Managerial Accounting, Chapter 5 by Crosson, Needles

Chapter 5

Activity-Based Systems:ABM and JIT

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Activity-Based Systems and Management

• Objective 1– Explain the role of managers in activity-based

systems.


Activity-Based Systems and Management

• Companies measure value as revenueCustomer Value = Revenue Generated

• Value exists when some characteristic of a product or service satisfies customers’ wants or needs


Activity-Based Systems and Management (cont’d)

• Managers create value by satisfying customers’ needs for quality, reasonable price, and timely delivery– Work with suppliers and customers to find

ways of improving quality, reducing costs, and shortening delivery time

– View the organization as a collection of value-adding activities

– Use resources for value-adding activities


Activity-Based Systems and Management (cont’d)• Managers create value by satisfying

customers’ needs for quality, reasonable price, and timely delivery– Reduce or eliminate nonvalue-adding activities– Know the total cost of creating value for a

customerManagers must know the full product cost

Costs of direct materials and direct labor

Costs of all production and nonproduction activities required to satisfy the customer


Activity-Based Systems

• Create opportunities to provide cost information to managers

• Help managers view their organization as a collection of activities

• Help managers improve operating processes and make better pricing decisions

Information systems that provide quantitative information about an

organization’s activities


Activity-Based Systems (cont’d)

• Traditional systems are not designed to capture data on activities or to trace the full cost of a product

• Traditional systems could not: – Isolate the cost of unnecessary activities– Penalize for overproduction– Quantify measures that improve quality or

reduce throughput time


Activity-Based Systems (cont’d)

• Two types of activity-based systems1. Activity-based management (ABM)

2. Just-in-Time (JIT) operating environment

• Both help organizations manage activities (not costs)

– Can reduce or eliminate many nonvalue-adding activities


Planning

• Managers examine their company’s value-adding activities and related costs

• Offering quality products or services at the lowest cost is the goal


Performing

• Managers want to know: – What activities are being performed– How well they are being performed– What resources they are consuming

• Necessary nonvalue-adding activities are monitored

• An ABC system: – Measures actual quantities of activity– Accumulates related activity costs– Allows managers the flexibility to create cost pools for

different types of cost objects


Evaluating

• Managers measure an activity's performance by reviewing the difference between its actual and budgeted costs– Information used to

• Analyze variances in activity levels

• Identify waste and inefficiencies

• Take action to improve processes and activities

• Careful review and analysis will increase value for the customer by– Improving product quality

– Reducing costs and cycle time


Communicating

• Managers prepare reports about the company’s performance for– Internal users

• Reports show the application of costs of activities to cost objects (Results in better measurement of profitability)

– External users• Reports summarize past performance


Stop & Review

Q. Name two types of activity-based systems.

A. Activity-based management (ABM) and a just-in-time (JIT) operating environment


Activity-Based Management

• Objective 2– Define activity-based management (ABM) and

discuss its relationship to the supply chain and the value chain.


Activity-Based Management

• Identifies all major operating activities• Determines the resources consumed by each

activity and the cause of the resource usage• Categorizes the activities as either adding value

to a product or service or not adding value

Focuses on reducing or eliminating nonvalue-adding activities


Activity-Based Management (cont’d)

• Provides both financial and performance information at the activity level– Useful for

• Strategic planning• Making operational decisions about business

segments


Activity-BasedManagement (cont’d)

• Helps managers – Eliminate waste and inefficiencies– Redirect resources to activities that add value

• Employs activity-based costing (ABC) to assign activity costs to cost objects


Value Chains and Supply Chains

• Value chain– A sequence of

activities (primary processes) that add value to a company’s product or service

• Includes support services that facilitate the primary processes

• Supply chain– The path that leads from

the suppliers of the materials from which a product is made to the final customer

• Each link in the supply chain has its own value chain

– Also called supply network


Supply Chain and Value Chain for a Manufacturing Company


Value Chains and Supply Chains

• Give managers a better grasp of their company’s internal and external operations– How their company’s value-adding activities fit

into the their suppliers’ and customers’ value chains

– What their company’s role is in the overall process of creating and delivering products or services


ABM in a Service Organization Illustrated

• Designs mailing pieces• Creates and maintains marketing databases• Prints promotional pieces and prepares them

for mailing

Direct Ads, Inc. (DAI) offers database marketing strategies to help companies increase their sales.


ABM in a Service Organization Illustrated (cont’d)

La-Z-Boy

DAI

Licensed furniture stores

Customers of furniture stores

Each organization in the supply chain has its own value chain.

Supply chain


ABM in a Service Organization (cont’d)

Supply chain Value chainMarketing

Prepare MarketingDatabases

Purchase Supplies

Process Orders

Mail PromotionalPieces

Customer Relations

La-Z-Boy

DAI

Licensed furniture stores

Customers of furniture stores


Stop & Review

Q. How are a supply chain and a value chain related?

A. The supply chain is a system of organizations and customers that each have their own value chain.

The supply chain identifies the suppliers and customers involved in manufacturing a product or delivering a service to the final customer.

The value chain identifies the major operating activities for each organization in the supply chain.


Value-Adding and Nonvalue-Adding Activities and Process Value Analysis• Objective 3

– Distinguish between value-adding and nonvalue-adding activities, and describe process value analysis.


Value-Adding Activity

• Designing the components of a recliner

• Assembling and upholstering the recliner

Adds value to a product or service as perceived by the customer


Nonvalue-Adding Activity

Adds cost to a product or service but does not increase its market value

Essential nonvalue-adding activities include legal services, management accounting, machine repair,

materials handling, and building maintenance.

Essential nonvalue-adding activities

reduce costs

Nonessential nonvalue- adding activities

should be eliminated

Goal of ABM


How Can Managers Reduce Costs?

• Improve processes and activities

• Reduce an activity’s frequency

• Eliminate an activity

• Outsource


Value-Adding and Nonvalue- Adding Activities for DAI

Value-adding activities• Activities customers pay for

when they ask for database marketing services

Fran Teerlink, owner of DAI, has listed the value- and nonvalue-adding activities related to the design, processing,

and mailing of the company’s Direct Mailers.

• Nonvalue-adding activities• Preparing a job order form and

scheduling the job

• Ordering, receiving, inspecting, and storing paper, envelopes, supplies

• Setting up machines to process a specific letter size

• Logging the total number of items processed in a batch

• Billing the client and recording and

depositing payments from the client


Value-Adding and Nonvalue-Adding Activities for DA


Reduction of some costs was achieved by: – Having paper, envelopes, and other supplies

delivered the day a job is performed (reduces storage costs)

– Purchasing computer software that verifies addresses, determines postage, and automatically sorts letters (reduces cost of labor)

Value-Adding and Nonvalue-Adding Activities for DAI


Process Value Analysis (PVA)

Technique that managers use to identify and link all the activities involved in the value

chain


Process Value Analysis (cont’d)

• Relates activities to the events that prompt them and to the resources that they consume

• Effective way of reducing nonvalue-adding activities and their costs

• Improves cost traceability and results in more accurate product costs– Improves management decisions and increases

profitability


Stop & Review

Q. Is management accounting a value-adding or nonvalue-adding activity?

A. It is a nonvalue-adding activity because it adds cost to a product or service, but does not increase its market value. However, it is an essential activity and managers should strive to reduce the costs associated with it.


Activity-Based Costing

• Objective 4– Define activity-based costing and explain how a

cost hierarchy and bill of activities are used.


Activity-Based Costing

• Calculates a more accurate product cost than traditional methods– Categorizes all indirect costs by activity– Traces the indirect costs to those activities– Assigns those costs to products

• Uses a cost driver related to the cause of the cost

ABC improves the allocation of activity-driven costs to

cost objects


Steps to Implement ABC

1. Identify and classify each activity2. Estimate the cost of resources for each

activity3. Identify a cost driver for each activity and

estimate the quantity of each cost driver4. Calculate an activity cost rate for each activity5. Assign costs to products based on the level of

activity required to make the product or provide the service


The Cost Hierarchy and the Bill of

ActivitiesTwo tools used in implementing ABC:

1. Cost hierarchy

2. Bill of activities


The Cost Hierarchy

A framework for classifying activities according to the level at which their costs are incurred


The Cost Hierarchy (cont’d)

• Typically has four levels in a manufacturing company

1. Unit-level activities– Performed each time a unit is produced

2. Batch-level activities– Performed each time a batch of goods is produced

3. Product-level activities– Performed to support a particular product line

4. Facility-level activities– Performed to support a facility’s general manufacturing

process


The Cost Hierarchy (cont’d)

• The frequency of activities varies across levels• Includes both value-adding and nonvalue-adding

activities• Levels in service organizations

1. Unit level

2. Batch level

3. Service level

4. Operations level


Sample Activities in Cost Hierarchies


The Bill of Activities

A list of activities and related costs that is used to compute the costs assigned to activities

and the product unit cost

• May be used:– As the primary document or as a supporting

schedule to calculate product unit cost

– In both job order and process costing systems

– In both manufacturing and service businesses


The Bill of Activities (cont’d)

The bill of activities includes: – Activity cost rates– Cost driver levels used to assign

costs to cost objects

More complex bills of activities group activities into activity pools


Bill of Activities for a Service Organization


The Bill of Activities for DAI

• Cost information for each activity (including activity cost rate and cost driver level)

• Total activity costs• Activity cost per unit• Cost summary• Unit cost for each type of mailing piece

– Total cost divided by number of units mailed


The Bill of Activities for DAI

Must find ways to:– Increase fee revenue– Reduce costs– Increase volume

Positive gross margin Negative gross margin


Activity-Based Costing for Selling and Administrative Activities• Costs of these activities include

– Salaries– Benefits– Depreciation on buildings and equipment– Sales commissions– Utilities


Activity-Based Costing for Selling and Administrative Activities (cont’d)

• Costs are grouped into activity pools– Assigned to cost objects using cost drivers

• Cost objects– Products, services, customers, or sales territories

» Many companies treat similar customers as one group because it is difficult to assign costs to individual customers

• Cost drivers– Number of sales calls, sales orders, invoices, or billings


Income Statement for a Cost Object


Stop & Review

Q. What is the purpose of a bill of activities?

A. It is used to compute (1) the costs assigned to activities and (2) the product unit cos


The New OperatingEnvironment and JIT Operations• Objective 5

– Define the just-in-time (JIT) operating philosophy and identify the elements of a JIT operating environment.


• Just-in-time (JIT) operating philosophy– Requires that all resources be acquired and used

only as needed• Materials, personnel, and facilities

– Devised in response to the competitive business environment

The New OperatingEnvironment and JIT Operations


The New Operating Environment and JIT Operations (cont’d)

• Traditional operations– Large amounts of inventory– Materials purchased infrequently in large amounts– Long production runs with infrequent setups– Large batches of product manufactured– Workers trained to perform a limited number of

tasks



• Change was needed because– Large amounts of space and money were tied

up– Source of poor-quality materials, products, or

services difficult to pinpoint– Number of nonvalue-adding activities was

growing– Accounting for the manufacturing process

becoming even more complex



Basic concepts for achieving JIT’s objectives:– Simple is better– Quality of the product or service is critical– Work environment must emphasize continuous

improvement– Large inventories waste resources and may hide poor

work– Nonvalue-adding activities must be eliminated or

reduced– Produce goods only when needed– Workers must be multiskilled`

Application of these concepts creates a JIT operating environment


Minimum Inventory Levels

• Fundamental to the JIT operating environment• Materials and parts are purchased and received only when

needed– Lowers costs by reducing the

• Space needed for storage• Amount of materials handling• Amount of inventory obsolescence• Need for inventory control facilities• Amount of work in process inventory• Amount of capital tied up in inventories

– Increases the risk of stock depletion and downtime• Must plan for such risks


Pull-Through Production

• A system in which a customer’s order triggers– The purchase of materials– Scheduling of production

• Lowers costs by keeping inventory levels low

• Machines must be set up more frequently– Results in more work stoppages


Quick Setup and Flexible Work Cells

• By placing machines in more efficient locations, setup time can be minimized

• When workers perform frequent setups, they become more efficient at it

• Traditional layout– Similar machines grouped together

• Functional departments

• JIT layout– Machines needed for sequential processing grouped

together• Work cells


Quick Setup and Flexible Work Cells (cont’d)

• Work cell– Autonomous production line– Can perform all required operations efficiently

and continuously– Is flexible

• Can handle a “family of products”– Similar shape or size– Require minimum setup changes

• The more flexible the work cell, the greater the potential to minimize production time


A Multiskilled Work Force

• One worker is required to operate several types of machines simultaneously

• May have to – Set up and retool machines– Perform routine maintenance

• Contributes to high levels of productivity


High Levels of Product Quality

• Result of:– High-quality direct materials– Inspections made throughout the production

process• Inspection as a separate step does not add value, so

inspection is incorporated into ongoing operations– If the operator detects a flaw

» Work cell is shut down

» Operator fixes problem or helps engineer or quality control person to find a way to correct it


Effective Preventive Maintenance

• In a flexible work cell, each machine becomes an integral part of its cell– If one machine breaks down, the entire work cell

stops functioning– This means an effective preventive maintenance

system is required


Effective Preventive Maintenance (cont’d)

• Preventing machine breakdowns is considered more important and more cost-effective than keeping machines running continuously– Operators are trained to perform minor repairs– Machines are serviced regularly– Routine maintenance is conducted during periods

of downtime or between orders


Continuous Improvement of the Work Environment

JIT environment fosters loyalty among workers• See themselves as part of a team

– Are deeply involved in the production process• Skills

– Run several types of machines

– Detect defective products

– Suggest measures to correct problems

– Maintain machinery within work cell

• Encouraged to make suggestions for improving the production process

– Are rewarded for suggestions that improve processes


Stop & Review

Q. Is a goal of JIT to keep machines running continuously

A. No. Preventing machine breakdowns is considered more important and more cost-effective than keeping machines running continuously.

A goal of JIT is to reduce or eliminate nonvalue-adding activities.


Accounting for Product Costs in the New Operating Environment

• Objective 6– Identify the changes in product costing that

result when a firm adopts a JIT operating environment.


Accounting for Product Costs in the New Operating Environment

• When a company adopts JIT– Changes will affect

• How costs are determined

• What measures are used to monitor performance

– The work cells and the goal of reducing or eliminating nonvalue-adding activities change the way costs are classified and assigned


Classifying Costs

• Traditional production processes can be divided into five time frames1. Processing time

– Actual amount of time spent working on a product

2. Inspection time– Time spent looking for product flaws or

reworking defective units


Classifying Costs (cont’d)

3. Moving time– Time spent moving a product from one

operation or department to another

4. Queue time– Time a product spends waiting to be worked on

once it arrives at the next operation

5. Storage time– Time a product spends in Materials Inventory,

Work in Process Inventory, or Finished Goods Inventory


Classifying Costs (cont’d)

• In product costing under JIT– Costs associated with processing time are classified as

either • Direct materials costs

• Conversion costs – The sum of direct labor costs and overhead costs incurred by a

production department, work cell, or other work center

– Costs associated with inspection, moving, queue, and storage time should be reduced or eliminated

• They do not add value to the product


Assigning Costs

• In a JIT environment, managers focus on throughput time– The time it takes to move a product through the

entire production process– Measures of movement are used to apply

conversion costs to products• Such as machine time


Direct and Indirect Costs in Traditional and JIT Environments


Assigning Costs

• Several costs treated as indirect costs in a traditional environment are treated as direct costs in a JIT environment– Sophisticated computer monitoring allows many

costs to be traced directly to work cells


Stop & Review

Q. Would utilities costs be considered a direct or indirect cost in a traditional environment? In a JIT environment?

A. Traditional environment• Indirect

JIT environment• Direct to the work cell


Backflush Costing

• Objective 7– Define and apply backflush costing, and compare

the cost flows in traditional and backflush costing.


Backflush Costing

• All costs first accumulated in the Cost of Goods Sold account

• At the end of the accounting period, they are worked backward, or flushed back, into the appropriate inventory accounts

• Saves time– Eliminates the need to record several transactions


Backflush Costing (cont’d)

Backflush Costing

Traditional Costing

MaterialsInventory

Overhead

DirectLabor

Direct Materials

Work in ProcessInventory

Finished GoodsInventory

Cost ofGoods Sold

ConversionCosts (Direct

Labor &Overhead)

Direct Materials

Work in ProcessInventory

Finished GoodsInventory

Cost ofGoods Sold


Backflush Costing

• Direct materials costs are charged directly to the Cost of Goods Sold account

• Direct labor and overhead costs are combined and transferred to the Cost of Goods Sold account

• Once all product costs for the period have been entered in the Cost of Goods Sold account, calculate the amounts to transfer back to the inventory accounts


Backflush Costing (cont’d)

• Calculating amounts transferred back to inventory accounts– Finished Goods Inventory account

• Difference between the cost of units sold and the cost of completed units

– Work in Process Inventory account• Amount charged to the Cost of Goods Sold account

during the period less the actual cost of goods finished during the period


Stop & Review

Q. In backflush costing, how is the amount to be transferred to the Finished Goods Inventory account from the Cost of Goods Sold account determined?

A. The amount transferred is the difference between the cost of units sold and the cost of completed units


Comparison of ABM and JIT

• Objective 8– Compare ABM and JIT as activity-based systems.


Comparison of ABM and JIT

• Common elements– Activity-based systems

• Analyze processes

• Identify value-adding and nonvalue-adding activities

– To improve product or service quality, reduce costs, and improve an organization's efficiency and productivity, both seek to

• Eliminate waste

• Reduce nonvalue-adding activities


Comparison of ABM and JIT (cont’d)

Differences

• Methods of costing and cost assignment– ABM

• Uses ABC to calculate product cost using cost drivers to assign the indirect costs of production to cost objects

• May use job order costing or process costing


Comparisonof ABM and JIT (cont’d)

Differences• Methods of costing and cost assignment

– JIT• Organizes activities so they are performed in work cells• The costs of these activities become direct costs to the

work cell and of the products made in that cell– Total costs are assigned using simple cost drivers

• May use job order costing, process costing, or backflush costing


Comparison of ABM and JIT (cont’d)

• Companies can use both ABM and JIT– ABM and ABC

• Improve accuracy of product or service costing

• Help reduce or eliminate nonvalue-adding activities

– JIT• Simplifies processes

• Helps use resources effectively and eliminate waste


Stop & Review

Q. What do ABM and JIT have in common?

A. They are activity-based systems that analyze processes and identify value-adding and nonvalue-adding activities.

Both seek to improve product or service quality, reduce costs, and improve an organization's efficiency and productivity by eliminating waste and reducing nonvalue-adding activities.


Chapter Review

1. Explain the role of managers in activity-based systems.

2. Define activity-based management (ABM) and discuss its relationship to the supply chain and the value chain.

3. Distinguish between value-adding and nonvalue-adding activities, and describe process value analysis.


Chapter Review (cont’d)

4. Define activity-based costing and explain how a cost hierarchy and a bill of activities are used.

5. Define the just-in-time (JIT) operating philosophy and identify the elements of a JIT operating environment.

6. Identify the changes in product costing that result when a firm adopts a JIT operating environment.


Chapter Review (cont’d)

7. Define and apply backflush costing, and compare the cost flows in traditional and backflush costing.

8. Compare ABM and JIT as activity-based systems.

Documents

Managerial Accounting, Chapter 5 by Crosson, Needles