CH-4-6 Activity-Based Costing Systems – Cost Management: Strategies for Business Decisions : Chapter Notes

This Document Contains Chapters 4 to 6 Chapter 4 Activity-Based Costing Systems Chapter Outline A. Cost Management Challenges — There are three questions addressed in this chapter. 1. Why is activity-based information useful for making business decisions? 2. What data and knowledge are necessary to support the development of activity-based information? 3. Is activity-based information always better than average-cost information? B. Learning Objectives — This chapter has eight learning objectives. 1. Describe how traditional costing could lead to under costing or over costing products. 2. Discuss the four ways used in activity-based costing system. 3. Identify the different level of resources and activities used in production processes. 4. Estimate the cost of activities and calculate a cost driver rate. 5. Assign activity costs to goods and services. 6. Analyze the profitability of products and customers. 7. Apply activity-based costing to service and merchandising. 8. Distinguish between activity-based costing, unit level costing, and ABC full costing of goods and services. C. Activity-based costing (ABC) is a costing system that assigns costs based on how work is done in an organization and is based on the need to continuously provide incentives for improvements. Using the value chain to follow the flow of activities and costs provides a useful foundation by which costs can be identified, classified, and traced. Typically, the value chain is a set of linked processes that flow in a logical sequence. It is useful, in an ABC system to split these processes into two categories — production processes and business processes. 1. Production processes include all of the activities that occur in order to manufacture product, to obtain merchandise, or to provide services for customers. 2. Business processes are those activities which occur that initiate production activity and allow the proper delivery of product to customers. 3. ABC is applicable to all types of organizations — manufacturing, merchandising, and service organizations. D. Different processes in an organization use resources differently. 1. Processes use physical resources, human resources, or both. a. Physical resources include materials, production space, supplies, and electricity. b. Human resources refer to employees (or personnel from another organization when outsourcing is used). c. An activity-based costing system recognizes that different processes use physical and human resources in differing quantities, for different reasons. 2. By using the ABC framework, managers can answer some key questions that allow decision making to be based on good information. a. What resources and activities are needed to accomplish an objective? b. Does an activity result in a profitable outcome? c. Does the organization have the capacity to successfully complete the activity being considered? d. If capacity is not adequate, should the company rearrange other activities, increase capacity, or outsource? E. One very useful way to assess the need for resources and evaluate the use of resources is to categorize them based on hierarchies. There are five resource hierarchies. 1. Unit-level resources are acquired and used for specific individual units of product or services. For instance, the raw materials used to make a table can be traced directly to that table. 2. Batch-level resources are acquired and used to make a group (or batch) of similar products. For instance the use of outsourced supervision to complete a batch of products to meet a deadline is a cost directly traceable to that batch. The costs are indirect to each individual unit of product but are directly related to the batch. 3. Product-level resources are acquired and used to make a specific product. For instance, equipment useful only for the production of a certain product fits this category. These resources may be indirectly related to batches or units. Product design costs also belong to this group of costs. 4. Customer-level resources are acquired to meet the needs of specific customers. For example, if a customer orders custom designed furniture and a designer is hired to design it, the cost can be directly traced to one customer. The costs of this resource may be indirectly related to product, batch, or unit-level decisions. 5. Facility-level resources are acquired and used to produce any products and services the organization may decide to offer for sale. Examples of the types of resources are buildings, land, employees, and production equipment. These resource acquisition decisions are directly related to decisions about scale and scope of operations. 6. Traditional cost systems use a volume-based approach to overhead cost allocation. As a result, high-volume products are overcosted and low-volume products are undercosted resulting in miscasting and mismanagement of resources and non-optimal decisions with regards to pricing and utilization of resources. F. Cost drivers can be either structural cost drivers or executional cost drivers. 1. Structural cost drivers determine (or drive) the overall makeup and structure of costs. Decisions about which resource the organization obtains determines what the organization is able to accomplish. 2. Executional cost drivers determine how the organization carries out its work. They are the policies, methods, and procedures that the organization uses to conduct its work. G. Activities related to each of the five types of resources are described next. One note about these activities — higher-level resources may be used to perform lower level activities. For instance, facilities-level resources may be used to perform customer-level activities. 1. Unit-level activities are those activities that result in the transformation of resources into individual units of products or services. These activities must be performed for every unit of product. 2. Batch-level activities allow the organization to complete groups of product simultaneously. For instance, production of 100,000 copies of a CD by one musical group requires a common set of personnel, recording facilities, and musical equipment. Different batches require different sets of resources. 3. Product-level activities occur to allow production of an entire product-line. Examples of these activities include product design, marketing and advertising, and development. An easy way to think about the costs associated with these activities is to recognize that the costs would not exist if the production decision was rejected. 4. Customer-level activities are performed to meet the needs of specific customers. Costs associated with these activities can easily be monitored if an organization produces only based on specific orders. This is often not the case. However, there are some costs that can be traced directly to a specific customer, such as shipping costs or costs that arise because of requests made by one specific customer. 5. Facility-level activities support all of the organization’s processes. They are the highest activity level. Costs of having top management are facility level activities. At the other end of the spectrum, janitorial and plant maintenance services are also at the facility level. This is true because both top management activities and janitorial services serve the entire organization and cannot be traced to a customer, batch, product, or unit of product. A good way to think about facility-level activities is to recognize that they would not go away even if some activities at the lower hierarchies did go away. Facility-level activities only disappear if the activities at the entire facility are discontinued. H. Tracing resources to activities can be split into two stages. Stage 1 consists of tracing the use of resources to the costs of activities. Stage 2 consists of assigning costs to products and services. Stage 1 can be divided into four steps. They are (1) identify and classify activities; (2) select costdriver bases; (3) measure activity cost per unit of cost-driver base; and (4) trace costs to activities. 1. Identify and classify activities. A first and necessary step in assigning costs is to identify, in as much detail as is practical, the activities in the value chain. There are three approaches that may be used to generate these activity lists. a. A “top-down” approach relies solely on an analysis team to develop the list of activities. A disadvantage of this approach is that the team may not have a thorough understanding of the processes and activities they are assigned to describe. b. The “interview or participative” approach includes input from employees actually performing the activities under study. The analysis team might still develop the list, but incorporates information obtained from the employees who are most knowledgeable regarding the activities. Although this approach may result in a more accurate depiction of the activities performed, there is a risk that employees may be unwilling to divulge correct information, for fear of negative repercussions. Also, employees’ recollection of how activities are performed may be inaccurate. Also, the interview approach is time-consuming. c. The “recycling” approach requires the use of documentation that has already been used for other purposes. The documentation is modified to fit the specifics of the activity under study. A standardized list, such as the one used to obtain ISO 9000 certification can be used as a starting point. Regardless of the approach used, the objective is to develop a list of the activities completed to achieve the goal (in this instance, making product or providing services). The next step after developing the list is to classify the list according to the activity level. Thus, each activity must be classified as unit, batch, product, customer, or facility-level. Use of resources must be planned and organized in a way that maximizes the efficiency of operations. 2. Select cost-driver bases. Consumption of resources generates costs. A cost-driver is an activity that causes costs to rise as the activity rises. The simplest example is the direct relationship between unit costs and increased production of units of product. The more units that are made, the higher the total cost of materials will be. A cost-driver base is a measurable cause of performing an activity and is what causes a cost to be incurred. a. Inappropriate cost-drivers distort cost assignments. If an organization produces only one product, or all products use resources in a similar fashion, then a very simple approach to cost assignment can be used. Most organizations, however, produce diverse products that use resources in different ways and quantities. Improper assignment of costs to different products may lead to incorrect production decisions, pricing, and sales decisions. b. Assignment of unit-level costs is the simplest cost-assignment problem. The costdriver base can be the unit of product itself. The higher the hierarchy, the more difficult the cost assignment problem becomes. Decisions related to facility-level activities are often long-term. Assignment of these costs may result in unintentional errors in decision making for lower-level activities. 3. Measure costs of activities. In order to properly assign costs generated by an activity, there must be a way to identify and quantify these costs. Traditional accounting information does not usually accumulate costs by activity; instead, costs are typically accumulated and summarized by functional activity. Adoption of an ABC system requires that the accounting information system be modified. 4. Trace resource costs to activities. a. A method must be developed to allow costs to be traced to activities. Work performed by employees in a given area may need to be documented in order to identify the steps taken by workers to produce products or services. Each activity performed should be identified in the identification and classification phase of Stage 1. At this point, it is also useful to identify non-value-added activities. b. Summing up costs of the activities should be the next step in the process of developing activity-based rates. Once the activity is defined, add up the costs of each resource used by an activity. These costs are summed up across employees, departments, and functions. c. Unutilized cost of capacity may be separated and reported separately to be able to isolate those costs from the utilized balance. I. The second stage in the process of assigning costs is to use the activity list and activity classifications obtained in Stage 1 to develop cost-driver rates. As was the case with Stage 1, this stage can be broken into several steps. (1) Condense the activity list developed in Stage 1. This list may need to be collapsed into broader categories. (2) Choose appropriate cost-driver bases to use in assigning costs of the condensed activities. (3) Identify the costs of the activities identified in the condensed list. (4) Compute a rate for each cost-driver base identified. Using this activity-based approach results in cost assignments that reflects the true costs of products. This is in contrast to more traditional costing approaches that apply costs more generically to various products. 1. Condense the activity list developed in Stage 1. The activity list developed in Stage 1 should be comprehensive. The organization should try to identify as many activities as possible, because this information can be used both for process improvement and to develop product costs. It may not be cost-beneficial, however, to develop a cost-driver rate for each and every activity. 2. Choose appropriate cost-driver bases to use in assigning costs of the condensed activities. For all activities, a cost-driver base must be identified as an appropriate way to assign the costs of an activity to products. Quantities of the cost-driver base must also be developed by week, month, or year. Without these quantities, a rate cannot be computed. 3. Identify the costs of the resources used for activities identified in the condensed list. The cost information can be obtained from accounting information and from interviews with appropriate personnel. 4. Compute a rate for each cost-driver base identified. Divide the cost of total resources, supplied by the total quantity of the cost-driver base, to get a rate per unit of cost driver. A rate is expressed as a dollar amount per unit of cost-driver base. J. Tracing costs of activities to products and services. Once the cost-driver rates are developed, costs can be assigned to products and services. Before costs can be assigned, an organization’s manager must decide whether to assign using the unit-level (throughput) ABC approach or the ABC full-costing approach. 1. The unit-level ABC approach assigns costs using throughput costing. Assigning unit- level costs is the simplest part of the cost-assignment process. For a manufacturer of products the materials used to make product may be the only unit-level cost. Some labor costs may also be identified at the unit level. Unit-level costs are assigned to each product based on the amount of the resource expected to be used by the product. A unit-level costing report will also show the costs, by product, of batch-level, product-level, and customer-level resources. Facility-level resource costs are not split among products because they cannot be traced to individual products. 2. The full cost ABC approach shows how activities use all levels of resources. Higher level costs such as facility-level costs are assigned to lower-level activities (like unit-level activities), using the cost-driver rates developed in Stage 2. 3. The unit-level ABC costing approach differs from the full ABC costing approach in one critical way. The full-costing approach treats higher-level costs as product costs, while the unit-level cost approach treats only unit-level costs as product costs. For unit-level costing approaches, all higher level costs are treated as operating expenses for the period. The unit-level ABC costing approach is similar to the variable or throughput cost approach. 4. Both unit-level cost information and full-costing information are useful to managers but for different reasons. a. Unit-level costing shows managers the impact of making additional units of product. Managers can assess the impact of changes in production output on existing capacity. If there is excess capacity, then producing additional units will only increase unit-level costs. Use of full-cost information cannot be used for decisions of this type. b. Full costing information shows how an organization uses all of its resources to produce products and services. Although full cost information is not useful for making decisions related to one specific product, they are useful for evaluating the use of higher-level resources to produce the bundle of goods being made. Managers responsible for many diverse products in more than one location may have no choice but to take a broad-brush approach to analyzing product costs such as those given via the full costing approach. K. Product and customer profitability analyses are important because they allow managers to decide which products and which customers are profitable. These types of analyses address the questions regarding which products should be dropped (or added) and which customers create the most cost? Are some customers worth the extra costs they cause? 1. Product profitability requires analysis of only those costs that are related to a specific product — unit-level costs and product-level costs. If a product is produced solely for a particular customer then those costs are also customer costs. Not only can managers assess profitability by identifying costs associated with a particular problem, but they can also assess the need to revise pricing based on the better information set obtained by use of product-specific costs. Looking at the product costs individually also allows managers to focus on the other, higher-level costs as a separate cost management issue. 2. Customer profitability analysis provides similar benefits. Customer costing occurs when cost information traceable to specific customers is collected and analyzed. Comparing customer costing with revenues generated by an individual customer is called customer profitability analysis. Use of profit information at the customer level allows managers to see which customers it should focus on to maintain or build the relationship with. Other customers may be targeted by the company as customers to work with, to bring costs down. 3. ABC is a useful tool for estimating the costs of new products. If processes and activities for the new product are similar to existing activities and processes, then the costs of making the new product can be easily estimated using the ABC system. Chapter 4 – Problem 1 LO: 6 Completion time: 40 Customer profitability Arman Printing has two types of customers; those with large orders and those with small orders. Arman has determined that marketing cost amounts to approximately $36,000. This amount is currently allocated based on sales volume. Sales to small customers amounted to $80,000 and those to large customers has amounted to $120,000. Cost of sales is approximately 60% of net sales. A total of 200 orders were placed last year for a total ordering cost of $8,000. Only 30 of these orders were for the large orders. Billing costs around $9,000 for the period for 300 invoices issued. 240 of invoices were for small-order customers. Warehousing cost amounted to $4,000. The warehouse handled 4,000 packages - about ½ of which was for small-order customers. The balance of the marketing cost was for use of company vehicles. The drivers report that 2/3 of the cost and distance traveled has been for servicing small customers. Required: Determine a) profit or loss by customer type under the traditional method, b) profit or loss using ABC costing. Problem 2 LO: 1 Completion time: 30 minutes Traditional Costing Shortcomings Saba Signs produces approximately one thousand signs each period. The signs which vary in size and intricacies are sold anywhere between 10 to $325 for each piece. The overhead is estimated to amount to $160,000 assuming a direct labor cost of $80,000, and a total of 4,000 machine hours. Here is some general data on the signs make up for this period: Item Number of signs DL $ per job Mach. Hrs. per job Material cost Small signs 6,000 $5 1/4th of an hour $6 Medium size 4,000 $8 ½ of an hour $10 Large size 2,000 $12 One hour $25 Required: Determine a) the predetermined overhead rate based on direct labor cost, b) cost per job using budgeted overhead and direct labor cost for allocation purposes, c) determine cost for each job, and d) total cost for each category of products using normal costing. Problem 3: LO: 1 Repeat problem 2 using machine hours as the allocation base. Problem 4: LO: 1 Repeat problem 2 assuming that 50% of overhead costs are related to direct labor and the balance are related to machine hours. Problem 5: LO: 2 Repeat problem 2 assuming that 20% of overhead costs are batch related, and there were 60 batches for small and midsize, and 40 batches for the large size group. The balance of overhead is to be equally divided between labor-related and machine-related costs. Comment on the disparity in costs that you see between problems 2, 3, 4, and 5. Solutions to the above problems appear on the following pages. Solution to Problem 1: a) Income Statement under traditional costing Small C Large C Total Sales 80,000 120,000 200,000 Cost of sales 48,000 72,000 120,000 Gross profit 32,000 48,000 80,000 Marketing costs 14,400 21,600 36,000 Income 17,600 26,400 44,000 Solution to problem 2: a) Predetermined overhead rate based on DL $: $160,000 / $80,000 = $2 per direct labor dollar Item DM DL OH TOTAL QTY AMOUNT Small size $ 6.00 $ 5.00 $ 10.00 $ 21.00 6,000 $ 126,000.00 Medium size $ 10.00 $ 8.00 $ 16.00 $ 34.00 4,000 $ 136,000.00 Large size $ 25.00 $ 12.00 $ 24.00 $ 61.00 2,000 $ 122,000.00 Total $ 384,000.00 Solution to problem 3: a) Predetermined overhead rate based on machine hours: $160,000 / 4,000 = $40 Machine time needed: ¼ hour, ½ hour, one hour for the sizes below respectively: Item DM DL OH TOTAL QTY AMOUNT Small size $ 6.00 $ 5.00 $ 10.00 $ 21.00 6,000 $ 126,000.00 Medium size $ 10.00 $ 8.00 $ 20.00 $ 38.00 4,000 $ 152,000.00 Large size $ 25.00 $ 12.00 $ 40.00 $ 77.00 2,000 $ 154,000.00 Total $ 432,000.00 Solution to problem 4: a) Predetermined overhead rates: Labor-related overhead: (160,000/2)/80,000 = $1 per labor dollar Machine related overhead: (160,000/2)/4,000 = $20 per machine hour Item DM DL L. OH M. OH TOTAL QTY AMOUNT Small size $ 6.00 $ 5.00 $ 5.00 $ 5.00 $ 21.00 6,000 $ 126,000.00 Medium size $ 10.00 $ 8.00 $ 8.00 $ 10.00 $ 36.00 4,000 $ 144,000.00 Large size $ 25.00 $ 12.00 $ 12.00 $ 20.00 $ 69.00 2,000 $ 138,000.00 Total $ 408,000.00 Solution to problem 5: a) Predetermined overhead rates: Labor-related overhead: (160,000 * .40)/80,000 = .80 Machine-related overhead: (160,000 * .40)/4,000= 18 Batch-level related overhead (160,000 * .20)/160 = 200 Item DM DL L. OH M. OH B. OH TOTAL QTY AMOUNT Small size $ 6.00 $ 5.00 $ 4.00 $ 4.50 $ 2.00 $ 19.50 6,000 $ 117,000.00 Medium size $ 10.00 $ 8.00 $ 6.40 $ 9.00 $ 3.00 $ 33.40 4,000 $ 133,600.00 Large size $ 25.00 $ 12.00 $ 9.60 $ 18.00 $ 4.00 $ 64.60 2,000 $ 129,200.00 Total $ 379,800.00 Using different allocation bases provides different results. It is important to find the association between the costs and cost drivers to be able to arrive at the most accurate costs. Particularly in a competitive environment where margins are low, having a better handle on costs and margins is important for future viability of the firm. Sample Quiz 1. Facility-level resources are a. acquired for individual units of product or service. b. acquired for making a group of similar products. c. acquired to produce and sell a specific product. d. acquired to serve specific customers. e. acquired to provide a general capacity to produce products and services. Answer: e Learning Objective: 3 Facility-level costs are acquired to provide general capacity to produce products and services. These costs are often the hardest (and mostly impossible) to logically allocate or trace to individual cost objectives. 2. Unit-level resources are a. acquired for individual units of product or service. b. acquired for making a group of similar products. c. acquired to produce and sell a specific product. d. acquired to serve specific customers. e. acquired to provide a general capacity to produce products and services. Answer: a Learning Objective: 3 Unit-level resources are acquired for individual units of product or service. 3. Examples of facility level activities are a. central administration, legal services, finance, and accounting. b. human resources, security, and custodial services. c. advertising and promotion, material supply, and product design. d. All of the above. e. a and b Answer: e Learning Objective: 3 Facility-level activities (like those listed under a and b) service the whole spectrum of products or services and are difficult to pin-point them to either one. 4. Examples of customer-level activities are a. to set up machine and begin production run. b. to remove pieces and inspect. c. invoicing, packaging, and shipping. d. All of the above. e. a and b Answer: c Learning Objective: 3 Invoicing, packaging, and shipping are costs that are related to customers and can be broken down for proper analysis. 5. An appropriate cost driver base should a. have a cause-and-effect relationship with the activity and the use of resources. b. predict or explain activities use of resources with reasonable accuracy. c. be based on the practical capacity of the resource to support activities. d. All of the above. e. a and b Answer: d Learning Objective: 4 An appropriate cost driver would have all of these qualities in order to be useful and be a good predictor of costs. 6. An appropriate cost driver for a product-level resource is a. the number of units by type. b. the customer type. c. the hours spent. d. the employee headcount. e. None of the above. Answer: e Learning Objective: 4 An appropriate cost driver for a product-level resource are things such as product design or parts administration which are related to specific products and can be gauged accordingly. 7. XY Company produces products x and y. The direct cost of x is $250 per unit and y is $350 per unit. Fifty units of x and 150 units of y were produced. Overhead amounting to $130,000 is allocated to products using direct costs as the relevant cost driver. Cost of x per unit amounts to a. $750 b. $1,000 c. $1,250 d. $1,500 e. None of the above. Answer: a Learning Objective: 5 Direct cost: (250 * 50) + (350 * 150) = 12,500 + 52,500 = 65,000 Overhead rate: 130,000 / 65,000 = $2 per dollar of direct cost Cost of x: 250 + (250* 2) = $750. 8. XY Company produces products x and y. The direct cost of x is $250 per unit ($100 materials and $150 labor) and y is $350 ($230 material and $120 labor) per unit. Fifty units of x and 150 units of y were produced. Overhead amounts to $130,000 and is composed of material handling $12,000, labor support $60,000, machine operation $48,000, and general administration $10,000. Material handling cost driver is material cost, labor support cost driver is labor cost. Machine operation cost resulted from running the machines a total of 480 hours (3/4th of which was for product x). General administration effort related equally to product x and y. Material handling chargeable per unit of y (rounded) amounts to a. $30.00 b. $50.00 c. $60.00 d. $70.00 e. None of the above. Answer: d Learning Objective: 5 Direct material cost: (50 * 100) + (150 * 230) = 5,000 + 34,500 = $39,500. Material handling overhead to y: 12,000 * (34,500 / 39,500) = $10,480.80. Material handling and per unit: 10,480.80 / 150 = $69.87 or about $70. 9. XY Company produces products x and y. The direct cost of x is $250 per unit ($100 materials and $150 labor) and y is $350 ($230 material and $120 labor) per unit. Fifty units of x and 150 units of y were produced. Overhead amounts to $130,000 and is composed of material handling $12,000, labor support $60,000, machine operation $48,000, and general administration $10,000. Material handling cost driver is material cost, labor support cost driver is labor cost. Machine operation cost resulted from running the machines a total of 480 hours (3/4th of which was for product x). General administration effort related equally to product x and y. Machine operation chargeable per unit of x amounts to a. $80 b. $240 c. $480 d. $720 e. None of the above. Answer: d Learning Objective: 5 Machine operation per unit of x: 48,000 *. 75 = $36,000; 36,000 / 50 = $720. 10. XY Company produces products x and y. The direct cost of x is $250 per unit ($100 materials and $150 labor) and y is $350 ($230 material and $120 labor) per unit. Fifty units of x and 150 units of y were produced. Overhead amounts to $130,000 and is composed of material handling $12,000, labor support $60,000, machine operation $48,000, and general administration $10,000. Material handling cost driver is material cost, labor support cost driver is labor cost. Machine operation cost resulted from running the machines a total of 480 hours (3/4th of which was for product x). General administration effort related equally to product x and y. General administration per unit of y (rounded) amounts to a. $33 b. $67 c. $100 d. $132 e. None of the above. Answer: a Learning Objective: 5 General administration per unit of y: 10,000 * .50 = 5000; 5000 / 150 = 33.33. 11. ABC full costing a. is consistent with the theory of constraints. b. traces only the costs of unit-level resources supplied. c. traces only the costs of unit-level resources supplied and used. d. a and c e. None of the above. Answer: e Learning Objective: 8 ABC full costing attempts to trace all indirect costs to individual units of a product. 12. ABC unit level costing a. shows how the organization uses all of its resources to produce products and services. b. may not show an accurate measure of adding or deleting a product. c. shows which higher level resources are used to produce a specific output. d. All of the above. e. None of the above. Answer: e Learning Objective: 8 ABC unit level costing focuses on unit (volume) based costs and does not allocate the rest of the overhead. 13. ABC full costing a. may be an efficient way of identifying profitable and unprofitable products. b. is more appropriate for long-term decisions of product mix and profitability. c. is more appropriate for short-term decisions of product mix and profitability. d. a and b e. None of the above. Answer: d Learning Objective: 5 ABC full costing is an efficient way of determining profitable and unprofitable products and is more appropriate for long-term decisions of product mix and profitability. Use the following data to respond to questions 14 through 20. Consider the following facts for NM Company which produces product N and M. Activity Cost Driver N’s Share M’s Share Unused Cost Set ups # of set ups 10 40 5 $ 5,000 Ordering # of orders 5 10 5 3,200 Receiving # of receipts 22 12 6 2,400 Product dev. # of parts 180 120 100 2,800 Gen. Mgmt. # of labor hours 2,900 4,100 1,000 7,200 Security area covered 3,200 5,400 400 9,000 Materials # of units prod. 400 800 120,000 Labor # of DL hours 1,700 3,100 1,200 56,000 14. Set up cost chargeable per unit of N ignoring the unused capacity amounts to a. 2.50 b. 2.75 c. 5.00 d. 5.50 e. None of the above. Answer: a Learning Objective: 7 Set up cost per unit of N: 5,000 * (10/50) = 1,000; 1,000 / 400 = $2.50. 15. Ordering cost chargeable per unit of N accounting for unused capacity amounts to a. 2.00 b. 2.67 c. 3.00 d. 4.00 e. None of the above. Answer: a Learning Objective: 7 Ordering cost per unit: 3,200 / 20 = $160; 160 * 5 = 800; 800 / 400 = 2. 16. Receiving costs per unit of N ignoring the unused capacity amounts to a. .90 b. 1.06 c. 3.30 d. 3.88 e. None of the above. Answer: d Learning Objective: 7 Receiving cost per unit of N: 22/34 = .6471; .6471 * 2,400 = $3.88. 17. Product development cost per unit of M accounting for unused capacity costs amounts to a. 1.05 b. 1.40 c. 3.15 d. 4.20 e. None of the above. Answer: a Learning Objective: 7 2,800 / 400 = 7; 7 * 120 = 840; 840 / 800 = $1.05 product development cost per unit of M. 18. General management cost per unit of N ignoring unused capacity costs amount to a. 4.61 b. 5.27 c. 6.53 d. 7.46 e. None of the above. Answer: d Learning Objective: 7 2,900 / 7,000 * 7,200 = $2,983; 2,983 / 400 = $7.46 GM cost per unit of N. 19. Overhead cost per unit of N using ABC full costing amounts to a. $20.25 b. $22.31 c. $25.25 d. $27.25 e. None of the above. Answer: c Learning Objective: 8 [(5,000 / 55) * 10] + [(3,200 / 20) * 5] + [(2400 / 40) * 22] + [(2800 / 400) * 180] + [(9000 / 9000) * 3,200] = 10,099.10; 10,099.10 / 400 = $25.25 20. The cost of unused capacity amounts to a. $ 3,260 b. $ 3,660 c. $ 14,815 d. $ 16,260 e. $ 14,460 Answer: c Learning Objective: 5 [(5,000 / 55) * 5 ] + [(3,200 / 20) * 5 ] + [(2,400 / 40) * 6] + [(2,800 / 400) * 100] + [(9,000 / 9,000) * 400] + [(56,000 / 6,000) * 1,200] = $14,814.55. Chapter 5 Activity-Based Management Chapter Outline A. Cost Management Challenges — Chapter 5 presents three questions to be answered in this chapter. 1. Is activity-based costing (ABC) enough by itself to improve efficiency? Can cost managers ensure that an organization will meet its efficiency goals merely by measuring costs more accurately by using ABC? 2. Does the cost manager’s responsibility end with making recommendations for improvements? Are the numbers generated by ABC, by themselves, enough to guide managers to correct decisions regarding resource use? 3. How does one know that activity-based methods of cost management are worthwhile? B. Learning Objectives — This chapter has six learning objectives. 1. The key steps of an activity-based management system are presented. 2. How to use activity-based costing for target costing. 3. Ways to identify and measure the costs of activities that do or do not add value in organizations. 4. How the elements of an ABM system can help to identify opportunities for process improvements. 5. Evaluate capacity utilization by identifying resources supplied and resources used. 6. Understand the methods and the problems of implementing ABC and ABM. C. Activities-based Management (ABM) allows managers to evaluate costs and values of process activities to identify opportunities for improved efficiency. 1. Activity-based costing (ABC) focuses on (1) understanding how resources are used in current processes and (2) measuring accurate product and service costs, given those processes. 2. ABC provides input to but is not a cost management system. 3. ABM combines ABC analysis and value-added analysis. 4. ABC determines major activities within the value chain and identifies the organization’s cost drivers and cost-driver rates appropriate for each activity. ABM adds customer-perceived value of each activity, identifies value-added and nonvalue-added activities, and gives managers opportunities to enhance value-added activities and to reduce non-value-added activities. D. ABC is the foundation for process improvements. 1. There are five steps used in ABC. a. Identify and measure different levels of resource spending. Resources result from management decisions to supply capacity at unit, batch, product, customer, and facility levels to perform activities. b. Costs of individual activities are measured. This means determining the costs of resources used to perform activities at all levels (unit, batch, product, customer, and facility levels). c. Cost-driver bases are identified, and cost-driver rates are determined. d. Cost-driver rates are used to assign activity costs to products, jobs, services, and projects. e. Profitability of products and services is analyzed using ABC unit-level and fullcosting approaches. Unit-level costing considers the impact of various products on spending for resources. Full-costing considers the use of resources. Both unitlevel and full-costing information is useful for decision making with respect to products and services. It is also useful information for controlling the levels and amounts of resources required. 2. Once ABC is adopted and implemented in an organization, the next logical step toward achieving ABM is to combine ABC and target costing. Target costing is based on determining target revenues and subtracting target profits. If costs derived from the ABC system (called the currently feasible cost) exceed the target cost, then costs must be reduced. In a competitive environment, organizations must conclude that, if their currently feasible costs exceed what target costs are, there may be inefficiency in their operations or there may be non-value-added activities and costs that need to be eliminated. E. Value-added activities enhance the value of products and services in the eyes of the customer while meeting the goals of the organization. Non-value-added activities do not contribute to customer-perceived value. 1. Both internal and external customers determine what value-added activities are. However, the true measures of value-added qualities exhibit themselves when external customers agree to pay for them. Non-value-added activities do not contribute to customer-perceived value, and so eliminating such activities will not reduce customer value. Their elimination will, however, eliminate their cost. 2. Eliminating non-value-added activities is a competitive necessity. In a competitive environment, an organization should eliminate as much waste as possible, because competitors are constantly working to create more value for customers at lower cost. Failure to eliminate non-value-added activities and costs results in a price that is too high to be competitive. This results in lost sales. Alternatively, costs that are too high may result in profits that are too low to stay in business. a. Even in environments where competition is non-existent, organizations cannot afford to become complacent. For instance, American automobile manufacturers were unprepared for the onslaught of less expensive, more reliable Japanese automobiles during the late 1970s and early 1980s. It took many years for American auto companies to restructure production activities so that non-valueadded activities could be eliminated. Because of unionized workforces in the US auto industry, there are some non-value-added activities that cannot be eliminated because of contractual agreements between workers and the companies. Another non-competitive setting that was redefined occurred with the deregulation of industries like telecommunications, trucking, and the airlines. b. It is critical to identify non-value-added activities so that they can be reduced or eliminated. In manufacturing firms, non-value-added activities include unnecessary inventory — bottlenecks that slow productivity, time, and effort to move processing forward — and inefficient processing. 3. Value-added activities can be identified by answering two questions. First, one should ask whether an external customer would encourage the organization to do more of the activity. Second, one should ask whether an organization would be more likely to reach its goal by performing that activity. a. Organizations must not only determine whether activities are value-added or not, they must somehow quantify the value of activities. Some activities, while clearly not viewed as value-added from a customer’s perspective, may be necessary because of laws, organizational policy, or even societal norms. Even if a dollar amount cannot be assigned to an activity, it needs to at least be ranked or rated in some way. For instance, one could say that, on a scale of 1 to 5, some activities are rated as 1 (clearly non-value-added) to 5 (clearly valueadded). b. Measurement and evaluation of activities should be performed by someone who is objective and knowledgeable about what customers value. The evaluator must also know what the organization must do to meet its goals. There are two obvious barriers to finding such an evaluator. i. Everyone’s knowledge is limited to his or her own experiences and knowledge base. ii. Everyone is potentially biased in his or her responses. These two problems are reasons for seeking input to the evaluation process from as many, diverse evaluators as is practical. 4. If organizations use a team approach to evaluating value-added activities, they may seek input not only from team members but also from internal and external customers. a. The process of identifying and ranking activities can be an overwhelming task. Moreover, since reducing or eliminating non-value-added activities may affect the livelihood of employees, it can become a politically sensitive endeavor. b. Because functional areas and various departments and processes are linked and depend on each other, activities cannot be evaluated in isolation. For instance, suppose materials inventory is evaluated, and it is judged to be too large. Some organizations view any inventory on hand to be non-value-added. Evaluation of inventory levels without considering production needs or lead times necessary to obtain adequate materials would be a pointless exercise that might lead to bottlenecks, another non-value-added event. F. ABM requires that various tasks be performed. ABM has two objectives. First, ABM aims to identify non-value-added activities to reduce or eliminate. It also aims to identify value-added activities to enhance or build upon. Second, ABM aims to redesign processes so that productive activity can be completed without unneeded non-value-added activities. 1. Non-value-added activities cannot be eliminated without redesigning processes. A starting point for eliminating non-value-added activities is to perform detailed activity analysis. a. Activities must be listed item by item and ranked according to perceived customer value. A cost must be assigned to the activity. b. Once activities are split into broad categories, they should be broken down again into sub-categories. These sub-categories are ranked, costs assigned, and assessed for the contributions each makes to the total cost and its contribution to value. c. It is during this activity analysis that ideas for redesign of the process begin to emerge. Activities with low ratings on the value-added scale should be reduced or eliminated. G. A major objective of the activity analysis is to identify opportunities for process improvement. 1. Part of the analysis process should involve a persistent asking of the question “why” in order to determine the real reason an activity is performed. 2. After identifying non-value-added activities and taking steps to eliminate them, a next logical question to ask is what to do with the savings. If currently feasible costs exceed target costs, the first response must be to reduce costs to the level of the target. Any savings beyond that can be used to reduce prices, increasing the perceived value in the eyes of customers, or to shift the saved resources to value-added activities. H. Capacity utilization procedures help identify resources supplied and resources used. 1. Resources supplied provide the detail for available capacity to be utilized. 2. Resources used is that part of the capacity that is actually used in providing goods and services. 3. The difference between resources supplied and used is the total unused capacity. Keeping track of the cost of unused capacity provides information for management for better utilization of resources and for shifting or modifying or eliminating the unused capacity for optimum results. I. Activity-Based Costing and Management offer feasible ways to evaluate and improve efficiency of processes. Their benefit may well exceed their costs. While ABC provides improved product or service cost information, ABM identifies opportunities for improving processes. Most organizations can benefit from process improvements. Critics of ABC have cited its failure to generate product costs that are significantly different from traditional, functional costs and argue that the costs of developing, implementing, and maintaining ABC far outweigh the benefits. However, advocates of ABM respond by arguing that ABC product costs should be viewed merely as a by-product of ABM and process improvement efforts. This is much more important than having accurate product cost information. Activity-based costing and management, while conceptually appealing, are non-trivial to implement. There are several factors that appear to influence the likelihood of success or failure in implementing ABC or ABM. They are presented below. 1. Are ABC and ABM for every organization? ABC and ABM seem to be practical tools in complex organizations that produce many complex products. Organizations that have been confronted by intense competition have been at the forefront of the ABC/ABM movement. These organizations have chosen ABM as a way to improve processes and profitability. Organizations using ABM include manufacturing and service firms, as well as organizations facing competition because of deregulation of their industry. 2. Can the success of ABC and ABM be guaranteed? The obvious answer to this question is no. However, for those organizations that have found success in implementing ABC and ABM, a key to their success is in planning properly. The six Ps of planning that should be followed are Prior Planning Prevents Particularly Poor Performance. For ABC and ABM, there are five planning issues that should be considered. a. The intended scope of the ABC or ABM project needs to be decided upon. An ABC and/or ABM system can be implemented and used by cost managers, or it can be expanded to encompass all activities of an organization. Regardless of the planned scope of the use of ABC and ABM, it is most wise to begin small. A pilot project is the best way to introduce ABC or ABM to an organization. Translating the technical requirements of ABC and ABM into a feasible pilot project gives people in an organization time to learn, provides experience in identifying links across departments, groups, processes, and the data gathering and reporting requirements of the full-scale implementation. b. There are several factors that increase the likelihood of success in implementing an ABC and/or ABM system. The following resources need to be in place. i. Management commitment is critical to the success of planned development and implementation of ABC or ABM. Unless top management is willing to act on recommendations of the people who are planning and developing ABC/ABM, it is unlikely that the new system will have much of an impact on the organization. It is the responsibility of cost managers to clearly and accurately educate top management about the costs and benefits of the new system. ii. Adequate personnel and time must be dedicated to the development and implementation of ABC and ABM. A three or four-person team that is composed of cross-functional members must be freed of their other duties for as long as six months (sometimes longer). Failure to adequately man the project will result in a poorly planned endeavor that will, of necessity, include shortcuts and mistakes and increase the likelihood of failure. iii. Proper software and consultants to assist in the development and implementation of the system are also critical to the success of planned development and implementation of ABC/ABM. Most organizations must seek outside consultants to develop an ABC system. There is commercial software that can be purchased and adapted to the particular needs of an organization. Development of an ABC/ABM system inhouse makes it necessary for employees to maintain and update the system on an ongoing basis. This is not always possible. Using outside consultants who specialize in the development, implementation, and maintenance of computer systems will bring the needed technical expertise to the project. c. A factor that spells doom for ABC and ABM, if not addressed from the very beginning of planned development of ABC and ABM, is resistance to change. Employees may feel threatened by the changes that ABC or ABM will undoubtedly bring. For some employees, these fears are well-founded. One of the objectives of ABM is to identify and eliminate non-value-added activities. This may result in the elimination of employees. Preventing resistance to change can be minimized by educating and training employees, by encouraging widespread sponsorship and participation, and by rewarding change. The team responsible for planning may need to identify ways to shift employees doing non-valueadded work to areas of value-added work. This is not always possible. International companies need to be especially aware of cultural differences in deciding what roles should be played by employees. In some cultures, employees think it is unacceptable to challenge managers who are their superiors. In this case, a “bottom up,” participative approach to implementing the new system may not work. A “top down” approach may be necessary. d. Information that must be gathered by the team before the ABC/ABM system can be developed is not easy to obtain. First of all, the information is usually not available from the organization’s information system. Observation, interview, or survey of employees must be used to generate information needed. The information obtained must be as accurate as is possible and practical in order to develop a sound, workable system. e. The analysis team must make recommendations to top management after the study phase is complete. The team is the only group with intimate knowledge of the proposed system, including its strengths and weaknesses. The team needs to convey its recommendations clearly and honestly if the system is to succeed. Problem 1. Chapter 5 LO: 5 Capacity Utilization Required time: 30 minutes Arman Company has identified the following cost pools for its marketing and distribution functions: order processing, billing, and warehousing. Order processing can handle 200 orders in a period, but only 160 orders were processed. Billing can handle 300 invoices, but only 254 invoices were processed. Warehousing can accommodate 3000 packages, but only 2,150 packages were handled. Shipping can handle 500 shipments, but only 412 shipments were handled. Total cost for these four areas amount to $40,000, $30,000, $60,000, and $20,000 respectively. Required: Determine, a) the total cost of capacity provided, b) the total cost of capacity used, c) the total cost of unused capacity, d) what can be done with the unused capacity. Solution: Order processing 40000 # of orders 200 200 160 32000 40 8000 Billing 30000 # of invoices 300 100 254 25400 46 4600 Warehousing 60000 # of deliveries 3000 20 2150 43000 850 17000 Shipping 20000 # of shipments 500 40 412 16480 88 3520 Total amount 150000 116880 33120 Item Amount Cost driver Volume Unit cost C. Used Cost Unused Cost The company must think in terms of a) synchronizing the needs among activities in order to optimize the situation, b) reduce capacities and cut costs where-ever excess capacity exists, or c) rent or increase utilization of resources through additional marketing efforts. Problem 2. LO: 3 Value-added and non-value-added costs Estimated time: 20 minutes Ariana Ryan is attempting to assess its current cost structure. When a major customer complained about prices and said that, “you better start cutting your prices or I will take my business to China,” Ariana’s first response was, “Can’t you see how much I have to spend in storage costs, movement of materials from one plant to another, and the amounts paid to quality controllers, auditors, and middle-level managers?” The customer’s first response was, “How much?” Ariana being an astute manager was able to take her note book out and provide the following data in a matter of minutes: Storage costs $589,500 Movement one material from one station to another 348,750 Quality controllers 285,000 Auditors 438,390 Middle level managers 6,94,800 Total amount 2,356,440 She then said, we pay the lowest amount for material and our labor rates are quite competitive – giving us a cost of $3,200,000 excluding the above costs for the approximately 1,000 units that we are building. You figure out how much money we are making for the approximately one hundred units that you buy from us each year. It appeared that the customer was just warming up to the conversation and on his way out, he told Ariana, “Get rid of these costs and cut our prices by 30% or else our business will go to China from next year, as I already told you.”. Shocked by the customer’s insensitivity, Ariana complained to the Board and to the Executive Committee of this experience and inquired what they think should be done about the situation. Assume that you are part of the audit team and are asked to write an essay on the situation: Suggested answer: The conversation appears rather odd. It is not management’s responsibility to give cost details to the customer in order to justify the price. Determining the price is often based on competition in the market and what the market can bear for similar products. However, management needs to start seriously thinking in getting rid of these costs to the extent possible and as soon as possible to stay competitive. The enumerated costs are essentially non-value-added costs: a) possibilities for a JIT system must be explored to reduce or get rid of storage costs, b) reason and logic for substantial movement of materials from one station to another must be explored. Often, such cumbersome situation comes about due to lack of foresight or improper planning, etc., c) companies are finding out that if they train their workers in the first place and employ good, trustworthy, and dependable employees, they would not have to pay to another set of employees as quality controllers to check on the workers. Responsible workers would take pride in what they have done without somebody else watching over their head, d) while auditing is a necessary function, but the more responsible and trustworthy the employees are, and if they are trained properly and there are enough checks and balances within the organization, the audit team could be reduced if not totally eliminated, and finally e) often middle managers could become a dead-weight and a bottle-neck in organizations with decent and trained personnel who work in a modern and state-of-the-art computerized surroundings. In addition to reduction or elimination of these costs, management should study all other costs including material, labor, overhead, selling, and administrative costs and study the possible need for a major overhaul and reengineering of the products and the organizational structure. Furthermore, a current assessment of the current and potential market situation must be made to determine whether the firm can stay competitive and profitable or must retool to something else before competition runs them out of business. Problem 3: LO: 2 Target costing Estimated time: 15 minutes Anderson Motors had a product that sells for $520 a unit. a) What should be the target cost if the company expects a profit of 6% of the selling price? b) What should be the target cost if the company expects to make a 10% profit on cost? c) what should be the target cost if the company expects a 12% return on investment. Assume an investment of $80,000 and a total output of 200 units. Answer: a) 520 * 94% = $488.80 b) 520 / 110% = $472.73 c) ROI = 80,000 * 12% = $9,600; 9,600 / 200 = 48; 520 – 48 = 472.00 Problem 4 LO: 6 Estimated time: 15 minutes Problem 4: Consider the following scenarios: Company A produces three products which have significantly different machine time and labor time requirements. The market is quite competitive Company B produces three products; cost drivers are either labor related, batch related, or product related. Prices are fairly stable in this market. Company C produces three products; cost drivers are either labor related, batch related, or product related. With each product using a disproportionate share of those services. The market is also very competitive. Required: discuss the significance of ABC and ABM with regard to the above entities. Answer: Company A Traditional costing should be adequate as the cost drivers are primarily unit level. ABM could still apply in determining what costs are non-value-added and candidates for elimination. Company B As cost drivers are either unit level, batch level, or product level, ABC costing method applies. However, as prices are stable, there does not seem to be any urgency in changing over to the ABC method. ABM still applies for improving the system and identifying non-value-added costs. Company C As cost drivers are either unit level, batch level, or product level, ABC costing also applies in this case. Due to the very competitive nature of the market, there appears to be an urgency in implementing an ABC system for a more accurate costing routine. ABM also applies for improving the system and identifying as well as eliminating the non-value-added costs. Sample Quiz 1. Activity-Based management determines a. the organization’s cost drivers and cost driver rates for each activity. b. value-added and non-value-added activities. c. opportunities to enhance value-added activities and reduce or eliminate non-value-added activities. d. All of the above. e. b and c Answer: e Learning Objective: 1 ABM determines the value-added and the non-value-added activities and provides opportunities to enhance value-added activities and reduce or eliminate non-value-added activities. 2. Activity-based costing provides information about a. use of resources. b. identifying opportunities for decreasing costs. c. considering ways to increase value. d. All of the above. e. b and c Answer: a Learning Objective: 1 ABC provides more detailed and better information for the use of resources. 3. An appropriate cost driver for unit-level costs is often a. number of parts in a product b. customer type. c. customer orders. d. product design changes. e. None of the above. Answer: e Learning Objective: 1 None of these is an example of unit-level cost drivers. 4. In ABC costs are often divided into a. unit-level and batch-level. b. product level and facility-level. c. value-added and non-value-added. d. All of the above. e. a and b Answer: e Learning Objective: 1 ABC costs are viewed in an hierarchy of unit-level, batch-level, product-level, and facility-level costs. 5. ABC Company’s selling price of $480 for its product A is 20% higher than its current cost. What is the product’s selling price? a. $400 b. $480 c. $560 d. $600 e. None of the above. Answer: a Learning Objective: 2 Current selling price: 480 / 1.2 = $400 6. ABC Company’s cost of $480 for its product A is 20% lower than its current selling price. What should be the product’s cost if it expects a return of 30% on sales? a. $280 b. $384 c. $400 d. $420 e. None of the above. Answer: d Learning Objective: 2 Current selling price: 480 / .80 = $600. Target cost: 600 * .70 = $420. 7. NBC Company’s current selling price is $250 per unit on sales of 400 units per year. What should be the targeted cost if you expect a return of 15% on an investment of $200,000? a. $175 b. $200.75 c. $212.50 d. $225 e. None of the above. Answer: a Learning Objective: 2 Sales: 400 * 250 = $100,000; Target return on investment: 200,000 * 15% = $30,000; Target cost: 100,000 – 30,000 = $70,000; 70,000 / 400 = $175. 8. Robert Painting Company’s major activities include painting, transportation of workers’ to the work site, storing of paint in the shop, and supervision of the workers. Non-value-added activities include a. transportation of the workers. b. storing of paint. c. painting. d. All of the above. e. a and b Answer: e Learning Objective: 3 Transportation of workers and storing of paint are usually considered non-value-added costs. 9. Robert Painting has seen the light and terminated the job supervisors. Each supervisor costs the company $5,375 a month and supervises eight workers. Robert has gone on different sites and nurtured workers for higher level of responsibility and accountability. Workers have agreed to receive $1.50 more per hour and be totally accountable for timely completion of each project without the need for a supervisor. The average working hours per month is 140 hours. Due to the slow-down, Robert has currently one crew of workers. The net benefit of this improvement amounts to a. $1,680 b. $3,695 c. $4,295 d. $5,375 e. None of the above. Answer: b Learning Objective: 4 Savings: $5,375 – (1.50 * 140 * 8) = $3,695. 10. It finally dawned on Robert that, rather than transporting workers back and forth every day from Athens, Georgia to Atlanta where over 80% of the jobs are, he would hire painters in Atlanta for $1.60 more per hour (plus 25% added benefit) and let them be responsible for their own transportation for their regularly 40-hour week. The rental charge per vehicle is 45 cents per mile with no additional daily charge. Robert employs 20 painters — 16 of whom are regularly sent to Atlanta. Total mileage per day, per vehicle for a 5-day week comes to 220 miles for each vehicle. Every four employees ride in one car. Robert savings per week amounts to: a. $700 b. $650 c. $600 d. $550 e. None of the above. Answer: a Learning Objective: 4 Additional costs: 16 * 40 * 1.60 * 1.25 = $1,280; Savings: 220 * 5 * .45 * 4 = $1,980. Net savings: 1,980 – 1,280 = $700. 11. Value-added activities enhance the value of products and services in the eyes of the a. employees. b. customers. c. managers. d. shareholders. e. None of the above. Answer: b Learning Objective: 3 The focus in ABM is on customers. Use the following information to answer questions 12 and 13. Robert’s consultant has ranked his workers’ tasks in the following order, with the most non-value-added task receiving a ranking of one. Painting 800 hours @ $25 per hour Rank = 4 Warehouse management 150 hours @ $20 per hour Rank = 2 Transportation 75 hours @ $16 per hour Rank = 1 Workers’ monthly party one @ $600 per occasion = 3 12. If Robert succeeds in eliminating the lowest non-value-added task, it would save him a. $3,000 b. $4,200 c. $4,800 d. $5,200 e. None of the above. Answer: e Learning Objective: 4 Non-value-added (transportation): 75 * 16 = $1,200. 13. The three non-value-added tasks as a percentage of value-added activity amounts to a. 24% b. 21% c. 19.35% d. 17.25% e. None of the above. Answer: a Learning Objective: 4 [(150 * 20) + (75 * 16) + (1 * 600)] / (800 * 25) = 24% 14. Robert’s zeal for higher profit led him to purchase new painting tools that allow the workers to increase their productivity by 40%. Robert’s labor and overhead comes to $6500 per week. However, 40% of this amount is fixed. In addition, the new tools are rented for an additional $650 per week. This process results in a saving of a. $390 b. $490 c. $710 d. $910 e. None of the above. Answer: d Learning Objective: 4 Savings: (6500 * .60 * .40) – 650 = $910. 15. Example(s) of value-added activities are a. reprocessing payment. b. set-up of machines. c. moving and storing products. d. All of the above. e. None of the above. Answer: e Learning Objective: 4 None of these activities are value added. 16. Omid Printing has five employees as follows: order getter, type-setter, printer, receiver, shipper, invoicer. The first three receive a salary of $2,500 per month each, and the second three’s salary amounts to $1500 each. Omid has just returned from a seminar and believes that some, if not all, of the second group have to go because they add no-value to the printing product. a. The receiver is a non-value item of low value if supplies can be sent directly to the print shop without loss of accountability. b. The shipper is a non-value item of low value if customers can come pick up their orders without any complaint or inconvenience to them. c. The invoicer is a non-value item if customers can be billed automatically upon completion of a task without additional human intervention. d. All of the above. e. None of the above. Answer: d Learning Objective: 4 All these activities have a potential of being eliminated without reducing customer value. 17. Activity-based costing is suitable for a. manufacturing entities. b. service entities. c. governmental units. d. All of the above. e. a and b Answer: d Learning Objective: 6 Activity based costing can apply to any type of entity as long as it can be cost justified and there are more than one product or service. 18. A pilot project is a project that is a. limited in scope. b. intended to be a small-scale model of a larger project. c. applicable only in ABM. d. All of the above. e. a and b Answer: e Learning Objective: 6 19. Saba Printing had an average revenue of $90,000 per month. Variable costs are 60% of revenue and fixed costs amount to 50% of variable costs. The company had an investment of $720,000. Company’s return on investment amounts to a. 10% b. 15% c. 20% d. 25% e. None of the above. Answer: b Learning Objective: 3 Profit: 90,000 - [(90,000 * .60) + (54,000 / 2)] = $9,000; 9,000 * 12 = $81,000. Return on investment: 81,000 / 720,000 = 15%. 20. Omid Signs prepared 20 signs per day, costing a total of $800 — 30% of which is for variable costs. Hoping that variable costs can be reduced by 50%, selling price to provide a margin of 20% should be a. $580 b. $680 c. $750 d. $850 e. None of the above. Answer: d Learning Objective: 6 Cost: 800 – (800 * .3 *.50) = 680. Target price: 680 / .80 = $850. Chapter 6 Managing Customer Profitability Chapter Outline A. Cost Management Challenges — Chapter six addresses five cost management challenges. 1. How can you determine in advance whether investments of time, effort, and information systems to prepare customer profitability information are worthwhile? 2. How can customer profitability analysis be more relevant for service and governmental organizations than for others? 3. How do you evaluate the trade-offs among the desires for relevant, accurate, and timely information? 4. How do you evaluate the trade-offs among the desires for relevant, accurate, and timely information? 5. How can you determine whether operational changes in customer service have been beneficial or harmful? B. Learning Objectives 1. Explain the value of analyzing customer profitability according to major customer types. 2. Organize and prepare customer profitability analyses and reports using activity-based analysis. 3. Identify alternative actions and recommend improvements for overall and customer profitability based on analyzing customer related activities. C. Customer profitability analysis applies the concept of activity-based costing to determine how serving particular customers causes activities to be performed and costs to be incurred. Some activities that differ among customers include ordering in small quantities frequently or ordering in large quantities occasionally; changing orders; requiring special packaging or handling; requesting special (expedited) delivery or other special treatment. It is important to know customer profitability through identifying costs and benefits of specific customers or customer types to be able to improve an organization’s overall profitability. Identifying and assigning costs to customers can be a challenge. Customers may cause costs from the time marketing and salespeople have their first contact with them until they stop being customers. Identifying costs and then determining profits generated from different customers requires completion of customer profitability analysis. 1. The first step in developing a customer profitability system is to develop an activitybased costing analysis of certain customer-related costs. These costs can range from processing orders to special packaging. 2. The next step is to estimate costs, customer by customer, to see which customers cause how much cost. Revenue information is combined with cost of goods sold to get gross margin by customer. The customer costs that have been identified are subtracted from gross margin to get operating income generated by each customer. Companies whose customers are other businesses usually have major customers who generate a lot of revenues but who may also cause a lot of cost. Sometimes customers who generate little revenue cause a lot of cost too. These customers may actually be unprofitable. 3. The third step is to perform trend analysis of customer profitability to see if profit performance of customers is predictably high or low or following an upward or downward pattern. The most useful type of graphing is customer by customer, with a separate line for each major customer cost. Then managers can see which costs need attention. 4. A useful fourth step is to rank customers based on the amount of operating income they generate. A graph of this information is called a customer profitability profile. 5. It is important to identify effective and ineffective customer-related activities. Sometimes, we may suffer from over-satisfied customer-relations activities where customers are satisfied, but the company starts losing money because of providing excessive services. D. Traditional profitability analysis by product line is often done without adequate scrutiny and proper identification of costs to the relevant product lines. The approach taken in this chapter is to provide more accurate customer profitability analysis using the activity-based costing concepts. 1. Through establishing a customer profile, customers may be categorized according to major activities or factors that drive revenues and costs. 2. It must be noted that if the customer values a service, he would be probably be willing to pay for it. Free service escalates costs, and the company providing it could suffer. 3. It is also useful to keep track of customer’s sales patterns and the profitability that they generate. 4. Customer profitability analysis involves closer scrutiny of selling costs, marketing costs, ordering costs, distribution costs, and general and administration costs. a. Customer selling costs include the costs of all personnel databases, equipment, and facilities devoted to sales activities. The challenge is to segregate these costs by customer type. b. Marketing costs include the costs of personnel, databases, equipment, and facilities devoted to marketing research, marketing strategy, and marketing plans. The challenge here again is to be able to segregate these costs by customer type. c. Customer distribution costs include the costs of packing, shipping, and delivering the products or services to customers, and it should be determined how much of these resources are consumed by what type of customers. d. Customer general and administration costs include costs of research and development and other related administrative costs. E. Product life-cycle costs encompass the costs of five phases in a product’s life cycle. They are (1) product planning and concept design; (2) preliminary design; (3) detailed design and testing; (4) production; and (5) marketing, distribution, and customer service. 1. In order to justify a product’s costs, sales revenue that it will generate over its life should be sufficient to cover all of these costs. This is especially important for products with short life cycles, because there is little time to adjust one’s pricing strategy or production methods to ensure that the product will be profitable. F. With all the information on customer profitability, the final task is to see what we can do with it. 1. A common-size profitability report can show profitability by type of customer. If margins are satisfactory on all customer types or product lines, no action may be necessary. 2. If some product lines are losing money, action should be taken to improve their performance or review possible alternatives in case those product lines or customers are phased out. 3. If decision is made to phase out some product lines or customers, the company must make sure that the operating activity costs are proportionately reduced rather than being shifted to another product line. Problem 1 – Chapter 6 LO: 3 Customer profitability analysis Anderson Plumbing has two types of customers, commercial and residential. The company resources are spent as follows in this quarter: Activity Cost driver Commercial Customers Residential Customers Total Amount in dollars Phone operator Number of calls 240 760 $13,200 Billing Number of invoices 55 745 $19,200 Direct marketing Number of promotional packs 390 1,410 $34,200 Accounting tasks Number of accounts 135 1,165 $28,600 Plumbing work Number of hours 5,500 7,500 $315,000 Sales $275,000 $202,500 $575,000 Required: Determine segment profitability if a) customer-related costs are allocated based on sales, b) customer-related costs are allocated based on cost of sales (plumbing work). Assume that the cost of plumbing tasks are at $30 an hour for commercial work and $20 an hour for residential work, c) customerrelated costs are allocated based on plumbing work hours, d) customer-related costs are allocated using ABC costing, e) discuss in what way using ABC costing for this enterprise is more useful for management’s decision making. Problem 1 – Solution Problem 2. LO: 1 Assessing customer’s profitability Estimated time: 15 minutes Shahnaz Design has two groups of customers: small and large. There are 90 small customers and 10 large ones. Shahnaz has determined that many of these small customers are quite a headache – although the accounting records do not show the loss, if any, associated with it. Shahnaz has determined that small customer’s billing takes an average of four hours whereas large customer’s billing takes an average of eight hours. However, the average small customer bill is $1,850 whereas, the average large customer bill is $9,950. Furthermore, the small customer post-sale service needs is an average of three hours per order and the large customer post-sale service needs is an average of six hours. Billing costs amount to $30,720 and customer service costs amount to $48,000. Assume an average of two bills for small customers and four bills for each of the large customers. Twice as much time is needed for customer service on each bill. Determine the billing and customer service costs associated with each order. Solution: Billing costs: 30,720 / ((90 * 2*4) + (10 *3*8)) = $32 Customer service: 48,000 / ((90 * 2* 8) + (10 *3*16)) = $25 Small order billing and customer service per order: (4*32) + (8*25) = $328 Large order billing and customer service per order: (8*32) + (16*25) = $656 The Company may want to take this cost breakdown in the pricing of future orders. Problem 3: LO: 1 and 2 Determine customer profitability Estimated time: 20 minutes Shahnaz Design has two groups of customers: small and large. There are 90 small customers and 10 large ones. Shahnaz has determined that many of these small customers are quite a headache – although the accounting records do not show the loss, if any, associated with it. Shahnaz has determined that small customer’s billing takes an average of four hours whereas large customer’s billing takes an average of eight hours. However, the average small customer bill is $1,850 whereas, the average large customer bill is $9,950. Small customers had an average of two bills and large ones three bills for the period. Associated billing and customer service costs amount to $328 per invoice for small customers and $656 for large customers (see problem 2 above). Assuming that direct cost per job of small customers amounts to $1,150 and $7,140 for large customers, prepare an income statement by customer category and assess the profitability of each group. Item Number Small Number Large Total Sales 180 333,000.00 30 298,500.00 631,500.00 Direct cost 180 207,000.00 30 214,200.00 421,200.00 Billing cost 180 23,040.00 30 7,680.00 30,720.00 Customer service 180 36,000.00 30 12,000.00 48,000.00 Total cost 266,040.00 233,880.00 499,920.00 Net income 66,960.00 64,620.00 131,580.00 Problem 4 LO: 2 and 3 Analyzing customer profitability Estimated time: 15 minutes Use the data in problem 3 above to provide a detailed analysis in terms of small and large customers. Also determine the company’s ROI and margin, assuming that company investment amounts to $657,900. Solution: The above data indicates that the direct margin (sales less direct cost) on small jobs is an average of 38% and on large jobs only 28%. This makes sense because large jobs are a lot less time consuming, and the larger customers have potentially more leeway in choosing their suppliers and negotiating their prices. Billing costs for small jobs amount to 6.9% of sales whereas, billing costs for large jobs amounts to about 2.6% of the sales amount. Customer service costs amount to 10.8% of sales for small jobs and only 4% of sales for large jobs. Even though small jobs have a larger direct margin, their net profit is slightly lower (20.1% versus 21.6%) as compared to large jobs because of the incurrence of more billing and customer service costs. Finally, Return on investment: 131,580 / 675,900 = 19.47%; Margin: 131,580 / 631,500 = 20.84% Sample Quiz Use this data to respond to questions 1 through 9. CNS Company has three major customers. Customer related costs and applicable cost drivers are as follows: Activity Cost driver Amount Activity Level Processing orders Purchase orders $120,000 2,000 Sales visits Visits 48,000 80 Billing Invoices 36,000 1,200 Engineering/design changes Design changes 90,000 300 Customer use of the above activities, sales, and gross margin on sales are as follows: Activity Customer 101 Customer 102 Customer 103 Processing orders 1,200 600 200 Sales visits 50 20 10 Billing 700 350 150 Engineering/design changes 180 85 35 Sales $256,000 $329,000 $396,000 Gross margin on sales $129,500 $137,500 $112,600 Under traditional costing, selling expenses were allocated based on sales value. 1. The cost rate per purchase order amounts to a. $30 b. $60 c. $300 d. $600 e. None of the above. Answer: b Learning Objective: 2 120,000 / 2,000 = $60 2. The cost per sales visit amounts to a. $30 b. $60 c. $300 d. $600 e. None of the above. Answer: d Learning Objective: 2 48,000 / 80 = $600 3. Billing cost chargeable to customer 101 amounts to a. $4,500 b. $10,500 c. $14,500 d. $21,000 e. None of the above. Answer: d Learning Objective: 2 36,000 / 1,200 = $30; 30 * 700 = $21,000 4. Engineering change costs chargeable to customer 102 amounts to a. $10,500 b. $25,500 c. $30,500 d. $54,000 e. None of the above. Answer: b Learning Objective: 2 90,000 / 300 = 300; 85 * 300 = 25,500 5. Sales visits chargeable to customer 103 amounts to a. $6,000 b. $12,000 c. $18,000 d. $30,000 e. None of the above. Answer: a Learning Objective: 2 48,000 / 80 = 600; 600 * 10 = $6,000 6. Order processing cost chargeable to customer 102 amounts to a. $12,000 b. $36,000 c. $48,000 d. $72,000 e. None of the above. Answer: b Learning Objective: 2 120,000 / 2000 = 60; 60 * 600 = $36,000 7. Net income under activity-based costing for customer 101 amounts to a. $47,500 b. - $47,500 c. $53,500 d. - $53,500 e. None of the above. Answer: b Learning Objective: 2 8. Net income under traditional costing for customer 102 amounts to a. $38,900 b. - $38,900 c. $52,788 d. - $52,788 e. None of the above. Answer: a Learning Objective: 2 9. Net income under activity-based costing for customer 103 amounts to a. $6,079 b. $- 6,079 c. $79,600 d. $- 79,600 e. None of the above. Answer: c Learning Objective: 2 10. Customer profitability analysis identifies a. the benefits of serving specific customers b. the costs of serving specific customers c. both the costs and benefits of serving specific customers d. product cost associated with each customer but not the non-productive costs. e. none of the above Answer: c LO: 1 11. Some studies suggest that only a. 20% of customers generate profit b. 30% of customers generate profit c. 40% of customers generate profit d. 50% of customers generate profit e. none of the above. Answer: a LO: 1 12. Customer profile categorizes a. individual or types of customers according to the major activities that drive revenues b. individual or types of customers according to the major activities that drive costs c. customers according to the number of years they have been in business d. customers according to their level of income e. a and b only. Answer: e LO: 2 13. Saba Company anticipates to sell 500 units of the software it has developed that has a cost per unit of $300. If the company wants a return of 15% of its investment of $200,000, what should be the target cost? a. $220 b. $240 c. $260 d. $280 e. none of the above. Answer: b LO: 2 14. Arman Company has a product that cost $200, if he wants a return of 20% on sales, the selling price should be a. $240 b. $245 c. $250 d. $260 e. none of the above Answer: c LO: 2 15. The following cost category(s) should be included in determining customer profitability: a. selling cost b. marketing cost c. ordering cost d. distribution costs e. all of the above. Answer: e LO: 2 16. Distribution costs include the cost(s) of a. packing b. shipping c. delivering products to customers d. all of the above e. b and c. Answer: d LO: 2 Instructor Manual for Cost Management: Strategies for Business Decisions Ronald W. Hilton, Michael W. Maher, Frank H. Selto 9780073526805, 9780072430332, 9780072830088, 9780072299021, 9780072881820, 9780072882551, 9780070874664, 9780072388404, 9780072343533