Activity-Based Costs Management System

1. Activity-Based Costs Management System Topic 4 Management Accounting III

2. Simple Cost Accounting Systems: Ericson Ice Cream Company Example • Ericson had been the low-cost producer of chocolate and vanilla ice cream, with profit margins exceeding 20% of sales • Several years ago Ericson expanded their business by extending their product line into products with premium selling prices

3. Ericson Ice Cream Company Example • Five years ago strawberry ice cream was introduced • The same basic production technology • Could be sold at a price that was 3% higher than for blue and black pens • Last year mocha-almond ice cream was added • Could be sold at a 10% price premium • The controller of Ericson was disappointed with the most recent quarter’s financial results

4. Total Profitability by Product

5. Management’s Concern • The controller wondered whether the company should continue to deemphasize the chocolate and vanilla products and keep introducing new specialty premium flavors • Ericson’s manufacturing manager commented on how the introduction of specialty flavors had changed the production environment

6. Ericson’s Indirect Cost Allocation • Because it was a small company and historically had produced only a narrow range of products, Ericson used a simple costing system • All the plant’s indirect expenses were aggregated at the plant level and allocated to products based on each product’s direct labor cost • Currently the cost system’s 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

7. Ericson’s Cost System • Ericson’s management accountants designed the system years ago when: • Production operations were mostly manual • Total indirect costs were less than direct labor costs • Cooper’s two products had similar production volumes and batch sizes

8. An Outdated Cost System • Ericson operates with only a single cost center • Even if Ericson used multiple production and service department cost centers, it could still encounter severe distortions in its reported product costs

9. Reason for Cost Distortions • 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

10. 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

11. Traditional v. ABC System Traditional: • Uses actual departments or cost centers for accumulating and redistributing costs • 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

12. Traditional v. ABC System 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

13. Tracing Costs to Activities ABC at Ericson : • 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

14. Indirect Labor Activities • 50% of indirect labor was involved in what the controller called “handle production runs” • 40% of indirect labor actually performed the physical changeover from one flavor to another, an activity that she labeled “perform setups” • 10% of the time was spent on activities the controller called “support products”

15. First Steps in Design of An ABC System • Develop the activity dictionary: the list of major activities performed by both the factory’s human and physical resources • Obtain sufficient information to assign resource expenses to each activity in the activity dictionary

16. Computer System Expenses 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 80% of the computer resource was involved in the production run activity and seemed to relate well to the “handle production runs” activities

17. 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 ice cream: • The controller labeled this production activity “run machines”

18. Identifying Cost Hierarchies • The four activities for Ericson’s indirect costs represent the three different levels of the manufacturing cost hierarchy: ACTIVITY COST HIERARCHY RUN MACHINES UNIT LEVEL HANDLE PRODUCTION RUNS BATCH LEVEL SETUP MACHINES BATCH LEVEL SUPPORT PRODUCTS PRODUCT SUSTAINING

19. Benefits from first steps in an ABC System The ABC model shifts the focus from what the money was being spent on (labor, equipment, supplies) to what the resources acquired by spending are actually doing

20. From ABC to ABM Operational activity-based management (ABM) - managers use information collected by the ABC system at the activity level to identify opportunities for reducing costs in indirect and support activities

21. Activity Cost Drivers Activity cost drivers represent the quantity of activities used to produce individual products:

22. Completing the ABC Model • Once the activity cost drivers had been determined, the following quantitative information is needed: • The total quantity of each activity cost driver • The quantity of cost driver used by each product

23. Completing the ABC Model • Calculate the activity cost driver rate (ACDR) by dividing the activity expense by the total quantity of the activity cost driver • Multiply the activity cost driver rate by the quantity of each activity cost driver used by each of the four products

24. Activity Cost Drivers

25. Activity Cost Driver Rates (ACDR)

26. Activity Expenses Assigned

27. ABC Profitability Report ABC profitability report: • The results from the activity-based costing system were quite different from the results based on the traditional cost system • 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

28. Total ABC Profitability by Product

29. Using ABC to Improve Profitability • The ABC information provides managers with numerous insights about how to increase the company’s profitability: • Increase either their sales volume or prices for the specialty products • Impose minimum order sizes to eliminate short, unprofitable production runs • Increase demand for the highly profitable standard products • The goal of these ABM actions is to enable the company to produce the same volume and mix of products with fewer resources

30. Problems Implementing ABC Problems may arise in practice from the approach to activity-based costing that assigns many resource expenses to activities based on interviews, surveys, and direct observation of production and support processes because these activities are time-consuming and expensive

31. Problems Implementing ABC • 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 • 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

32. Tracing Marketing-Related Costs to Customers(Customer Profitability Analysis) • The costs of marketing, selling, and distribution expenses have been increasing rapidly in recent years • Many of these expenses do not relate to individual products or product lines but are associated with: • Companies need to understand the cost of selling to and serving their diverse customer base

33. Carver – Delta Example • Carver and Delta are customers generating about equal revenue and seen as equally valuable customers • A conventional cost accounting system, marketing, selling, distribution, and administrative (MSDA) expenses were allocated to customers at a rate of 35% of Sales

34. Carver – Delta Example • Delta required a great deal of hand-holding and was continually inquiring whether the company could modify products to meet its specific needs • Delta 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

35. Carver – Delta Example • Carver, 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 suspected that Carver was a much more profitable customer than the financial statements were currently reporting

36. Carver – Delta Example • The picture of relative profitability of Carver and Delta shifted dramatically

37. Carver – Delta Example • As the manager suspected, Carver was a highly profitable customer • Its ordering and support activities placed few demands on the company’s marketing, selling, distribution, and administrative resources • Almost all the gross margin earned by selling to Alpha dropped to the operating margin bottom line

38. 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)

39. Customer Profitability • 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

40. Managing Customer Profitability • High-profit customers appear in the left section of the profitability whale curve • These customers should be protected • They could be vulnerable to competitive inroads • The managers should be prepared to offer discounts, incentives, and special services to retain the loyalty of these valuable customers if a competitor threatens

41. Managing Customer Profitability • The challenging customers appear on the right tail of the whale curve, dragging the company’s 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

42. Managing Customer Profitability • The opportunities for a company to transform its unprofitable customers into profitable ones is perhaps the most powerful benefit the company’s 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

43. 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 • Customize products at the latest possible stage • Use information technology to enhance the linkages from design to manufacturing

44. 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 • Special services may be priced just to cover costs or also to earn a margin • Activity-based pricing prices orders, not products

45. Managing Relationships • Companies can transform unprofitable customers into profitable ones by persuading the customer to use a greater scope of the company’s products and services • 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 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 CUSTOMER’S 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 CUSTOMER’S 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.

46. ABC at Service Companies • 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

47. ABC at Service Companies • 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

48. Implementation Issues • Not all ABC systems have been sustained or contributed to higher profitability for the company • Lack of clear business purpose • Lack of senior management commitment • Delegating the project to consultants • Poor ABC model design • Individual and organizational resistance to change