Activity Based Costing

- Investopedia
What is 'Activity-Based Costing - ABC'
Activity-based costing (ABC) is an accounting method that identifies the activities
that a firm performs and then assigns indirect costs to products. An activity-based
costing (ABC) system recognizes the relationship between costs, activities and
products, and through this relationship, it assigns indirect costs to products less
arbitrarily than traditional methods.

Some costs are difficult to assign through this method of cost accounting. Indirect
costs, such as management and office staff salaries are sometimes difficult to
assign to a particular product produced. For this reason, this method has found its
niche in the manufacturing sector.

Activity-based costing (ABC) is mostly used in the manufacturing industry since it

enhances the reliability of cost data, hence producing nearly-true costs and better
classifying the costs incurred by the company during its production process.

DEFINITION AND GOING DEEPER

This costing system is used in target costing, product costing, product line
profitability analysis, customer profitability analysis and service pricing. It is also
hugely popular since organizations can develop a much better corporate focus and
strategy if costs are better grasped.

The ABC system of cost accounting is based on activities, which is any event, unit
of work or task with a specific goal such as setting up machines for production,
designing products, distributing finished goods or operating machines. Activities
consume overhead resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or
event that is a cost driver. A cost driver, also known as an activity driver, is used
to refer to an allocation base. Examples of cost drivers include machine setups,
maintenance requests, power consumed, purchase orders, quality inspections or
production orders.

There are two categories of activity measures: transaction drivers, which involves
counting how many times an activity occurs, and duration drivers, which measure
how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count such
as machine hours and/or direct labor hours to allocate indirect or overhead costs
 to products, the ABC system classifies five broad levels of activity that are to a
certain extent unrelated to how many units are produced. These levels include
batch-level activity, unit-level activity, customer-level activity, organization-
sustaining activity and product-level activity.

Activity-based costing enhances the costing process in three ways. First, it

expands the number of cost pools that can be used to assemble overhead costs.
Instead of accumulating all costs in one companywide pool, it pools costs by
activity. It also creates new bases for assigning overhead costs to items such that
costs are allocated on the basis of the activities that generate costs instead of on
volume measures such as machine hours or direct labor costs. Finally, ABC
system alters the nature of several indirect costs, making costs previously
considered indirect such as depreciation, inspection or power are traced to certain
activities.

- Accounting coach
Activity based costing first assigns costs to the activities that are the real cause of
the overhead. It then assigns the cost of those activities only to the products that
are actually demanding the activities.

Example
Let's discuss activity based costing by looking at two products manufactured by
the same company. Product 124 is a low volume item which requires certain
activities such as special engineering, additional testing, and many machine
setups because it is ordered in small quantities. A similar product, Product 366, is
a high volume productrunning continuouslyand requires little attention and no
special activities. If this company used traditional costing, it might allocate or
"spread" all of its overhead to products based on the number of machine hours.
This will result in little overhead cost allocated to Product 124, because it did not
have many machine hours. However, it did demand lots of engineering, testing,
and setup activities. In contrast, Product 366 will be allocated an enormous amount
of overhead (due to all those machine hours), but it demanded little overhead
activity. The result will be a miscalculation of each product's true cost of
manufacturing overhead. Activity based costing will overcome this shortcoming by
assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing,
machine setups, and others are activities that cause coststhey cause the
company to consume resources. Under ABC, the company will calculate the cost
of the resources used in each of these activities. Next, the cost of each of these
activities will be assigned only to the products that demanded the activities. In our
example, Product 124 will be assigned some of the company's costs of special
 engineering, special testing, and machine setup. Other products that use any of
these activities will also be assigned some of their costs. Product 366 will not be
assigned any cost of special engineering or special testing, and it will be assigned
only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1)
manufacturing overhead costs have increased significantly, (2) the manufacturing
overhead costs no longer correlate with the productive machine hours or direct
labor hours, (3) the diversity of products and the diversity in customers' demands
have grown, and (4) some products are produced in large batches, while others
are produced in small batches.

Lean Production
- Search ManufacturingErp
Lean production is an assembly-line methodology developed originally for Toyota
and the manufacturing of automobiles. It is also known as the Toyota Production
System (TPS) or just-in-time production. Lean production principles are also
referred to as lean management or lean thinking.

Engineer Taiichi Ohno is credited with developing the principles of lean production
after World War II. His philosophy, which focused on eliminating waste and
empowering workers, reduced inventory and improved productivity. Instead of
maintaining resources in anticipation of what might be required for future
manufacturing, as Henry Ford did with his production line, the management team
at Toyota built partnerships with suppliers. In effect, under the direction of Engineer
Ohno, Toyota automobiles became made-to-order. By maximizing the use of multi-
skilled employees, the company was able to flatten their management structure
and focus resources in a flexible manner. Because the company was able make
changes quickly, they were often able to respond faster to market demands than
their competitors could.

Many industries, including software development, have adopted the principles of

lean production. The ten rules of lean production can be summarized:

1. Eliminate waste
2. Minimize inventory
3. Maximize flow
4. Pull production from customer demand
5. Meet customer requirements
6. Do it right the first time
7. Empower workers
8. Design for rapid changeover
 9. Partner with suppliers
10. Create a culture of continuous improvement (Kaizen)

- Investopedia

Lean enterprise is the production and management philosophy that considers any
part of the enterprise which does not directly add value to the final product to be
superfluous and in need of elimination. Lean enterprise considers the product or
service from the consumer's perspective to determine what is of value (i.e. what
the consumer is willing to pay for), then examines at the process with the aim of
reducing all of its aspects except for the value-adding ones.

- Lean.Org
Although there are instances of rigorous process thinking in manufacturing all the
way back to the Arsenal in Venice in the 1450s, the first person to truly integrate
an entire production process was Henry Ford. At Highland Park, MI, in 1913 he
married consistently interchangeable parts with standard work and moving
conveyance to create what he called flow production. The public grasped this in
the dramatic form of the moving assembly line, but from the standpoint of the
manufacturing engineer the breakthroughs actually went much further.

Ford lined up fabrication steps in process sequence wherever possible using

special-purpose machines and go/no-go gauges to fabricate and assemble the
components going into the vehicle within a few minutes, and deliver perfectly fitting
components directly to line-side. This was a truly revolutionary break from the shop
practices of the American System that consisted of general-purpose machines
grouped by process, which made parts that eventually found their way into finished
products after a good bit of tinkering (fitting) in subassembly and final assembly.

The problem with Fords system was not the flow: He was able to turn the
inventories of the entire company every few days. Rather it was his inability to
provide variety. The Model T was not just limited to one color. It was also limited
to one specification so that all Model T chassis were essentially identical up
through the end of production in 1926. (The customer did have a choice of four or
five body styles, a drop-on feature from outside suppliers added at the very end of
the production line.) Indeed, it appears that practically every machine in the Ford
Motor Company worked on a single part number, and there were essentially no
changeovers.

When the world wanted variety, including model cycles shorter than the 19 years
for the Model T, Ford seemed to lose his way. Other automakers responded to the
need for many models, each with many options, but with production systems
whose design and fabrication steps regressed toward process areas with much
longer throughput times. Over time they populated their fabrication shops with
larger and larger machines that ran faster and faster, apparently lowering costs
per process step, but continually increasing throughput times and inventories
except in the rare caselike engine machining lineswhere all of the process
steps could be linked and automated. Even worse, the time lags between process
steps and the complex part routings required ever more sophisticated information
management systems culminating in computerized Materials Requirements
Planning(MRP) systems .

As Kiichiro Toyoda, Taiichi Ohno, and others at Toyota looked at this situation in
the 1930s, and more intensely just after World War II, it occurred to them that a
series of simple innovations might make it more possible to provide both continuity
in process flow and a wide variety in product offerings. They therefore revisited
Fords original thinking, and invented the Toyota Production System.

This system in essence shifted the focus of the manufacturing engineer from
individual machines and their utilization, to the flow of the product through the total
process. Toyota concluded that by right-sizing machines for the actual volume
needed, introducing self-monitoring machines to ensure quality, lining the
machines up in process sequence, pioneering quick setups so each machine could
make small volumes of many part numbers, and having each process step notify
the previous step of its current needs for materials, it would be possible to obtain
low cost, high variety, high quality, and very rapid throughput times to respond to
changing customer desires. Also, information management could be made much
simpler and more accurate.

The Machine that Changed the WorldThe thought process of lean was thoroughly
described in the book The Machine That Changed the World (1990) by James P.
Womack, Daniel Roos, and Daniel T. Jones. In a subsequent volume, Lean
Thinking (1996), James P. Womack and Daniel T. Jones distilled these lean
principles even further to five:

Specify the value desired by the customer

Identify the value stream for each product providing that value and challenge all of
the wasted steps (generally nine out of ten) currently necessary to provide it
Make the product flow continuously through the remaining value-added steps
Introduce pull between all steps where continuous flow is possible
Manage toward perfection so that the number of steps and the amount of time and
information needed to serve the customer continually falls
Lean Today

As these words are written, Toyota, the leading lean exemplar in the world, stands
poised to become the largest automaker in the world in terms of overall sales. Its
 dominant success in everything from rising sales and market shares in every global
market, not to mention a clear lead in hybrid technology, stands as the strongest
proof of the power of lean enterprise.

This continued success has over the past two decades created an enormous
demand for greater knowledge about lean thinking. There are literally hundreds of
books and papers, not to mention thousands of media articles exploring the
subject, and numerous other resources available to this growing audience.

As lean thinking continues to spread to every country in the world, leaders are also
adapting the tools and principles beyond manufacturing, to logistics and
distribution, services, retail, healthcare, construction, maintenance, and even
government. Indeed, lean consciousness and methods are only beginning to take
root among senior managers and leaders in all sectors today.

Theory of Constraints

What is the Theory of Constraints?

The Theory of Constraints is an organizational change method that is focussed on profit

improvement. The essential concept of TOC is that every organization must have at
least one constraint. A constraint is any factor that limits the organization from getting
more of whatever it strives for, which is usually profit. The Goal focuses on constraints
as bottleneck processes in a job-shop manufacturing organization. However, many non-
manufacturing constraints exist, such as market demand, or a sales departments ability
to translate market demand into orders.

The Theory of Constraints defines a set of tools that change agents can use to manage
constraints, thereby increasing profits. Most businesses can be viewed as a linked set
of processes that transform inputs into saleable outputs. TOC conceptually models this
system as a chain, and advocates the familiar adage that a "chain is only as strong as
its weakest link." Goldratt defines a five-step process that a change agent can use to
strengthen the weakest link, or links. In The Goal, Goldratt proves that most
organizations have very few true constraints. Since the focus only needs to be on the
constraints, implementing TOC can result in substantial improvement without tying up a
great deal of resources, with results after three months of effort.

The Five Steps of the Theory of Constraints

1. Identify the System Constraint

 The part of a system that constitutes its weakest link can be either physical or a
policy.

2. Decide How to Exploit the Constraint

Goldratt instructs the change agent to obtain as much capability as possible from a
constraining component, without undergoing expensive changes or upgrades.

An example is to reduce or eliminate the downtime of bottleneck operations.

3. Subordinate Everything Else

The non-constraint components of the system must be adjusted to a "setting" that

will enable the constraint to operate at maximum effectiveness. Once this has been
done, the overall system is evaluated to determine if the constraint has shifted to
another component. If the constraint has been eliminated, the change agent jumps
to step five.

4. Elevate the Constraint

"Elevating" the constraint refers to taking whatever action is necessary to eliminate

the constraint. This step is only considered if steps two and three have not been
successful. Major changes to the existing system are considered at this step.

5. Return to Step One, But Beware of "Inertia"

6. Box Summary: Theory of Constraints versus Lean Thinking

Theory of Constraints Lean Thinking

Goal Increase Profit by increasing Increase Profit by adding value
Throughput from customers perspective
Measures Throughput Cost

Inventory Lead Time

Operating Expense Value-Added Percentage

What to Change? Constraints: the "weakest links" Eliminate Waste and Add Value
in the system considering the entire system
How to Implement Five-Step, Continuous Process Five-Step, Continuous Process
the Change: emphasizing acting locally emphasizing thinking globally
Time Both can achieve immediate results, but require a long term
(about five year) effort to sustain the results

7.
 KAIZEN
DEFINITION of 'Kaizen'
Kaizen is a philosophy and practice that sees improvement in productivity as a
gradual and methodical process. Kaizen is a Japanese term meaning "change for
the better." The concept of kaizen encompasses a wide range of ideas. It involves
making the work environment more efficient and effective by creating a team
atmosphere, improving everyday procedures, ensuring employee satisfaction ,
and making a job more fulfilling, less tiring and safer.

BREAKING DOWN 'Kaizen'

Some of the key objectives of the Kaizen philosophy include the elimination of
waste, quality control, just-in-time delivery, standardized work, and the use of
efficient equipment. An example of the Kaizen philosophy in action is the Toyota
production system, in which suggestions for improvement are encouraged and
rewarded, and the production line is stopped when a malfunction occurs.

The overall goal of kaizen is to make small changes over a period of time to create
improvements within a company. That doesn't mean alterations happen slowly, it
just recognizes that small changes now can have huge impacts in the future.
Improvements can come from any employee at any time. The idea is that everyone
has a stake in the company's success and everyone should strive, at all times, to
help make the business model better.

Traditional Concepts
Traditional Japanese ideas of kaizen follow five basic tenets, which are teamwork,
personal discipline, improved morale, quality and suggestions for improvement.
These five tenets lead to three major outcomes: elimination of waste, good
housekeeping and standardization. Ideally, kaizen becomes so ingrained in a
company's culture that it happens naturally among all of its employees, from the
CEO all the way to entry-level floor workers. The firm also learns to work well with
less, which means less inventory, fewer problems and less waste, and all of these
lead to greater efficiency. In addition to all of the technology marvels that help 21st
century companies succeed, kaizen plays an important role for those who follow
the philosophy.

Contemporary Attitudes
Nothing gets done in a kaizen framework without teamwork. Regular team
meetings discuss improvements, changes and projects. Minor changes might only
affect a small team. Large projects may require the entire company to undergo an
overhaul.
 Improvements generally follow the PDCA format, which stands for "plan-do-check-
act." The "plan" portion includes mapping out the changes so that everyone knows
what to expect when teams try to solve a problem. The "do" means implementing
the best solution for the problem. The "check" step involves evaluating the solution
to the problem to see if it worked. When a company performs the "act" stage, it
determines whether or not the solution should become a company standard or if it
needs further changes. If managers decide to implement more changes, kaizen
goes back to the plan step and the process starts all over again.

Life Cycle Costing

Target Pricing Costing
Six Sigma
Total Quantity Management