204 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

Summary of Activity-Based Costing

Activity-based accou n tin g system s can tu rn m an y in direct m an u factu rin g over-

h ead costs in to direct costs—costs iden tified specifically with given cost objectives. Appropriate selection of activities an d cost drivers allows m an agers to trace m an y m an u factu rin g overh ead costs to cost objectives ju st as specifically as th ey

h ave traced direct m aterial an d direct labou r costs. Becau se activity-based accou n tin g system s classify m ore costs as direct th an do tradition al system s, m an agers h ave greater con fiden ce in th e costs of produ cts an d services reported by activity-based system s.

Becau se activity-based accou n tin g system s are m ore com plex an d costly th an tradition al system s, n ot all com pan ies u se th em . Bu t m ore an d m ore orga- n ization s in both m an u factu rin g an d n on -m an u factu rin g in du stries are adoptin g activity-based system s for a variety of reason s:

• O BJECTI V E 1 1 Fierce com petitive pressu re h as resu lted in sh rin kin g m argin s.

Com pan ies m ay kn ow th eir overall m argin , bu t th ey often do n ot

Explain why activity-

believe in th e accu racy of th e m argin s for individual produ cts or services.

based costing systems

• Bu sin ess com plexity h as in creased, wh ich resu lts in greater diversity in

are being adopted.

th e types of produ cts an d services as well as cu stom er classes. Th erefore, th e con su m ption of a com pan y’s sh ared resou rces also varies su bstan tially across produ cts an d cu stom ers.

• New produ ction tech n iqu es h ave in creased th e proportion of in direct costs—th at is, in direct costs are far m ore im portan t in today’s world- class m an u factu rin g en viron m en t. In m an y in du stries direct labou r is bein g replaced by au tom ated equ ipm en t. In direct costs are som etim es over 50 percen t of total cost.

• Th e rapid pace of tech n ology ch an ge h as sh orten ed produ ct life-cycles. Hen ce, com pan ies do n ot h ave tim e to m ake price or cost adju stm en ts on ce errors are discovered.

• Com pu ter tech n ology h as redu ced th e costs of developin g an d operat-

in g cost system s th at track m an y activities.

Chapter 5 Cost Allocation and Activity-Based Costing Systems

6 EX H I B I T 5 - 1 0

Key Results of Activity- Based Costing Study

D RI VER CO STS

Traceable Costs

Total Physical Flow of

Cost Per

(From Exhibit 5-9)

D river U nits

D river U nit

(1) 4 ( 2) Activity/ Resource (D river U nits)

(From Exhibit 5-9)

Account Inquiry (Labour H ours)

Correspondence (Letters)

Account Billing (Lines)

Account Verification (Accounts)

CO ST PER CU STO M ER CLASS

Cost Per

Residential

Commercial

D river U nit

Physical

Physical Flow

Flow of

Cost

of D river Cost

D river U nits

U nits

Account Inquiry

Account Billing

Account Verification

0 20,000 Accts. $ 88,847

Total Cost

N umber of Accounts

Cost per Account

Cost per Account (Traditional System)

3.69 $ 6.15 Note: Some differences may exist due to rounding.

P E R S P E CT I V E S O N

D E CI S I O N - M A K I N G

Identifying Activities, Resources, and Cost Drivers

Arkan sas Blu e Cross Blu e Sh ield

of the information management function.

(ABCBS) is th e largest h ealth in su rer in

This map reflected the flow of activities and

Arkan sas with an n u al reven u e of m ore

resources in support of the cost centres.

th an $450 m illion . Recen tly, ABCBS

Th e m ap also iden tified th e data th at

im plem en ted activity-based m an age-

needed to be collected to complete the

m en t. Th e iden tification of key activities,

study. (Note that the process map is very

resou rces, an d cost drivers was on e of th e

similar to Exhibit 4-12 in appearance.)

early steps perform ed.

• On ce th e ABC m odel was bu ilt an d

• A pilot study was performed on one

validated, th e resu lts were in terpreted

area of the firm—information manage-

an d recom m en dation s for im provem en t

ment. The criteria for selection of a pilot

were m ade.

area included significant costs, the possibil-

As a resu lt of th e ABC stu dy, th e fol-

ity of improving the existing cost allocation

lowin g action s were taken by m an age-

system, access to data, and a receptive staff.

m en t:

• The cost objectives were defined—

• A separate u tility m eter was placed

th e in tern al cu stom ers of in form ation

on th e com pu ter room .

management.

• CRT pu rch ases are n ow ch arged

• Activities, resources, and cost drivers

directly to th e u ser. Main ten an ce costs for

were identified based on meetings with

CRTs are n ow assign ed based on CRT

m an agers. Exam ples of key activities cou n t. are Produ ction (job sch edu lin g, pro-

• Th ree n ew cost cen tres were cre-

duction control), Electronic Media Claims

ated—EMC System s, Ch an ge Con trol,

Processing, Printing, and Mail Processing.

an d Produ ction Con trol.

Resources include Systems Programmers,

• CPU was u pgraded.

Mail Labour, Print Labour, Tape Labour,

ABCBS is n ow in th e process of Data Base Adm in istrators, 3080 CPU, expan din g th e n ew ABM system corpo- 3090 CPU, LSM (robotic cartridge rate-wide to in clu de pu rch asin g, actu ar- system), DASD (hard disk storage), and

ial, advertisin g, an d claim s processin g.

Telecommunications, Cost drivers included

Th e com pan y is also u sin g th e n ew ABM

CPU m in u tes, sin gle-den sity volu m es

system for activity-based bu dgetin g.

Institute of M anagement

(DASD), number of tape/cartridge mounts

Accountants

(LSM), number of jobs, and number of

Source: “Im plem en tin g Activity-Based

www.imanet.org

CRTs (telecommunications).

Costin g—Th e Model Approach ,” In stitu te

Sapling: Software Aided

• Once the key activities, resources, and

of Man agem en t Accou n tan ts an d Saplin g

Planning

drivers were identified, the project team

Corporation , Orlan do (Novem ber, 1994).

www.sapling.com

developed a process map of the operations

Cost M anagement Systems

Cost M anagement System.

To better su pport m an agers’ decision s, accou n tan ts go beyon d sim ply deter-

Identifies how manage-

m in in g th e cost of produ cts an d services. Th ey develop cost m an agem en t sys-

ment’s decisions affect

tem s. A co st m an age m e n t sy st e m iden tifies h ow m an agem en t’s decision s

costs, by first measuring the resources used in per-

affect costs. To do so, it first m easu res th e resou rces u sed in perform in g th e

forming the organization’s

organ ization ’s activities an d th en assesses th e effects on costs of ch an ges in

activities and then assess-

th ose activities.

ing the effects on costs of changes in those activities.

Activity-Based M anagement

Recall th at m an agers’ day-to-day focu s is on m an agin g activities, n ot costs. So, becau se ABC system s also focu s on activities, th ey are very u sefu l in cost

Chapter 5 Cost Allocation and Activity-Based Costing Systems

Activity-Based

m an agem en t. Usin g an activity-based costin g system to im prove th e operation s

M anagement (ABM ).

of an organ ization is activity-base d m an age m e n t (A BM). In th e broadest

The use of an activity- based costing system to

term s, activity-based m an agem en t aim s to im prove th e valu e received by cu s-

improve the operations

tom ers an d to im prove profits by providin g th is valu e.

of an organization.

Th e corn erston e of ABM is distin gu ish in g between valu e-added costs an d n on -valu e-added costs. A valu e -ad d e d co st is th e cost of an activity th at can -

Value-Added Cost. The necessary cost of an

n ot be elim in ated with ou t affectin g a produ ct’s valu e to th e cu stom er. Valu e-

activity that cannot be

added costs are n ecessary (as lon g as th e activity th at drives su ch costs is

eliminated without

perform ed efficien tly). In con trast, com pan ies try to m in im ize n o n -valu e -

affecting a product’s

ad d e d co st s —costs th at can be elim in ated with ou t affectin g a produ ct’s valu e to

value to the customer.

th e cu stom er. Activities su ch as h an dlin g an d storin g in ven tories, tran sportin g

partly fin ish ed produ cts from on e part of th e plan t to an oth er, an d ch an gin g th e

N on-Value-Added Costs.

Costs that can be elimi-

set-u p of produ ction lin e operation s to produ ce a differen t m odel of th e produ ct

nated without affecting a

are all n on -valu e-added activities th at can be redu ced, if n ot elim in ated, by care-

product’s value to the

fu l redesign of th e plan t layou t an d th e produ ction process.

customer.

Let u s retu rn n ow to Pacific Power Com pan y to see h ow th e billin g depart- m en t cou ld u se th e ABC system to im prove its operation . Recall th at th e BD n eeded to fin d a way to in crease its capacity to h an dle accou n ts du e to an expected large in crease in dem an d from a n ew h ou sin g developm en t an d sh op- pin g cen tre. BD m an agers also were in terested (as always is th e case) in redu c- in g th e operatin g costs of th e departm en t wh ile n ot im pairin g th e qu ality of th e service it provided to its cu stom ers. To do so, th ey u sed th e ABC in form ation from Exh ibit 5-10 to iden tify n on -valu e-added activities th at h ad sign ifican t costs. Accou n t in qu iry an d bill verification activities are n on -valu e-added an d costly, so m an agem en t asked for ideas cost redu ction s. Th e n ew in form ation provided by th e ABC system gen erated th e followin g ideas for im provem en t:

• Use the service bureau for commercial accounts because of the significant cost savings. From Exhibit 5-10, the service bureau’s bid is for $8.50 per account compared to the BD’s activity-based cost of $14.57, a difference of more than $6 per account! The freed-up capacity can be used to meet the expected increase in residential demand. Bill verification, a non-value-added activity, would also be eliminated because only commercial bills are verified.

• Exhibit 5-10 indicates that account inquiry activity is very costly, accounting for a significant portion of total BD costs. One idea is to make bills more descriptive in order to reduce the number of inquiries. Doing so would add lines to each bill, resulting in higher billing-activity costs, but the number of inquiries would be reduced, thus reducing a significant non-value-added cost. Whether this idea would result in a net cost reduction needs to be evaluated by the accountants with the help of the new ABC system.

Just-in-Time (JIT) Systems

Just-In-Time (JIT)

Attempts to minimize non-value-added costs have led many organizations to adopt

Production System.

A sys-

just-in-time systems to eliminate waste and improve quality. In a just-in-tim e

tem in which an organization purchases materials

(JIT) p ro d u ctio n syste m , an organization purchases materials and parts and pro-

and parts and produces

duces components just when they are needed in the production process. Goods are

components just when

not produced until it is time for them to be shipped to a customer. The goal is to have

they are needed in the

zero inventory, because holding inventory is a non-value-added activity.

production process, the

JIT com pan ies are cu stom er-orien ted becau se cu stom er orders drive th e

goal being to have zero inventory, because hold-

produ ction process. An order triggers th e im m ediate delivery of m aterials, fol-

ing inventory is a non-

lowed by produ ction an d delivery of th e goods. In stead of produ cin g in ven tory

value-added activity.

204 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS