ACTIVITY BASED COSTING AND COST MANAGEMENT SYSTEMS A revolution is transforming the manufacturing industry.

Not since the mid nineteen century have we seen changes as sweeping and dramatic. The growth of international competition, thebreacneck pace of technological innovation, and startling advances computerized systems have created a new playing field for manufacturers around globe. Some manufacturers have emerged as world class producers, while others has fallen by the wayside. AEROTECH CORPORATION: A TALE OF TWO CITIES Aerotech corporation manufactures complex printed circuit boards used in aircraf radar and communications e uipment. The company has operated its !hoenix plant for "# years. $ithin the past years, Aerotech opened a new production facility %akersfield, &alifornia. $hile the !hoenix plant utilizes a traditional plant layout at production process, the %akersfield plant employs the lates in advanced manufacturing technology. AEROTECHS PHOENIX PLANT: TRADITIONAL PRODUCTION PROCESS Three complex printed circuit boards are manufacturedin Aerotech !hoenix plant. These product are referred to as 'ode (, 'ode ((, and 'ode ((( boards. 'ode i is a simplest of the three circuit boards, and Aerotech sell )#.### units of the product every year. The 'ode (( circuit board, which is only slightly more complex, has a high volume cmpared to the other two boards. Aerotech sells "#.### 'ode (( boards every year. The 'ode ((( circuit board, which is the most complicated, is a low volume product with annual sales of *### units Product o! Proc"## The production process for all there printed circuit boards involves the attachment various electrical components to a raw circuit board. Aerotech purchases the boards and all of the electrical components from other electronics manufacturers. 'any of the electrical devicess are small axial lead components, such as diodes and resistent. These components are attached to a circuit board by bending the two lead wires at +# degree angles and inserting the leads into predrilled holes in the raw boards. A few the electrical components are large or oddly shaped instruments the re uire speed handling in the production process. The se uence of production steps is the same for all three boards. 1. Se uencing. The small axial lead components are placed in the proper se uence for insertion into the board. ,ach tipe of axial lead component is purchased in taped reels. The individual components can be peeled off the reel one at a time, -ust as a piece of tape can be peeled off a roll. A se uencing machine is programmed to select the components from the proper reels in the se uence re uired for each tipe of circuit board. 2. Auto insertion. The se uenced axial lead components are fed into an auto inserter machine, which bends the leads and inserts them into the predrilled holes in the raw boards.

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6. 7.

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.and insertion. The large or oddly shaped components are manually attached to the boards. $afe soldering. The boards pass through a wave/solder machine. .ere a wave of molten solder passes under each board, and the components leads are secured. $ash0dry. The wash0dry cycle is similiar to the operation of a home dish/ washer. The boards are washed to remove foreign particle1 then they are dried with warm air. .and/insertion. The next step is to insert manually any components that could not withstand either the wave/solder or wash/dry operation. %ed of nails. ,ach completed circuit board then is placed on a bed/of/nails tester. This machine consists of a set of vertical probes thet make contact with the lead wires from each component on the circuit board. ,ach individual component then is tested independently. The bed/of/nails tester can be programmed so that its probes make contact with the differnt patterns of lead wires on the 'ode (, 'ode ((, and 'ode ((( circuit boards. %urn/in. The final step is a burn/ in test where in electrical power is applied to each circuit board. The entire board is tested for functionality. (f problems are detected, it is sent immediately to enginering for a full checkout producere. !ackaging. The printed circuit boards are packaged and sent to finished/goods storage.

P$%!t L%&out The layout of Aerotech2s !hoenix plant is shown in ,xhibit 3/). &olored arrows depict the flow of production from one operation to the next. Notice that each production operation is performed in a separate department. A storage area for work/in/process inventory is located next to each department. .ere, partially completed circuit boards are stored until the next production department is ready for them. Tr%d t o!%$' Vo$u(")B%#"d Product)Co#t !* S&#t"( 4ntil recently, Aerotech2s !hoenix plant used a -ob/order costing system similiar to the one described in &hapter 5 for Adirondack 6utfitters. The cost of each proooducty was the sum of its actual direct/material cost, actual direct/labour cost, and applied manufacturing overhead. 6verhead was applied using a predetermined overhead rate based on direct labour/hours. ,xhibit 3/" provides the basic data upon which the traditional costing systems was based.

Model I Produksi: Unit Berjalan 10.000 1 dari 10,000 unit

Mode II 20.000 4 dari 5,000 unit

Mode III 4.000 10 dari 400 unit

Bahan Baku Langsung !enaga "erja Langsung B%P Pa&rik !otal

Mode I Mode II Mode III $ 50,00 $ 0,00 $ 20,00 #0,00 $0,00 40,00 ,00 1'2,00 ##,00 $ 20 ,00 $ '02,00 $ 12#,00

Unit (ang )i*roduksi !enaga "erja Langsung !otal +a, !otal +a, (ang )i -aji&kan

Mode I 10.000 ' '0.000

Mode II 20.000 4 $0.000 11$.000

Mode III 4.000 2 $.000

Bahan Baku Langsung !enaga "erja Langsung Pengaturan -aktu +a, Mesin

Mode I Mode II Mode III $ 50,00 $ 0,00 $ 20,00 ' 4 2 10 10 10 1 1,25 2

Mode I !enaga "erja Langsung !ingkat %.erhead Per +a, %.erhead *er unit $ $ ' '' $ $

Mode II 4 '' 1'2 $ $

Mode III 2 '' ##

Trou+$" I! P,o"! The profitability of Aerotech2s !hoenix operation has been faltering in recent years. The company2s pricing policy has been to set a target price for each circuit board e ual to )"37 of the full product cost, thus, the target prices were determined as shown in ,xhibit 3/*. Also shown are the actual prices that Aerotech has been obtaining for its product.

Bia/a Per Unit !arget 0arga Penjualan

Mode I Mode II Mode III 20 ,00 $ '02,00 $ 12#,00 2#1,25 '11,50 151,50

Bahan Baku Langsung !enaga "erja Langsung B%P Pa&rik !otal

Mode I Mode II Mode III $ 50,00 $ 0,00 $ 20,00 #0,00 $0,00 40,00 ,00 1'2,00 ##,00 $ 20 ,00 $ '02,00 $ 12#,00

Act . t&)B%#"d Co#t !* S&#t"(

Aerotech &orporation2s controller. &huck 8ickens, had been thinking for some about a refinement in the !hoenix plant2s product/costing systems. .e wondered if traditional, volume/based systems was providing management with accurate data about product cost. 8ickens had read about activity/based costing 9A%&: system, what follow a two stage procedure to assign overhead cost to products. The first stage identifies significant activities and assigns overhead cost to each activity depending on proportion of the organization;s recources it uses. The overhead cost assigned to activity comparise an activity cost pool. St%*" O!". Aerotech2s A%& pro-ect team identified eight activity cost pool which fall into four broad categories. These are shown in ,xhibit 3/3 1. 4nit level. This type of activity must be done for each unit of production. Aerotech2s machine/related activity cost pool represents a unit/level activity since every product unit re uires machine time. 2. %atch level. These activities must be performed for each batch of products rather than each unit. Aerotech2s batch/level activities include the setup, receiving and inspection, material/handling, packaging and shipping, and uality/assurance activity cost pools. 3. !roduct/sustaining level. This category includes activities that are needed support an entire product line but are not always performed every time a unit or batch of products is produced. Aerotech2s pro-ect team identified engineering costs as a product/sustaining/level/activity cost pool. 4. <acility level. <acility/level activities are re uired in order for the entire production process to occur. St%*" t/o. (n stage two of the activity/based costing pro-ect, 8ickens and 'arley identified cost drivers for each activity cost pool. Then they assigned the cost in each activity cost pool to Aerotech2s three product lines according to the proportion of each cost driver consumed by each product line. (n the following sections, we will discuss in detail how stage two of A%& pro-ect was carried out for fourof the activity cost pool identified in stage one. Then we will complete the A%& pro-ect by developing new product for each Aerotech2s three circuit boards. M%c, !"r& co#t 0oo$. The machinery cost pool, a unit/level activity, totals = ).")".>## includes the cost of machine maintenance, depreciation, computer support, lubrication, electricity, and calibration.

S"tu0 Co#t Poo$. Setting up production runs is an example of a batch/level activity.

E!* !""r !* Co#t Poo$. ,ngineering is classified as a product/sustaining/level activiy.

F%c $ t& Co#t Poo$. The facility/level activity pool includes such cost as plant depreciation, plant management salaries, plant maintenance, property taxes, and insurance.

Product Co#t U!d"r Act . t&)B%#"d Co#t !* . The A%& calculations for the four remaining cost pools/receiving and inspecting material handling, uallity assurance, packing and shipping/follow the approach for the engineering cost pool. I!t"r0r"t !* T," ABC Product Co#t &huck 8ickens was amazed to see the product costs reported under the activity/ based costing system. %oth the 'ode ( and 'ode (( circuit boards exhibited much lower product cost under the A%& system than under the traditional system. This could explain the price competition Aerotech faced on its 'ode (( circuit board. Aerotech2s competitor could sell their 'ode (( boards at a lower price because they realized it cost less to produce a 'ode (( board than Aeroech2s traditional costing system had indicated. .owever, as 8ickens scanned the new product costs shown in ,xhibit 3/)# was alarmed by the substantial increase in the reported cost of a 'ode ((( circuit board. The cost of a 'ode ((( board had skyrocketed to over three times the company2s original estimate. The complexity of the 'ode ((( boards, and its impact

on costs, was hiddden completely by the traditional, volume/based costing system. To compare the result of the two alternative costing system, 8ickens prepared ,xhibit 3/)).
Mod" I B%,%! B%1u L%!*#u!* 4 23'33 93'33 T" !%*% 7" r8% L%!*# u!* M"# ! 6:'63 S"tu0 3'36 T"1! 1 =>'23 F%# $ t%# =6'53 DLL =;':6 Tot%$ 4 =:<';; Mod" II 4 53'33 :3'33 <2'62 3'3; =2'>2 =>'63 6<'2> 4 69=':= Mod" III 4 63'33 ;3'33 29';3 3'23 26'23 :'93 6=6':2 4 <53':2

T," Pu!c, L !"

T," Pu!c, L !" $hat has happenened at Aerotech2s !hoenix plant? The essence of the problem is that the traditional, volume/based costing system was overcosting the high/volume product lines 9'ode ( dan 'ode ((: and undercosting the complex, low/volume product line 9'ode (((:. The high/volume product basically subsidized the low/volume line. The activity/based costing system revealed this problem by more accurately assigning overhead costs to the three product lines. W,& Tr%d t o!%$' Vo$u(")B%#"d S&#t"(# D #tort Product Co#t# $hy did Aerotech2s traditional product/costing systems distort its product costs? The answer lies in the use of a single, volume/based cost driver. Aerotech2s old costing system assigned overheaad to products on the basis their relative usage of direct labor. Since the 'ode ( and 'ode (( circuits board use more direct labor than the 'ode ((( boards, the traditional systems assigned them more overhead costs. A review of ,xhibit 3/5 comfirms this conclusion. Notice, for example, that each 'ode (( board is assigned twice as much overhead cost as a 'ode ((( board re uires twice as much direct labor as a 'ode ((( board. No!u! t)L"."$ O."r,"%d Co#t. $hen Aerotech2s A%& pro-ect team designed activity/based costing system, only the machine/related overhead cost pool was clasified as a unit/level activity. All of the other activities were classified as a batch/ level product/sustaining level, or facility/level activities. This means that Aerotech2s overhead cost are not incurred every time a unit is produced. 'any of these overhead costs are related to starting new production batches, supporting an entire product line, or running the entire operation. Since direct labor is a unit/level cost driver, it fail to capture the forces that drive these order types of costs. (n Aerotech2s new A%& system, cost drivers werw chosen thet were appropriate for each activity cost pool. Product D ."r# t&. Aerotech2s manufactures three different product. Althought all three are circuit boards use in aircraft radar and communications e uipment, the three boards are uite different. The 'ode ( and 'ode (( boards are high/volume, relatively simple boards. The 'ode ((( board is highly complex, low/volume product. As a result of this product diresity, Aerotech2s three products consume overhead activities in different proportions. T/o 7"& Po !t#. To summarize, each of the following charasteristics will undermine the ability of a volume/based product/costing systems to assign overhead cost accurately.

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A large proportion of nonunit/level activities. A unit/level cost driver, such as direct labor, machine hours, or throughput, will not be able to assign the costs of nounit/level activities accurately. !roduct diversity. $hen the consumption ratios differ widely between activities, no single cost driver will accurately assign the resulting overhead cost.

COST MANAGEMENT)SYSTEMS $hen Aerotech corporation 'oved to an activity/based costing system in its !hoenix plant, the company was in a better position to price its products competitively. The firms management was able to see why Aerotech was being forced to lower the volume 'ode (( circuit boards. 'oreover, the high cost of the complexlow/volume 'ode ((( boards became apparent. The type of analysis undertaken Aerotech2s controller in the !hoenix plant sometimes is called strategic cost analysis. Tis is a broad/based, managerial/accounting analysis that supports strategic management decisions, such as pricing and product/mix decision. (n addition to facilitating strategic pricing decision, Aerotech2s new product costing system served as the catalyst for a new perspective on the role of management accounting in the company. 'anagement no longer viewed the managerial/ accounting system merely as a means of costing its product. (nstead, management came to fiew the firm2s managerial/accounting function as a cost management systems 9&'S:. A cost management system is a management planning and control system with the ob-ective.
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To measure the cost of the resources consumed in performing the organization2s significant activities. To identify and eliminate non/value/added costs. To determine the efficiency and effectiveness of all ma-or activities performed in the enterprise. To identify and evaluated new activities that can improve the future performance of the organization.

No!)V%$u")Add"d Co#t# The emphasis of a cost management system on activities can help management to identify non value/added cost and eliminate the activities that cause them. To see how this might occur, let2s return to our ilustration of Aerotech &orporation2s !hoenix plant. .ow is the time spent in Aerotech2s production process from the moment raw material arrives at the !hoenix plant until a finished circuit board is shipped to a customer? As in most manufacturing operations, the time is spent in the following five ways. 1. !rocess time@ the time during which a product is undergoing converion activity. 2. (nspection time@ the amount of time spent ensuring that the product is of high uality.

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'ove time@ the time spent moving raw materials, work in process,or finished goods between operations. $aiting time@ the amount of time that raw materials or work in process spend waiting for the nex operation. Storage time@ the time during which materials, patially completed products, or finished goods are held in stock before further processing or shipment to constomers.

Id"!t ?& !* No!)V%$u" Add"d Co#t ! T," P,o"! - P$%!t The identification of non/value/added activities will vary from company to company, but each of the five types of activities mentioned above has least some potential for causing non/value/added costs. Stor%*" T (". !erhaps the most obvious is storage tome. 'anufacturers traditionally have stored large inventories of materials, parts, and finished goods in order avoid running out. (n recent years, however, that philosophy has been challenges. 'ore and more manufacturers are adopting a -ust in time approach. $here nothing purchased or produced until it needed. (n Aerotech2s !hoenix operation,the large amounts of space devoted to storage activities are indicative of potentially large non/value/added cost of storage W% t !* t (". Notice the large amount of space devoted in the factory to partially completed circuit boards waiting for the next operation. This is again indicative of potentially large non/value/added costs. This firm working capital is tied up in work in process, and space is unnecessarilly wasted numerous production ueues. Mo." T (". Think about the amount of time Aerotech2s !hoenix employee must spend -ust moving materials and product in the plant. ,very product must be moved )A time between the axial/lead se uencing operation finished/good storage. I!#0"ct o! t (". Aerotech employs three inspection it is difficult to say whether inspection procedures result in non/#value/added cost without detailed knowledge of the production technology and spection procedures. Proc"## T (". The actual production process that transforms raw material finished products is certainly a value/added activity overall. .owever, this doesn2t preclude the npossibility that some non/value/added activities exist within the over production process. The goal of the cost management system is to evaluate the efficienci of every part of the production process. CTIVITY)BASED COSTING IN THE SERVICE INDUSTRY There have been many A%& success stories in such diverse organization as airlines, insurance companies, banks, hospitals, financial service firms, hotels, and railroads. The overal ob-ektives of A%& in service firms are no different than they are in manufacturing companies. 'anagers want more accurate information about the cost

of producing the service they are selling. 'oreover, they want to use this information to improve operations and to better meet the needs of their constomer in a more cost/effective manner. The general approach of identifying activities, activity cost pools, and cost drivers may be used in the service industry as well as in manufacturing. The classification of activities@ 1. 4nit level@ entering initial claim data into the computer 2. %atch level@ moving abatch of claims from one processing step to the next. 3. !roduct/sustaining level@ maintenance of the medical/services provider net/ work 4. <acility 9general operation: level. Beneral administration of the claims business unit.