Module 18

Activity-Based Costing, Customer Profitability, and Activity-Based Management

Traditional Product Costing

Overhead Costs allocated to Products By direct labor or machine hours

Traditional results will be inaccurate when Products differ on use of resources, like

Frequent design changes Specialized equipment Complex setups Difficult customer specifications

Activity-Based Costing (ABC)

Resources are assigned to activity costs, which are then assigned to

objectives by cost drivers.

Staff SalariesSupervisorOther

Assign by time

• Place orders

• Verify orders

• Unload & Unpack & Inspect

Assign by cost driver

PO 1PO 2…

For example, consider purchasing and receiving:*Based on units of activity utilized by the cost objective

Example Activity CostsPurchasing

Placing Purcha

se Orders

Verifying Purchase Orders

UnloadUnpackInspect

Total Costs

Salaries Purchasing agents ($7,800 × 3 agents) $23,400 Receiving room employees ($2,400 × 2 emp.) ($2,400 × 2 employees × 15% verifying) $ 720 ($2,400 × 2 employees × 85% unload, etc) $4,080 Supervisor

($5,000 × 3/5 purchasing) 3,000 ($5,000 × 2/5 receiving x 30% verifying) 600 ($5,000 × 2/5 receiving x 70% verifying) 1,400

Other costs ($4,500 × 25% purchasing) 1,125 ($4,500 × 75% receiving) - - 3,375 Total $27,525 $ 1,320 $ 8,855 $37,700

Interviews determined that 15% of the time, receiving room

employees verified purchase orders, and 85% of their time was spent unloading, unpacking, and

inspecting.

Supervisors were found to spend 30% of their receiving time on verifying issues, with the other 70%

on unloading, unpacking, and inspecting issues.

Cost per Unit of Activity Each activity results in a different rate Rates are used to apply costs to cost

objectives

Placing Purchase Orders

Verifying Purchase Orders

Unloading Unpackin

g Inspecting

Total cost of activity $27,525 $ 1,320 $ 8,855 Units of cost driver: Number of purchase orders ÷300 Number of purchase orders ÷300

Number of dollars of materials - - 120,000 Cost per unit of activity $ 91.75 $ 4.40 $ 0.074

Assume direct materials totaling $120,000 are to be acquired during the

month with 300 purchase orders.

Assume direct materials totaling $120,000 are to be acquired during the

month with 300 purchase orders.

Assigning Activity Costs to Cost Objectives

Costs for Purchase order 1

Direct materials costs $ 1,600

Activity costs:

Placing purchase order $ 91.75

Verifying purchase order 4.40

Unloading/unpacking/inspecting ($0.074 × $1,600) 118.40

Costs assigned to cost objective $214.55

Total cost of materials on PO 1 $1,814.55

Assigning costs to a purchase order which has a materials cost of $1,600 for 500 parts.Assigning costs to a purchase order which

has a materials cost of $1,600 for 500 parts.

ABC Implementation ABC is expensive to implement After switching to ABC, companies

may find that only 10 to 15% of their products are profitable Causes management to alter the

product mix by minimizing unprofitable products which causes profits to increase

Customer Profitability

ABC may be used for customer profitability analysis.

Customer costs to be analyzed Cost incurred to sell the goods or

services Cost incurred to provide service

Actions possible from analysis Convert customers to profitability or

increase profitability Seek to terminate unprofitable

customer relationships

ABC Customer Profitability Analysis Example

What activities are required to serve customers? Activity Activity Cost Driver Cost per Unit of Activity

Visits to customers Visits $ 400

Remote contact Number of contacts 30

Processing and shipping Customer orders 150

Packaging Number of requests 120

Billing and collection Invoices 40

Customer activity costs for Haskell Construction: Activity Cost

Driver Data Cost per Unit of Driver Activity

Customer Activity Cost

Visits to customers 4 $400 $1,600 Remote contact 3 30 90 Processing and shipping 6 150 900 Packaging 2 120 240 Billing and collection 5 40 200 Total customer activity cost $3,030

Continued

ABC Customer Profitability Analysis Example

Customer Profitability Analysis: Customer sales $79,000. Less cost of goods sold 62,000. Gross profit on sales 17,000. Less activity costs (3,030) Customer profitability $13,970.

Customer profitability ratio:$13,970 ÷ $79,000 = 17.7%

Customers found to generate losses should be flagged and efforts made to correct the situation or

terminate the customer.

Customers found to generate losses should be flagged and efforts made to correct the situation or

terminate the customer.

Activity-Based Management

Identification and selection of activities to maximize the value of activities while minimizing their cost from the perspective of the final consumer

From the perspective of the final customer, what adds value to the product?

Activity-Based Management

Value Added: Required activities to produce a product and serve customers. Examples: Produce product, fill

customer order Non-Value Added: Not required to

produce a product or serve customers well. Examples: Inspections, waiting,

customer returns, storage, downtime for repairs, redoing anything