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Activity-Based Cost Systems
Chapter 4
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Simple Cost Accounting Systems: Ericson Ice Cream Company
Example• Ericson had been the low-cost producer of
chocolate and vanilla ice cream, with profit margins exceeding 20% of sales
• Several years ago Ericson expanded their business by extending their product line into products with premium selling prices
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Ericson Ice Cream Company Example• Five years ago strawberry ice cream was
introduced– The same basic production technology– Could be sold at a price that was 3% higher
than for blue and black pens
• Last year mocha-almond ice cream was added– Could be sold at a 10% price premium
• The controller of Ericson was disappointed with the most recent quarter’s financial results
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Total Profitability by Product
vanilla chocolate strawberry Mocha-almond
Total
Units 50,000 40,000 9,000 1,000 100,000
Price $ 4.50 $ 4.50 $ 4.65 $ 4.95
Sales $225,000 $180,000 $41,850 $4,950 $451,800
Material 75,000 60,000 14,040 1,650 150,690
Labor 30,000 24,000 5,400 600 60,000Overhead 90,000 72,000 16,200 1,800 180,000Total Mfg. Expenses
195,000 156,000 35,640 4,050 390,690
Gross Margin
$ 30,000 $ 24,000 $ 6,210 $ 900 $ 61,110
G.M. % 13.3% 13.3% 14.8% 18.2% 13.5%
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Management’s Concern
• The controller wondered whether the company should continue to deemphasize the chocolate and vanilla products and keep introducing new specialty premium flavors
• Ericson’s manufacturing manager commented on how the introduction of specialty flavors had changed the production environment
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Ericson’s Indirect Cost Allocation
• Because it was a small company and historically had produced only a narrow range of products, Ericson used a simple costing system– All the plant’s indirect expenses were aggregated at
the plant level and allocated to products based on each product’s direct labor cost
– Currently the cost system’s overhead burden rate was 300% of direct labor cost
– Before the new specialty products were introduced, the overhead rate was only 200% of direct labor cost
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Ericson’s Cost System
• Ericson’s management accountants designed the system years ago when:– Production operations were mostly manual– Total indirect costs were less than direct labor
costs– Cooper’s two products had similar production
volumes and batch sizes
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Changes in the Production Environment
• Direct labor costs have decreased and indirect expenses have increased as a result of automation
• As specialty low-volume products were added, Ericson needed:– More scheduling– More setups– More quality control personnel– A computer to track orders and product
specifications
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An Outdated Cost System
• Ericson operates with only a single cost center
• Even if Ericson used multiple production and service department cost centers, it could still encounter severe distortions in its reported product costs
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Reason for Cost Distortions
– schedule machine and production runs
– perform setups– inspect produced items after
setup– move materials– ship orders– expedite orders– rework defective items
– design new products– improve existing products– negotiate with vendors– schedule materials receipts– order, receive, and inspect
incoming materials and parts– update and maintain the
much larger computer-based information system
• A complex factory has a much larger production support staff because it requires more people to:
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Reason for Cost Distortions• Because the factory has the same physical
output, it has roughly the same cost of materials
• The company’s factory has about the same property taxes, security costs, and heating bills as before, but it has much higher indirect and support costs because of its more varied product mix and complex production tasks
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Reason for Cost Distortions• On a per unit basis, high-volume standard flavors
require about the same amount of direct labor costs (the allocation basis) as the low volume flavors
• The traditional costing system would report essentially identical product costs for all products, standard and specialty, irrespective of their relative production volumes
• Clearly, however, considerably more indirect and support resources are required on a per-unit basis for the low-volume specialty products than for the high-volume, standard products
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Activity-Based Cost Systems• Activity-based cost systems have been
developed to eliminate this major source of cost distortion
• Activity-based cost (ABC) management systems use a simple two-stage approach similar to but more general than traditional cost systems
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Traditional v. ABC SystemTraditional:
– Uses actual departments or cost centers for accumulating and redistributing costs
– Asks how much of an allocation basis (usually based on volume) is used by the production department
– Service department expenses are allocated to a production department based on the ratio of the allocation basis used by the production department
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Traditional v. ABC System
ABC:– Uses activities, for accumulating costs and
redistributing costs– Asks what activities are being performed by
the resources of the service department– Resource expenses are assigned to activities
based on how much of the resource is required or used to perform the activities
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Tracing Costs to Activities
ABC at Ericson :– The controller started an analysis of indirect
expenses, beginning with indirect labor– The controller interviewed department heads in
charge of indirect labor and found that the people in these departments performed three main activities
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Indirect Labor Activities
• 50% of indirect labor was involved in what the controller called “handle production runs”
• 40% of indirect labor actually performed the physical changeover from one flavor to another, an activity that she labeled “perform setups”
• 10% of the time was spent on activities the controller called “support products”
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First Steps in Design of An ABC System
1) Develop the activity dictionary: the list of major activities performed by both the factory’s human and physical resources
2) Obtain sufficient information to assign resource expenses to each activity in the activity dictionary
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Computer System Expenses
20% of computer expenses should be assigned to “support products,” an activity already defined in her activity dictionary, because it was used to keep records on the four products
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Computer System Expenses (2 of 2)
80% of the computer resource was involved in the production run activity and seemed to relate well to the “handle production runs” activities
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Other Overhead Expenses• There were three remaining categories of
overhead expense:– Machine depreciation– Machine maintenance– Energy to operate the machines
• These expenses were incurred to supply machine capacity to produce the ice cream:
• The controller labeled this production activity “run machines”
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Identifying Cost Hierarchies• The four activities for Ericson’s indirect
costs represent the three different levels of the manufacturing cost hierarchy:
PRODUCT SUSTAININGSUPPORT PRODUCTS
BATCH LEVELSETUP MACHINES
BATCH LEVELHANDLE PRODUCTION RUNS
UNIT LEVELRUN MACHINES
COST HIERARCHYACTIVITY
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Benefits from first steps in an ABC System
The ABC model shifts the focus from what the money was being spent on (labor, equipment, supplies) to what the resources acquired by spending are actually doing
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From ABC to ABM
Operational activity-based management (ABM) - managers use information collected by the ABC system at the activity level to identify opportunities for reducing costs in indirect and support activities
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Activity Cost DriversActivity cost drivers represent the quantity of activities used to produce individual products:
ACTIVITY ACTIVITY COST DRIVER
HANDLE PRODUCTION RUNS PRODUCTION RUNS
SET UP MACHINES SETUP HOURS
SUPPORT PRODUCTS NUMBER OF PRODUCTS
RUN MACHINES MACHINE HOURS
PROVIDE FRINGE BENEFITS LABOR DOLLARS
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Completing the ABC Model • Once the activity cost drivers had been
determined, the following quantitative information is needed:
– The total quantity of each activity cost driver
– The quantity of cost driver used by each product
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Completing the ABC Model
– Calculate the activity cost driver rate (ACDR) by dividing the activity expense by the total quantity of the activity cost driver
– Multiply the activity cost driver rate by the quantity of each activity cost driver used by each of the four products
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Activity Cost Drivers
Activity Cost
Driver Vanilla Chocolate Strawberry
Mocha-almond Total**
DL hr/unit 0.02 0.02 0.02 0.02 2,000
Mach. hr/unit 0.1 0.1 0.1 0.1 10,000
Prod. runs 70 65 50 15 200
Setup time/run
4 2.4 5.6 5.6 --
Total setup hr 280 156 280 84 800
# of products 1 1 1 1 4
**Total = per unit X quantity 50,000 40,000 9,000 1,000
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Activity Cost Driver Rates (ACDR)Activity
ExpenseActivity Cost
DriverDriver
Quantity ACDRHandle Production Runs
$66,000 Number of production runs
200 $330 per run
Set up machines $33,600 Number of setup hours
800 $42 per setup hr
Support Products
$14,400 Number of products
4 $3,600 per product
Run Machines $42,000 Number of machine hours
10,000 $4.20 per machine hr
$156,000
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Activity Expenses Assigned
Vanilla Chocolate Strawberry
Mocha-almond Total
Handle Production Runs
$23,100 $21,450 $16,500 $4,950 $66,000
Set up machines
11,760 6,552 11,760 3,528 33,600
Support Products
3,600 3,600 3,600 3,600 14,400
Run Machines
21,000 16,800 3,780 420 42,000
Total Costs Assigned $ 59,460 $ 48,402 $ 35,640 $ 12,498 $ 156,000
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ABC Profitability ReportABC profitability report:
• The results from the activity-based costing system were quite different from the results based on the traditional cost system– The two specialty products, which the previous cost
system had reported as the most profitable, were in fact the most unprofitable, and losing lots of money
– The company had added large quantities of overhead resources to enable these products to be designed and produced, but their incremental revenue did not cover those costs
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Total ABC Profitability by Product
Vanilla Chocolate Strawberry
Mocha-almond Total
Sales $225,000 $180,000 $41,850 $4,950 $451,800
Material 75,000 60,000 14,040 1,650 150,690
Labor 30,000 24,000 5,400 600 60,000
40% fringe on DL
12,000 9,600 2,160 240 24,000
Support 59,460 48,402 35,640 12,498 156,000
Total Mfg. Expenses
176,460 142,002 57,240 14,988 390,690
Gross Margin
$ 48,540 $ 37,998 $(15,390) $(10,038) $ 61,110
G.M. % 21.6% 21.1% -36.8% -202.8% 13.5%
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Using ABC to Improve Profitability• The ABC information provides managers
with numerous insights about how to increase the company’s profitability:– Increase either their sales volume or prices for
the specialty products– Impose minimum order sizes to eliminate short,
unprofitable production runs– Increase demand for the highly profitable
standard products
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Using ABC to Improve ProfitabilityThe goal of these ABM actions is to enable the company to produce the same volume and mix of products with fewer resources
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Problems Implementing ABC
Problems may arise in practice from the approach to activity-based costing that assigns many resource expenses to activities based on interviews, surveys, and direct observation of production and support processes because these activities are time-consuming and expensive
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Problems Implementing ABC
– Inaccuracies and bias may affect the accuracy of cost driver rates derived from individuals’ subjective estimates of their past or future behavior
– Companies must periodically repeat the interviewing and surveying processes if they want to keep their activity-based cost systems updated
– Adding new activities to the system is also difficult, requiring re-estimates of the relative amount of resource time and effort required by the new activity
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Problems Implementing ABC
A more subtle and serious problem arises from the interview or survey process• People estimating how much time they
spend on a list of activities handed to them invariably report percentages that add up to 100%
• Few individuals report that a significant percentage of their time is idle or unused
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Measuring The CostOf Resource Capacity
• The calculation of activity cost driver rates are sometime based on the capacity actually used
• Analysts can obtain a better estimate for the cost of resources required to handle each production run by dividing activity expenses by the practical capacity of work the resources could perform
• The cost of unused capacity should not be assigned to products produced or customers served during a period
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Cost of Unused Capacity
• The cost of unused capacity remains someone’s or some department’s responsibility
• Usually you can assign unused capacity after analyzing the decision that authorized the level of capacity supplied
• Such an assignment is done on a lump-sum basis; it will be treated as a sustaining, not a unit-level, expense.
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Cost of Unused Capacity
• If the unused capacity relates to a particular product line then the cost of unused capacity is assigned to that product line, where the demand failed to materialize
• In making assignment of unused capacity costs, trace the costs at the level in the organization where decisions are made that affect the supply of capacity resources and the demand for those resources
• The lump-sum assignment of unused capacity costs provides feedback to managers on their supply and demand decisions
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Measuring The CostOf Resource Capacity
• The activity cost driver rate should reflect the underlying efficiency of the process: the cost of resources to handle each production order
• This efficiency is measured better by using the capacity of the resources supplied as the denominator when calculating activity cost driver rates
• The cost of unused capacity should not be ignored
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Fixed and Variable Expenses
• Most indirect expenses assigned by an ABC system are committed costs
• Committed costs become variable via a two-step procedure:– demands for resources change either because of
changes in the quantity of activities performed or because of changes in the efficiency of performing activities
– managers must make decisions to change the supply of committed resources to meet the new level of demand for the activities performed by these resources
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Making Committed CostsVariable
• After unused capacity has been created, committed costs will vary downward if managers actively reduce the supply of unused resources
• A resource cost varies downward if management acts:– To reduce the demands for the resource– To lower the spending on it
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Activity in Excess of Capacity
• If activity volumes exceed the capacity of existing resources, the result is bottlenecks, shortages, increased pace of activity, delays and poor-quality work
• Facing such shortages, companies typically make committed costs variable
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Decreased Demand for Resources
• Demands for indirect and support resources also can decline
• Even for many unit-level resources reduced demands for work does not immediately lead to spending decreases
• The reduced demand for organizational resources lowers the cost of resources used, but this decrease is offset by an equivalent increase in the cost of unused capacity
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Managers Make Costs Fixed
• Organizations often create unused capacity through activity-based management actions
• They keep existing resources in place, when demands for the activities performed by the resources have diminished
• They also fail to find new activities that could be done by the unused resources already in place
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Managers Make Costs Fixed• The organization receives no benefits from
activity-based management decisions that reduce demands on their resources if capacity is not reduced or redeployed
• Failure to capture benefits from activity-based management is not because their costs are “fixed”
• The cost of these resources is only “fixed” if managers do not exploit the opportunities from the unused capacity they helped to create
• Making decisions based solely upon resource usage may not increase profits if managers are not prepared to reduce spending to align resource supply with future lower levels of demand
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Time-Driven ABC:An Alternative Approach
• Several companies have overcome these problems by using a new approach for estimating their ABC models
• Homogeneity assumption:– Most ABC systems use a large number of
transactional cost drivers that assume each occurrence of the event (a production run, a customer order, a product to support) consumes the same quantity of resources
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Time-Driven ABC:• This homogeneity assumption provides
the foundation for an alternative approach to estimating cost driver rates.
• The new approach requires two new estimates:– The unit cost of supplying capacity, and– The consumption of capacity (unit times) by
each activity
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Unit Cost Estimate
The new procedure starts with the same information used by a traditional ABC approach:
– The cost of resources that supply capacity and
– The practical capacity of the resources supplied
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Unit Cost Estimate
• With estimates of the cost of supplying capacity and practical capacity, the analyst can calculate the unit cost of supplying capacity:
Unit cost =Cost of capacity supplied
Practical capacity of resources supplied
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Unit Cost Estimate• Assume that indirect labor employees supply
2,500 hours of labor in total each quarter at a cost of $84,000.
• The practical capacity (at 80% of theoretical) is about 2,000 hours per quarter, leading to a unit cost (per hour) of supplying indirect labor capacity of:
Indirect labor cost per hour =$84,000
2000 hours
= $42 per hour
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Unit Time Estimate
• Estimate the time used each time a committed resource performs a transactional activity– Precision is not critical– Rough accuracy is sufficient
• Estimates for the indirect labor for Ericson are:
Resource Activity Unit Time
Indirect Labor
Production Run 5 hours
Support Products 50 hours
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Cost Driver Rate• Assume similar calculations regarding computer
resources produced estimates of $60 per hour and 2 hours per production run
• The cost driver rate for the activity, handle production runs, can now be calculated as the costs of using indirect labor and the computer for each production run:
Unit Cost Unit Time Cost Driver
Indirect Labor Resource $42 per hour 5 hours/run $210 per run
+ Computer Resource $60 per hour 2 hours/run 120 per run
= Activity Cost Driver Rate $330 per run
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Advantages of Time-Driven ABC
• Managers may easily update their time-driven ABC model to reflect changes in their operating conditions
• Managers may also easily update the activity cost driver rates– Changes in the prices of resources supplied
affect the hourly cost rate– Activity cost driver rates change when there
has been a shift in the efficiency of the activity
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Tracing Marketing-RelatedCosts to Customers
• The costs of marketing, selling, and distribution expenses have been increasing rapidly in recent years
• Many of these expenses do not relate to individual products or product lines but are associated with:
• Companies need to understand the cost of selling to and serving their diverse customer base
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Carver – Delta Example• Carver and Delta are customers generating about equal
revenue and seen as equally valuable customers• A conventional cost accounting system, marketing, selling,
distribution, and administrative (MSDA) expenses were allocated to customers at a rate of 35% of Sales
CARVER DELTA
Sales $320,000 $315,000
CGS 154,000 156,000
Gross Margin $166,000 $159,000
MSDA expenses (@35% of Sales)
112,000 110,250
Operating profit $ 54,000 $ 48,750
Profit percentage 16.9% 15.5%
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Carver – Delta Example
• Delta required a great deal of hand-holding and was continually inquiring whether the company could modify products to meet its specific needs
• Delta also:– Tended to place many small orders for special
products– Required expedited delivery– Tended to pay slowly
• All of which increased the demands on the order processing, invoicing, and accounts receivable process
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Carver – Delta Example
• Carver, on the other hand:– Ordered only a few products and in large
quantities– Placed its orders predictably and with long lead
times– Required little sales and technical support
• The Accounting Manager in Marketing suspected that Carver was a much more profitable customer than the financial statements were currently reporting
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Carver – Delta Example
• The picture of relative profitability of Carver and Delta shifted dramatically
Carver Delta
Gross Margin (as previously) $166,000 $159,000
Marketing & tech. support 7,000 54,000
Travel to customer 1,200 7,200
Distribute sales catalog 100 100
Service customers 4,000 42,000
Handle customer orders 500 18,000
Warehouse inventory 800 8,800
Ship to customers 12,600 42,000
Total activity expenses 26,200 172,100
Operating profit $ 139,800 $ (13,100)
Profit percentage 43.7% (4.2%)
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Carver – Delta Example
• As the manager suspected, Carver was a highly profitable customer– Its ordering and support activities placed few
demands on the company’s marketing, selling, distribution, and administrative resources
– Almost all the gross margin earned by selling to Alpha dropped to the operating margin bottom line
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ABC Customer Analysis• The output from an ABC customer analysis is often
portrayed as a whale curve– A plot of cumulative profitability versus the number of
customers– Customers are ranked, on the horizontal axis from
most profitable to least profitable (or most unprofitable)
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Customer Profitability
• A whale curve for cumulative profitability typically reveals:– The most profitable 20% of customers generate
between 150% and 300% of total profits– The middle 70% of customers break even– The least profitable 10% of customers lose 50%
- 200% of total profits, leaving the company with its 100% of total profits
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Managing Customer Profitability
• High-profit customers appear in the left section of the profitability whale curve– These customers should be protected– They could be vulnerable to competitive
inroads– The managers should be prepared to offer
discounts, incentives, and special services to retain the loyalty of these valuable customers if a competitor threatens
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Managing Customer Profitability
• The challenging customers appear on the right tail of the whale curve, dragging the company’s profitability down with their low margins and high cost-to-serve
• The high cost of serving such customers can be caused by their:– Unpredictable order pattern– Small order quantities for customized
products– Nonstandard logistics and delivery
requirements– Large demands on technical and sales
personnel
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Managing Customer Profitability
• The opportunities for a company to transform its unprofitable customers into profitable ones is perhaps the most powerful benefit the company’s managers can receive from an activity-based costing system
• Managers have a full range of actions for transforming unprofitable customers into profitable ones– Process improvements– Activity-based pricing– Managing customer relationships
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Process Improvements• Managers should first examine their internal operations
to see where they can improve their own processes to lower the costs of serving customers
• If customers are migrating to smaller order sizes:– Strive to reduce batch-related costs, such as setup
and order handling– Electronic systems greatly lower the cost of
processing large quantities of small orders• If customers prefer suppliers offering high variety
– Customize products at the latest possible stage– Use information technology to enhance the linkages
from design to manufacturing
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Activity-Based Pricing
• Pricing is the most powerful tool a company can use to transform unprofitable customers into profitable ones
• Activity-based pricing establishes a base price for producing and delivering a standard quantity for each standard product
• Special services may be priced just to cover costs or also to earn a margin
• Activity-based pricing prices orders, not products
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Managing Relationships
• Companies can transform unprofitable customers into profitable ones by persuading the customer to use a greater scope of the company’s products and services
• If these efforts fail, the company may then contemplate “firing” the customer
• Some customers may be unprofitable only because it is the start of the relationship with the company
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ABC at Service Companies
• Although ABC had its origins in manufacturing companies, many service organizations today are obtaining great benefits from this approach– In practice, the actual construction of an ABC model is
nearly identical for both types of companies– This should not be surprising since, in manufacturing
companies, the ABC system focuses on the “service” component of the company
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ABC at Service Companies
• Service companies in general are ideal candidates for activity-based costing– Virtually all costs are indirect and appear fixed– They often do not have direct, traceable costs to
serve as convenient allocation bases– They must supply virtually all their resources in
advance to provide the capacity to perform work for customers during each period
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Implementation Issues
• Not all ABC systems have been sustained or contributed to higher profitability for the company
• Lack of clear business purpose
• Lack of senior management commitment
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Implementation Issues
• Delegating the project to consultants
• Poor ABC model design
• Individual and organizational resistance to change