Activity-Based Cost Systems

Chapter 4

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

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

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%

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

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

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

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

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

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:

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

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

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

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

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

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

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”

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

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

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

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”

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

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

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

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

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

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

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

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

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

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

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%

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

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

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

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

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

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

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.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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%

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

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

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%)

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

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)

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

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

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

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

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

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

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

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

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

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

Implementation Issues

• Delegating the project to consultants

• Poor ABC model design

• Individual and organizational resistance to change