Chapter 5 Activity-Based Costing and Customer ... · PDF fileChapter 05 - Activity-Based Costing and Customer Profitability Analysis 5-8 5- 2 Colombo Soft-Serve Frozen Yogurt In 1994,

Chapter 05 - Activity-Based Costing and Customer Profitability Analysis

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Chapter 5 Activity-Based Costing and Customer Profitability

Analysis Cases 5-1 Blue Ridge Manufacturing (Activity-Based Costing for Marketing

Channels) 5-2 Columbo Soft-Serve Frozen Yogurt: Using Activity Based Costing To

Assess Channel/Customer Profitability Required: 1. Briefly summarize Colombo’s competitive environment and General Mills’ strategy in

response to that environment. 2. Using the ABC analysis, determine new segment profitability statements. 3. Based on your analysis in Questions 1 and 2, what changes would you suggest to General

Mills? Give specific examples and explain. 5-3 Wilson Electronics (A) 5-4 Wilson Electronics (B) 5-5 5-6 5-7

The Buckeye National Bank (ABC Costing in the Service Sector) Precision Paint Forest Hill Paper Company

Readings 5-1: “Activity-Based Costing and Predatory Pricing: The Case of the Petroleum Retail Industry” by Thomas L Burton and John B MacArthur, Management Accounting Quarterly, (Spring 2003). The assignment of indirect costs in a volume-based costing system can lead to product-cost subsidization—overcost high-volume products and undercost low-volume products. Undercosted products can lead to the appearance of predatory pricing where it actually does not exist. This article focuses on a lawsuit brought against a major chain of retail motor fuel (gasoline) service centers for allegedly selling regular-grade gasoline below cost, as defined by state statutes. The defendant employed ABC analysis to support its position that it was not selling its regular gasoline below cost. After the ABC analysis was presented, the case was settled, and the judge lifted the initial injunction. Discussion Questions: 1. What are product-cost subsidizations? 2. What are possible consequences of product-cost subsidizations? 3. List alternative approaches to assign costs in a gasoline service center. 4. Identify cost hierarchy level groups in classifying activities at the retail level of a gasoline service center and

give at least one example each. 5. What are overheads activity-cost pools pertaining to selling gasoline in a retail gasoline service center and what

is the activity level for each of the cost pools? 6. Identify the activity drivers for overheads activity-cost pools identified in this study and explain the reasons for

the selection? 7. List examples of gasoline-dispensing facilities for a gasoline service center and identify whether each of the

facilities is a common or a gasoline grade-specific asset.


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5-2: “Activity-Based Benchmarking and Process Management—Managing the Case of Cardiac Surgery” by Bea Chiang, Management Accounting Quarterly (Fall 2002). Through a study of resource consumption, hospitals can get a more accurate picture of how practices are linked to cost. Discussion Questions: 1. Describe briefly hospital’s costing system. 2. Describe steps in activity-based benchmarking for medical-care processes. 5-3 “Using Activity Based Costing To Assess Channel/Customer Profitability” by DeWayne L. Searcy, PhD., CMA, CPA, Management Accounting Quarterly (Winter 2004). This article explains how ABC was used by a firm (TEC) in the temporary employment industry to better identify the profitability of its service distribution channels and individual customers. Discussion Questions: 1. What are the four steps used in implementing ABC costing at TEC? 2. What are the activity consumption drivers that TEC has chosen for each of the three activities: filling work orders, hiring temporaries, and processing payroll? 3. Which customer channel is most profitable, clerical or industrial, and why? 4. Within the industrial channel, which class of customers is most profitable and why? 5. In the study of the four largest customers, which is the most profitable and why? 5-4 “Cost System Redesign at a Medium-Sized Company”, by David E. Stout, Ph.D., and Gregory P. Bedenis, CPIM, Management Accounting Quarterly (Summer 2007), Vol. 8, No. 4 This article looks at a company that was experiencing unprofitable growth and weak cash-flow activity. The authors examine how an ABC method allowed the company to become more competitive, to look at their current product mix and product lines, and ultimately, to improve cash flow and product profitability. Discussion Questions

1. Why for any manufacturer is proper inventory management important? 2. What are the elements of an ABC system? 3. What is a cost objective? 4. Why are duration drives used in an ABC system? 5. What internal factors limit the ABC model’s ability to influence the decision-making process in a

company?


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5- 2 Colombo Soft-Serve Frozen Yogurt

In 1994, General Mills Incorporated, a $6 billion consumer goods company, acquired Colombo Frozen Yogurt. General Mills Inc. (GMI) believed they could add Colombo frozen yogurt to their existing product lineup to increase net sales with little addition in marketing cost. Frozen yogurt is sold through two distinct segments – independent shops and impulse locations such as cafeterias, colleges, and buffets. Frozen yogurt is the main business for the shops whereas yogurt is incremental to the impulse locations’ main business. GMI’s large sales force already served the impulse market. The financial results in the first couple of years were mixed. Earnings increased slightly and then dropped each year even though sales volume was relatively flat. In total, merchandising costs dropped, while pricing promotion rates escalated. The GMI sales force focused on the impulse segments and pricing promotions were believed to be driving volume increases. However, volume in the shop segment declined at alarming rates and there was widespread dissatisfaction in the sales organization. While GMI knew sales by segment, they didn’t track costs by segment. Instead costs were allocated based on sales dollars. The situation was ripe for a clearer look using ABC methods. TODAY’S FROZEN YOGURT MARKET STRUCTURE: When Colombo Yogurt Company began marketing soft-serve frozen yogurt in the early 1980’s, their main distribution was through independent yogurt shops. In the early 90’s, they faced competition from franchise operations such as TCBY and Freshens that replaced many of the independent yogurt shops. And the market changed as Foodservice operators such as cafeterias, colleges, and buffets started to add soft-serve yogurt to their business. By the late 90’s, these Impulse locations accounted for 2/3 of the soft-serve market. In the late 90’s, Shop sales began to increase with the addition of distinctive new products such as smoothies, boosters, and granitas. The Shops make their living from the soft-serve business and must innovate or go out of business (as thousands have done in the last decade). On the other hand, the Impulse locations make their living from other items and the soft-serve trade is only performance topspin. These firms are unwilling to take any risk (new equipment or extra labor) to serve highly differentiated products like smoothies or granitas. THE GMI-COLOMBO MARKETING PLAN: The GMI Foodservice Division markets brands such as Cheerios, Yoplait, Betty Crocker, Gold Medal Flour, Hamburger Helper, Pop-Secret, and Chex Snack to Food Management Firms, Hospitals, and schools. Colombo yogurt was added to this product lineup and the Foodservice sales force covered both Shop and Impulse locations. Salesforce: Colombo’s salesforce was merged into the Foodservice salesforce. Customers were reassigned to salespeople who already serviced that geographical area. The salespeople varied in their reaction to the product. Some found shops easy to sell to while others avoided the shops despite the possible lost commission. Many spent a lot of time helping their impulse customers understand how to use the machinery. Merchandising Promotions: Colombo traditionally charged the Shops for merchandising that was large scale and eye popping (neon signs). The Shops used these signs to draw customers inside. GMI chose not to charge for merchandising and to provide the same large scale merchandising to both Shops and Impulse locations. Shops were very interested in the kits while many Impulse locations didn’t even hang them up. Pricing Promotions: Pricing promotions are a mainstay of GMI’s impulse location approach. GMI’s salesforce generally used these promotion events as an opportunity to visit their accounts and take advantage of the occasion to meet service needs and sell other products that may not be featured.


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GMI made price promotions available to both segments of the market. While the deals were typically around $5 per case, they averaged $3 per case against all the volume shipped during the year. GMI marketing knew price was not a major decision factor for Shops and they did not target pricing promotions to them. However, Shops were aware of the promotions and took advantage of them. THE BUSINESS STATUS – PRE-ABC:

PROFIT AND LOSS BY SEGMENT – PRE-ABC Category Impulse Segment Yogurt Shops

Total Sales in cases

1,200,000 300,000 1,500,000

Sales revenue $23,880,000 $5,970,000 $29,850,000 Less: Price Promotions - $ 3,600,000 - $ 900,000 - $ 4,500,000 Net Sales $20,280,000 $5,070,000 $25,350,000 Less: Cost of Goods Sold - $13,800,000 - $3,450,000 - $17,250,000 Gross Margin $ 6,480,000 $1,620,000 $ 8,100,000 Less: Merchandising - $ 1,380,000 - $ 345,000 - $ 1,725,000 Less: SG&A - $ 948,000 - $ 237,000 - $ 1,185,000 Net income $ 4,152,000 $1,038,000 $ 5,190,000 ABC ANALYSIS OF COST OF GOODS SOLD: Cost of Goods Sold is made up of $14,250,000 for ingredients, packaging, and storage and $3,000,000 for pick/pack and shipping. Since the product is the same across segments, the cost to produce should be the same. However, pick/pack and shipping costs were found to vary with whether or not the order was for a full pallet. Full pallets cost $75 to pick and ship whereas individual orders cost $2.25 per case. There are 75 cases in a pallet and the segments differ in their utilization of full pallets as shown below. Impulse Segment Yogurt Shops Total Cases in full Pallets 60,000 240,000 300,000 Individual cases 1,140,000 60,000 1,200,000 Total cases 1,200,000 300,000 1,500,000 ABC ANALYSIS OF MERCHANDISING: Merchandising costs consist mainly of kits costing $500 each. A review of where the kits were sent indicated that 3,450 kits were sent out and 90 of them were sent to shops. ABC ANALYSIS OF SELLING, GENERAL AND ADMINISTRATIVE:

Since sales representatives service several products, their costs are allocated to the various products based on gross sales dollars. GMI gave diaries to 10% of the sales force in randomly selected markets of the country and asked them to track their time in activity classifications for 60 days. The diaries indicated that sales reps spent almost 3 times as much time on the yogurt than GMI had estimated. The total allocation to Yogurt jumped from $1,185,000 to $3,900,000. Of their time spent on Yogurt, only 1% of the time was spent on the shops.

1M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y S P R I N G 2 0 0 3 , V O L . 4 , N O . 3

Activity-based costing (ABC) was originally developedby companies to deal with the problem of product-costsubsidization in traditional costing systems.1 This iswhere the assignment of indirect costs leads to exces-sive costs being charged to high-volume products and

insufficient costs being charged to low-volume prod-ucts. The result can lead to increased consumerdemand for the undercosted—and underpriced—products and reduced customer demand for the over-costed—and thus overpriced—high-volume product.2

Spring2003

VOL.4 NO.3

Spring2003

ABC ANALYSIS HELPED SETTLE A LAWSUIT AGAINST A GASOLINE RETAILER, PROVING THE

COMPANY HAD NOT COMMITTED PREDATORY PRICING.

B Y T H O M A S L . B A R T O N A N D J O H N B . M A C A R T H U R

Activity-Based Costingand Predatory Pricing:The Case of thePetroleum RetailIndustry

EXECUTIVE SUMMARY: The assignment of indirect costs in a traditional costing system can lead to product-cost

subsidization. This is where excessive costs are charged to high-volume products and insufficient costs are

charged to low-volume products. The result can lead to increased consumer demand for the undercosted—and

underpriced—products and reduced customer demand for the overcosted—and thus overpriced—high-volume

product. One way to deal with this problem is to employ activity-based costing (ABC). Product-cost subsidiza-

tion also may have legal consequences, which ABC can help address. Undercosted products can lead to the

appearance of predatory pricing where it actually does not exist. This article focuses on a lawsuit brought against

a major chain of retail motor fuel (gasoline) service centers for allegedly selling regular-grade gasoline below

cost, as defined by state statutes. The defendant employed ABC analysis to support its position that it was not

selling its regular gasoline below cost. After the ABC analysis was presented, the case was settled, and the judge

lifted the initial injunction.


Subsequently, ABC has been found useful for severalother purposes, such as costing nonvalue-added activi-ties, long-term pricing, and capacity management.3

When prices are based on cost, product-cost subsi-dization can lead to increased demand for undercostedand underpriced low-volume products, which are proba-bly being sold at unprofitable prices. Conversely, com-panies experience reduced customer demand forovercosted, overpriced high-volume products and ser-vices. These are unwanted economic consequencesfrom product-cost subsidization that ABC seeks to cor-rect by assigning indirect costs to products and servicesusing appropriate unit-level and nonunit-level activitydrivers that reflect resource consumption by the cost

objects. ABC can also help address any legal conse-quences of the product-cost subsidization problem.

LEGAL CONSEQUENCES FROM PRODUCT-

COST SUBSIDIZATION

State and federal laws have been enacted against preda-tory pricing, which is the selling of products below costas a deliberate action to drive out the competition.4

Alternatively, products may appear to be priced belowcost because of the use of unrealistic, unit-based tradi-tional costing systems, which results in the appearanceof predatory pricing where it does not exist. Thisoccurred in a case brought under the “Motor Fuel Mar-keting Practices Act” of Florida.

Table 1: Comparative Cost Assignment Bases in a Gasoline Service Center1

A. Unit-Based Approach:ACTIVITY

FACILITY-WIDE COST TOTAL DRIVER REGULAR PLUS PREMIUM

Average Monthly Cost $26,300 Gas Sold2 $16,674 $5,129 $4,497

Cost Per Gallon Sold $ 0.058 $0.058 $0.058

B. Simple Average Approach:ACTIVITY

FACILITY-WIDE COST TOTAL DRIVER REGULAR PLUS PREMIUM

Average Monthly Cost $26,300 1/3 each $8,766 $8,767 $8,767

Cost Per Gallon Sold $0.030 $0.099 $0.113

C. ABC Approach:ACTIVITY

ACTIVITY COST POOLS TOTAL DRIVER REGULAR PLUS PREMIUM

Pool 1-Labor $ 9,300 Gas Sold2 $ 5,896 $1,814 $1,590

Pool 2-Kiosk $ 2,737 Gas Sold2 $ 1,735 $0.534 468

Pool 3-Gas Dispensing $14,263 1/3 each $ 4,754 $ 4,754 $ 4,755

Total Cost $26,300 $12,385 $7,102 $6,813

Cost Per Gallon Sold $ 0.043 $0.080 $0.088

1 The original information has been disguised.2 Gasoline Sold Proxy Transactional Cost Assignment Base Calculations:

TOTAL REGULAR PLUS PREMIUMAverage gallons of gas sold per month 454,000 288,000 88,500 77,500

(100.0%) (63.4%) (19.5%) (17.1%)


COST ASSIGNMENT USING ABC IN A

RETAIL GASOLINE SERVICE CENTER

The lawsuit was brought against a major chain of retailmotor fuel (gasoline) service centers, alleging that thechain was selling regular-grade gasoline below cost, asdefined under state statutes. The plaintiff’s expert useda unit-based approach to assign the gasoline servicecenter’s average monthly costs (as defined by statute) tothe three grades of gasoline: regular (87 octane), plus(89 octane), and premium (93 octane). When thesemonthly costs were added to the purchase costs of thegasoline, this approach supported the allegation ofpredatory pricing. See Table 1A for the results.

On the other hand, the defendant’s original expertused a simple average-cost approach to assign the aver-age monthly gasoline service center costs equally to thethree grades of gasoline (see Table 1B), which support-ed the defendant’s position that regular gasoline was notbeing sold below cost. The judge in the case made apreliminary ruling that rejected the defendant’s analysisand accepted the plaintiff’s. The judge then issued aninjunction prohibiting the defendant from selling regu-lar gasoline below cost as determined in the plaintiff’sanalysis.

The defendant engaged an accounting professor asan expert witness to review the cost-assignment processand make his own recommendation as to the most rea-sonable determination of cost in applying state statutes.The expert witness used ABC as a third approach tocost assignment (see Table 1C), which involved per-forming activity analysis and selecting activity drivers.

ACTIVITY ANALYSIS

The purchase, storage, dispensing, and sale of gasolineat the retail level can be divided into activities groupedaccording to their cost hierarchy level:

◆ Unit-level activities are undertaken for each gallonof gasoline sold (such as electricity to powerpumps when dispensing gasoline);

◆ Batch-level activities are the same for each gasolinetransaction irrespective of the volume of gasolinepurchased (for example, transactions to processcustomer payments for gasoline by cash, check, ordebit/credit card);

◆ Product-level activities are conducted for specific

gasoline products such as regular, plus, and premi-um gasoline and motor oil (for instance, gasolinetanks that are dedicated to specific gasolinegrades);

◆ Customer-level activities are conducted for specificgasoline customers (such as using billboard adver-tisements to promote the benefits of premiumgasoline); and

◆ Organizational-supporting activities are for the gaso-line dispensing organization as a whole and cannotbe causally identified with units, batches, or indi-vidual products (including payroll and many othercentralized activities).

Activities at the same hierarchy level that share acommon activity driver could further be grouped intohomogeneous activity cost pools.

The defendant’s retail stores consisted of two mainactivities: the sale of gasoline and the sale of conve-nience store merchandise, such as bread and milk. Withlimited data, the expert witness developed a straightfor-ward ABC model that identified three distinct overheadactivities involved in selling gasoline in a retail outlet.First, it is necessary to have at least one attendant toreceive payments for the gasoline sales transactions.Second, it is necessary to have a facility to house thegasoline attendant(s). This does not require a space thesize of a convenience store, so the expert assumed thata small kiosk would be used if there were no store.Third, it is necessary to have gasoline storage and dis-pensing assets.

Activity Cost Pool 1: Gasoline Sales Attendants (Labor).Attendants are needed to receive payments from cus-tomers who do not pay electronically at the gasolinepump. Attendants also can deal with malfunctioninggasoline pumps, security issues, and other problems asthey arise. This is a batch-level activity because pay-ment transactions occur only once for each purchase ofgasoline, regardless of the volume of gasolinepurchased.

Each service center has a convenience store withattendants who handle payments from the customersfor gasoline and for any purchase of food, drink, andother products sold in the store. For the purpose of thecase, it was necessary to estimate the labor cost (includ-


ing fringe benefits) of attendants, assuming that gaso-line was the only product sold. It was decided that onlyone attendant would be required for the gasoline salesactivity in the absence of a convenience store. Multipleregression analysis results confirmed that conveniencestore sales, not gasoline sales, were the major cost driverof labor cost above the base salary and benefits of onesales attendant.

Activity Cost Pool 2: Kiosk Facility and Activity Cost Pool 3:Gasoline-Dispensing Facility. Under state statutes, it wasnecessary to determine a “reasonable rental value” forthe retail gasoline facility.5 In the absence of a separateconvenience store, it would be the rental value of thekiosk. It can be argued that this is a batch-level activity,

following labor, as it facilitates the payment transactionsthat occur once per gasoline purchase.

Also, it was necessary to determine a “reasonablerental value” for the gasoline-dispensing facility, which,in general, can be classified as a product-level activity.6

This activity cost pool includes assets that are specificto a particular gasoline grade and common gasoline-dispensing assets. In a more comprehensive activityanalysis, this cost pool could be divided into two ormore activity cost pools that would be more homoge-neous in nature.

In determining a reasonable rental value, lease infor-mation was obtained for the assumed rental of a kioskand gasoline-dispensing assets in comparable gasolineretail outlets in the surrounding geographical market

Table 2: Estimated Cost of Kiosk and Gasoline Dispensing1

Description Percent

Cost of Gasoline-Dispensing Facilities2 $422,000 83.9%

Cost of the Convenience Store Building2 $506,250

Kiosk Cost Estimate versus Existing Convenience Store 16%

Imputed Kiosk Cost3 81,000 16.1%

Total Imputed Cost of Facility without Convenience Store

(Excluding Land) $503,000 100.0%

Rental4 and Other Costs5 Assigned to Gasoline Sales $17,000

Rental and Other Costs Assigned to Activity Cost Pool 2, Kiosk 2,737 16.1%

Rental and Other Costs Assigned to Activity Cost Pool 3, Gasoline

Dispensing 14,263 83.9%

$17,000 100.0%

1 The original information has been disguised.2 Asset values were obtained from the company’s fixed-asset master listing.3 If the location had mainly gasoline sales with no large, separate convenience store, this is the imputed cost of a “kiosk” to house an

attendant to ring up gasoline sales.4 See endnote 7 for details of the sources of rental cost data.5 The actual cost of insurance and average cost of repairs and maintenance, utilities, and real/property taxes was added to the reasonable

rental value of the kiosk and gasoline-dispensing facilities.


area.7 The actual cost of insurance and average cost ofrepairs and maintenance, utilities, and real/propertytaxes was added to the reasonable rental value.8 Thetotal cost was divided between the kiosk facility andgasoline-dispensing facility in proportion to the estimat-ed kiosk and actual gasoline-delivery assets total valueobtained from the company’s fixed-asset master listing(see Table 2).

ACTIVITY DRIVERS

The volume of gasoline sold was readily available andwas selected as the proxy activity driver for both thelabor and kiosk activity cost pools. The average quanti-ties of the three grades of gasoline sold over a 14-monthperiod (October 1996-November 1997) were used toassign the activity costs. This was basically the sameapproach used by the plaintiff. The gasoline-dispensingactivity cost pool was assigned equally to the threegrades of gasoline because each grade of gasoline hadexactly the same dispensing infrastructure.

Labor Activity Cost Pool. The volume of gasoline sold is aunit-level activity driver but can be justified for assign-

ing labor activity costs to the gasoline grades as follows:◆ The principal responsibility of a kiosk attendant

would be to receive payments from customers forgasoline purchases, which is a batch-level activity.The volume of gasoline sold can be used as aproxy activity driver for these payment transac-tions if the average volume of gasoline sold toeach customer is about the same, regardless of thegasoline grade, which appeared to be true in thiscase. The volume of gasoline sold is a better trans-action proxy cost driver than the dollar salesbecause receiving payment from customers is notdriven by the dollar amount of the purchases. Inthe case of credit/debit card payments madedirectly at the pump, an attendant is necessary tomonitor these transactions, especially if the pumpmalfunctions, such as not printing a receipt. Inany case, it can reasonably be assumed that salestransactions of each grade of gasoline that involvean attendant directly in processing customer pay-ments are proportionate to the total gallons sold ofeach grade of gasoline.

◆ The number of gasoline sales transactions will be

Table 3: Gasoline-Dispensing Facilities

Facilities Type of Asset

Gasoline Sign Common Fixed Asset

Canopy Common Fixed Asset

Cooler Vault Common Fixed Asset

Gasoline Tanks Gasoline Grade-Specific Fixed Asset

Pump & Tank Equipment Common and Gasoline Grade-Specific Fixed Assets

Multi-Product Dispensers (MPDs) Common Fixed Asset

Plumbing Common and Gasoline Grade-Specific Fixed Assets

Electrical—Equipment Common and Gasoline Grade-Specific Fixed Assets

Electrical—Canopy/MPDs Common Fixed Asset

Lighting Fixtures Common Fixed Asset

Area Lighting Common Fixed Asset

Islands Common Fixed Asset

Tank Excavation Gasoline Grade-Specific Fixed Asset

Piping Common and Gasoline Grade-Specific Fixed Assets


a major factor in determining the number of kioskattendants and the hours a gasoline station isopen, which directly affect the level of salary andbenefits payments.

Kiosk Facility Activity Cost Pool. The volume of gasolinesold can be justified as an activity driver for the kioskactivity cost pool in the following ways:

◆ The entire purpose of the kiosk facility is tohouse the attendants who receive payments fromcustomers for gasoline purchases. It is logical touse the same activity driver to assign both thelabor and kiosk facility activity cost pools.

◆ The expected volume of gasoline sales will helpdetermine the size of the kiosk necessary to housethe number of attendants, which directly impactsthe imputed rental payments.

◆ The volume of gasoline sales will determine thehours a gasoline station is open, which directlyaffects the level of repairs and maintenance, utili-ties costs, and so on.

Gasoline-Dispensing Activity Cost Pool. The facilities usedfor dispensing the three grades of gasoline are eithercommon fixed assets (like the gasoline sign) or fixedassets that are identical in size and cost for each gradeof gasoline irrespective of the volume of gasoline sold(for example, the gasoline tanks). Note that the gasolinetanks are identical in size and cost even though thedemand is considerably higher for regular gasoline ver-sus the other two grades. Table 3 identifies the majorgasoline-dispensing fixed assets and whether they arecommon and/or gasoline grade-specific fixed assets.

This commonality of some gasoline-dispensing fixedassets with the cost equality of other, grade-specificgasoline-dispensing fixed assets means, for example,that if two grades of gasoline were sold instead of three,the reasonable rental and other long-run variable costsof the gasoline-dispensing facility would likely be one-third less than is the case when three grades are sold.For example, one less tank excavation and gasolinetank would be required. Also, one-third fewer pumpand tank equipment items would be needed, assumingeach pump serves one grade of gasoline only. In termsof common assets, this would likely result in one-third

fewer islands, a smaller canopy, and so on. In the case ofmultipurpose pumps that provide each grade of gaso-line, the complexity and cost should be lower forpumps that serve two versus three grades of gasoline.Therefore, an equal assignment of the gasoline-dispensing activity costs among the three grades ofgasoline is a reasonable activity cost-driver measure.

ABC ANALYSIS RESULTS

The results from this straightforward ABC analysis canbe considered from both the legal and cost manage-ment points of view.

Legal Outcome. According to the ABC analysis, the costper gallon sold actually fell in between the amountsderived from the plaintiff’s unit-level approach and thedefendant’s equal split of labor and overhead costs. Inessence, the ABC approach split the differencebetween the costs per gallon sold obtained from thetwo extreme approaches. After this analysis was pre-sented, the case was settled and the injunction lifted.

Cost Management Outcome. From a cost management per-spective, the ABC model obtained a result that helpedto correct the problem of product-cost subsidization oflow-volume products by high-volume products, whichoften occurs when a pure unit-level cost assignmentbase is used. In this case, the low-volume products(plus and premium gasoline) were undercosted by thevolume-based approach, whereas the high-volumeproduct (regular gasoline) was overcosted. Thus theregular gasoline appeared to be more costly and pricedunder cost because of the use of the inappropriate unit-based cost assignment method.

FURTHER REFINEMENT

Clearly, an ABC approach improves costing in a gaso-line dispensing retail facility, but this model could befurther refined. The use of practical capacity ratherthan expected or budgeted capacity may avoid chargingthe grades of gasoline for the costs of unused capacity.9

A likely refinement would be the identification andmeasurement of nonunit-based activity drivers for thelabor and kiosk facility costs. It is important to realizethat more driver refinement away from unit-based


activity drivers would only continue to strengthen thedefendant’s case by further lowering the cost of regulargasoline per gallon. Also, greater costing refinementusually entails greater information processing costs. It isimportant to ensure that the costs of ABC models arejustified by the benefits obtained. ■

Thomas L. Barton is the Kathryn and Richard Kip Professorof Accounting and KPMG Research Fellow at the Universityof North Florida, Jacksonville, Fla. He can be reached at(904) 620-2630 or [email protected].

John B. MacArthur is the Kathryn and Richard Kip Profes-sor of Accounting and Cost Management at the University ofNorth Florida, Jacksonville, Fla. He can be reached at (904)620-2630 or [email protected].

1 See “John Deere Component Works (A),” Harvard BusinessSchool Case Series 9-187-107 (Rev. November 1987).

2 For a numerical example of overcosting and undercosting prod-ucts, see John B. MacArthur, “Activity-Based Costing andActivity-Based Management: An Introduction,” in Guide to CostManagement, Barry J. Brinker, editor, John Wiley & Sons, NewYork, N.Y., 2000, pp. 397-410.

3 For discussion on ABC and capacity management, see RobinCooper and Robert S. Kaplan, “Activity-Based Systems: Mea-suring the Costs of Resource Usage,” Accounting Horizons, Sep-tember 1992, pp. 1-13.

4 For example, in Florida, the “Motor Fuel Marketing PracticesAct” (526.302) states that: “Predatory practices and, under cer-tain conditions, discriminatory practices, are unfair trade prac-tices and restraints which adversely affect motor fuelcompetition.” This legislation, in section 526.304, stipulatesthat: “(1)(a) It is unlawful for any refiner engaged in commercein this state to sell any grade or quality of motor fuel at a retailoutlet below refiner cost, where the effect is to injure competi-tion” and “(b) It is unlawful for any nonrefiner engaged in com-merce in this state to sell any grade or quality of motor fuel at aretail outlet below nonrefiner cost, where the effect is to injurecompetition.”

5 In Florida, the “Motor Fuel Marketing Practices Act” (526.303)states: “(9) ‘Reasonable rental value’ means the bona fideamount of rent which would reasonably be paid in an arm’slength transaction for the use of the specific individual retailoutlet, including land and improvements, utilized for the sale ofmotor fuel. The value of the land and improvements shallinclude the costs of equipment; signage; utilities, property tax-es, and insurance, if paid by the owner; and environmental com-pliance, such as testing, detection, and containment systems;but does not include the costs of environmental cleanup andremediation. In determining the reasonable rental value of thespecific retail outlet, the rental amount of comparable retail out-lets in the relevant geographic market shall be considered.When motor fuel is sold at the retail level along with otherproducts, the reasonable rental value attributable to the sale of

motor fuel at the retail outlet shall be allocated by the percent-age of gross sales attributable to motor fuel sales.”

6 Ibid.

7 Comparable lease information was obtained from an outsideappraisal service. This allowed the conversion of asset valueinto a reasonable rental value.

8 The current actual cost of insurance was obtained from thedefendant company, and the average cost of repairs and mainte-nance, utilities, and real/property taxes was calculated frommonthly company data.

9 See Cooper and Kaplan, September 1992.

21M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y F A L L 2 0 0 2 , V O L . 4 , N O . 1

The increasingly competitive nature of thehealthcare market and the managed care sys-tem have put tremendous pressure on hospi-tals to control costs, manage serviceprocesses, improve quality of care, and mar-

ket services competitively. Healthcare providers arenow expected to manage economic resources prudentlyand need to be on top of their costs to ensure that rev-enues are sufficient for them to survive. Benchmarkingis a strategic approach used widely in the manufacturingsector to monitor costs. It is a continuous process ofmeasuring products, services, and activities against thebest levels of performance.1 This approach can alsobenefit healthcare organizations where the close moni-

toring of resources is critical to ensure the organization’seffectiveness.

COSTING PROCESSES AND ACTIVITY-BASED

BENCHMARKING

Healthcare organizations are increasingly sharing costdata on a per patient and per case basis for benchmark-ing the performance of individual units. There are sev-eral external industry benchmarks that a hospital canuse to compare its operation to other healthcareproviders. Examples include total margin, occupancy,cost per certain medical procedure, total cost per case,and cost per inpatient day. Some of these externalbenchmarks, however, confound direct cost compar-

Activity-BasedBenchmarking andProcess Management—Managing the Case ofCardiac Surgery

Fall2002

VOL.4 NO.1

Fall2002

THESE TECHNIQUES FOCUS ON IN-DEPTH IDENTIFICATION OF BEST PROCESSES AND

PRACTICES THROUGH A STUDY OF RESOURCE CONSUMPTION. FROM THEM, HOSPITALS

CAN GET A MORE ACCURATE PICTURE OF HOW PRACTICES ARE LINKED TO COST.

B Y B E A C H I A N G , P H . D . , C P A


isons, as costs may be aggregated in different ways bydifferent hospitals. For instance, the selection of directcost centers and the methods chosen to spread theindirect costs to other departments are hospitalenvironment specific and affect the cost accumulationprocess for services delivered.

Generally, the hospital’s costing system begins withthe division of each general ledger account into costtypes: variable direct cost, fixed direct cost, and fixedindirect cost. At the cost center or department level,each indirect cost center is assigned an allocation base(such as total cost, square feet, or gross revenue) to beused to spread the indirect costs to the direct cost cen-ters. The departmental direct costs and allocated indi-rect costs become departmental total costs. The directcost center or department is defined as a primaryproduct/service unit. An example of a primary product/service is a prescription, an injection, or a bed bath.

The next step is to calculate the standard unit cost ofthe primary product/service. This is done by first allo-cating the departmental total cost based on the relativevalue units (RVUs) multiplied by the budgeted vol-umes of each individual product/service to obtain thebudgeted total cost of each basic product/service.2

Finally, the standard unit cost is calculated by divid-ing the total cost of the individual product/service by itsbudgeted volume. Once standard unit costs are estab-lished for primary products/services, they can besummed up into intermediate products, such as a surgi-cal procedure. These, in turn, can be rolled up into finalproduct/service, such as inpatient days or admissions.The hospital costing process is presented in Figure 1.

From the hospital’s costing procedure, the unit costof a product actually includes allocated indirect coststhat are beyond the control of physicians and othermedical personnel. Indirect cost is the cost that doesnot relate directly to the provision of medical services topatients. Examples include the salary of the administra-tive staff, the cost of the laundry department, cafeteria,and so forth. For pricing purposes, the accounting sys-tem needs to allocate these indirect costs to direct costcenters to account for each unit of product/service. Thephysicians or medical personnel, however, do not havecontrol over the method or the amount of the indirectcost to be allocated to the department. Total unit cost,

which includes both direct and indirect costs, does notreflect the efficiency of activities performed in themedical processes. Therefore, instead of total cost,activity-related measurements such as equipment set-up time or surgery time tie in more to the resourcesconsumption in the process and are more appropriatefor benchmarking.

IMPROVING CARDIAC CARE PROCESSES BY

ACTIVITY-BASED BENCHMARKING

In an economic sense, macro-level costs (like cost percertain diagnosis) are driven by numerous and complexmicro-level decisions, such as procedures taken orequipment used by physicians and specialties. Macrocost control can be achieved only through reference tomicro-level analysis.3 Therefore, the benchmarkingprocess should also use internal procedures data. Thistype of data is more activity specific and task related. Itfacilitates direct benchmark comparisons among physi-cians or staff so that these groups can see clearly howtheir practices need to be improved. The internal pro-cedure level of performance may be identified in anorganization through internal benchmarking. The inter-nal benchmarks help the hospital ask why its costs dif-fer from other hospitals, why costs differ among patientswith the same diagnosis within the same hospital, andidentify which practices can be transferred from lesscost-effective to more cost-effective methods.

Studies have found that physicians do respond tobenchmarking.4 They also are more likely to be per-suaded to change their practices if they see how theycan use such data to improve their processes.5 Activity-based benchmarking for medical-care processesinvolves three steps: (1) analyzing process flow andidentifying major activities, (2) choosing the appropriatemeasurement of resource consumption for benchmark-ing, and (3) identifying the best process and practice asbenchmarks.

ANALYZING PROCESS FLOW AND

IDENTIFYING MAJOR ACTIVITIES

The first step in the benchmarking process is to per-form an analysis of the activity across all operations andprocesses required to move the patient from admissionto discharge. The case of a cardiac patient can be used


Other IndirectCost Centers

INDIRECTCOST CENTERS

Other Direct Cost Centers

DIRECT COST CENTERS

DEPARTMENTTOTAL COST

UNIT COST OFLAB PROCEDURE/

TEST X

UNIT COST OFLAB PROCEDURE/

TEST Y

TOTAL COSTOF PRIMARY

PRODUCT/SERVICE

UNIT COST OFPRIMARYPRODUCT/SERVICE

UNIT COST OFPROCEDURE 1

UNIT COST OFPROCEDURE 2

UNIT COST OFMEDICINE A

UNIT COST OFMEDICINE B

PATIENT DAY

PRIMARY PRODUCT/SERVICE

INTERMEDIATEPRODUCT/SERVICE

FINAL PRODUCT/SERVICE

Costs of Intermediate and Final Products/Services

FIGURE 1Costs of Primary Products/Services

LAUNDRY PATIENT DISCHARGE ADMINISTRATION

LAB OPERATINGROOM PHARMACY

TC OF LAB PROCEDURE/

TESTING

TC OF OR DEPARTMENT

TC OF PHARMACY

DEPARTMENT

OTHER PRIMARY PRODUCT COSTS

UNIT COST OF A CHEST X-RAY

UNIT COST OF A PRESCRIPTION

UNIT COST OF AN INJECTION CORONARY ARTERY

BYPASS GRAFT—AN OPEN HEART SURGERY

PROCEDURE

A CARDIAC CATHETERIZATION

PROCEDURE


to illustrate the benchmarking process. The patient isadmitted on the scheduled date for an open-heartsurgery. After going through the administration process,the patient will undergo many tests. Immediatelybefore surgery, the patient will be given specific pre-operative medications and will then be “prepped” forsurgery. An intravenous (IV) line will be administered.The patient will then be given a sleep-inducing med-ication through the IV and anesthetic gas to breathe(general anesthesia). After the patient is asleep, the car-diac surgery procedure begins.

There are a variety of different types of open-heartsurgeries, depending upon the condition being treatedand the overall health of the patient. The surgery itselftakes an average of five hours. After surgery, the patientis moved to a hospital bed in the cardiac surgical inten-sive care unit. The patient is carefully monitored in thecardiac intensive care unit for 12-24 hours and then onthe general floor (step-down units). Throughout theprocess, from admission to discharge, major activitiesinclude general administration and patient education,lab procedure/test, medical equipment and suppliesadministration, setup, operation, nursing, and generalservices. The summary presented in Figure 2 detailsthe process flow and activities engaged in providing theservices. Costs incurred at each stage depend upontypes of personnel, equipment, and supplies involvedin the process. They are listed as cost inputs.

CHOOSING THE APPROPRIATE

MEASUREMENT FOR BENCHMARKING

For different costs, there are different activity character-istics that drive the costs. For example, nursing costsare different when comparing the operating room to thecardiac intensive care unit because different types andnumbers of nurses engage in different activities. To bet-ter capture cost incurrence in the case of a cardiacsurgery patient, an activity-related measurement mustbe selected to measure the resource consumption.

Pre-Surgery

At the admission stage, the number of patients perregistration staff or number of documents generated perstaff hour can be used to measure the efficiency of theregistration process. During the preparation for surgery(ambulatory care unit), medical staff explain the opera-

tion process to the patient, perform additional tests, andprepare the patient for surgery. At this stage, the prepa-ration time, patient education time, number of testsperformed by type, and the amount of medical suppliesused can be drawn on to measure the performance.

Operating Room

The number of specialists and medical staff assignedto the operating room are defined by the hospital’ssurgery policy and remain consistent from patient topatient. Resource consumption among physicians andother medical personnel varies, however, in three signif-icant ways: surgery time, operating room setup time,and medical supplies usage.

Surgery time is a critical indicator of cost. It relates tocosts associated with the time for the operation, anesthe-sia, perfusion service, and nursing staff. Setup time isthe time required to prepare equipment, tools, and med-ical supplies for the surgery. It is considered a majorindicator of efficiency.6 Reducing setup time shortensthe lead-time of service delivery and helps to keep it ata reasonable level. Medical supplies and equipment rep-resent a significant part of hospital expenditures and areone of the major factors that drive healthcare costs.7

Finding the best practices in using the facilities and sup-plies will help healthcare providers manage their costs.Benchmarks can be established to measure the perfor-mance of an operating room in terms of operation time,setup time, and medical supplies usage.

Post-Surgery

After the surgery, most of the resources and time arespent on monitoring surgery results, providing patienteducation, performing additional tests, taking vitalsigns, assessing post-surgery outcome, and providinggeneral and dietary services. Major cost inputs in thisstage include nursing staff, cardiologist, lab technician,general service staff, and medical supplies. Benchmarkssuch as results-assessment time, nursing care time bynurse type, medical supply usage, and patient educa-tion hours can be established to measure theperformance.

NURSING-CARE SERVICES

Nursing services count as a significant part of activitiesin every stage of the process. The essence of the prob-lem with nursing services is that the costs usually are


ADMINISTRATION AND PATIENT EDUCATION

◆ Registration◆ Provide complete medical records of surgery◆ Provide patient education◆ Patient screening interview◆ Collect and record pre-surgery informationCOST INPUTS:Administration personnel

SURGERY PREPARATION

◆ Perform pre-surgery tests: urine and blood tests, electrocardiogram, chest x-ray◆ Prepare equipment, supplies, and medication for surgery◆ Swab patient, surgical area, and create sterile environment◆ Insert IVCOST INPUTS: Lab technician, nurses, cardiologist, and medical equipment and supplies

SETUP

◆ Set up surgical equipment, supplies, and monitoring devicesCOST INPUTS: Medical staff and medical equipment and supplies

PRE-SURGERY ANESTHESIA

◆ Provide sleep-inducing medication through IV: mixture of oxygen and anesthetic gas

COST INPUTS:Anesthesiologist, nurses, and medical equipment and supplies

CARDIAC SURGERY

◆ Perform surgical proceduresCOST INPUTS:Specially trained OR personnel, 2 cardiac surgeons, 1 resident, 1 cardiologist, 2 cardiac intensive care nurses, 2 scrub nurses, 2 circulation nurses, 1 CRNA, 2 pump technicians, medical equipment and supplies

CLOSELY MONITORING

◆ Provide nursing care◆ Perform post-surgery diagnostics and report results◆ Collect post-surgery data such as recovery scores and vital signs◆ Assess post-surgery outcomeCOST INPUTS:Nurses, staff cardiologist, lab technician, and medical equipment and supplies

MONITORING AND TESTING

◆ Perform more tests to assess and report results◆ Provide general and dietary services◆ Provide patient education◆ Measure post-surgery outcomeCOST INPUTS:Nurses, staff cardiologist, lab technician, and medical equipment and supplies

DISCHARGE INSTRUCTION

◆ Patient education and discharge instructionCOST INPUTS:Nurse, medical personnel

ACTIVITIESPROCESS

ADMISSION

DISCHARGE

AMBULATORY CAREUNIT

OPERATING ROOM

CARDIAC SURGICALINTENSIVE CARE UNIT

STEP-DOWN UNIT

FIGURE 2: Process Flow, Activities, and Cost Inputs for Cardiac Surgery Patient


averaged into room and board in most hospitals. As aresult, all patients in a given unit of the hospital willreceive the same daily charge for nursing-care services.It is presumed that all patients consume exactly thesame amount of nursing resources. The fact that differ-ent patients have different nursing needs does not enterinto consideration. For the purpose of improving theprocess through benchmarking, this approach providesvery poor information. The most accurate methodwould be to measure the time each nurse spent witheach patient. This, however, is an impractical, costly,and time-consuming way to account for the cost. Onealternative, suggested by B. Dieter and J. Moorhead, is

assigning each nursing procedure a predetermined rela-tive value unit (RVU) based on the time taken to per-form that task.8 Initially, the relative value might bedetermined according to prior experience or by pollingfull-time staff nurses on the amount of time it takesthem to complete each procedure. Thus, instead ofcounting nursing time spent on each activity with eachpatient, nursing care will be benchmarked based onRVU for procedures or tasks performed.

Figure 3 summarizes a set of benchmarks establishedto measure the performance of major activities in thecare process. Benchmarks can be established at adetailed activity level as well as at the case level.

◆ Number of patients per registration staff hour◆ Number of documents generated per staff hour

◆ Number of tests by type◆ Nursing care by relative value unit◆ Medical equipment and supply usage◆ Number of tests by type◆ Surgery preparation time◆ Patient transportation time

◆ Surgery time◆ Medical equipment and supply usage ◆ Operating room setup time◆ Surgical team combination◆ Patient transport time◆ Nursing care by relative value unit

◆ Number of procedures by type◆ Number of tests by type◆ Nursing care by relative value unit◆ Medical equipment and supply usage

◆ Number of procedures by type◆ Number of tests by type◆ Nursing care by relative value unit◆ Medical equipment and supply usage◆ Patient education hours◆ Results assessment time

◆ Discharge instruction and patient education hours

BENCHMARKSPROCESS

ADMISSION

DISCHARGE

AMBULATORY CAREUNIT

OPERATING ROOM

CARDIAC SURGICALINTENSIVE CARE UNIT

STEP-DOWN UNIT

FIGURE 3: Activity-Based Benchmarking

BENCHMARKSFOR ENTIREPROCESS ATCASE LEVEL:Length of stay by diagnosis, total medicalequipment and supplyusage, total nursing timeby nurse type, total med-ical records recordingand handling time, totalsetup time, total surgerytime, total patient education and instruc-tion time


IDENTIFYING BEST PROCESS AND BEST

PRACTICE AS BENCHMARKS

Table 1 shows an internal benchmarking report of ahospital. The hospital combined clinical records, nurs-ing logs, and surgery logs with the financial accountingrecords to benchmark performance. The data were sort-ed by Diagnosis Related Group (DRG), primary proce-dure code, and severity level.9 Benchmarks are thecases that have the lowest-quantity usage in terms ofsurgery time, setup time, nursing-care time, labtests/procedures time, and consumption of medicalequipment and supplies. The benchmarks were deter-mined by data collected from 259 patients admitted tothe hospital for heart surgery in 1998 and 1999. Thebenchmarking report compares individual informationto the overall average of the 259 cases and to the bestpractice. The first part of the report presents the com-parative benchmarking data of two cardiac surgeries inthe operating room (cardiac primary procedure code36.12), performed by physician #11111, one at severitylevel 2 and the other at level 3 (Note: The report isshown as a subset of the results, so it does not includeall benchmarking items).

The report shows that the surgery time taken byphysician #11111 for a principal procedure code 36.11 atseverity level 2 was 300 minutes, compared to an aver-age time of 281 minutes and 225 minutes for the bestpractice. The same comparisons are made for anesthesiaand perfusion service. The benchmarking also showsmedical equipment and supply usage. It reveals thatsome equipment items were required for the surgery,such as a blood warmer set (individual, average, andbest practice all show one unit). Some items, such asclip applier, however, could be used in a more cost-effective way: Nine units of clip appliers were actuallyused, compared to an average of 3.52 units in all casesand two units for the best practice. Some items, such astransducers, were used on average in 104 cases out of260 (an average of 0.4 usage) but were not used at all bythe best practice. This raises the question of whether ornot this procedure can be performed without the use oftransducers.

The report provides a general internal profile of prac-tices in the operating room. Physicians could reviewsuch a report to determine exactly how their consump-

tion of supplies compares to the average consumptionlevel in all cases and to the consumption level of thebest performer. The report also is useful to physiciansand other clinical personnel because it highlights theusage differences in a principal cardiac procedure andshows what supplies were not used in the bestpractices.

The second part of the benchmarking report showspre- and post-surgery data. In the interest of providing asimple illustration, the report only shows a subset ofbenchmarking data. For nursing care, different types ofnurses and nursing assistants, such as registered nurses,licensed nurses, unlicensed assistants, and apprenticenurses, are employed to provide services. Each of themhas a different hour rate and skill set. Some tasksrequire a specific type of nurse for a specific task; forexample, the operating room requires cardiac registerednurses for assistance. In the step-down unit, only regis-tered nurses can perform certain tasks, such as an IV orany injection. Others, such as a bed bath, however, canbe performed by licensed nurses. The benchmarkreport shows the time (measured by RVU) spent oneach type of nursing activity. Detailed nursing activitiescan be reported by nurse type. For example, vital signstook 40 RVUs of a registered nurse’s time, 25 RVUs of alicensed nurse’s time, and 18 RVUs of an unlicensedassistant’s time. In the best practice, 32 RVUs of a regis-tered nurse’s time, 32 RVUs of a licensed nurse’s time,and 17 RVUs of an unlicensed assistant’s time weredevoted to taking vital signs. In this instance, the bestpractice utilizes more licensed nurses instead of regis-tered nurses to take vital signs. Having licensed nursestake vital signs instead of registered nurses, therefore,can lower costs. The use of unlicensed assistants isabout the same because of restrictions on the use ofunlicensed assistants for quality considerations. Thesebenchmarking data help the hospital monitor nursingservices to ensure the quality of nursing care. In addi-tion, the nursing department manager is able to assignthe lowest-cost combination of nursing staff to providethe required services at the desired level of quality care.

The lab tests are also measured and benchmarked byRVU. The performance of the cardiac catheterizationlab and respiratory therapy are benchmarked by setuptime, procedure time, and medical supplies usage.


1 . B E N C H M A R K I N G D A T A : C A R D I A C O P E R A T I N G R O O M ( A C T I V I T Y L E V E L )

DRG: 107—Coronary Bypass with Cardiac Catheterization

Principal Procedure Code: 36.11 Severity Level: 2

Attending MD: # 11111

PATIENT ENCOUNTER NO.: 00000100 PATIENT ENCOUNTER NO.: 00000500SEVERITY LEVEL: SEVERITY LEVEL 2 SEVERITY LEVEL 3

PHYSICIAN AVERAGE BEST PHYSICIAN AVERAGE BEST #11111 PRACTICE #11111 PRACTICE

1. Cardiac Surgery Time 300 281.35 225 345 300.63 228

(minutes per surgery)

Perfusion Service (minutes) 300 281.35 225 345 300.63 228

Anesthesia (minutes) 300 281.35 225 345 300.63 228

2. Operating Room Total Setup Time 65 53.2 38 66 49.72 40

(minutes per surgery)

Anesthesia Setup Time (minutes) 31 26.01 22 35 27.21 25

3. Equipment and Medical Supplies

(number of units used)

Aortic Punch 1 1 1 1 1 1

Bovie Pencil 3 2.74 2 2 2.57 2

Bulb Syringe 1 1 0 1 1.11 0

Bifur Blood Infusion Set 0 0.31 0 0 0.1 0

Breathing Circuits 1 1 1 1 1 1

Cable Ven 2 1.95 1 2 1.95 1

Cautery Electro Unit 1 1.62 1 1 1.48 1

Chest Tube 2 2 2 2 2 2

CO2 Coupling 1 1 1 1 1 1

CVP Tray Arrow 1 0.8 0 1 1 0

Ioban Drape 2 1.19 1 1 1.15 0

Mayo Cover 2 1.24 0 1 1.22 0

Scapel Blade 6 5.19 4 4 4.86 4

Saphenous Vein Adaptor 2 2.19 1 2 2.38 2

Stopcocks 3 Ways 1 1 0 1 1 0

Sutures Cabg Pack 2 1.05 1 1 1 1

Y-Adaptor 0 0.2 0 2 0 0

Temp Sensing Foley 1 1 1 1 1 1

Blood Warmer Set 1 1 1 1 1 1

Imed Cassette 3 3.62 3 4 4.5 2

Hemaclip 4 3.2 2 3 3.2 2

Skin Prep 3 2.81 2 1 1.5 1

Transducer 1 0.4 0 3 2.77 0

Transducer Triple 1 1 1 1 1 1

Disposable Gown 3 3.43 2 3 3.9 2

Clip Applier 9 3.52 2 7 3.75 2

Extra Pressure Transducer 0 0.4 0 1 1 0

TABLE 1: Benchmarking Report—A Case of Cardiac Surgery


2 . B E N C H M A R K I N G D A T A : P R E - A N D P O S T - S U R G E R Y ( A C T I V I T Y L E V E L )

PATIENT 00000100 AVERAGE BEST PRACTICE

1. NURSING CARE1 (RVU)2

Vital Signs (Registered nurse, Licensed nurse, Unlicensed assistant)

Registered nurses 40 38.44 32

Licensed nurses 25 30.12 32

Unlicensed assistants 18 18.20 17

Patient Education and General Service (Registered nurse, Licensed nurse, 40 40.51 35

Unlicensed assistant)

Medical Records Assessment (Registered nurse) 62 60.21 60

Administration of Medications (Registered or Licensed nurse) 81 70.21 60

Surgery Preparation (Unlicensed assistant or Apprentice nurse) 22 30.21 25

IV, Diagnostic Tests (Registered nurse) 75 70.21 66

2. LAB (RVU)Blood Tests 98 78.21 75

Pathological Tests 45 50.30 38

Other Tests and Procedures3 39 36.12 34

Radiology Films 40 42.69 39

3. CARDIAC CATHETERIZATIONCardiac Catheterization Time (minutes) 45 35.78 30

Cardiac Catheterization Setup Time (minutes) 20 18.23 16

4. RESPIRATORY THERAPYSetup Time (minutes) 17 18.20 15

Cont Oxygen Therapy (units) 114 96.25 88

Pause Oximeter (units) 3 4.55 3

5. TOTAL PATIENT TRANSPORTATION AND PREPARATION (minutes) 55 47.33 45

3 . B E N C H M A R K I N G D A T A : C A S E L E V E L 4

1. Length of Stay (days) 7 8.20 5

2. Total Actual Costs $24,188 $22,521.20 $19,888

3. Total Surgery Time (minutes) 630 561.25 450

4. Total Cardiac Catheterization Time (minutes) 890 897.30 750

5. Total Nursing Costs5 1,419 1,410.42 952

6. Total RVU of Lab Test 1,418 1,082.52 899

7. Total RVU of Radiology 101 81.33 67

8. Total Medical Records Handling and Assessment Time (RVU) 772 630.55 521

9. Total Medical Supplies and Sterile (units) 250 225.17 155

10. Total Respiratory Therapy Time (minutes) 387 301.22 280

1 To simplify the illustration, only vital signs are reported by nurse type. Total RVUs are shown for the rest of the activities.

2 In the lab-testing and nursing-care areas, RVU represents the amount of time to complete a certain task or procedure.

3 A detailed benchmarking report will be sorted by test types.

4 The average and benchmarking data are based on patients with the same diagnosis and level of severity.

5 Total nursing costs are determined as follows: (nursing hours) x (nurse-patient ratio) x (hour rate). The hour rate will depend on the type of

nurse.

TABLE 1 (continued): Benchmarking Report—A Case of Cardiac Surgery


Section three of the report presents the benchmarkingdata at case level. This information facilitates compar-isons of cardiac surgery cases at a broader level. If thecase and benchmarks show significant differences (forexample, total RVUs of lab tests are 1,418 compared to899 of the best practice), the case can be traced down tothe activity level in order to explore the factors respon-sible for the high cost.

FOCUSING ON PROCESS IMPROVEMENT

Activity-based benchmarking focuses on in-depth iden-tification of best processes and practices. The best prac-tices can be found through the use of internalbenchmarking. One of the benefits is that we canobtain specific and detailed information with which tofacilitate process improvement. Hospitals can usebenchmarking data to identify critical success factorsand appropriate measures in the service process. Bench-marking also enables us to use both clinical andaccounting information more effectively. When appliedalong with external benchmarking measures, internal-procedure benchmarking helps the organization todetermine major areas for improvement.

Information provided by the internal activity bench-marking process benefits hospitals by highlighting theresource consumption of particular procedures in theprocess flow so that physicians and staff have a moreaccurate picture of how practices are linked to cost.More important, activity benchmarking provides specif-ic direction for the continual improvement of the careprocess and provides an explicit means of communica-tion among various departments. ■

Bea Chiang, Ph.D., CPA, is an assistant professor of accoun-tancy at the College of New Jersey in Ewing, N.J. She can bereached at (609) 771-3056 or [email protected].

1 Charles T. Horngren, George Foster, and Srikant M. Datar, CostAccounting: A Managerial Emphasis, Prentice Hall, 2000, pp. 236.

2 The relative value unit (RVU) is a measure of resource con-sumption in the healthcare organization. It is defined as theamount of time to complete one unit or the amount of suppliesfor one unit.

3 Ron Eden and Colin Lay, “Benchmarking on costs in health-care,” Management Accounting, March 1998, pp. 28-31.

4 J. Evans, III, Y. Hwang, and N. Nagarajan, “Physicians’ responseto length-of-stay profiling,” Medical Care, Vol. 33, No. 11, 1995,p. 1106.

5 Girard Senn, “Clinical buy-in is key to benchmarking success,”

Healthcare Financial Management, Vol. 52, No. 5, May 1998, p. 46.6 Horngren, Foster, et al., p. 726.7 Material Management in Healthcare, April 2000, Vol. 9, No. 4,

pp. 6-9.8 B. Dieter, “Determining the Cost of Emergency Department

Services,” Hospital Cost Accounting Advisor, Vol. 2, No. 1, Febru-ary 1987, pp.1, 5-7; J. Moorhead, “Costing Accounting for Emer-gency Services,” Hospital Cost Management and Accounting, Vol. 1,No. 2, May 1999, pp. 1-7.

9 DRG is a system used for classification of inpatient hospital services based on principal diagnosis, secondary diagnosis, surgi-cal procedures, age, sex, and presence of complications. Thissystem of classification is used as a financing mechanism toreimburse hospitals and selected other providers for servicesrendered.

51M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y W I N T E R 2 0 0 4 , V O L . 5 , N O . 2

“With better information and accounting systems,firms are beginning to disaggregate revenues and coststo customer or account level. This analysis oftenreveals previously hidden subsidies across customers,products, and markets.”1

Most firms are well aware of the 80/20 rulein which a small fraction of customersaccounts for a large share of revenues andmost of a firm’s profits. As the abovequote states, that small fraction of prof-

itable customers subsidizes the firm’s other unprofitableor, at best, breakeven customers. Instead of acceptingthe 80/20 rule, firms should strive to identify those sub-sidized customers and work with them in either alteringthe servicing of those customers (including pricing) to amore equitable arrangement or outsourcing the servic-ing of those customers altogether.

Temp Employment Company, Inc. (TEC), a firm inthe employment services industry, used Activity-BasedCosting (ABC) in assessing the profitability picture inorder to better understand which customers were prof-

itable and which were subsidized. This articledescribes the journey of TEC’s chief financial officerthrough the ABC implementation and subsequentanalysis. (Note: The name of the actual company hasbeen changed and the financial data altered to protectthe company’s confidentiality.)

ABC AND THE FIRM

TEC is a multi-office employment services firm offer-ing temporary employment and permanent placements.The temporary employment division represents over70% of TEC’s business and is the focus of this article.Before covering how TEC used ABC information toassess its profitability picture, TEC’s ABC implementa-tion will be briefly discussed. Table 1 summarizes thefour-step process TEC completed in transforming itscost management system.

Step 1. Develop the activity dictionary.

In the first step, TEC was divided into activities. Itwould have been possible to divide TEC into severalactivities, but it was important to develop a simple, yet

Using Activity-BasedCosting to AssessChannel/CustomerProfitability

BETTER UNDERSTANDING OF YOUR CUSTOMERS’ PROFITABILITY PICTURE IS

IMPERATIVE FOR SURVIVAL IN TODAY’S COMPETITIVE ENVIRONMENT. HERE THE CFO OF

AN EMPLOYMENT SERVICES COMPANY USED ABC TO ANALYZE THE COMPANY’S

PROFITABILITY PICTURE AT THE CUSTOMER CHANNEL- AND INDIVIDUAL CUSTOMER-LEVEL.

B Y D E W A Y N E L . S E A R C Y , P H . D . , C M A , C P A


meaningful, system. Three activities were defined asrelevant to the operations of the firm: 1) filling workorders, 2) hiring temporary employees, and 3) process-ing payroll/billing.

The filling work orders activity begins once an order isreceived from a customer and ends when the customeris provided with the name(s) of the temporary employ-ee(s) assigned to work for them. The hiring temporaryemployees activity involves the process of hiring employ-ees for temporary assignments. This activity beginswhen an application is completed and ends once theemployee is debriefed on company polices and enteredin the system. The last activity, processing payroll/billing,involves the weekly payroll and customer billingprocess.

Step 2. Determine how much the organization is spending

on each of its activities.

Once the activities were identified, the CFO assignedthe direct costs associated with each one. Any resourcethat could not be directly traced to an activity was ini-tially assigned to a general overhead account. Once thedirectly traceable resources were assigned to each activi-ty, the general overhead was allocated. Table 2 summa-rizes the results of assigning the costs to the threeactivities of TEC. The general overhead was allocatedto each activity on the basis of the directly traceablecosts of each activity to total directly traceable costs.

Step 3. Identify the organization’s products, services, and

customers.

As mentioned earlier, TEC offers two services, tempo-rary employment and permanent placements. Withineach service offering, TEC’s customers are separatedbetween two channels, industrial and clerical, depend-ing upon the job classification of the position they areseeking to fill. Industrial customers hire temporaryemployees to fill touch-labor positions (such as assem-bly, machine operator). On the other hand, clerical cus-tomers seek to hire office positions (such as receptionistor secretarial).

Step 4. Select activity cost drivers that link activity costs

to the organization’s products, services, and customers.

The goal of identifying a cost driver for an activity is todetermine the source that causes the consumption ofthat activity—what drives the activity. The cost driveridentified must be quantifiable and reasonably accessi-ble. The three activities and the related cost drivers arediscussed next.

FILLING WORK ORDERS

The first activity identified was “filling work orders.”As stated earlier, customer service coordinators begin tofill work orders once a customer calls in a request for atemporary employee. If a customer does not call in anorder, there is no work order to fill. It makes sense thenthat the cost driver for the “filling work orders” activityis the number of temporaries ordered by customers.This is used as the cost driver instead of the number oforders generated because an individual order can be formore than one temporary employee. The more tempo-raries on an order, the more servicing of the account isrequired. Thus, the number of temporaries ordered is abetter indicator of resources consumed by the activitythan the number of orders.

HIRING TEMPORARY EMPLOYEES

The company cannot hire temporaries unless someonecomes in seeking employment. The cost driver used for“hiring temporary employees” is the number of appli-cants seeking employment. Each person seekingemployment at TEC requires significant resources andtime before he/she is eligible for a job assignment.

Table 1: Four Steps in Developing an ABC System

1. Develop the activity dictionary.

2. Determine how much the organization is spending

on each of its activities.

3. Identify the organization’s products, services, and

customers.

4. Select activity cost drivers that link activity costs to

the organization’s products, services, and customers.

R. S. Kaplan and R. Cooper, Cost & Effect: Using Integrated Cost

Systems to Drive Profitability and Performance, Harvard Busi-

ness School Press, Boston, Mass.,1998.


PROCESSING PAYROLL/BILLING

Processing a paycheck for each employee and generat-ing an invoice for each customer is performed weeklyand is based on the number of hours worked. Becauseeach hour worked requires this activity, the number ofhours worked during the period in question appears tobe the best cost driver for the “processing payroll/billing” activity.

Step 5. Calculate activity rates for each activity identified.

TEC added another step, which was to calculate theactivity rate for each activity identified. The followingactivity rates were calculated (see Table 2):

Filling work orders $48.2390

Hiring temporary employees $26.5710

Processing payroll/billing $ 0.1655

The information collected from these five steps wasused to assess TEC’s profitability at the customer level.Customer profitability analysis was conducted in threestages. The first stage assessed customer-channel prof-itability (industrial and clerical channels). In the secondstage, the information obtained from the first stage wasused to assess classes of customers within each channel.Finally, the third stage involved assessing the profitabil-ity of individual customers.

CHANNEL PROFITABILITY

Table 3 displays the profitability picture by customerchannel. When the gross margins are examined, majordifferences between the channels become apparent.TEC’s margin in the industrial channel is significantlyless than its margin in the clerical channel. The indus-trial customers demand lower rates for temporaryemployees, but the tight labor market prevents TEC

Table 2: Temp Employment Company, Inc.Activity-Rate Calculations

ACCOUNT FILLING HIRING PROCESSING GENERAL TOTAL NAME TOTAL WORK ORDERS TEMPORARIES PAYROLL OVERHEAD ALLOCATED

Salaries & wages $ 125,638 $ 57,501 $ 16,197 $ 12,308 $ 39,632 $ 125,638

Payroll taxes 11,192 5,118 1,442 1,095 3,537 11,192

Advertising 55,896 25,494 30,402 — — 55,896

Automotive 15,718 7,722 — — 7,996 15,718

Telephone 11,746 7,048 2,349 2,349 — 11,746

Rent 9,600 2,400 2,400 4,800 — 9,600

Other Operating Expenses 91,144 10,760 1,961 4,305 74,118 91,144

Total Operating Expenses $ 320,934 $ 116,043 $ 54,751 $ 24,857 $ 125,283 $ 320,934

Allocation of General Overhead 74,307 35,059 15,917 (125,283) $ —

$ 320,934 $ 190,350 $ 89,810 $ 40,774 $ — $ 320,934

Cost drivers

# of temporaries ordered 3,946

# of applicants 3,380

# of hours worked 246,370

Activity rates $ 48.239 $26.571 $ 0.1655


from lowering wage rates. Also, industrial customershave significantly higher workers’ compensation ratesthan clerical customers, which we will discuss later.Customers in the clerical channel demand quality overprice, so a higher bill-to-pay rate is permissible.

In allocating activity cost between channels for the

“hiring temporary employees” activity, the CFO discov-ered there was no easily accessible procedure for deter-mining if an applicant applied for clerical or industrialemployment. That information is documented only ifthe applicant is hired by TEC. For the initial analysis,the CFO decided to use the ratio of the number of

Table 3: Temp Employment Company, Inc.Profitability Analysis by Customer Channels

CLERICAL % INDUSTRIAL % TOTAL %

Sales $ 294,714 100.0% $ 1,859,852 100.0% $2,154,566 100.0%

Cost of Sales

Wages–Temporary employees 200,377 68.0% 1,323,827 71.2% 1,524,204 70.7%

Payroll taxes & fees 28,629 9.7% 251,879 13.5% 280,508 13.0%

Total cost of sales 229,006 77.7% 1,575,706 84.7% 1,804,712 83.8%

Gross margin 65,708 22.3% 284,146 15.3% 349,854 16.2%

OVERHEAD ALLOCATIONS

Filling work orders:

Number of Temporaries ordered 508 3,438 3,946X Activity rate $ 48.239 $ 48.239 $ 48.239

24,505 8.3% 165,846 8.9% 190,351 8.8%

Hiring temporary employees:

Number of applicants 3,380 3,380 3,380X% of orders to total 12.9% 87.1% 100%

Applicants by channel 436 2,944 3,380XActivity rate $ 26.571 $ 26.571 $ 26.571

11,585 3.9% 78,225 4.2% 89,810 4.2%

Processing payroll/billing:

Hours worked 32,890 213,480 246,370XActivity rate $ 0.1655 $ 0.1655 $ 0.1655

5,443 1.8% 35,331 1.9% 40,774 1.9%

Total overhead allocation 41,534 14.1% 279,402 15.0% 320,936 14.9%

Net profit $ 24,174 8.2% $ 4,744 0.3% $ 28,918 1.3%


temporaries ordered by channel to total temporariesordered across both channels. Multiplying this ratio bythe total number of applicants provided the number ofapplicants for each channel.

There is some logic with the formula. The numberof temporaries ordered determines the types of tempo-raries needed; this, in turn, forces the firm to focus itsenergies on hiring those types of temporaries. In otherwords, there is a close relationship between the numberof temporaries ordered and the type of individualsapplying for employment at TEC. Procedures wereinstituted to capture the relevant information duringthe application process to assign “hiring temporaryemployees” costs more accurately to the appropriatechannel in the future.

As shown in Table 3, the industrial channel compris-es only 16% of total company profits, while its sales areover 86% of total company sales. The channel’s netprofit is only 0.3% of sales. In sharp contrast, the clericalside shows profits of 8.2% of sales. From the initialanalysis of Table 3, the CFO began to see potentialsigns of trouble. TEC’s largest customer channel is onthe verge of going into the red. The clerical channeldoes not have enough sales to support the entire com-pany for any length of time. Conclusion: The industrialchannel must be an income producer for the overallsuccess of the company. The initial analysis shows over-all signs of weakness, but the CFO decided to analyzethe industrial channel in more detail by applying ABCto the three classes of customers in the industrial chan-nel to identify problems better.

INDUSTRIAL CLASS PROFITABILITY

By examining the composition of the industrial channel,the CFO discovered it was possible to divide the chan-nel into three classifications by workers’ compensation(WC) rates. As previously stated, the industrial cus-tomers are charged a much higher workers’ compensa-tion rate than clerical customers. In addition, there is awide range of rates charged within the industrial chan-nel. The industrial customers are divided into threeclasses by workers’ compensation rates: Low WC class(WC rates under $5.00/$1,000 of wages paid), AverageWC class (WC rates $5.00 to $8.99/$1,000 of wagespaid), and High WC class (WC rates $9.00 and

over/$1,000 of wages paid). Table 4 displays the costallocation of the industrial channel by workers’ com-pensation rates.

Low WC class

The Low WC rate class is 20% of the total industrialchannel, but it is responsible for over 400% of the indus-trial channel profits. An obvious conclusion is that thecompany is incurring losses elsewhere (i.e., the Low WCrate class is subsidizing other unprofitable customers).TEC budgeted an 18% gross margin for the industrialchannel; the Low WC class’s gross margin is in line withthe budget. From this analysis, the Low WC classappears to be contributing to the overall success andprofits of the company. The goal of TEC should be tomaintain the current pricing arrangements for these cus-tomers. The company also should look into targetingindustries that would fall into this class to increase thesales volume and, in turn, the net profits of the company.

High WC class

As expected, the gross margin is lower in the High WCclass than in the other classes due to the large increasein the WC rate. What is surprising, however, is that thewages paid to the temporary employees are over 73% ofsales as compared to just over 70% for Low WC classemployees. Ideally, higher rates should be charged tothose customers with higher variable costs, but thecompany is unable to do so because of the competitivenature of the industry. The low gross margin is partlyattributable to one customer who accounts for nearly70% of the total sales generated in this class. Thecustomer, a trailer manufacturer, is a consistent user of long-term temporaries. TEC conceded a price breakto the customer due to the high-volume use oftemporaries.

The High WC class generates a net profit even withthe low gross margin. The overhead allocation is signifi-cantly less than with the other two classes because ofthe long-term nature of the assignments of the tempo-rary employees in this class. Only 165 temporaries wereordered during the period of analysis. The low numberof temporaries ordered (the cost driver for the “fillingwork orders” activity) results in the class being allocat-ed less cost for the “filling work orders” activity.


Average WC Class

The last class in the industrial channel to examine, theAverage WC class, is suffering from a net loss. Thelargest class in relation to total sales volume, it is alsoallocated over 77% of the overhead costs based on theactivity analysis and is responsible for only 69% of theindustrial sales. Is the Average WC class being penal-ized with excessive overhead allocation? No. The cus-tomers in the Average WC class consume considerable

time and effort to service.The typical job assignments within this class vary

from one day to several weeks. Customers order fromone to more than 20 temporaries for these assignments,and customer service coordinators are continuallysearching for temporaries to fill these jobs. The firm’sclassified advertisements heavily recruit for employeesin this class, and the heavy recruitment means moreindividuals apply for employment. The Average WC

Table 4: Temp Employment Company, Inc.Profitability Analysis by Industrial Channel Classes

LOW WC AVERAGE WC HIGH WCRATES % RATES % RATES % TOTAL %

Sales $ 369,911 100.0% $ 1,280,184 100.0% $ 209,757 100.0% $ 1,859,852 100.0%

Cost of Sales

Wages–Temporary employees 260,019 70.3% 909,247 71.0% 154,561 73.7% 1,323,827 71.2%

Payroll taxes & fees 43,284 11.7% 174,037 13.6% 34,558 16.5% 251,879 13.5%

Total cost of sales 303,303 82.0% 1,083,284 84.6% 189,119 90.2% 1,575,706 84.7%

Gross margin $ 66,608 18.0% $ 196,900 15.4% $ 20,638 9.8% $ 284,146 15.3%



Number of Temporaries ordered 554 2,719 165 3,438XActivity rate $ 48.239 $ 48.239 $ 48.239 $ 48.239

26,724 7.2% 131,162 10.2% 7,959 3.8% 165,846 8.9%


Number of applicants 2,944 2,944 2,944 2,944X% of orders to total 16.1% 79.1% 4.8% 100%

Applicants by channel 474 2,329 141 2,944XActivity rate $ 26.571 $ 26.571 $ 26.571 $ 26.571

12,594 3.4% 61,876 4.8% 3,755 1.8% 78,225 4.2%


Hours worked 45,140 146,023 22,317 213,480XActivity rate $ 0.1655 $ 0.1655 $ 0.1655 $ 0.1655

7,471 2.0% 24,167 1.9% 3,693 1.8% 35,331 1.9%

Total overhead allocation 46,789 12.6% 217,205 17.0% 15,408 7.3% 279,402 15.0%

Net profit $ 19,819 5.4% $ (20,305) -1.6% $ 5,230 2.5% $ 4,744 0.3%


class should be allocated a large portion of overhead.The activity analysis accomplishes that task.

Examining the net profits shown in Table 4 demon-strates the classic whale-curve effect. The Low WCclass generates over 400% of total profits while theAverage WC class loses over 400% of total profits. Thisleaves the profits generated by the High WC classcomprising nearly 100% of the industrial channel prof-its. Even at this second stage of analysis, areas thatneed further investigation are revealed.

CUSTOMER PROFITABILITY

Table 5 summarizes the activity analysis of the fourlargest customers of TEC according to sales volume.The four customers account for almost 42% of the totalsales volume of the company and over 48% of theindustrial channel sales. Using activity-based costing, ananalysis of these four customers was undertaken touncover problem areas with them.

Chemical Company

TEC supplies 100% of the chemical company’s pro-duction and supervisory personnel. Initial results indi-cate a net profit of 9.8%, much higher than even theclerical channel net-profit percentage. One reason forthis is the low overhead allocation to this customer.For example, under the “filling work orders” activity,only 86 temporaries were ordered, a relatively lownumber. One of the reasons for this is the long-termnature of the assignments. Another reason is the hiringpractices of the company. The chemical company hasone person on-site to recruit employees. Once thechemical company hires a recruit, TEC is notifiedabout the new employee, and the application is sent tohim or her. For these two reasons, the overhead con-sumed by the chemical company is minimal as com-pared to other customers. As long as the companycontinues the use of an on-site coordinator to recruit,it should continue to generate profits for TEC.

Trailer Manufacturer

Similar to the chemical company, the trailer manufactur-er requests long-term employees. Orders for the trailermanufacturer are for normal turnover and peak periodsof production. For the period under examination, only

56 temporaries were ordered, normal for the time ofyear. The gross margin for the customer is uncomfort-ably low due to the billing arrangement with the cus-tomer and the high WC rates incurred. Because thecustomer does not consume a large portion of the activi-ties identified, however, it is not burdened with a highoverhead allocation and is generating just over 3% netprofit. As long as the trailer manufacturer maintains thelow consumption of activities, TEC should be able tomaintain the current profit level.

Newspaper Publisher

The newspaper company is a good example of the typi-cal customer in the Average WC class. It manages itstemporary employment needs differently from the oth-er two customers discussed. The customer calls daily toorder the number of temporaries needed that night,usually ranging from 10 to 40 individuals. Customer ser-vice coordinators are constantly searching for tempo-raries to fill the needs of this customer. The newspaperpublisher consumes a significantly higher proportion ofactivities than the other two customers.

One of the peculiar situations regarding this companyis the standing request by a few of the temporaryemployees themselves to work at the newspaper pub-lisher. As a result, the customer service coordinatorsonly have to call the temporaries and ask what shiftthey want to work. Even though the company request-ed 928 temporaries during the time period investigated,some of those requests were filled rather easily. Howwas the situation handled by the activity-based costingmodel? Basically, the situation was ignored. The news-paper company was allocated the same rate no matterhow easy or difficult it was for TEC to fill the orders.This was one of the deficiencies of the activity analysisperformed by the CFO.

Table 5 illustrates some startling results for the news-paper publisher, the first being the low gross margin.The culprit is the low ratio of bill-to-pay rates. TECwas required to lower its rates to retain the customer.The low bill rates along with the high overhead alloca-tion result in a large net-loss situation. The company isallocated 27% of the “filling work orders” activity whileaccounting for just over 6% of the industrial channel’srevenue. A similar pattern holds true for the “hiring


temporaries” activity. Some tough decisions must beaddressed regarding the future of servicing the news-paper publisher.

Food Processing Company

The company uses temporary employees for its produc-

tion line on a consistent basis throughout the year, witha mix of long- and short-term assignments. As displayedin Table 5, the company generated higher sales thanthe newspaper publisher, but it only had requests for332 temporaries as compared to 928. The gross marginfor the food processor is the highest among the cus-

Table 5: Temp Employment Company, Inc.Profitability Analysis by Selected Customers

CHEMICAL TRAILER NEWSPAPER FOODCOMPANY % MANUFACTURER % PUBLISHER % PROCESSOR %

Sales $ 466,733 100.0% $ 145,764 100.0% $ 122,604 100.0% $ 167,327 100.0%

Cost of Sales

Wages–Temporary employees 341,620 73.2% 110,473 75.8% 92,205 75.2% 120,451 72.0%

Payroll taxes & fees 65,366 14.0% 24,350 16.7% 18,621 15.2% 23,411 14.0%

Total cost of sales 406,986 87.2% 134,823 92.5% 110,826 90.4% 143,862 86.0%

Gross margin $ 59,747 12.8% $ 10,941 7.5% $ 11,778 9.6% $ 23,465 14.0%



Number of Temporaries ordered 86 56 928 332XActivity rate $ 48.239 $ 48.239 $ 48.239 $ 48.239

4,149 0.9% 2,701 1.9% 44,766 36.5% 16,015 9.6%


Number of applicants 2,944 2,944 2,944 2,944X% of orders to total 2.5% 1.6% 27.0% 9.7%

Applicants by channel 74 47 794 285XActivity rate $ 26.571 $ 26.571 $ 26.571 $ 26.571

1,954 0.4% 1,250 0.9% 21,099 17.2% 7,580 4.5%


Hours worked 47,371 15,113 13,000 22,762XActivity rate $ 0.1655 $ 0.1655 $ 0.1655 $ 0.1655

7,840 1.7% 2,501 1.7% 2,152 1.8% 3,767 2.3%

Total overhead allocation 13,942 3.0% 6,453 4.4% 68,017 55.5% 27,363 16.4%

Net profit $ 45,805 9.8% $ 4,488 3.1% $ (56,239) -45.9% $ (3,898) -2.3%


tomers examined, but the high gross margin does notoffset the activities consumed by the customer. Thebottom-line result is a net loss. As with the newspaperpublisher, TEC must address the net-loss situation.

FINAL ANALYSIS

The activity analysis conducted by the CFO generat-ed some startling results. It reaffirmed some beliefsand destroyed others held by TEC’s management.The company held to the notion that the sales com-position of the company was 60% industrial and 40%clerical. Table 3 clearly indicates the composition as85% industrial and 15% clerical. This is one explana-tion for the overall weak profit. As explained earlier,the industrial customers traditionally generate lowerprofits. Driving the analysis to the industrial channelclass provides a richer description of TEC’s profitabil-ity picture.

Table 4 shows that the largest industrial class, theAverage WC class, is generating significant losses. Inother words, almost 70% of the company’s business isgenerating losses. What can be done to reverse this sit-uation? An immediate response might be to attempt toincrease the bill rates charged, but the industrial tem-porary employment industry is very elastic, and anyattempt at increasing rates will produce an immediatedecrease in demand. Another area of concern is the payrates. TEC has been forced to increase the pay ratesdue to the low unemployment rate. The pool of tem-porary employees is small, so they demand a higherrate. Because the company cannot raise billing rates orlower pay rates, the only area available for improve-ment is overhead reduction.

Some revealing results are encountered in Table 5.TEC’s first problem is with the newspaper publisher.The bill rates and pay rates are fixed, so can the over-head allocated to this customer be lowered? One way isto change the way the customer requests and uses tem-poraries. As mentioned earlier, the customer calls dailywith an order for temporaries and is unconcernedwhether the temporaries are new or repeats. A preferredmethod would have the customer call, or be called,once a week with an order for the entire week. Thetemporaries could be assigned on a weekly basis. Also,an analysis of the number of temporaries usually

ordered would be helpful to determine if a small core oflong-term assignments could be employed. Thismethod would reduce the consumption of activities bythe customer and turn it into a profitable venture forTEC.

A key point: A reduction in the overhead allocated toa customer will not, in and of itself, reduce the over-head incurred by the company. Activity-based costingdoes not reduce costs—it only reallocates them basedon the consumption of activities identified. As a result,a customer who begins to consume fewer activitieswithout the simultaneous reduction in overhead by thecompany will only result in a shifting of overhead allo-cation to another customer, creating a possible deathspiral effect. Once a customer consumes fewer activi-ties, the company must either permanently remove theassociated overhead to benefit from the reduction incosts consumed by the customer or utilize the freedcapacity to generate additional revenue.

Overall, the activity analysis described here hasshown that activity-based costing can be used as astrategic tool. It produced useful information to providemanagement with direction for costing and marketingstrategies. The ABC model used will allow for better-informed decision making at TEC. Traditionally, TECused gross margin analysis to set prices and developbudgets. Now it can use ABC for setting prices anddeveloping budgets. This case study also demonstratesthat ABC information can be used for more than justcosting products and services: It can be used to developa firm’s profitability picture.

Developing strategic initiatives designed to transformTEC’s unprofitable customers into profitable customersis the CFO’s next challenge. In addition, the activityanalysis will assist in bidding for contracts in the future.Before the ABC analysis, a bid was prepared withoutunderstanding the true cost of servicing the contract. Asa result, the company was awarded contracts in the pastthat did not generate profits. By using ABC, the compa-ny can better understand the costs associated with ser-vicing a contract and provide a competitive bid that, ifwon, will be profitably serviced. ■

DeWayne L. Searcy, Ph.D., CMA, CPA, CIA, is an assistantprofessor in the department of accounting at the University


of Miami in Coral Gables, Fla. His research interests aresupply chain management, lean enterprises, and continuousauditing. He can be reached at (305) 284-4821 [email protected].

1 J. N. Sheth, R. S. Sisodia, and A. Sharma, “The Antecedentsand Consequences of Customer-Centric Marketing,” Journal ofthe Academy of Marketing Science, Vol. 28, No. 1, 2000, pp. 55-66.

9M A N A G E M E N T A C C O U N T I N G Q U A R T E R L Y S U M M E R 2 0 0 7 , V O L . 8 , N O . 4

Many businesses today are pursuing a

growth strategy. Typically, small- to

medium-sized enterprises must fund

growth internally, which, in turn, is a

function of the company’s ability to

generate positive cash flows. A domestic electronic

consumer products manufacturer, referred to in this

article as XYZ, was experiencing cash-flow difficulties

and unprofitable growth, so it responded by imple-

menting a simple activity-based costing (ABC) system.

This cost system redesign allowed XYZ to estimate

return on sales (ROS) and return on investment (ROI)

results for both product lines and customers. In short,

the ABC system provided the owners with strategies

for pursuing profitable growth.

We will look at how ABC improved XYZ’s pricing

and product decisions and spurred business process

improvements, all of which allowed the company to

become more competitive. To help accountants and

managers who otherwise might hesitate to engage in a

cost-system redesign project, we also discuss ABC

implementation issues likely faced by small- to

medium-sized manufacturers.

BACKGROUND

Founded in 1999, XYZ Corporation caught the Internet

wave squarely by offering domestically produced,

value-based consumer electronics products directly to

Cost-System Redesignat a Medium-SizedCompany: Getting theRight Numbers to DriveImprovements inBusiness Performance

ACTIVITY-BASED COSTING ALLOWED A MANUFACTURER TO MAKE BUSINESS PROCESS

CHANGES THAT HELPED IMPROVE CASH FLOW, PRODUCT AND CHANNEL PROFITABILITY,

AND THE COMPANY’S COMPETITIVE POSITION.

B Y D A V I D E . S T O U T , P H . D . , A N D G R E G O R Y P. B E D E N I S , C P I M


the end user through the company’s website. The com-

pany separates its products into six families:

◆ Product family A consists of purchased

accessories.

◆ Product family T items have textured finishes and

can be purchased locally in small-lot quantities.

All other finish types must be purchased in ocean-

container quantities.

◆ Product family V comprises items with a vinyl

finish.

◆ Product family W includes premium wood-

finished items.

◆ Product family U is uniquely designed and exclu-

sively manufactured items.

◆ Product family S items represent complete assem-

blies, which XYZ purchases from foreign

manufacturers.

Annual sales for all products amount to approximate-

ly $9 million. Currently, the company ships all orders

from a single U.S. manufacturing facility. XYZ sells

products directly to domestic customers, but foreign

customers purchase items through an exclusive dealer

network. The company has three owners and 16

employees, most of whom work at home in various

parts of the country.

Since XYZ’s founding, the company’s competitive

advantage has been low overhead costs and high cus-

tomer service—a combination that equates to high val-

ue in the customer’s mind. XYZ’s primary competitors

include low-cost Internet direct distributors that pur-

chase complete products from foreign manufacturers

and high-end product manufacturers that distribute

merchandise via specialty retail shops. Technical inno-

vations and new product offerings principally fuel

growth in the industry in which XYZ competes.

During each of its first five years, the company expe-

rienced significant sales growth. The first three years

saw 40% sales volume and revenue growth per year fol-

lowed by 20% growth in each of the next two years.

Sales volume and total revenues are still increasing,

although cash flow is becoming a problem for the com-

pany. Shrinking dividend payouts and slowing payment

cycles to suppliers suggested that the proverbial “edge

of the cliff” for this company was fast approaching!1

Growth in sales revenues is a desired outcome for

most businesses, as it is with XYZ, but growth in sales

without sufficient cash to fuel expansion may actually

be counterproductive. This could occur, for example,

when growth is fueled by new product offerings that do

not recover their full costs. In short, cash flow and

working capital, not sales revenue or sales volume, are

the lifeblood of a business.2

Continued success for XYZ was therefore being

jeopardized by the lack of sufficient cash flow. Under-

standably, the owners wanted to know the causes of the

deteriorating situation, so they put together a cross-

functional team consisting of the chief financial officer,

plant manager,3 and director of engineering to investi-

gate the situation. After considerable deliberations, the

team identified the following problem areas:

◆ Poor inventory management,

◆ Lack of control of overhead (i.e., manufacturing

support) costs, and

◆ Inefficient business processes (for example,

disorganized inventory information).

PROBLEM SPECIFICATION—A DEEPER LOOK

For virtually any manufacturer, proper inventory man-

agement ensures the availability of the right items at

the right time and in the right place. This, in turn, sup-

ports organizational objectives of customer service, pro-

ductivity, profit, and return on investment (ROI). There

are, however, both out-of-pocket and opportunity costs

associated with inventory holdings. For example, inven-

tory ties up capital, uses storage space, requires han-

dling, deteriorates, becomes obsolete, incurs property

taxes, requires insurance, and sometimes is lost or

stolen.4 For XYZ, increased inventory holdings to

accommodate anticipated sales increases were straining

cash flow. Further, inventory levels increased at XYZ

when the company was pursuing a growth strategy of

product-line diversity. Realized sales increases, how-

ever, were not sufficient to offset the increased invest-

ment in inventory for the company, which, consequent-

ly, was robbing the company of much-needed liquid

assets.

In addition, XYZ was experiencing increased spend-

ing on capacity-related (i.e., short-term fixed) costs and

manufacturing support costs (e.g., supply-chain man-

agement). XYZ’s humble beginning is probably similar


to that of many start-up manufacturers. Batch quantities

for the company were initially small, labor content was

high, and overhead was relatively low. As the company

matured and sales increased, labor content decreased

because of greater returns to scale, learning-curve

effects, and investments in an improved infrastructure.5

With increases in sales volume and a changing sales mix

that XYZ was experiencing, support costs were escalat-

ing. Capacity-related costs as well were increasing dis-

proportionably to increases in sales. Indirect labor costs,

capital expenditures (e.g., tooling costs), and factory

overhead costs were all increasing faster than sales rev-

enue. XYZ had always excelled at delivering and sup-

porting a superior product. As such, cost control was

never an area of focus for the company, but now it was

becoming a strategic issue. In short, support costs for

XYZ were escalating rapidly, overrunning profits and

draining cash.

Increased inventory holdings and excessive overhead

spending combined to reduce the company’s net cash

flow. Determining which inventory items to reduce and

which overhead costs to focus on, however, was unclear

to the owner-managers. The necessary cost-control tools

and supporting business processes were not in place at

XYZ to guide these decisions, so the cross-functional

team ultimately decided to critically examine the com-

pany’s accounting system.

COST-SYSTEM REFINEMENT

XYZ had been using a traditional cost system that was

fairly rudimentary. In fact, the view of the owners was

that the cost system was necessary only for compiling

data for income-tax purposes and periodically for

preparing financial reports (e.g., to support a bank loan

request). As a result, the company had done no budget-

ing or forecasting to track and control costs. Thus,

XYZ’s existing cost system could not capture the under-

lying economics of the company’s production function

and, therefore, could not assist the company in respond-

ing to the deteriorating situation in which it found

itself. The plant manager had just completed an MBA

course in management accounting and was intrigued by

the prospect of introducing a rudimentary activity-

based costing system at XYZ. This was the primary pro-

posal that the three-person team dealt with over an

ensuing six-month period.

Companies use ABC systems to improve product

and/or customer costing principally because such sys-

tems provide better (i.e., more accurate) estimates of

the resource demands (or resource consumption) of an

organization’s outputs, its customers, and its distribution

channels. The plant manager at XYZ thought that use-

ful insights for improving cash flow and profitability

might be possible if the company had a better handle

on the resource demands of its various product offerings

and distribution choices. Such insights, the team hoped,

would enable the company to respond to the strategic

challenges it was facing.

Further, the plant manager read an article in the Fall

2005 issue of Management Accounting Quarterly, “Product

Line and Customer ROI: The Next Generation of

ABC,” which introduced him to using ABC data to

evaluate product- and customer-level ROI.6 The article

asserts that ABC concepts can be extended to encom-

pass the allocation of assets to activities. Just as

resources under ABC are assigned to activities (e.g.,

production setups) for costing purposes, assets can simi-

larly be assigned to activities. Once the level of assets

associated with a given activity is determined, it is pos-

sible to assign assets to customers and products in the

same fashion that ABC assigns costs to products and

customers. Thus, the plant manager at XYZ wondered

whether the company could use a simple ABC system

to guide strategic decisions such as those related to

product mix, product selling price, overhead cost con-

trol, and business process improvement.

ABC ELEMENTS

Figure 1 illustrates the general elements of an ABC sys-

tem: resources, activities, resource drivers, cost objects,

and activity cost drivers. Resources are devoted to the

performance of activities; they are the sources of cost.7

Examples of resources would be direct material, direct

labor, office support staff, professional salaries, office

space, and advertising costs. At XYZ—and common to

many accounting systems we observe today—most

resource costs are gathered in functional or descriptive

accounts. Thus, XYZ’s general ledger (the source of

resource expenditures) was ultimately redesigned to

accommodate the proposed ABC system. For example,


marketing, accounting, customer service, engineering,

assembly, and plant management were designated as

resources for the ABC model. Resources that are not

functional areas at XYZ include facilities and materials.

Activities are units of work performed by the organi-

zation’s resources. Typical activities ABC captures

include things such as creating a customer order, pro-

cessing returns, creating invoices, and handling materi-

als. In an ABC system, activities typically are organized

in a master list called an Activity Dictionary. Table 1 is a

portion of the Activity Dictionary XYZ developed. This

example includes the major activities performed by the

customer-service resource and the corresponding cost-

level hierarchy for each identified activity. The cost-

level hierarchy is a framework for classifying activities

according to the level at which costs are incurred. Unit-

level, batch-level, product sustaining, and business sus-

taining are activity levels in conventional ABC

implementations.

Related activities are grouped in activity cost centers,

which at XYZ include order processing, inventory, ware-

housing, engineering and marketing, assembly, cus-

tomer service, and accounting. These activity centers

parallel XYZ’s organization chart. The activity cost cen-

ter’s purpose is to organize activities in a meaningful

way and, ultimately, to facilitate business process

improvements and strategic cost management. For

instance, the order-processing activity cost center in

Figure 2 groups activities specific to the customer

order-entry process at XYZ.

Resource drivers assign costs from descriptive

accounts contained in an organization’s existing cost

system to activities. Resource drivers link resources

and activities and are chosen to approximate the

resources activities use. For example, in Figure 2, cus-

tomer service and accounting resource costs are traced

Resources

Activities andActivity Cost

Pools

Activity Center

ResourceDriver Cost

Element

Source: Peter B.B. Turney, Common cents: how to succeed with activity-based costing and activity-based management, rev. ed., McGraw-Hill,New York, N.Y., 2005, p. 95.

ActivityDriver

Cost Objects

Figure 1: ELEMENTS IN A TYPICAL ABC SYSTEM


to five order-processing activities. Most resource driver

amounts are based on estimates of the effort expended

on each activity. XYZ used interviews and question-

naires to generate these estimates. Other resources,

such as materials, are assigned to activities using more

exact information. Pinpoint accuracy is not required for

ABC systems, particularly for initial system develop-

ment and for a small- to medium-sized company such

as XYZ.

The cost object is the final point to which costs are

assigned and is the reason work is performed. For

example, it can be a product, a service, a customer or

Figure 2: ORDER-PROCESSING ACTIVITY COST CENTER AT XYZ

AccountingCustomer

Service

DomesticCustomers

InternationalDealers

ProductFamily V

ProductFamily W

ProductFamily U

No. of Orders

Enter andMonitor Orders

ProcessAccounts

Receivable

ProductFamily A

ProductFamily S

ProcessCreditCards

Activity Resource Cost Hierarchy

Advertise Products Customer Service Product Sustaining

Ship Product Customer Service Unit Level

Answer Product Information Question Customer Service Product Sustaining

Support Post Sales Customer Service Product Sustaining

Process Warranty Claims Customer Service Unit Level

Maintain Shopping Cart Customer Service Business Sustaining

Enter and Monitor Orders Customer Service Unit Level

Create Priority List Customer Service Batch Level

Create Invoices Customer Service Unit Level

Process Credit Cards Customer Service Unit Level

Table 1: EXCERPT FROM XYZ’S ACTIVITY DICTIONARY

ProductFamily T

Create Priority

List

CreateInvoices


customer group, or a distribution channel. Cost objects

can also vary in detail depending on the ABC system’s

purpose and the organization’s nature. For XYZ’s initial

ABC model, the cost objects consist of the aforemen-

tioned six product families and two distribution chan-

nels. The product families and distribution channels are

distinct because of differences in resource

requirements.

Activity cost drivers assign the costs of activities to cost

objects by measuring the level of activity consumption

by each cost object. In conventional ABC systems,

there are three basic types of activity drivers.8 Transac-

tion drivers count the frequency of an activity and are

the least expensive cost driver. Transaction drivers,

however, may be the least accurate drivers because they

assume the same quantity of resources is required every

time an activity is performed. For example, the activity

“number of admissions” is a possible transaction driver

for all hospital-related support costs associated with the

admissions/discharge process. Each admission/discharge

is counted as a single activity, and this information is

readily obtainable from admission records. Figure 3

shows the inventory-management cost center for XYZ.

All activity drivers in Figure 3 are transaction activity

drivers.

Duration drivers represent the amount of activity per-

formed. Duration drivers are used in an ABC system

when significant variation exists in the amount of activi-

ty required for different outputs. For example, in a hos-

pital setting a logical duration driver for routine care

(“room and board”) costs would be number of patient-

days; in a manufacturing setting, a duration driver

regarding setup activity would be number of setup

hours. Figure 4 contains a representation of the market-

ing and engineering cost center for XYZ in which a

duration driver was used in a unique way. To assign

engineering and marketing activity costs at XYZ, the

product family’s position in the product life cycle was

used. The product life cycle was split into four stages:

introduction, growth, maturity, and decline. Each prod-

Figure 3: INVENTORY-MANAGEMENT COST CENTER

DomesticCustomers


ProductFamily T

ProductFamily V

ProductFamily W

ProductFamily U

# of Part Numbers

# of Forecasted Items

ProductFamily A

ProductFamily S

Marketing

Assembly Team

FactoryManagement

Maintain InventoryDatabase

ForecastingDemand

SourcingMaterials

# of Part N

umbers


uct family was allotted the appropriate numerical value

based on its stage in the product life cycle. Subsequent-

ly, engineering and marketing costs were assigned to

product families based on their comparative product

life-cycle position. The product life-cycle duration dri-

ver was used because a transaction driver or traditional

duration driver for marketing and engineering, such as

number of engineering change notices, was not avail-

able. Going forward, XYZ will need to determine if the

additional accuracy that comes from using a transaction

driver such as number of engineering change notices is

worth the additional information-collection costs that

would be involved.

Intensity drivers charge directly for the resources used

each time an activity is performed and are generally the

most accurate activity cost drivers. They also are the

most expensive to implement. In a manufacturing set-

ting, an intensity driver for setup activity might be

direct-cost tracing for labor. For XYZ, engineering activ-

ity costs (see Figure 4) could be assigned more accu-

rately if logs were used to track an individual’s time

worked on each product family (A, T, W, etc.).

BENEFITS FROM THE INITIAL

ABC IMPLEMENTATION

Although still in its nascent stage, the ABC system at

XYZ has yielded a number of financial and process-

related benefits.

Financial (Profit-Loss) Effects

The company used initial ABC data to construct a pro

forma profit and loss (P&L) statement by product fami-

ly and distribution channel (see Table 2). The ABC

model was used to assign revenue, manufacturing costs,

and operating expenses across product families. Prior to

the ABC system, XYZ was unable to generate financial

information to this level of detail. Based on the infor-

mation in Table 2, several recommendations emerged

for improving cash flow and for maximizing ROI across

cost objects.

Figure 4: ENGINEERING AND MARKETING ACTIVITY COST CENTER

DomesticCustomers


ProductFamily T

ProductFamily V

ProductFamily W

ProductFamily U

ProductFamily A

ProductFamily S

CustomerService

AssemblyTeam

Engineering MarketingFactory

Management

AdvertiseProducts

Develop New

Products

MaintainWebsite

ImplementDesign

Changes

Misc.Engineering

Activities

DevelopProduct

Costs

ManageProductDemos

MaintainDealer

Relationships

IntroduceNew

Products

Relative position in Product Life Cycle

2 1 2 3 3 2


Use of Common Components: A recently released

study concludes that automakers can increase profitabil-

ity by using common components across platforms.9

The study reports that Toyota saves an estimated

$1,000 per vehicle over five years by using common

components. The decision team at XYZ reviewed prod-

uct configurations and estimated that the company

could reduce inventory investments by approximately

$132,000 by emphasizing a common-component strate-

gy in product family T, product family V, and the for-

eign distribution channel. For example, product fami-

lies T and V use unique electrical components that can

be replaced by electrical components used by other

product families. In addition, most foreign dealers

require their electrical components to accept 220v pow-

er input. These components can be eliminated by

adding a voltage selection switch to the domestic 110v

electrical component equivalent. Table 3 shows the

expected results of the proposed changes. With the

ABC model, XYZ is able to reveal the positive financial

effects of using common components.

Product-Mix Decisions: When products and customers

are served from the same constrained asset, which for

XYZ is dollars of working capital, it is necessary to

Product Family Distribution Channel

A T V W U S Direct Dealers

Sales $23,901 $100,435 $138,557 $136,094 $117,560 $60,762 $462,108 $115,201

COGS $24,181 $66,256 $81,347 $72,798 $62,765 $30,618 $261,265 $76,670

Gross Profit ($281) $34,179 $57,210 $63,295 $54,794 $30,145 $200,842 $38,530

Operating Expenses $5,676 $18,375 $31,056 $21,370 $16,729 $17,415 $100,808 $10,338

Operating Income ($5,956) $15,803 $26,155 $41,926 $38,065 $12,730 $100,034 $28,192

Return on Sales (ROS) (24.92%) 15.74% 18.88% 30.81% 32.38% 20.95% 21.65% 24.47%

Total Inventory $27,540 $106,266 $186,440 $229,380 $92,091 $121,242 $568,488 $194,471

Return on Inventory (21.63%) 14.87% 14.03% 18.28% 41.33% 10.50% 17.60% 14.50%

Table 2: PROFIT AND LOSS (P&L) STATEMENT BY PRODUCTFAMILY AND DISTRIBUTION CHANEL

BEFORE ABC: AFTER ABC:

Cost Objects Cost Objects

(T) (V) (F) (T) (V) (F)

Textured Vinyl Dealers Textured Vinyl Dealers

Total Income $100,435 $138,557 $115,201 Total Income $100,435 $138,557 $115,201

Net Operating Income $15,803 $26,155 $28,192 Net Operating Income $15,257 $24,255 $28,192

Return on Sales 15.74% 18.88% 24.47% Return on Sales 15.19% 17.51% 24.47%

Total Inventory $106,266 $186,440 $194,471 Total Inventory $65,266 $163,440 $126,753

Return on Inventory 14.87% 14.03% 14.50% Return on Inventory 23.38% 14.84% 22.24%

Table 3: PROJECTED PROFIT AND LOSS (P&L) STATEMENTSREGARDING COMMON COMPONENTS RECOMMENDATION


determine the appropriate product mix that will maxi-

mize profits subject to the constraint. Based on its

review of profitability figures for all product families

and products (see Table 2), the decision team recom-

mended eliminating some product options. That is,

from a profitability perspective, sometimes “less is

more.” Conventional accounting systems can obscure

the cost of product-line complexity and product

proliferation—costs that ABC systems attempt to

uncover.

For product family W, the walnut-finished products

were eliminated because of weak sales globally. That

recommendation was easy to explain because walnut-

finished products made up only 2% of the wood-

finished products sold while accounting for an estimat-

ed 10% of the inventory investment in the product

family. The other product-mix recommendation of

eliminating off-color finishes from product family V was

more difficult to justify. For product family V, off-color

products account for 20% of sales. On the surface, it’s

hard to walk away from that amount of sales until you

realize that, because of minimum-order quantity

requirements from the supplier, one-third (i.e., $40,000)

of the company’s inventory investment in the product

family is tied up in off-color products. Table 4 shows

the estimated financial effect of eliminating off-color

inventory at XYZ.10 The lesson here is straightforward:

With cash-flow constraints, it may be necessary to elimi-

nate products that sell and that have good profit mar-

gins but that tie up too much cash in inventory. This

insight is a direct result of the estimated cost data pro-

vided by the new ABC system.

The last recommendation from the team was surpris-

ing. Product family U comprises the first products

designed and manufactured by XYZ. Products in this

line are unique in the marketplace but are “long in the

tooth.” Because product family U’s sales were shrinking

in comparison to total sales, it was assumed that these

products were at the end of their life cycle. On the con-

trary, based on ABC data, product family U had the

highest ROS and ROI. It was, in effect, XYZ’s cash cow.

As such, the team recommended that XYZ do every-

thing possible to increase sales, including expanding

markets, reintroducing products with improved aesthet-

ics, and initiating a complete redesign of the product

line. Increasing sales in product family U would not

decrease absolute inventory levels, but it would

increase overall ROS and ROI.

Because of the cash-flow issues, the decision team’s

main focus was reducing inventory to increase cash flow

and product-level ROI. Recommendations focusing on

using common components and eliminating poor-

performing products account for an estimated inventory

reduction of $172,000. Other recommendations, includ-

ing renegotiating minimum-order quantities on pur-

chased components, accounted for an additional esti-

BEFORE ABC: AFTER ABC:

Cost Objects Cost Objects

(V) (W) (S) (V) (W) (S)

Vinyl Wood Purch. Vinyl Wood Purch.Comp. Comp.

Total Income $138,557 $136,094 $60,762 Total Income $138,557 $136,094 $60,762

Net Operating Income $26,155 $41,926 $12,730 Net Operating Income $26,155 $41,926 $12,730

Return on Sales 18.88% 30.81% 20.95% Return on Sales 18.88% 30.81% 20.95%

Total Inventory $186,440 $229,380 $121,242 Total Inventory $168,440 $212,380 $81,242

Return on Inventory 14.03% 18.28% 10.50% Return on Inventory 15.53% 19.74% 15.67%

Table 4: PROJECTED PROFIT AND LOSS (P&L) STATEMENTSREGARDING SELECTED OFF-COLOR PRODUCTS


mated inventory reduction of $35,000. The expected

result of all recommendations combined is an estimated

inventory reduction of $207,000 and a 37% increase in

overall ROI.

Process-Related Improvements

As illustrated previously, organizations typically imple-

ment ABC-type systems to realize improved financial

performance (based on improved pricing decisions, bet-

ter product-mix decisions, improved cost control, etc.).

ABC implementations, however, can provide additional

benefits in the form of improved business processes. In

the case of XYZ, process improvements in the account-

ing and inventory control systems were attributed to the

ABC implementation.

The starting point for establishing the flow of costs in

an ABC system is the general ledger.11 As noted earlier,

the general ledger at XYZ was reconfigured to accom-

modate the ABC implementation. Redundant and relat-

ed accounts (e.g., various factory overhead accounts)

were combined to reduce the number of required calcu-

lations, and singular income and cost-of-goods-sold

accounts were disaggregated by product-family level.

For example, the overall sales revenue account associat-

ed with the old accounting system was split into multi-

ple sales revenue accounts, one for each product family.

Similarly, selected expense accounts (e.g., fringe bene-

fits) were subdivided to obtain resource costs easily.12

All these changes represented improvements to the

company’s accounting system and were related directly

to the ABC implementation.

Another significant process change attributed to the

ABC implementation was the institution of spending

budgets. An ABC system is able to attribute costs to

specific products or product families, but spending bud-

gets are better equipped to manage costs. XYZ had

been aware of the need to implement spending con-

trols, but it lacked motivation. With a better under-

standing of ROS and ROI because of the ABC imple-

mentation, XYZ was now in a position to employ

spending budgets to improve profitability.

The time and effort required to create the ABC mod-

el made it evident that considerable changes to the

management information system (MIS) at XYZ would

be required to make the costing process efficient and

accurate. Problems with the existing MIS came primari-

ly from information silos that existed throughout the

company, making information gathering difficult.13

Sales revenues, manufacturing costs, and operating

expenses were all maintained in separate systems. No

cost information could be shared or reconciled

electronically.

To eliminate the information silos and implement

the new costing system effectively, the inventory con-

trol and order-shipping processes at XYZ were incorpo-

rated into the existing accounting information system.

All inventory control functions are now performed in

QuickBooks Enterprise Solutions.14 This integration

process allows revenue information and manufacturing

costs to be related to shipments, which extends the

ABC information related to product families and distri-

bution channels. In addition, all costing information

now resides in one database.

LESSONS LEARNED

“Work is infinite; time is finite. Therefore, you must

manage your time, not your work.”15 Managing time for

an ABC implementation means managing the access,

flow, and level of information. In this section, we offer

some recommendations based on the ABC implementa-

tion experience at XYZ.

When possible, reorganize the general ledger and

income statement to accommodate ABC. The reorgani-

zation of the financial information allows easy accessi-

bility to data. Integrating vital information systems con-

trols the flow of information and automates many of the

required calculations needed to develop the ABC mod-

el, thereby reducing the amount of time required to

generate cost data. In addition, system integration

improves data accuracy and the ability to replicate the

information-generation process. Finally, when imple-

menting an ABC model, it is important to embrace the

concept of “good enough” when determining the

required fineness of the data and for getting the ABC

project off the ground. As General George S. Patton

said, “A good plan, violently executed now, is better

than a perfect plan next week.”

Another overriding lesson is that an organization’s

structure and financial status influence the duration and

effectiveness of its ABC implementation. Many internal


factors, including corporate culture, available informa-

tion systems, and current financial performance, have a

bearing on the ability of the ABC model to influence

the organization’s decision-making process. XYZ’s

decision-making process had been primarily subjective

in nature, with little financial analysis. Thus, consider-

able time was required to educate the decision team

and board members on ABC, P&L statements, and

ROI. Inefficient business processes at XYZ, information

silos, and lack of information were obstacles that had to

be overcome as part of the ABC model-creation process.

Finally, the most important lesson was that signifi-

cant change does not occur without crisis. Or as Louis

V. Gerstner, former chairman of IBM, put it: “No orga-

nization is going to change in a fundamental way unless

it believes there’s real pain staying the way we are.”

XYZ was open to the recommendations from the deci-

sion team because the company found itself in the

midst of a crisis. Developing solutions before problems

reach crisis proportions is most prudent, although the

message may not be fully received.

BENEFITS OF COST-SYSTEM REDESIGN

ABC systems are not meant solely for large companies.

Small- to medium-sized companies, such as XYZ, can

benefit from data provided by an ABC model. In the

present case, the ABC information motivated business

process changes (e.g., in accounting), reduced product

complexity for several product lines (e.g., moving to the

use of common components), and influenced changes

in the company’s product mix (e.g., by highlighting

underperforming products). Collectively, these changes

helped improve cash flow, product and channel prof-

itability, and the organization’s competitive position. ■

Gregory P. Bedenis, CPIM, is an MBA candidate in the

Williams College of Business Administration at Youngstown

State University in Youngstown, Ohio. You can reach

Gregory at (330) 856-3231 or [email protected].

David E. Stout, Ph.D., is the Andrews Chair in Accounting

in the Williamson College of Business Administration at

Youngstown State University in Youngstown, Ohio. You can

reach David at (330) 941-3509 or [email protected].

ENDNOTES

1 Dividend payouts are made to the owners and select employ-ees on a quarterly basis.

2 Suzanne Caplan, Streetwise Finance & Accounting: How to KeepYour Books and Manage Your Finances without an MBA, CPA, orPh.D., Adams Media Corporation, Avon, Mass., 2000.

3 One of the coauthors of this article.4 Lee J. Krajewski, Operations Management: Strategy and Analysis,

6th ed., Pearson Education, Inc., Upper Saddle River, N.J.,2002.

5 Thus, the start-up of XYZ was probably similar to that ofApple Computer or Dell: Assembly began in someone’sgarage, one product at a time, progressing to a multi-stagefactory producing batches of products.

6 Kevin Devine, Tom Lammert, and Priscilla O’Clock, “ProductLine and Customer ROI: The Next Generation of ABC,”Management Accounting Quarterly, Fall 2005, pp. 1-11.

7 Peter B. B. Turney, Common cents: how to succeed with activity-based costing and activity-based management, rev. ed., McGraw-Hill, New York, N.Y., 2005, p. 94.

8 Anthony A. Atkinson, Robert S. Kaplan, and S. Mark Young,Management Accounting, 4th ed., Prentice Hall, Upper SaddleRiver, N.J., 2004.

9 http://oesa.org/publications/articledetail.php?articleId=5142(accessed September 13, 2007).

10 XYZ believed that few to no sales would be lost by eliminatingoff colors because competitors do not offer multiple colorchoices in this product category.

11 Turney, op. cit., pp. 268-269.12 Ibid., pp. 270-271.13 An “information silo” is a management system incapable of

reciprocal operation with other, related management systems.For instance, order information, initially captured in the Inter-net shopping cart, must be rekeyed into the inventory controlsystem to determine the build schedule for the assemblydepartment.

14 Accounting software for small businesses from Intuit. 15 Kenneth Atchity, A Writer’s Time: Making the Time to Write, rev.

ed., W.W. Norton and Company, Inc., New York, N.Y., 1995.

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