Running head: ACTIVITY-BASED COSTING
A Case Study of Activity-Based Costing
R. Scott Felter
Bellevue University
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ACTIVITY-BASED COSTING
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Abstract
The purpose of this essay is to perform a case study of Activity-Based Costing (ABC)
analysis. The facts of the analysis involves an enterprise trying to secure a contract on
two separate products. However, to ensure the Sales Team has vetted the purposed
sales price of each unit correctly for the bid submittal, an ABC analysis of variable cost
for each respective product needs to be accomplished. Once this is completed, a
clearer picture of each product will be ascertained either vetting the purposed sales
price or not. Furthermore, a comparison of traditional Cost-Volume-Profit (CVP) analysis
will be discussed with potential outcomes versus the ABC analysis.
Keywords: Activity-Based Costing analysis, Break-Even Point, Cost Drivers,
Cost-Volume-Profit analysis.
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A Case Study of Activity-Based Costing
A manufacturing company that produces specialty tools has a direct customer
requesting price quotes for two of your products: a portable flammable-gas sensing tool
(SKU A1) and a self-contained radon measuring device (SKU B1). There are at least
two other competing manufacturers that are submitting bids for these products. Your
sales manager believes that quotes of $335.00 for SKU A1 and $725.00 for SKU B1 per
unit would secure the customer’s orders, leading to significant additional orders in the
future. Your company’s typical profit markup is 25% of the total unit cost. Reference
Figure 1 for the costs and specifications for the two products.
As part of the vetting process, I have been asked to run an ABC analysis to
ensure we can produce the units for profit; all calculations are for per unit cost. I am
tasked with answering what should be the Target Cost (TC) for SKU 1A and SKU 1B?
What is the projected total unit cost of production and delivery for SKU 1A and SKU 1B?
Based on the given information and the answers to afore mentioned questions, should
the company produce the products or even offer to bid the customer?
ABC Analysis SKU 1A
SKU 1A will be reviewed first to ascertain if the suggested bid price is in
alignment of internal targeted cost. We know that the sales manager has suggested a
bid price of $335.00 per unit. Working backwards to calculate the TC is simply dividing
$335.00 by ratio of 1.25 (1 is the factor and .25 representing the 25% markup) providing
the TC of $268.00 per unit.
Now that the TC has been established, the ABC analysis can begin by using the
variable cost figures from Figure 1. The raw and purchased materials, manufacturing
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and assembly labors, machine hours, material handling, and product delivery cost will
be calculated providing the total cost of SKU 1A; reference Figure 2 for calculations of
SKU 1A. Moreover, this cost will vet the viability of producing the product and if the
sales manager’s purposed sales price is correct. As the ABC analysis calculated the
total unit cost for SKU 1A as $239.16, this is under the targeted unit cost of $268.00 with
positive reserve for variances of $28.84. The company sales manager can proceed with
the bid process to obtain the contract for the anticipated demand of 26,500 units of SKU
1A. The company can with this analysis build the product under targeted cost and
maintain the company standard markup of 25% for total sale price of $335.00.
ABC Analysis SKU 1B
SKU 1B will be reviewed now to ascertain if the suggested bid price is in
alignment of internal targeted cost. We know that the sales manager has suggested a
bid price of $725.00 per unit. Working backwards to calculate the TC is simply dividing
$725.00 by ratio of 1.25 (1 is the factor and .25 representing the 25% markup) providing
the TC of $580.00 per unit.
Now that the TC has been established, the ABC analysis can begin by using the
variable cost figures from Figure 1. The raw and purchased materials, manufacturing
and assembly labors, machine hours, material handling, and product delivery cost will
be calculated providing the total cost of SKU 1B; reference Figure 3 for calculations of
SKU 1B. Moreover, this cost will vet the viability of producing the product and if the
sales manager’s purposed sales price is correct. As the ABC analysis calculated the
total unit cost for SKU 1B as $594.83, this is over the targeted unit cost of $580.00 with
negative reserve for variances of -$14.83. The company sales manager cannot proceed
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with the bid process to obtain the contract for the anticipated demand of 18,500 units of
SKU 1B. The company cannot with this analysis build the product under targeted cost
and maintain the company standard markup of 25% for total sale price of $725.00.
ABC vs CVP
If conventional costing methods had been deployed, it would have changed the
managerial decision-making process in this case, as presented values would differ from
the ABC analysis (Velmurugan, 2010). In my studied opinion, the company would have
a false positive for SKU 1B unit, and submitted the purposed bids for each SKU not
knowing that SKU 1B was not profitable at the bid cost of $725.00.
As I do not have the overhead values or fixed cost that would have been used for
a CVP analysis, I will state what is factual. The fact that the ABC cost drivers
differentiated the materials (raw and purchased) and labor (manufacturing and
assembly) into two cost pools, this provided clarification of cost drivers to each specific
product. Furthermore, what normally would have been classified as overhead in a lump
value, was clearly identified by afore mentioned cost drivers with additional cost drivers
such as product delivery, machine hours, and materials-handling.
Conventional analysis values would be less exact and cannot differentiate, as
minimal or direct relationship of how each SKU uniquely consumed resources is not
apparent; this will result in distorted product costs (IMA, 2006). In fact, conventional
CVP analysis values used could potentially represent several products together,
causing one product to appear more or less expensive and/or used more or less
resources incorrectly predicting the costs of each SKU (Dalci & Tanis, 2005).
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ABC analysis avoids these problems, as ABC analysis traces indirect costs, aka
“overhead”, to individual products, services, and customers by identifying resources and
their costs. Moreover, ABC analysis traces the consumption of these resources by
activities, and the performance of activities to produce output (IMA, 2006). Lastly,
conventional CVP analysis uses only volume-based cost drivers such as the number of
units produced; moreover, the products produced is the only revenue and cost driver. In
addition, overhead expenses can vary due to multiple processes, which can lead to
false indications of the Break-Even Point (BEP) for profitability (Dalci & Tanis, 2005).
It is suggested that an ABC - CVP analysis be performed as a Best Business
practice for this company. The ABC analysis requires the modification of the CVP
analysis utilizing identified cost drivers, in effect ascertaining a truer projection of
product total cost. For example, if the ABC analysis identified the ability to reduce cost
by standardizing specific applicable parts across multiple product lines, aka the cost
driver, the variable cost would change for not only one product, but multiple product
lines. The CVP analysis would require the new variable cost, aka the modification,
establishing the new BEP for these multiple products. The ABC-CVP process is
applicable for any fixed or variable cost i.e. customer support, marketing efforts, and
change in the manufacturing process (Velmurugan, 2010).
Conclusion
In our case study, if conventional costing methods had been deployed, it would
have changed the managerial decision-making process in this case. What normally
would have been classified as overhead in a lump value averaged across product lines,
was clearly identified by afore mentioned cost drivers for each SKU. Because the ABC
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analysis ascertained a better projected cost for each SKU, the company was able to
understand that SKU 1A was a go bid and SKU 1B was a no bid, avoiding costly loss in
profitability in producing the product. CVP analysis coupled with ABC analysis should
become the Best Business Practice for any enterprise serious about profitability,
delivering competitive products to their customers, and longevity in a growing global
business environment.
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References
Dalci, I. & Tanis, V. (2005). Activity-Based Cost-Volume-Profit Analysis: Another
Approach to Break-Even Analysis. Ç.Ü. Sosyal Bilimler Enstitüsü Dergisi, 14(2),
227-244. Retrieved November 8, 2015, from http://dergipark.ulakbim.gov.tr/
cusosbil/article/viewFile/5000001066/5000001757
IMA. (2006). Implementing Activity-Based Costing. Retrieved November 8, 2015, from
http://www.imanet.org/docs/default-source/research/sma/implementing-activitybased-costing.pdf?sfvrsn=2
Velmurugan, M. (2010). The Success and Failure of Activity-Based Costing Systems.
Journal of Performance Managment, 23(2), 3-33.
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Figures
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Category 1
Category 2
Series 1
Category 3
Series 2
Category 4
Series 3
Figure 1. Related variable cost for each product that will be used to perform ABC
analysis (Bellevue University FBUS 465 C4P4, 2015).
Total Cost Unit SKU 1 A
Total Material Cost
raw materials @ 31.00 + purchased materials @ 15.00
total material cost = 46.00
Total Labor Cost
manufacturing (2.8 hours x 12.50 rate) = 35.00 + assembly (3.6 hours x 14.50) = 52.20
total labor cost = 87.20
Machine Cost
6.8 hours x 3.45
machine cost = 23.46
Material Handling
1.25 x per dollar total material cost @ 46.00
material handling = 57.50
Delivery per Unit
delivery per unit = 25.00
Total Cost
Total Cost = 46.00 + 87.20 + 23.46 + 57.50 +25.00
Total Cost per Unit SKU 1 A = 239.00
Figure 2. Calculations for SKU 1A.
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Figures
Total Cost Unit SKU 1B
Total Material Cost
raw materials @ 66.00 + purchased materials @ 45.00
total material cost = 111.00
Total Labor Cost
manufacturing (5.0 hours x 15.50 rate) = 77.50 + assembly (8.4 hours x 16.50) = 138.60
total labor cost = 216.10
Machine Cost
28.4 hours x 3.45
machine cost = 97.98
Material Handling
1.25 x per dollar total material cost @ 111.00
material handling = 138.75
Delivery per Unit
delivery per unit = 31.00
Total Cost
Total Cost = 111.00 + 216.10 + 97.98 + 138.75 +31.00
Total Cost per Unit SKU 1 A = 594.83
Figure 3. Calculations for SKU 1B.