Bab 7
Bab 7
Bab 7
Management
ª Pixelfabrik/Alamy
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EXPERIENCE MANAGERIAL DECISIONS
with Cold Stone Creamery
Experts believe that ice cream as we know it was invented activity drivers associated with each type of ice cream order
in the 1600s and was popularized in part by Charles I and to estimate the costs of these activities.
of England, who made it a staple of the royal table. Two important drivers of costs for Cold Stone include
Ice cream remains as popular as ever today, but trips to ingredients and time, both of which vary significantly across
the local ice cream parlor have changed dramatically. different ice cream product orders. With the insights
Cold Stone Creamery, founded in 1988 in Tempe, gained from its ABC analysis, Cold Stone understands the
change with its innovative busi- ‘‘These options are great for ration time, which is meas-
ness model focused on making ured in seconds. In addition
customers with varied tastes, but
the ice cream trip an entertain- to labor, Cold Stone’s ABC
are challenging for Cold Stone
ment experience for the entire system considers the costs
nearly 1,500 stores worldwide. types of activities associated with forms, and employee bene-
Cold Stone executives must different types of product orders. fits when estimating the cost
understand and control the com- Therefore, Cold Stone adopted of each second required in
pany’s complex cost structure in activity-based costing (ABC) to making each product. When
boasts 16 basic ice cream flavors costs of these activities.’’ product is not making its
cream product options! These options are great for custom- the product and to fine-tune that activity. This understand-
ers with varied tastes, but are challenging for Cold Stone to ing of Cold Stone’s complex cost structure has provided
manage given the different types of activities associated the company with a valuable competitive advantage to
with different types of product orders. Therefore, Cold become one of the most profitable and fastest-growing
281
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282 Chapter 7 Activity-Based Costing and Management
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Chapter 7 Activity-Based Costing and Management 283
vary with other factor(s), besides units, and identifying such factor(s) is helpful in pre-
dicting and managing these costs. Proponents of activity-based costing (ABC) refer to
the ABC cost hierarchy that categorizes costs either as unit-level (i.e., vary with output
volume), batch-level (i.e., vary with the number of groups or batches that are run), product-
sustaining (i.e., vary with the diversity of the product or service line), or facility-
sustaining (i.e., do not vary with any factor but are necessary in operating the plant).1
Exhibit 7.1 shows the activity-based costing hierarchy.
EXHIBIT 7.1
ABC Hierarchy
1
R. Cooper, Cost Classification in Unit-Based and Activity-Based Manufacturing Cost Systems, Journal of Cost
Management for the Manufacturing Industry (Fall 1990): 4–14.
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284 Chapter 7 Activity-Based Costing and Management
Product Diversity
The presence of significant nonunit overhead costs is a necessary but not sufficient con-
dition for plantwide and departmental rate failure (i.e., distorted costs). For example, if
products consume the nonunit-level overhead activities in the same proportion as the
unit-level overhead activities, then no product-costing distortion will occur (with the use
of traditional overhead assignment methods). The presence of product diversity is also
necessary for product cost distortion to occur. Product diversity means that products
consume overhead activities in systematically different proportions. This may occur for
several reasons, including differences in:
. product size
. product complexity
. setup time
. size of batches
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Chapter 7 Activity-Based Costing and Management 285
EXHIBIT 7.2
Product-Costing Data for Rio Novo’s Porto Behlo Plant
Problems with Costing Accuracy The activity usage data in Exhibit 7.2 reveal
some serious problems with either plantwide or departmental rates for assigning over-
head costs. The main problem with either procedure is the assumption that unit-level
drivers such as machine hours or direct labor hours drive or cause all overhead costs.
From Exhibit 7.2, it can be seen that regular models, the high-volume product, use
four times as many direct labor hours as deluxe models, the low-volume product (80
hours vs. 20 hours). Thus, if a plantwide rate is used, the regular models will be assigned
four times more overhead cost than the deluxe models. But is this reasonable? Do unit-
based drivers explain the consumption of all overhead activities? In particular, is it
reasonable to assume that each product’s consumption of overhead increases in direct
proportion to the direct labor hours used? Now consider the four overhead activities to
see if the unit-level drivers accurately reflect the demands of regular and deluxe model
production.
Examination of the data in Exhibit 7.2 suggests that a significant portion of over-
head costs is not driven or caused by direct labor hours. Each product’s demands for
setup and material-moving activities are more logically related to the setup hours and
the number of moves, respectively. These nonunit activities represent 50% ($2,000/
$4,000) of the total overhead costs—a significant percentage. Notice that the low-
volume product, deluxe models, uses three times more setup hours than the regular
models (3/1) and one and a half as many moves (6/4). However, using a plantwide rate
based on direct labor hours, a unit-based activity driver assigns four times more setup
and material moving costs to the regular models than to the deluxe. Thus, product
diversity exists, and we should expect product cost distortion because the quantity of
unit-based overhead that each product consumes does not vary in direct proportion to
the quantity consumed of nonunit-based overhead.
Regardless of the nature of the product diversity, product cost will be distorted
whenever the quantity of unit-based overhead that a product consumes does not vary in
direct proportion to the quantity consumed of nonunit-based overhead. The proportion
of each activity consumed by a product is defined as the consumption ratio and is calcu-
lated as:
Cornerstone 7.1 (p. 286) illustrates how to calculate the consumption ratios for the
two products.
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286 Chapter 7 Activity-Based Costing and Management
7.1 activity consumption. Consumption ratios, then, represent the proportion of an activity
consumed by individual products, calculated using activity drivers.
Information:
Refer to the activity usage information for Rio Novo’s Porto Behlo plant in Exhibit 7.2
(p. 285).
Required:
Calculate the consumption ratios for each product.
Solution:
Step 1: Identify the activity driver for each activity.
Step 2: Divide the amount of driver used for each product by the total driver quantity.
Consumption Ratios
Overhead Activity Deluxe Model Regular Model Activity Driver
Setting up equipment 0.75a 0.25a Setup hours
Moving goods 0.60b 0.40b Number of moves
Machining 0.20c 0.80c Machine hours
Assembly 0.20d 0.80d Direct labor hours
a
3/4 (deluxe) and 1/4 (regular).
ª Pixelfabrik/Alamy
b
6/10 (deluxe) and 4/10 (regular).
c
10/50 (deluxe) and 40/50 (regular).
d
20/100 (deluxe) and 80/100 (regular).
The consumption ratios in Cornerstone 7.1 suggest that a plantwide rate based on
direct labor hours will overcost the regular models and undercost the deluxe models.
Solving the Problem of Cost Distortion This cost distortion can be solved using
activity rates. Instead of assigning the overhead costs using a single, plantwide rate, a
rate for each overhead activity can be calculated and used to assign overhead costs.
Cornerstone 7.2 shows how to calculate these rates.
7.2 (Continued)
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Chapter 7 Activity-Based Costing and Management 287
Information: CORNERSTONE
Rio Novo’s Porto Behlo plant activity cost and driver data follow:
7.2
Activity Activity Cost ($) Driver Driver Quantity
Setting up equipment 1,000 Setup hours 4 (Continued)
Moving goods 1,000 Number of moves 10
Machining 1,500 Machine hours 50
Assembly 500 Direct labor hours 100
Required:
Calculate the activity rates.
Solution:
Divide the activity cost by the total driver quantity:
Machine hours 10 40 $ 30
Direct labor hours 20 80 $ 5
(Continued)
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288 Chapter 7 Activity-Based Costing and Management
CORNERSTONE Required:
Calculate the unit cost for deluxe and regular models.
7.3
Solution:
(Continued)
Deluxe Regular
Prime costs $ 800 $ 8,000
Overhead costs:
Setups:
$250 3 3 setup hours 750
$250 3 1 setup hour 250
Moving materials:
$100 3 6 moves 600
$100 3 4 moves 400
Machining:
$30 3 10 machine hours 300
$30 3 40 machine hours 1,200
Assembly:
$5 3 20 direct labor hours 100
$5 3 80 direct labor hours 400
Total manufacturing costs $2,550 $10,250
Units produced 410 4100
Unit cost (Total costs/Units) $ 255 $102.50
Exhibit 7.3 visually summarizes the calculations in Cornerstones 7.2 and 7.3.
EXHIBIT 7.3
Activity Rates and Activity-Based Unit Costs for Rio Novo’s Porto Behlo Plant
Setup $ Moving $ Machining $ Assembly $
Configuration
1
Configuration
2
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Chapter 7 Activity-Based Costing and Management 289
Now compare these product costs with the activity-based cost of Cornerstone 7.3.
This comparison clearly illustrates the effects of using only unit-based activity drivers to
assign overhead costs. The activity-based cost assignment reflects the pattern of over-
head consumption and is, therefore, the most accurate. Activity-based product costing
reveals that functional-based costing undercosts the low volume deluxe models and
overcosts the high volume regular models. In fact, the ABC assignment increases the
reported cost of the deluxe models by $95 per unit and decreases the reported cost of
the regular models by $9.50 per unit—a movement in the right direction given the pat-
tern of overhead consumption.
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290 Chapter 7 Activity-Based Costing and Management
Overhead Cost ¼ Average Consumption Ratio 3 Total Cost of Each Set of Activities
The average consumption ratios for the Regular product are:
Unit-Level Activities ¼ ð0:80 þ 0:80Þ=2
¼ 0:80
Nonunit-Level Activities ¼ ð0:25 þ 0:40Þ=2
¼ 0:325
This is the same as the assignments using individual activities and activity rates.
To explore the effect of product diversity on accuracy, hold the unit-level consump-
tion ratios constant and allow the average nonunit-level consumption ratio to vary. This
produces the following overhead cost assignment equation for the Regular product:
Overhead Cost ¼ $1,600 þ Average Nonunit Consumption Ratio 3 $2,000
Using this equation, Exhibit 7.4 shows the overhead cost assigned to the Regular
model as the average nonunit-level consumption ratio varies. The red line represents the
average nonunit consumption ratio function. The blue horizontal line is the overhead
cost assignment using the plantwide rate. Notice that when it intersects $3,200 the over-
head cost assignment is the same for both ABC and plantwide assignments (the average
consumption ratio is 0.80, which is the same as the consumption ratio for the plantwide
rate). As the average consumption ratio decreases, the difference between the ABC and
plantwide assignments increases. The vertical lines indicate the difference between the
ABC and plantwide rate overhead assignments. Clearly, some values can occur that
would produce little difference between the plantwide and ABC assignments, and thus
it would be cheaper and simpler to use a single-rate costing system. For example, the
vertical lines are small between 0.70 and 1.00, indicating that when the average nonunit
consumption ratio is in this range, then a plantwide rate would provide good accuracy.
The green vertical line represents the accuracy loss when the product diversity corre-
sponds to the original example data.
The key message of the relationship analysis is that in a diverse product environ-
ment, activity-based costing promises greater accuracy. Given the importance of mak-
ing decisions based on accurate facts, a detailed look at activity-based costing is
certainly merited.
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Chapter 7 Activity-Based Costing and Management 291
EXHIBIT 7.4
Diversity and Product Costing Accuracy
3,600
3,200
Overhead Cost of
2,800
Regular Model
2,400
2,000
1,600
1,200
ª Cengage Learning 2014
800
400
0
0.00 0.10 0.20 0.30 0.40 0.50 0.60 0.70 0.80 0.90 1.00
Average Nonunit Consumption Ratio
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292 Chapter 7 Activity-Based Costing and Management
EXHIBIT 7.5
Activity-Based Costing: Assigning Cost of Overhead
1
2
Activity Driver
ª Cengage Learning 2014
Accounting
Dept.
derived from these questions provides data helpful for assigning resource costs to indi-
vidual activities. To prevent the number of activities from becoming unmanageably
large, a common rule of thumb employed by the interviewer is to tell the interviewee to
ignore activities that require less than 5% of an individual’s time. Examples of questions
that interviewers might ask to gather information include the following:
1. How many employees are in your department? (Activities consume labor.)
2. What do they do (please describe)? (Activities are people doing things for other people.)
3. Do customers outside your department use any equipment? (Activities also can be
equipment working for other people. In other words, the equipment provides the
service for someone by itself).
4. What resources are used by each activity (equipment, materials, energy)? (Activities
consume resources in addition to labor.)
5. What are the outputs of each activity? (Helps to identify activity drivers.)
6. Who or what uses the activity output? (Identifies the cost object: products, other
activities, customers, etc.)
7. How much time do workers spend on each activity? Time on each activity by
equipment? (Information assigns the cost of labor and equipment to activities.)
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Chapter 7 Activity-Based Costing and Management 293
Illustrative Example: Hemingway Bank Exhibit 7.6 (p. 294) illustrates the activity dic-
tionary for Hemingway’s credit card department. The three products, classic, gold, and
platinum credit cards, in turn, consume the activities. It is not unusual for a typical or-
ganization to produce an activity dictionary containing 200 to 300 activities.
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294 Chapter 7 Activity-Based Costing and Management
EXHIBIT 7.6
Activity Dictionary for Hemingway Bank’s Credit Card Department
identifies the amount of labor consumed by each activity and is derived from the inter-
view process (or a written survey).
Illustrative Example: Hemingway Bank Exhibit 7.7 provides an example of a work dis-
tribution matrix supplied by the manager of Hemingway’s credit card department for
individual activities (refer to Question 7).
EXHIBIT 7.7
Work Distribution Matrix for Hemingway Bank’s Credit Card Department
Percentage of
Activity Time per Activity
From Exhibit 7.5 (p. 292), we know that both direct tracing and driver tracing are used
to assign resource costs to activities. For this example, the time spent on each activity is the
basis for assigning the labor costs to the activity. If the time is 100%, then labor is exclusive
to the activity, and the assignment method is direct tracing. If the resource is shared by
several activities (as is the case of the clerical resource), then the assignment is driver tracing,
and the drivers are called resource drivers. Resource drivers are factors that measure the
consumption of resources by activities. Once resource drivers are identified, then the costs of
the resource can be assigned to the activity. Cornerstone 7.4 shows how resource drivers
and direct tracing are used to assign labor cost to the credit department activities.
using direct tracing and driver tracing. When resources are exclusively used by an activity,
7.4 direct tracing is used. For shared resources, resource drivers are used.
(Continued)
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Chapter 7 Activity-Based Costing and Management 295
Information: CORNERSTONE
Refer to the work distribution matrix for Hemingway Bank’s credit card department in
Exhibit 7.7. Assume that each clerk is paid a salary of $30,000 ($150,000 total clerical cost 7.4
for five clerks).
(Continued)
Required:
Assign the cost of labor to each of the activities in the credit department. Is this assignment
driver tracing or direct tracing?
Solution:
The amount of labor cost assigned to each activity is given below. (Note: The percentages
come from the work distribution matrix.)
Labor is a shared resource and is assigned using a resource driver (using labor con-
sumption ratios).
Labor, of course, is not the only resource consumed by activities. Activities also
consume materials, capital, and energy. The interview, for example, reveals that the
activities within the credit card department use computers (capital), phones (capital),
desks (capital), and paper (materials). The automatic teller activity uses the automatic
teller (capital) and energy. The cost of these other resources must also be assigned
to the various activities. They are assigned in the same way as was described for labor
(using direct tracing and resource drivers). The cost of computers could be assigned
by using direct tracing (for the supervising activity) and hours of usage for the remain-
ing activities. From the interview, we know the relative usage of computers by each
activity. The general ledger reveals that the cost per computer is $1,200 per year.
Thus, an additional $6,000 (5 3 $1,200) would be assigned to three activities based on
relative usage:
. 70% to processing transactions ($4,200)
. 20% to preparing statements ($1,200)
. 10% to answering questions ($600)
Repeating this process for all resources, the total cost of each activity can be calcu-
lated. Exhibit 7.8 (p. 296) gives the cost of the activities associated with Hemingway’s
credit card department under the assumption that all resource costs have been assigned
(these numbers are assumed because all resource data are not given for their calcula-
tion).
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296 Chapter 7 Activity-Based Costing and Management
EXHIBIT 7.8
Activity Costs for Hemingway Bank’s Credit Card Department
activity drivers. Exhibit 7.6 (p. 294) identified the activity drivers for each of the four
credit card activities:
. number of transactions for processing transactions
. number of statements for preparing statements
. number of calls for answering questions
. number of teller transactions for the activity of providing automatic tellers
To calculate an activity rate, the practical capacity of each activity must be determined.
To assign costs, the amount of each activity consumed by each product must also be
known.
Illustrative Example: Hemingway Bank Assuming that the practical activity capacity is
equal to the total activity usage by all products, the following actual data have been col-
lected for Hemingway’s credit card department:
Applying Cornerstone 7.2 (p. 287) by using the data and costs from Exhibit 7.8, the
activity rates are calculated as follows:
Rate calculations:
Processing transactions: $130,000/1,000,000 ¼ $0.13 per transaction
Preparing statements: $102,000/120,000 ¼ $0.85 per statement
Answering questions: $92,400/30,000 ¼ $3.08 per call
Providing automatic tellers: $250,000/200,000 ¼ $1.25 per transaction
These rates provide the cost of each activity usage. Using these rates, costs are
assigned as shown in Exhibit 7.9. However, we now know the whole story behind the
development of the activity rates and usage measures. Furthermore, the banking exam-
ple emphasizes the utility of ABC in service organizations.
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Chapter 7 Activity-Based Costing and Management 297
EXHIBIT 7.9
Assigning Costs for Hemingway Bank’s Credit Card Department
Processing transactions:
$0.13 3 600,000 $ 78,000
$0.13 3 300,000 $ 39,000
$0.13 3 100,000 $13,000
Preparing statements:
$0.85 3 60,000 51,000
$0.85 3 36,000 30,600
$0.85 3 24,000 20,400
Answering questions:
$3.08 3 10,000 30,800
$3.08 3 12,000 36,960
$3.08 3 8,000 24,640
Providing automatic tellers:
$1.25 3 15,000 18,750
$1.25 3 3,000 3,750
ª Cengage Learning 2014
3
Gary Cokins, ‘‘Are All of Your Customers Profitable (To You)?’’ (June 14, 2001): www.bettermanagment.com/Library
(accessed May 2010).
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298 Chapter 7 Activity-Based Costing and Management
EXHIBIT 7.10
Whale Curve of Cumulative Customer Profitability
350.0%
300.0%
250.0%
Cummulative 200.0%
Profits
(percent of 150.0%
total profits)
100.0%
50.0%
the hump, or peak, increase the company’s profitability, while the customers to the right
decrease the company’s profitability. Therefore, activity-based customer costing is help-
ful in determining where each customer falls on the curve and, subsequently, how each
customer should therefore be treated given its position on the curve. Of particular inter-
est are those customers to the far right because they severely decrease the company’s
profitability and need to be terminated as unacceptably bad customers or altered in
some way so as to become profitable customers for the company.
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Chapter 7 Activity-Based Costing and Management 299
customers. The same model and procedures that apply to products apply to customers as
well. Cornerstone 7.5 illustrates how ABC assigns costs to customers.
Information:
Milan Company produces precision parts for 11 major buyers. Of the 11 customers, one
7.5
accounts for 50% of the sales, with the remaining 10 accounting for the rest of the sales. The
10 smaller customers purchase parts in roughly equal quantities. Orders placed by the smaller
customers are about the same size. Data concerning Milan’s customer activity follow:
Currently, customer-driven costs are assigned to customers based on units sold, a unit-level
driver.
Required:
Assign costs to customers using an ABC approach.
Solution:
The appropriate drivers are orders placed and number of sales calls. The activity rates are:
$404,000=202 orders ¼ $2,000 per order
$220,000=220 calls ¼ $1,000 per call
Using this information, the customer-driven costs can be assigned to each group of cus-
tomers as follows:
$14,000 $610,000
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300 Chapter 7 Activity-Based Costing and Management
The activity-based cost assignments reveal a much different picture of the cost of
servicing each type of customer. The smaller customers cost more due to their smaller,
more frequent orders and the need of the sales force to engage in more negotiations to
make a sale.
What does this analysis tell management that it didn’t know before? First, the large
customer costs much less to service than the smaller customers and perhaps should be
charged less. Second, it raises some significant questions relative to the smaller custom-
ers. For example, is it possible to encourage larger, less frequent orders? Perhaps offer-
ing discounts for larger orders would be appropriate. Why is it more difficult to sell to
the smaller customers? Why are more calls needed? Are they less informed than the
larger customer about the products? Can we improve profits by influencing our custom-
ers to change their buying behavior?
7.6 Information:
Assume that a purchasing manager uses two suppliers, Murray Inc. and Plata Associates,
as the source of two machine parts: Part A1 and Part B2. Consider two activities: repairing
ª Pixelfabrik/Alamy
products (under warranty) and expediting products. Repairing products occurs because of
part failure (bought from suppliers). Expediting products occurs because suppliers are late
(Continued)
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Chapter 7 Activity-Based Costing and Management 301
in delivering needed parts. Activity cost information and other data needed for supplier CORNERSTONE
costing follow:
I. Activity Costs Caused by Suppliers (e.g., failed parts or late delivery)
7.6
Activity Costs (Continued)
Repairing products $800,000
Expediting products $200,000
Required:
Determine the cost of each supplier by using ABC.
Solution:
Using the above data, the activity rates for assigning costs to suppliers are computed as follows:
Repair Rate ¼ $800,000=2,000 unit
¼ $400 per failed unit
*(1,600 þ 380 þ 10 þ 10)
Using these rates and the activity data, the total purchasing cost per unit of each component is computed:
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302 Chapter 7 Activity-Based Costing and Management
As a consultant, you recently implemented an activity-based cus- lower level and improving business processes are ways to
tomer-profitability system. In your written report to management, increase customer satisfaction while at the same time maintaining
you classified the customers of the company into one of four cate- or increasing profitability. For customers with low profitability but
gories based on current profitability and the potential for future substantial potential, the goal is to move these customers up to a
profitability4: high profitability state. Pricing policies or initiatives related to
both the order and the transactions caused by the order is one
High Profitability, Substantial Future Potential way to increase profitability (e.g., activity-based pricing is based
Low Profitability, Substantial Future Potential on the costs-to-serve, something clearly revealed by the ABC cus-
High Profitability, Limited Future Potential tomer model). Another way is to lower the costs to serve by
improving activity efficiency and eliminating nonvalue-added
Low Profitability, Limited Future Potential
activities. The final category of customers (low-profitability and
After discussing the report with the CEO, he asks you to an- limited potential) is managed up or out—these customers need
swer the following question: to be made profitable quickly or simply dropped.
How would you manage the customers in each of the four Knowing customer profitability is important because not every
categories? revenue dollar contributes equally to overall profitability.
Thus, it is critical for a manager to understand the net profit
For highly profitable customers, and especially those with long- contribution that each customer makes to the company.
term potential, special efforts should be made to retain these cus- Understanding individual customer profitability and the associ-
tomers as it is much more expensive to attract new customers. ated drivers allows managers to take actions to sustain and
Offering these customers special discounts and new products and maintain profitable customers and transform unprofitable cus-
service lines coupled with managing their costs-to-serve to a tomers into profitable customers.5
The example in Cornerstone 7.6 (p. 300) shows that Murray, the ‘‘low-cost’’ supplier
(as measured by the purchase price of the two parts), actually costs more when the
supplier-related activities of repairing and expediting are considered. If all costs are consid-
ered, then the choice becomes clear: Plata Associates is the better supplier with a higher-
quality product, more on-time deliveries, and, consequently, a lower overall cost per unit.
EXHIBIT 7.11
Process-Value Analysis Model
ª Cengage Learning 2014
Driver Performance
Activities
Analysis Analysis
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Chapter 7 Activity-Based Costing and Management 303
. driver analysis
. activity analysis
. performance measurement
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304 Chapter 7 Activity-Based Costing and Management
with legal mandates. Activities needed to comply with the reporting requirements of the
Securities and Exchange Commission (SEC) and the filing requirements of the Internal
Revenue Service (IRS) are examples. These activities are value-added by mandate. The
remaining activities in the firm are discretionary. A discretionary activity is classified as
value-added provided it simultaneously satisfies all of the following conditions:
. The activity produces a change of state.
. The change of state was not achievable by preceding activities.
. The activity enables other activities to be performed.
For example, consider the production of rods used in hydraulic cylinders. The first
activity, cutting rods, cuts long rods into the correct lengths for the cylinders. Next, the
cut rods are welded to cut plates. The cutting rods activity is value-added because:
. It causes a change of state—uncut rods become cut rods.
. No prior activity was supposed to create this change of state.
. It enables the welding activity to be performed.
Though the value-added properties are easy to see for an operational activity like
cutting rods, what about a more general activity like supervising production workers? A
managerial activity is specifically designed to manage other value-added activities—to
ensure that they are performed in an efficient and timely manner. Supervision certainly
satisfies the enabling condition. Is there a change in state? There are two ways of
answering affirmatively:
. First, supervising can be viewed as an enabling resource that is consumed by the
operational activities that do produce a change of state. Thus, supervising is a
secondary activity that serves as an input that is needed to help bring about the
change of state expected for value-added primary activities.
. Second, it could be argued that the supervision brings order by changing the state
from uncoordinated activities to coordinated activities.
Once value-added activities are identified, we can define value-added costs. Value-added
costs are the costs to perform value-added activities with perfect efficiency.
Nonvalue-Added Activities All activities other than those that are absolutely essen-
tial to remain in business, and therefore considered unnecessary, are referred to as non-
value-added activities. A nonvalue-added activity can be identified by its failure to
satisfy any one of the three previous defining conditions for adding value. Violation of
the first two conditions is the usual case for nonvalue-added activities. Inspecting cut
rods (for correct length), for example, is a nonvalue-added activity. Inspection is a
state-detection activity, not a state-changing activity. (It tells us the state of the cut
rod—whether it is the right length.) Thus, it fails the first condition (activity produced a
change of state). Consider the activity of reworking goods or subassemblies. Rework is
designed to bring a good from a nonconforming state to a conforming state. Thus, a
change of state occurs. Yet the activity is nonvalue-added because it repeats work; it is
doing something that should have been done by preceding activities Condition 2
(change of state was not achievable by preceding activities) is violated.
Nonvalue-added costs are costs that are caused either by nonvalue-added activities or
the inefficient performance of valued-added activities. For nonvalue-added activities,
the nonvalue-added cost is the cost of the activity itself. For inefficient value-added
activities, the activity cost must be broken into its value-added and nonvalue-added
components. For example, if Receiving should use 10,000 receiving orders but uses
20,000, then half of the cost of Receiving is value-added and half is nonvalue-added.
The value-added component is the waste-free component of the value-added activity
and is, therefore, the value-added standard. Due to increased competition, many firms
are attempting to eliminate nonvalue-added activities because they add unnecessary cost
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Chapter 7 Activity-Based Costing and Management 305
and impede performance. Firms are also striving to optimize value-added activities.
Thus activity analysis identifies and eventually eliminates all unnecessary activities and,
simultaneously, increases the efficiency of necessary activities.
The theme of activity analysis is waste elimination. As waste is eliminated, costs are
reduced. The cost reduction follows the elimination of waste. Note the value of managing
the causes of the costs rather than the costs themselves. Though managing costs may
increase the efficiency of an activity, if the activity is unnecessary, what does it matter if it’s
performed efficiently? An unnecessary activity is wasteful and should be eliminated. For
example, moving raw materials and partially finished goods is often cited as a nonvalue-
added activity. Installing an automated materials handling system may increase the effi-
ciency of this activity, but changing to cellular manufacturing with on-site, just-in-time deliv-
ery of raw materials could virtually eliminate the activity. It’s easy to see which is preferable.
For Stillwater Designs, warranty work is decides whether or not the problem is covered under warranty.
a significant cost. Warranty work associ- Sometimes, problems are covered even though they are not at-
ated with defective products is typically tributable to a defective product. When the company decides to
labeled a nonvalue-added cost. Stillwater Designs recog- replace a nondefective product, it is making a conscious decision
nizes the nonvalue-added nature of this activity and takes meas- to increase customer satisfaction and brand loyalty. This part of
ures to eliminate the causes of the defective units. The company the warranty cost is a ‘‘marketing warranty cost’’ and could be
tracks return failures (over time) and provides this information to classified as a value-added cost. For example, customers some-
its research and development (R&D) department. R&D then uses times buy amplifiers that are more powerful than the subwoofers
this information to make design improvements on existing models can handle, resulting in burnt voice coils. By replacing the
(running changes) as well as to change the design on future mod- product (even though technically it’s the customer’s fault), the
ª Jackson Smith/Getty Images
els. The objective of the design changes is to reduce the demand customer will be more likely to buy again and to provide good
for the warranty activity, thus reducing warranty cost. word-of-mouth advertising for Kicker products.
However, not all Kicker warranty costs can be classified as
nonvalue-added. When products are returned, customer service
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306 Chapter 7 Activity-Based Costing and Management
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 lowest possible cost. These conditions mean that an organization
must continually strive for cost improvement. Activity management can reduce costs in
four ways:6
. activity elimination
. activity selection
. activity reduction
. activity sharing
Activity Selection Activity selection involves choosing among different sets of activities
that are caused by competing strategies. Different strategies cause different activities.
Different product design strategies, for example, can require significantly different
activities. Activities, in turn, cause costs. Each product design strategy has its own set of
activities and associated costs. All other things being equal, the lowest-cost design strat-
egy should be chosen. In a continual-improvement environment, redesign of existing
products and processes can lead to a different, cheaper set of activities. Thus activity
selection can have a significant effect on cost reduction.
Activity Reduction Activity reduction decreases the time and resources required by an
activity. This approach to cost reduction should be primarily aimed at improving the ef-
ficiency of necessary activities or a short-term strategy for improving nonvalue-added
activities until they can be eliminated. Setup activity is a necessary activity that is often
cited as an example for which less time and fewer resources need to be used. Finding
ways to reduce setup time—and thus lower the cost of setups—is another example of
the concept of gradual reductions in activity costs.
Activity Sharing Activity sharing increases the efficiency of necessary activities by using
economies of scale. Specifically, the quantity of the cost driver is increased without
increasing the total cost of the activity itself. This lowers the per-unit cost of the cost
driver and the amount of cost traceable to the products that consume the activity. For
example, a new product can be designed to use components already being used by other
products. By using existing components, the activities associated with these components
already exist, and the company avoids the creation of a whole new set of activities.
6
Peter B. B. Turney, ‘‘How Activity-Based Costing Helps Reduce Cost,’’ Journal of Cost Management (Winter 1991): 29–35.
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Chapter 7 Activity-Based Costing and Management 307
Information:
Consider the following two activities: (1) Performing warranty work, cost: $120,000. The
7.7
warranty cost of the most efficient competitor is $20,000. (2) Purchasing components, cost:
$200,000 (10,000 purchase orders). A benchmarking study reveals that the most efficient
level will use 5,000 purchase orders and entail a cost of $100,000.
Required:
Determine the nonvalue-added cost of each activity.
Solution:
Determine the value content of each activity: Is the activity nonvalue-added or value-
added?
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308 Chapter 7 Activity-Based Costing and Management
Time The time required to perform an activity is also critical. Longer times usually
mean more resource consumption and less ability to respond to customer demands.
Time measures of performance tend to be nonfinancial, whereas efficiency and quality
measures are both financial and nonfinancial.
Cycle time and velocity are two operational measures of time-based performance.
Cycle time can be applied to any activity or process that produces an output, and it meas-
ures how long it takes to produce an output from start to finish. In a manufacturing proc-
ess, cycle time is the length of time that it takes to produce a unit of output from the time
raw materials are received (starting point of the cycle) until the good is delivered to fin-
ished goods inventory (finishing point of the cycle). Thus, cycle time is the time required
to produce one unit of a product (Time/Units produced). Velocity is the number of units
of output that can be produced in a given period of time (Units produced/Time). Notice
that velocity is the reciprocal of cycle time. For the cycle time example, the velocity is two
units per hour. Cornerstone 7.8 demonstrates how to compute cycle time and velocity.
7.8 Information:
Assume that Frost Company takes 10,000 hours to produce 20,000 units of a product.
Required:
What is the velocity in hours? Cycle time in hours? Cycle time in minutes?
Solution:
Velocity ¼ 20,000=10,000 ¼ 2 units per hour
ª Pixelfabrik/Alamy
Cycle Time ¼ 10,000=20,000 ¼ 1=2 hour
¼ 10,000ð60 minutesÞ=20,000 ¼ 30 minutes
Quality Quality is concerned with doing the activity right the first time it
is performed. If the activity output is defective, then the activity may need
to be repeated, causing unnecessary cost and reduction in efficiency. Qual-
ity cost management is a major topic and is discussed in more detail next.
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Chapter 7 Activity-Based Costing and Management 309
For example, when Toyota sold more cars and trucks than General Motors for the
first time ever in 2007, some automotive industry experts attributed this crowning
achievement to Toyota’s long-time commitment to quality-related issues, such as qual-
ity cost management.7
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310 Chapter 7 Activity-Based Costing and Management
Control Activities Environmental prevention costs are the costs of activities carried
out to prevent the production of contaminants and/or waste that could cause damage to
the environment. Examples of prevention activities include evaluating and selecting sup-
pliers, evaluating and selecting equipment to control pollution, designing processes and
products to reduce or eliminate contaminants, training employees, studying environ-
mental impacts, auditing environmental risks, undertaking environmental research,
developing environmental management systems, and recycling products.
Environmental detection costs are the costs of activities executed to determine if
products, processes, and other activities within the firm are in compliance with appro-
priate environmental standards. The environmental standards and procedures that a
firm seeks to follow are defined in three ways:
. regulatory laws of governments
. voluntary standards developed by private organizations
. environmental policies developed by management
Examples of detection activities are auditing environmental activities, inspecting prod-
ucts and processes (for environmental compliance), developing environmental perform-
ance measures, carrying out contamination tests, verifying supplier environmental
performance, and measuring levels of contamination.
Failure Activities Environmental internal failure costs are costs of activities per-
formed because contaminants and waste have been produced but not discharged into
the environment. Thus, internal failure costs are incurred to eliminate and manage con-
taminants or waste once produced. Internal failure activities have one of two goals:
. to ensure that the contaminants and waste produced are not released to the environment
. to reduce the level of contaminants released to an amount that complies with
environmental standards
8
Baxter Environmental Financial Statement, 2008, at www.baxter.com/sustainability (accessed May 2010).
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Chapter 7 Activity-Based Costing and Management 311
activity drivers.
. Finally, the costs of primary activities are assigned to products, customers, and other
cost objects.
. The cost assignment process is described by the following general steps: (1) identifying
the major activities and building an activity dictionary, (2) determining the cost of
those activities, (3) identifying a measure of consumption for activity costs (activity
drivers), (4) calculating an activity rate, (5) measuring the demands placed on activi-
ties by each product, and (6) calculating product costs.
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312 Chapter 7 Activity-Based Costing and Management
managers.
. Accurate customer costs allow managers to make better pricing decisions, customer-
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