1. Activity-Based Cost Systems
Chapter 4

2. 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

3. 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

4. Total Profitability by Product
vanilla
chocolate
strawberry
Mocha-almond
Total
Units
50,000
40,000
9,000
1,000
100,000
Price
$ 4.50
$ 4.65
$ 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
Overhead
90,000
72,000
16,200
1,800
180,000
Total 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%
14.8%
18.2%
13.5%

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

6. 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

7. 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

8. 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

9. 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

10. Reason for Cost Distortions
A complex factory has a much larger production support staff because it requires more people to:
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

11. 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

12. 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

13. 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

14. Traditional v. ABC System
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

15. Traditional v. ABC System
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

16. 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

17. 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”

18. First Steps in Design of An ABC System
Develop the activity dictionary: the list of major activities performed by both the factory’s human and physical resources
Obtain sufficient information to assign resource expenses to each activity in the activity dictionary

19. 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

20. 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

21. 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”

22. Identifying Cost Hierarchies
The four activities for Ericson’s indirect costs represent the three different levels of the manufacturing cost hierarchy:
ACTIVITY
COST HIERARCHY
RUN MACHINES
UNIT LEVEL
HANDLE PRODUCTION RUNS
BATCH LEVEL
SETUP MACHINES
BATCH LEVEL
SUPPORT PRODUCTS
PRODUCT SUSTAINING

23. 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

24. 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

25. Activity Cost Drivers
Activity 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

26. 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

27. 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

28. Activity Cost Drivers Activity Cost Driver Vanilla Chocolate
Strawberry
Mocha-almond
Total**
DL hr/unit
0.02
2,000
Mach. hr/unit
0.1
10,000
Prod. runs 70 65 50 15
200
Setup time/run 4
2.4
5.6 --
Total setup hr
280
156 84
800
# of products 1
**Total = per unit X quantity
50,000
40,000
9,000
1,000

29. Activity Cost Driver Rates (ACDR)
Activity Expense
Activity Cost Driver
Driver Quantity
ACDR
Handle 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

30. 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
3,528
33,600
Support Products
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

31. ABC 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

32. 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
40% fringe on DL
12,000
9,600
2,160
240
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%

33. 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

34. Using ABC to Improve Profitability
The goal of these ABM actions is to enable the company to produce the same volume and mix of products with fewer resources

35. 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

36. 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

37. 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

38. Measuring The Cost Of 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

39. 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.

40. 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

41. Measuring The Cost Of 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

42. 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

43. Making Committed Costs Variable
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

44. 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

45. 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

46. 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

47. 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

48. 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

49. 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

50. Unit Cost Estimate The cost of resources that supply capacity and
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

51. Cost of capacity 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

52. 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:
$84,000
Indirect labor cost per hour =
2000 hours
= $42 per hour

53. 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

54. 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

55. 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

56. Tracing Marketing-Related Costs 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

57. 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 of Sales)
112,000
110,250
Operating profit
$ 54,000
$ 48,750
Profit percentage
16.9%
15.5%

58. 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

59. 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

60. 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
Service customers
4,000
42,000
Handle customer orders
500
18,000
Warehouse inventory
800
8,800
Ship to customers
12,600
Total activity expenses
26,200
172,100
Operating profit
$ 139,800
$ (13,100)
Profit percentage
43.7%
(4.2%)

61. 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

62. 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)

63. 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

64. 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

65. 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

66. 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

67. 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

68. 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

69. 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
SOME CUSTOMERS MAY BE UNPROFITABLE ONLY BECAUSE IT IS THE START OF THE RELATIONSHIP WITH THE COMPANY. THE COMPANY MAY HAVE INCURRED HIGH COSTS TO ACQUIRE THE CUSTOMER AND THE CUSTOMER’S INITIAL PURCHASES OF PRODUCTS OR SERVICES WERE INSUFFICIENT TO COVER ITS ACQUISITION AND MAINTENANCE COSTS. NO ACTION IS REQUIRED AT THIS POINT. THE COMPANY EXPECTS AND HOPES THAT THE CUSTOMER’S PURCHASES OF PRODUCTS AND SERVICES WILL INCREASE AND SOON BECOME PROFITABLE, INCLUDING RECOVERING ANY LOSSES INCURRED IN THE START-UP YEARS. COMPANIES CAN AFFORD TO BE MORE TOLERANT OF NEWLY-ACQUIRED UNPROFITABLE CUSTOMERS THAN THEY CAN OF UNPROFITABLE CUSTOMERS THEY HAVE SERVED FOR 10 OR MORE YEARS.

70. 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

71. 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

72. 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

73. Implementation Issues
Delegating the project to consultants
Poor ABC model design
Individual and organizational resistance to change