Training Presentation: Activity-Based CostingBy David Fukuda

What Will Be CoveredABC DefinedNuts and BoltsHow It WorksA Real World ExampleSummary

ABC DefinedHistoryTraditional costingEngineering DecisionsPricingProduct Mix

ABC Defined-ContinuedActivity-based costing focuses on work activities and facilitates decision-making processes by managers.

ABC Defined-ContinuedTransition to ABCCost StructureProduct Diversity

BrainstormingDevelop a list of major costs that exist within your firm.Develop a list of activities that make up these costs.

Brainstorming-ContinuedDiscuss how managers maybe able to improve their decision-making abilities by viewing these major costs as activities.

Nuts & BoltsGoal: Use traditional costing information to provide more focused data for improved decision support.Costs must be assigned to the appropriate categories.

Nuts & Bolts-ContinuedUnit-Level CostsExamples: equipment depreciation, repairs, maintenance, and energy costs.Batch-Level CostsExamples: machine set-up costs, placing, orders, receiving materials, and paying suppliers.

Nuts & Bolts-ContinuedProduct-Level CostsExamples: design costs, engineering costs.Facility-Level CostsExamples: presidents salary, building security.

Nuts & Bolts-ContinuedCost Drivers-activities associated with incurred costsCost Pools-combined costs affected by the same activitiesCost Rates = total costs / # of activity units

How It WorksABC requirementsClear GoalsManagement SupportCommitted ResourcesPriorityAppropriate Training

How It Works- ContinuedProcessGroup overhead costs into unit-, batch-, product-, and facility-level items.Identify cost drivers for each item.Items are placed into the appropriate cost pools.

How It Works-ContinuedProcess (continued)Within each cost pool, cost rates per activity are determined.Calculated cost rates are multiplied by the number of product or service units consumed.

How It Works-ContinuedThe ABC process is:ContinuousFlexibleTraceableUnderstandableLogical

How It Works-ContinuedABC data may result in activities being:Favorably impactedChangedImprovedEliminated

A Real World Example: Farrall Inc.ExplanationManufacturer of filter materialsAnnual sales of $500 millionDecides to implement an ABC system

Farrall, Inc.-ContinuedFindings of ABC analysisActivities varied with both unit production volume and work orders (batch production).Low volume custom products were costing the company.

Farrall, Inc.-ContinuedConclusionTop customers were providing a tremendous share of the profits.Low volume customers were increasing product costs.

ExerciseABC Cost PoolsProduction ($50,000)Inspection ($25,000)Warehousing ($30,000)Purchasing ($95,000)Receiving ($40,000)Order Entry ($40,000)

Exercise-ContinuedMatch the cost with the appropriate ABC cost driver.

ProductionInspectionWarehousingPurchasingReceivingOrder Entry

InspectionsCustomer OrdersPurchase OrdersParts PlannedStore ReceiptsDock Receipts

Exercise-ContinuedCalculate Cost Rates

What areas should management focus on?

Production $50,000Inspection $25,000Warehousing $30,000Purchasing $95,000Receiving $40,000Order Entry $40,000

$40 per part$5 per inspection$3 per receipt$10 per order$10 per receipt$40 per order

Parts Planned 20,000Inspections 5,000Store Receipts 10,000Purchase Orders 9,500Dock Receipts 4,000Customer Orders 1,000

SummaryFocusing on the ABC method:Considers all costs.Assigns costs to specific products or customers.Helps to identify business-sustaining and low-valued activities.

Summary-ContinuedActivity-based costing provides management with an alternate way of viewing costs within an organization.

Readings ListCokins, G. (2002). Activity-Based Costing: Optional or Required? Transactions of AACE International. Colson, R. and J. Lere. (March 2002). Selling Activity-Based Costing. CPA Journal. Vol. 72, Issue 3.Cortese-Danile, T. and C. Latshaw. (Winter 2002). Activity-Based Costing: Usage and Pitfalls. Review of Business. Vol. 23, Issue 1.Ittner, C., Lanen, W., & D. Larcker. (June 2002). The Association Between Activity-Based Costing and Manufacturing Performance. Journal of Accounting Research. Vol. 40, Issue 3.

Readings List-ContinuedNaidoo, S. (May 2002). Voyage of Discovery. Financial Management. Peckenpaugh, J. (April 2002). Teaching the ABCs. Government Executive. Vol. 34, Issue 4.Taylor, J. (May/June 2002). Activity-Based Costing. AFP Exchange. Vol. 22, Issue 3.

Traditional costing reports costs as lump sum amounts and leaves questions as to which areas of the business are successful and those that managers need to concerned with. General Electric led the way as many firms searched for ways to account for the costs of engineering decisions. The next step involved acquiring crucial product cost information that affects pricing and product mix decisions.Improved decision-making through the use of ABC has resulted in higher quality levels, improvements in cycle time, and cost reductions for manufacturing firms.Companies would traditionally spend the majority of their total manufacturing costs on direct labor and materials. Costs are now structured less around these items and the bulk of budgets are put toward overhead costs. Firms now offer much larger and more diverse product lines. Many firms have outgrown the need for the traditional costing method.

Claims Processing Department [Cokins]Major costs (examples): Salaries, Equipment, Travel Expenses, Supplies, etc.Activities (examples): Scan Claims, Analyze Claims, Resolve Member Problems, Determine Eligibility, Make Copies, Write Correspondence, Attend Training, etc.Further Questions [Cokins]How do we access all this data?What do we do with it?How do we shape the data and put it in a form with which we can work?ABC does not replace an accounting system, it reassigns costs from balance sheet data so that it can be used by a firms decision makers. It can be characterized as an organizational methodology.Unit-level costs stem from the consumption of resources for each individual product/service unit. Batch-level costs can be identified as groups of units that are not directly related to unit-level costs.Product-level costs are those costs related to resources that support the product/service. Facility-level costs do not fit into unit-, batch-, or product-level costs but are needed to support the organization as a whole.Cost drivers show the cause and effect relationship between the various costs and the operations of the business. Examples of cost drivers include: units, produced (unit-level), number of set-ups (batch-level), and engineering change notices (product-level). Cost pools give decision-makers visibility into which products are incurring specific costs. The cost rates show costs on a per activity basis.Firms who wish to implement ABC must have a plan that works toward specific goals that are in line with the goals of their business. Upper management must show commitment by make the use and develop of ABC a priority and appropriating resources towards their goals. Lastly, the firm must provide adequate training that will it allow its employees to be a part of the ABC process.Each product or service must be put separately through this process. It is important that resources consumed by these products/services are identified and dedicated to the proper cost levels and cost pools.The causal relationship between costs and activities must watched closely and should not be mistaken as the same for each product or service. This relationship will have a definite impact on the calculated cost rates and ultimately the decision-making process.The ABC process will continuously improves as each iteration will provide more insight into the needs of a firms decision-makers. The ability for a firm to establish its own activities give business much need flexibility over the traditional costing method. Cost are easily traced from each product/service back through to the resources it has consumed. This process gives an understandable and logical path as a product or service moves through a firms operations and ultimately finds its way to the customer.The end result of specifically categorized costs allows managers to have a better view into the health of each activity. From this information they can more easily diagnose the problems and enhance the strengths of its operations.Linda Taylor shared this case study in her article titled Activity-Based Costing: Why Your Company Cant Succeed Without It. Farrall took on the task of implementing ABC in an effort to obtain more accurate product costs, customer profitability data, resource management/cost reduction opportunities, and investment justification.Farrall had believed that half of their manufacturing activities varied direct with unit level production, but discovered that only 23% varied with unit production and 21% varied with each batch of product. Inventory carrying costs for low volume custom products that had been produced in large batches and stored were a significant burden on the company.Farrall needed to focus on the customers who were going to make them profitable. They had two options with regard to the low volume customers, either end their relationship with them and focus on their top customers or improve their process so that inventory costs and batch changeovers costs were less significant.Traditionally, these costs would be grouped as overhead costs of $280,000. The only driver for examining these costs would be labor hours.Each cost pool in the table on the left has a corresponding cost driver (activity) in the table on the right. Match the costs up with the activities. Pressing the space bar will reveal each answer one at a time.Calculate the cost rates by dividing the monetary amount for each cost pool by the number of activities. For example, Production ($50,000) divided Parts Planned (20,000) equals $40 per planned part. Pressing the space bar will make all of the cost rates appear. Management may need to be concerned with the cost pools that deal with Production and Order Entry, as these areas yield high cost rates. Further exploration may lead an organization to change its processes and reduce costs or the number of transaction related to these cost pools.The traditional costing method allowed some costs to be overlooked or combined in areas where managers were not able to identify opportunities or problems. ABC breaks down these costs and provides directions for managers and encourages further exploration into the activities of the organization.Managers can use this tool to effectively improve their processes. ABC gives specific information on any product or service that concerns the firm and is flexible in its ability to examine different activities that may affect these areas.