Activity-Based Systems: ABM and JIT
CHAPTER 18
Activity-Based Systems: ABM and JIT
reviewing the chapter
Objective 1: Explain the role of managers in activity-based systems.
1. Activity-based systems are information systems that provide quantitative information about an organization’s activities. These systems help managers view the organization as a collection of related activities. The cost information they provide enables managers to improve operating processes and make better pricing decisions.
2. Successful business plans make optimal use of available resources. Activity-based systems help managers identify value-adding activities, determine the resources required for those activities, and estimate product costs. They are also used by managers to evaluate operating performance. Activity-based systems help managers determine the full product cost (which includes not only the costs of direct materials and direct labor, but also the costs of all production and nonproduction activities), identify actions that may reduce product cost, and determine if cost-reduction goals for nonvalue-adding activities were achieved. Managers communicate plans and performance results when they prepare reports about the company's performance for internal and external users.
Objective 2: Define activity-based management (ABM) and discuss its relationship to the supply chain and the value chain.
3. Activity-based management (ABM) is an approach to managing an organization that identifies all major operating activities, determines the resources consumed by each activity and the cause of the resource usage, and categorizes the activities as either adding value to a product or service or not adding value. ABM focuses on reducing or eliminating nonvalue-adding activities. Because it provides financial and performance information at the activity level, ABM is useful both for strategic planning and for making operational decisions about business segments, such as product lines, market segments, and customer groups. It also helps managers eliminate waste and inefficiencies and redirect resources to activities that add value to a product or service.
4. A value chain is a sequence of activities inside the organization, also known as primary processes, that add value to a company's product or service. The value chain also includes support services, such as management accounting, that facilitate the primary processes. ABM enables managers to see their organization's value chain as part of a larger system that includes the value chains of suppliers and customers. This larger system is the supply chain (also called the supply network)—the path that leads from the suppliers of the materials from which a product is made to the final customer. Managers who understand the supply chain and how their company's value-adding activities fit into their suppliers' and customers' value chains can see their company's role in the overall process of creating and delivering products or services. Such an understanding can make a company more profitable. When organizations work cooperatively with others in their supply chain, they can develop new processes that reduce the total costs of their products or services.
Objective 3: Distinguish between value-adding and nonvalue-adding activities, and describe process value analysis.
5. A value-adding activity adds value to a product or service as perceived by the customer. Examples include assembling a car, painting it, and installing seats and airbags. A nonvalue-adding activity is an activity that adds cost to a product or service but does not increase its market value. ABM focuses on eliminating nonvalue-adding activities that are not essential to an organization and on reducing the costs of those that are essential, such as legal services, materials handling, and building maintenance. It thus enables managers to redirect resources to value-adding activities.
6. Process value analysis (PVA) is a technique that managers use to identify and link all the activities involved in the value chain. It analyzes business processes by relating activities to the events that prompt the activities and to the resources that the activities consume. PVA forces managers to look critically at all phases of their operations. It improves cost traceability and results in significantly more accurate product costs, which in turn improves management decisions and increases profitability.
Objective 4: Define activity-based costing and explain how a cost hierarchy and a bill of activities are used.
7. Activity-based costing (ABC) is a method of assigning costs that calculates a more accurate product cost than traditional methods. It does so by categorizing all indirect costs by activity, tracing the indirect costs to those activities, and assigning those costs to products using a cost driver related to the cause of the cost. Implementing ABC involves five steps: (a) identifying and classifying each activity, (b) estimating the cost of resources for each activity, (c) identifying a cost driver for each activity and estimating the quantity of each cost driver, (d) calculating an activity cost rate for each activity, and (e) assigning costs to cost objects based on the level of activity required to make the product or provide the service.
8. Two tools that help managers implement ABC are a cost hierarchy and a bill of activities. A cost hierarchy is a framework for classifying activities according to the level at which their costs are incurred. In a manufacturing company, a cost hierarchy typically has four levels. Unit-level activities are performed each time a unit is produced and are generally considered variable costs. Batch-level activities are performed each time a batch or production run of goods is produced. Product-level activities are performed to support a particular product line. Facility-level activities are performed to support a facility’s general manufacturing process and are generally fixed. A cost hierarchy includes both value-adding and nonvalue-adding activities; the frequency of activities varies across levels. Service organizations can also use a cost hierarchy to group activities.
9. After managers have created a cost hierarchy, they prepare a summary in the form of a bill of activities. A bill of activities is a list of activities and related costs that is used to compute the costs assigned to activities and the product unit cost. A bill of activities may be used as the primary document or as a supporting schedule for calculating product unit cost in both job order and process costing systems and in both manufacturing and service organizations.
Objective 5: Define the just-in-time (JIT) operating philosophy and identify the elements of a JIT operating environment.
10. The just-in-time (JIT) operating philosophy is one of the management philosophies that evolved to help companies stay competitive in today’s business environment. It requires that all resources—materials, personnel, and facilities—be acquired and used only as needed. Its objectives are to enhance productivity, eliminate waste, reduce costs, and improve product quality. To meet the objectives of this management philosophy, a company must redesign its operating systems, plant layout, and management methods to conform to several basic concepts.
11. The elements in a JIT operating environment that support the concepts of the JIT philosophy are (a) maintaining minimum inventory levels; (b) using pull-through production, in which production is triggered by a customer order (as opposed to the traditional push-through method, in which products are manufactured in long production runs and stored in anticipation of customers’ orders); (c) performing quick, inexpensive machine setups by using a cluster of machinery known as a work cell, an autonomous production line that can efficiently and continuously perform all required operations; (d)developing a multiskilled work force; (e) maintaining high levels of product quality; (f)enforcing a system of effective preventive maintenance; and (g) encouraging continuous improvement of the work environment.
Objective 6: Identify the changes in product costing that result when a firm adopts a JIT operating environment.
12. The traditional operating environment divides the production process into five time frames: (a) processing time, the actual time required to work on a product; (b) inspection time, the time spent detecting product flaws or reworking defective units; (c) moving time, the time needed to transfer a product from one operation or department to another; (d) queue time, the time a product waits to be worked on once it reaches the next operation or department; and (e) storage time, the time a product spends in materials inventory, work in process inventory, or finished goods inventory.
13. In product costing under JIT, costs associated with processing time are categorized as either direct materials costs or conversion costs. Conversion costs are the sum of the direct labor costs and overhead costs incurred by a production department, JIT work cell, or other work center. According to the JIT philosophy, product costs associated with inspection, moving, queue, and storage time should be reduced or eliminated because they do not add value to the product.
14. The key measure in a JIT operating environment is throughput time, the time it takes to move a product through the entire production process. Measures of product movement are used to apply conversion costs to products. With computerized monitoring of the JIT work cells, many costs that are treated as indirect costs in traditional manufacturing settings, such as the costs of utilities and operating supplies, can be traced directly to work cells. The only costs that remain indirect costs of the work cells are those associated with building occupancy, insurance, and property taxes.
Objective 7: Define and apply backflush costing, and compare the cost flows in traditional and backflush costing.
15. A JIT environment can reduce waste of resources and time not only in production operations, but in other areas as well, including the accounting process. Because materials arrive just in time to be used in the production process, there is little reason to maintain a separate Materials Inventory account, and because a JIT environment reduces labor costs, the accounting system can add direct labor costs and allocated manufacturing costs into the Work in Process Inventory account. Thus, by simplifying cost flows through the accounting records, a JIT environment makes it possible to reduce the time it takes to record and account for the costs of the manufacturing process.
16. A JIT organization can also streamline its accounting process by using backflush costing. When backflush costing is used, all product costs are first accumulated in the Cost of Goods Sold account, and at the end of the accounting period, they are “flushed back,” or worked backward, into the appropriate inventory accounts. By having all product costs flow straight to a final destination and working back to determine the proper balances for the inventory accounts at the end of the period, backflush costing saves recording time.
17. When direct materials arrive at a factory in which traditional costing methods are used, their costs flow into the Materials Inventory account. Then, when the direct materials are requisitioned into production, their costs flow into the Work in Process Inventory account. When direct labor is used, its costs are added to the Work in Process Inventory account. Overhead is then applied and is added to the other costs in the Work in Process Inventory account. At the end of the manufacturing process, the costs are transferred to the Finished Goods Inventory account, and when the units are sold, their costs are transferred to the Cost of Goods Sold account.
18. In a JIT setting in which backflush costing is used, the direct materials costs and the conversion costs (direct labor and overhead) are immediately charged to the Cost of Goods Sold account. At the end of the period, the costs of goods in work in process inventory and in finished goods inventory are determined, and those costs are flushed back to the Work in Process Inventory account and the Finished Goods Inventory account. Once those costs have been flushed back, the Cost of Goods Sold account contains only the costs of units completed and sold during the period.
Objective 8: Compare ABM and JIT as activity-based systems.
19. ABM and JIT are similar in that as activity-based systems, both analyze processes and identify value-adding and nonvalue-adding activities. Both seek to eliminate waste, reduce costs, improve product or service quality, and enhance an organization’s efficiency and productivity. Both also improve the quality of the information managers use in making decisions.
20. ABM and JIT differ in their approaches to the calculation of product or service cost and cost assignment. Using ABC, ABM calculates product or service cost by using cost drivers to assign indirect manufacturing overhead costs to cost objects. ABC is used with job order and process costing systems.
21. JIT reorganizes activities so that they are performed within work cells. The costs of those activities become direct costs of the work cell. The total production costs within the work cell can be assigned by using simple cost drivers, such as process hours or direct materials cost. This approach focuses on the output at the end of the production process and simplifies the accounting system.