Chapter 5 Activity-Based Costing and Customer Profitability Analysis Learning Objectives

1. Explain the strategic role of activity-based costing. 2. Describe activity-based costing (ABC), the steps in developing an ABC system, and the benefits and limitations of an ABC system. 3. Determine product costs under both the volume-based method and the activity-based method and contrast the two. 4. Explain activity-based management (ABM). 5. Describe how ABC/M is used in manufacturing companies, service companies, and governmental organizations. 6. Use an activity-based approach to analyze customer profitability. 7. Identify key factors for successful ABC/M implementation.

Teaching Suggestions
A thorough coverage of activity-based costing and activity-based management is an important part of the development of strategic cost management. Knowing the true costs is critical to attain a better result for all firms and organizations. It is particularly important for firms with complex operations, where analysis of cost flows and product profitability are important. Moreover, the concept of activity analysis has important implications for many cost management methods. For these reasons, we have put the coverage of ABC very early in the book. This allows us to include activity-based concepts when other topics are covered in later chapters. Our teaching plan for ABC costing is to begin with a thorough coverage of the benefits and limitations of ABC systems, including a discussion of why and when they are preferred to other cost systems. The coverage focuses on the comparison of the volume-based and ABC systems, looking particularly at the effects of the systems on such strategic decisions as product line additions or deletions.

New in this Edition

New coverage of Resource Consumption Accounting (RCA) and Lean Accounting New Real-World Focus (RWF) examples, including surveys of current practice Expanded coverage of time-driven ABC (TDABC) Expanded coverage of customer lifetime value, introduction of the concept of customer equity, and discussion of strategy implementation for customer profitability analysis New exercises and problems focusing on strategy, the cost of capacity, resource consumption cost drivers, and ethics Continuing support for Oros supplement using ABC software (SAS Institute) including tutorial, cases, and teaching notes

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Assignment Matrix
managementStrategic role of ABC Volume-based l costing vs. ABC ABC/ABM implementation Customer profitability analyses Service Activity-based management organizationsABC in service and not-for-profit Customer cost categories International Strategy Ethics X X Describe ABC Costing administrative activitiesABC in marketing and industryABC in the manufacturing customer valueCustomer profitability and Estimated time Spreadsheet

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Lecture Notes
A. Volume-based Costing Systems Volume-based overhead rate 1. Plantwide overhead rate Budgeted (total) overhead Budgeted (total) direct labor or machine hours 2. Departmental overhead rate Budgeted departmental overhead Budgeted departmental direct labor or machine hours Example: Volume-based overhead rate: Division 1 DLH 1,000 MH 400 Budget $OH $5,000 Overhead rate: Per DLH $ 5.00 Per MH $12.50 Division 2 200 2,000 $7,000 $35.00 $ 3.50 Plant Total 1,200 2,400 $12,000 $10.00 $ 5.00 Plantwide Rates

Departmental Rates

Required resources to manufacture one unit each of Widget and Gidget: Division 1 Division 2 Total DLH MH DLH MH DLH MH Widget 20 1 10 5 30 6 Gidget 2 10 6 20 8 30 Factory OH applied to: Widget Using Plantwide rate: Based on DLH rate $10 x 30 = $300 Based on MH rate $5 x 6 = $ 30 Using departmental rate: Based on DLH $5 x 20 + $3.5 x 5 = $117.50 Based on MH What is Widgets true OH per unit? $300, $30, or $117.50? What is Gidgets true OH per unit? $80 or $150? Gidget $10 x 8 = $ 80 $5 x 30 = $150 $5 x 2 + $3.5 x 20 = $80

Limitation of volume-based costing systems One major limitation of volume-based costing systems is the use of a single plant-wide factory overhead rate such as direct labor hours or volume-based departmental rates such as machine hours and direct materials cost to firms with diverse products, processes, and volume. They produce inaccurate product costs when more factory overhead costs such as setup and materials handling costs are not volume-based, and when firms produce a diverse mix of products with different volume, sizes, and complexities. In summary, a volume-based costing system is likely to suffer from the following weaknesses: Blocher, Stout, Cokins: Cost Management 5e 5-4 The McGraw-Hill Companies, Inc., 2010

Undercosting low-volume products and overcosting high-volume products. Distorting product costs for operational and strategic decisions. Separating product costs and activities.

B. Comparison of Volume-based and Activity-based Costing Systems. 1. Volume-based Two-stage allocation process a. First stage -- overhead costs are assigned to cost centers (e.g. departments or individual operations). b. Second stage -- costs are applied from departments to individual jobs or products using volume as the main factor.

Note: Where diversity exists between products (e.g. lot size, complexity of production), overhead costs assignments based on volume will not provide accurate product costs.
Typically high-volume products have higher and low-volume products have lower cost than their true cost. The two stage cost allocation procedures is illustrated for both the volume-based and the activitybased methods:

2. Activity-Based Costing (ABC) is a costing approach that assigns costs to products or services
based on their consumption of resources via activities required for the manufacturing of the products or providing services. It is based on the premise that a firm's products or services are performed by activities and that the required activities incur costs. Cost of resources are assigned to activities, then activities are assigned to cost objects based on their use. ABC recognizes the causal relationships of cost drivers to activities. ABCs major advantage is

that it improves the traceability of overhead costs thus minimizes distortion of product costs.
3. Steps in ABC Costing Step 1 Identify resource costs and activities

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Step 2 Assign overhead to activity center or cost pools using resource consumption cost driver Step 3 Costs are assigned to products according to the number of the activities needed to complete the product. An activity is any event or transaction that is a cost driver (e.g. it causes the incurrence of cost, examples: machine time, purchase order, and machine setups.

Resources

Input Information

Activities

Performance Evaluation

Products and Services

C. Activity-Based Cost Hierarchy: a. Unit, b. Batch, c. Product-Sustaining, d. Facility-Sustaining. a. Unit Level - Performed for each unit of product produced Examples of activity cost Cost of inserting a component Utilities to operate equipment Sales commissions b. Batch Level - Performed for each batch of product produced Examples of activity cost Cost of processing sales order Cost of issuing and tracking purchase order Cost of equipment setup Cost of moving batch between workstations Inspection cost per batch c. Product Level - Performed to support each type of product Examples of activity cost Cost of administering product parts Cost of product marketing, such as advertising Cost of designing product d. Facility Level - Performed to maintain general manufacturing capabilities Examples Blocher, Stout, Cokins: Cost Management 5e 5-6 The McGraw-Hill Companies, Inc., 2010

Maintenance cost pertaining to general facilities such as buildings and ground Property taxes Insurance Two factors must be considered in selecting cost drivers: a. the ease of obtaining data relating to the cost driver, and b. the degree to which the cost driver measures actual consumption by products of the activity. D. Benefits and limitations of ABC Benefits Better profitability measures. Better decision and control. Better information for controlling capacity copst. Limitations Not all costs have appropriate or unambiguous activity drivers. Product or service costs identified by an ABC system are likely to not include all costs associated with the product or service. ABC system is not cost free and is time-consuming to develop and implement. E. Activity-Based management (ABM). ABM focuses on managing activities in order to improve business efficiency and effectiveness, and to improve the value received by customers as well as the firm's profits. ABC uses the information to improve the allocation of cost to products and

services. ABM uses activity information to reduce costs and improve product profitability.
Activity-based management focuses on managing activities--including identifying activities that can be eliminated--and making sure that needed activities that cannot be eliminated are carried out efficiently. To improve operations, management must search out unnecessary or inefficient activities, determine the cost drivers for the activities, and change the level of those cost drivers. The major task of the activity analysis is to identify high-value-added and low-value-added activities. A high-value-added activity is an activity that is judged to contribute to (1) customer value and satisfaction or (2) satisfy an organizational need. Examples include designing products, direct labor processing, addition of direct materials, machining, and delivering products. A low-value-added activity is an activity that is considered to contribute little or nothing to customer value or to the organization's needs. Examples include setting up, moving, waiting, repairing, inspecting, and storing.

The percentages of high-value and low-value added activity differ by industry and company. As a general rule, process manufacturers (chemical, food) and service companies (insurance, banks) initially find a lower percentage of low-value (10-20%). Discrete part manufacturers (automotive, computers) and governmental agencies typically find a higher low-value percentage (20-35%). When excess capacity and activity best practices are incorporated into the low-value calculation, waste typically reaches 35-45% in many industries. F. Customer-Profitability Analysis
Customer profitability analyses analyze and report revenues earned from customers and costs incurred to earn these revenues. Objectives of Customer Profitability Analysis

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 Identifying highly profitable customers, Providing better services to highly profitable customers, Setting prices according to cost to serve, Furnishing relevant data for negotiations with customers, Transforming unprofitable customers into profitable customers, and Identifying and conceding permanent loss customers to competitors. Customer cost analyses classify customer-related costs into cost categories based on activities and cost drivers to service customers. Customer cost hierarchy: Unit-level resources spent on activities performed to sell and deliver each unit to a customer. Batch-level - resources spent on activities performed to sell and deliver a group of units to a customer, regardless of the number of units involved. Customer-sustaining- resources spent on activities performed to earn or support a customer, regardless of the number of units or batches involved. Distribution-channel- resources spent on each distribution channel that serves customers, regardless of the number of units, batches, or customers involved. Sales-sustaining - resources consumed to sustain sales and service activities that cannot be traced to an individual unit, batch, customer, or distribution channel. Customer Lifetime Value: Using customer profitability analysis, and taking it a step further, the value of a customer to an organization can be determined by calculating the net present value of all future profits expected from the customer. This calculation is called customer lifetime value (CLV) and is used widely in marketing and cost management in developing marketing plans and assessing customer relationship programs. Customer Equity: When the CLV for all of an organizations customers is added together, we have customer equity (CE). CE is viewed as a measure of the overall value of the organization. It is also used to assess more broadly the effectiveness of the organizations marketing and production planning. CE is considered to have three drivers: value equity, brand equity, and retention equity. Value equity reflects the inherent value, or differentiation, that customers have the products and services of the company. Brand equity is the value of the organizations products and services that cannot be explained in objective quantitative terms, and retention equity comes from building customer loyalty through relationship programs and other efforts. All of the three contribute to CE.

G. ABC/ABM Implementation
Activity-based costing helps to reduce distortions caused by the volume-based costing system and obtains more accurate product costs. It provides a clear view of how the mix of a firm's diverse products, services, and activities contributes in the long run to the bottom line. But developing and implementing an ABC system is expensive and time-consuming. Resistance to change is most often given as the

prime reason for the failure of most ABC initiatives. Next come with the general lack of improvement targets, timeframes and training. The management accountant needs to get involved as
a team player to help the firm develop and implement a successful ABC system. Implementing ABC/M involves three possible extensions of the basic ABC/M model multistage ABC, Resource Consumption Accounting (RCA), and Time-Drive Activity-Based Costing (TDABC). Blocher, Stout, Cokins: Cost Management 5e 5-8 The McGraw-Hill Companies, Inc., 2010

Multistage ABC Multistage ABC exists often in practice, where organizations have a complex interactions among activities such that support departments serve other support departments as well as production departments. The higher level of complexity is captured by more complex ABC models, as illustrated below:

Resource Consumption Accounting (RCA)

Resource consumption accounting (RCA) is an adaption of ABC that emphasizes resource consumption by greatly increasing the number of resource cost pools, which allows more direct tracing of resource costs to cost objects than an ABC system with fewer cost centers. RCA is particularly appropriate for large organizations with repetitive operations and high-level information systems such as those provided by SAP, Oracle, and SAS. These information systems, usually called enterprise resource planning systems (ERPs), allow the use of the large number of cost centers, which would be impractical or infeasible with simpler information systems. The RCA approach, with ERP support, allows much finer detail in the calculation of cost, by increasing the number of cost centers and thereby increasing the opportunity to trace costs directly to products and services; the objective is that cost assignment be based only on causality. Time-Driven Activity-Based Costing (TDABC) Another resource-centric approach to the implementation of large ABC costing systems is based on the idea that the common element in the utilization of activities is the unit of time. ABC traces and re-assigns resource expenses to the activities that consume them and then further re-assigns them proportionately to the final cost objects based on the quantity of each activitys cost driver. When a substantial amount of the cost of a companys activities are in a highly repetitive process (much like in the RCA example above), the cost assignment can be based on the average time required for each activity. Time-Driven Activity-Based Costing (TDABC) assigns resource costs directly to cost objects using the cost per time unit of supplying the resource, rather than first assigning costs to activities and then from activities to cost objects.

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To illustrate TDABC. TDABC computes the cost per minute of the resources performing the work activity. Assume 2 clerical workers paid $45,000 annually perform a certain activity that is expected to require 17 minutes. TDABC calculates the total cost as $45,000 x 2 = $90,000; TDABC then calculates the total time available for the activity as 180,000 minutes (assuming 30 hours per week with two weeks vacation: 2 workers x 50 weeks x 30 hours x 60 minutes per hour = 180,000 minutes per year). The TDAC rate for the activity is $0.50 per minute ($90,000 / 180,000). The cost of a unit of activity is $0.50 x 17 min = $8.50; if the activity required 20 min, then the allocation would be $.50 x 20 = $10.

An Illustration of the Five Steps for Strategic Decision Making for ABC Costing Follows:
The Five Steps of Strategic Decision Making for Haymarket BioTech Inc Haymarket Biotech, Inc. (HBT) produces and sells two secure communications systems, AW(Anywhere) and SZ(SecureZone). AW uses satellite technology and allows customers to communicate anywhere on the earth. SZ uses similar technology except it allows communication between two parties who are within 10 miles of each other. HBT operates in a very small but competitive industry. The customers are governmental and corporate customers for whom these products are critical; the customers rely on HBTs ability to quickly adapt its products to threats from devices that would compromise the security of the products. SZ has been successful for nearly 10 years and has undergone a number of improvements in this time; sales are expected to continue to grow at 8-10% per year. AW, a more recent product, has also been successful, but demand has not been as strong and sales growth is expected to be 3-5% per year. Because of the higher profitability of the AW system (Exhibit 5.5), HBT is considering an extensive advertising campaign to boost sales of AW, and to make plans for reallocating manufacturing facilities from SZ to AW to make this possible. HBT has the following operating data for the two products. 1. Determine the Strategic Issues Surrounding the Problem. HBT competes on product leadership (differentiation) as its customers rely on the ability of these products to provide secure communications. Because innovation is a key customer buying criteria, HBT must take a long-term focus on developing innovations that meet expected future customer expectations, and to implement these innovations into successful, profitable products. 2. Identify the Alternative Actions: HBT is considering an advertising campaign and reallocation of manufacturing facilities to favor the AW product line over the SZ. 3. Obtain Information and Conduct Analyses of the Alternatives The information available to HBT under the volume-based cost system shows a unit margin of $100 for AW and $45 for SZ, while the ABC-based cost system shows unit margins for AW and SZ of $45 and $58.75, respectively. As the ABC system provides more comprehensive and accurate cost information, HBT should rely on the latter figures which show that on a unit basis the SZ product is more profitable. 4. Based on Strategy and Analysis, Choose and Implement the Desired Alternative Considering the ABC cost information, and the higher margins for SZ relative to AW, the plans to promote AW and reallocate manufacturing facilities from SZ to AW are not consistent with HBTs

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long-term growth and profitability. The firms best advantage for future growth and profitability would be to put resources behind SZ rather than AW. 5. Provide an On-going Evaluation of the Effectiveness of implementation in Step 4. HBT should continue to review the ABC based costs and unit margins of existing and new products, together with long-term projections of sales and customer expectations for these products, to choose the products with the best advantage for long-term growth and profitability.

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