chapter 5 activity-based costing and management mcgraw-hill/irwin © 2005 the mcgraw-hill companies,...

Chapter 5

Activity-Based Costing and Management

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McGraw-Hill/Irwin © 2005 The McGraw-Hill Companies, Inc., All Rights Reserved.

Learning Objectives

Explain why traditional volume-based costing systems tend to undercost or overcost products or services

Describe an activity-based costing system and its benefits and limitations

Compute and contrast product costs using volume-based and activity-based costing systems

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Learning Objectives

Describe an activity-based management system and distinguish between high-value-added and low-value-added activities

Describe how activity-based costing systems are used in the manufacturing industry

Describe how activity-based costing systems are used in marketing and administrative activities

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Learning Objectives

Demonstrate how activity-based costing systems are used in service and not-for-profit organizations

Analyze factors affecting revenues and selling and administrative costs and determine customer profitability

Describe customer cost categories and identify the costs to serve a customer

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Learning Objectives

Conduct customer profitability analysis and determine customer value

Relate activity-based costing to strategic cost management

Identify key factors for a successful ABC/M implementation

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Learning Objective One

Explain why traditional volume-based costing systems tend to undercost or

overcost products or services

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Changes in Manufacturingand Business

Recent changes in manufacturing and business environments, such as:

1. advances in manufacturing technology2. changes in the competitive environment3. expansions in product diversity4. increases in factory overhead amounts and

categories

have made traditional volume-based costing systems unreliable and inaccurate

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Limitations of TraditionalCosting Systems

PlantwidePlantwide allocationis simple but omits

allocation of servicedepartment costs.

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Limitations of TraditionalCosting Systems

A departmental departmental rateprovides more detailed costmeasures, particularly ifthe departments performquite different activities.

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Single Plant-wide Overhead Rate

Dole Company has two divisions: Machining and Dole Company has two divisions: Machining and Finishing. Machining is a highly automated while Finishing Finishing. Machining is a highly automated while Finishing is a labor-intensive.The company uses a single plant-wide is a labor-intensive.The company uses a single plant-wide

overhead rate based upon labor hours.overhead rate based upon labor hours.

Dole Company has two divisions: Machining and Dole Company has two divisions: Machining and Finishing. Machining is a highly automated while Finishing Finishing. Machining is a highly automated while Finishing is a labor-intensive.The company uses a single plant-wide is a labor-intensive.The company uses a single plant-wide

overhead rate based upon labor hours.overhead rate based upon labor hours.

Annual Budget DataAlpha

DivisionBeta

Division TotalBudgeted overhead 400,000$ 200,000$ 600,000$ Budgeted labor hours 10,000 50,000 60,000 Budgeted machine hours 20,000 4,000 24,000

Single Plant-wideOverhead Rate

$600,000 60,000

= $10 per labor hour=

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Dole spent the following hours in July to manufacture 2,000 Dole spent the following hours in July to manufacture 2,000 units of each of its two products, Widget and Gidget:units of each of its two products, Widget and Gidget:

Dole spent the following hours in July to manufacture 2,000 Dole spent the following hours in July to manufacture 2,000 units of each of its two products, Widget and Gidget:units of each of its two products, Widget and Gidget:

Machining Finishing Total

Widget:

Labor hours 500 4,000 4,500

Machine hours 900 300 1,200

Gidget:

Labor hours 500 1,000 1,500

Machine hours 1,000 300 1,300

Machining Finishing Total

Widget:

Labor hours 500 4,000 4,500

Machine hours 900 300 1,200

Gidget:

Labor hours 500 1,000 1,500

Machine hours 1,000 300 1,300

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Using the predetermined plantwide overhead rate of $10 per Using the predetermined plantwide overhead rate of $10 per direct labor hour, the firm calculates factory overhead costs direct labor hour, the firm calculates factory overhead costs

for these two products as follows:for these two products as follows:

Using the predetermined plantwide overhead rate of $10 per Using the predetermined plantwide overhead rate of $10 per direct labor hour, the firm calculates factory overhead costs direct labor hour, the firm calculates factory overhead costs

for these two products as follows:for these two products as follows:

Total Direct Overhead Total

Labor Hours Rate/DLH Overhead

Widget 4,500 10$ 45,000$ Gidget 1,500 10 15,000

Total 60,000$

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Widget Overhead Cost per Unit

$45,000 2,000

= $22.50=

Gidget Overhead Cost per Unit

$15,000 2,000

= $7.50=


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A plantwide overhead rate assumes that all products or services benefit from or consume overhead costs in proportion to the quantity of the chosen activity (driver) for applying overhead

In the previous example, each direct labor hour spent on Widget uses the same amount of overhead as each direct labor hour spent on Gidget

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Departmental Overhead Rates

To obtain more accurate product costing, the company To obtain more accurate product costing, the company decided to use departmental overhead rates. The overhead decided to use departmental overhead rates. The overhead in Machining is to based on machine hours, and Finishing in Machining is to based on machine hours, and Finishing

will use labor hours. will use labor hours.

To obtain more accurate product costing, the company To obtain more accurate product costing, the company decided to use departmental overhead rates. The overhead decided to use departmental overhead rates. The overhead in Machining is to based on machine hours, and Finishing in Machining is to based on machine hours, and Finishing

will use labor hours. will use labor hours.

Machining Overhead Rate

$400,000 20,000

= $20 per machinemachine hour=

Finishing Overhead Rate

$200,000 50,000

= $4 per laborlabor hour=

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Departmental Overhead Rates

Using the new departmental overhead rates, the factory Using the new departmental overhead rates, the factory overhead cost assigned to the two products is:overhead cost assigned to the two products is:

Using the new departmental overhead rates, the factory Using the new departmental overhead rates, the factory overhead cost assigned to the two products is:overhead cost assigned to the two products is:

Widget Gidget

Machining

$20 x 900 18,000$

$20 x 1,000 20,000$

Finishing

$4 x 4,000 16,000

$4 x 1,000 4,000

Overhead applied 34,000$ 24,000$

Units Manufactured 2,000 2,000

Overhead / Unit 17.00$ 12.00$

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Amounts of Applied Overhead

The following table summarizes the amounts of applied The following table summarizes the amounts of applied overhead in July with different overhead application rates:overhead in July with different overhead application rates:The following table summarizes the amounts of applied The following table summarizes the amounts of applied

overhead in July with different overhead application rates:overhead in July with different overhead application rates:

Total OverheadOverhead /

UnitTotal

OverheadOverhead /

Unit

Widget 45,000$ 22.50$ 34,000$ 17.00$

Gidget 15,000 7.50 24,000 12.00

Total 60,000$ 58,000$

Plantwide Rate Based on DLH Departmental Rate

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Amounts of Applied Overhead

Widget’s overhead per unit with the plantwide overhead rate is $22.50, which is $5.50 higher than the overhead determined with departmental rates ($17.00)

In contrast, Gidget’s overhead per unit with the plantwide overhead rate is $7.50, which is $4.50 lower than the overhead calculated with departmental overhead rates ($12.00)

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Volume, Size, and Complexity

The traditional volume-based costing system may provide reasonably accurate costs when a firm’s operation possess the following characteristics:

1. Few and very similar products and service lines2. Relatively low overhead expenses3. Homogeneous conversion processes for all products or

services4. Similar distribution channels, customer demands, and

customers

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Volume, Size, and Complexity

A traditional volume-based overhead costing system, whether plantwide or departmental, often leads to inaccurate product costs (especially for firms with complex manufacturing operations)

Distortions of volume-based overhead cost systems increase as product diversity increases

Inaccurate cost information can lead to undesirable strategic results, such as wrong product-line decisions, unrealistic pricing, and ineffective resource allocations

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Learning Objective Two

Describe an activity-based costing system and its benefits and limitations

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Activity-Based Costing

Activity-Based Costing Activity-Based Costing (ABC) is a costing (ABC) is a costing approach that assigns approach that assigns resource costs to a cost resource costs to a cost object based on object based on activities performed for activities performed for the cost objectthe cost object

Activity-Based Costing Activity-Based Costing (ABC) is a costing (ABC) is a costing approach that assigns approach that assigns resource costs to a cost resource costs to a cost object based on object based on activities performed for activities performed for the cost objectthe cost object

Direct labor hoursMachine hours

Number of setups

Number of engineering hours

Lot size

Number of layers

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An activity is an action or an aggregation of actions performed within an organization

A resource is an economic element needed or consumed in performing activities

A resource consumption cost driver is an activity or characteristic that consumes resources

An activity consumption cost driver measures how much of an activity a cost object uses

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A two-stage cost assignment assigns factory overhead costs to activity centers or cost pools and then to costs objects

Activity-based systems differ from traditional volume-based costing systems in two ways:

1. The ABC system defines cost pools as activities or activity centers rather than production plant or department cost centers

2. The cost drivers that the ABC system uses to assign activity costs to cost objects are drivers based on an activity or activities performed for the cost objects

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Traditional Volume-BasedTwo-Stage Procedure

Insert Exhibit 5.2

(Traditional Procedure)

Here

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The Activity-BasedTwo-Stage Procedure

Insert Exhibit 5.3

(Activity-Based Procedure)

Here

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When Is an Activity-BasedCosting System Needed?

ABC should be implemented when . . . ABC should be implemented when . . .

1.1. the cost of measuring the activities and their the cost of measuring the activities and their costs is reduced, perhaps because of costs is reduced, perhaps because of computerized scheduling systems on the computerized scheduling systems on the production floor.production floor.

2.2. stronger competition increases the cost of stronger competition increases the cost of errors caused by erroneous pricing.errors caused by erroneous pricing.

3.3. product diversity is high in volume, size, or product diversity is high in volume, size, or complexity.complexity.

ABC should be implemented when . . . ABC should be implemented when . . .

1.1. the cost of measuring the activities and their the cost of measuring the activities and their costs is reduced, perhaps because of costs is reduced, perhaps because of computerized scheduling systems on the computerized scheduling systems on the production floor.production floor.

2.2. stronger competition increases the cost of stronger competition increases the cost of errors caused by erroneous pricing.errors caused by erroneous pricing.

3.3. product diversity is high in volume, size, or product diversity is high in volume, size, or complexity.complexity.

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Steps in Designing anActivity-Based Costing System

Identify resource costs and Identify resource costs and

activitiesactivities Assign resource costs to activitiesAssign resource costs to activities Assign activity costs to cost objectsAssign activity costs to cost objects

Identify resource costs and Identify resource costs and activitiesactivities

Assign resource costs to activitiesAssign resource costs to activities Assign activity costs to cost objectsAssign activity costs to cost objects

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Categories of Activities

Unit-level activity Unit-level activity –– An activity that is An activity that is performed for each unit of production (direct performed for each unit of production (direct materials, direct labor hours, inserting a materials, direct labor hours, inserting a component)component)

Batch-level activity Batch-level activity –– An activity that is An activity that is performed for each batch of products rather performed for each batch of products rather than for each unit of production (machine than for each unit of production (machine setup, purchase ordering, production setup, purchase ordering, production scheduling)scheduling)

Unit-level activity Unit-level activity –– An activity that is An activity that is performed for each unit of production (direct performed for each unit of production (direct materials, direct labor hours, inserting a materials, direct labor hours, inserting a component)component)

Batch-level activity Batch-level activity –– An activity that is An activity that is performed for each batch of products rather performed for each batch of products rather than for each unit of production (machine than for each unit of production (machine setup, purchase ordering, production setup, purchase ordering, production scheduling)scheduling)

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Categories of Activities

Product-sustaining activity Product-sustaining activity – – An activity that An activity that is performed to support the production of a is performed to support the production of a given product (product design, parts given product (product design, parts administration, issuance of engineering change administration, issuance of engineering change orders, expediting)orders, expediting)

Facility-sustaining activity Facility-sustaining activity – – An activity that is An activity that is performed to sustain the production of performed to sustain the production of products in general (security, safety, products in general (security, safety, maintenance, plant management)maintenance, plant management)

Product-sustaining activity Product-sustaining activity – – An activity that An activity that is performed to support the production of a is performed to support the production of a given product (product design, parts given product (product design, parts administration, issuance of engineering change administration, issuance of engineering change orders, expediting)orders, expediting)

Facility-sustaining activity Facility-sustaining activity – – An activity that is An activity that is performed to sustain the production of performed to sustain the production of products in general (security, safety, products in general (security, safety, maintenance, plant management)maintenance, plant management)

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Activities and Activity Levels at Seimens Electric Motor Works

Insert Exhibit 5.4

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Insert Exhibit 5.5

Resource and Resource Consumption Drivers at AT&T Plant

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Benefits and Limitations of an Activity-Based Costing System

Some costs may require allocations to departments and products based on arbitrary volume measures.

Some costs that can be identified with specific products are omitted.

Expensive to develop and implement; it is also very time-consuming.

Some costs may require allocations to departments and products based on arbitrary volume measures.

Some costs that can be identified with specific products are omitted.

Expensive to develop and implement; it is also very time-consuming.

It provides more accurate and informative product costs.

It provides more accurate measurements of activity- driving costs.

It helps managers identify and control the cost of unused capacity.

It provides more accurate and informative product costs.

It provides more accurate measurements of activity- driving costs.

It helps managers identify and control the cost of unused capacity.

BenefitsBenefits LimitationsLimitations

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Traditional Volume-Based vs. Activity-Based Costing Systems

Insert Exhibit 5.6

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Learning Objective Three

Compute and contrast product costs using volume-based and activity-based costing

systems

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Illustration of System Comparison

The following example (Haymarket BioTech, Inc.) contrasts Steps 2 and 3 of the

traditional volume-based costing system using direct labor-hours as the cost driver with an activity based costing system that uses both volume-based and non-volume

based cost drivers

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Illustration of System Comparison

Haymarket BioTech, Inc. (HBT) produces and sells two Haymarket BioTech, Inc. (HBT) produces and sells two secure communication systems, AW (Anywhere) and SZ secure communication systems, AW (Anywhere) and SZ

(SecureZone). HBT has the following operating data for the (SecureZone). HBT has the following operating data for the two products:two products:

Haymarket BioTech, Inc. (HBT) produces and sells two Haymarket BioTech, Inc. (HBT) produces and sells two secure communication systems, AW (Anywhere) and SZ secure communication systems, AW (Anywhere) and SZ

(SecureZone). HBT has the following operating data for the (SecureZone). HBT has the following operating data for the two products:two products:

AW SZ

Production Volume 5,000 20,000

Selling Pricing $400.00 $200.00

Unit direct materials and labor $200.00 $80.00

Direct labor-hours 25,000 75,000

Direct labor-hours per unit 5 3.75

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Volume-Based Costing System

The traditional volume-based costing system that the firm use assigns The traditional volume-based costing system that the firm use assigns factory overhead (OH) based on direct labor-hours (DLH). The firm has a factory overhead (OH) based on direct labor-hours (DLH). The firm has a total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 direct labor hours for the year, the overhead rate per direct labor hour is direct labor hours for the year, the overhead rate per direct labor hour is

$20 per direct labor hour:$20 per direct labor hour:

The traditional volume-based costing system that the firm use assigns The traditional volume-based costing system that the firm use assigns factory overhead (OH) based on direct labor-hours (DLH). The firm has a factory overhead (OH) based on direct labor-hours (DLH). The firm has a total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 total budgeted overhead of $2,000,000. Since the firm budgeted 100,000 direct labor hours for the year, the overhead rate per direct labor hour is direct labor hours for the year, the overhead rate per direct labor hour is

$20 per direct labor hour:$20 per direct labor hour:

Total overhead $2,000,000

Total DLH 25,000 + 75,000 = 100,000

Overhead rate per DLH $20.00

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Since the firms spent 25,000 direct labor hours to Since the firms spent 25,000 direct labor hours to manufacture 5,000 units of AW, the factory overhead manufacture 5,000 units of AW, the factory overhead

assigned to AW is $500,000 in total and $100 per unit:assigned to AW is $500,000 in total and $100 per unit:

Since the firms spent 25,000 direct labor hours to Since the firms spent 25,000 direct labor hours to manufacture 5,000 units of AW, the factory overhead manufacture 5,000 units of AW, the factory overhead

assigned to AW is $500,000 in total and $100 per unit:assigned to AW is $500,000 in total and $100 per unit:

Total OH assigned

to AW $20 x 25,000 = $500,000

Numer of units of AW 5,000

Factory overhead per unit of AW $100.00

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The factory overhead for SZ is $1,500,000 in total and $75 The factory overhead for SZ is $1,500,000 in total and $75 per unit since the firm spent 75,000 direct labor hours to per unit since the firm spent 75,000 direct labor hours to

manufacture 20,000 units of SZ:manufacture 20,000 units of SZ:

The factory overhead for SZ is $1,500,000 in total and $75 The factory overhead for SZ is $1,500,000 in total and $75 per unit since the firm spent 75,000 direct labor hours to per unit since the firm spent 75,000 direct labor hours to

manufacture 20,000 units of SZ:manufacture 20,000 units of SZ:

Total OH assigned

to SZ $20 x 75,000 = $1,500,000

Numer of units of SZ 20,000

Factory overhead per unit of SZ $75.00

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Product Profitability Analysis under the Traditional Costing System

Insert Exhibit 5.7

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Activity-Based Costing Analysis

In an attempt to use an activity-based costing, HBT has In an attempt to use an activity-based costing, HBT has identified the following activities, budgeted costs, and activity identified the following activities, budgeted costs, and activity

consumption cost drivers:consumption cost drivers:

In an attempt to use an activity-based costing, HBT has In an attempt to use an activity-based costing, HBT has identified the following activities, budgeted costs, and activity identified the following activities, budgeted costs, and activity

consumption cost drivers:consumption cost drivers:

Budgeted Activity Consumption

Activity Cost Cost Driver

Engineering $125,000 Engineering hours

Setups 300,000 Number of setups

Machine running 1,500,000 Machine-hours

Packing 75,000 Number of packing orders

Total $2,000,000

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HBT also has gathered the following operating data pertaining HBT also has gathered the following operating data pertaining to each of its products:to each of its products:

HBT also has gathered the following operating data pertaining HBT also has gathered the following operating data pertaining to each of its products:to each of its products:

AW SZ Total

Engineering hours 5,000 7,500 12,500 Number of setups 200 100 300 Machine-hours 50,000 100,000 150,000 Packing orders 5,000 10,000 15,000

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Using the gathered data, the cost driver rate for each activity Using the gathered data, the cost driver rate for each activity consumption cost driver is calculated as follows:consumption cost driver is calculated as follows:

Using the gathered data, the cost driver rate for each activity Using the gathered data, the cost driver rate for each activity consumption cost driver is calculated as follows:consumption cost driver is calculated as follows:

(1) (2) (3) (4) = (2)/(3) Activity Consumption Activity Activity Cost Driver Cost Consumption Rate

Engineering hours $125,000 12,500 $10 Number of setups 300,000 300 1000 Machine-hours 1,500,000 150,000 10 Packing orders 75,000 15,000 5

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AW (5,000 units)

Factory overhead costs are assigned to both products by Factory overhead costs are assigned to both products by these calculations:these calculations:


(1) (2) (3) (4) = (2) x (3) (5)

Activity Consumption Activity Total Overhead Overhead

Cost Driver Rate Activities Rate Per Unit

Engineering hours $10 5,000 $50,000 $10.00 Number of setups 1,000 200 200,000 40.00 Machine-hours 10 50,000 500,000 100.00 Packing orders 5 5,000 25,000 5.00

Overhead cost per unit $775,000 $155.00

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SZ (20,000 units)



(1) (2) (3) (4) = (2) x (3) (5)

Activity Consumption Activity Total Overhead Overhead

Cost Driver Rate Activities Rate Per Unit

Engineering hours $10 7,500 $75,000 $3.75 Number of setups 1,000 100 100,000 5.00 Machine-hours 10 100,000 1,000,000 50.00 Packing orders 5 10,000 50,000 2.50

Overhead cost per unit $1,225,000 $61.25

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Product Profitability Analysis under the ABC Costing System

Insert Exhibit 5.8

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Comparison of AlternativeCosting Approaches

Insert Exhibit 5.9

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Limitation of a Traditional Volume-based Costing System

One major limitation of a traditional volume-based costing system is that it tends to undercost complex low-volume products and overcost high-volume products

The ABC system presents a more accurate measurement of product costs by tracing overhead consumption

The preceding comparison shows that the traditional volume-based product costing system significantly undercosts AW and overcosts SZ

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Learning Objective Four

Describe an activity-based management system and distinguish between high-value-

added and low-value-added activities

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Activity-Based Management (ABM)

The management of activities to improve the value The management of activities to improve the value

received by the customer and to increase the received by the customer and to increase the profit achieved by providing this value.profit achieved by providing this value.

Management can pinpoint avenues for improving Management can pinpoint avenues for improving operations, reducing costs, or increasing values to operations, reducing costs, or increasing values to customers.customers.

ABM improves management’s focus on the firm’s critical ABM improves management’s focus on the firm’s critical success factors and enhances its competitive advantagesuccess factors and enhances its competitive advantage..

The management of activities to improve the value The management of activities to improve the value received by the customer and to increase the received by the customer and to increase the

profit achieved by providing this value.profit achieved by providing this value.

Management can pinpoint avenues for improving Management can pinpoint avenues for improving operations, reducing costs, or increasing values to operations, reducing costs, or increasing values to customers.customers.

ABM improves management’s focus on the firm’s critical ABM improves management’s focus on the firm’s critical success factors and enhances its competitive advantagesuccess factors and enhances its competitive advantage..

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ABM can be classified into two categories:

1. Operational – enhances operation efficiency and asset utilization and lowers costs

2. Strategic – attempts to alter the demand for activities and increaseprofitability at thecurrent activity efficiency

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Cost driver analysis examines, quantifies, and explains the effects of the cost driver on the cost of an activity

A cause-and-effect diagram maps out causes that affect an activity, process, stated problem, or outcome

A Pareto analysis is a histogram of cost drivers that contribute to the total cost

Performance measurement identifies the work performed and the results achieved by an activity, process, or organizational unit

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The Role of ABC/ABM Tools

Insert Exhibit 5.10

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Activity Analysis

To be competitive, a firm must assess each of its activities based on:

1. its need by the product or customer2. its efficiency, and3. its value content

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Activity Analysis

A firm performs an activity because it is:

1. required to meet the specification of the productor service or satisfy customer demand

2. required to sustain the organization, or3. deemed beneficiary to the firm

A firm may or may not performan activity at the highest levelof efficiency

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Activity Analysis

Insert Exhibit 5.11(Activity Analysis)

Here

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Value-Added Activities

A value-added activity increases the value of the product or service to the customers

A high-value-added activity increases significantly the value of the product or service to the customers

A low-value-added activity consumes time, resources, or space, but adds little or does not contribute to satisfying customer needs

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Examples of High-Value-Added and Low-Value-Added Activities

Insert Exhibit 5.12

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Low-Value-Added Activities

Firms need to realize that low-value-added activities decrease competitiveness and profitability

Efforts to eliminate or reduce low-value-added activities are never-ending tasks

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A Classification of High-Value-Added and Low-Value-Added Activities

Insert Exhibit 5.13

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Learning Objective Five

Describe how activity-based costing systems are used in the manufacturing industry

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Manufacturing Industry Applications

Activity-based costing started in the manufacturing industry

Many manufacturing companies have successfully implemented activity-based costing and management systems

ABC in manufacturing can focus on the costs of different activities at each production process

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Manufacturing Industry Applications

Insert Exhibit 5.14

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Learning Objective Six

Describe how activity-based costing systems are used in marketing and administrative

activities

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ABC for Marketing andAdministrative Activities

ABC can be used for marketing activities, such as sales calls, advertising, selling, order filling, shipping, etc.

ABC can be used for administrative activities, such as accounting, data processing, personnel, quality assurance, etc.

The procedures to apply ABC to marketing and administrative activities are similar to the steps for manufacturing applications

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Cost Drivers for Marketing Activities

Insert Exhibit 5.15

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Learning Objective Seven

Demonstrate how activity-based costing systems are used in service and not-for-

profit organizations

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Service and Not-For-Profit Applications of ABC

Service and not-for profit organizations have many operating characteristics that make them different from manufacturing companies, such as:

1. changeable outputs2. less predictability on service request activity3. ambiguous relations between overhead or indirect

costs and products or service outputs

However, many service and not-for-profit organizations have developed and implemented ABC systems

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Learning Objective Eight

Analyze factors affecting revenues and selling and administrative costs and

determine customer profitability

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Customer Profitability Analysis

ABC/ABM product costing can be extended to customer profitability analysis to identify the best customers

Customer profitability analysis focuses on selling, general, and administrative costs

Customer profitability analysis analyzes activities, identifies proper cost drivers, and determines realized profits form customers

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Customer profitability analysis allows managers to:

1. identify the most profitable customers2. manage each customer’s “costs-to-serve” to a lower

level3. establish a surcharge for or re-pricing of expensive

activities4. reduce services5. introduce new products and services6. raise prices for “demanders”7. abandon products, services, or customers

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Customer profitability analysis also allows managers to:

1. improve their processes2. offer the customer profit-positives service level

options3. shift the customer’s purchase mix toward richer,

higher-margin products and service lines4. discount to gain more volume with low “cost-to-

serve”customers5. select the customer mix6. choose various kinds of after-sale services to provide

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Insert Exhibit 5.16(Profitability Matrix)

Here

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Customer profitability analysis traces and reports customer revenues and customer costs

Customer profitability analysis can provide many benefits, such as:

1. providing better services to highly profitable customers

2. securing highly profitable customers from competitors3. setting prices based on the cost to serve4. negotiating with customers to reach mutually

beneficial levels of services5. conceding permanent “loss customers” to competitors

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Customer Revenue Analysis

Customer revenue analysis considers all activities that affect the net amount received from the customers

Customer revenue analysis traces prices and discounts (including sales and cash discounts) to customers and identifies financing costs associated with customer revenues

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Illustration of Revenue-Related Activities

Insert Exhibit 5.17

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Example of Customer Revenue Analysis

Insert Exhibit 5.18

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Learning Objective Nine

Describe customer cost categories and identify the costs to serve a customer

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Customer Cost Analysis

Not all customers require the same type of activities. Examples of customer-specific activities include:

1. order processing costs2. billing, collection,and payment processing costs3. accounts receivable and carrying costs4. customer service costs5. return or allowance processing costs6. restocking costs7. selling and marketing costs

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Customer cost analysis identifies activities and cost drivers to service customers

Traditionally, these costs are hidden in the customer support, marketing, and sales function

ABC/ABM can help managers to grasp activities and their costs to serve customers

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Customer cost can be classified into the following categories:

1. customer unit-level cost2. customer batch-level cost3. customer-sustaining cost4. distribution-channel cost5. sales-sustaining costs

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Customer-Related Activity

Insert Exhibit 5.19(Customer-Related Activity)

Here

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Customer-Related Activity

Insert Exhibit 5.20

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Insert Exhibit 5.21

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Learning Objective Ten

Conduct customer profitability analysisand determine customer value

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A customer profitability analysis combines customer revenue and customer cost analyses to assess customer profitability and helps identify actions to improve customer profitability

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Insert Exhibit 5.22

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Customer Value Assessment

Customer profitability analysis provides valuable information to the assessment of customer values

However, firms must also weigh other relevant factors, such as:

1. Growth potential of the customer2. Possible reactions of the customer to changes3. Importance of having the firm as a customer for future

sales references

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Learning Objective Eleven

Relate activity-based costing to strategiccost management

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Strategic Cost Management Activity-based costing facilitates strategic cost

management ABC provides information for mangers to manage

activities to improve competitiveness and achieve strategic goals

Successful firms use their resources on activities that lead to the greatest strategic benefit

ABC/ABM helps managers to understand the relationship between the firm’s strategy and the activities and resources needed to implement the strategy

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Strategic Cost Management

For firms following a cost leadership strategy, ABC/ABM identifies key activities, cost drivers, and ways to improve processes to reduce cost

For firms following a differentiation strategy, ABC/ABM can help to:

1. identify value-enhancement opportunities2. develop a customer strategy3. support a technological leadership strategy4. establish a pricing strategy

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Learning Objective Twelve

Identify key factors for a successfulABC/M implementation

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Successful ABC/ABM Implementation

A successful ABC/ABM implementation requires close cooperation among management accountants, engineers, and manufacturing and operating managers

According to a recent survey, a main reason for unsuccessful implementations was that many companies overemphasized the architectural and software design of ABC systems and failed to pay adequate attention to other issues

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Successful ABC/ABM Implementation

Key factors for a successful ABC/ABM implementation include:

1. involve management and employees in creating an ABC system

2. maintain a parallel system3. use ABC/ABM on a job that will succeed4. keep the initial ABC/ABM design simple5. create desired incentives6. educate management

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End of Chapter Five

chapter 5 activity-based costing and management mcgraw-hill/irwin © 2005 the mcgraw-hill companies,...

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