Activity-Based Cost Management Systems

Rishiraj

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

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

Total Profitability by Product

Units Price Sales Material Labor
Overhead Total Mfg. Expenses

Blue 50,000 4.50

225,000

Black 40,000 4.50

180,000

Red 9,000 4.65

41,850

Purple 1,000 4.95

4,950

Total 100,000
451,800

75,000 30,000 90,000 195,000 30,000 13.3%

60,000 24,000 72,000 156,000 24,000 13.3%

14,040 5,400 16,200 35,640 6,210 14.8%

1,650 600 1,800 4,050 900 18.2%

150,690 60,000 180,000 390,690 61,110 13.5%

Gross Margin

G.M. %

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

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

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

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

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

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

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

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

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

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

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 lowvolume, newly designed products than for the highvolume, standard blue and black pens

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

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

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

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

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

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: 1) Develop the activity dictionary: the list of major activities performed by both the factorys human and physical resources 2) 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)

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

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

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

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:
ACTIVITY RUN MACHINES COST HIERARCHY UNIT LEVEL

HANDLE PRODUCTION RUNS

SETUP MACHINES SUPPORT PRODUCTS

BATCH LEVEL
BATCH LEVEL PRODUCT SUSTAINING

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

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

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

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

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

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 HANDLE PRODUCTION RUNS SET UP MACHINES SUPPORT PRODUCTS ACTIVITY COST DRIVER PRODUCTION RUNS SETUP HOURS NUMBER OF PRODUCTS

RUN MACHINES
PROVIDE FRINGE BENEFITS

MACHINE HOURS
LABOR DOLLARS

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

Completing the ABC Model (2 of 2)

The controller now had sufficient information to estimate a complete activitybased 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

Activity Cost Drivers

Activity Cost Driver Blue Black Red Purple Total**

DL hr/unit
Mch. hr/unit Prod. runs Setup time/run Total setup hr # of products **Total = per unit X quantity

0.02
0.1 70 4 280 1

0.02
0.1 65 2.4 156 1

0.02
0.1 50 5.6 280 1

0.02
0.1 15 5.6 84 1

2,000
10,000 200 -800 4

50,000

40,000

9,000

1,000

Activity Cost Driver Rates (ACDR)

Activity Activity Cost Driver Expense Driver Quantity
Handle Production Runs
Set up machines Support Products Run Machines

ACDR

66,000
33,600

Number of production runs

Number of setup hours Number of products Number of machine hours

200
800

330 per
run

42 per
setup hr

14,400
42,000 156,000

4
10,000

3,600 per
product

4.20 per
machine hr

Activity Expenses Assigned

Blue Black 21,450 6,552 3,600 16,800 Red 16,500 11,760 3,600 3,780 Purple 4,950 3,528 3,600 420 Total 66,000 33,600 14,400 42,000

Handle Production Runs

Set up machines Support Products Run Machines Total Costs Assigned

23,100 11,760 3,600 21,000

59,460

48,402

35,640

12,498

156,000

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

Total ABC Profitability by Product

Blue Sales
225,000

Black
180,000

Red
41,850

Purple
4,950

Total
451,800

Material Labor
40% fringe on DL

75,000 30,000 12,000

60,000 24,000 9,600

14,040 5,400 2,160

35,640 57,240

1,650 150,690 600 60,000 240 24,000

12,498 156,000 14,988 390,690

Support
Total Mfg. Expenses

59,460 48,402 176,460 142,002

Gross Margin

48,540
21.6%

37,998
21.1%

(15,390)
-36.8%

(10,038)
-202.8%

61,110
13.5%

G.M. %

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 productsustaining 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

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

Selecting Activity Cost Drivers (1 of 2)

Activity cost drivers are the central innovation of activitybased 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

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

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

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

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

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

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

Measuring The Cost Of 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

Measuring The Cost Of 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

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.

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

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

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

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

Making Committed Costs Variable 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

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

Managers Make Costs Fixed (2 of 2)

The organization receives no benefits from its activitybased 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

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

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

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

Time-Driven ABC: An 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

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

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

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

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

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: Resource Activity Indirect Labor Production Run Unit Time 5 hours

Support Products 50 hours

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:
Unit Cost Indirect Labor Resource + Computer Resource = Activity Cost Driver Rate 42 per hour 60 per hour Unit Time 5 hours/run 2 hours/run Cost Driver 210 per run 120 per run 330 per run

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

Tracing Marketing-Related Costs 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

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
ALPHA Sales 320,000 BETA 315,000

CGS
Gross Margin MSDA expenses (@35% of Sales) Operating profit Profit percentage

154,000
166,000 112,000 54,000 16.9%

156,000
159,000 110,250 48,750 15.5%

In many respects, however, the customers were not similar

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

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

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

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

Alpha Beta Example (6 of 7)

The picture of relative profitability of Alpha and Beta shifted dramatically
Alpha Gross Margin (as previously) Marketing & tech. support Travel to customer Distribute sales catalog Service customers Handle customer orders Warehouse inventory Ship to customers Total activity expenses Operating profit Profit percentage 166,000 7,000 1,200 100 4,000 500 800 12,600 26,200 139,800 43.7% Beta 159,000 54,000 7,200 100 42,000 18,000 8,800 42,000 172,100 (13,100) (4.2%)

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

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)

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

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

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

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

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

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

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

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

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

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

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

If you have any comments or suggestions concerning this PowerPoint presentation, please contact: Rishiraj Dasgupta (dasgupta.rishraj@gmail.com)