5.4. ABC in manufacturing (1)

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En provenance du cours de Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

notes

Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

notes

Cours 3 sur 5 dans Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

À partir de la leçon

Activity-Based Costing (ABC). Relevant Costs

In Week 5 we will study the more advanced approaches to costing – activity-based costing (ABC) and relevant costs – that provide for the more accurate costing of products, projects, and divisions, and allow to reveal actual relationship between numbers and people. We start with the analysis of ABC on an example of a small retail firm. Then we move on to the more detailed example of the use of ABC in manufacturing. Both examples will help us gain insight in the role of ABC in identifying ways to improve performance. Finally, we analyze the idea of relevant costs and its application to managerial actions –make-or-buy decisions, product mix under capacity constraints, customer profit analysis. Of special attention will be the role of relevant and opportunity costs in valuation.

5.1. Activity-based costing (ABC) – an overview8:38

5.2. ABC for a retail firm (1)9:01

5.3. ABC for a retail firm (2)13:21

5.4. ABC in manufacturing (1)13:37

5.5. ABC in manufacturing (2)13:21

5.6. Insights provided by ABC8:30

5.7. Relevant costs – an idea10:53

5.8. Make-or-buy decisions (1)6:04

5.9. Make-or-buy decisions (2)10:30

5.10. Product mix under capacity constraints8:33

5.11. Customer profit, ABC, and relevant costs7:32

5.12. Irrelevance of past costs10:43

Rencontrer les enseignants

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now let's take a look at what's going on at

the manufacturing company if we try to apply ABC.

We talk about, again ABC,

in manufacturing, and this is sort of one.

The example that we will use will be very much simplified example,

the company that will be called printed circuit boards incorporated

that makes printed circuit boards and we will study only two that it makes, X and Y.

Now, first, we have to see what old system they

had because if we do not talk about this old system,

we will not be able to identify the core of the problem.

They are making printed circuit boards and,

again, here are indirect cost pools.

Now these are two,

so this is procurement

and this is sort of production support.

Now these are cost allocation bases,

again, cost object is the board, the product.

Then here, there are also some direct costs.

Direct costs are of two kinds.

I would put it right away,

so this is direct materials

and direct manufacturing labor.

Direct manufacturing labor.

These are direct costs and they contribute to the bottom part so this is

direct and the top part

is indirect costs.

As we know, this is the most interesting part.

Now, we have to think about the cost allocation bases here.

This is procurement here as a base with a direct materials

and that will be

40 percent cost in direct materials.

Here, we take direct manufacturing labor,

but that will be 800 percent of direct labor.

Basically, the story is that in production when we do something,

we take the amount of time that is needed and then multiply by 800 percent.

That is the system that has been used and this system

results in certain numbers that we'll study on the next page of the flip chart.

Well, you can see that this huge number that doesn't

make any distinction between the kinds of operations you made.

For example, let's say you put some piece there,

a capacitor that costs 50 cents and then that takes

the same amount of time compared to if you put manually

a transistor that is a hundred dollars or let's say,

some other piece that is,

for this maybe as a poor example but you just put a chip that is a hundred dollars.

So you use the same amount of time,

the same amount of labor but the difference in costs would be the fielders of magnitude.

That doesn't seem to be very smart.

Let's still see how the system is used and what actual results does it produce.

We have two kinds of boards,

this is X and this is Y.

And then we study.

These are the direct costs,

I'll drop manufacturing here and that includes as we know,

direct materials, and then direct labor.

Then let's say we calculated that and this is for

board X this is 900 dollars and for board Y this is 420.

Fuel materials here and then direct labor here

is 48 dollars and 84 dollars here.

Now, the total direct costs are

therefore 948 for board X and then 504 for board Y.

Great so far so good but now we come at the interesting part and this is indirect costs.

What do we see here?

We have procurement and

again procurement was 40 percent of direct materials.

Let's see so with a direct materials 900 and take 40 percent so here it's 360.

It will be 40 percent and here it will be 168 because that's 40 percent of that.

Great. Now we take this offensive part,

this is production support and this

is at the 800 percent of direct labor.

We take direct labor,

multiply that by eight times so this is 384 here and 672 there.

The overall total

indirect costs there,

744 here, this is the sum of these two

and then it's 840 there and we arrive at the total cost

that I will put in the red and

that will be 1,692 here and 1,344 here.

You can see that based on the old system,

we can say that board X is much more expensive in production than board Y.

Well, what can we do about that?

We have to say, "Well,

if this is the case,

we cannot, for example,

bring down the selling price of board X.

And what has been noticed that recently,

the company started to lose market share in boards X because it was selling that

at a cost that was not quite competitive and looking at these numbers we can say,

"Well, we can not go below this number because then we'll run a loss."

But you can see that direct costs that are difficult to control here.

This was 948 and 504 and it really seems

that it's half of that that may maybe indeed board Y is cheaper.

Well, now we would

like to refine the system and take a look at maybe we are sort of overlooking something.

This is a cost refining system

at this company and it consists of steps.

Step one, we identify

a job so a number of boards.

Then step two, we identify direct costs.

So far so good and that's quite of clear.

Now come step three,

which is I will put in red or exclamation mark,

this is cost pools using ABC.

And then from here,

there is step four, cost delegation basis.

So these are drivers as we know in ABC.

And then step five, cost allocation rates.

As soon as we are done with that,

we will be able to approach our cost assignment system better.

Again, we said why is that?

Because we saw that some pieces of the old system,

they really would lead to strange results.

Let's see what they did here.

They identified the following activities.

So this is activity, and that's the cost driver,

which is the cost allocation base and this is the cost allocation rate.

That's an important table.

First of all, they found this is materials handling.

So regardless of what that this is a chip or a capacitor or even a screw, whatever,

we have to prepare these parts and here the cost driver clearly is

the parts and they calculated their costs for the previous year and they said,

"Well, that was like three dollars per part."

Now, the next thing was the machine insertion.

Some of the parts here they are inserted by the robot and that was clearly here,

the driver is machine inserted parts.

The rate is 0.75 per machine inserted part, I would note.

Now, the next thing is manual insertion of some real delicate parts for example and here

clearly this is manually inserted parts and the rate here is six per part,

six dollars it's much higher.

Now the next thing is let's say wave soldering so they just prepare everything and then,

in one way, they just sold everything.

Here are boards and this is let's say,

75 dollars per board.

And finally, but importantly in this case is quality testing.

Here we have test time

and that's because we use expensive computers so therefore,

it's 75 dollars per hour.

Now, for example, how did we get this number?

So they have budgeted number of parts for machine insertion let's say,

four million and they calculated that

the budget cost for these parts was three million dollars.

They just calculated that then they divide one by the other and that gives you

0.75 dollars per part that is machine inserted.

So far, we have prepared some important inputs and in what follows,

we take these cost allocation rates and then just count the amount of these drivers

used and that will give us the corresponding cost associated with this kind of activity.

Now, no wonder that we will find some interesting things in our next episode,

in which we will use all these numbers and arrive at

the new refined indirect cost

that is associated with the manufacturing of boards X and Y.

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