Matakuliah
Tahun
Versi
: J0274/Akuntansi Manajemen
: 2005
: 01/00
Pertemuan 24
Mengatasi Kelemahan Akuntansi Biaya
Konvensional
1
Learning Outcomes
Pada akhir pertemuan ini, diharapkan mahasiswa
akan mampu :
• Memahami alternatif untuk mengatasi
keterbatasan informasi akuntansi
konvensional
2
Outline Materi
• Karakteristik lingkungan produksi dimana
informasi akuntansi konvensional masih
akurat
• Ilustrasi kasus
3
Volume, Size, and Complexity
• The traditional volume-based costing
system may provide reasonably accurate
costs when a firm’s operation possess the
following characteristics:
1. Few and very similar products and
service lines
2. Relatively low overhead expenses
3. Homogeneous conversion processes for
all products or services
4. Similar distribution channels, customer
demands, and customers
4
Volume, Size, and Complexity
• A traditional volume-based overhead costing
system, whether plantwide or departmental,
often leads to inaccurate product costs
(especially for firms with complex manufacturing
operations)
• Distortions of volume-based overhead cost
systems increase as product diversity increases
• Inaccurate cost information can lead to
undesirable strategic results, such as wrong
product-line decisions, unrealistic pricing, and
ineffective resource allocations
5
Problems With Simple Cost
Accounting Systems: The Cooper
Pen Company Example
• Cooper Pen had been the low-cost
producer of blue pens and black pens,
with profit margins exceeding 20% of sales
• Several years ago Cooper Pen expanded
their business by extending their product
line into products with premium selling
prices
6
The Cooper Pen Company Example
• Five years ago red pens were introduced
– The same basic production technology
– Could be sold at a price that was 3% higher than for
blue and black pens
• Last year purple pens were added
– Could be sold at a 10% price premium
• The controller of Cooper Pen was disappointed
with the most recent quarter’s financial results
– Overall profitability for all four together had decreased
– The red and purple pens, however, were more profitable
than the blue and black pens
7
Total Profitability by Product
Blue
50,000
$ 4.50
Black
40,000
$ 4.50
Red
9,000
$ 4.65
Purple
1,000
$ 4.95
Total
100,000
Sales
Material
Labor
$225,000
$180,000
$41,850
$4,950
$451,800
75,000
30,000
60,000
24,000
14,040
5,400
1,650
600
150,690
60,000
Overhead
90,000
195,000
72,000
156,000
16,200
35,640
1,800
4,050
180,000
390,690
$ 30,000 $ 24,000
$ 6,210
$ 900 $ 61,110
Units
Price
Total Mfg.
Expenses
Gross
Margin
G.M. %
13.3%
13.3%
14.8%
18.2%
13.5%
8
Concern at Cooper Pen
• The controller of Cooper Pen wondered whether
the company should continue to deemphasize the
blue and black commodity products and keep
introducing new specialty colored pens
• Cooper’s manufacturing manager commented on
how the introduction of colored pens had
changed the production environment:
– Everything ran smoothly when producing just
blue and black pens in long production runs
– Difficulties started when the red pens were
introduced and required more changeovers
9
Changes Caused by New Pens (1 of 2)
• Making black ink was simple; there was not even
a need to clean out the residual blue ink from
the previous run if enough black ink was
dumped in to cover it up
• Red required Cooper to stop production, empty
the vats, clean out all remnants of the previous
color, and then start the production of the red ink
– Even small traces of the blue or black ink
created quality problems
• The ink for the purple pens also had demanding
specifications, though not quite as demanding
as the red ink
10
Changes Caused by New Pens (2 of 2)
• Cooper Pens was also spending more time on
purchasing and scheduling activities and
keeping track of existing, backlogged, and future
orders
• Cooper’s manufacturing manager was
concerned about rumors that new colors may be
introduced in the near future
– He did not think they had any more capability to
handle additional confusion and complexity in the
operations
• Last year’s new computer system helped to
reduce some of the confusion
11
Pen Production At Cooper’s
• Pen production at the factory involved:
– Preparing and mixing the ink for the different color pens
– Inserting the ink into the pens in a semiautomated
process
– Packing and shipping the pens in a manual stage
• Each product had a:
– Bill of materials that identified the quantity and cost of
direct materials required for the product
– Routing sheet that identified the sequence of
operations required for each operating step
• This information was used to calculate the labor
expenses for each of the four products
– From this information, it was easy to calculate the direct
materials costs and direct labor costs for each color
pen
12
Cooper’s Indirect Cost Allocation
• Because it was a small company and historically
had produced only a narrow range of products,
Cooper 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
13
Cooper Pen’s Cost System
• Cooper’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
• Given the high cost of measuring and recording
information, the accountants at the time judged
correctly that a complex costing system would
cost more to operate than the benefits it would
provide
14
A Changed Production Environment
• Direct labor costs have decreased and indirect
expenses have increased as a result of
automation
• As custom low-volume products, such as red
and purple pens were added, Cooper needed:
–
–
–
–
More scheduling
More setups
More quality control personnel
A computer to track orders and product specifications
15
An Outdated Cost System
• Cooper operates with only a single cost center,
the plant
– Most complex companies use many cost centers for
cost accumulation
• Even if Cooper Pen used multiple production
and service department cost centers, it could still
encounter severe distortions in its reported
product costs:
– In an environment of high product variety, using only
unit-level drivers (such as direct labor costs) to
allocate overhead costs to products could lead to
product cost distortion
16
Reason for Cost Distortions (1 of 3)
• 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
• A complex factory generally also operates with higher
levels of idle time, setup time, overtime, inventory, rework,
and scrap
17
Reason for Cost Distortions (2 of
3)
• Because the factory has the same physical
output, it has roughly the same cost of materials
(ignoring the slightly higher acquisition costs for
smaller orders of specialty colors and other
materials)
• Because all pens are about the same complexity,
each pen would require the same number of
direct labor hours and machine hours to produce
• The Cooper Pen Company 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
18
Reason for Cost Distortions (3 of 3)
• On a per unit basis, high-volume standard blue and black
pens require about the same amount of direct labor costs
(the allocation basis) as the low volume color pens
• Therefore, the traditional costing system would report
essentially identical product costs for all products,
standard and specialty, irrespective of their relative
production volumes
– This would hold true even if the cost system had
multiple production and service cost centers
• Clearly, however, considerably more indirect and support
resources are required on a per-unit basis for the lowvolume, newly designed products than for the highvolume, standard blue and black pens
19
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
• The next slide compares the essential elements
of the two systems
20
Traditional v. ABC System
• Traditional:
– 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
• 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
21
Tracing Costs to Activities
• Here’s how an ABC system works, using
the Cooper Pen Company as an example:
– 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
22
Indirect Labor Activities (1 of 2)
• 50% of indirect labor was involved in what the
controller called “handle production runs”
– Scheduling production orders
– Purchasing, preparing, and releasing materials
– Inspecting the first few units produced each time the
process was changed to a new-colored pen
• 40% of indirect labor actually performed the
physical changeover from one color pen to
another, an activity that she labeled “perform
setups”
– Change to Black pens takes 2.4 hours
– Change to Red or Purple pens takes 5.6 hours
23
Indirect Labor Activities (2 of 2)
• 10% of the time was spent on activities the
controller called “support products:” maintaining
records on the four products, such as:
– Making up the bill of materials and routing information
– Monitoring and maintaining a minimum supply of raw
materials and finished goods inventory for each
product
– Improving the production processes
– Performing engineering changes for the products
24
First Steps in Design of An ABC System
•
As she conducted the interviews, the controller
was performing the first two steps for designing
an activity-based cost 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 (50% of indirect labor to “handle
production runs,” 40% to “perform setups,” and
10% to “support products”)
25
Computer System Expenses (1 of 2)
• The controller next turned her attention to the
$30,000 of expenses needed to operate the
company’s computer system and interviewed the
manager of the data center and the manager of
the management information system department
• 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,
including:
– Production process
– Associated engineering change notice information
26
Computer System Expenses (2 of 2)
• About 80% of the computer resource was
involved in the production run activity and
seemed to relate well to the “handle production
runs” activity already defined:
– Schedule production runs in the factory
– Order and pay for the materials required in each
production run
– Since each production run was made for a particular
customer, also included in this activity was the
computer time required to:
• Prepare shipping documents
• Invoice a customer
• Collect from a customer
27
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 pens:
– A practical capability of 10,000 hours of productive
time could be supplied to pen production
• The controller labeled this production activity
“run machines”
28
Identifying Cost Hierarchies
• The controller noted that even though she had defined
only four activities for Cooper’s indirect costs, they
represented 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
• Finding at least one activity for each hierarchy level gave
her confidence that the complexity of the manufacturing
process could be represented well enough by the
activity-based cost system
29
Benefits from Half an ABC System
• The ABC model was only half completed (costs
have not yet been driven down to products), yet it
had already provided some important insights:
– Now the controller could see why Cooper Pens was
incurring expenditures for resources instead of seeing
categories of expenses
– In particular she saw how expensive activities such as
handling production runs and setting up machines were
• The ABC model shifted the focus from what the
money was being spent on (labor, equipment,
supplies) to what the resources acquired by
spending were actually doing
30
From ABC to ABM (1 of 2)
• In the past, industrial engineers at Cooper Pen
had studied labor and materials usage closely:
– These had been the high cost resources
– They were also the primary cost categories featured by
Cooper’s traditional cost system
– The high overhead rate on direct labor seemed to
amplify any benefits from direct labor cost savings that
the industrial engineers could achieve
31
From ABC to ABM (2 of 2)
• It would be worthwhile to have industrial
engineers study the way Cooper handled and
scheduled production runs and how the
employees set up machines to uncover new
opportunities for cost reduction and process
improvement projects
– This is an example of operational activity-based
management (ABM), where managers use
information collected by the ABC system at the
activity level to identify opportunities for reducing
costs in indirect and support activities
32
Tracing Costs From Activities To Products
• The controller next turned her attention to
understanding the demands for these
activities by the four different products
• By understanding how products use
activities, she would be able to relate the
cost of performing activities to individual
products
33
Activity Cost Drivers
• Activity cost drivers represent the quantity of activities
used to produce individual products
• The controller identified the following activity cost drivers
for the activities in her activity dictionary:
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
34
Completing the ABC Model (1 of 2)
• Once the activity cost drivers had been
determined, the controller obtained
quantitative information on:
– The total quantity of each activity cost driver
– The quantity of cost driver used by each
product
35
Completing the ABC Model (2 of 2)
• The controller now had sufficient
information to estimate a complete activitybased cost model for Cooper Pen’s factory
– She calculated the activity cost driver rate
(ACDR) by dividing the activity expense by
the total quantity of the activity cost driver
– She then multiplied the activity cost driver rate
by the quantity of each activity cost driver
used by each of the four products
36
Activity Cost Drivers
Activity Cost
Driver
Blue
Black
Red
Purple
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
4
2.4
5.6
5.6
--
Total setup hr
280
156
280
84
800
# of products
1
1
1
1
4
50,000
40,000
9,000
1,000
Setup time/run
**Total = per unit
X quantity
37
Activity Cost Driver Rates (ACDR)
Activity Activity Cost
Driver
Expense
Driver Quantity
Handle
Production Runs
$66,000
Set up machines
$33,600
Support
Products
$14,400
Run Machines
$42,000
Number of
production runs
200
Number of
setup hours
800
Number of
products
4
Number of
machine hours
10,000
ACDR
$330 per
run
$42 per
setup hr
$3,600
per product
$4.20 per
machine hr
$156,000
38
Activity Expenses Assigned
Blue
Black
Red
Purple
Total
$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
$ 48,402 $ 35,640 $ 12,498
$ 156,000
Handle
Production
Runs
Total Costs
Assigned
$ 59,460
39
ABC Profitability Report
• The controller combined the activity expense analysis for
each product with their direct materials and labor costs
to obtain a new ABC profitability report
• The results from the activity-based costing system were
quite different from the results based on the traditional
cost system
• The controller now understood why the profitability of
Cooper Pen has deteriorated in recent years:
– 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
40
Total ABC Profitability by Product
Blue
Sales
Material
Labor
40%
fringe on
DL
Support
Total Mfg.
Expenses
Gross
Margin
G.M. %
Black
Red
$225,000 $180,000
$41,850
$4,950 $451,800
60,000
24,000
9,600
14,040
5,400
2,160
1,650 150,690
600 60,000
240 24,000
59,460 48,402
176,460 142,002
35,640
57,240
12,498 156,000
14,988 390,690
75,000
30,000
12,000
Purple
Total
$ 48,540 $ 37,998 $(15,390) $(10,038) $ 61,110
21.6%
21.1%
-36.8%
-202.8%
13.5%
41
Using ABC to Improve Profitability (1 of 2)
• The ABC information provides managers
with numerous insights about how to
increase the profitability of Cooper Pen:
– Increase either their sales volume or prices to
compensate for the large batch and productsustaining expenses of the red and purple pens
– Impose minimum order sizes to eliminate short,
unprofitable production runs
– Try to increase demand for the highly profitable
black and blue pens, which could generate new
revenues that exceed their incremental costs
42
Using ABC to Improve Profitability (2 of 2)
– Improve processes, particularly the processes
performing batch and product-sustaining activities
• Manufacturing personnel can redirect their attention:
– From trying to run their production equipment faster, in
order to improve the performance of unit-level activities
– To learning how to reduce setup times, in order to
improve the performance of batch-level activities so that
small batches of the specialty products would require
fewer resources to produce and be less expensive
• The goal of these ABM actions is to enable the company
to produce the same volume and mix of products with
fewer resources
– This leads to lower costs for producing low-volume, specialty
products, and reduces the pressure to raise prices or impose
minimum order sizes on customers in order to make such
products profitable
43
Selecting Activity Cost Drivers (1 of 2)
• Activity cost drivers are the central innovation of activitybased cost systems
• They are also the most costly to measure
– Particularly the quantity of each activity cost driver
used by each product
• Accordingly, it is important to understand the issues
involved in selecting activity cost drivers
• The selection of an activity cost driver reflects a
subjective trade-off between accuracy and the cost of
measurement
– An ABC system with 50 activity cost drivers and 2,000
products would require that 100,000 data elements be
estimated
44
Selecting Activity Cost Drivers (2 of 2)
• Because of the large number of potential activity-to-product
linkages, management accountants attempt to economize
on the number of different activity cost drivers
• Activities triggered by the same event may all use the
same activity cost driver
– For example, preparing production orders, scheduling production
runs, performing first part inspections, and moving materials may all
use the number of production runs
• ABC system designers choose from three different types of
activity cost drivers:
– Transaction
– Duration
– Intensity (direct charging)
• The choice of a transaction, duration, or intensity cost
driver can occur for almost any activity
45
Transaction Drivers
• Least expensive type of cost driver
• Also the least accurate
– They assume that the same quantity of resources is
required every time an activity is performed
• For example, a transaction driver such as the number of setups
assumes that all setups take about the same time to perform
• For many activities, the variation in the quantity of
resources used by each is small enough that a transaction
driver will be fine for assigning activity expenses to the cost
object
– E.g., all setup times are between 30 and 35 minutes
• If the amount of resources required to perform the activity
varies considerably from product to product then more
accurate and more expensive types of cost drivers should
be used
– E.g., Setup times range from 30 minutes to 6 hours
46
Duration Drivers
• Represent the amount of time required to perform an activity
• Should be used when significant variations exist in the
amount of activity required for different outputs
– A transaction driver such as number of setups will overcost the
resources required to set up simple products and undercost the
resources required for complex products
• More expensive to implement because they require an
estimate of time needed each time an activity is performed
• The choice between a duration driver and a transactional
driver is, as always, one of economics:
– Balancing the benefits of increased accuracy against the costs of
increased measurement
47
Intensity Drivers
• Directly charge for the resources used each time an activity
is performed
• A duration driver, such as setup cost per hour, assumes
that all hours are equally costly but does not reflect the
higher costs that may be required on some setups:
– E.g., extra personnel, more skilled personnel, more expensive
machinery
• Activity costs may have to be charged directly to the
output, based on work orders or other records that
accumulate the activity expenses incurred for that output
• Intensity drivers are the most accurate activity cost drivers
but the most expensive to implement
• Intensity drivers should be used only when the resources
associated with performing an activity are both expensive
and variable each time an activity is performed unless the
measurements are inexpensive
48
Designing an ABC System (1 of 2)
• Sometimes ABC system designers get
carried away with the potential capabilities
of an activity-based cost system
• For product costing and customer costing
purposes, most companies:
– Limit their activity dictionary to 30 to 50
different activities
– Choose activity cost drivers that can be
obtained simply and are available within their
organization’s existing information system
49
Designing an ABC System (2 of 2)
• The goal of an ABC system should be to have
the best cost system -- not the most accurate
one
• The ABC system designer should balance the
cost of errors resulting from inaccurate estimates
with the cost of measurement
• Most of the benefits from a more accurate cost
system can be obtained with simple ABC
systems
50
Measuring The Cost
Of Resource Capacity (1 of 2)
• 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
• Otherwise, the activity cost driver rates
overestimate the cost of the activity provided
• The cost of unused capacity should not be
assigned to products produced or customers
served during a period
51
Measuring The Cost
Of Resource Capacity (2 of 2)
• 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
• Still, the cost of unused capacity should not be
ignored
52
Cost of Unused Capacity (1 of 2)
• 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
– For example, if the capacity was acquired to meet anticipated
demands from a particular customer or a particular market
segment, then the costs of unused capacity due to lower than
expected demands can be assigned to the person or
organizational unit responsible for that customer or segment
• Such an assignment is done on a lump-sum basis; it will
be treated as a sustaining, not a unit-level, expense.
53
Cost of Unused Capacity (2 of 2)
• 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
• Unused capacity should not be treated as a general cost,
to be shared across all product lines
• In making assignment of unused capacity costs, we
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
54
Fixed and Variable Expenses
• Most indirect expenses assigned by an ABC
system are committed costs
• Committed costs become variable via a two-step
procedure:
– First, demands for resources change either because of
changes in the quantity of activities performed or
because of changes in the efficiency of performing
activities
– Second, managers must make decisions to change the
supply of committed resources, either up or down, to
meet the new level of demand for the activities
performed by these resources
55
Activity in Excess of Capacity
• If activity volumes exceed the capacity of existing
resources, the result is
–
–
–
–
–
Bottlenecks
Shortages
Increased pace of activity
Delays
Poor-quality work
• Such shortages occur often on machines, but can also
occur in human resources who perform support activities
• Facing such shortages, companies typically make
committed costs variable
– They relieve the bottleneck by spending more to increase the
supply of resources to perform work
– This is why many indirect costs increase over time
56
Decreased Demand for Resources
• Demands for indirect and support resources also can
decline
– Consciously through activity-based management
– Inadvertently through competitive or economy-wide forces that lead
to declines in sales
• Should the demands for batch and product-sustaining
resources decrease, few immediate spending reductions
will be noticed
• Even for many unit-level resources, such as machines and
direct labor, 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
57
Making Committed Costs
Variable Downward
• After unused capacity has been created,
committed costs will vary downward if, and only
if, managers actively reduce the supply of
unused resources
• What makes a resource cost “variable”
downward is not inherent in the nature of the
resource
• It is a function of management decisions
– To reduce the demands for the resource
– To lower the spending on it
58
Managers Make Costs Fixed (1 of 2)
• Organizations often create unused capacity
through activity-based management actions
– Process improvement
– Repricing to modify the product mix
– Imposing minimum order sizes on customers
• 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
59
Managers Make Costs Fixed (2 of 2)
• The organization receives no benefits from its activitybased management decisions that reduced the demands
on their resources if capacity is not reduced or redeployed
• The failure to capture benefits from activity-based
management is not because their costs are “fixed”
– The failure occurs because managers are unwilling or unable to
take advantage of the unused capacity they have created by
• Spending less on capacity resources
• Increasing the volume of work processed by the capacity
resources
• 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 (the
ABC system) may not increase profits if managers are not
prepared to reduce spending to align resource supply with
future lower levels of demand
60
Problems Implementing ABC (1 of 3)
• Several problems arise in practice from the
common approach to activity-based costing that
assigns many resource expenses to activities
based on interviews, surveys, and direct
observation of production and support processes
– The interview and survey processes are time
consuming and costly
• This front-end cost to an ABC analysis is often a
barrier to widespread ABC adoption
61
Problems Implementing ABC (2 of 3)
– 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
• High updating cost leads to infrequent updates of
many ABC systems and, eventually, to obsolete cost
driver estimates
– 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
62
Problems Implementing ABC (3 of 3)
– 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
– Accordingly, the cost driver rates calculated
from this process assume that resources are
working at full capacity
– But operations at capacity are more the
exception than the rule
63
Time-Driven ABC:
An Alternative Approach
• Several companies have overcome these
problems by using a new approach for
estimating their ABC models
• The insight for the new approach is
simple:
– 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
64
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
65
Unit Cost Estimate (1 of 3)
• 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
• Practical capacity is often estimated as a
percentage (e.g., 80% or 85%) of theoretical
capacity
• This estimate allows time (e.g., 15 – 20%) for
nonproductive time:
– For personnel, time for breaks, arrival and
departure, and communication and reading
unrelated to actual work performance
66
Unit Cost Estimate (2 of 3)
– For machines, an allowance for downtime due to
maintenance, repair, and scheduling fluctuations
• 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
67
Unit Cost Estimate (3 of 3)
• For example, assume that indirect labor
employees supply about 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
68
Unit Time Estimate
• The second piece of new information is an estimate of
time used each time a committed resource performs a
transactional activity
– Precision is not critical
– Rough accuracy is sufficient
• Estimates for the indirect labor from the Cooper Pen
example are:
Resource
Activity
Unit Time
Indirect Labor Production Run 5 hours
Support Products 50 hours
69
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
70
Advantages of Time-Driven ABC
• Managers may easily update their time-driven
ABC model to reflect changes in their operating
conditions
– They can incorporate the new knowledge by providing
reasonable estimates about the unit times required for
different activities for each type of product
• 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
71
Tracing Marketing-Related
Costs to Customers
• The costs of marketing, selling, and distribution expenses
have been increasing rapidly in recent years
– Result of increased importance of customer satisfaction
and market-oriented strategies
• Many of these expenses do not relate to individual
products or product lines but are associated with:
– Individual customers
– Market segments
– Distribution channels
• Companies need to understand the cost of selling to and
serving their diverse customer base
72
Alpha – Beta Example (1 of 7)
• Assume Alpha and Beta are customers generating about
equal revenue and seen as equally valuable customers
• Using a conventional cost accounting system, marketing,
selling, distribution, and administrative (MSDA) expenses
were allocated to customers at a rate of 35% of Sales
ALPHA
BETA
Sales
$320,000
$315,000
CGS
154,000
156,000
$166,000
$159,000
112,000
110,250
$ 54,000
$ 48,750
16.9%
15.5%
Gross Margin
MSDA expenses (@35% of Sales)
Operating profit
Profit percentage
• In many respects, however, the customers were not similar
73
Alpha – Beta Example (2 of 7)
• Beta’s account manager spent a huge amount of time
on that account
• Beta required a great deal of hand-holding and was
continually inquiring whether the company could modify
products to meet its specific needs
• Beta’s account required many technical resources, in
addition to marketing resources
• Beta 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
74
Alpha – Beta Example (3 of 7)
• Alpha, 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 knew that
Alpha was a much more profitable customer than
the financial statements were currently reporting
• He launched an activity-based cost study of the
company’s marketing, selling, distribution, and
administrative costs
75
Alpha – Beta Example (4 of 7)
• The multifunctional project team:
– Studied the resource spending of the various accounts
– Identified the activities performed by the resources
– Selected activity cost drivers that could link each
activity to individual customers
• The Accounting Manager used:
– Transactional activity cost drivers
• Number of orders, number of mailings
– Duration drivers
• Estimated time and effort
– Intensity drivers when he had readily-available data
• Actual freight and travel expenses
76
Alpha – Beta Example (5 of 7)
• The manager also used a customer cost
hierarchy that was similar to the manufacturing
cost hierarchy
– Some activities were order-related
• Handle customer orders
• Ship to customers
– Others were customer-sustaining
• Service customers
• Travel to customers
• Provide marketing and technical support
77
Alpha – Beta Example (6 of 7)
• The picture of relative profitability of Alpha and Beta
shifted dramatically
Alpha
Beta
$166,000
$159,000
Marketing & tech. support
7,000
54,000
Travel to customer
1,200
7,200
100
100
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
$ 139,800
$ (13,100)
43.7%
(4.2%)
Gross Margin (as previously)
Distribute sales catalog
Service customers
Operating profit
Profit percentage
78
Alpha – Beta Example (7 of 7)
• As the manager suspected, Alpha Company 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
• Beta Company was now seen to be the most
unprofitable customer that the company had
• While the manager intuitively sensed that Alpha
was a more profitable customer than Beta, he
had no idea of the magnitude of the difference
79
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)
80
Customer Profitability
• Cumulative sales follow the usual 20-80 rule
– 20% of the customers provide 80% of the sales
• 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
• It is not unusual for some of the largest customers to turn
out being the most unprofitable
– The largest customers are either the company’s most
profitable or its most unprofitable
– They are rarely in the middle
81
Managing Customer Profitability (1
of 3)
• High-profit customers, such as Alpha, appear in
the left section of the profitability whale curve
– These customers should be cherished and
protected
– They could be vulnerable to competitive
inroads
– The managers of a company serving them
should be prepared to offer discounts,
incentives, and special services to retain the
loyalty of these valuable customers if a
competitor threatens
82
Managing Customer Profitability (2
of 3)
• The challenging customers, like Beta, 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
83
Managing Customer Profitability (3
of 3)
• 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
84
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
– Try to customize products at the latest possible stage
– Use information technology to enhance the linkages
from design to manufacturing
85
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
– To this base price, the company provides a menu of
options, with associated prices, for any special
services requested by the customer
• Special services may be priced just to cover
costs or also to earn a margin
• Activity-based pricing prices orders, not products
86
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
– The margins from such increased business
purchases contribute to covering customer-sustaining
costs
• 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
– 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
87
ABC at Service Companies (1 of 2)
• 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
88
ABC at Service Companies (2 of 2)
• 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
89
Implementation Issues (1 of 2)
• Not all ABC systems have been sustained or contributed
to higher profitability for the company
– Some companies have experienced difficulties and frustrations
in building and using activity-based cost and profitability models
for some of the following reasons
• Lack of clear business purpose
– The project may start in Accounting/Finance, and nobody outside
the department understands what changes need to be made and
why
• Lack of senior management commitment
– The group (usually Accounting/Finance) that initiates the project
probably does not have the authority to make decisions about
processes, product designs, etc., without full senior management
support
90
Implementation Issues (2 of 2)
• Delegating the project to consultants
– Consultants are usually not familiar enough with the business’s
organization and problems and may not be able to build
management consensus
• Poor ABC model design
– The model may be too complicated to build and maintain and too
complex for managers to understand and act upon
– Or the model may use arbitrary allocations that merely create
different distortions than the old system
– The new data requirements may increase the workload of other
functions without increasing the benefits to them
• Individual and organizational resistance to change
– People may feel threatened by the suggestion that their work
might be improved
– Resistance may be overt, but it may be more subtle and passive
91