Principles of MANAGEMENT

ACCOUNTING

Class 2 : Traditional vs Activity

Based Costing (ABC) & Customer
Profitability Analysis
1
 Cost allocation: practical example (1/3)
A. The case of a bakery that sells only bread and has the following cost:

1. Bread’s ingredients: €1.000/month

2. Salary of shop employee: €1.500/month
3. Number of breads per month: 2000 breads

=> Cost per bread:

1. Ingredients: €1.000 / 2.000 breads = €0,5/bread
2. Salary of shop employee: €1.500 / 2.000 breads = €0,75/bread
=> Total cost per bread: €1,25

B. Now, the bakery starts selling cake as well, the cost of the ingredient are the following:

=> Cake ingredient: €1.500/month

=> Number of cakes per month: 1.000 cakes

=> Cost per cake:

1. Ingredients: €1.500 / 1.000 cakes = €1,5/cake
2. Quid salary cost of the shop employee? 2
 Cost allocation: practical example
(2/3)
A. Shared based method
In this method we look for an allocation key to divide proportionally the salary of the shop employee over the number of breads & cakes
sold. For example, the number of units sold.
=> Division of salary of shop employee = 1.500/(2.000 breads + 1.000 cakes) = €0,5 per unit sold
=> Cost per bread = €1 & cost per cake = €2

B. Incremental method
1. Head activity = sell bread, salary of shop employee needs to be allocated to bread
=> Then, the cost of one bread is:
1. Ingredients: €1.000 / 2.000 breads = €0,5/bread
2. Salary of shop employee: €1.500 / 2.000 breads = €0,75/bread
=> Total cost per bread: €1,25
Additional activity = Sell cake, only the incremental cost need to be allocated
=> Cost per bread = €1,25 & cost per cake (only ingredients) = €1,5
2. Head activity = Sell cake, salary of shop employee needs to be allocated to cakes
=> Then, the cost of one cake:
1. Ingredients: €1.500 / 1.000 cakes = €1,5/cake
2. Salary of shop employee: €1.500 / 1.000 cakes = €1,5/cake
=> Total cost per cake: €3
Additional activity = sell bread, only the incremental cost need to be allocated
=> Cost per cake = €3 & cost per bread (only ingredients) = €0,5
3
 Cost allocation: practical example
(3/3)
Example

Situation Cost of bread Cost of cupcake

Shared based method

Labor costs allocated by turnover 1€ 2€

Incremental method
Bread primary activity 1,25 € 1,5 €

Cupcake primary activity 0,5 € 3€

 As shown in the table above, the cost calculation method has a significant influence on the cost of the different
products.
 When someone is selling only one product, the common costs have to be fully allocated to this product
 Shared based method: The common costs will be allocated to both products using an allocation key. Each product
carries, besides its directly attributable costs, a share of the common costs.
 The hierarchy of the products (meaning which is the main product and which is the side product) is not important
because of the use of allocation keys.
 Incremental cost calculation method: An incremental cost is an additional cost that is caused by offering an
additional product or service. The existing and the new product are respectively called the primary and the secondary
product.
 When calculating the incremental cost, the hierarchy plays an essential role. What will be the primary product that
will be used to determine the incremental costs? All common costs will be allocated to this primary product. The
incremental cost of the secondary product is thus composed entirely out of costs that can be directly allocated, both
fixed as well as variable. 4
Costing in a changing competitive
environment: Activity-based costing
 Traditional cost accounting
 Focus on calculating full cost per unit for stock
valuation
 Use of a volume-related allocation base
 Low level of overheads relative to direct costs
 Relatively uncompetitive market
 Changing competitive environment
 Higher level of overheads relative to direct costs
 Highly competitive international market
 Focus on customer satisfaction
5
 Traditional vs. ABC

The Past The Present

 Small number of products  Numerous products with
which did not differ much in more and complicated
required manufacturing production requirements.
support.  Labour is becoming an ever
 Labour was the dominant smaller part component of
element in the cost structure. total production costs.

6
 Traditional vs. ABC: Example
 Two clients require an equal number of
consulting hours. Customer 2 is using more
overhead such as phone calls, site visits, …
 If we allocate overhead based on number of
consulting hours (traditionally), both clients
are allocated half of the total overhead,
whereas actually customer 2 uses up much
more resources.
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Traditional vs. ABC : Example (2)
Required
special
packaging.

Demand
Orders fast
small service.
quantities.

Often Orders
changes frequently.
orders.

A costly customer 8
 Traditional vs. ABC (2)

Volume-Based Costing Activity-Based Costing

All production costs except An effort is made to
direct materials and direct account for as many costs
labour are lumped together as possible as direct costs
in one overhead cost pool. of production.

Indirect
Costs

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 Activity Based Costing System (ABC)
Assigning
overhead to products is
a
ABC systems follow difficult process.
I agree!
a two-stage
procedure to
assign overhead
costs to products.

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Activity-Based Costing System (ABC) (2)

In the ABC method,

we recognize that many
activities within a
department drive
overhead costs.

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 Activity Based Costing System (ABC) (3)

Let’s begin
ABC systems follow a by identifying
two-stage our major activities.

procedure to
assign overhead
costs to products.

Stage One
Identify significant
activities and assign overhead
costs to each activity in
proportion to resources used.
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 Activity Based Costing System (ABC) (4)

ABC systems follow a Overhead assigned to

activities are called
two-stage “activity cost pools.”
procedure to
assign overhead
costs to products.
Stage Two
Identify cost drivers
appropriate to each activity
and allocate overhead to
the products.
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 Activity Based Costing System (ABC) (5)

Traditional Costing Activity Based Costing

RESOURCES RESOURCES
Resource driver

Allocation base ACTIVITIES

Activity driver

COST OBJECTS COST OBJECTS

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Activities

- production
- product design
PROCESS - customer service
- helpdesk
ACTIVITY - technical support
- handling complaints
- answer telephone
TASK - take notes
- pass information

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Levels of activities
 Unit level:
 For each item produced

 Assembly, adding materials, …

 Batch level:
 For each batch of items produced or for each order

 Machine set-up, ordering materials,…

 Product-sustaining level:
 For each product (but not depending on number of items
produced)
 Product design, product testing,…

 Facility-sustaining level:
 For the whole business

 General management, accounting, …

 Customer-level 16
Cost objects
 Products
 Product range
 Product
 One unit of a product
 Customers
 Market or region
 Distribution channel
 Individual customer
 Process
 Specific questions
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 Cost Drivers
A characteristic of an event or activity that
results in the incurrence of costs. In selecting
a cost driver, we must consider . . .

Degree of Behavioral
Correlation Effects
The degree of correlation Definition: Behavioral effects
refers to how closely a cost refer to the impact that the
driver is related to the cost it choice of cost driver might have

Cost of
is supposed to represent. on the behavior of employees or
managers.

The cost of measurement refers to the

Measurement
expense and effort involved in tracking
and collecting data for the chosen cost
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driver.
Resource drivers
 Relation between activities and resource
consumption
 Examples:
 Labour time spent on each activity
 Machine time
 Floor space occupied by activity
 …
 Some costs that are indirect to the cost objects
may be direct to an activity
 Example: a car specifically used to visit customers
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Activity drivers
 Transaction drivers:
 Number of times an activity is performed

 Examples: number of internal transports, number of orders, …

 Duration drivers:
 Time spent on each cost object

 Examples: internal transportation time, machine hours,…

 Intensity drivers:
 Specific registration of resources used

 Example: set-up activity for simple versus complex products

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 Indicators of Need for ABC
Direct labour is a Product-line profit
small percentage margins are hard
of total costs to explain

Line managers do not

Sales are increasing,
believe the product
but profits are declining.
costs reports

Some products that

Marketing does not
have reported high
use costs reports for
profit margins are not
pricing decisions
sold by competitors
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 Activity Based Costing: Example
Identification
Overhead Costs
Total budgeted cost = $2.423.000
of Activity
Cost Pools

Activity
Cost
Pools
Product-
Unit Batch Sustaining Facility
Level Level Level Level
Machinery Setup Engineering Facility
cost pool cost pool cost pool cost pool
$1.212.600 $3.000 $700.000 $507.400
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 STAGE ONE
Maintenance Lubrication
Various overhead
costs related Depreciation Electricity
to machinery Computer Support Calibration

Activity
cost Machinery Cost Pool
pool Total budgeted cost = $1.212.600

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 STAGE TWO
Calculate Budgeted Machinery Costs $1.212.600
the pool Budgeted Machine Hours 43.000
rate $28,20/hour

Mode I: Mode II:

$28,20 per hr. $28,20 per hr.
1 hr. per unit 1,25 hr. per unit
$28,20 per unit $35,25 per unit
Cost
Assignment
Mode III:
$28,20 per hr.
2 hr. per unit
$56,40 per unit

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 STAGE ONE
Total budgeted setup cost
Calculation of $20 per hour
10 hr. per setup
total setup cost
$200 cost per setup
15 production runs
$ 3.000 Total

Activity
cost Setup Cost Pool
pool Total budgeted cost = $3.000

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 STAGE TWO
Calculate Budgeted Setup Costs $3.000
the pool Planned Production Runs 15 runs
rate $200 per run

Mode I: (1 Run) Mode II: (4 Runs)

$200 per run $200 per run
10.000 units per run 5.000 units per run
= $0,02 per unit = $0,04 per unit
Cost
Assignment
Mode III: (10 Runs)
$200 per run
400 units per run
= $0,50 per unit

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 STAGE ONE
Various overhead Engineering salaries Engineering software
costs related
to engineering Engineering supplies Depreciation

Activity
cost Engineering Cost Pool
pool Total budgeted cost = $700.000

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 STAGE TWO
Allocate based Engineering Cost Pool
on engineering Total budgeted cost = $700.000
transactions

Mode I: Mode II:

25% × $700.000 45% × $700.000
10.000 units 20.000 units
Cost = $17,50 per unit = $15,75 per unit
Assignment
Mode III:
30% × $700.000
4.000 units
= $52,50 per unit

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 STAGE ONE
Various overhead Plant depr. Property taxes
costs related
Plant mgmt. Insurance
to general
operations Plant maint. Security

Activity
cost Facility Cost Pool
pool Total budgeted cost = $507.400

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 STAGE TWO
Calculate Budgeted Facilities Cost $507.400
the pool Budgeted Direct-Labour Hours 118.000
rate $4,30/hour

Mode I: Mode II:

$4,30 per hr. $4,30 per hr.
× 3 hr. per unit × 4 hr. per unit
$12,90 per unit $17,20 per unit
Cost
Assignment
Mode III:
$4,30 per hr.
× 2 hr. per unit
$8,60 per unit

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 Product Cost from ABC

Here are the new product costs so far . . .

Mode I Mode II Mode III

Direct materials $ 50,00 $ 90,00 $ 20,00
Direct labor 60,00 80,00 40,00
Machinery 28,20 35,25 56,40
Setup 0,02 0,04 0,50
Engineering 17,50 15,75 52,50
Facilities 12,90 17,20 8,60
Total ABC 168,62 238,24 178,00 31
 Product cost of ABC: Example

 Total overhead: €100.000

 Inspection cost = 10% of total overhead
=> Inspection cost = ..............
 3 products: X, Y, Z
 # of inspections: 0,2 (X); 0,3 (Y); 0,25 (Z)
 Production level: 1.000 (X), 2.000 (Y), 800 (Z)

=> Please calculate the inspection cost for

each unit of X, Y, Z
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 ABC: cost / benefits?
As the level of detail
i n c r e a s e s ,
measurement costs
Costs rise.
Failure costs

high measurement decrease as the level

of detail increases.

costs

failure costs
low
low Optimal high Level of detail
system 33
 ABC: cost / benefits? (2)

 Keeping track of the time an employee

spends on every activity could prove to be
inefficient, if done with too much detail
 One needs to determine the optimal level of
detail
 Measurement costs tend to decrease as
(information) technology advances

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Advantages of ABC
 Better, and more accurate, overview of cost
objects’ cost structure
 Base for improved management decisions
f.in. Non-profitable customers could be rejected
 Adapted to contemporary complex competitive
business environment
 Allows more efficient cost controlling and
identification of possible cost savings

35
 Drawbacks of ABC
 Complex method
 Measurement costs of data gathering &
processing could be high
 Difficult integration with financial
statements

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 Application area
 High overhead costs
 Product diversity

 Complex production process

 Little confidence in existing cost management

systems
Remark: not all companies tend to benefit from the
application of ABC
f.in. Companies with standard production process
where overhead is related to one single cost
driver
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 ABC in the Service Industry

Activities tend to
be non-repetitive
Implementation human tasks.
Problems

High proportion of
facility-level costs

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Customer profitability analysis (CPA)
Customer Profitability Analysis (CPA) is a management
accounting tool used to assess the profitability of individual
customers or customer segments by analyzing the revenue
generated and the costs incurred to serve them.

 Focus : Customer as cost object

 Extended value chain : do not forget pre- & post
production costs
 Strongly related to marketing function
 20-80 rule of Cooper and Kaplan
 CPA as management and action tool
 Differences in revenues and costs
 Illustration 20-80 rule

150%
100%
cumulative percentage of profit

Cumulativ
e
% of profit
20% cumulative 100%
Source : Cooper and Kaplan cumulative percentage of factors contributing to the profit

% of
Customer profitability analysis (2)
What can be improved ?
 Indirect costs such as marketing, sales,
administration… continue to increase (increasing % of
sales)
 Those indirect costs are often caused by the customer
 How to allocate these costs to individual customers ?
(f.in. ABC)
 So as to be able to :
 Identify profitable customers
 Allocate resources effectively and efficiently
 1. Customer profitability analysis : Actions
Positive contribution
Volume discount Promotions
Extend product 2 1 Encourage
or service range Protect
Potential Winners
Protect Special service

Low volume High volume

4 3 Increase price
Increase price Reduce
Diminish service Losers Problems
costs

Negative contribution
1. Customer profitability analysis (4)
Required
special
packaging.
Orders Demand
small fast
quantities. service.

Often
Orders
changes
frequently.
orders.

A costly customer