Activity-Based CostingActivity-Based Costing

Classic Pen Company CaseClassic Pen Company Case

Problems With Simple Cost Accounting Problems With Simple Cost Accounting Systems: The Classic Pen Company Systems: The Classic Pen Company

ExampleExample

Classic Pen had been the low-cost producer Classic Pen had been the low-cost producer of blue pens and black pens, with profit of blue pens and black pens, with profit margins exceeding 20% of salesmargins exceeding 20% of sales

Several years ago Classic Pen expanded Several years ago Classic Pen expanded their business by extending their product their business by extending their product line into products with premium selling line into products with premium selling pricesprices

The Classic Pen Company ExampleThe Classic Pen Company Example

Five years ago red pens were introducedFive years ago red pens were introduced The same basic production technologyThe same basic production technology Could be sold at a price that was 3% higher than for Could be sold at a price that was 3% higher than for

blue and black pensblue and black pens

Last year purple pens were addedLast year purple pens were added Could be sold at a 10% price premiumCould be sold at a 10% price premium

The controller of Classic Pen was disappointed The controller of Classic Pen was disappointed with the most recent quarter’s financial resultswith the most recent quarter’s financial results Overall profitability for all four together had decreasedOverall profitability for all four together had decreased The red and purple pens, however, were more profitable The red and purple pens, however, were more profitable

than the blue and black pensthan the blue and black pens

Total Profitability by ProductTotal Profitability by Product

BlueBlue BlackBlack RedRed PurplePurple TotalTotal

UnitsUnits 50,00050,000 40,00040,000 9,0009,000 1,0001,000 100,000100,000

PricePrice $ 4.50$ 4.50 $ 4.50$ 4.50 $ 4.65$ 4.65 $ 4.95$ 4.95

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

MaterialMaterial 75,00075,000 60,00060,000 14,04014,040 1,6501,650 150,690150,690

LaborLabor 30,00030,000 24,00024,000 5,4005,400 600600 60,00060,000OverheadOverhead 90,00090,000 72,00072,000 16,20016,200 1,8001,800 180,000180,000Total Mfg. Total Mfg. ExpensesExpenses

195,000195,000 156,000156,000 35,64035,640 4,0504,050 390,690390,690

Gross Gross MarginMargin

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

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

Concern at Classic PenConcern at Classic Pen The controller of Classic Pen wondered whether The controller of Classic Pen wondered whether

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

Classic’s manufacturing manager commented on Classic’s manufacturing manager commented on how the introduction of colored pens had how the introduction of colored pens had changed the production environment:changed the production environment: Everything ran smoothly when producing just Everything ran smoothly when producing just

blue and black pens in long production runsblue and black pens in long production runs Difficulties started when the red pens were Difficulties started when the red pens were

introduced and required more changeoversintroduced and required more changeovers

Changes Caused by New PensChanges Caused by New Pens

(1 of 2)(1 of 2) Making black ink was simple; there was not even Making black ink was simple; there was not even a need to clean out the residual blue ink from the a need to clean out the residual blue ink from the previous run if enough black ink was dumped in previous run if enough black ink was dumped in to cover it upto cover it up

Red required Classic to stop production, empty Red required Classic to stop production, empty the vats, clean out all remnants of the previous the vats, clean out all remnants of the previous color, and then start the production of the red inkcolor, and then start the production of the red ink Even small traces of the blue or black ink Even small traces of the blue or black ink

created quality problemscreated quality problems The ink for the purple pens also had demanding The ink for the purple pens also had demanding

specifications, though not quite as demanding as specifications, though not quite as demanding as the red inkthe red ink

Changes Caused by New PensChanges Caused by New Pens

(2 of 2)(2 of 2) Classic Pens was also spending more time on Classic Pens was also spending more time on purchasing and scheduling activities and purchasing and scheduling activities and keeping track of existing, backlogged, and future keeping track of existing, backlogged, and future ordersorders

Classic’s manufacturing manager was Classic’s manufacturing manager was concerned about rumors that new colors may be concerned about rumors that new colors may be introduced in the near futureintroduced in the near future He did not think they had any more capability to He did not think they had any more capability to

handle additional confusion and complexity in the handle additional confusion and complexity in the operationsoperations

Last year’s new computer system helped to Last year’s new computer system helped to reduce some of the confusionreduce some of the confusion

Pen Production At Classic’sPen Production At Classic’s Pen production at the factory involved:Pen production at the factory involved:

Preparing and mixing the ink for the different color pensPreparing and mixing the ink for the different color pens Inserting the ink into the pens in a semiautomated Inserting the ink into the pens in a semiautomated

processprocess Packing and shipping the pens in a manual stagePacking and shipping the pens in a manual stage

Each product had a:Each product had a: Bill of materials that identified the quantity and cost of Bill of materials that identified the quantity and cost of

direct materials required for the productdirect materials required for the product Routing sheet that identified the sequence of Routing sheet that identified the sequence of

operations required for each operating stepoperations required for each operating step This information was used to calculate the labor This information was used to calculate the labor

expenses for each of the four productsexpenses for each of the four products From this information, it was easy to calculate the direct From this information, it was easy to calculate the direct

materials costs and direct labor costs for each color materials costs and direct labor costs for each color penpen

Classic’s Indirect Cost Classic’s Indirect Cost AllocationAllocation

Because it was a small company and historically Because it was a small company and historically had produced only a narrow range of products, had produced only a narrow range of products, Classic used a simple costing systemClassic used a simple costing system All the plant’s indirect expenses were aggregated at All the plant’s indirect expenses were aggregated at

the plant level and allocated to products based on the plant level and allocated to products based on each product’s direct labor costeach product’s direct labor cost

Currently the cost system’s overhead burden rate was Currently the cost system’s overhead burden rate was 300% of direct labor cost300% of direct labor cost

Before the new specialty products were introduced, Before the new specialty products were introduced, the overhead rate was only 200% of direct labor costthe overhead rate was only 200% of direct labor cost

Classic Pen’s Cost SystemClassic Pen’s Cost System Classic’s management accountants designed the Classic’s management accountants designed the

system years ago when:system years ago when: Production operations were mostly manualProduction operations were mostly manual Total indirect costs were less than direct labor costsTotal indirect costs were less than direct labor costs Classic’s two products had similar production volumes Classic’s two products had similar production volumes

and batch sizesand batch sizes

Given the high cost of measuring and recording Given the high cost of measuring and recording information, the accountants at the time judged information, the accountants at the time judged correctly that a complex costing system would cost correctly that a complex costing system would cost more to operate than the benefits it would providemore to operate than the benefits it would provide

A Changed Production A Changed Production EnvironmentEnvironment

Direct labor costs have decreased and indirect Direct labor costs have decreased and indirect expenses have increased as a result of expenses have increased as a result of automationautomation

As custom low-volume products, such as red As custom low-volume products, such as red and purple pens were added, Classic needed:and purple pens were added, Classic needed: More schedulingMore scheduling More setupsMore setups More quality control personnelMore quality control personnel A computer to track orders and product specificationsA computer to track orders and product specifications

An Outdated Cost SystemAn Outdated Cost System

Classic operates with only a single cost center, Classic operates with only a single cost center, the plantthe plant Most complex companies use many cost centers for Most complex companies use many cost centers for

cost accumulationcost accumulation Even if Classic Pen used multiple production and Even if Classic Pen used multiple production and

service department cost centers, it could still service department cost centers, it could still encounter severe distortions in its reported encounter severe distortions in its reported product costs:product costs: In an environment of high product variety, using only In an environment of high product variety, using only

unit-level drivers (such as direct labor costs) to allocate unit-level drivers (such as direct labor costs) to allocate overhead costs to products could lead to product cost overhead costs to products could lead to product cost distortiondistortion

Reason for Cost DistortionsReason for Cost Distortions (1 of 3) (1 of 3)

schedule machine and schedule machine and production runsproduction runs

perform setupsperform setups inspect produced items after inspect produced items after

setupsetup move materialsmove materials ship ordersship orders expedite ordersexpedite orders rework defective itemsrework defective items

design new productsdesign new products improve existing productsimprove existing products negotiate with vendorsnegotiate with vendors schedule materials receiptsschedule materials receipts order, receive, and inspect order, receive, and inspect

incoming materials and partsincoming materials and parts update and maintain the much update and maintain the much

larger computer-based larger computer-based information systeminformation system

• A complex factory has a much larger production support staff because it requires more people to:

• A complex factory generally also operates with higher levels of idle time, setup time, overtime, inventory, rework, and scrap

Reason for Cost DistortionsReason for Cost Distortions (2 of 3) (2 of 3) Because the factory has the same physical Because the factory has the same physical

output, it has roughly the same cost of materials output, it has roughly the same cost of materials (ignoring the slightly higher acquisition costs for (ignoring the slightly higher acquisition costs for smaller orders of specialty colors and other smaller orders of specialty colors and other materials)materials)

Because all pens are about the same complexity, Because all pens are about the same complexity, each pen would require the same number of each pen would require the same number of direct labor hours and machine hours to produce direct labor hours and machine hours to produce

The Classic Pen Company factory has about the The Classic Pen Company factory has about the same property taxes, security costs, and heating same property taxes, security costs, and heating bills as before, but it has much higher indirect and bills as before, but it has much higher indirect and support costs because of its more varied product support costs because of its more varied product mix and complex production tasksmix and complex production tasks

Reason for Cost DistortionsReason for Cost Distortions (3 of 3(3 of 3))

On a per unit basis, high-volume standard blue and black On a per unit basis, high-volume standard blue and black pens require about the same amount of direct labor costs pens require about the same amount of direct labor costs (the allocation basis) as the low volume color pens(the allocation basis) as the low volume color pens

Therefore, the traditional costing system would report Therefore, the traditional costing system would report essentially identical product costs for all products, essentially identical product costs for all products, standard and specialty, irrespective of their relative standard and specialty, irrespective of their relative production volumesproduction volumes This would hold true even if the cost system had This would hold true even if the cost system had

multiple production and service cost centersmultiple production and service cost centers Clearly, however, considerably more indirect and support Clearly, however, considerably more indirect and support

resources are required resources are required on a per-unit basison a per-unit basis for the low- for the low-volume, newly designed products than for the high-volume, newly designed products than for the high-volume, standard blue and black pensvolume, standard blue and black pens

Activity-Based Cost SystemsActivity-Based Cost Systems Activity-based cost systems have been Activity-based cost systems have been

developed to eliminate this major source of cost developed to eliminate this major source of cost distortiondistortion

Activity-based cost (ABC) management systems Activity-based cost (ABC) management systems use a simple two-stage approach similar to but use a simple two-stage approach similar to but more general than traditional cost systemsmore general than traditional cost systems

The next slide compares the essential elements The next slide compares the essential elements of the two systemsof the two systems

Traditional v. ABC SystemTraditional v. ABC System Traditional:Traditional:

Uses actual departments or Uses actual departments or cost centers for accumulating cost centers for accumulating and redistributing costsand redistributing costs

Asks how much of an Asks how much of an allocation basis (usually allocation basis (usually based on volume) is used by based on volume) is used by the production departmentthe production department

Service department Service department expenses are allocated to a expenses are allocated to a production department based production department based on the ratio of the allocation on the ratio of the allocation basis used by the production basis used by the production departmentdepartment

ABC:ABC: Uses activities, for Uses activities, for

accumulating costs and accumulating costs and redistributing costsredistributing costs

Asks what activities are Asks what activities are being performed by the being performed by the resources of the service resources of the service departmentdepartment

Resource expenses are Resource expenses are assigned to activities based assigned to activities based on how much of the on how much of the resource is required or used resource is required or used to perform the activitiesto perform the activities

Tracing Costs to ActivitiesTracing Costs to Activities Here’s how an ABC system works, using Here’s how an ABC system works, using

the Classic Pen Company as an example:the Classic Pen Company as an example: The controller started an analysis of indirect The controller started an analysis of indirect

expenses, beginning with indirect laborexpenses, beginning with indirect labor The controller interviewed department heads in The controller interviewed department heads in

charge of indirect labor and found that the charge of indirect labor and found that the people in these departments performed three people in these departments performed three main activitiesmain activities

Indirect Labor ActivitiesIndirect Labor Activities (1 of 2) (1 of 2)

50% of indirect labor was involved in what the 50% of indirect labor was involved in what the controller called “controller called “handle production runshandle production runs” ” Scheduling production ordersScheduling production orders Purchasing, preparing, and releasing materialsPurchasing, preparing, and releasing materials Inspecting the first few units produced each time the Inspecting the first few units produced each time the

process was changed to a new-colored penprocess was changed to a new-colored pen 40% of indirect labor actually performed the 40% of indirect labor actually performed the

physical changeover from one color pen to another, physical changeover from one color pen to another, an activity that she labeled “an activity that she labeled “perform setupsperform setups”” Change to Black pens takes 2.4 hoursChange to Black pens takes 2.4 hours Change to Red or Purple pens takes 5.6 hoursChange to Red or Purple pens takes 5.6 hours

Indirect Labor ActivitiesIndirect Labor Activities (2 of 2) (2 of 2)

10% of the time was spent on activities the 10% of the time was spent on activities the controller called “controller called “support productssupport products:” maintaining :” maintaining records on the four products, such as:records on the four products, such as: Making up the bill of materials and routing informationMaking up the bill of materials and routing information Monitoring and maintaining a minimum supply of raw Monitoring and maintaining a minimum supply of raw

materials and finished goods inventory for each materials and finished goods inventory for each productproduct

Improving the production processesImproving the production processes Performing engineering changes for the productsPerforming engineering changes for the products

First Step in Design of An ABC SystemFirst Step in Design of An ABC System As she conducted the interviews, the controller As she conducted the interviews, the controller

was performing the first two steps for designing was performing the first two steps for designing an activity-based cost system: an activity-based cost system:

1)1) Develop the activity dictionary: the list of major Develop the activity dictionary: the list of major activities performed by both the factory’s activities performed by both the factory’s human and physical resourceshuman and physical resources

2)2) Obtain sufficient information to assign resource Obtain sufficient information to assign resource expenses to each activity in the activity expenses to each activity in the activity dictionary (50% of indirect labor to “handle dictionary (50% of indirect labor to “handle production runs,” 40% to “perform setups,” and production runs,” 40% to “perform setups,” and 10% to “support products”)10% to “support products”)

Computer System ExpensesComputer System Expenses (1 of 2) (1 of 2)

The controller next turned her attention to the The controller next turned her attention to the $30,000 of expenses needed to operate the $30,000 of expenses needed to operate the company’s computer system and interviewed the company’s computer system and interviewed the manager of the data center and the manager of manager of the data center and the manager of the management information system departmentthe management information system department

20% of computer expenses should be assigned 20% of computer expenses should be assigned to “to “support productssupport products,” an activity already ,” an activity already defined in her activity dictionary, because it was defined in her activity dictionary, because it was used to keep records on the four products, used to keep records on the four products, including:including: Production processProduction process Associated engineering change notice informationAssociated engineering change notice information

Computer System ExpensesComputer System Expenses (2 of 2) (2 of 2)

About 80% of the computer resource was About 80% of the computer resource was involved in the production run activity and involved in the production run activity and seemed to relate well to the “seemed to relate well to the “handle production handle production runsruns” activity already defined:” activity already defined: Schedule production runs in the factorySchedule production runs in the factory Order and pay for the materials required in each Order and pay for the materials required in each

production runproduction run Since each production run was made for a particular Since each production run was made for a particular

customer, also included in this activity was the customer, also included in this activity was the computer time required to:computer time required to:• Prepare shipping documentsPrepare shipping documents• Invoice a customerInvoice a customer• Collect from a customerCollect from a customer

Other Overhead ExpensesOther Overhead Expenses

There were three remaining categories of There were three remaining categories of overhead expense:overhead expense: Machine depreciationMachine depreciation Machine maintenanceMachine maintenance Energy to operate the machinesEnergy to operate the machines

These expenses were incurred to supply These expenses were incurred to supply machine capacity to produce the pens:machine capacity to produce the pens: A practical capability of 10,000 hours of productive A practical capability of 10,000 hours of productive

time could be supplied to pen productiontime could be supplied to pen production The controller labeled this production activity The controller labeled this production activity

““run machinesrun machines””

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

four activities for Classic’s indirect costs, they represented the four activities for Classic’s indirect costs, they represented the three different levels of the manufacturing cost hierarchy:three different levels of the manufacturing cost hierarchy:

PRODUCT SUSTAININGPRODUCT SUSTAININGSUPPORT PRODUCTSSUPPORT PRODUCTS

BATCH LEVELBATCH LEVELSETUP MACHINESSETUP MACHINES

BATCH LEVELBATCH LEVELHANDLE PRODUCTION RUNSHANDLE PRODUCTION RUNS

UNIT LEVELUNIT LEVELRUN MACHINESRUN MACHINES

COST HIERARCHYCOST HIERARCHYACTIVITYACTIVITY

• Finding at least one activity for each hierarchy level gave her confidence that the complexity of the manufacturing process could be represented well enough by the activity-based cost system

Benefits from Half an ABC SystemBenefits from Half an ABC System The ABC model was only half completed (costs The ABC model was only half completed (costs

have not yet been driven down to products), yet it have not yet been driven down to products), yet it had already provided some important insights:had already provided some important insights: Now the controller could see why Classic Pens was Now the controller could see why Classic Pens was

incurring expenditures for resources instead of seeing incurring expenditures for resources instead of seeing categories of expensescategories of expenses

In particular she saw how expensive activities such as In particular she saw how expensive activities such as handling production runs and setting up machines werehandling production runs and setting up machines were

The ABC model shifted the focus from what the The ABC model shifted the focus from what the money was being spent on (labor, equipment, money was being spent on (labor, equipment, supplies) to what the resources acquired by supplies) to what the resources acquired by spending were actually doingspending were actually doing

From ABC to ABMFrom ABC to ABM (1 of 2) (1 of 2) In the past, industrial engineers at Classic Pen In the past, industrial engineers at Classic Pen

had studied labor and materials usage closely:had studied labor and materials usage closely: These had been the high cost resourcesThese had been the high cost resources They were also the primary cost categories featured by They were also the primary cost categories featured by

Classic’s traditional cost systemClassic’s traditional cost system The high overhead rate on direct labor seemed to The high overhead rate on direct labor seemed to

amplify any benefits from direct labor cost savings that amplify any benefits from direct labor cost savings that the industrial engineers could achievethe industrial engineers could achieve

From ABC to ABMFrom ABC to ABM (2 of 2) (2 of 2)

It would be worthwhile to have industrial It would be worthwhile to have industrial engineers study the way Classic handled and engineers study the way Classic handled and scheduled production runs and how the scheduled production runs and how the employees set up machines to uncover new employees set up machines to uncover new opportunities for cost reduction and process opportunities for cost reduction and process improvement projectsimprovement projects This is an example of operational This is an example of operational activity-based activity-based

managementmanagement ( (ABMABM), where managers use ), where managers use information collected by the ABC system at the information collected by the ABC system at the activity level to identify opportunities for reducing activity level to identify opportunities for reducing costs in indirect and support activitiescosts in indirect and support activities

Tracing Costs From Activities To Tracing Costs From Activities To ProductsProducts

The controller next turned her attention to The controller next turned her attention to understanding the demands for these understanding the demands for these activities by the four different productsactivities by the four different products

By understanding how products use By understanding how products use activities, she would be able to relate the activities, she would be able to relate the cost of performing activities to individual cost of performing activities to individual productsproducts

Activity Cost DriversActivity Cost Drivers Activity cost drivers represent the quantity of activities Activity cost drivers represent the quantity of activities

used to produce individual productsused to produce individual products The controller identified the following activity cost drivers The controller identified the following activity cost drivers

for the activities in her activity dictionary:for the activities in her activity dictionary:

ACTIVITY ACTIVITY COST DRIVER

HANDLE PRODUCTION RUNS PRODUCTION RUNS

SET UP MACHINES SETUP HOURS

SUPPORT PRODUCTS NUMBER OF PRODUCTS

RUN MACHINES MACHINE HOURS

PROVIDE FRINGE BENEFITS LABOR DOLLARS

Completing the ABC ModelCompleting the ABC Model (1 of 2) (1 of 2)

Once the activity cost drivers had been Once the activity cost drivers had been determined, the controller obtained determined, the controller obtained quantitative information on:quantitative information on: The total quantity of each activity cost driverThe total quantity of each activity cost driver

The quantity of cost driver used by each The quantity of cost driver used by each productproduct

Completing the ABC ModelCompleting the ABC Model (2 of 2) (2 of 2)

The controller now had sufficient The controller now had sufficient information to estimate a complete activity-information to estimate a complete activity-based cost model for Classic Pen’s factorybased cost model for Classic Pen’s factory She calculated the activity cost driver rate She calculated the activity cost driver rate

(ACDR) by dividing the activity expense by (ACDR) by dividing the activity expense by the total quantity of the activity cost driverthe total quantity of the activity cost driver

She then multiplied the activity cost driver rate She then multiplied the activity cost driver rate by the quantity of each activity cost driver by the quantity of each activity cost driver used by each of the four productsused by each of the four products

Activity Cost DriversActivity Cost DriversActivity CostActivity Cost

DriverDriver BlueBlue BlackBlack RedRed PurplePurple Total**Total**

DL hr/unitDL hr/unit 0.020.02 0.020.02 0.020.02 0.020.02 2,0002,000

Mach. hr/unitMach. hr/unit 0.10.1 0.10.1 0.10.1 0.10.1 10,00010,000

Prod. runsProd. runs 7070 6565 5050 1515 200200

Setup time/runSetup time/run 44 2.42.4 5.65.6 5.65.6 ----

Total setup hrTotal setup hr 280280 156156 280280 8484 800800

# of products# of products 11 11 11 11 44

**Total = per unit **Total = per unit X quantityX quantity 50,00050,000 40,00040,000 9,0009,000 1,0001,000

Activity Cost Driver Rates (Activity Cost Driver Rates (ACDRACDR))

Activity Activity ExpenseExpense

Activity Cost Activity Cost DriverDriver

Driver Driver QuantityQuantity ACDRACDR

Handle Handle Production RunsProduction Runs

$66,000$66,000 Number of Number of production runsproduction runs

200200 $330$330 per per runrun

Set up machinesSet up machines $33,600$33,600 Number of Number of setup hourssetup hours

800800 $42$42 per per setup hrsetup hr

Support Support ProductsProducts

$14,400$14,400 Number of Number of productsproducts

44 $3,600$3,600 per productper product

Run MachinesRun Machines $42,000$42,000 Number of Number of machine hoursmachine hours

10,00010,000 $4.20$4.20 per per machine hrmachine hr

$156,000$156,000

Activity Expenses AssignedActivity Expenses Assigned

BlueBlue BlackBlack RedRed PurplePurple TotalTotal

Handle Handle Production Production RunsRuns

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

Set up Set up machinesmachines

11,76011,760 6,5526,552 11,76011,760 3,5283,528 33,60033,600

Support Support ProductsProducts

3,6003,600 3,6003,600 3,6003,600 3,6003,600 14,40014,400

Run Run MachinesMachines

21,00021,000 16,80016,800 3,7803,780 420420 42,00042,000

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

ABC Profitability ReportABC Profitability Report The controller combined the activity expense analysis for The controller combined the activity expense analysis for

each product with their direct materials and labor costs each product with their direct materials and labor costs to obtain a new ABC profitability reportto obtain a new ABC profitability report

The results from the activity-based costing system were The results from the activity-based costing system were quite different from the results based on the traditional quite different from the results based on the traditional cost systemcost system

The controller now understood why the profitability of The controller now understood why the profitability of Classic Pen has deteriorated in recent years:Classic Pen has deteriorated in recent years:

The two specialty products, which the previous cost system had The two specialty products, which the previous cost system had reported as the most profitable, were in fact the most reported as the most profitable, were in fact the most unprofitable, and losing lots of moneyunprofitable, and losing lots of money

The company had added large quantities of overhead resources The company had added large quantities of overhead resources to enable these products to be designed and produced, but their to enable these products to be designed and produced, but their incremental revenue did not cover those costsincremental revenue did not cover those costs

Total ABC Profitability by ProductTotal ABC Profitability by ProductBlueBlue BlackBlack RedRed PurplePurple TotalTotal

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

MaterialMaterial 75,00075,000 60,00060,000 14,04014,040 1,6501,650 150,690150,690

LaborLabor 30,00030,000 24,00024,000 5,4005,400 600600 60,00060,00040% 40% fringe on fringe on DLDL

12,00012,000 9,6009,600 2,1602,160 240240 24,00024,000

SupportSupport 59,46059,460 48,40248,402 35,64035,640 12,49812,498 156,000156,000Total Mfg. Total Mfg. ExpensesExpenses

176,460176,460 142,002142,002 57,24057,240 14,98814,988 390,690390,690

Gross Gross MarginMargin

$ 48,540$ 48,540 $ 37,998$ 37,998 $(15,390)$(15,390) $(10,038)$(10,038) $ 61,110$ 61,110

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

Using ABC to Improve ProfitabilityUsing ABC to Improve Profitability (1 of 2) (1 of 2) The ABC information provides managers The ABC information provides managers

with numerous insights about how to with numerous insights about how to increase the profitability of Classic Pen:increase the profitability of Classic Pen: Increase either their sales volume or prices to Increase either their sales volume or prices to

compensate for the large batch and product-compensate for the large batch and product-sustaining expenses of the red and purple penssustaining expenses of the red and purple pens

Impose minimum order sizes to eliminate short, Impose minimum order sizes to eliminate short, unprofitable production runsunprofitable production runs

Try to increase demand for the highly profitable Try to increase demand for the highly profitable black and blue pens, which could generate new black and blue pens, which could generate new revenues that exceed their incremental costsrevenues that exceed their incremental costs

Using ABC to Improve ProfitabilityUsing ABC to Improve Profitability (2 of 2) (2 of 2) Improve processes, particularly the processes Improve processes, particularly the processes

performing batch and product-sustaining activitiesperforming batch and product-sustaining activities• Manufacturing personnel can redirect their attention:Manufacturing personnel can redirect their attention:

From trying to run their production equipment faster, in From trying to run their production equipment faster, in order to improve the performance of unit-level activitiesorder to improve the performance of unit-level activities

To learning how to reduce setup times, in order to To learning how to reduce setup times, in order to improve the performance of batch-level activities so that improve the performance of batch-level activities so that small batches of the specialty products would require small batches of the specialty products would require fewer resources to produce and be less expensivefewer resources to produce and be less expensive

The goal of these ABM actions is to enable the company The goal of these ABM actions is to enable the company to produce the same volume and mix of products with to produce the same volume and mix of products with fewer resourcesfewer resources

This leads to lower costs for producing low-volume, specialty This leads to lower costs for producing low-volume, specialty products, and reduces the pressure to raise prices or impose products, and reduces the pressure to raise prices or impose minimum order sizes on customers in order to make such minimum order sizes on customers in order to make such products profitable products profitable

Selecting Activity Cost DriversSelecting Activity Cost Drivers (1 of 2) (1 of 2)

Activity cost drivers are the central innovation of activity-Activity cost drivers are the central innovation of activity-based cost systemsbased cost systems

They are also the most costly to measureThey are also the most costly to measure Particularly the quantity of each activity cost driver Particularly the quantity of each activity cost driver

used by each productused by each product Accordingly, it is important to understand the issues Accordingly, it is important to understand the issues

involved in selecting activity cost driversinvolved in selecting activity cost drivers The selection of an activity cost driver reflects a The selection of an activity cost driver reflects a

subjective trade-off between accuracy and the cost of subjective trade-off between accuracy and the cost of measurementmeasurement An ABC system with 50 activity cost drivers and 2,000 An ABC system with 50 activity cost drivers and 2,000

products would require that 100,000 data elements be products would require that 100,000 data elements be estimatedestimated

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

linkages, management accountants attempt to economize linkages, management accountants attempt to economize on the number of different activity cost driverson the number of different activity cost drivers

Activities triggered by the same event may all use the Activities triggered by the same event may all use the same activity cost driversame activity cost driver

For example, preparing production orders, scheduling production For example, preparing production orders, scheduling production runs, performing first part inspections, and moving materials may runs, performing first part inspections, and moving materials may all use the number of production runsall use the number of production runs

ABC system designers choose from three different types of ABC system designers choose from three different types of activity cost drivers:activity cost drivers:

TransactionTransaction DurationDuration Intensity (direct charging)Intensity (direct charging)

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

Transaction DriversTransaction Drivers Least expensive type of cost driverLeast expensive type of cost driver Also the least accurateAlso the least accurate

They assume that the same quantity of resources is They assume that the same quantity of resources is required every time an activity is performedrequired every time an activity is performed

• For example, a transaction driver such as the number of setups For example, a transaction driver such as the number of setups assumes that all set ups take about the same time to performassumes that all set ups take about the same time to perform

For many activities, the variation in the quantity of For many activities, the variation in the quantity of resources used by each is small enough that a transaction resources used by each is small enough that a transaction driver will be fine for assigning activity expenses to the cost driver will be fine for assigning activity expenses to the cost objectobject

E.g., all setup times are between 30 and 35 minutesE.g., all setup times are between 30 and 35 minutes If the amount of resources required to perform the activity If the amount of resources required to perform the activity

varies considerably from product to product then more varies considerably from product to product then more accurate and more expensive types of cost drivers should accurate and more expensive types of cost drivers should be usedbe used

E.g., Setup times range from 30 minutes to 6 hoursE.g., Setup times range from 30 minutes to 6 hours

Duration DriversDuration Drivers Represent the amount of time required to perform an activityRepresent the amount of time required to perform an activity Should be used when significant variations exist in the Should be used when significant variations exist in the

amount of activity required for different outputsamount of activity required for different outputs A transaction driver such as number of setups will overcost the A transaction driver such as number of setups will overcost the

resources required to set up simple products and undercost the resources required to set up simple products and undercost the resources required for complex productsresources required for complex products

More expensive to implement because they require an More expensive to implement because they require an estimate of time needed each time an activity is performedestimate of time needed each time an activity is performed

The choice between a duration driver and a transactional The choice between a duration driver and a transactional driver is, as always, one of economics:driver is, as always, one of economics:

Balancing the benefits of increased accuracy against the costs of Balancing the benefits of increased accuracy against the costs of increased measurementincreased measurement

Intensity DriversIntensity Drivers Directly charge for the resources used each time an activity Directly charge for the resources used each time an activity

is performedis performed A duration driver, such as setup cost per hour, assumes A duration driver, such as setup cost per hour, assumes

that all hours are equally costly but does not reflect the that all hours are equally costly but does not reflect the higher costs that may be required on some setups:higher costs that may be required on some setups:

E.g., extra personnel, more skilled personnel, more expensive E.g., extra personnel, more skilled personnel, more expensive machinerymachinery

Activity costs may have to be charged directly to the Activity costs may have to be charged directly to the output, based on work orders or other records that output, based on work orders or other records that accumulate the activity expenses incurred for that outputaccumulate the activity expenses incurred for that output

Intensity drivers are the most accurate activity cost drivers Intensity drivers are the most accurate activity cost drivers but the most expensive to implementbut the most expensive to implement

Intensity drivers should be used only when the resources Intensity drivers should be used only when the resources associated with performing an activity are both expensive associated with performing an activity are both expensive and variable each time an activity is performed unless the and variable each time an activity is performed unless the measurements are inexpensivemeasurements are inexpensive

Designing an ABC SystemDesigning an ABC System (1 of 2) (1 of 2)

Sometimes ABC system designers get carried Sometimes ABC system designers get carried away with the potential capabilities of an away with the potential capabilities of an activity-based cost systemactivity-based cost system

For product costing and customer costing For product costing and customer costing purposes, most companies:purposes, most companies: Limit their activity dictionary to 30 to 50 different Limit their activity dictionary to 30 to 50 different

activitiesactivities Choose activity cost drivers that can be obtained Choose activity cost drivers that can be obtained

simply and are available within their organization’s simply and are available within their organization’s existing information systemexisting information system

Designing an ABC SystemDesigning an ABC System (2 of 2) (2 of 2)

The goal of an ABC system should be to have The goal of an ABC system should be to have the best cost system -- not the most accurate the best cost system -- not the most accurate oneone

The ABC system designer should balance the The ABC system designer should balance the cost of errors resulting from inaccurate estimates cost of errors resulting from inaccurate estimates with the cost of measurementwith the cost of measurement

Most of the benefits from a more accurate cost Most of the benefits from a more accurate cost system can be obtained with simple ABC system can be obtained with simple ABC systemssystems

Measuring The CostMeasuring The CostOf Resource CapacityOf Resource Capacity (1 of 2) (1 of 2)

The calculation of activity cost driver rates are The calculation of activity cost driver rates are sometime based on the capacity actually usedsometime based on the capacity actually used

Analysts can obtain a better estimate for the cost of Analysts can obtain a better estimate for the cost of resources required to handle each production run by resources required to handle each production run by dividing activity expenses by the practical capacity of dividing activity expenses by the practical capacity of work the resources could performwork the resources could perform

Otherwise, the activity cost driver rates overestimate Otherwise, the activity cost driver rates overestimate the cost of the activity providedthe cost of the activity provided

The cost of unused capacity should not be assigned The cost of unused capacity should not be assigned to products produced or customers served during a to products produced or customers served during a periodperiod

Measuring The CostMeasuring The CostOf Resource CapacityOf Resource Capacity (2 of 2) (2 of 2)

The activity cost driver rate should reflect the The activity cost driver rate should reflect the underlying efficiency of the process: the cost of underlying efficiency of the process: the cost of resources to handle each production orderresources to handle each production order

This efficiency is measured better by using the This efficiency is measured better by using the capacity of the resources supplied as the capacity of the resources supplied as the denominator when calculating activity cost driver denominator when calculating activity cost driver ratesrates

Still, the cost of unused capacity should not be Still, the cost of unused capacity should not be ignoredignored

Cost of Unused CapacityCost of Unused Capacity (1 of 2) (1 of 2)

The cost of unused capacity remains someone’s or The cost of unused capacity remains someone’s or some department’s responsibilitysome department’s responsibility

Usually you can assign unused capacity after analyzing Usually you can assign unused capacity after analyzing the decision that authorized the level of capacity the decision that authorized the level of capacity suppliedsupplied For example, if the capacity was acquired to meet anticipated For example, if the capacity was acquired to meet anticipated

demands from a particular customer or a particular market demands from a particular customer or a particular market segment, then the costs of unused capacity due to lower than segment, then the costs of unused capacity due to lower than expected demands can be assigned to the person or expected demands can be assigned to the person or organizational unit responsible for that customer or segmentorganizational unit responsible for that customer or segment

Such an assignment is done on a lump-sum basis; it will Such an assignment is done on a lump-sum basis; it will be treated as a sustaining, not a unit-level, expense.be treated as a sustaining, not a unit-level, expense.

Cost of Unused CapacityCost of Unused Capacity (2 of 2) (2 of 2)

If the unused capacity relates to a particular product line If the unused capacity relates to a particular product line then the cost of unused capacity is assigned to that then the cost of unused capacity is assigned to that product line, where the demand failed to materializeproduct line, where the demand failed to materialize

Unused capacity should not be treated as a general cost, Unused capacity should not be treated as a general cost, to be shared across all product linesto be shared across all product lines

In making assignment of unused capacity costs, we trace In making assignment of unused capacity costs, we trace the costs at the level in the organization where decisions the costs at the level in the organization where decisions are made that affect the supply of capacity resources and are made that affect the supply of capacity resources and the demand for those resourcesthe demand for those resources

The lump-sum assignment of unused capacity costs The lump-sum assignment of unused capacity costs provides feedback to managers on their supply and provides feedback to managers on their supply and demand decisionsdemand decisions

Fixed and Variable ExpensesFixed and Variable Expenses Most indirect expenses assigned by an ABC Most indirect expenses assigned by an ABC

system are committed costssystem are committed costs Committed costs become variable via a two-step Committed costs become variable via a two-step

procedure:procedure: First, demands for resources change either because of First, demands for resources change either because of

changes in the quantity of activities performed or changes in the quantity of activities performed or because of changes in the efficiency of performing because of changes in the efficiency of performing activitiesactivities

Second, managers must make decisions to change the Second, managers must make decisions to change the supply of committed resources, either up or down, to supply of committed resources, either up or down, to meet the new level of demand for the activities meet the new level of demand for the activities performed by these resourcesperformed by these resources

Activity in Excess of CapacityActivity in Excess of Capacity If activity volumes exceed the capacity of existing If activity volumes exceed the capacity of existing

resources, the result isresources, the result is BottlenecksBottlenecks ShortagesShortages Increased pace of activityIncreased pace of activity DelaysDelays Poor-quality workPoor-quality work

Such shortages occur often on machines, but can also Such shortages occur often on machines, but can also occur in human resources who perform support activitiesoccur in human resources who perform support activities

Facing such shortages, companies typically make Facing such shortages, companies typically make committed costs variablecommitted costs variable

They relieve the bottleneck by spending more to increase the They relieve the bottleneck by spending more to increase the supply of resources to perform worksupply of resources to perform work

This is why many indirect costs increase over timeThis is why many indirect costs increase over time

Decreased Demand for ResourcesDecreased Demand for Resources Demands for indirect and support resources also can Demands for indirect and support resources also can

declinedecline Consciously through activity-based managementConsciously through activity-based management Inadvertently through competitive or economy-wide forces that lead Inadvertently through competitive or economy-wide forces that lead

to declines in salesto declines in sales

Should the demands for batch and product-sustaining Should the demands for batch and product-sustaining resources decrease, few immediate spending reductions resources decrease, few immediate spending reductions will be noticedwill be noticed

Even for many unit-level resources, such as machines and Even for many unit-level resources, such as machines and direct labor, reduced demands for work does not direct labor, reduced demands for work does not immediately lead to spending decreasesimmediately lead to spending decreases

The reduced demand for organizational resources lowers The reduced demand for organizational resources lowers the cost of resources used, but this decrease is offset by the cost of resources used, but this decrease is offset by an equivalent increase in the cost of unused capacityan equivalent increase in the cost of unused capacity

Making Committed CostsMaking Committed CostsVariable DownwardVariable Downward

After unused capacity has been created, committed After unused capacity has been created, committed costs will vary downward if, and only if, managers costs will vary downward if, and only if, managers actively reduce the supply of unused resourcesactively reduce the supply of unused resources

What makes a resource cost “variable” downward is What makes a resource cost “variable” downward is not inherent in the nature of the resourcenot inherent in the nature of the resource

It is a function of management decisionsIt is a function of management decisions To reduce the demands for the resourceTo reduce the demands for the resource To lower the spending on itTo lower the spending on it

Managers Make Costs FixedManagers Make Costs Fixed (1 of 2) (1 of 2)

Organizations often create unused capacity Organizations often create unused capacity through activity-based management actionsthrough activity-based management actions Process improvementProcess improvement Repricing to modify the product mixRepricing to modify the product mix Imposing minimum order sizes on customersImposing minimum order sizes on customers

They keep existing resources in place, when They keep existing resources in place, when demands for the activities performed by the demands for the activities performed by the resources have diminishedresources have diminished

They also fail to find new activities that could be They also fail to find new activities that could be done by the unused resources already in placedone by the unused resources already in place

Managers Make Costs FixedManagers Make Costs Fixed (2 of 2) (2 of 2) The organization receives no benefits from its activity-The organization receives no benefits from its activity-

based management decisions that reduced the demands based management decisions that reduced the demands on their resources if capacity is not reduced or redeployedon their resources if capacity is not reduced or redeployed

The failure to capture benefits from activity-based The failure to capture benefits from activity-based management is not because their costs are “fixed”management is not because their costs are “fixed”

The failure occurs because managers are unwilling or unable to The failure occurs because managers are unwilling or unable to take advantage of the unused capacity they have created bytake advantage of the unused capacity they have created by

• Spending less on capacity resourcesSpending less on capacity resources• Increasing the volume of work processed by the capacity Increasing the volume of work processed by the capacity

resourcesresources The cost of these resources is only “fixed” if managers do The cost of these resources is only “fixed” if managers do

not exploit the opportunities from the unused capacity they not exploit the opportunities from the unused capacity they helped to createhelped to create

Making decisions based solely upon resource usage (the Making decisions based solely upon resource usage (the ABC system) may not increase profits if managers are not ABC system) may not increase profits if managers are not prepared to reduce spending to align resource supply with prepared to reduce spending to align resource supply with future lower levels of demand future lower levels of demand

Problems Implementing ABCProblems Implementing ABC (1 of 3) (1 of 3)

Several problems arise in practice from the Several problems arise in practice from the common approach to activity-based costing that common approach to activity-based costing that assigns many resource expenses to activities assigns many resource expenses to activities based on interviews, surveys, and direct based on interviews, surveys, and direct observation of production and support processesobservation of production and support processes The interview and survey processes are time consuming The interview and survey processes are time consuming

and costlyand costly• This front-end cost to an ABC analysis is often a This front-end cost to an ABC analysis is often a

barrier to widespread ABC adoptionbarrier to widespread ABC adoption

Problems Implementing ABCProblems Implementing ABC (2 of (2 of

3)3) Inaccuracies and bias may affect the accuracy of cost Inaccuracies and bias may affect the accuracy of cost

driver rates derived from individuals’ subjective driver rates derived from individuals’ subjective estimates of their past or future behaviorestimates of their past or future behavior

Companies must periodically repeat the interviewing Companies must periodically repeat the interviewing and surveying processes if they want to keep their and surveying processes if they want to keep their activity-based cost systems updatedactivity-based cost systems updated• High updating cost leads to infrequent updates of High updating cost leads to infrequent updates of

many ABC systems and, eventually, to obsolete cost many ABC systems and, eventually, to obsolete cost driver estimates driver estimates

Adding new activities to the system is also difficult, Adding new activities to the system is also difficult, requiring re-estimates of the relative amount of resource requiring re-estimates of the relative amount of resource time and effort required by the new activitytime and effort required by the new activity

Problems Implementing ABCProblems Implementing ABC (3 of 3)(3 of 3)

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

of activities handed to them invariably report of activities handed to them invariably report percentages that add up to 100%percentages that add up to 100%

• Few individuals report that a significant percentage of Few individuals report that a significant percentage of their time is idle or unusedtheir time is idle or unused

Accordingly, the cost driver rates calculated from Accordingly, the cost driver rates calculated from this process assume that resources are working at this process assume that resources are working at full capacityfull capacity

But operations at capacity are more the exception But operations at capacity are more the exception than the rulethan the rule

Time-Driven ABC:Time-Driven ABC:An Alternative Approach An Alternative Approach

Several companies have overcome these Several companies have overcome these problems by using a new approach for problems by using a new approach for estimating their ABC modelsestimating their ABC models

The insight for the new approach is simple:The insight for the new approach is simple: Most ABC systems use a large number of Most ABC systems use a large number of

transactional cost drivers that assume each transactional cost drivers that assume each occurrence of the event (a production run, a occurrence of the event (a production run, a customer order, a product to support) customer order, a product to support) consumes the same quantity of resourcesconsumes the same quantity of resources

Time-Driven ABC:Time-Driven ABC:

This homogeneity assumption provides This homogeneity assumption provides the foundation for an alternative approach the foundation for an alternative approach to estimating cost driver rates. The new to estimating cost driver rates. The new approach requires two new estimates:approach requires two new estimates: The unit cost of supplying capacity, andThe unit cost of supplying capacity, and The consumption of capacity (unit times) by The consumption of capacity (unit times) by

each activityeach activity

Unit Cost EstimateUnit Cost Estimate (1 of 3) (1 of 3) The new procedure starts with the same The new procedure starts with the same

information used by a traditional ABC approach: information used by a traditional ABC approach: The cost of resources that supply capacity and The cost of resources that supply capacity and The practical capacity of the resources suppliedThe practical capacity of the resources supplied

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

• This estimate allows time (e.g., 15 – 20%) for This estimate allows time (e.g., 15 – 20%) for nonproductive time:nonproductive time:

For personnel, time for breaks, arrival and For personnel, time for breaks, arrival and departure, and communication and reading departure, and communication and reading unrelated to actual work performanceunrelated to actual work performance

Unit Cost EstimateUnit Cost Estimate (2 of 3)(2 of 3)

For machines, an allowance for downtime due to For machines, an allowance for downtime due to maintenance, repair, and scheduling fluctuationsmaintenance, repair, and scheduling fluctuations

With estimates of the cost of supplying capacity With estimates of the cost of supplying capacity and practical capacity, the analyst can calculate and practical capacity, the analyst can calculate the unit cost of supplying capacity: the unit cost of supplying capacity:

Unit cost =Cost of capacity supplied

Practical capacity of resources supplied

Unit Cost EstimateUnit Cost Estimate (3 of 3) (3 of 3)

For example, assume that indirect labor For example, assume that indirect labor employees supply about 2,500 hours of labor in employees supply about 2,500 hours of labor in total each quarter at a cost of $84,000. The total each quarter at a cost of $84,000. The practical capacity (at 80% of theoretical) is about practical capacity (at 80% of theoretical) is about 2,000 hours per quarter, leading to a unit cost (per 2,000 hours per quarter, leading to a unit cost (per hour) of supplying indirect labor capacity of:hour) of supplying indirect labor capacity of:

Indirect labor cost per hour =$84,000

2000 hours

= $42 per hour

Unit Time Estimate Unit Time Estimate The second piece of new information is an estimate of time The second piece of new information is an estimate of time

used each time a committed resource performs a used each time a committed resource performs a transactional activitytransactional activity Precision is not criticalPrecision is not critical Rough accuracy is sufficientRough accuracy is sufficient

Estimates for the indirect labor from the Classic Pen Estimates for the indirect labor from the Classic Pen example are:example are:

ResourceResource ActivityActivity Unit TimeUnit Time

Indirect Indirect LaborLabor

Production RunProduction Run 5 hours5 hours

Support ProductsSupport Products 50 hours50 hours

Cost Driver RateCost Driver Rate

Assume similar calculations regarding computer Assume similar calculations regarding computer resources produced estimates of $60 per hour and 2 resources produced estimates of $60 per hour and 2 hours per production runhours per production run

The cost driver rate for the activity, The cost driver rate for the activity, handle production handle production runsruns, can now be calculated as the costs of using , can now be calculated as the costs of using indirect labor and the computer for each production run:indirect labor and the computer for each production run:

Unit CostUnit Cost Unit TimeUnit Time Cost DriverCost Driver

Indirect Labor ResourceIndirect Labor Resource $42 per hour$42 per hour 5 hours/run5 hours/run $210 per run$210 per run

+ Computer Resource+ Computer Resource $60 per hour$60 per hour 2 hours/run2 hours/run 120 per run120 per run

= Activity Cost Driver Rate= Activity Cost Driver Rate $330 per $330 per runrun

Advantages of Time-Driven ABCAdvantages of Time-Driven ABC

Managers may easily update their time-driven ABC Managers may easily update their time-driven ABC model to reflect changes in their operating conditionsmodel to reflect changes in their operating conditions They can incorporate the new knowledge by providing They can incorporate the new knowledge by providing

reasonable estimates about the unit times required for reasonable estimates about the unit times required for different activities for each type of productdifferent activities for each type of product

Managers may also easily update the activity cost Managers may also easily update the activity cost driver ratesdriver rates Changes in the prices of resources supplied affect the Changes in the prices of resources supplied affect the

hourly cost ratehourly cost rate Activity cost driver rates change when there has been a Activity cost driver rates change when there has been a

shift in the efficiency of the activityshift in the efficiency of the activity

Tracing Marketing-RelatedTracing Marketing-RelatedCosts to CustomersCosts to Customers

The costs of marketing, selling, and distribution expenses The costs of marketing, selling, and distribution expenses have been increasing rapidly in recent yearshave been increasing rapidly in recent years Result of increased importance of customer satisfaction Result of increased importance of customer satisfaction

and market-oriented strategiesand market-oriented strategies Many of these expenses do not relate to individual Many of these expenses do not relate to individual

products or product lines but are associated with:products or product lines but are associated with: Individual customersIndividual customers Market segmentsMarket segments Distribution channelsDistribution channels

Companies need to understand the cost of selling to and Companies need to understand the cost of selling to and serving their diverse customer baseserving their diverse customer base

Activity-Based PricingActivity-Based Pricing

Pricing is the most powerful tool a company can Pricing is the most powerful tool a company can use to transform unprofitable customers into use to transform unprofitable customers into profitable onesprofitable ones

Activity-based pricing establishes a base price for Activity-based pricing establishes a base price for producing and delivering a standard quantity for producing and delivering a standard quantity for each standard producteach standard product To this base price, the company provides a menu of To this base price, the company provides a menu of

options, with associated prices, for any special services options, with associated prices, for any special services requested by the customerrequested by the customer

Special services may be priced just to cover costs Special services may be priced just to cover costs or also to earn a marginor also to earn a margin

Activity-based pricing prices orders, not productsActivity-based pricing prices orders, not products

ABC at Service CompaniesABC at Service Companies (1 of 2) (1 of 2) Although ABC had its origins in manufacturing Although ABC had its origins in manufacturing

companies, many service organizations today are companies, many service organizations today are obtaining great benefits from this approachobtaining great benefits from this approach In practice, the actual construction of an ABC model is In practice, the actual construction of an ABC model is

nearly identical for both types of companiesnearly identical for both types of companies This should not be surprising since, in manufacturing This should not be surprising since, in manufacturing

companies, the ABC system focuses on the “service” companies, the ABC system focuses on the “service” component of the companycomponent of the company

ABC at Service CompaniesABC at Service Companies (2 of 2) (2 of 2)

Service companies in general are ideal Service companies in general are ideal candidates for activity-based costingcandidates for activity-based costing Virtually all costs are indirect and appear fixedVirtually all costs are indirect and appear fixed They often do not have direct, traceable costs to They often do not have direct, traceable costs to

serve as convenient allocation basesserve as convenient allocation bases They must supply virtually all their resources in They must supply virtually all their resources in

advance to provide the capacity to perform work for advance to provide the capacity to perform work for customers during each periodcustomers during each period

Implementation IssuesImplementation Issues (1 of 2) (1 of 2)

Not all ABC systems have been sustained or contributed to Not all ABC systems have been sustained or contributed to higher profitability for the companyhigher profitability for the company

Some companies have experienced difficulties and frustrations in Some companies have experienced difficulties and frustrations in building and using activity-based cost and profitability models for building and using activity-based cost and profitability models for some of the following reasonssome of the following reasons

Lack of clear business purposeLack of clear business purpose The project may start in Accounting/Finance, and nobody outside the The project may start in Accounting/Finance, and nobody outside the

department understands what changes need to be made and whydepartment understands what changes need to be made and why

Lack of senior management commitmentLack of senior management commitment The group (usually Accounting/Finance) that initiates the project The group (usually Accounting/Finance) that initiates the project

probably does not have the authority to make decisions about probably does not have the authority to make decisions about processes, product designs, etc., without full senior management processes, product designs, etc., without full senior management supportsupport

Implementation IssuesImplementation Issues (2 of 2) (2 of 2) Delegating the project to consultantsDelegating the project to consultants

Consultants are usually not familiar enough with the business’s Consultants are usually not familiar enough with the business’s organization and problems and may not be able to build organization and problems and may not be able to build management consensusmanagement consensus

Poor ABC model designPoor ABC model design The model may be too complicated to build and maintain and too The model may be too complicated to build and maintain and too

complex for managers to understand and act uponcomplex for managers to understand and act upon Or the model may use arbitrary allocations that merely create Or the model may use arbitrary allocations that merely create

different distortions than the old systemdifferent distortions than the old system The new data requirements may increase the workload of other The new data requirements may increase the workload of other

functions without increasing the benefits to themfunctions without increasing the benefits to them Individual and organizational resistance to changeIndividual and organizational resistance to change

People may feel threatened by the suggestion that their work People may feel threatened by the suggestion that their work might be improvedmight be improved

Resistance may be overt, but it may be more subtle and passiveResistance may be overt, but it may be more subtle and passive