Activity Based Costing and Management

Job-order and process costing are functional-based systems. They are based on volume measures, such as direct labor hours and machine hours. They use plantwide rates and departmental rates. Often, they produce average costs that severely under or over state the individual product costs.

Two major factors impair their ability to assign overhead costs accurately. The first is the proportion of non-unit-related overhead costs to total overhead costs is large. The second is that the degree of product diversity is great.

Unit and Non-Unit Activities

In the use of plantwide rates or departmental rates, a product's consumption of overhead resources is related strictly to the units produced. This assumption makes sense for unit-level activities. Unit-level activities are activities that are performed each time a unit is produced.

Non-unit level activities are activities that are not performed each time a unit of product is produced. Costs associated with these activities are unlikely to vary with units produced. Sometimes, these costs will vary with other factors besides units. Identifying these factors is very helpful in predicting and managing costs. Activity Based Costing (ABC) refer to a cost hierarchy that categorizes costs either as unit-level, batch-level, product-sustaining, or facility-sustaining. These are activity drivers. The non-unit-level activity drivers are factors that measure the consumption of non-unit-level activities by products and other cost objects. Unit-level drivers measure the consumption of unit-level activities.

Product Diversity

The presence of product diversity is also necessary for product cost distortion to occur. Products consume overhead activities in systematically different proportions. The consumption ratio is the proportion of each activity consumed by a product.

Activity-Based Product Costing

A set of key questions is asked in which answers provide much of the data needed for an ABC system. The interview-derived data are used to prepare an activity dictionary. An activity dictionary lists the activities in an organization along with some critical activity attributes. Activity attributes are financial and non-financial information items that describe individual items.

There are seven key questions to identify activities.

1. How many employees are in your department?
2. What do they do?
3. Do customers outside your department use any equipment?
4. What resources are used by each activity?
5. What are the outputs of each activity?
6. Who or what uses the activity output?
7. How much time do workers spend on each activity? Time on each activity by equipment?

Based on the answers to the survey, an activity is prepared. The activity dictionary names the activity, describes the tasks that make up the activity, lists the users (cost objectives), and identifies a measure of activity output (activity driver).

Assigning Costs to Activities

After identifying and describing the activities, the next step is to determine how much it costs to perform each activity. This requires identification of the resources being consumed by each activity. The cost of the resources is found in the general ledger. Resources must be assigned using driver tracing. For labor resources, a work distribution matrix is often used. This identifies the amount of labor consumed by each activity.

If the resource is shared by several activities, then the assignment is driver tracing, and the drivers are called resource drivers. Resource drivers are factors that measure the consumption of resources by activity.

Costs are assigned to products by taking the usage of the activity as measured by the activity drivers, and multiplying it by the predetermined activity rate. To calculate this rate, the practical capacity of each activity must be determined.

Activity Based Customer Costing

In activity based customer costing, customers are the cost objects of fundamental interest. It is possible to have customer diversity just as it is to have product diversity. Customer management can produce significant gains in profit. Customers can consume customer driven activities in different proportions. Knowing how much it costs to service different customers can be vital information for such purposes as setting pricing, determining customer mix, and improving profitability.

Assigning the costs of customer service to customers is much the same as assigning manufacturing costs to products. Customer driven activities are identified in an activity dictionary. The cost of the resources consumed is assigned to activities, and the cost of the activities is assigned to individual customers.

Activity Based Supplier Costing

Cost of a supplier is much more than the purchase price of the components or materials acquired. Suppliers can affect many internal activities of a firm and significantly increase the cost of purchasing. A more correct view is one where the costs associated with quality, reliability, and late deliveries are added tot he purchase costs.

Assigning the cost to suppliers is similar to cost assignments we have seen for products and customers. The cost of the resources consumed is assigned to activities, and the cost of the activities is assigned to individual suppliers.

Process-Value Analysis

Process-value analysis is fundamental to activity-based management. Process-value analysis focuses on cost reduction instead of cost assignment. It emphasizes the maximization of systemwide performance. There are three main items that process-value analysis is concerned with. These are driver analysis, activity analysis, and performance measurement.

Every activity has inputs and outputs. Activity inputs are resources consumed by the activity in producing its output. Activity outputs are the result or product of an activity. An activity output measure is the number of times the activity is performed. It is a quantifiable measure of the output. Driver analysis is the effort expended to identify those factors that are the root causes of activity costs. Once the root cause is known, then action can be taken to improve the activity.

Activity Analysis

The core of process-value analysis is activity analysis. Activity analysis is the process of identifying, describing, and evaluating the activities that an organization performs. It should produce four outcomes.

  1. What activities are done
  2. How many people perform the activities
  3. The time and resources required to perform the activities
  4. An assessment of the value of the activities to the organization.

Value-Added Activities

Some activities are necessary to remain in business. These are called value-added activities. There are two types of value added activities. The first are activities that are necessary to comply with legal mandates. The second are discretionary value-added activities. There are three conditions that must be met simultaneously for the activity to be classified as value-added. First, it must produce a change of state. Second, the change of state was not achievable by the preceding (prior to the activity) conditions. Third, it enables other activities to be performed.

Non-Value Added Activities

All activities other than those that are absolutely essential to remain in business are known as non-value added activities. The challenge of activity analysis is to find ways to produce the good without using any of these activities. Examples of non-value added activities include scheduling, moving, waiting, inspecting and storing.

Cost Reduction

Activity management carries with it the objective of cost reduction. Competitive conditions dictate that companies must deliver customer-desired products on time and at the lower possible cost. There are four ways activity management can reduce costs.

1. Activity elimination - Once activities that fail to add value are identified, measures must be taken to rid the organization of these activities.
2. Activity selection - Involves choosing among different sets of activities that are caused by competing strategies. The lowest-cost design strategy should be chosen.
3. Activity reduction - Decreases the time and resources required by an activity. This approach focuses on improving efficiency.
4. Activity sharing - Increases the efficiency by using economies of scale. This lowers the per-unit cost of the cost driver and the amount of cost traceable to the products that consume the activity.

Activity Performance Measurement

Accessing how well activities and processes are performed, and results achieved, is fundamental to management's efforts to improve profitability. Its measures are both financial and non-financial. Measures of activity performances centers on three dimensions.

1. Efficiency - Focuses on the relationship of activity inputs to activity outputs.
2. Quality - Concerned with doing the activity right the first time.
3. Time - Longer times usually mean more resource consumption and less ability to respond to customer demands.