MANAGEMENT ACCOUNTING REVIEWER

CHAPTER 10

ACTIVITY-BASED COSTING
The most difficult task in computing accurate unit cost lies in determining the proper amount of
overhead cost to assign to each job, a unit of product or service activity.

Today, accountants recognize that manufacturing and providing services are related activities.
Thus, they direct attention to the cost of these activities. The activity-based management
system links resource consumption to the activities a company performs and costs the activities
to products or customers. Activity- based management uses activity-based costing (also called
transaction-based costing) to measure and control these relationships.

Activity-based costing (ABC) has been developed in response to the manager's need for more
accurate product costs to make them more globally competitive.

ABC helps managers identify more clearly the costs involved in manufacturing a product or
providing a service and thereby provides more accurate unit cost information on which to base
pricing and other decisions.

Activity-based costing (ABC) is a costing method that is designed to provide managers with
cost information for strategic and other decisions that potentially affect capacity and therefore
"fixed" costs. ABC is ordinarily used as a supplement to, rather than as a replacement for the
company's usual costing system.

Most organizations that use activity-based costing have two costing systems: the official costing
system that is used for preparing external financial reports and the activity-based costing
system that is used for internal decision making and for managing activities.

Advantages and Limitations of ABC

-​ Activity-based costing provides several benefits to the manager, namely

1 More accurate product costs

2 Better data for decision making

3 Tighter cost control

ABC has also several limitations, the chief of which is the difficulty and high costs involved with
gathering data relating to activity centers and cost drivers.
Design of an Activity-Based Costing System

The steps or activities required in designing an ABC system are

Process Value Analysis (PVA)

2. Identifying Activity Centers

3 Assigning Costs to Activity Centers

4 Selecting Cost Drivers

Step 1. Process Value Analysis involves the following steps.

a) Analyze activities required to make the product or perform the service. This can be done
through the preparation of a flowchart detailing each in the manufacturing process from the
receiving of materials to the final inspection of the completed product. This requires walking
through an operation and documenting every activity observed as well as the time involved. An
activity is any event or transaction that is a cost driver that is, it causes the incurrence of cost in
an organization.

b) Classify each activity as value-added or non-value-added.

c) Identify ways to either reduce or eliminate the non-value-added activities

Step 2. Identifying Activity Centers

An activity center can be defined as a part of the production process for which management
wants a separate reporting of the cost of the activity involved. Generally, the levels of activities
can be classified into four as follows:

1. Unit-level activities, which are performed each time a unit is produced;

2. Batch-level activities, which are performed each time a batch of goods is handled or
processed;

3. Product-level activities, which are performed as needed to support the production of each
different type of product; and

4. Facility-level activities which simply sustain a facility's general manufacturing process

Step 3. Assign Cost to Activity Centers

Assign costs to the activity centers where they are accumulated while waiting to be applied to
products. Costs that are traceable to the activity center should be assigned directly to activity
centers. Other costs shared by two or more activity centers should be assigned according to
some cost driver that controls the utilization of the costs involved.

Step 4. Select Cost Drivers

This involves assigning costs from the activity center to the product using appropriate cost
drivers. When selecting a cost driver, one must consider the following factors

1. The case of obtaining data relating to the cost driver

2. The degree to which the cost driver measures actual consumption by products of the activity
involved

ACTIVITY-BASED MANAGEMENT
Activity-based management (ABM) is a management tool that involves analyzing and costing
activities with the goal of improving efficiency and effectiveness. Basically, this management
approach aims to improve the value of products or services to customers and increase the firm's
profit. ABM draws on ABC as its major source of information and focuses on the efficiency and
effectiveness of key business processes and activities.

Using ABM enhances management's ability to pinpoint avenues for improving operations,
reducing costs, or increasing values to customers. By identifying the resources spent on
products customers, and activities, ABM improves management's focus on the firm's critical
success factors and enhances its competitive advantage.

ABM is closely related to ABC, but the two schemes differ in their primary goals. To clarify the
difference, consider activities involved in setting up machinery for production user. ABC seeks to
measure the cost of setups and then assign a cost to products based on how many setups each
product requires. The objective of ABM on the other hand, is to improve the efficiency and
effectiveness of these activities. Therefore, ABM would focus on ways to improve the setup
process and ways to eliminate the demand for set-up activity (thus reducing setup cost). In other
words, one needs to know the costs of activities before one can do a good job of managing
them.

There are basically two categories of ABM applications, namely

●​ Operational ABM, and

●​ Strategic ABM.

Operational ABM enhances operation efficiency and asset utilization and lowers cost. It
focuses on doing things right and performing activities more efficiently. Among the management
techniques that are applied in operational ABM are activity management, business process
reengineering, total quality management and performance management.

Strategic ABM, on the other hand, attempts to alter the demand for activities and increase
profitability at the current or improved activity efficiency. It focuses on choosing the activities for
the operations. Strategic ABM applications use management techniques such as process
design, product-line and customer mix. supplier, relationships; customer relationship (delivery,
pricing, order size, packaging, etc.) market segmentation and distribution channel.

Frequently, ABM uses cost-driver analysis, activity analysis and performance measurement, to
improve operations. A brief explanation of these techniques follows:

Cost-driver analysis

This technique examines, quantifies, and explains the effects of the cost driver on the cost of an
activity. Its purpose is to search for the root cause of activity costs. Among the tools used in cost
driver analysis include benchmarking, cause-and-effect diagrams, and Pareto analysis

Benchmarking involves the search for the best practices anywhere to identify ways to improve
the operation for a task, activity, or process. A cause-and-effect diagram maps out causes that
affect an activity, process, stated problem or desired outcome.

A cause-and-effect diagram maps out causes that affect an activity, process, stated problem or
desired outcome.

A Pareto analysis is a histogram of the cost drivers that contribute to the total cost. Most
analyses under this technique show that 20 percent of the cost drivers are responsible for 80
percent of the total cost incurred

Activity analysis

To be competitive a firm must assess each of its activities based on its need by the product or
customer, its efficiency, and its value content. performs an activity because it is: A fir

●​ Required to meet the specification of the product or service or satisfy customer demand;

●​ Required to sustain the organization; or

●​ Deemed beneficial to the firm.

Activity analysis identifies and describes the activities in an organization. Through interviews,
questionnaires, observation, and interview of documentation, an activity analysis collects
information.

Performance measurement

This involves the identification of the work performed and the results achieved by an activity
process, or organizational unit. Performance measures include both financial and nonfinancial.
Examples of financial performance measures are the cost per unit of output, return on sales,
and cost of every department's high-value-added activities and low-valued-added activities.
Nonfinancial performance measures-evaluate operating characteristics of manufacturing
process and measures of or feedback from customers or personnel. Examples of nonfinancial
performance measures are the:

(a) number of customer complaints

(b) customer satisfaction

(c) number of defective parts or output

(d) number of output unit

(e) cycle-time

(f) on-time delivery rate

(g) number of employee suggestions

(h) scores on employee morale

Opportunity Costing Concepts

One significant factor that managers should include in their decision process information is the
capacity usage of the plant and the other resources of the entity. Capacity usage information is
a critical signal of the potential relevance of opportunity costs, the benefit lost when one benefits
from an alternative option. chosen option precludes the

When a firm has excess capacity, that is, it is able to produce the current demand as well as
handle a special order or new product, no opportunity cost is present. When the plant is
operating at full capacity, opportunity costs are an important consideration because the decision
to produce a special order or add a new product line can cause the reduction, delay, or loss of
sales of products and services currently offered.

When opportunity costs are relevant, the manager must consider the value of lost sales as well
as the contribution from the new order or new product.

Managers can because never be sure whether their decisions were wise or unwise

1. Unexpected events can influence subsequent results, and

2. What would have happened had the decision been different can never be Known.
Before making a decision, managers must gain a thorough understanding of the cost
information that is relevant. In previous chapters, we have examined various issues involving
costs: determining the costs of products and services using job order and process costing
systems, activity-based costing, and variable costing. In the course of those discussions, we
considered examples of how cost information is used in decision making.

The basic approach to decision making is to compare decision alternatives in terms of costs and
revenues that are incremental. Costs that can be avoided by taking a particular course of action
are always incremental costs and, therefore,relevant to the analysis of a decision. Costthat arre
sunk (e.e., already incurred and not reversible) are never incremental costs, because they do
not differ among the decision alternatives. Therefore, they are not relevant in making a decision.

Students of managerial accounting often assume that fixed costs are equivalent to sunk costs
and are thus irrelevant (i.e., are not incremental costs), but this is not always the case. Fixed
costs may be sunk and, therefore, irrelevant. Fixed costs may not be sunk but still irrelevant.
Finally, fixed costs may not be sunk and may be relevant.

Finally, opportunity costs represent the benefit foregone by selecting a particular decision
alternative over another. By their nature, they are always incremental costs, and they must be
considered when making a decision. To illustrate opportunity costs, consider this example. The
company is considering dropping the garden supplies product line. Suppose that if garden
supplies are dropped, more space can be devoted to selling tools, sales of tools will increase
and the contribution margin associated with tools will increase by P20,000. In this case there is
a P20,000 opportunity cost associated with the decision to keep the garden supplies product
line. Considering this opportunity cost would make dropping the product line desirable rather
than undesirable if the contribution margin of the garden supplies is lesser.

If a resource can be used in more than one way, it has an opportunity cost. An opportunity cost
is the benefit lost by taking one action as opposed to another. The other action is the best
alternative available other than the one being contemplated.
 CHAPTER 11

Definition of Cost Behavior

Cost behavior means how a cost will react as changes take place in the level of business
activity. Managers who understand how costs behave are better able to predict what costs will
be under various operating circumstances. An understanding of cost behavior under varying
conditions is essential to adequate decision making in the planning and control of firm activity.

Importance of Understanding Cost Behavior

Planning requires that management make decisions based in part on expectations as to the
future. These expectations should be based on data relevant to the decision objectives,
gathered and analyzed in a competent, unbiased fashion. Failure in this activity could mean
displacement costs due to unexpected events. Control is the process of using feedback
information for comparison with expectations and the implementation of actions on the basis of
that comparison.

Cost Analysis is an integral part of the planning and control function. The key to effective cost
prediction lies in an understanding of cost behavior patterns.

This chapter reviews and discusses in greater depth variable costs, fixed costs and mixed costs
which were introduced in Chapter 7.

Types of Cost Behavior Patterns

1.​ Variable Costs

Variable costs are those costs that change in total as the level of activity changes in the short
run and within the relevant range. To the economist, the short run is the time period long enough
to allow management to change the level of production or other activity within the constraints of
current total productive or operating capacity. Furthermore, the estimates of variable and other
costs are applicable only if the contemplated level of activity is within the relevant range.
Relevant range is the range activity within which assumptions relative to variable cost and fixed
cost behavior are valid. Variable cost latinitis assumed to remain constant within this range. For
a cost to be variable, it must be variable with respect to its activity base. An activity base is a
measure of whatever causes the incurrence of variable cost. An activity base is sometimes
referred to as a cost driver. Some of the most common activity drivers are units sold, units
produced, direct labor- hours and machine hours. Other activity bases (cost drivers) might
include the number of miles driven by salespersons, the number of pounds of laundry cleaned
by a hotel, the number of calls handled by technical support staff at a software company, and
the number of beds occupied in a hospital.
 2.​ Fixed Costs

Fixed costs are costs that remain constant in total regardless of changes in the level of activity
within the relevant range. Fixed costs however may change due to some outside force, such as
price changes. Fixed cost per unit will react inversely with change in activity. Fixed costs
decrease per unit as the activity level rises and increase per unit as the activity level fall. The
concept of a fixed cost is shown in graphic form in Figure 11.2.

Types of Fixed Costs

Fixed costs are sometimes referred to as capacity costs, since they result from outlays made for
buildings, equipment, skilled professional employees, and other items operations. needed to
provide the basic capacity for sustained For planning purposes, fixed costs can be viewed as
being either committed or discretionary

Committed fixed costs relate to the investment in facilities, equipment, and the basic
organizational structure of a firm. Examples of such costs include depreciation of buildings and
equipment, taxes on real estate, insurance, and salaries of top management and operating
personnel. The two key characteristics of committed fixed costs are that (1) they are long term in
nature, and (2) they can't be significantly reduced even for short periods of time without
seriously impairing the profitability or long-run goals of the organization. Even if operations are
interrupted or cut back, the committed fixed costs will still continue largely unchanged.

Discretionary fixed costs (often referred to as managed fixed costs) usually arise from annual
decisions by management to spend in certain fixed cost areas. Examples of discretionary fixed
costs include advertising, research, public relation, management development programs, and
internships for students. The most important characteristic of discretionary fixed costs is that
management is not locked into a decision regarding such costs. They can be adjusted from year
to year or even perhaps during the course of a year if circumstances demand such a
modification.

Fixed Costs and the Relevant Range

The concept of relevant range is also important in understanding fixed costs particularly
discretionary fixed costs. The levels of discretionary fixed costs. The levels of discretionary fixed
costs are typically decided at the beginning of the year and depend on the support needs of
planned programs such as advertising and training. scope of these programs will depend, in
turn, on the overall anticipated level of activity for the year. At very high levels of activity,
programs are usually broadened or expanded.

For example, if the company hopes to increase sales by 25%, it would probably plan for much
larger advertising costs than if no sales increase were planned. So the planned level of activity
might affect total discretionary fixed costs. However, once the total discretionary fixed costs
have been budgeted, they are unaffected by the actual level of activity. For example, once the
advertising budget has been decided on and has been spent, it will not be affected by how many
units are actually sold. Therefore, the cost is fixed with respect to the actual number of units
sold.

3.​ Mixed Costs (Semivariable. Costs)

A mixed cost is one that contains both variable and fixed cost elements. Mixed costs are also
known as semi variable costs. Figure 11.3 shows the behavior of mixed costs in relation to
volume. Note that the total cost line slopes upward as the variable cost element is added to the
fixed cost element.

Common Examples of Mixed or Semivariable Costs include: Costs, Electric Utility Costs
Maintenance

The relationship between mixed cost and the level of activity also be expressed in the following
equation:

Y= a + bX

where:
Y = The total mixed cost (the dependent variable)
a = The total fixed cost (vertical intercept of the line)
b = The variable cost per unit of activity (the slope of the line)
X = The level of activity (the independent variable)

The independent variable is also called the explanatory variable or cost driver. In cost
estimation,we identify some independent variable (the activity) and the functional relationship
that permit computation of the corresponding value of the dependent variable (the cost)

Cost Estimation

The Analysis of Mixed Costs

The fixed portion of mixed cost represents the basic, minimum cost of just having a service
ready and available for use while the variable portion represents the cost incurred for the actual
consumption of the service. The variable element varies in proportion to the amount of service
that is consumed

How does management go about in estimating the fixed and variable components of a mixed
cost?

The basic idea in cost estimation is to estimate the relation between costs and the variables
(factors) affecting the costs.
This chapter discusses the methods of estimating the relation between cost behavior and
activity levels that are commonly used in practice as well as a brief overview of the theory and
some important considerations for their application. These are:

1.​ Account Analysis method

2.​ Industrial Engineering method or Work Measurement method

3.​ Conference method

4.​ Quantitative Analysis of Current and Past Costs Relationships

a.​ High-Low Method

b.​ Regression Analysis Method

1.​ Scattergraph or Visual fit method

2.​ The Least-squares Regression method

Account Analysis Method

Account analysis is considered a very useful and easier way to estimate costs. It makes use of
the experience and judgment of managers and accountants who are familiar with company
operations and the way costs react to changes in activity level.

The account analysis involves the following steps:

1.​ Review each cost account used to record the costs that are of interest. Each cost is
identified as either fixed or variable depending on the relationship between the cost and
some activity.
2.​ Each major class of manufacturing overhead or other mixed cost is itemized. Each cost
is then divided into its estimated variable and fixed components. This is done on the
basis of the experience and judgment of accounting and other personnel.

An advantage of account analysis is that it involves a detailed examination of the database by

accountants and managers who are familiar with it. Other methods may overlook this expert
judgment in uncovering cost behavior patterns. A disadvantage of this method is that it uses a
subjective, judgmental approach so that different analysts may provide different estimates of
cost behavior.
Industrial Engineering Method

The industrial engineering method estimates cost functions by analyzing the relationship
between inputs and outputs in physical forms. Engineering estimates indicate what costs should
be. This method is so named because it was first used in estimating manufacturing costs from
industrial engineers specifications of the required input to the manufacturing process for a unit
of manufactured output. This method is not just confined to manufacturing. Time and-motion
have also been used in banks, fast food companies, government units, hospitals, and many
other nonmanufacturing operations.

Steps in Applying the Engineering Method of Estimating Costs

1 of the physical relation between the quantities of inputs And Study, be hand each unit of
output (finished product) is done. This involves the following activities. cach

21. A detailed step-by-step analysis of phase of each manufacturing process together with the
kinds of work performed, and uner to perform each step is done. (This is sometimes part of
time-and-motion study). This serves as a basis for estimating

b. direct labor time. Engineering estimates of the materials required for each unit of