Module 18 Activity-Based Costing, Customer Profitability, and Activity-Based Management

Traditional Product Costing Overhead Costs allocated to Products By direct labor or machine hours Traditional results will be inaccurate when Products differ on use of resources, like Frequent design changes Specialized equipment Complex setups Difficult customer specifications

Activity-Based Costing (ABC) Resources are assigned to activity costs, which are then assigned to objectives by cost drivers. *Based on units of activity utilized by the cost objective For example, consider purchasing and receiving: Staff Salaries Supervisor Other Assign by time Place orders Verify orders Unload & Unpack & Inspect Assign by cost driver PO 1 PO 2 …

Example Activity Costs Purchasing Interviews determined that 15% of the time, receiving room employees verified purchase orders, and 85% of their time was spent unloading, unpacking, and inspecting. Supervisors were found to spend 30% of their receiving time on verifying issues, with the other 70% on unloading, unpacking, and inspecting issues. Placing Purchase Orders Verifying Purchase Orders Unload Unpack Inspect Total Costs Salaries Purchasing agents ($7,800 × 3 agents) $23,400 Receiving room employees ($2,400 × 2 emp.) ($2,400 × 2 employees × 15% verifying) $ 720 ($2,400 × 2 employees × 85% unload, etc) $4,080 Supervisor ($5,000 × 3/5 purchasing) 3,000 ($5,000 × 2/5 receiving x 30% verifying) 600 ($5,000 × 2/5 receiving x 70% verifying) 1,400 Other costs ($4,500 × 25% purchasing) 1,125 ($4,500 × 75% receiving) - 3,375 Total $27,525 $ 1,320 $ 8,855 $37,700

Cost per Unit of Activity Each activity results in a different rate Rates are used to apply costs to cost objectives Assume direct materials totaling $120,000 are to be acquired during the month with 300 purchase orders. Placing Purchase Orders Verifying Purchase Orders Unloading Unpacking Inspecting Total cost of activity $27,525 $ 1,320 $ 8,855 Units of cost driver: Number of purchase orders ÷300 Number of dollars of materials - 120,000 Cost per unit of activity $ 91.75 $ 4.40 $ 0.074

Assigning Activity Costs to Cost Objectives Assigning costs to a purchase order which has a materials cost of $1,600 for 500 parts. Costs for Purchase order 1 Direct materials costs $ 1,600 Activity costs: Placing purchase order $ 91.75 Verifying purchase order 4.40 Unloading/unpacking/inspecting ($0.074 × $1,600) 118.40 Costs assigned to cost objective $214.55 Total cost of materials on PO 1 $1,814.55

ABC Implementation ABC is expensive to implement After switching to ABC, companies may find that only 10 to 15% of their products are profitable Causes management to alter the product mix by minimizing unprofitable products which causes profits to increase

Customer Profitability ABC may be used for customer profitability analysis. Customer costs to be analyzed Cost incurred to sell the goods or services Cost incurred to provide service Actions possible from analysis Convert customers to profitability or increase profitability Seek to terminate unprofitable customer relationships

ABC Customer Profitability Analysis Example What activities are required to serve customers? Activity Activity Cost Driver Cost per Unit of Activity Visits to customers Visits $ 400 Remote contact Number of contacts 30 Processing and shipping Customer orders 150 Packaging Number of requests 120 Billing and collection Invoices 40 Customer activity costs for Haskell Construction: Activity Cost Driver Data Cost per Unit of Driver Activity Customer Activity Cost Visits to customers 4 $400 $1,600 Remote contact 3 30 90 Processing and shipping 6 150 900 Packaging 2 120 240 Billing and collection 5 40 200 Total customer activity cost $3,030 Continued

ABC Customer Profitability Analysis Example Customer sales $79,000. Less cost of goods sold 62,000. Gross profit on sales 17,000. Less activity costs (3,030) Customer profitability $13,970. Customer profitability ratio: $13,970 ÷ $79,000 = 17.7% Customers found to generate losses should be flagged and efforts made to correct the situation or terminate the customer.

Activity-Based Management Identification and selection of activities to maximize the value of activities while minimizing their cost from the perspective of the final consumer From the perspective of the final customer, what adds value to the product?

Activity-Based Management Value Added: Required activities to produce a product and serve customers. Examples: Produce product, fill customer order Non-Value Added: Not required to produce a product or serve customers well. Examples: Inspections, waiting, customer returns, storage, downtime for repairs, redoing anything