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The early adopters of activity-based costing (ABC) used it to produce more accurate product (or service) costs but it soon became apparent to the users that it could be extended beyond purely product costing to a range of cost management applications. The terms activity-based management (ABM) or activity-based cost management (ABCM) are used to describe the cost management applications of ABC.
Business process re-engineering
Business process re-engineering involves examining business processes and making substantial changes to how the organization currently operates. It involves the redesign of how work is done through activities. A business process consists of a collection of activities that are linked together in a co-ordinate manner to achieve a specific objective. For example, material handling might be classed as a business process consisting of separate activities relating to scheduling production, storing materials, processing purchase orders, inspecting materials and paying suppliers.
The aim of business process re-engineering is to improve the key business processes in an organization by focusing on simplification, cost reduction, improved quality and enhanced customer satisfaction. Consider the materials handling process outlined in the above paragraph. The process might be re-engineered by sending the production schedule
Cost of quality
To compete profitably in today's global competitive environment companies are becoming 'customer-driven' and making customer satisfaction an overriding priority. Customers are demanding ever-improving levels of service regarding cost, quality, reliability, delivery and the choice of innovative new products. Quality has become one of the key competitive variables and this has created the need for management accountants to become more involved in the provision of information relating to the quality of products and services and activities that produce them.
Cost management and the value chain
Coordinating the individual parts of the value chain together creates the conditions to improve customer satisfaction, particularly in terms of cost efficiency, quality and delivery. A firm which performs the value chain activities more efficiently, and at a lower cost, than its competitors will gain a competitive advantage. Therefore it is necessary to understand how value chain activities are performed and how they interact with each other. The activities are not just a collection of independent activities but a system of inter-dependent activities in which the performance of one activity affects the performance and cost of other activities.
It is also appropriate to view the value chain from the customer's perspective, with each link being seen as the customer of the previous link. If each link in the value chain is designed to meet the needs of its customers, then end-customer satisfaction should ensue. Furthermore, by viewing each link in the value chain as a supplier-customer relationship, the opinions of the customers can be used to provide useful feedback information on assessing the quality of service provided by the supplier. Opportunities are thus identified for improving activities throughout the entire value chain.
In order to identify the best way of performing activities and business processes organizations are turning their attention to benchmarking, which involves comparing key activities with world-class best practices. Benchmarking attempts to identify an activity, such as customer order processing, that needs to be improved and finding a non-rival organization that is considered to represent world-class best practice for the activity and studying how it performs the activity. The objective is to find out how the activity can be improved and ensure that the improvements are implemented.
Implementing a JIT system is a mechanism for reducing non-value added costs and long-run costs it is important that you understand the nature of such a system and its cost management implications.
The JIT approach involves a continuous commitment to the pursuit of excellence in all phases of manufacturing systems design and operations. The aims of JIT are to produce the required items, at the required quality and in the required quantities, at the precise time they are required. In particular, JIT seeks to achieve the following goals:
elimination of non-value added activities
batch sizes of one
a 100% on-time delivery service.
The above goals represent perfection, and are most unlikely to be achieved in practice. They do, however, offer targets, and create a climate for continuous improvement and excellence.
The balanced scorecard as a strategic management system
According to Kaplan and Norton the objectives of the balanced scorecard are more than just an ad hoc collection of financial and non-financial performance measures; they are derived from a top-down process driven by the mission and strategy of the business unit.
Kaplan and Norton describe how innovative companies are using the measurement focus of the scorecard to accomplish the following critical management processes:
1. Clarifying and translating vision and strategy into specific strategic objectives and identifying the critical divers of the strategic objectives.
2. Communicating and linking strategic objectives and measures. Ideally, once all the employees understand the high level objectives and measures, they should establish local objectives that support the business unit's global strategy.
3. Planning, setting targets, and aligning strategic initiatives. Such targets should be over a 3-5 year period broken down on a yearly basis so that progression targets can be set for assessing the progress that is being made towards achieving the longer-term targets.
4. Enhancing strategic feedback and learning so that managers can monitor and adjust the implementation of their strategy, and, if necessary, make fundamental changes to the strategy itself. They approach strategy as choosing the market and customer segments the business unit intends to serve, identifying the critical internal processes that the unit must excel at to deliver value to customers in the targeted market segments, and selecting the individual and organizational capabilities required for the internal and financial objectives.
Establishing objectives and performance measures
Having explained the general principles of the balanced scorecard we shall now consider the process of establishing objectives and performance measures in each of the four scorecard perspectives (financial, customer, internal business process, and learning and growth).
The financial perspective
At the strategic business unit level operating prior, return on investment, residual income and economic value added were discussed and such measures should be used for measuring the financial objective of the business unit. Other financial objectives include revenue growth, cost reduction and asset utilization. Typical financial objectives are to increase return on investment by 20% and/or to increase sales and operating income by 100% over the next five years.
The Customer perspective
In the customer perspective of the balanced scorecard managers should identify the customer and market segments in which the businesses unit will compete. Target segments may include both existing and potential customers. Managers should then develop performance measures that track the business unit's ability to create satisfied and loyal customers in the targeted segments. The customer perspective typically includes several core or generic objectives and measures that relate to customer loyalty and the outcomes of the strategy in the targeted segments. They include core objectives relating to increasing market share, customer retention, new customer acquisition, customer satisfaction and customer profitability. Possible core measures for these objectives are following:
Customer retention and loyalty
Measuring value propositions
The internal business perspective
In the internal business process perspective, managers identify the critical internal processes for which the organization must excel in implementing its strategy. The internal business process measures should focus on the internal processes that are required to achieve the organization's customer and financial objectives. Kaplan and Norton identify three principal internal business processes. They are:
Post-service sales processes.
The learning and growth perspective
The fourth and final perspective on the balanced scorecard identifies the infrastructure that the business must build to create long-term growth and improvement. This perspective stresses the importance of investing for the future in areas other than investing in assets and new product research and development (which is included in the innovation process of the internal business perspective). Organizations must also invest in their infrastructure (people, systems and organizational procedures) to provide the capabilities that enable the accomplishment of the other three perspectives' objectives. Based upon their experiences of building balanced scorecards across a wide variety of organizations Kaplan and Norton have identified the following three principal categories, or enablers, for the learning and growth objectives:
information system capabilities;
Motivation, empowerment and alignment.
ANSWER # 2:
The relevant costs and benefits required for decision-making are only those that will be affected by the decision. Costs and benefits that are independent of a decision are obviously not relevant and need not be considered when making that decision. The relevant financial inputs for decision-making purposes are therefore future cash lows, which will differ between the various alternatives being considered.
As with relevant costs, irrelevant costs may be irrelevant for some situations but relevant for others. Examples of irrelevant costs are fixed overheads, notional costs, sunk costs and book values.
Sunk costs are costs that were incurred in the past. Committed costs are costs that will occur in the future, but that cannot be changed. As a practical matter, sunk costs and committed costs are equivalent with respect to their decision-relevance; neither is relevant with respect to any decision, because neither can be changed. Sometimes, accountants use the term "sunk costs" to encompass committed costs as well.
You can see that different approaches can be used for presenting relevant cost and revenue information. Cost information can be presented that includes The Caledonian Company is a manufacturer of clothing that sells its output directly to clothing retailers. One of its departments manufactures jumpers. The department has a production capacity of 50 000 jumpers per month. Because of the liquidation of one of its major customers the company has excess capacity. For the next quarter current monthly production and sales volume is expected to be 35 000 jumpers at a selling price of £40 per jumper. Expected costs and revenues for the next month at an activity level of 35 000 jumpers are as follow:
Caledonian is expecting an upsurge in demand and considers that the excess capacity is temporary. A company in the leisure industry has offered to buy for its staff 3000 jumpers each month for the next three months at a price of £20 per jumper. The company would collect the jumpers from Caledonian's factory and thus no marketing and distribution costs will be incurred. No subsequent sales to this customer are anticipated. The company would require its company logo inserting on the jumper and Caledonian has predicted that this will cost £1 per jumper. Should Caledonian accept the offer from the company?
Direct labour 420 000 12
Direct materials 280 000 8
Variable manufacturing overheads 70000 2
Manufacturing non-variable overheads 280000 8
Marketing and distribution costs 105 000 _3
Total costs 1 155 000 33
Sales 1400 000 40
Profit 245 000
Both relevant and irrelevant costs and revenues for all alternatives under consideration, If this approach is adopted the same amount for the irrelevant items (i.e. those items that remain unchanged as a result of the decision which are direct labor, manufacturing non-variable overheads and the marketing and distribution costs in our example) are included for all alternatives, thus making them irrelevant to the decision.-This information is presented in columns (1) and (2). Alternatively, you can present cost information in columns (1) and (2) that excludes the irrelevant costs and revenues because they are identical for both alternatives. A third alternative is to present only the relevant (differential) costs. This approach is shown in column (3). Note that column (3) represents the difference between columns (1) and (2). All of the methods show that the company is better of by £27 000 per month if the order is accepted.
Four important factors must be considered before recommending acceptance of the order. Most of these relate to the assumption that there are no long-run implications from accepting the offer at a selling price of £20 per jumper. First, it is assumed that the future selling price will not be affected by selling some of the output at a price below the going market price. If this assumption is incorrect then competitors may engage in similar practices of reducing their selling prices in an attempt to unload spare capacity. This may lead to a fall in the market price, which in turn would lead to a fall in profits from future sales. The loss of future profits may be greater than the short-term gain obtained from accepting special orders at prices below the existing market price. Given that Caledonian Evaluation of three month order from the company in the leisure industry has found a customer in a different market from its normal market it is unlikely that the market price would be affected. However, if the customer had been within Caledonian's normal retail market there would be a real danger that the market price would be affected. Secondly, the decision to accept the order prevents the company from accepting other orders that may be
Do not Accept order Difference
accept order (relevant costs)
(£ per month) (£ per month) (£ per month)
Direct labour 420 000 420 000
Direct materials 280 000 304 000 24000
Variable manufacturing overheads 70000 76000 6000
Manufacturing non-variable overheads 280 000 280 000
Inserting company logo 3 000 3000
Marketing and distribution costs 105 000 105 000
Total costs 1 155 000 1 188 000 33 000
Sales 1400 000 1460 000 60000
Profit per month 245 000 272 000 27 000
Obtained during the period at the going price, In other words, it is assumed that no better opportunities will present themselves during the period. Thirdly, it is assumed that the company has unused resources that have no alternative uses that will yield a contribution to profits in excess of £27 000 per month. Finally, it is assumed that the fixed costs are unavoidable for the period under consideration. In other words, we assume that the direct labour force and the fixed overheads cannot be reduced in the short term, or that they are to be retained for an upsurge in demand, which is expected to occur in the longer term.
It is important that great care is taken in presenting financial information for decision-making. For stock valuation external financial reporting regulations require that the jumpers must be valued at their manufacturing cost of £30. Using this cost would lead to the incorrect decision being taken. For decision-making purposes only future costs that will be relevant to the decision should be included. Costs that have been computed for meeting stock valuation requirements must not therefore be used for decision-making purposes.
When you are trying to establish which costs are relevant to a particular decision you may find that some costs will be relevant in one situation but irrelevant in another. In Example 4.1 we assumed mat direct labour was-not a relevant cost. The company wishes to retain the direct labour for an expected upsurge in demand and therefore the direct labour cost will be same whether or not the offer is accepted. Alternatively, Caledonian may have had an agreement with its workforce that entitled them to at least three months notice in the event of any redundancies. Therefore, even if Caledonian was not expecting an upsurge in demand direct labour would have been a fixed cost within the three month time horizon.
But now let us consider what the relevant cost would be if direct labour consisted of casual labour who are hired on a daily basis. In this situation direct labour will be a relevant cost, since the labour costs will not be incurred if the order is not accepted.
The identification of relevant costs depends on the circumstances. In one situation a cost may be relevant, but in another the same cost may not be relevant. It is not therefore possible to provide a list of costs that would be relevant in particular situations. In each situation you should follow the principle that the relevant costs are future costs that differ among alternatives. The important question to ask when determining the relevant cost is: What difference will it make? The accountant must be aware of all the issues relating to a decision and ascertain full details of the changes that will result, and then proceed to select the relevant financial information to present to management.
Activity-based costing (ABC) is a costing model that identifies actions in an JESSUP and assigns the cost of each activity resource to all products and services according to the actual spending by each: it assigns more indirect costs into direct costs.
ABC systems seek to use only cause-and-effect cost drivers whereas traditional systems often rely on arbitrary allocation bases. ABC systems tend to establish separate cost driver rates for support departments whereas traditional systems merge support and production centre costs.
It helps to recognize incompetent products, departments and behavior.
It helps to assign more capital on beneficial products, department and actions.
It helps to controlling the costs at an entity level and on a departmental level.
It helps to judgment out needless costs.
It helps setting up the price of a product or service systematically.
It boost the number of cost pools used to collect in direct costs such as over head costs, rather than collect all the costs only.
It change the basis used to assign indirect costs to products rather than conveying costs on the bases of simple measure such as volume, costs are assigned on the bases of activities that produce costs.
It changes the scenery of many indirect costs, reclassifying them into direct costs, so that they can be traced to particular activities.
Better considerate overhead.
Simple to understand for everyone.
Utilizes division cost relatively than just total cost.
Makes detectable waste and non-value added activities.
Supports performance of the management and scorecards of the organization.
Enables costing of processes and value streams.
Activity Based Costing (ABC) mirrors way work is done in proper way.
Facilitates into the benchmarking.
Implementing an ABC system is a major task that requires considerable wealth. Once implemented an activity based costing (ABC) system is expensive to maintain. Data concerning several activity measures must be composed, checked, and entered into the system.
ABC produces information such as product margins, which are likelihood with the numbers produced by traditional costing systems. But managers are familiar to using traditional costing systems to run theirs operations and traditional costing systems are often used in presentation evaluations.
Â Activity based costing (ABC) data can be simply misinterpreted and must be used with care when used in manufacture decisions. Costs assign to products, customers and other cost objects are only potentially important. Before making any significant decision using activity based costing (ABC) data, managers must identify which costs are really related for the decisions at hand.
It may be difficult to set up and establish, particularly if an organization is using more traditional accounting methodologies.
Can be time consuming if all activities are to be cost.
May provide too much detail - obscuring the bigger picture.