Big Picture in Focus: ULOb.

apply the concept and objective of activity based

costing and management.

Metalanguage
In this section, the most essential terms relevant to the topic and to demonstrate ULOb
will be operationally defined to establish a common frame of reference as to how the texts
work in your chosen field or career.
1. 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.

2. Activity based management (ABM) – is a discipline that focuses on the activities

incurred during the production/performance process as the way to improve the
value received by a customer and the resulting profit achieved by providing this
value.

Please proceed immediately to the “Essential Knowledge”.

Essential Knowledge

Cost are important in the business. Mismanagement of cost will affect the business
profitability and cash flow. To efficiently and effective control cost, management must
have a thorough knowledge and understanding of all activities and process employed
within the business to create value for the final product.

Activity based costing has been developed in response to the manager’s need for more
accurate product cost 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.

1. Activity– is a repetitive action performed in fulfillment of business function.

2. Activity based Costing

 A costing system that allocates cost to products on the basis of the resources
consumed in each activity involved in the design, production and distribution of a
particular product.
 A process using multiple cost drivers to predict and allocate costs to products and
services
 An accounting system collecting financial and operational data on the basis of the
underlying nature and extent of business activities.
  An accounting information and costing system that identifies the various activities
performed in an organization, collects costs on the basis of the underlying nature
and extent of those activities, and assigns costs to products and services based
on consumption of those activities by the products and services.

2.1. Benefits from ABC

 Improved productivity.
 The creation of a chart of the flow of activities through an organization.
 The identification and elimination (or reduction) of non value activities.
 The identification of causes of delay in performing activities.
 The ability to track indicators of waste.

2.2. Criticism of ABC

 Requires a significant amount of time and thus, cost to implement.
 It does not conform specifically to GAAP, since some non-products costs (such
as those in research and development) are allocated to products and certain
other traditionally designated product costs (such as factory building
depreciation) not be allocated to products.
 It does not promote TQM and continuous improvement.

2.3. 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

3. Design of an ABC System

The step or activities required in designing an ABC are:

Process Value Analysis (PVA)

Identifying Activty Centers

Assigning Costs to Activity Centers

Selecting Cost Drivers

3.1. 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.
b) Classify each activity as value-added or non-value-added.
c) Identify ways to either reduce or eliminate the non-value-added activities.

3.1.1. Activity analysis – the process of detailing the various repetitive actions
that are performed in making a product or providing a service, classifying them
as Value Added (VA) and Non – Value Added (NVA), and devising ways of
minimizing or eliminating NVA activities.

3.1.2. Classification of activities:

 Value Added activity (VA) – is an activity that increases the worth of
the product or service to the customer. The cost associated with this
activity is value added costs that cannot be eliminated without the
customer perceiving a decline in product quality or performance.
 Non Value Added activity (NVA) – is an activity that increases the time
spent on a product or services but does not increase its worth or value
to the customer. The cost related to this activity is called non value
added costs that can be eliminated without the customer perceiving a
decline in product quality or performance.

3.1.3. Value chain – is the sequence of business functions in which value is

added to a firm’s products or services. This sequences includes research and
development, product design, manufacturing, marketing, distribution and
customer service.
3.1.4. Process map – is a flowchart or diagram indicating every step that goes
into making a product or providing a service.
3.1.5. Value chart – is a visual representation indicating the VA and NVA activities
and the time spent in those activities from the beginning to the end of a
process.
 3.2. 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 if 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.
4. Facility – level activities – which simply sustain a facility’s general
manufacturing process.

Unit – Level Activities

Activity Centers Cost Drivers Traceable Costs
Machine related activities Machine hours Power costs
Labor related activities Labor hours Maintenance costs
Number of units of output Labor costs
Factory supplies

Batch – Level Activities

Activity Centers Cost Drivers
Purchase order Number of orders
processing processed
Equipment setups Number of setups
Material handling Hours of setup time
Quality inspection Number of inspection
Hours of inspection time
Traceable Costs
Clerical costs
Supplies consumed
Labor setup costs
Labor cost to handle
material
Quality control costs

Product – Level Activities

Activity Centers Cost Drivers Traceable Costs
Product testing Number of tests Testing facility costs
Parts inventory Hours of testing time Parts administration costs
management
Product design Number of part types Parts carrying costs
Hours of design time Design costs

Facility – Level Activities

Activity Centers Cost Drivers Traceable Costs
General factory Machine hours Plant depreciation
Plant occupancy Labor hours Property taxes &
insurance
 3.3. 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.

3.4. Step 4: Select Cost Drivers

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

Sample Problem I: Application of Activity based costing

Barmaid Company provides the following ABC costing information:

Activities Total Costs Activity-cost drivers
Account inquiry hours P 400,000 10,000 hours
Account billing lines 280,000 4,000,000 lines
Account verification accounts 150,000 40,000 accounts
Correspondence letters 50,000 4,000 letters

The above activities are used by department A and Department B as follows:

Department A Department B
Account inquiry hours 2,000 hours 4,000 hours
Account billing lines 400,000 lines 200,000 lines
Account verification accounts 10,000 accounts 8,000 accounts
Correspondence letters 1,000 letters 1,600 letters

I. Compute for the ABC rate.

Activities Total Cost Rate

Costs Driver
Account inquiry hours 400,000 ÷ 10,000 = P 40 per hour
Account billing lines 280,000 ÷ 4,000,000 = P 0.07 per line
Account verification accounts 150,000 ÷ 40,000 = P 3.75 per accounts
Correspondence letters 50,000 ÷ 4,000 = P 12.50 per letter
 II. Allocate factory overhead.

DEPARTMENT A
Activities Cost Rate Factory Overhead
Driver
Account inquiry hours 2,000 X P 40 = P 80,000
Account billing lines 400,000 X P 0.07 = 28,000
Account verification accounts 10,000 X P 3.75 = 37,500
Correspondence letters 1,000 X P 12.50 = 12,500
TOTAL P 158,000.00

DEPARTMENT B
Activities Cost Rate Factory Overhead
Driver
Account inquiry hours 4,000 X P 40 = P 160,000
Account billing lines 200,000 X P 0.07 = 14,000
Account verification accounts 8,000 X P 3.75 = 30,000
Correspondence letters 1,600 X P 12.50 = 20,000
TOTAL P 224,000.00

Sample Problem II: Application of Activity based costing

Food Corner Supermarket found that its ABC analysis provided important insights. It
extends the analysis to cover three more product lines – breads, soft drinks, ice cream.
The revenues, cost of goods sold, store support costs and activity area usage of the three
product lines is as follows:

Breads Soft drinks Ice cream

Financial data
Revenues P 57,000 P 63,000 P 52,000
Cost of goods sold 38,000 47,000 35,000
Store support 11,400 14,100 10,500

Activity area usage (cost driver)

Ordering (purchase orders) 30 25 13
Delivery (deliveries) 98 36 28
Shelf-stocking (hours) 183 166 24
Customer support (item sold) 15,500 20,500 7,900

Required:
I. Use the ABC system to compute a product line profitability report for Food Corner.
Note: ordering at P100 per purchase order, delivery at P80 per delivery, shelf-
stacking at P20 per hour and customer support at P0.20 per item sold
Solution: Food Corner Supermarket
The ABC system reports the following

Breads Soft drinks Ice cream Total

Revenues P 57,000 P 63,000 P 52,000 P 172,000
Costs
Cost of goods sold 38,000 47,000 35,000 120,000
Ordering (purchase orders) 3,000 2,500 1,300 6,800
Delivery (deliveries) 7,840 2,880 2,240 12,960
Shelf-stocking (hours) 3,660 3,320 480 7,460
Customer support (item sold) 3,100 4,100 1,580 8,780
TOTAL COSTS 55,600 59,800 40,600 156,000
Operating income P 1,400 P 3,200 P 11,400 P 16,000

Net profit margin 2.46% 5.08% 21.92% 9.30%

These activity costs are based on the following:
Breads
Activity Cost allocation rate Activity level Costs
Ordering P100 per purchase order 30 P 3,000
Delivery P80 per delivery 98 7,840
Shelf-stacking P20 per hour 183 3,660
Customer support P0.20 per item sold 15,500 3,100

Soft drinks
Activity Cost allocation rate Activity level Costs
Ordering P100 per purchase order 25 P 2,500
Delivery P80 per delivery 36 2,880
Shelf-stacking P20 per hour 166 3,320
Customer support P0.20 per item sold 20,500 4,100

Ice cream
Activity Cost allocation rate Activity level Costs
Ordering P100 per purchase order 13 P 1,300
Delivery P80 per delivery 28 2,240
Shelf-stacking P20 per hour 24 480
Customer support P0.20 per item sold 7,900 1,580

The ranking of products in terms of relative profitability are:

I. Ice cream
II. Soft drinks
III. Breads
4. ACTIVITY BASED MANAGEMENT

4.1. 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.

There are two categories of ABM application, namely:

1. Operational ABM – enhances operation efficiency and asset utilization and
lowers costs. It focuses on doing things right and performing activities more
efficiency.
2. Strategic ABM – attempts to alter the demand for activities and increase
profitability at the current or improved activity efficiency. If focuses on
choosing the activities for the operations.

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

4.2. Cost driver analysis

This technique examines, quantifies and explains the effects of the costs driver on the
costs 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 – involve the search for the best practices anywhere to identify
ways to improve the operation for a task, activity or process.
Cause-and-effect diagrams– maps out causes that affect an activity, process,
stated problem or desired outcome.
Pareto analysis – is a histogram of the cost driver that contribute to the total cost.

4.3. 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. A firm performs an activity
because it is:
 Required to meet the specification of the product or service or satisfy customer
demand.
 Required to sustain the organization
 Deemed beneficial to the firm.

Activity analysis identifies and describes the activities in an organization.

4.4. 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. Financial performance measures are cost per unit of output, return
on sales and cost of every department.

Nonfinancial performance measure evaluate operating characteristics of

manufacturing process and measures of or feedbacks from customers or personnel.
Examples of nonfinancial performance measures are the:
 Number of customer complaint
 Customer satisfaction
 Number of defective parts or output
 Number of output unit
 Cycle time