Using the activity-proportion method results in:

Activity Based Costing (ABC)

• ·        Activity based costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require.  ABC is a two-stage process in which indirect costs are first assigned to activities and then to individual products and services based on their activity requirements.

• o       Stage One:  Assign Indirect Costs To Activities
  • §        Identify and Classify Activities – The first step in an ABC system is to identify the activities required to make the product or provide the service.  Activities can be classified by the following methods:
    • ·        Facility or Company-wide activities – these are activities that support the entire company.
    • ·        Product or Customer activities – these are activities that relate to a specific product line or customer.
    • ·        Batch activities – activities performed for a group of units all at once.
    • ·        Unit activities – activities that must be performed for each individual unit.

• §        Form Activity Cost Pools and Assign Indirect Costs to Each Activity – When the activities have been identified and classified (facility, product, batch, unit), the next step is to combine similar activities into activity cost pools.  To keep the cost system manageable, we must simplify the number of activities by grouping like or similar activities together.  The goal is to create as few cost pools as possible while still capturing the major activities identified in the previous step.  When allocating costs to each activity, one will need to come up with a uniform cost drivers (Stage one allocation cost drivers such as supervision hours, machine hours) that relate to each activity.  We will talk about this in Stage Two.

• o       Stage Two:  Assign Activity Costs to Individual Products or Services

• §        Select an Activity Cost Driver for Each Cost Pool – The next step is to select an activity cost driver for each of the activity cost pools.  An activity cost driver is a measure of the underlying activity that occurs in each activity cost pool.  The goal is to identify a driver that has a cause-and-effect relationship with the underlying activity. 

Unlike traditional cost systems which rely on strictly volume based allocation measures, ABC systems include measures that capture something other than the sheer volume of units produced or customers served.  These measures are called non-volume based cost drivers. Here are some examples:

• ·        Volume Based Allocation Measures – Number of units produced, number of direct labor hours, number of machine hours, direct materials costs (used in traditional cost systems)
• ·        Nonvolume Based Cost Drivers – Number of batches or setup time, processing time per unit number of quality inspections, number of design changes (used in activity based costing systems)

These drivers can be both volume based and activity based at the same time.  One needs to choose the appropriate activity (machine hours (volume activity), Setup time (activity based), direct labor hours (volume activity), and quality inspections (activity based)) that best describes the activity pool.  These cost drive are called Stage 2 cost drivers; they can have volume and nonvolume based cost drivers that represent the cost in the activity cost pools.

• §        Assign Indirect Costs to Products of Services Based on their Activity Demands – The next step is to assign the costs from the activity cost pools to the individual products using the Stage 2 activity drivers.  Two methods can be used to assign indirect costs to individual products or services based on their activity requirements:  the activity rate method and the activity proportion method.  These two methods are mathematically equivalent and will provide identical results as long as there are no rounding errors in the rates or proportions.  The method used depends on the type of information provided and whether complete information on all product or service lines is available.

• ·        Activity Rate Method – This method involves computing an activity rate that is very similar to calculating a predetermined overhead rate, except that now we have an activity rate for each activity cost pool.

• ·        Activity Proportion Method – This method for assigning activity costs to individual products is by calculating activity proportions or percentages.

To complete the Stage 2 ABC allocations, we need to add the cost of all four activities for each product line, and they should equal the total manufacturing overhead.  To calculate the manufacturing overhead cost per unit, we need to divide the total manufacturing overhead (for each product) by the number of units (for each product).

• o       Comparison of Volume-Based and Activity Based Cost Systems – Activity based costing allows for a more allocation of indirect costs that the traditional volume based costing system.  This is crucial to allocate costs appropriately for not only reporting purposes, but for the accurate pricing of products.  Products can be undercosted or overcosted under traditional overhead allocation systems.  Traditional allocation systems (direct labor hours) cause distortions in costs and prices simply due to the amount of hours used to make a product versus the activities that cost the most (quality inspections) which can be the real cost driver. Products could then be overpriced or underpriced in the marketplace, which could affect sale volumes for the product and overall profitability of the firm.

• o      Calculation of Total Manufacturing Cost and Gross margin – The only difference between ABC and traditional cost systems is the treatment of indirect costs, or manufacturing overhead.  To compute the full manufacturing costs, we still need to add the direct materials and direct labor costs, which do not change as a result of the cost allocation method used.

Traditional cost systems tend to undercost low-volume products and overcost high volume products.  By focusing strictly on volume, traditional costing systems do not take into account other factors that drive cost, such as the complexity of the production process or the additional setup, design, and quality control activities required by newer or more innovative products.

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Activity Based Management (ABM)

• ·       Activity based costing (ABC) is a method of assigning indirect costs to products or services based on the activities they require.  Activity based management (ABM) encompasses all of the actions that managers take to improve operations or reduce costs based on the ABC data.  To reap the benefits of ABC, managers must use it to manage the underlying activities and identify areas that would benefit form process improvements

The first step in any improvement program is to target areas that need improvement.  Managers should start by asking the following questions:

• o      What activities are performed? – This question focuses managers’ attention on activities as the driver of cost within the organization.  Managers who want to manage costs must manage the underlying activities.  Reducing the number of activities required to perform a task can improve profit by either reducing costs (e.g., reduced workforce) or allowing more work to be performed for the same cost (e.g., increased capacity).
• o      How much does it cost to perform each activity? – This question focuses managers’ attention on those activities that have the most potential for improvement.  The activity rates identified by the ABC system provide insight into how much it costs to perform key activities.  Managers can compare their activity rate with other firms in the industry (benchmarking) and provide managers with incentives to improve operations.  Alternatively, managers might decide to outsource some activities to an outside firm that do the task more cost effectively.
• o      Does the activity add value to the customer? –  This question relates to one of the most important steps in ABM, which is the identification and elimination of nonvalue-added activities. A non value activity is one that, if eliminated, would not reduce the value of the product or service to the customer.  To the extent possible, managers should eliminate any non-value adding activities.  As part of ABM, managers should attempt to streamline these activities to be performed as cost effectively as possible.  Managers can also rethink the pricing of a product or service and can eliminate a product or service which is not profitable.

• §       Life Cycle Cost Management – This is a part of ABM where managers need to set their cost reduction goals across all stages of the product life cycle (introduction, growth, maturity, and decline).  Even if a product is unprofitable in the early stages of its life cycle, it may make up for it in its latter stages.  Costs tend to be higher in the early stages of the product life cycle, while most of the revenues are earned in the growth and maturity stages.

• §       Total Quality Management – One has to question if quality inspections are a value added activity or a non-value added activity.  In managing quality costs, managers must balance four types of quality costs:

• ·       Prevention Costs – incurred to prevent quality problems from occurring in the first place.
• ·       Appraisal (inspection) Costs – incurred to identify defective products before they get to the customer.
• ·       Internal Failure Costs – defects which are caught before the product is shipped to the customer.
• ·       External Failure Costs – occur when a defective product makes its way into the customers’ hands.

In ABM, quality processes should prevent problem for the most part.  Managers must balance this cost of quality with the cost of the product.

• §       Target Costing – The basic idea behind target costing is to determine what the target cost should be to meet the market price and still provide a profit for the company shareholders..  Target costing requires managers to think about costs upfront so that they can design and manufacture products at a cost that will satisfy both customers and shareholders.

The goal of target costing is to determine the target cost of a product before manufacturing ever starts, and target costing should reflect all of the costs that will be incurred across the entire value chain.  The value chain is the linked set of activities required to design, develop, produce, market, deliver, and provide service after the sale.  Under target costing, products should not be manufactured unless the estimated cost is less than the target cost.

ABM plays a key role in target costing by helping managers find ways to achieve the target cost while still providing the value and features consumers are willing to pay for.  The key is to eliminate activities which do not add value to consumers.  Manufacturers (and service providers) can reduce cost while improving quality and value is by streamlining operations and reducing unnecessary inventory.

• §       Just In Time (JIT) – Under a JIT system, a firm purchases materials and manufactures products based on customer demand.  JIT is a demand-pull system in which materials and products are pulled through the manufacturing system based on customer demand.  In a traditional manufacturing setting, precuts are pushed through the system and many times creates excess inventory because of a mismatch of production and customer demand.

Most managers realize that inventory adds many more problems than it solves including inventory carrying costs and quality problems.  To successfully implement a JIT strategy, a company must rethink almost everything it does.  JIT requires an extreme commitment to quality and very strong relationships with suppliers and customers.  Although few firms have realized the full potential of JIT, most companies that implement it experience a substantial decrease in ordering and warehousing costs as well as many benefits related to quality and flexibility.

• o      Summary of ABC and ABM – To gain the true benefits of ABC/ABM, managers must move from simply measuring costs to finding ways to manage costs or reduce costs.  Although ABC/ABM has many potential benefits,  it must be weighed against the costs of obtaining more accurate information.

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Cost-Volume-Profit Analysis

• ·        Cost-Volume-Profit (CVP) is a managerial decision-making tool that focuses on the relationships among product prices, the volume and mix of units sold, variable and fixed costs, and profit.  This approach allows managers to see how a change in one or more of these variables will impact profitability while holding everything else constant.

• o       Assumptions of Cost-Volume-Profit Analysis – CVP analysis is based on the following assumptions:
  • §        A straight line can be used to describe how total cost and total revenue change across the relevant range of activity – The first assumption continues the linear approach we learned in the cost behavior section.  Although total cost and activity are not always perfectly linear, a straight line should provide a reasonable approximation, at least within a limited range of activity (relevant range).
  • §        All costs can be accurately described as either fixed or variable – all costs can be classified as variable or fixed.  For mixed costs or those that have both a fixed and variable component, we can use the high-low method or least squares regression to separate the two effects.
  • §        Changes in total cost are due strictly to changes in the volume of units produced or customers served – The third assumption is that total costs change only as a result of a change in the number of units produced or customers served.  We ignore other factors that can affect total cost such as employee learning curves, productivity gains, and quantity discounts for buying in bulk.
  • §        Production and sales are equal – Production equals sales, keeps inventory levels constant and avoids any difference in profit that can occur due to the accounting method used to value inventory.
  • §        Companies that sell more than one product or service maintain a constant product or sales mix – this assumption is needed to perform multi-product CVP analysis.

• o       Cost-Volume-Profit (CVP) Graph – A CVP graph is useful for visualizing the relationship between total revenue, total costs, the volume of units sold, and profit.  Although the CVP graph is useful for conceptualizing cost and revenue relationships, we must use equations or formulas to compute the exact numbers.

• o       Break-Even Analysis – determines the level of sales (unit or total sales dollars) needed to break even, or earn zero profit.  Several methods used to find the break even point are:

• §        Profit Equation Method – uses an equation in which profit is defined as the difference between total sales revenue and total fixed and variable costs. The equation is as follows:
  • ·        Total Sales – Total Var. Costs – Total Fixed Costs = Profit

(Unit Price x Q) – (Unit VC x Q) – Total FC = Profit.  To find the break even point we set the equation equal to zero and solve for Q, which is the quantity of units which need to be sold in order to break even.

• §        Unit Contribution Margin Method – the unit contribution margin tells us how much contribution margin is generated by each additional unit sold.  The contribution margin is used to cover fixed costs, and what ever is left is profit.  At break even, the total contribution margin equals total fixed costs so that profit is zero. The equation is: BE units = Total Fixed Costs/Unit Contribution Margin.

• §        Contribution Margin Ratio Method – the third way to calculate the breakeven point is based on the contribution margin (CM) ratio.  Recall that the contribution margin ratio is calculated by dividing the contribution margin by the sales revenue.  The contribution margin ratio tells us how much contribution margin is generated by each dollar of sales revenue.  At break even the total contribution margin must equal total fixed costs, with no profit leftover.  The equation is: BE sales = Total Fixed Costs/Contribution Margin Ratio (%)

• o       Target Profit Analysis – Although break-even is a common starting point for performing CVP, most managers want to do more than just break even.  They want to earn a profit.  Target profit analysis is extension of break-even analysis that allows managers to determine the number of units or total sales revenue needed to earn a target profit.  To earn a target profit, the total contribution margin must be enough to cover the fixed costs plus the target profit.  The following equations show the target profit in units or sales dollars:

Target Units = Total FC + Target profit/Unit Contribution Margin

Target Sales – Total FC + Target Profit/Contribution Margin Ratio (%)