Activity-Based CostManagement SystemsChapter 4

Problems With Simple Cost Accounting Systems: The Cooper Pen Company ExampleCooper Pen had been the low-cost producer of blue pens and black pens, with profit margins exceeding 20% of salesSeveral years ago Cooper Pen expanded their business by extending their product line into products with premium selling prices

The Cooper Pen Company ExampleFive years ago red pens were introducedThe same basic production technologyCould be sold at a price that was 3% higher than for blue and black pensLast year purple pens were addedCould be sold at a 10% price premiumThe controller of Cooper Pen was disappointed with the most recent quarters financial resultsOverall profitability for all four together had decreasedThe red and purple pens, however, were more profitable than the blue and black pens

Total Profitability by Product

Concern at Cooper PenThe controller of Cooper Pen wondered whether the company should continue to deemphasize the blue and black commodity products and keep introducing new specialty colored pensCoopers manufacturing manager commented on how the introduction of colored pens had changed the production environment:Everything ran smoothly when producing just blue and black pens in long production runsDifficulties started when the red pens were introduced and required more changeovers

Changes Caused by New Pens (1 of 2)Making black ink was simple; there was not even a need to clean out the residual blue ink from the previous run if enough black ink was dumped in to cover it upRed required Cooper to stop production, empty the vats, clean out all remnants of the previous color, and then start the production of the red inkEven small traces of the blue or black ink created quality problemsThe ink for the purple pens also had demanding specifications, though not quite as demanding as the red ink

Changes Caused by New Pens (2 of 2)Cooper Pens was also spending more time on purchasing and scheduling activities and keeping track of existing, backlogged, and future ordersCoopers manufacturing manager was concerned about rumors that new colors may be introduced in the near futureHe did not think they had any more capability to handle additional confusion and complexity in the operationsLast years new computer system helped to reduce some of the confusion

Pen Production At CoopersPen production at the factory involved:Preparing and mixing the ink for the different color pensInserting the ink into the pens in a semiautomated processPacking and shipping the pens in a manual stageEach product had a:Bill of materials that identified the quantity and cost of direct materials required for the productRouting sheet that identified the sequence of operations required for each operating stepThis information was used to calculate the labor expenses for each of the four productsFrom this information, it was easy to calculate the direct materials costs and direct labor costs for each color pen

Coopers Indirect Cost AllocationBecause it was a small company and historically had produced only a narrow range of products, Cooper used a simple costing systemAll the plants indirect expenses were aggregated at the plant level and allocated to products based on each products direct labor costCurrently the cost systems overhead burden rate was 300% of direct labor costBefore the new specialty products were introduced, the overhead rate was only 200% of direct labor cost

Cooper Pens Cost SystemCoopers management accountants designed the system years ago when:Production operations were mostly manualTotal indirect costs were less than direct labor costsCoopers two products had similar production volumes and batch sizesGiven the high cost of measuring and recording information, the accountants at the time judged correctly that a complex costing system would cost more to operate than the benefits it would provide

A Changed Production EnvironmentDirect labor costs have decreased and indirect expenses have increased as a result of automationAs custom low-volume products, such as red and purple pens were added, Cooper needed:More schedulingMore setupsMore quality control personnelA computer to track orders and product specifications

An Outdated Cost SystemCooper operates with only a single cost center, the plantMost complex companies use many cost centers for cost accumulationEven if Cooper Pen used multiple production and service department cost centers, it could still encounter severe distortions in its reported product costs:In an environment of high product variety, using only unit-level drivers (such as direct labor costs) to allocate overhead costs to products could lead to product cost distortion

Reason for Cost Distortions (1 of 3)schedule machine and production runsperform setupsinspect produced items after setupmove materialsship ordersexpedite ordersrework defective itemsdesign new productsimprove existing productsnegotiate with vendorsschedule materials receiptsorder, receive, and inspect incoming materials and partsupdate and maintain the much larger computer-based information systemA 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 Distortions (2 of 3)Because the factory has the same physical output, it has roughly the same cost of materials (ignoring the slightly higher acquisition costs for smaller orders of specialty colors and other materials)Because all pens are about the same complexity, each pen would require the same number of direct labor hours and machine hours to produce The Cooper Pen Company factory has about the same property taxes, security costs, and heating bills as before, but it has much higher indirect and support costs because of its more varied product mix and complex production tasks

Reason for Cost Distortions (3 of 3)On a per unit basis, high-volume standard blue and black pens require about the same amount of direct labor costs (the allocation basis) as the low volume color pensTherefore, the traditional costing system would report essentially identical product costs for all products, standard and specialty, irrespective of their relative production volumesThis would hold true even if the cost system had multiple production and service cost centersClearly, however, considerably more indirect and support resources are required on a per-unit basis for the low-volume, newly designed products than for the high-volume, standard blue and black pens

Activity-Based Cost SystemsActivity-based cost systems have been developed to eliminate this major source of cost distortionActivity-based cost (ABC) management systems use a simple two-stage approach similar to but more general than traditional cost systemsThe next slide compares the essential elements of the two systems

Traditional v. ABC SystemTraditional:Uses actual departments or cost centers for accumulating and redistributing costsAsks how much of an allocation basis (usually based on volume) is used by the production departmentService department expenses are allocated to a production department based on the ratio of the allocation basis used by the production department

ABC:Uses activities, for accumulating costs and redistributing costsAsks what activities are being performed by the resources of the service departmentResource expenses are assigned to activities based on how much of the resource is required or used to perform the activities

Tracing Costs to ActivitiesHeres how an ABC system works, using the Cooper Pen Company as an example:The controller started an analysis of indirect expenses, beginning with indirect laborThe controller interviewed department heads in charge of indirect labor and found that the people in these departments performed three main activities

Indirect Labor Activities (1 of 2)50% of indirect labor was involved in what the controller called handle production runs Scheduling production ordersPurchasing, preparing, and releasing materialsInspecting the first few units produced each time the process was changed to a new-colored pen40% of indirect labor actually performed the physical changeover from one color pen to another, an activity that she labeled perform setupsChange to Black pens takes 2.4 hoursChange to Red or Purple pens takes 5.6 hours

Indirect Labor Activities (2 of 2)10% of the time was spent on activities the controller called support products: maintaining records on the four products, such as:Making up the bill of materials and routing informationMonitoring and maintaining a minimum supply of raw materials and finished goods inventory for each productImproving the production processesPerforming engineering changes for the products

First Steps in Design of An ABC SystemAs she conducted the interviews, the controller was performing the first two steps for designing an activity-based cost system: Develop the activity dictionary: the list of major activities performed by both the factorys human and physical resourcesObtain sufficient information to assign resource expenses to each activity in the activity dictionary (50% of indirect labor to handle production runs, 40% to perform setups, and 10% to support products)

Computer System Expenses (1 of 2)The controller next turned her attention to the $30,000 of expenses needed to operate the companys computer system and interviewed the manager of the data center and the manager of the management information system department20% of computer expenses should be assigned to support products, an activity already defined in her activity dictionary, because it was used to keep records on the four products, including:Production processAssociated engineering change notice information

Computer System Expenses (2 of 2)About 80% of the computer resource was involved in the production run activity and seemed to relate well to the handle production runs activity already defined:Schedule production runs in the factoryOrder and pay for the materials required in each production runSince each production run was made for a particular customer, also included in this activity was the computer time required to:Prepare shipping documentsInvoice a customerCollect from a customer

Other Overhead ExpensesThere were three remaining categories of overhead expense:Machine depreciationMachine maintenanceEnergy to operate the machinesThese expenses were incurred to supply machine capacity to produce the pens:A practical capability of 10,000 hours of productive time could be supplied to pen productionThe controller labeled this production activity run machines

Identifying Cost HierarchiesThe controller noted that even though she had defined only four activities for Coopers indirect costs, they represented the three different levels of the manufacturing cost hierarchy:PRODUCT SUSTAININGSUPPORT PRODUCTSBATCH LEVELSETUP MACHINESBATCH LEVELHANDLE PRODUCTION RUNSUNIT LEVELRUN MACHINESCOST HIERARCHYACTIVITYFinding 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 SystemThe ABC model was only half completed (costs have not yet been driven down to products), yet it had already provided some important insights:Now the controller could see why Cooper Pens was incurring expenditures for resources instead of seeing categories of expensesIn particular she saw how expensive activities such as handling production runs and setting up machines wereThe ABC model shifted the focus from what the money was being spent on (labor, equipment, supplies) to what the resources acquired by spending were actually doing

From ABC to ABM (1 of 2)In the past, industrial engineers at Cooper Pen had studied labor and materials usage closely:These had been the high cost resourcesThey were also the primary cost categories featured by Coopers traditional cost systemThe high overhead rate on direct labor seemed to amplify any benefits from direct labor cost savings that the industrial engineers could achieve

From ABC to ABM (2 of 2)It would be worthwhile to have industrial engineers study the way Cooper handled and scheduled production runs and how the employees set up machines to uncover new opportunities for cost reduction and process improvement projectsThis is an example of operational activity-based management (ABM), where managers use information collected by the ABC system at the activity level to identify opportunities for reducing costs in indirect and support activities

Tracing Costs From Activities To ProductsThe controller next turned her attention to understanding the demands for these activities by the four different productsBy understanding how products use activities, she would be able to relate the cost of performing activities to individual products

Activity Cost DriversActivity cost drivers represent the quantity of activities used to produce individual productsThe controller identified the following activity cost drivers for the activities in her activity dictionary:

ACTIVITYACTIVITY COST DRIVERHANDLE PRODUCTION RUNSPRODUCTION RUNSSET UP MACHINESSETUP HOURSSUPPORT PRODUCTSNUMBER OF PRODUCTSRUN MACHINESMACHINE HOURSPROVIDE FRINGE BENEFITSLABOR DOLLARS

Completing the ABC Model (1 of 2)Once the activity cost drivers had been determined, the controller obtained quantitative information on:The total quantity of each activity cost driverThe quantity of cost driver used by each product

Completing the ABC Model (2 of 2)The controller now had sufficient information to estimate a complete activity-based cost model for Cooper Pens factoryShe calculated the activity cost driver rate (ACDR) by dividing the activity expense by the total quantity of the activity cost driverShe then multiplied the activity cost driver rate by the quantity of each activity cost driver used by each of the four products

Activity Cost Drivers

Activity Cost Driver Rates (ACDR)

Activity Expenses Assigned

ABC Profitability ReportThe controller combined the activity expense analysis for each product with their direct materials and labor costs to obtain a new ABC profitability reportThe results from the activity-based costing system were quite different from the results based on the traditional cost systemThe controller now understood why the profitability of Cooper Pen has deteriorated in recent years:The two specialty products, which the previous cost system had reported as the most profitable, were in fact the most unprofitable, and losing lots of moneyThe company had added large quantities of overhead resources to enable these products to be designed and produced, but their incremental revenue did not cover those costs

Total ABC Profitability by Product

Using ABC to Improve Profitability (1 of 2) The ABC information provides managers with numerous insights about how to increase the profitability of Cooper Pen:Increase either their sales volume or prices to compensate for the large batch and product-sustaining expenses of the red and purple pensImpose minimum order sizes to eliminate short, unprofitable production runsTry to increase demand for the highly profitable black and blue pens, which could generate new revenues that exceed their incremental costs

Using ABC to Improve Profitability (2 of 2) Improve processes, particularly the processes performing batch and product-sustaining activitiesManufacturing personnel can redirect their attention:From trying to run their production equipment faster, in order to improve the performance of unit-level activitiesTo learning how to reduce setup times, in order to improve the performance of batch-level activities so that small batches of the specialty products would require fewer resources to produce and be less expensiveThe goal of these ABM actions is to enable the company to produce the same volume and mix of products with fewer resourcesThis leads to lower costs for producing low-volume, specialty products, and reduces the pressure to raise prices or impose minimum order sizes on customers in order to make such products profitable

Selecting Activity Cost Drivers (1 of 2)Activity cost drivers are the central innovation of activity-based cost systemsThey are also the most costly to measureParticularly the quantity of each activity cost driver used by each productAccordingly, it is important to understand the issues involved in selecting activity cost driversThe selection of an activity cost driver reflects a subjective trade-off between accuracy and the cost of measurementAn ABC system with 50 activity cost drivers and 2,000 products would require that 100,000 data elements be estimated

Selecting Activity Cost Drivers (2 of 2)Because of the large number of potential activity-to-product linkages, management accountants attempt to economize on the number of different activity cost driversActivities triggered by the same event may all use the same activity cost driverFor example, preparing production orders, scheduling production runs, performing first part inspections, and moving materials may all use the number of production runsABC system designers choose from three different types of activity cost drivers:TransactionDurationIntensity (direct charging)The choice of a transaction, duration, or intensity cost driver can occur for almost any activity

Transaction DriversLeast expensive type of cost driverAlso the least accurateThey assume that the same quantity of resources is required every time an activity is performedFor example, a transaction driver such as the number of setups assumes that all setups take about the same time to performFor many activities, the variation in the quantity of resources used by each is small enough that a transaction driver will be fine for assigning activity expenses to the cost objectE.g., all setup times are between 30 and 35 minutesIf the amount of resources required to perform the activity varies considerably from product to product then more accurate and more expensive types of cost drivers should be usedE.g., Setup times range from 30 minutes to 6 hours

Duration DriversRepresent the amount of time required to perform an activityShould be used when significant variations exist in the amount of activity required for different outputsA transaction driver such as number of setups will overcost the resources required to set up simple products and undercost the resources required for complex productsMore expensive to implement because they require an estimate of time needed each time an activity is performedThe choice between a duration driver and a transactional driver is, as always, one of economics:Balancing the benefits of increased accuracy against the costs of increased measurement

Intensity DriversDirectly charge for the resources used each time an activity is performedA duration driver, such as setup cost per hour, assumes that all hours are equally costly but does not reflect the higher costs that may be required on some setups:E.g., extra personnel, more skilled personnel, more expensive machineryActivity costs may have to be charged directly to the output, based on work orders or other records that accumulate the activity expenses incurred for that outputIntensity drivers are the most accurate activity cost drivers but the most expensive to implementIntensity drivers should be used only when the resources associated with performing an activity are both expensive and variable each time an activity is performed unless the measurements are inexpensive

Designing an ABC System (1 of 2)Sometimes ABC system designers get carried away with the potential capabilities of an activity-based cost systemFor product costing and customer costing purposes, most companies:Limit their activity dictionary to 30 to 50 different activitiesChoose activity cost drivers that can be obtained simply and are available within their organizations existing information system

Designing an ABC System (2 of 2)The goal of an ABC system should be to have the best cost system -- not the most accurate oneThe ABC system designer should balance the cost of errors resulting from inaccurate estimates with the cost of measurementMost of the benefits from a more accurate cost system can be obtained with simple ABC systems

Measuring The CostOf Resource Capacity (1 of 2)The calculation of activity cost driver rates are sometime based on the capacity actually usedAnalysts can obtain a better estimate for the cost of resources required to handle each production run by dividing activity expenses by the practical capacity of work the resources could performOtherwise, the activity cost driver rates overestimate the cost of the activity providedThe cost of unused capacity should not be assigned to products produced or customers served during a period

Measuring The CostOf Resource Capacity (2 of 2)The activity cost driver rate should reflect the underlying efficiency of the process: the cost of resources to handle each production orderThis efficiency is measured better by using the capacity of the resources supplied as the denominator when calculating activity cost driver ratesStill, the cost of unused capacity should not be ignored

Cost of Unused Capacity (1 of 2)The cost of unused capacity remains someones or some departments responsibilityUsually you can assign unused capacity after analyzing the decision that authorized the level of capacity suppliedFor example, if the capacity was acquired to meet anticipated demands from a particular customer or a particular market segment, then the costs of unused capacity due to lower than expected demands can be assigned to the person or organizational unit responsible for that customer or segmentSuch an assignment is done on a lump-sum basis; it will be treated as a sustaining, not a unit-level, expense.

Cost of Unused Capacity (2 of 2)If the unused capacity relates to a particular product line then the cost of unused capacity is assigned to that product line, where the demand failed to materializeUnused capacity should not be treated as a general cost, to be shared across all product linesIn making assignment of unused capacity costs, we trace the costs at the level in the organization where decisions are made that affect the supply of capacity resources and the demand for those resourcesThe lump-sum assignment of unused capacity costs provides feedback to managers on their supply and demand decisions

Fixed and Variable ExpensesMost indirect expenses assigned by an ABC system are committed costsCommitted costs become variable via a two-step procedure:First, demands for resources change either because of changes in the quantity of activities performed or because of changes in the efficiency of performing activitiesSecond, managers must make decisions to change the supply of committed resources, either up or down, to meet the new level of demand for the activities performed by these resources

Activity in Excess of CapacityIf activity volumes exceed the capacity of existing resources, the result isBottlenecksShortagesIncreased pace of activityDelaysPoor-quality workSuch shortages occur often on machines, but can also occur in human resources who perform support activitiesFacing such shortages, companies typically make committed costs variableThey relieve the bottleneck by spending more to increase the supply of resources to perform workThis is why many indirect costs increase over time

Decreased Demand for ResourcesDemands for indirect and support resources also can declineConsciously through activity-based managementInadvertently through competitive or economy-wide forces that lead to declines in salesShould the demands for batch and product-sustaining resources decrease, few immediate spending reductions will be noticedEven for many unit-level resources, such as machines and direct labor, reduced demands for work does not immediately lead to spending decreasesThe reduced demand for organizational resources lowers the cost of resources used, but this decrease is offset by an equivalent increase in the cost of unused capacity

Making Committed CostsVariable DownwardAfter unused capacity has been created, committed costs will vary downward if, and only if, managers actively reduce the supply of unused resourcesWhat makes a resource cost variable downward is not inherent in the nature of the resourceIt is a function of management decisionsTo reduce the demands for the resourceTo lower the spending on it

Managers Make Costs Fixed (1 of 2)Organizations often create unused capacity through activity-based management actionsProcess improvementRepricing to modify the product mixImposing minimum order sizes on customersThey keep existing resources in place, when demands for the activities performed by the resources have diminishedThey also fail to find new activities that could be done by the unused resources already in place

Managers Make Costs Fixed (2 of 2)The organization receives no benefits from its activity-based management decisions that reduced the demands on their resources if capacity is not reduced or redeployedThe failure to capture benefits from activity-based management is not because their costs are fixedThe failure occurs because managers are unwilling or unable to take advantage of the unused capacity they have created bySpending less on capacity resourcesIncreasing the volume of work processed by the capacity resourcesThe cost of these resources is only fixed if managers do not exploit the opportunities from the unused capacity they helped to createMaking decisions based solely upon resource usage (the ABC system) may not increase profits if managers are not prepared to reduce spending to align resource supply with future lower levels of demand

Problems Implementing ABC (1 of 3)Several problems arise in practice from the common approach to activity-based costing that assigns many resource expenses to activities based on interviews, surveys, and direct observation of production and support processesThe interview and survey processes are time consuming and costlyThis front-end cost to an ABC analysis is often a barrier to widespread ABC adoption

Problems Implementing ABC (2 of 3)Inaccuracies and bias may affect the accuracy of cost driver rates derived from individuals subjective estimates of their past or future behaviorCompanies must periodically repeat the interviewing and surveying processes if they want to keep their activity-based cost systems updatedHigh updating cost leads to infrequent updates of many ABC systems and, eventually, to obsolete cost driver estimates Adding new activities to the system is also difficult, requiring re-estimates of the relative amount of resource time and effort required by the new activity

Problems Implementing ABC (3 of 3)A more subtle and serious problem arises from the interview or survey processPeople estimating how much time they spend on a list of activities handed to them invariably report percentages that add up to 100%Few individuals report that a significant percentage of their time is idle or unusedAccordingly, the cost driver rates calculated from this process assume that resources are working at full capacityBut operations at capacity are more the exception than the rule

Time-Driven ABC:An Alternative Approach Several companies have overcome these problems by using a new approach for estimating their ABC modelsThe insight for the new approach is simple:Most ABC systems use a large number of transactional cost drivers that assume each occurrence of the event (a production run, a customer order, a product to support) consumes the same quantity of resources

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

Unit Cost Estimate (1 of 3)The new procedure starts with the same information used by a traditional ABC approach: The cost of resources that supply capacity and The practical capacity of the resources suppliedPractical capacity is often estimated as a percentage (e.g., 80% or 85%) of theoretical capacityThis estimate allows time (e.g., 15 20%) for nonproductive time:For personnel, time for breaks, arrival and departure, and communication and reading unrelated to actual work performance

Unit Cost Estimate (2 of 3)For machines, an allowance for downtime due to maintenance, repair, and scheduling fluctuationsWith estimates of the cost of supplying capacity and practical capacity, the analyst can calculate the unit cost of supplying capacity: Unit cost =Cost of capacity suppliedPractical capacity of resources supplied

Unit Cost Estimate (3 of 3)For example, assume that indirect labor employees supply about 2,500 hours of labor in total each quarter at a cost of $84,000. The practical capacity (at 80% of theoretical) is about 2,000 hours per quarter, leading to a unit cost (per hour) of supplying indirect labor capacity of:Indirect labor cost per hour =$84,0002000 hours= $42 per hour

Unit Time Estimate The second piece of new information is an estimate of time used each time a committed resource performs a transactional activityPrecision is not criticalRough accuracy is sufficientEstimates for the indirect labor from the Cooper Pen example are:

Cost Driver RateAssume similar calculations regarding computer resources produced estimates of $60 per hour and 2 hours per production runThe cost driver rate for the activity, handle production runs, can now be calculated as the costs of using indirect labor and the computer for each production run:

Advantages of Time-Driven ABCManagers may easily update their time-driven ABC model to reflect changes in their operating conditionsThey can incorporate the new knowledge by providing reasonable estimates about the unit times required for different activities for each type of productManagers may also easily update the activity cost driver ratesChanges in the prices of resources supplied affect the hourly cost rateActivity cost driver rates change when there has been a shift in the efficiency of the activity

Tracing Marketing-RelatedCosts to CustomersThe costs of marketing, selling, and distribution expenses have been increasing rapidly in recent yearsResult of increased importance of customer satisfaction and market-oriented strategiesMany of these expenses do not relate to individual products or product lines but are associated with:Individual customersMarket segmentsDistribution channelsCompanies need to understand the cost of selling to and serving their diverse customer base

Alpha Beta Example (1 of 7)Assume Alpha and Beta are customers generating about equal revenue and seen as equally valuable customersUsing a conventional cost accounting system, marketing, selling, distribution, and administrative (MSDA) expenses were allocated to customers at a rate of 35% of SalesIn many respects, however, the customers were not similar

ALPHABETASales$320,000$315,000CGS154,000156,000Gross Margin$166,000$159,000MSDA expenses (@35% of Sales)112,000110,250Operating profit$ 54,000$ 48,750Profit percentage16.9%15.5%

Alpha Beta Example (2 of 7)Betas account manager spent a huge amount of time on that accountBeta required a great deal of hand-holding and was continually inquiring whether the company could modify products to meet its specific needsBetas account required many technical resources, in addition to marketing resourcesBeta also:Tended to place many small orders for special productsRequired expedited deliveryTended to pay slowlyAll of which increased the demands on the order processing, invoicing, and accounts receivable process

Alpha Beta Example (3 of 7)Alpha, on the other hand:Ordered only a few products and in large quantitiesPlaced its orders predictably and with long lead timesRequired little sales and technical supportThe Accounting Manager in Marketing knew that Alpha was a much more profitable customer than the financial statements were currently reportingHe launched an activity-based cost study of the companys marketing, selling, distribution, and administrative costs

Alpha Beta Example (4 of 7)The multifunctional project team:Studied the resource spending of the various accountsIdentified the activities performed by the resourcesSelected activity cost drivers that could link each activity to individual customersThe Accounting Manager used:Transactional activity cost driversNumber of orders, number of mailingsDuration driversEstimated time and effortIntensity drivers when he had readily-available dataActual freight and travel expenses

Alpha Beta Example (5 of 7)The manager also used a customer cost hierarchy that was similar to the manufacturing cost hierarchySome activities were order-relatedHandle customer ordersShip to customersOthers were customer-sustainingService customersTravel to customersProvide marketing and technical support

Alpha Beta Example (6 of 7)The picture of relative profitability of Alpha and Beta shifted dramatically

Alpha Beta Example (7 of 7)As the manager suspected, Alpha Company was a highly profitable customerIts ordering and support activities placed few demands on the companys marketing, selling, distribution, and administrative resourcesAlmost all the gross margin earned by selling to Alpha dropped to the operating margin bottom lineBeta Company was now seen to be the most unprofitable customer that the company hadWhile the manager intuitively sensed that Alpha was a more profitable customer than Beta, he had no idea of the magnitude of the difference

ABC Customer AnalysisThe output from an ABC customer analysis is often portrayed as a whale curveA plot of cumulative profitability versus the number of customersCustomers are ranked, on the horizontal axis from most profitable to least profitable (or most unprofitable)

Customer ProfitabilityCumulative sales follow the usual 20-80 rule20% of the customers provide 80% of the salesA whale curve for cumulative profitability typically reveals:The most profitable 20% of customers generate between 150% and 300% of total profitsThe middle 70% of customers break evenThe least profitable 10% of customers lose 50% - 200% of total profits, leaving the company with its 100% of total profitsIt is not unusual for some of the largest customers to turn out being the most unprofitableThe largest customers are either the companys most profitable or its most unprofitableThey are rarely in the middle

Managing Customer Profitability (1 of 3)High-profit customers, such as Alpha, appear in the left section of the profitability whale curveThese customers should be cherished and protectedThey could be vulnerable to competitive inroadsThe managers of a company serving them should be prepared to offer discounts, incentives, and special services to retain the loyalty of these valuable customers if a competitor threatens

Managing Customer Profitability (2 of 3)The challenging customers, like Beta, appear on the right tail of the whale curve, dragging the companys profitability down with their low margins and high cost-to-serveThe high cost of serving such customers can be caused by their:Unpredictable order patternSmall order quantities for customized productsNonstandard logistics and delivery requirementsLarge demands on technical and sales personnel

Managing Customer Profitability (3 of 3)The opportunities for a company to transform its unprofitable customers into profitable ones is perhaps the most powerful benefit the companys managers can receive from an activity-based costing systemManagers have a full range of actions for transforming unprofitable customers into profitable onesProcess improvementsActivity-based pricingManaging customer relationships

Process ImprovementsManagers should first examine their internal operations to see where they can improve their own processes to lower the costs of serving customersIf customers are migrating to smaller order sizes:Strive to reduce batch-related costs, such as setup and order handlingElectronic systems greatly lower the cost of processing large quantities of small ordersIf customers prefer suppliers offering high varietyTry to customize products at the latest possible stageUse information technology to enhance the linkages from design to manufacturing

Activity-Based PricingPricing is the most powerful tool a company can use to transform unprofitable customers into profitable onesActivity-based pricing establishes a base price for producing and delivering a standard quantity for each standard productTo this base price, the company provides a menu of options, with associated prices, for any special services requested by the customerSpecial services may be priced just to cover costs or also to earn a marginActivity-based pricing prices orders, not products

Managing RelationshipsCompanies can transform unprofitable customers into profitable ones by persuading the customer to use a greater scope of the companys products and servicesThe margins from such increased business purchases contribute to covering customer-sustaining costsIf these efforts fail, the company may then contemplate firing the customerSome customers may be unprofitable only because it is the start of the relationship with the companyCompanies can afford to be more tolerant of newly-acquired unprofitable customers than they can of unprofitable customers they have served for 10 or more yearsSOME CUSTOMERS MAY BE UNPROFITABLE ONLY BECAUSE IT IS THE START OF THE RELATIONSHIP WITH THE COMPANY. THE COMPANY MAY HAVE INCURRED HIGH COSTS TO ACQUIRE THE CUSTOMER AND THE CUSTOMERS INITIAL PURCHASES OF PRODUCTS OR SERVICES WERE INSUFFICIENT TO COVER ITS ACQUISITION AND MAINTENANCE COSTS. NO ACTION IS REQUIRED AT THIS POINT. THE COMPANY EXPECTS AND HOPES THAT THE CUSTOMERS PURCHASES OF PRODUCTS AND SERVICES WILL INCREASE AND SOON BECOME PROFITABLE, INCLUDING RECOVERING ANY LOSSES INCURRED IN THE START-UP YEARS. COMPANIES CAN AFFORD TO BE MORE TOLERANT OF NEWLY-ACQUIRED UNPROFITABLE CUSTOMERS THAN THEY CAN OF UNPROFITABLE CUSTOMERS THEY HAVE SERVED FOR 10 OR MORE YEARS.

ABC at Service Companies (1 of 2)Although ABC had its origins in manufacturing companies, many service organizations today are obtaining great benefits from this approachIn practice, the actual construction of an ABC model is nearly identical for both types of companiesThis should not be surprising since, in manufacturing companies, the ABC system focuses on the service component of the company

ABC at Service Companies (2 of 2)Service companies in general are ideal candidates for activity-based costingVirtually all costs are indirect and appear fixedThey often do not have direct, traceable costs to serve as convenient allocation basesThey must supply virtually all their resources in advance to provide the capacity to perform work for customers during each period

Implementation Issues (1 of 2)Not all ABC systems have been sustained or contributed to higher profitability for the companySome companies have experienced difficulties and frustrations in building and using activity-based cost and profitability models for some of the following reasonsLack of clear business purposeThe project may start in Accounting/Finance, and nobody outside the department understands what changes need to be made and whyLack of senior management commitmentThe group (usually Accounting/Finance) that initiates the project probably does not have the authority to make decisions about processes, product designs, etc., without full senior management support

Implementation Issues (2 of 2)Delegating the project to consultantsConsultants are usually not familiar enough with the businesss organization and problems and may not be able to build management consensusPoor ABC model designThe model may be too complicated to build and maintain and too complex for managers to understand and act uponOr the model may use arbitrary allocations that merely create different distortions than the old systemThe new data requirements may increase the workload of other functions without increasing the benefits to themIndividual and organizational resistance to changePeople may feel threatened by the suggestion that their work might be improvedResistance may be overt, but it may be more subtle and passive

If you have any comments or suggestions concerning this PowerPoint presentation, please contact:Terry M. Lease(terry.lease@sonoma.edu)Sonoma State University