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Activity-Based Cost

Management Systems

Rishiraj

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Problems With Simple CostAccounting Systems: The Cooper

Pen Company Example

Cooper Pen had been the low-cost

producer of blue pens and black pens,with profit margins exceeding 20% of sales

Several years ago Cooper Pen expanded

their business by extending their productline into products with premium sellingprices

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The Cooper Pen Company Example

Five years ago red pens were introduced

The same basic production technology

Could be sold at a price that was 3% higher than forblue and black pens

Last year purple pens were added Could be sold at a 10% price premium

The controller of Cooper Pen was disappointedwith the most recent quarters financial results

Overall profitability for all four together had decreased

The red and purple pens, however, were more profitablethan the blue and black pens

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Total Profitability by Product

Blue Black Red Purple Total

Units 50,000 40,000 9,000 1,000 100,000

Price 4.50 4.50 4.65 4.95

Sales 225,000 180,000 41,850 4,950 451,800

Material 75,000 60,000 14,040 1,650 150,690Labor 30,000 24,000 5,400 600 60,000

Overhead 90,000 72,000 16,200 1,800 180,000

Total Mfg.

Expenses

195,000 156,000 35,640 4,050 390,690

GrossMargin

30,000 24,000 6,210 900 61,110

G.M. % 13.3% 13.3% 14.8% 18.2% 13.5%

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Concern at Cooper Pen

The controller of Cooper Pen wondered whetherthe company should continue to deemphasize theblue and black commodity products and keepintroducing new specialty colored pens

Coopers manufacturing manager commented onhow the introduction of colored pens hadchanged the production environment:

Everything ran smoothly when producing just

blue and black pens in long production runs

Difficulties started when the red pens wereintroduced and required more changeovers

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Changes Caused by New Pens (1 of 2)

Making black ink was simple; there was not evena need to clean out the residual blue ink fromthe previous run if enough black ink wasdumped in to cover it up

Red required Cooper to stop production, emptythe vats, clean out all remnants of the previouscolor, and then start the production of the red ink

Even small traces of the blue or black inkcreated quality problems

The ink for the purple pens also had demandingspecifications, though not quite as demandingas the red ink

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Changes Caused by New Pens(2 of 2)

Cooper Pens was also spending more time onpurchasing and scheduling activities andkeeping track of existing, backlogged, and futureorders

Coopers manufacturing manager wasconcerned about rumors that new colors may beintroduced in the near future He did not think they had any more capability to

handle additional confusion and complexity in the

operations Last years new computer system helped to

reduce some of the confusion

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Pen Production At Coopers

Pen production at the factory involved:

Preparing and mixing the ink for the different color pens Inserting the ink into the pens in a semiautomated

process Packing and shipping the pens in a manual stage

Each product had a: Bill of materials that identified the quantity and cost of

direct materials required for the product Routing sheet that identified the sequence of

operations required for each operating step

This information was used to calculate the laborexpenses for each of the four products From this information, it was easy to calculate the direct

materials costs and direct labor costs for each colorpen

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Coopers Indirect Cost Allocation

Because it was a small company and historicallyhad produced only a narrow range of products,Cooper used a simple costing system

All the plants indirect expenses were aggregated at

the plant level and allocated to products based oneach products direct labor cost

Currently the cost systems overhead burden rate was

300% of direct labor cost

Before the new specialty products were introduced,the overhead rate was only 200% of direct labor cost

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Cooper Pens Cost System

Coopers management accountants designed

the system years ago when:

Production operations were mostly manual

Total indirect costs were less than direct labor costs

Coopers two products had similar productionvolumes and batch sizes

Given the high cost of measuring and recordinginformation, the accountants at the time judged

correctly that a complex costing system wouldcost more to operate than the benefits it wouldprovide

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A Changed Production Environment

Direct labor costs have decreased and indirectexpenses have increased as a result ofautomation

As custom low-volume products, such as red

and purple pens were added, Cooper needed: More scheduling

More setups

More quality control personnel

A computer to track orders and product specifications

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An Outdated Cost System

Cooper operates with only a single cost center,the plant Most complex companies use many cost centers for

cost accumulation

Even if Cooper Pen used multiple productionand service department cost centers, it could stillencounter severe distortions in its reportedproduct costs: In an environment of high product variety, using only

unit-level drivers (such as direct labor costs) toallocate overhead costs to products could lead toproduct cost distortion

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Reason for Cost Distortions (1 of 3)

schedule machine andproduction runs

perform setups

inspect produced items aftersetup

move materials

ship orders

expedite orders

rework defective items

design new products

improve existing products

negotiate with vendors

schedule materials receipts order, receive, and inspect

incoming materials and parts

update and maintain the muchlarger computer-based

information system

A complex factory has a much larger production support

staff because it requires more people to:

A complex factory generally also operates with higherlevels of idle time, setup time, overtime, inventory, rework,and scrap

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Reason for Cost Distortions (2 of 3) Because the factory has the same physical

output, it has roughly the same cost of materials(ignoring the slightly higher acquisition costs forsmaller orders of specialty colors and othermaterials)

Because all pens are about the same complexity,each pen would require the same number ofdirect labor hours and machine hours to produce

The Cooper Pen Company factory has about the

same property taxes, security costs, and heatingbills as before, but it has much higher indirect andsupport costs because of its more varied productmix and complex production tasks

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Reason for Cost Distortions(3 of 3) On a per unit basis, high-volume standard blue and black

pens require about the same amount of direct labor costs(the allocation basis) as the low volume color pens

Therefore, the traditional costing system would reportessentially identical product costs for all products,standard and specialty, irrespective of their relativeproduction volumes

This would hold true even if the cost system hadmultiple production and service cost centers

Clearly, however, considerably more indirect and supportresources are required on a per-unit basisfor the low-volume, newly designed products than for the high-volume, standard blue and black pens

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Activity-Based Cost Systems Activity-based cost systems have been

developed to eliminate this major source of costdistortion

Activity-based cost (ABC) management systemsuse a simple two-stage approach similar to butmore general than traditional cost systems

The next slide compares the essential elementsof the two systems

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Traditional v. ABC System

Traditional:

Uses actual departments orcost centers for accumulatingand redistributing costs

Asks how much of anallocation basis (usually

based on volume) is used bythe production department

Service departmentexpenses are allocated to aproduction department based

on the ratio of the allocationbasis used by the productiondepartment

ABC:

Uses activities, foraccumulating costs andredistributing costs

Asks what activities arebeing performed by the

resources of the servicedepartment

Resource expenses areassigned to activities basedon how much of the

resource is required or usedto perform the activities

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Tracing Costs to Activities

Heres how an ABC system works, using

the Cooper Pen Company as an example:

The controller started an analysis of indirectexpenses, beginning with indirect labor

The controller interviewed department heads incharge of indirect labor and found that thepeople in these departments performed threemain activities

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Indirect Labor Activities (1 of 2)

50% of indirect labor was involved in what the

controller called handle production runs Scheduling production orders

Purchasing, preparing, and releasing materials

Inspecting the first few units produced each time the

process was changed to a new-colored pen 40% of indirect labor actually performed the

physical changeover from one color pen toanother, an activity that she labeled perform

setups Change to Black pens takes 2.4 hours

Change to Red or Purple pens takes 5.6 hours

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Indirect Labor Activities (2 of 2)

10% of the time was spent on activities the

controller called support products: maintainingrecords on the four products, such as:

Making up the bill of materials and routing information

Monitoring and maintaining a minimum supply of rawmaterials and finished goods inventory for eachproduct

Improving the production processes

Performing engineering changes for the products

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First Steps in Design of An ABC System

As she conducted the interviews, the controller

was performing the first two steps for designingan activity-based cost system:

1) Develop the activity dictionary: the list of major

activities performed by both the factoryshuman and physical resources

2) Obtain sufficient information to assign resourceexpenses to each activity in the activity

dictionary (50% of indirect labor to handleproduction runs, 40% to perform setups, and

10% to support products)

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Computer System Expenses (1 of 2) The controller next turned her attention to the

$30,000 of expenses needed to operate thecompanys computer system and interviewed the

manager of the data center and the manager ofthe management information system department

20% of computer expenses should be assignedto support products, an activity already

defined in her activity dictionary, because it was

used to keep records on the four products,including:

Production process

Associated engineering change notice information

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Computer System Expenses (2 of 2) About 80% of the computer resource was

involved in the production run activity andseemed to relate well to the handle productionruns activity already defined: Schedule production runs in the factory

Order and pay for the materials required in eachproduction run

Since each production run was made for a particularcustomer, also included in this activity was thecomputer time required to:

Prepare shipping documents Invoice a customer

Collect from a customer

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Other Overhead Expenses There were three remaining categories of

overhead expense: Machine depreciation

Machine maintenance

Energy to operate the machines

These expenses were incurred to supplymachine capacity to produce the pens: A practical capability of 10,000 hours of productive

time could be supplied to pen production

The controller labeled this production activityrun machines

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Identifying Cost Hierarchies The controller noted that even though she had defined

only four activities for Coopers indirect costs, theyrepresented the three different levels of themanufacturing cost hierarchy:

PRODUCT SUSTAININGSUPPORT PRODUCTS

BATCH LEVELSETUP MACHINES

BATCH LEVELHANDLE PRODUCTION RUNSUNIT LEVELRUN MACHINES

COST HIERARCHYACTIVITY

Finding at least one activity for each hierarchy level gaveher confidence that the complexity of the manufacturingprocess could be represented well enough by theactivity-based cost system

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Benefits from Half an ABC System

The ABC model was only half completed (costs

have not yet been driven down to products), yet ithad already provided some important insights:

Now the controller could see why Cooper Pens wasincurring expenditures for resources instead of seeingcategories of expenses

In particular she saw how expensive activities such ashandling production runs and setting up machines were

The ABC model shifted the focus from what themoney was being spent on (labor, equipment,supplies) to what the resources acquired byspending were actually doing

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From ABC to ABM (1 of 2)

In the past, industrial engineers at Cooper Penhad studied labor and materials usage closely:

These had been the high cost resources

They were also the primary cost categories featured by

Coopers traditional cost system The high overhead rate on direct labor seemed to

amplify any benefits from direct labor cost savings thatthe industrial engineers could achieve

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From ABC to ABM (2 of 2)

It would be worthwhile to have industrialengineers study the way Cooper handled andscheduled production runs and how theemployees set up machines to uncover new

opportunities for cost reduction and processimprovement projects

This is an example of operational activity-basedmanagement(ABM), where managers use

information collected by the ABC system at theactivity level to identify opportunities for reducingcosts in indirect and support activities

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Tracing Costs From Activities To Products

The controller next turned her attention tounderstanding the demands for theseactivities by the four different products

By understanding how products useactivities, she would be able to relate thecost of performing activities to individualproducts

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Activity Cost Drivers Activity cost drivers represent the quantity of activities

used to produce individual products The controller identified the following activity cost drivers

for the activities in her activity dictionary:

ACTIVITY ACTIVITY COST DRIVER

HANDLE PRODUCTION RUNS PRODUCTION RUNS

SET UP MACHINES SETUP HOURS

SUPPORT PRODUCTS NUMBER OF PRODUCTS

RUN MACHINES MACHINE HOURS

PROVIDE FRINGE BENEFITS LABOR DOLLARS

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Completing the ABC Model (1 of 2)

Once the activity cost drivers had been

determined, the controller obtainedquantitative information on:

The total quantity of each activity cost driver

The quantity of cost driver used by eachproduct

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Completing the ABC Model (2 of 2)

The controller now had sufficientinformation to estimate a complete activity-based cost model for Cooper Pens factory

She calculated the activity cost driver rate

(ACDR) by dividing the activity expense bythe total quantity of the activity cost driver

She then multiplied the activity cost driver rate

by the quantity of each activity cost driverused by each of the four products

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Activity Cost Drivers

Activity Cost

Driver Blue Black Red Purple Total**

DL hr/unit 0.02 0.02 0.02 0.02 2,000

Mch. hr/unit 0.1 0.1 0.1 0.1 10,000

Prod. runs 70 65 50 15 200

Setup time/run 4 2.4 5.6 5.6 --

Total setup hr 280 156 280 84 800

# of products 1 1 1 1 4

**Total = per unitX quantity 50,000 40,000 9,000 1,000

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Activity Cost Driver Rates (ACDR)

Activity

Expense

Activity Cost

Driver

Driver

Quantity ACDR

HandleProduction Runs

66,000 Number ofproduction runs

200 330 perrun

Set up machines 33,600 Number ofsetup hours

800 42 persetup hr

SupportProducts

14,400 Number ofproducts

4 3,600 perproduct

Run Machines 42,000 Number of

machine hours

10,000 4.20 per

machine hr

156,000

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Activity Expenses Assigned


HandleProductionRuns

23,100 21,450 16,500 4,950 66,000

Set upmachines

11,760 6,552 11,760 3,528 33,600

SupportProducts

3,600 3,600 3,600 3,600 14,400

Run

Machines

21,000 16,800 3,780 420 42,000

Total CostsAssigned 59,460 48,402 35,640 12,498 156,000

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ABC Profitability Report The controller combined the activity expense analysis for

each product with their direct materials and labor coststo obtain a new ABC profitability report

The results from the activity-based costing system werequite different from the results based on the traditional

cost system The controller now understood why the profitability of

Cooper Pen has deteriorated in recent years: The two specialty products, which the previous cost system had

reported as the most profitable, were in fact the most

unprofitable, and losing lots of money The company had added large quantities of overhead resources

to enable these products to be designed and produced, but theirincremental revenue did not cover those costs

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Total ABC Profitability by Product


Sales 225,000 180,000 41,850 4,950 451,800Material 75,000 60,000 14,040 1,650 150,690

Labor 30,000 24,000 5,400 600 60,000

40%

fringe onDL

12,000 9,600 2,160 240 24,000

Support 59,460 48,402 35,640 12,498 156,000

Total Mfg.

Expenses

176,460 142,002 57,240 14,988 390,690

GrossMargin

48,540 37,998 (15,390) (10,038) 61,110

G.M. % 21.6% 21.1% -36.8% -202.8% 13.5%

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Using ABC to Improve Profitability (1 of 2)

The ABC information provides managers

with numerous insights about how toincrease the profitability of Cooper Pen:

Increase either their sales volume or prices to

compensate for the large batch and product-sustaining expenses of the red and purple pens

Impose minimum order sizes to eliminate short,unprofitable production runs

Try to increase demand for the highly profitableblack and blue pens, which could generate newrevenues that exceed their incremental costs

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Using ABC to Improve Profitability (2 of 2) Improve processes, particularly the processes

performing batch and product-sustaining activities Manufacturing personnel can redirect their attention: From trying to run their production equipment faster, in

order to improve the performance of unit-level activities

To learning how to reduce setup times, in order toimprove the performance of batch-level activities so thatsmall batches of the specialty products would requirefewer resources to produce and be less expensive

The goal of these ABM actions is to enable the companyto produce the same volume and mix of products withfewer resources This leads to lower costs for producing low-volume, specialty

products, and reduces the pressure to raise prices or imposeminimum order sizes on customers in order to make suchproducts profitable

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Selecting Activity Cost Drivers (1 of 2) Activity cost drivers are the central innovation of activity-

based cost systems They are also the most costly to measure

Particularly the quantity of each activity cost driverused by each product

Accordingly, it is important to understand the issuesinvolved in selecting activity cost drivers

The selection of an activity cost driver reflects asubjective trade-off between accuracy and the cost of

measurement An ABC system with 50 activity cost drivers and 2,000

products would require that 100,000 data elements beestimated

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Selecting Activity Cost Drivers(2 of 2) Because of the large number of potential activity-to-product

linkages, management accountants attempt to economizeon the number of different activity cost drivers

Activities triggered by the same event may all use thesame activity cost driver For example, preparing production orders, scheduling production

runs, performing first part inspections, and moving materials may alluse the number of production runs

ABC system designers choose from three different types ofactivity cost drivers: Transaction

Duration Intensity (direct charging)

The choice of a transaction, duration, or intensity costdriver can occur for almost any activity

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Transaction Drivers Least expensive type of cost driver

Also the least accurate They assume that the same quantity of resources is

required every time an activity is performed For example, a transaction driver such as the number of setups

assumes that all setups take about the same time to perform

For many activities, the variation in the quantity ofresources used by each is small enough that a transactiondriver will be fine for assigning activity expenses to the costobject E.g., all setup times are between 30 and 35 minutes

If the amount of resources required to perform the activityvaries considerably from product to product then moreaccurate and more expensive types of cost drivers shouldbe used E.g., Setup times range from 30 minutes to 6 hours

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Duration Drivers Represent the amount of time required to perform an activity

Should be used when significant variations exist in theamount of activity required for different outputs A transaction driver such as number of setups will overcost the

resources required to set up simple products and undercost theresources required for complex products

More expensive to implement because they require anestimate of time needed each time an activity is performed

The choice between a duration driver and a transactionaldriver is, as always, one of economics: Balancing the benefits of increased accuracy against the costs of

increased measurement

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Intensity Drivers Directly charge for the resources used each time an activity

is performed

A duration driver, such as setup cost per hour, assumesthat all hours are equally costly but does not reflect thehigher costs that may be required on some setups: E.g., extra personnel, more skilled personnel, more expensive

machinery

Activity costs may have to be charged directly to theoutput, based on work orders or other records thataccumulate the activity expenses incurred for that output

Intensity drivers are the most accurate activity cost driversbut the most expensive to implement

Intensity drivers should be used only when the resourcesassociated with performing an activity are both expensiveand variable each time an activity is performed unless themeasurements are inexpensive

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Designing an ABC System (1 of 2)

Sometimes ABC system designers getcarried away with the potential capabilitiesof an activity-based cost system

For product costing and customer costing

purposes, most companies: Limit their activity dictionary to 30 to 50

different activities

Choose activity cost drivers that can beobtained simply and are available within theirorganizations existing information system

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Designing an ABC System (2 of 2)

The goal of an ABC system should be to have

the best cost system -- not the most accurateone

The ABC system designer should balance the

cost of errors resulting from inaccurate estimateswith the cost of measurement

Most of the benefits from a more accurate costsystem can be obtained with simple ABC

systems

M i Th C

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Measuring The CostOf Resource Capacity (1 of 2)

The calculation of activity cost driver rates aresometime based on the capacity actually used

Analysts can obtain a better estimate for the costof resources required to handle each production

run by dividing activity expenses by the practicalcapacity of work the resources could perform

Otherwise, the activity cost driver ratesoverestimate the cost of the activity provided

The cost of unused capacity should not beassigned to products produced or customersserved during a period

M i Th C t

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Measuring The CostOf Resource Capacity (2 of 2)

The activity cost driver rate should reflect theunderlying efficiency of the process: the cost ofresources to handle each production order

This efficiency is measured better by using the

capacity of the resources supplied as thedenominator when calculating activity cost driverrates

Still, the cost of unused capacity should not be

ignored

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Cost of Unused Capacity (1 of 2) The cost of unused capacity remains someones or

some departments responsibility Usually you can assign unused capacity after analyzing

the decision that authorized the level of capacitysupplied

For example, if the capacity was acquired to meet anticipateddemands from a particular customer or a particular marketsegment, then the costs of unused capacity due to lower thanexpected demands can be assigned to the person ororganizational unit responsible for that customer or segment

Such an assignment is done on a lump-sum basis; it willbe treated as a sustaining, not a unit-level, expense.

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Cost of Unused Capacity (2 of 2)

If the unused capacity relates to a particular product line

then the cost of unused capacity is assigned to thatproduct line, where the demand failed to materialize

Unused capacity should not be treated as a general cost,to be shared across all product lines

In making assignment of unused capacity costs, wetrace the costs at the level in the organization wheredecisions are made that affect the supply of capacityresources and the demand for those resources

The lump-sum assignment of unused capacity costsprovides feedback to managers on their supply anddemand decisions

Fi d d V i bl E

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Fixed and Variable Expenses

Most indirect expenses assigned by an ABC

system are committed costs Committed costs become variable via a two-step

procedure:

First, demands for resources change either because ofchanges in the quantity of activities performed orbecause of changes in the efficiency of performingactivities

Second, managers must make decisions to change thesupply of committed resources, either up or down, tomeet the new level of demand for the activitiesperformed by these resources

A ti it i E f C it

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Activity in Excess of Capacity

If activity volumes exceed the capacity of existingresources, the result is Bottlenecks

Shortages

Increased pace of activity

Delays

Poor-quality work Such shortages occur often on machines, but can also

occur in human resources who perform support activities

Facing such shortages, companies typically makecommitted costs variable They relieve the bottleneck by spending more to increase the

supply of resources to perform work

This is why many indirect costs increase over time

Decreased Demand for Resources

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Decreased Demand for Resources Demands for indirect and support resources also can

decline

Consciously through activity-based management Inadvertently through competitive or economy-wide forces that lead

to declines in sales

Should the demands for batch and product-sustaining

resources decrease, few immediate spending reductionswill be noticed

Even for many unit-level resources, such as machines anddirect labor, reduced demands for work does notimmediately lead to spending decreases

The reduced demand for organizational resources lowersthe cost of resources used, but this decrease is offset byan equivalent increase in the cost of unused capacity

M ki C itt d C t

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Making Committed CostsVariable Downward

After unused capacity has been created,committed costs will vary downward if, and onlyif, managers actively reduce the supply ofunused resources

What makes a resource cost variable

downward is not inherent in the nature of theresource

It is a function of management decisions To reduce the demands for the resource

To lower the spending on it

Managers Make Costs Fixed

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Managers Make Costs Fixed (1 of 2)

Organizations often create unused capacity

through activity-based management actions Process improvement

Repricing to modify the product mix

Imposing minimum order sizes on customers

They keep existing resources in place, whendemands for the activities performed by theresources have diminished

They also fail to find new activities that could bedone by the unused resources already in place

Managers Make Costs Fixed

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Managers Make Costs Fixed (2 of 2)

The organization receives no benefits from its activity-based management decisions that reduced the demands

on their resources if capacity is not reduced or redeployed The failure to capture benefits from activity-based

management is not because their costs are fixed The failure occurs because managers are unwilling or unable to

take advantage of the unused capacity they have created by

Spending less on capacity resources Increasing the volume of work processed by the capacity

resources

The cost of these resources is only fixed if managers donot exploit the opportunities from the unused capacity theyhelped to create

Making decisions based solely upon resource usage (theABC system) may not increase profits if managers are notprepared to reduce spending to align resource supply withfuture lower levels of demand

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Problems Implementing ABC (1 of 3)

Several problems arise in practice from thecommon approach to activity-based costing thatassigns many resource expenses to activitiesbased on interviews, surveys, and direct

observation of production and support processes The interview and survey processes are time

consuming and costly

This front-end cost to an ABC analysis is often a

barrier to widespread ABC adoption

P bl I l i ABC

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Problems Implementing ABC (2 of 3)

Inaccuracies and bias may affect the accuracy of cost

driver rates derived from individuals subjectiveestimates of their past or future behavior

Companies must periodically repeat the interviewingand surveying processes if they want to keep their

activity-based cost systems updated High updating cost leads to infrequent updates of

many ABC systems and, eventually, to obsolete costdriver estimates

Adding new activities to the system is also difficult,requiring re-estimates of the relative amount of resourcetime and effort required by the new activity

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Problems Implementing ABC(3 of 3) A more subtle and serious problem arises from the

interview or survey process People estimating how much time they spend on a

list of activities handed to them invariably reportpercentages that add up to 100%

Few individuals report that a significant percentageof their time is idle or unused

Accordingly, the cost driver rates calculatedfrom this process assume that resources are

working at full capacity But operations at capacity are more the

exception than the rule

Time-Driven ABC:

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Time-Driven ABC:An Alternative Approach

Several companies have overcome theseproblems by using a new approach forestimating their ABC models

The insight for the new approach issimple: Most ABC systems use a large number of

transactional cost drivers that assume each

occurrence of the event (a production run, acustomer order, a product to support)consumes the same quantity of resources

Ti D i ABC

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Time-Driven ABC:

This homogeneity assumption provides

the foundation for an alternative approachto estimating cost driver rates. The newapproach requires two new estimates:

The unit cost of supplying capacity, and The consumption of capacity (unit times) by

each activity

Unit Cost Estimate

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Unit Cost Estimate (1 of 3)

The new procedure starts with the same

information used by a traditional ABC approach: The cost of resources that supply capacity and

The practical capacity of the resources supplied

Practical capacity is often estimated as apercentage (e.g., 80% or 85%) of theoreticalcapacity

This estimate allows time (e.g., 15 20%) fornonproductive time:

For personnel, time for breaks, arrival anddeparture, and communication and readingunrelated to actual work performance

U it C t E ti t

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Unit Cost Estimate(2 of 3)

For machines, an allowance for downtime due to

maintenance, repair, and scheduling fluctuations

With estimates of the cost of supplying capacityand practical capacity, the analyst can calculate

the unit cost of supplying capacity:

Unit cost =

Cost of capacity supplied

Practical capacity of resources supplied

U it C t E ti t

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Unit Cost Estimate (3 of 3)

For example, assume that indirect laboremployees supply about 2,500 hours of labor intotal each quarter at a cost of 84,000. Thepractical capacity (at 80% of theoretical) is about

2,000 hours per quarter, leading to a unit cost(per hour) of supplying indirect labor capacity of:

Indirect labor cost per hour =84,000

2000 hours= 42 per hour

Unit Time Estimate

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Unit Time Estimate

The second piece of new information is an estimate of

time used each time a committed resource performs atransactional activity

Precision is not critical

Rough accuracy is sufficient

Estimates for the indirect labor from the Cooper Penexample are:

Resource Activity Unit Time

Indirect Labor Production Run 5 hours

Support Products 50 hours

Cost Driver Rate

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Cost Driver Rate

Assume similar calculations regarding computer

resources produced estimates of 60 per hour and 2hours per production run

The cost driver rate for the activity, handle productionruns, can now be calculated as the costs of usingindirect labor and the computer for each production run:

Unit Cost Unit Time Cost Driver

Indirect Labor Resource 42 per hour 5 hours/run 210 per run

+ Computer Resource 60 per hour 2 hours/run 120 per run

= Activity Cost Driver Rate 330 per run

Advantages of Time Driven ABC

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Advantages of Time-Driven ABC

Managers may easily update their time-driven

ABC model to reflect changes in their operatingconditions

They can incorporate the new knowledge by providingreasonable estimates about the unit times required for

different activities for each type of product Managers may also easily update the activity

cost driver rates

Changes in the prices of resources supplied affect the

hourly cost rate

Activity cost driver rates change when there has beena shift in the efficiency of the activity

Tracing Marketing-Related

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Tracing Marketing RelatedCosts to Customers

The costs of marketing, selling, and distribution expenseshave been increasing rapidly in recent years

Result of increased importance of customer satisfactionand market-oriented strategies

Many of these expenses do not relate to individualproducts or product lines but are associated with:

Individual customers

Market segments

Distribution channels Companies need to understand the cost of selling to and

serving their diverse customer base

Alpha Beta Example (1 of 7)

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Alpha Beta Example (1 of 7) Assume Alpha and Beta are customers generating about

equal revenue and seen as equally valuable customers

Using a conventional cost accounting system, marketing,selling, distribution, and administrative (MSDA) expenseswere allocated to customers at a rate of 35% of Sales

ALPHA BETA

Sales 320,000 315,000CGS 154,000 156,000

Gross Margin 166,000 159,000

MSDA expenses (@35% of Sales) 112,000 110,250

Operating profit 54,000 48,750Profit percentage 16.9% 15.5%

In many respects, however, the customers were not similar


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Betas account manager spent a huge amount of time

on that account Beta required a great deal of hand-holding and was

continually inquiring whether the company could modifyproducts to meet its specific needs

Betas account required many technical resources, inaddition to marketing resources

Beta also: Tended to place many small orders for special products

Required expedited delivery

Tended to pay slowly

All of which increased the demands on the order processing,invoicing, and accounts receivable process


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Alpha, on the other hand:

Ordered only a few products and in large quantities Placed its orders predictably and with long lead times

Required little sales and technical support

The Accounting Manager in Marketing knew thatAlpha was a much more profitable customer thanthe financial statements were currently reporting

He launched an activity-based cost study of the

companys marketing, selling, distribution, andadministrative costs


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The multifunctional project team:

Studied the resource spending of the various accounts Identified the activities performed by the resources

Selected activity cost drivers that could link eachactivity to individual customers

The Accounting Manager used: Transactional activity cost drivers

Number of orders, number of mailings

Duration drivers Estimated time and effort

Intensity drivers when he had readily-available data Actual freight and travel expenses


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The manager also used a customer cost

hierarchy that was similar to the manufacturingcost hierarchy

Some activities were order-related

Handle customer orders

Ship to customers

Others were customer-sustaining

Service customers

Travel to customers

Provide marketing and technical support


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The picture of relative profitability of Alpha and Beta

shifted dramatically Alpha BetaGross Margin (as previously) 166,000 159,000

Marketing & tech. support 7,000 54,000

Travel to customer 1,200 7,200

Distribute sales catalog 100 100Service customers 4,000 42,000

Handle customer orders 500 18,000

Warehouse inventory 800 8,800

Ship to customers 12,600 42,000

Total activity expenses 26,200 172,100

Operating profit 139,800 (13,100)

Profit percentage 43.7% (4.2%)


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As the manager suspected, Alpha Company was

a highly profitable customer Its ordering and support activities placed fewdemands on the companys marketing, selling,distribution, and administrative resources

Almost all the gross margin earned by selling to Alpha

dropped to the operating margin bottom line

Beta Company was now seen to be the mostunprofitable customer that the company had

While the manager intuitively sensed that Alphawas a more profitable customer than Beta, hehad no idea of the magnitude of the difference

ABC Customer Analysis

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ABC Customer Analysis The output from an ABC customer analysis is often

portrayed as a whale curve

A plot of cumulative profitability versus the number ofcustomers

Customers are ranked, on the horizontal axis frommost profitable to least profitable (or most unprofitable)

Customer Profitability

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Customer Profitability Cumulative sales follow the usual 20-80 rule

20% of the customers provide 80% of the sales

A whale curve for cumulative profitability typically reveals: The most profitable 20% of customers generate

between 150% and 300% of total profits

The middle 70% of customers break even

The least profitable 10% of customers lose 50% - 200%of total profits, leaving the company with its 100% oftotal profits

It is not unusual for some of the largest customers to turnout being the most unprofitable

The largest customers are either the companys mostprofitable or its most unprofitable

They are rarely in the middle

Managing Customer Profitability (1 of 3)

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High-profit customers, such as Alpha, appear in

the left section of the profitability whale curve These customers should be cherished and

protected

They could be vulnerable to competitiveinroads

The managers of a company serving themshould be prepared to offer discounts,

incentives, and special services to retain theloyalty of these valuable customers if acompetitor threatens


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The challenging customers, like Beta, appear onthe right tail of the whale curve, dragging thecompanys profitability down with their lowmargins and high cost-to-serve

The high cost of serving such customers can becaused by their:

Unpredictable order pattern Small order quantities for customized

products Nonstandard logistics and delivery

requirements Large demands on technical and sales

personnel


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The opportunities for a company to transform its

unprofitable customers into profitable ones isperhaps the most powerful benefit thecompanys managers can receive from an

activity-based costing system

Managers have a full range of actions fortransforming unprofitable customers intoprofitable ones

Process improvements

Activity-based pricing

Managing customer relationships

Process Improvements

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Process Improvements

Managers should first examine their internal operations

to see where they can improve their own processes tolower the costs of serving customers

If customers are migrating to smaller order sizes:

Strive to reduce batch-related costs, such as setup

and order handling Electronic systems greatly lower the cost of

processing large quantities of small orders

If customers prefer suppliers offering high variety

Try to customize products at the latest possible stage Use information technology to enhance the linkages

from design to manufacturing

Activity-Based Pricing

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ct ty ased c g

Pricing is the most powerful tool a company can

use to transform unprofitable customers intoprofitable ones

Activity-based pricing establishes a base pricefor producing and delivering a standard quantity

for each standard product To this base price, the company provides a menu ofoptions, with associated prices, for any specialservices requested by the customer

Special services may be priced just to covercosts or also to earn a margin

Activity-based pricing prices orders, not products

Managing Relationships

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g g p

Companies can transform unprofitable customers intoprofitable ones by persuading the customer to use agreater scope of the companys products and services

The margins from such increased businesspurchases contribute to covering customer-sustainingcosts

If these efforts fail, the company may then contemplatefiring the customer

Some customers may be unprofitable only because it isthe start of the relationship with the company Companies can afford to be more tolerant of newly-acquired

unprofitable customers than they can of unprofitable customersthey have served for 10 or more years

ABC at Service Companies (1 of 2)

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Although ABC had its origins in manufacturing

companies, many service organizations today areobtaining great benefits from this approach

In practice, the actual construction of an ABC model isnearly identical for both types of companies

This should not be surprising since, in manufacturingcompanies, the ABC system focuses on the service

component of the company


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Service companies in general are ideal

candidates for activity-based costing Virtually all costs are indirect and appear fixed

They often do not have direct, traceable costs toserve as convenient allocation bases

They must supply virtually all their resources inadvance to provide the capacity to perform work forcustomers during each period

Implementation Issues (1 of 2)

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p ( )

Not all ABC systems have been sustained or contributedto higher profitability for the company Some companies have experienced difficulties and frustrations

in building and using activity-based cost and profitability modelsfor some of the following reasons

Lack of clear business purpose

The project may start in Accounting/Finance, and nobodyoutside the department understands what changes need to bemade and why

Lack of senior management commitment The group (usually Accounting/Finance) that initiates the project

probably does not have the authority to make decisions aboutprocesses, product designs, etc., without full senior managementsupport

Implementation Issues (2 of 2)

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p ( ) Delegating the project to consultants

Consultants are usually not familiar enough with the businesss

organization and problems and may not be able to buildmanagement consensus

Poor ABC model design The model may be too complicated to build and maintain and too

complex for managers to understand and act upon

Or the model may use arbitrary allocations that merely createdifferent distortions than the old system

The new data requirements may increase the workload of otherfunctions without increasing the benefits to them

Individual and organizational resistance to change

People may feel threatened by the suggestion that their workmight be improved

Resistance may be overt, but it may be more subtle and passive

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If you have any comments or suggestions concerningthis PowerPoint presentation, please contact:

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abc final asb 110211

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