Chapter 4

Chapter 4

Activity-Based Cost Management Systems

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 quarter's 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

Blue Black Red Purple Total

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

Price $4.50 $4.50 $4.65 $4.95

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

Material 75,000 60,000 14,040 1,650 150,690

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

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

Total Mtg. Expenses 195,000 156,000 35,640 4,050 390,690

Gross Margin $30,000 $24,000 $6,210 $900 $61,110

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

5

Concern at Cooper Pen

whether the company should continue to deemphasize the blue and black commodity products and keep introducing new specialty colored pens

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

Cooper'5 Indirect Cost Allocation

Cooper 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

Cooper Pen's Cost System

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 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

8

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

9

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

10

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 cost.

– Asks what activities are being performed by the resources of the service department

– Resource expense. ere assigned to activities based on how much of the resource i. required or used to perform the activities

11

Tracing Costs to Activities

Here's how an ABC system works, using the Cooper Pen Company as an example: – 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

12

Indirect Labor Activities (1of2)

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

13

Indirect Labor Activitie5 (2of2)

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 or materials and routing

information – Monitoring and maintaining a minimum supply or raw

materials and finished goods inventory for each product

– Improving the production processes – Performing engineering changes for the products

14

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 factory's 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")

15

Computer System Expenses (1of2) The controller next turned her attention to the $30,000

of expenses needed to operate the company's 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

16

Computer System Expenses (2of2) 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

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 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"

18

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

only four activities for Cooper's indirect costs. they represented 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

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

19

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

20

From ABC to ABM (1of2)

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 Cooper's 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

21

From ABC to ABM (2of2)

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

22

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

23

Activity Cost Drivers

Activity cost drivers represent the quantity of activities used to produce individual products

The controller identified the following activity cost drivers for the activities in her activity dictionary:

ACTIVITY ACTIVITY COST DRIVER

HANDLE PRODUCTION RUNS PRODUCTION RUNS

SETUP MACHINES SETUP HOURS

SUPPORT PRODUCTS NUMBER OF PRODUCTS

RUN MACHINES MACHINE HOURS

PROVIDE FRINGE BENERFITS LABOR DOLLARS

24

Completing the ABC Model (1of2)

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

25

Completing the ABC Model (2of2)

The controller now had sufficient information to estimate a complete activity- based cost model for Cooper Pen's 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

26

Activity Cost Drivers

Activity Cost Driver

Blue Black Red Purple Total**

DL hr/unit 0.02 0.02 0.02 0.02 2,000

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

Prod. Runs 70 65 50 15 200

Setup time/run 4 2.4 5.6 5.6 -

Total setup hr 280 156 280 84 800

# of products 1 1 1 1 4

**Total = per unit x quantity 50,000 40,000 9,000 1,000

27

Activity Cost Driver Rates (ACDR)

Activity Expense

Activity Cost Driver

Driver Quantity

ACDR

Handle Production Runs $66,000 Number of

production runs 200 $330 per run

Setup machines $33,600 Number of setup hours 800 $42 per

setup hr

Support Products $14,400 Number of products 4 $3,600 per

product

Run Machines $42,000 Number of machine hours 10,000 $4.20 per

machine hr

$156,000

28

Activity Expenses Assigned

Blue Black Red Purple Total

Handle Production Runs $23,100 $21,450 $16,500 $4,950 $66,000

Setup machines

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

Support Products

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

Run Machines

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

Total Costs Assigned $59,460 $48,402 $35,640 $12,498 $156,000

29

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 or 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

30

Total ABC Profitability by Product

Blue Black Red Purple Total

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

Material 75,000 60,000 14,040 1,650 150,690

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

40% fringe on DL 12,000 9,600 2,160 240 24,000

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

Total Mtg. Expenses 176,460 142,002 57,240 14,988 390,690

Gross Margin $48,540 $37,988 $(15,390) $(10,038) $61,110

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

31

Using ABC to Improve Profitability (1of2)

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

32

Using ABC to Improve Profitability (2of2) – 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 or unit-revel activities

– To reaming how to reduce setup times, in order to improve the performance or batch-Level activities so that small batches or the specialty products would require fewer resources to produce and be less expensive

The goal or 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 row-volume, specialty

products, end reduces the pressure to raise prices or impose minimum order sizes on customers in order to make such products profitable

33

Selecting Activity Cost Drivers (1of2) 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

34

Selecting Activity Cost Drivers (2of2) Because or the large number or potential activity-to-product

linkages, management accountants attempt to economize on the number or 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 or activity cost drivers:

– Transaction – Duration – Intensity (direct charging)

The choice or a transaction, duration, or intensity cost driver can occur for almost any activity

35

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 set-ups lake 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

36

Duration Drivers Represent the amount or 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 or 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 or 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

37

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

38

Designing an ABC System (1of2)

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 organization's existir1g information system

39

Designing an ABC System (2of2)

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

40

Measuring The Cost Of Resource Capacity (1of2)

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

41

Measuring The Cost Of Resource Capacity (2of2)

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

42

Cost of Unused Capacity (1of2) The cost of unused capacity remains someone's or

some department's responsibility Usually you can assign unused capacity after analyzing

the decision that authorized the lever of capacity supplied – For example, it the capacity was acquired to meet anticipated

demands from a par1icular 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-Ievel, expense.

43

Cost of Unused Capacity (2of2) 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

44

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

45

Activity in Excess of Capacity If activity volumes exceed the capacity or 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

46

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-Ievel 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

47

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

48

Managers Make Costs Fixed (1of2) 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

49

Managers Make Costs Fixed (2of2) 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

50

Problems Implementing ABC (1of3)

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

51

Problems Implementing ABC (2of3) – 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

52

Problems Implementing ABC (3of3)

– A more subtle and serious problem arises from the interview or survey process People estimating how much time they spend on

a list or activities handed to them invariably report percentages that add up to 100%

Few individuals report that a significant percentage or 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

53

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

54

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

55

Unit Cost Estimate (1of3) The new procedure starts with the same information

used by a traditional ABC approach: – The cost or resources that supply capacity and – The practical capacity or the resources supplied

Practical capacity is often estimated as a percentage (e.g., 80% or 85%) or 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

56

Unit Cost Estimate (2of3) – 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

57

Unit Cost Estimate (3of3) 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:

Indirect labor cost per hour =

= $42 per hour

$84,000

2,000 hours

58

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 Unit Time

Indirect Labor Production Run 5 hours

Support Products 50 hours

59

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 Unit Time Cost Driver

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

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

= Activity Cost Driver Rate $330 per run

60

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

61

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

62

Alpha -Beta Example (1of7) 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 or 35% or Sales

In many respects, however, the customers were not similar

ALPHA BETA

Sales $320,000 $315,000

CGS 154,000 156,000

Gross Margin $166,000 $159,000

MSDA expense (35% of sales) 112,000 110,250

Operating profit $54,000 $48,750

Profit percentage 16.9% 15.5%

63

Alpha- Beta Example (2of7)

Beta's 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

Beta's 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

64

Alpha- Beta Example (3of7) 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 company's marketing, selling, distribution, and administrative costs

65

Alpha- Beta Example (4of7)

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 or orders, number or mailings

– Duration drivers Estimated time and effort

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

66

Alpha- Beta Example (5of7)

The manager also used a customer cost hierarchy that was similar to the manufacturing cost hierarchy – Some activities were order-related

Handle customer ordersShip to customers

– Others were customer-sustaining Service customers Travel to customers Provide marketing and technical support

67

Alpha- Beta Example (6of7) The picture of relative profitability of Alpha and Beta Shifted dramatically

Alpha Beta

Gross Margin (as previously) $166,000 $159,000

Marketing & tech. support 7,000 54,000

Travel to customer 1,200 7,200

Distribute sales catalog 100 100

Service customers 4,000 42,000

Handle customer orders 500 18,000

Warehouse inventory 800 8,800

Ship to customers 12,600 42,000

Total activity expenses 26,200 172,100

Operating profit $139,800 $(13,100)

Profit percentage 43.7% (4.2%)

68

Alpha- Beta Example (7of7) As the manager suspected, Alpha Company 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

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

69

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)

70

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 company's most profitable or its most unprofitable

– They are rarely in the middle

71

Managing Customer Profitability (1of3)

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

72

Managing Customer Profitability (2of3) The challenging customers, like Beta, appear on the

right tail of the whale curve, drag9ing 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

73

Managing Customer Profitability (3of3) 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

74

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

75

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

76

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 – 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 or newly-acquired

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

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ABC at Service Companies (1of2)

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

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ABC at Service Companies (2of2)

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

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Implementation Issues (1of2) 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

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Implementation Issues (2of2) Delegating the project to consultants

– Consultants are usually not familiar enough with the business's organization and problem, 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 manager, 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 function,

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