Chapter 4Activity Based Cost Management

PowerPoint Authors:Jon A. Booker, Ph.D., CPA, CIACharles W. Caldwell, D.B.A., CMASusan Coomer Galbreath, Ph.D., CPA

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin

Traditional Volume-Based Cost Systems

Because indirect costs cannot be directly traced to specific products or services, they must be assigned or allocated

based on some other observable measure called an allocation base or cost driver.

IndirectCosts

$$

Cost Driveror

Allocation Base

IndividualProducts

or Services

We have used units produced or direct labor hours to assign indirect manufacturing overhead costs to specific products.

Units produced and direct labor hours are examples of a volume-based allocation measure.

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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.

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Stage 1: Assign Indirect Costs To Activities

Level Activities Sample Activities Facility Performed to support all of the Installing and maintaining

level company's products or services. equipment. Paying forinsurance, utilities, and taxes.

Customer Performed for specific Designing for special customerlevel customers. needs. Negotiating prices for a

large customer.

Product Performed to support individual Research and development forlevel product lines. a new product. Special tools

used only for certain models.

Batch Performed for a group of units Resetting robotics for alevel or customers all at once. specific batch run for a

model being produced.

Unit Performed for each unit or Installation of frame,level customer (one at a time). engine, body style, and

tires for a specific model.

Level Activities Sample Activities Facility Performed to support all of the Installing and maintaining

level company's products or services. equipment. Paying forinsurance, utilities, and taxes.

Customer Performed for specific Designing for special customerlevel customers. needs. Negotiating prices for a

large customer.

Product Performed to support individual Research and development forlevel product lines. a new product. Special tools

used only for certain models.

Batch Performed for a group of units Resetting robotics for alevel or customers all at once. specific batch run for a

model being produced.

Unit Performed for each unit or Installation of frame,level customer (one at a time). engine, body style, and

tires for a specific model.

4-4

Form Activity Pools and Assign Indirect Costs to Each Pool

MachiningMachiningandand

InstallationInstallationMachineMachine

SetupSetup

ProductProductEngineeringEngineeringand Designand Design

QualityQualityControlControl

TMMK Manufacturing Overhead Cost PoolsTMMK Manufacturing Overhead Cost Pools

TMMK has identified the following cost pools:

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Form Activity Pools and Assign Indirect Costs to Each Pool

Recall that the total manufacturing overhead cost in our Toyota example was $3,720,000 (in thousands). Now we must assign

this total cost to one of the four activity cost pools.

4-6

Select an Activity Cost Driver for Each Cost Pool

Machine hours will be used as the driver for the machining and installation activity. Number of set-ups will be used as the

activity driver for the set-up activity. Engineering hours will be used as the driver to assign engineering and design costs. Inspection time will be used to assign quality control costs.

4-7

CamryAvalon Camry Hybrid Total

Machine Hours 3,000 10,500 1,500 15,000

Activity Rate MethodThe activity rate method is very similar to the

predetermined overhead rate computed earlier.

ActivityRate

Total Activity CostTotal Activity

Driver=

Total indirect costs assigned to the machining pool was $825,000, the total machine hours required by each of the

three Toyota models is as follows:

Activity Rate =$825,00015,000

= $55 per machine hour

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Activity Based Management

Activity based management (ABM) includes all the actions that managers take to improve operations or reduce costs based on the ABC data. The first step in any improvement program is to target areas that need improvement.

What Activities

Are Performed?

How Much Does it Cost to Perform

Each Activity?

Does the Activity Add Value to the Customer?

4-9

Life Cycle Cost Management

In pursuing cost management, managers need to set their cost reduction goals across all stages of the product life cycle, including1.product introduction, 2.growth, 3.maturity, and 4.eventual decline.

Costs tend to be higher.Costs tend to be higher.

Most revenue earned.Most revenue earned.

In today’s digital and technological age, product life cycles become increasingly short.

In today’s digital and technological age, product life cycles become increasingly short.

4-10

Total Quality Management

The second highest cost assigned to the Camry-Hybrid was due to quality control. In managing quality costs, managers must balance four types of quality costs: 1.Prevention costs,2.Appraisal or inspection costs,3.Internal failure costs, and4.External failure costs.

4-11

Target CostingThe target cost would be computed by subtracting the target profit from the market price, as follows:

Market Price

$30,000

Target Profit(20% × $30,000)

$6,000

TargetCost

$24,0000̶ =

The $24,000 target cost is the most that can be spent on the product and still achieve the 20% return on sales (given a market sales price of $30,000). It is important to realize that the target cost includes more than just the manufacturing costs.

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Target CostingOnce the target cost is set, the next step is to determine

whether it is feasible to design, develop, manufacture and deliver the product at this target cost.

Target Cost

Design Product

DevelopProcess

Estimate

Cost

Cost Reduction Goals

MakeProduct

??

Compare the estimated cost with the target cost to see if cost reduction is necessary.

Compare the estimated cost with the target cost to see if cost reduction is necessary.

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Just-in-Time (JIT) Inventory

In a JIT system, materials are purchased and units are made only as they are needed to satisfy customer demand. JIT is a

"demand pull" system, where materials and products are pulled through the manufacturing system based on customer

demand. In a traditional manufacturing setting where products are

pushed through the system and often end up sitting in inventory. One advantage of a JIT system is that it eliminates problems in product costing associated with holding inventory.

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End of Chapter 4

Copyright © 2011 by The McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin