).

Issues Influencing Cost Management Systems Design Product costs are so critical to managerial decisions that greater precision and accuracy are needed today than were demanded in the past. Thus, a major effort is under way in many companies to upgrade their cost systems.

The level of detail that a cost system needs is based on the following considerations:

1. The competitive environment, which will impact the degree of accuracy needed and the toleration of costing errors

2. The homogeneity or heterogeneity of the products or services 3. The complexity of the production process 4. The volumes of each product or service produced 5. The costs of measuring and collecting activity and cost data 6. The impacts that more accurate and relevant data will have on managerial behavior

Detailed cost systems are expensive to design and to operate. Yet the value of better cost information can also be extremely high.

Definition of Activity-Based Costing Activity-based costing (ABC) is a system of accounting that focuses on activities performed to produce products or services. Activities become the fundamental cost accumulation points. This is because it is activities such as purchasing, moving materials, and machine setup that cause overhead costs to be incurred. Costs are traced to activities, and activities are traced to products based on each product’s use of the activities. We show these relationships for allo- cating costs in Figure 4.1.

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Section 4.1 Activity-Based Costing

Figure 4.1: An overall view of ABC cost linkage

Products or Services Resources

(Costs) Activities

Under activity-based costing, an effort is made to identify and account for as many costs as possible as direct costs of production. Any cost that can reasonably be traced to a particular product or service is treated as a direct cost. For example, under the traditional cost system, the cost of setup time (the factory downtime incurred in converting equipment from produc- ing one product to another) is included in manufacturing overhead and applied to products on the basis of direct labor hours. Under ABC, setup time might be measured for each product line, and setup costs would be directly assigned to each part or product manufactured.

An ABC system identifies the major activities in a production process, aggregates those activi- ties into activity centers, accumulates costs in activity centers, selects cost drivers that link activities to products, and assigns the costs of activities to products. We show this process in Figure 4.2. An activity center is a segment of the organization for which management wants the costs of a set of activities to be reported separately. A mechanism called a cost driver is used for linking a given activity’s pool of costs. A cost driver is an event, action, or activity that results in cost incurrence. It is any factor that causes costs to change. The basic concept is that cost drivers, such as number of purchase orders issued, measure the amount of resources a specific product uses. A cost function is created from the activity’s planned costs and cost driver activity level.

Figure 4.2: An overall view of the ABC process

Example: Moving and handling materials in the factory

Group similar activities

Define activity centers

Classify activity

center costs

Identify cost drivers

Estimate cost driver activity

Create cost driver cost function

Measure actual cost driver

activity

Assign costs to cost

objective

All activities that move materials,

parts, and products in the plant

Materials handling

Labor costs Equipment costs Supplies costs

Equipment repairs

Pounds moved Pieces moved Dollar value of materials moved Number of parts moved

Planned activity Actual

activity

Materials handling costs assigned to products produced

Cost per pound moved Cost per piece moved Cost per dollar of materials moved Cost per part number moved

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Section 4.1 Activity-Based Costing

Although not always obvious, several different cost drivers could link an activity’s costs and the cost objective. However, only one cost driver is chosen for each cost pool. In the materi- als handling case in Figure 4.2, four possible cost drivers are listed. Assume that pounds of materials moved is considered to be the most appropriate cost driver. We therefore divide the planned materials handling costs by the planned pounds to be moved. Cost per pound moved is the cost function. Then, the actual pounds handled in the production of a product times the cost per pound moved is the amount of materials handling costs assigned to that product. Again, the overall process is to identify the best cost driver that links costs and activities and then to use that cost driver to link activities with products (or other cost objectives).

Flow of Costs Under Activity-Based Costing In applying ABC to a specific organization, we follow five basic steps:

1. Assemble similar actions into activity centers. 2. Classify costs by activity center and by type of expense. 3. Select cost drivers. 4. Calculate a cost function to link costs and cost drivers with resource use. 5. Assign costs to the cost objective—often the product cost.

These steps are consistent with Figure 4.2.

Step 1: Assemble Similar Actions into Activity Centers. The number of actions performed in any organization can be quite numerous. Although the ideal is to relate the cost of every action to a cost driver and then to the product, the costs of doing this can far exceed the ben- efits. Therefore, we combine actions into activity centers. For instance, the actions of placing a product in a box, sealing the box, and then labeling the box can be combined into a packaging activity. Treating collections of actions as activity centers eliminates the need to measure and track the performance of numerous individual actions and costs.

One meaningful way of grouping actions is to classify them with different levels of activi- ties. A common outline is unit-level activities, batch-level activities, product-level activities, and facility-level activities. Figure 4.3 illustrates the four types. Unit-level activities are per- formed each time a unit is produced or handled. These are repetitive activities. Direct labor or machining activities are examples. Costs of these activities vary with the number of units pro- duced. Batch-level activities are performed each time a batch of goods is produced or han- dled. Machine setups, order processing, and materials handling are related to batches rather than individual units. The costs of these activities vary according to the number of batches but are common or fixed for all units in the batch. Product-level activities are those performed as needed to support the production of each different type of product or service. Maintaining bills of materials and routing information, processing engineering changes, and performing testing routines are examples of activities in this category. Facility-level activities are those which simply sustain a facility’s general production process. Examples would include plant supervision and building occupancy. These costs are common to a variety of products and are the most difficult to link to product-specific activities. For this reason, many people question whether facility-level costs should be linked to products.