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Extending and Applying ABC concepts
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Activity Based Costing-Review
Mechanism for cost allocation Single cost pool to Multiple Cost Pool
Single Cost Driver to Multiple activity based drivers
Better Costing of Products
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Over and Undercosting Overcostinga product consumes a low level of
resources but is allocated high costs per unit.
Undercostinga product consumes a high level ofresources but is allocated low costs per unit.
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Cross-subsidization The results of overcosting one product and
undercosting another.
The overcosted product absorbs too much cost,
making it seem less profitable than it really is. The undercosted product is left with too little cost,
making it seem more profitable than it really is.
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When is ABC most useful
When Increase in product diversity
Increase in indirect costs
Advances in information technology
Competition in foreign markets
Decision Making
Product pricing
Activity based management Customer Profitability Analysis
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Activity-Based ManagementA method of management that uses ABC as an integral
part in critical decision-making situations, including:
Pricing and product-mix decisions
Cost reduction and process improvement decisions
Design decisions
Planning and managing activities
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ABC vs. ABM
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Activity Based Management:
Customer Profitability Analysis Customer-Profitability Analysis is the reporting and
analysis of
revenues earned from customers and
costs incurred to earn those revenues
An analysis of cross-customer differences in revenuesand costs can provide insight into
why differences exist in the operating income earned
from different customers
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Customer Cost Analysis Customer Cost Hierarchy categorizes costs related to
customers into different cost pools on the basis ofdifferent:
types of drivers
cost-allocation bases
degrees of difficulty in determining cause-and-effect or
benefits-received relationships
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Example: Freedom Card at
Bank of Bodega Bay The Freedom Card is a credit card that competes with
national credit cards such as Visa and Master card. It ismarketed by the Bank of Bodega Bay. Tommy LeeZhang is the manager of the Freedom Card Divisionand wishes to develop a customer profitabilityreporting system.
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Four Representative Users
A B C D
Annual purchase at retail merchants $80,000 $26,000 $34,000 $8,000
Number of retail transactions 800 520 272 200
Annual fee $50 $0 $50 $0
Average annual balance on whichinterest is paid
$6,000 $0 $2,000 $100
Number of customer inquiries 6 12 8 2
Number of replacements (loss/theft) 0 2 1 0
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Example contnued
Customer B card issued under special promotion of
no lifetime fee with minimum of one transaction peryear.
Customer D is currently a student no fee program atselect Universities.
Activity based costing shows Customer transaction at retail merchants costs $0.50 to
process.
Customer inquiry costs $5 per inquiry.
Replacing a lost or stolen card costs @120. Annual cost to bank for account (including account
maintenance and statement mailing) is $108.
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Additional Facts
BOB receives 2% of purchase amount from retailmerchants per usage.
2006 bad debts were 0.5% of total purchases.
Thus, net amount =2.0-0.5=1.5%
Interest spread (rate for customers less BOBs cost ofborrowing)=9% on average balance.
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Customer Profitability
Analysis CustomerA B C D
Customer revenuesAnnual feeMerchant paymentsa
$ 501,600
$ 0520
$ 50680
$ 0160
Interest spreadb 540 0 180 9Total 2,190 520 910 169
Customer costs
Annual maintenance costsBad debt provisioncTransaction costsd
108400400
108130260
108170136
10840
100Customer inquiriese 30 60 40 10Card replacementsf 0 240 120 0
Total 938 798 574 258
Customer operating income $1,252 $(278) $336 $ (89)a 2% $80,000; $26,000; $34,000; $8,000 d $0.50 800; 520; 272; 200b 9% $6,000; $0; $2,000; $100 e $5 6; 12; 8; 2c 0.5% $80,000; $26,000; $34,000; $8,000 f$120 0; 2; 1; 0
Note: The above analysis uses the average 0.5% bad debt provision. Bay Bank may want to adjust individualcustomer-profitability reports at a subsequent date to reflect actual bad debt experience.
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Develop profiles of Profitable and
Unprofitable Customers2. ProfitableCustomers
Unprofitable
Customers
Revenues
Fees
Merchant payments
Interest spread
Pays fee
High billings and high billings
per transactionHigh outstanding balance
Fee waived
Low billings and low billings
per transactionPays on time and has no
outstanding balance
Costs
Bad debt provision
Transaction costs
Customer inquiries
Card replacement
Pays account
Low number of transactions &
high billings per
transactionZero or few inquiries
No replacements
Defaults on account
High number of transactions &
low billings per transaction
Many inquiries
Multiple replacements
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Should BOB charge its card holders for making inquiries (outstanding
balance/ disputed charges) and Replacement of lost or stolen cards?
The pros of charging for individual services include: Additional source of revenues. If BOB is able to charge more than the cost
of each service, it may prefer that customers be prolific users of its services. If BOB is not able to charge the full cost" for each service, the charge may
reduce customer usage (thus reducing the losses associated with providingservices at below cost). For example, Customer B may make fewer inquiriesabout his or her balance.
The cons of charging for individual services include: May cause customers to drop card or decrease its usage vis--vis
competitors cards that have zero or minimal charges. May attract negative publicity from consumer groups who target companies
such as banks and credit card companies.
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Proposal: discontinue the sizable number of
low-volume customers Factors to consider include:
The growth potential of individual customers. Some low-volumecredit customers (such as students) may be high-volume users inthe medium run.
The costs saved by discontinuing low-volume credit card customers.Many costs may be relatively fixed and may not be eliminated bydropping customers.
The publicity BOB may attract from discontinuing these customers.There is the potential for much negative publicity from such
decisions. Alternatives available to discontinuance, e.g., adopt individual
service charges.
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Branch Teller Service Customers who visit branch offices cost the bank considerable
money. It is much more economical for customers to use an ATM,mail, or PC banking.
Some banks have tried to discourage branch visits by charging a fee.
Profitability analysis shows that such policies may be a seriousmistake. In most bank es, branches are visited most by two groups: the most
profitable and the least profitable. Policies that turn away unprofitable customers may also turn off
Gold customers.
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Grouping Customers by
ProfitabilityGroup IHigh revenue,low cost most
profitable group
Group 2
High revenue,high cost
Group 3
Low revenue,low cost
Group 4
Low revenue,high cost-least
profitable group
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Measuring and Managing Customer
Profitability
Low
Customers that areabove the cost-plus diagonal aremore profitable
Hi
Profits
Net (ABC)
Margin
Realized
Types of Customers
Passive:
Product is crucial
Good supplier match
Price-sensitive and
few specialdemands
Costly to service,
but pay top dollar
Aggressive:
Leverage their buying powerLow price and lots of customized service
and features
Low HiCost to Serve Losses
P 6 38 41
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Pro em 6-38 41:Fresno Fiber Optics
CustomerActivity Cost Driver Cost Rate
Sales Sales visits $1000
Order taking Purchase orders $200
Special Handling Units handled 50
Special shipping Shipments 500
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Fresno Fiber Optics: Customer Info I
Customer Trace Caltex
Activity Telecom Computer
Sales 8 visits 6 visits
Order taking 15 orders 20 orders
Special Handling 800 units handled 600 unitsSpecial shipping 18 Shipments 20 shipments
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Fresno Fiber Optics: Customer Info II
Customer Trace Caltex
Activity Telecom Computer
Sales revenue $190,000 $123,800
Cost of goods sold $80,000 $62,000General selling
Costs $24,000 $18,000
General administration
costs $19,000 $16,000