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Activity-based management is an extension of activity-based costing that uses the link between activities and costs for better management. There are four types of activities that cause overhead costs: activities that occur by facility, by product, by batch, and by unit. These four tiers of activities are referred to as cost hierarchies. A cost hierarchy is a classification system that is used to categorize costs into unit-level, batch-level, facility-level, and product-level activities. Cost hierarchies designate activities based on how easily they can be traced to a product, with the costs arranged in an order based on how difficult it is to trace them back to the product. An activity-based costing system might use any number of activity levels depending on whether or not the cost drivers for the activities reflect the cost incurred by the activity.
Starting at the bottom of the hierarchy with the level that’s most easily traced to the final product, unit-level activities are performed on each unit of a product. For example, the amount of raw materials that are used per unit is a unit-level activity. Unit-level activities are related to the volume of the cost driver that is used; therefore, unit-level costs change with the number of units that they produce.
EXAMPLE
High Challenge Company offers a mountain bicycle that has additional features that the hybrid bicycle doesn’t have. With machine hours being the cost driver for machining, the mountain bicycle uses more machine hours than the hybrid bicycle to assemble the suspension and the complex gearing. The unit-level activity of adding the additional components is volume-based and will depend on the number of mountain bicycles that are produced.The next level in the cost hierarchy is batch level, which consists of activities that are performed only on each batch or group of one product. A batch might be grouped by color, by model, by product, or by size. Each batch might have a different machine setup or different methods for quality testing. Batch-level costs do not vary with the number of units; instead, they vary with the number of batches.
EXAMPLE
High Challenge Company offers the hybrid bicycle and the mountain bicycle; therefore, we might have a batch for the hybrid bicycle and a batch for the mountain bicycle, incurring batch-level costs for each product. If it plans to make one product on Monday, Wednesday, and Friday and the other product on Tuesday and Thursday, it will have lower batch-level costs than if it produced both products every day since it is using only one machine setup on any given day rather than multiple setups to accommodate multiple products.The third level of the cost hierarchy holds the product-level activities. These activities consist of tasks that are performed on each product line, such as the development of a product design. Product-level activities are not affected by either the number of units or batches. For example, a watch manufacturer that produces different styles of watches will create a product design for each different product line. A product design is needed for each product line; therefore, it is a product-level activity. Product-level costs do not vary with the number of units or batches produced.
EXAMPLE
High Challenge Company’s engineering team designed the company’s hybrid bicycle model and its mountain bicycle model; therefore, the design activities are product-level activities that apply to the bicycles.At the farthest removed from the final product is the facility-level activities, which are activities that are performed to sustain facility capacity as a whole and are not linked to any specific product. For example, rent and factory maintenance costs are incurred no matter what is being produced in the facility. Facility-level activities do not vary with what is produced, the number of batches produced, or the output quantity; instead, they support the company’s operations in general.
EXAMPLE
High Challenge Company pays monthly rent for its factory, resulting in a facility-level activity.Using the cost hierarchy will allow managers to analyze the costs that are related to each hierarchy level and determine how easily these costs can be traced to the product. The hierarchy provides managers with a structured way to look at the activities that occur at different levels and identify the relationships between activities and the resources that they use. Managers are able to use this information to make costing decisions.
The following chart provides example activities and activity drivers for each of the four activity levels.
| Cost Hierarchy | ||
|---|---|---|
| Hierarchy Level | Activity | Activity Driver |
| Unit Level | Printing checks | Number of checks |
| Assembling parts | Direct labor hours | |
| Machine repair | Number of units | |
| Batch Level | Calibrating machines | Number of batches |
| Receiving shipments | Number of orders | |
| Setup costs | Setup hours | |
| Facility Level | Personnel support | Number of employees |
| Cleaning facility | Square feet of floors | |
| Product Level | Organizing production | Engineering hours |
| Controlling inventory | Parts per product | |
| Design modifications | Change requests | |
Activity-based management uses activity-based costing data to evaluate the cost of activities within the company and identify opportunities for improvement. Value-added activities are activities that transform raw materials into a finished product that a customer will buy.
EXAMPLE
Examples of value-added activities are the paint on a bike’s frame, the effort of the worker to apply the paint neatly, and the rent for the manufacturing facility. The opposite of value-added activities is non-value-added activities.Activity-based management uses the cost data for value-added activities to manage and improve the company’s operations. Non-value-added activities do not add worth to a specific product, though they may be valuable to the company in other ways.
EXAMPLE
An example of a non-value-added activity is machine repair, which does not add worth or value to a specific product.With activity-based management, managers will analyze the entire sequence of activities that were involved in converting raw materials into products, in order to determine if any improvements or changes need to be made to the overall production process. This sequence of activities is referred to as the value chain, and it consists of the set of activities that are used to convert raw materials into products for customers. The value chain is similar to the production process, but the key difference is that the value chain goes back to the initial design of the product, while the production process is only considered from the point of introduction of raw materials. In order to maximize profits, companies must manage activities and the resources that are used to pay for those activities in order to minimize costs while continuing to provide desired products for customers.
The value chain can be considered to consist of three phases: upstream, operations, and downstream. The upstream phase consists of product development and the use of suppliers in the production process. The operations phase focuses on the production processes that the company uses to produce products. The last phase is the downstream phase, which focuses on the linkages with customers including the delivery of products or providing a service. Below is an example of some of the activities and costs that will be attributed to a company’s value chain.
EXAMPLE
High Challenge Company incurs a cost of $50 per setup for the machine that is used in the assembly process to make a batch of units. This cost can be reduced by reducing the number of setups that it performs by running larger batches or by eliminating small-volume products. Reducing these costs can improve the overall value of the products being produced.If a company uses activity-based costing and has minimal resources to use, it might consider implementing activity-based management to help managers decide what steps they can take to make the best use of their resources. Making these decisions requires an analysis of the experience of customers as well as an analysis of the activity costs that are related to producing the products.
EXAMPLE
If the owner of High Challenge Company is concerned with increased costs in the production process, they might implement activity-based management to gather cost data for each activity. Gathering these data will allow them to see what activity within the production process is driving costs. The owner and the production manager can then strategize to determine how to handle the increased costs given that they are already limited in the amount of resources that they have available. They might consider dropping products or limiting customer services to reduce costs, or they might decide to use new materials that have a lower cost.The goal of activity-based management is to provide better information about product costs and better information about the cost of activities and production processes. Having better cost information for products will help managers with making pricing decisions, including whether to keep or drop products and how best to set prices for their products. If managers have better process and activity cost data, they will be able to analyze useful information that might not be evident with other costing methods. Looking at individual activities will provide more detailed information than analyzing overhead based on an individual process while looking at individual activities will allow managers to know which specific activities are driving costs and make the necessary changes to control those costs.
Activity-based management is often paired with a production approach called lean manufacturing. Lean manufacturing focuses on reducing production costs and eliminating waste while satisfying customers. One of the common methods that is used in lean manufacturing is the just-in-time inventory system. The just-in-time inventory system consists of putting raw materials into production only after a customer places an order, rather than based on the estimated demand for the product. The finished goods are then delivered to the customer soon after completion, instead of being transferred to the finished goods inventory until they are sold. Using the just-in-time inventory system reduces the costs of storing and moving inventory since the raw materials are purchased when they are needed and the finished products are sold when they are finished.
Lean manufacturers might organize their production around the process flow of a single major product rather than around groups of similar machines. This will allow them to avoid inventory buildup and reduce or eliminate the amount of waste that is related to the production processes. Since lean manufacturing has the ability to eliminate inventories and some of the activities related to inventory handling, a lot of the overhead costs will be eliminated. This will allow the accountants to more directly assign costs to their appropriate value chain activity.
Source: THIS TUTORIAL HAS BEEN ADAPTED FROM “ACCOUNTING PRINCIPLES: A BUSINESS PERSPECTIVE” BY hermanson, edwards, and maher. ACCESS FOR FREE AT www.solr.bccampus.ca. LICENSE: CREATIVE COMMONS ATTRIBUTION 3.0 UNPORTED.
