Activity-Based Cost Management Systems

1
Activity-Based CostManagement Systems

• Chapter 4

2
Problems With Simple Cost Accounting 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 product line into
  products with premium selling prices

3
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
  for blue and black pens
• Last year purple pens were added
• Could be sold at a 10 price premium
• The controller of Cooper Pen was disappointed
  with the most recent quarters financial results
• Overall profitability for all four together had
  decreased
• The red and purple pens, however, were more
  profitable than the blue and black pens

4
Total Profitability by Product
5
Concern at Cooper Pen

• The controller of Cooper Pen wondered whether the
  company should continue to deemphasize the blue
  and black commodity products and keep introducing
  new specialty colored pens
• Coopers manufacturing manager commented on how
  the introduction of colored pens had changed the
  production environment
• Everything ran smoothly when producing just blue
  and black pens in long production runs
• Difficulties started when the red pens were
  introduced and required more changeovers

6
Changes Caused by New Pens (1 of 2)

• Making black ink was simple there was not even a
  need to clean out the residual blue ink from the
  previous run if enough black ink was dumped in to
  cover it up
• Red required Cooper to stop production, empty the
  vats, clean out all remnants of the previous
  color, and then start the production of the red
  ink
• Even small traces of the blue or black ink
  created quality problems
• The ink for the purple pens also had demanding
  specifications, though not quite as demanding as
  the red ink

7
Changes Caused by New Pens (2 of 2)

• Cooper Pens was also spending more time on
  purchasing and scheduling activities and keeping
  track of existing, backlogged, and future orders
• Coopers manufacturing manager was concerned
  about rumors that new colors may be introduced 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

8
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 labor
  expenses for each of the four products
• From this information, it was easy to calculate
  the direct materials costs and direct labor costs
  for each color pen

9
Coopers Indirect Cost Allocation

• Because it was a small company and historically
  had 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 on each 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

10
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 production
  volumes and batch sizes
• Given the high cost of measuring and recording
  information, the accountants at the time judged
  correctly that a complex costing system would
  cost more to operate than the benefits it would
  provide

11
A Changed Production Environment

• Direct labor costs have decreased and indirect
  expenses have increased as a result of automation
• 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

12
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 production and
  service department cost centers, it could still
  encounter severe distortions in its reported
  product costs
• In an environment of high product variety, using
  only unit-level drivers (such as direct labor
  costs) to allocate overhead costs to products
  could lead to product cost distortion

13
Reason for Cost Distortions (1 of 3)

• A complex factory has a much larger production
  support staff because it requires more people to

• schedule machine and production runs
• perform setups
• inspect produced items after setup
• 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 much larger
  computer-based information system

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

14
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
  for smaller orders of specialty colors and other
  materials)
• Because all pens are about the same complexity,
  each pen would require the same number of direct
  labor hours and machine hours to produce
• The Cooper Pen Company factory has about the same
  property taxes, security costs, and heating bills
  as before, but it has much higher indirect and
  support costs because of its more varied product
  mix and complex production tasks

15
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
  report essentially identical product costs for
  all products, standard and specialty,
  irrespective of their relative production volumes
• This would hold true even if the cost system had
  multiple production and service cost centers
• Clearly, however, considerably more indirect and
  support resources are required on a per-unit
  basis for 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 cost distortion
• Activity-based cost (ABC) management systems use
  a simple two-stage approach similar to but more
  general than traditional cost systems
• The next slide compares the essential elements of
  the two systems

17
Traditional v. ABC System

• Traditional
• Uses actual departments or cost centers for
  accumulating and redistributing costs
• Asks how much of an allocation basis (usually
  based on volume) is used by the production
  department
• Service department expenses are allocated to a
  production department based on the ratio of the
  allocation basis used by the production
  department

• ABC
• Uses activities, for accumulating costs and
  redistributing costs
• Asks what activities are being performed by the
  resources of the service department
• Resource expenses are assigned to activities
  based on how much of the resource is required or
  used to 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 indirect
  expenses, beginning with indirect labor
• The controller interviewed department heads in
  charge of indirect labor and found that the
  people in these departments performed three main
  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 to
  another, 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 maintaining
  records on the four products, such as
• Making up the bill of materials and routing
  information
• Monitoring and maintaining a minimum supply of
  raw materials and finished goods inventory for
  each product
• 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 designing
  an activity-based cost system
• Develop the activity dictionary the list of
  major activities performed by both the factorys
  human and physical resources
• Obtain sufficient information to assign resource
  expenses to each activity in the activity
  dictionary (50 of indirect labor to handle
  production runs, 40 to perform setups, and
  10 to support products)

22
Computer System Expenses (1 of 2)

• The controller next turned her attention to the
  30,000 of expenses needed to operate the
  companys computer system and interviewed the
  manager of the data center and the manager of the
  management information system department
• 20 of computer expenses should be assigned to
  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 and seemed to
  relate well to the handle production runs
  activity already defined
• Schedule production runs in the factory
• Order and pay for the materials required in each
  production run
• Since each production run was made for a
  particular customer, also included in this
  activity was the computer 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 supply machine
  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 activity
  run machines

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Identifying Cost Hierarchies

• The controller noted that even though she had
  defined only four activities for Coopers
  indirect costs, they represented the three
  different levels of the manufacturing cost
  hierarchy

COST HIERARCHY
ACTIVITY
UNIT LEVEL
RUN MACHINES
BATCH LEVEL
HANDLE PRODUCTION RUNS
BATCH LEVEL
SETUP MACHINES
PRODUCT SUSTAINING
SUPPORT PRODUCTS

• Finding at least one activity for each hierarchy
  level gave her confidence that the complexity of
  the manufacturing process could be represented
  well enough by the activity-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 it had
  already provided some important insights
• Now the controller could see why Cooper Pens was
  incurring expenditures for resources instead of
  seeing categories of expenses
• In particular she saw how expensive activities
  such as handling production runs and setting up
  machines were
• The ABC model shifted the focus from what the
  money was being spent on (labor, equipment,
  supplies) to what the resources acquired by
  spending were actually doing

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From ABC to ABM (1 of 2)

• In the past, industrial engineers at Cooper Pen
  had 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 that the industrial engineers could
  achieve

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From ABC to ABM (2 of 2)

• It would be worthwhile to have industrial
  engineers study the way Cooper handled and
  scheduled production runs and how the employees
  set up machines to uncover new opportunities for
  cost reduction and process improvement projects
• This is an example of operational activity-based
  management (ABM), where managers use information
  collected by the ABC system at the activity level
  to identify opportunities for reducing costs in
  indirect and support activities

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Tracing Costs From Activities To Products

• The controller next turned her attention to
  understanding the demands for these activities by
  the four different products
• By understanding how products use activities, she
  would be able to relate the cost of performing
  activities to individual products

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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

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Completing the ABC Model (1 of 2)

• Once the activity cost drivers had been
  determined, the controller obtained quantitative
  information on
• The total quantity of each activity cost driver
• The quantity of cost driver used by each product

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Completing the ABC Model (2 of 2)

• The controller now had sufficient information 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 by the
  total quantity of the activity cost driver
• She then multiplied the activity cost driver rate
  by the quantity of each activity cost driver used
  by each of the four products

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Activity Cost Drivers
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Activity Cost Driver Rates (ACDR)
35
Activity Expenses Assigned
36
ABC Profitability Report

• The controller combined the activity expense
  analysis for each product with their direct
  materials and labor costs to obtain a new ABC
  profitability report
• The results from the activity-based costing
  system were quite 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 their incremental
  revenue did not cover those costs

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Total ABC Profitability by Product
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Using ABC to Improve Profitability (1 of 2)

• The ABC information provides managers with
  numerous insights about how to increase 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 profitable
  black and blue pens, which could generate new
  revenues 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
  to improve the performance of batch-level
  activities so that small batches of the specialty
  products would require fewer resources to produce
  and be less expensive
• The goal of these ABM actions is to enable the
  company to produce the same volume and mix of
  products with fewer resources
• This leads to lower costs for producing
  low-volume, specialty products, and reduces the
  pressure to raise prices or impose minimum order
  sizes on customers in order to make such products
  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
  driver used by each product
• Accordingly, it is important to understand the
  issues involved in selecting activity cost
  drivers
• The selection of an activity cost driver reflects
  a subjective 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 be estimated

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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 economize on the number of
  different activity cost drivers
• Activities triggered by the same event may all
  use the same activity cost driver
• For example, preparing production orders,
  scheduling production runs, performing first part
  inspections, and moving materials may all use the
  number of production runs
• ABC system designers choose from three different
  types of activity cost drivers
• Transaction
• Duration
• Intensity (direct charging)
• The choice of a transaction, duration, or
  intensity cost driver 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 of resources used by each is small
  enough that a transaction driver will be fine for
  assigning activity expenses to the cost object
• E.g., all setup times are between 30 and 35
  minutes
• If the amount of resources required to perform
  the activity varies considerably from product to
  product then more accurate and more expensive
  types of cost drivers should be 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 the amount 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 the resources
  required for complex products
• More expensive to implement because they require
  an estimate of time needed each time an activity
  is performed
• The choice between a duration driver and a
  transactional driver is, as always, one of
  economics
• Balancing the benefits of increased accuracy
  against the costs of increased measurement

44
Intensity Drivers

• Directly charge for the resources used each time
  an activity is performed
• A duration driver, such as setup cost per hour,
  assumes that all hours are equally costly but
  does not reflect the higher 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
  the output, based on work orders or other records
  that accumulate the activity expenses incurred
  for that output
• Intensity drivers are the most accurate activity
  cost drivers but the most expensive to implement
• Intensity drivers should be used only when the
  resources associated with performing an activity
  are both expensive and variable each time an
  activity is performed unless the measurements are
  inexpensive

45
Designing an ABC System (1 of 2)

• Sometimes ABC system designers get carried away
  with the potential capabilities of 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 be obtained
  simply and are available within their
  organizations existing information system

46
Designing an ABC System (2 of 2)

• The goal of an ABC system should be to have the
  best cost system -- not the most accurate one
• The ABC system designer should balance the cost
  of errors resulting from inaccurate estimates
  with the cost of measurement
• Most of the benefits from a more accurate cost
  system can be obtained with simple ABC systems

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Measuring The CostOf Resource Capacity (1 of 2)

• The calculation of activity cost driver rates are
  sometime based on the capacity actually used
• Analysts can obtain a better estimate for the
  cost of resources required to handle each
  production run by dividing activity expenses by
  the practical capacity of work the resources
  could perform
• Otherwise, the activity cost driver rates
  overestimate the cost of the activity provided
• The cost of unused capacity should not be
  assigned to products produced or customers served
  during a period

48
Measuring The CostOf Resource Capacity (2 of 2)

• The activity cost driver rate should reflect the
  underlying efficiency of the process the cost of
  resources to handle each production order
• This efficiency is measured better by using the
  capacity of the resources supplied as the
  denominator when calculating activity cost driver
  rates
• Still, the cost of unused capacity should not be
  ignored

49
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 capacity supplied
• For example, if the capacity was acquired to meet
  anticipated demands from a particular customer or
  a particular market segment, then the costs of
  unused capacity due to lower than expected
  demands can be assigned to the person or
  organizational unit responsible for that customer
  or segment
• Such an assignment is done on a lump-sum basis
  it will be treated as a sustaining, not a
  unit-level, expense.

50
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 that product 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, we
  trace the costs at the level in the organization
  where decisions are made that affect the supply
  of capacity resources and the demand for those
  resources
• The lump-sum assignment of unused capacity costs
  provides feedback to managers on their supply and
  demand decisions

51
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 of changes in the quantity of activities
  performed or because of changes in the efficiency
  of performing activities
• Second, managers must make decisions to change
  the supply of committed resources, either up or
  down, to meet the new level of demand for the
  activities performed by these resources

52
Activity in Excess of Capacity

• If activity volumes exceed the capacity of
  existing resources, 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 make
  committed 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

53
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 reductions will be noticed
• Even for many unit-level resources, such as
  machines and direct labor, reduced demands for
  work does not immediately lead to spending
  decreases
• The reduced demand for organizational resources
  lowers the cost of resources used, but this
  decrease is offset by an equivalent increase in
  the cost of unused capacity

54
Making Committed CostsVariable Downward

• After unused capacity has been created, committed
  costs will vary downward if, and only if,
  managers actively reduce the supply of unused
  resources
• What makes a resource cost variable downward is
  not inherent in the nature of the resource
• It is a function of management decisions
• To reduce the demands for the resource
• To lower the spending on it

55
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, when
  demands for the activities performed by the
  resources have diminished
• They also fail to find new activities that could
  be done by the unused resources already in place

56
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 do not exploit the opportunities from
  the unused capacity they helped to create
• Making decisions based solely upon resource usage
  (the ABC system) may not increase profits if
  managers are not prepared to reduce spending to
  align resource supply with future lower levels of
  demand

57
Problems Implementing ABC (1 of 3)

• Several problems arise in practice from the
  common approach to activity-based costing that
  assigns many resource expenses to activities
  based 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

58
Problems Implementing ABC (2 of 3)

• Inaccuracies and bias may affect the accuracy of
  cost driver rates derived from individuals
  subjective estimates of their past or future
  behavior
• Companies must periodically repeat the
  interviewing and 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
  cost driver estimates
• Adding new activities to the system is also
  difficult, requiring re-estimates of the relative
  amount of resource time and effort required by
  the new activity

59
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
  report percentages that add up to 100
• Few individuals report that a significant
  percentage of their time is idle or unused
• Accordingly, the cost driver rates calculated
  from this process assume that resources are
  working at full capacity
• But operations at capacity are more the exception
  than the rule

60
Time-Driven ABCAn Alternative Approach

• Several companies have overcome these problems by
  using a new approach for estimating their ABC
  models
• The insight for the new approach is simple
• Most ABC systems use a large number of
  transactional cost drivers that assume each
  occurrence of the event (a production run, a
  customer order, a product to support) consumes
  the same quantity of resources

61
Time-Driven ABC

• This homogeneity assumption provides the
  foundation for an alternative approach to
  estimating cost driver rates. The new approach
  requires two new estimates
• The unit cost of supplying capacity, and
• The consumption of capacity (unit times) by each
  activity

62
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 a
  percentage (e.g., 80 or 85) of theoretical
  capacity
• This estimate allows time (e.g., 15 20) for
  nonproductive time
• For personnel, time for breaks, arrival and
  departure, and communication and reading
  unrelated to actual work performance

63
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 capacity
  and practical capacity, the analyst can calculate
  the unit cost of supplying capacity

Unit cost
Cost of capacity supplied
Practical capacity of resources supplied
64
Unit Cost Estimate (3 of 3)

• For example, assume that indirect labor employees
  supply about 2,500 hours of labor in total each
  quarter at a cost of 84,000. The practical
  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

84,000
Indirect labor cost per hour
2000 hours
42 per hour
65
Unit Time Estimate

• The second piece of new information is an
  estimate of time used each time a committed
  resource performs a transactional activity
• Precision is not critical
• Rough accuracy is sufficient
• Estimates for the indirect labor from the Cooper
  Pen example are

66
Cost Driver Rate

• Assume similar calculations regarding computer
  resources produced estimates of 60 per hour and
  2 hours per production run
• The cost driver rate for the activity, handle
  production runs, can now be calculated as the
  costs of using indirect labor and the computer
  for each production run

67
Advantages of Time-Driven ABC

• Managers may easily update their time-driven ABC
  model to reflect changes in their operating
  conditions
• They can incorporate the new knowledge by
  providing reasonable 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
  been a shift in the efficiency of the activity

68
Tracing Marketing-RelatedCosts to Customers

• The costs of marketing, selling, and distribution
  expenses have been increasing rapidly in recent
  years
• Result of increased importance of customer
  satisfaction and market-oriented strategies
• Many of these expenses do not relate to
  individual products 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

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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) expenses were allocated to
  customers at a rate of 35 of Sales

• In many respects, however, the customers were not
  similar

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Alpha Beta Example (2 of 7)

• 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 modify products to meet its specific needs
• Betas account required many technical resources,
  in addition 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 Beta Example (3 of 7)

• 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 that
  Alpha was a much more profitable customer than
  the financial statements were currently reporting
• He launched an activity-based cost study of the
  companys marketing, selling, distribution, and
  administrative costs

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Alpha Beta Example (4 of 7)

• 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
  each activity 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

73
Alpha Beta Example (5 of 7)

• The manager also used a customer cost hierarchy
  that was similar to the manufacturing cost
  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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Alpha Beta Example (6 of 7)

• The picture of relative profitability of Alpha
  and Beta shifted dramatically

75
Alpha Beta Example (7 of 7)

• As the manager suspected, Alpha Company was a
  highly profitable customer
• Its ordering and support activities placed few
  demands 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 most
  unprofitable customer that the company had
• While the manager intuitively sensed that Alpha
  was a more profitable customer than Beta, he had
  no idea of the magnitude of the difference

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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 of customers
• Customers are ranked, on the horizontal axis from
  most profitable to least profitable (or most
  unprofitable)

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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 of total profits
• It is not unusual for some of the largest
  customers to turn out being the most unprofitable
• The largest customers are either the companys
  most profitable or its most unprofitable
• They are rarely in the middle

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Managing Customer Profitability (1 of 3)

• 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 competitive inroads
• The managers of a company serving them should be
  prepared to offer discounts, incentives, and
  special services to retain the loyalty of these
  valuable customers if a competitor threatens

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Managing Customer Profitability (2 of 3)

• The challenging customers, like Beta, appear on
  the right tail of the whale curve, dragging the
  companys profitability down with their low
  margins and high cost-to-serve
• The high cost of serving such customers can be
  caused 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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Managing Customer Profitability (3 of 3)

• The opportunities for a company to transform its
  unprofitable customers into profitable ones is
  perhaps the most powerful benefit the companys
  managers can receive from an activity-based
  costing system
• Managers have a full range of actions for
  transforming unprofitable customers into
  profitable ones
• Process improvements
• Activity-based pricing
• Managing customer relationships

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Process Improvements

• Managers should first examine their internal
  operations to see where they can improve their
  own processes to lower 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

82
Activity-Based Pricing

• Pricing is the most powerful tool a company can
  use to transform unprofitable customers into
  profitable ones
• Activity-based pricing establishes a base price
  for producing and delivering a standard quantity
  for each standard product
• To this base price, the company provides a menu
  of options, with associated prices, for any
  special services requested by the customer
• Special services may be priced just to cover
  costs or also to earn a margin
• Activity-based pricing prices orders, not products

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Managing Relationships

• Companies can transform unprofitable customers
  into profitable ones by persuading the customer
  to use a greater scope of the companys products
  and services
• The margins from such increased business
  purchases contribute to covering
  customer-sustaining costs
• If these efforts fail, the company may then
  contemplate firing the customer
• Some customers may be unprofitable only because
  it is the start of the relationship with the
  company
• Companies can afford to be more tolerant of
  newly-acquired unprofitable customers than they
  can of unprofitable customers they have served
  for 10 or more years

SOME CUSTOMERS MAY BE UNPROFITABLE ONLY BECAUSE
IT IS THE START OF THE RELATIONSHIP WITH THE
COMPANY. THE COMPANY MAY HAVE INCURRED HIGH COSTS
TO ACQUIRE THE CUSTOMER AND THE CUSTOMERS
INITIAL PURCHASES OF PRODUCTS OR SERVICES WERE
INSUFFICIENT TO COVER ITS ACQUISITION AND
MAINTENANCE COSTS. NO ACTION IS REQUIRED AT THIS
POINT. THE COMPANY EXPECTS AND HOPES THAT THE
CUSTOMERS PURCHASES OF PRODUCTS AND SERVICES
WILL INCREASE AND SOON BECOME PROFITABLE,
INCLUDING RECOVERING ANY LOSSES INCURRED IN THE
START-UP YEARS. COMPANIES CAN AFFORD TO BE MORE
TOLERANT OF NEWLY-ACQUIRED UNPROFITABLE CUSTOMERS
THAN THEY CAN OF UNPROFITABLE CUSTOMERS THEY HAVE
SERVED FOR 10 OR MORE YEARS.
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ABC at Service Companies (1 of 2)

• Although ABC had its origins in manufacturing
  companies, many service organizations today are
  obtaining great benefits from this approach
• In practice, the actual construction of an ABC
  model is nearly identical for both types of
  companies
• This should not be surprising since, in
  manufacturing companies, the ABC system focuses
  on the service component of the company

85
ABC at Service Companies (2 of 2)

• 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 to
  serve as convenient allocation bases
• They must supply virtually all their resources in
  advance to provide the capacity to perform work
  for customers during each period

86
Implementation Issues (1 of 2)

• Not all ABC systems have been sustained or
  contributed to higher profitability for the
  company
• Some companies have experienced difficulties and
  frustrations in building and using activity-based
  cost and profitability models for some of the
  following reasons
• Lack of clear business purpose
• The project may start in Accounting/Finance, and
  nobody outside the department understands what
  changes need to be made 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 about processes,
  product designs, etc., without full senior
  management support

87
Implementation Issues (2 of 2)

• Delegating the project to consultants
• Consultants are usually not familiar enough with
  the businesss organization and problems and may
  not be able to build management 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 create different distortions than the old
  system
• The new data requirements may increase the
  workload of other functions without increasing
  the benefits to them
• Individual and organizational resistance to
  change
• People may feel threatened by the suggestion that
  their work might 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
concerning this PowerPoint presentation, please
contactTerry M. Lease(terry.lease_at_sonoma.edu)S
onoma State University