5.5. ABC in manufacturing (2)

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From the course by Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

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Course 3 of 5 in the 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.

From the lesson

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

Meet the Instructors

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

Now we proceed.

I prepared that diagram for you, that basically shows the new cost system

at this company that makes circuit boards.

Now, you can see that these are indirect cost pools, materials handling,

machine insertion, manual insertion, wave soldering and quality testing.

Then cost allocation basis, then direct cost, by the way,

in this refined system, direct costs, these two the same.

And then here are parts, machine inserted parts,

manually inserted part, boards, and then time.

So this is the overall scheme.

You can see that the scheme is much more cumbersome.

And the important thing is that previously we had two pools,

now we have as many as five pools.

Now let's see what does that lead us to.

The next Step 6 now is cost assignment,

this is the key part.

Now we make table together, so this is x, this is y.

Now, we start with direct costs.

And we remember this is 948 and 504, and these don't change under the new system.

Remember, the bottom part hasn't changed at all.

But now, we have these pools, and what we do, for example, materials handling.

Now that deals with parts.

And we say that for board X, we have 81 parts.

We have 80 parts, plus the 81st one is the board itself.

And then, let's say for Y, these are 121 parts.

And we remember that this is at $3 per part, so we come up with the numbers.

So that will be 243 for X, and that will be 363 for Y.

To be consistent I will just put 948 here in black too,

although that doesn't matter much.

Now the next thing is machine insertion.

And again, here, for X this 70 parts, for Y this is 90 parts.

And remember, that was at,

The rate of 0.75.

So here we have 675, while here we will have,

I'm sorry this is 52.5,

this is 67.5, this is a point here.

Now the next thing is manual insertion.

Now remember, manual insertion was much more expensive per part.

For X we have 10, for Y we have, you can see,

120 minus 90, this is 30, at $6.

So here it's 180, while for board X, it's only 60.

Then wave soldering is the same for both, it's 75 and 75 here.

And the final, but the key story here, is this quality testing.

And for X this is 1.5 hours, while for

Y this is an astonishing 6.5 hours.

And that's at $75 per hour, so here we have 487.5,

while for board X, we have just 112.5.

So all that results to the overall total indirect costs,

Of 543 for board X, and then 1,173 for board Y.

And then the total cost output in red at the very bottom line here.

So this is total cost.

And that adds up to 1,491 for the first board,

and then 1,677 for the second board.

So, the key story here is that something has changed.

You can see that before board X was more expensive, now it's cheaper.

And that leads us to significantly different managerial decisions.

Let's put together this comparison.

So comparison, Of costs,

and that will be under ABC and the old system.

So this is X, this is Y, again, we start with direct costs.

And this is 948, this is 504, these don't change.

And now come indirect costs.

Indirect, Old system,

now that was 744 and 840.

This is from our previous episode.

So now the total cost,

Under the old system output, that was 1692.

And that was, 1,344.

But now, indirect costs under ABC, so

the new system, they are 543 and 1,173.

So here I will use red.

Total costs under ABC, they are now,

as we just found, 1,491 and 1,677.

And now let's put, what's the change,

the change delta in costs in percentage points.

It's now -11.9% under ABC, but here it's +24.8%.

So ABC results in the completely the upside down assessment.

It's says that, actually, under this system,

manufacturing of board X is cheaper for us.

And we will see why.

In the next episode, we will sort of analyze the actual reasons.

Although we've seen some of these contributions already.

Namely, this has many more parts, and

that requires much more time for quality testing, that is quite expensive.

But looking at these numbers, we can say,

well, we can, maybe, reconsider our pricing approach.

We can charge a lower price for board X, and

maybe we'll recover part or lost market share.

While looking at the price of the board Y, we'll have to be more careful,

and maybe we will have to bring it up a little bit.

So we can see that under both examples that we dealt with, the example of

a retail store and the example of a manufacturing company, well, those were

quite simplified, but still we've been able to identify a very important thing.

We saw that our initial costing system produced the results that

would force us to make managerial decisions that may prove wrong.

And it is the use of the ABC that allows us to reveal

the actual amount of resources that we devote to all these processes.

And that provides us with the much more valuable information for

proper future managerial decision making.

In the next episode, a wrapping our study of ABC.

We'll put everything together and

point out the areas in which ABC results in superior findings.

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