Activity Based Cost Analysis Review of key points Use in Customer Profitability Analysis

Activity Based Costing All students should have already covered this but we shall quickly review the key points – What is it ? – How are costs calculated ? – How can it be used ? We will do this fairly quickly and use question to help our review

What is ABC ? A costing methodology which recognises that costs usually arise because of certain activities – E.g. Number of deliveries of a product or number of production run set-ups needed As different products consume these activities in different numbers this will affect their cost structures ABC in practice involves identifying the key activities and the actions that drive these activities (and, therefore, drive costs)

Comparison with Traditional Costing ABC does not assume all overhead costs are volume related – Traditional costing would usually use labour or machine hours as a single volume-related overhead recovery base Result : – ABC tends not to overstate profitability of low-volume products/or understate profit of high-volume products ABC gives a clearer indication of long-term variable costs – Especially relevant for long-term decisions Basically ABC gives greater understanding about why costs are incurred

Product Costing Rationale Deregulation of industries and increasing international competition has resulted in : – New entrants looking for profitable business – Existing firms need to reduce any cross-subsidisation – Could lose profitable business and be left with loss- making products This has formed a strong rationale for more sophisticated and accurate costing systems

Other Uses of ABC It has quickly become apparent that ABC has a range of other applications The wider use of ABC has become known as Activity Based Cost Management – This can include incorporation into the budgeting process and into an ongoing process of understanding overall cost structures The article on Customer Profitability states “the actual calculation of customer profitability amounts to an extensive ABC exercise” Therefore, we should first make sure of the principles by working through question which shows some of the range of applications for ABC

Customer Profitability Analysis CPA Customer rather than product as the cost object We will use article and case study by Van Raaij et al to explore the issues The additional reading from Atkinson et al is also quite helpful on this topic

Why are some customers less profitable? – Some examples Customer makes frequent order changes Customer orders special parts Customer is difficult to please There are lots of customer visits Studies suggest that only 20% of customers are profitable! – This is based on the 80/20 rule – the article and case comes up with interesting figures

Activities CPA needs to capture the costs of all the activities associated with moving the goods from the point of manufacture to the point where the trade customers assumes a legal ownership over them It is important to see this as a starting point – as some of the literature will emphasise The objective ultimately is to manage costs rather than just to measure them

Customer related activities include: Invoicing Design changes Special packaging Special deliveries Late payments Visits Contacts

More customer related activities Cost to acquire customers After sales support Conduct research Maintain database Advertising These activities cut across the entire business and demands inputs from many functionally based sources of data.

Comparing customers Challenge is to find characteristics of “High profit” and “Low profit” customers – i.e. not just find the profit levels but try to explain them as this could help future decisions What steps can you make to improve profitability? Again here, we should use the article/case to develop some conclusions

Using the article We should use the attached article to help us appreciate some of the issues in this area – Otherwise this topic can seem a bit theoretical and basic Questions for you to discuss : – What does research suggest about customer contribution to profits – What is the theoretical basis for CPA – What is learnt from the case study (also in general terms what is the value of case study research) – What are the key problems and conclusions that arise

Summary Each customer is different Each £ of revenue does not contribute equally to company’s profitability Traditional costing systems not designed to provide information for CPA Order size and frequency can affect costs Post-sales support varies widely

Summary In some cases it is easy to trace costs directly to customer It is not always possible to avoid allocations Need to meet customer expectations in cost- effective way There is a past exam question in the handout which we can now use to help understand how this works in practice – Any future exam questions would include a strong focus on the sort of approach we have used for this topic