1. Module 18
Activity-Based Costing, Customer Profitability, and Activity-Based Management

2. Traditional Product Costing
Overhead Costs allocated to Products
By direct labor or machine hours
Traditional results will be inaccurate when
Products differ on use of resources, like
Frequent design changes
Specialized equipment
Complex setups
Difficult customer specifications

3. Activity-Based Costing (ABC)
Resources are assigned to activity costs, which are then assigned to objectives by cost drivers.
*Based on units of activity utilized by the cost objective
For example, consider purchasing and receiving:
Staff Salaries
Supervisor
Other
Assign by time
Place orders
Verify orders
Unload & Unpack & Inspect
Assign by cost driver
PO 1
PO 2 …

4. Example Activity Costs Purchasing
Interviews determined that 15% of the time, receiving room employees verified purchase orders, and 85% of their time was spent unloading, unpacking, and inspecting.
Supervisors were found to spend 30% of their receiving time on verifying issues, with the other 70% on unloading, unpacking, and inspecting issues.
Placing Purchase Orders
Verifying Purchase Orders
Unload
Unpack
Inspect
Total Costs
Salaries
Purchasing agents ($7,800 × 3 agents)
$23,400
Receiving room employees ($2,400 × 2 emp.)
($2,400 × 2 employees × 15% verifying) $
($2,400 × 2 employees × 85% unload, etc)
$4,080
Supervisor
($5,000 × 3/5 purchasing)
3,000
($5,000 × 2/5 receiving x 30% verifying)
600
($5,000 × 2/5 receiving x 70% verifying)
1,400
Other costs
($4,500 × 25% purchasing)
1,125
($4,500 × 75% receiving) -
3,375
Total
$27,525
$ 1,320
$ 8,855
$37,700

5. Cost per Unit of Activity
Each activity results in a different rate
Rates are used to apply costs to cost objectives
Assume direct materials totaling $120,000 are to be acquired during the month with 300 purchase orders.
Placing Purchase Orders
Verifying Purchase Orders
Unloading Unpacking Inspecting
Total cost of activity
$27,525
$ 1,320
$ 8,855
Units of cost driver:
Number of purchase orders
÷300
Number of dollars of materials -
120,000
Cost per unit of activity $ $ $

6. Assigning Activity Costs to Cost Objectives
Assigning costs to a purchase order which has a materials cost of $1,600 for 500 parts.
Costs for Purchase order 1
Direct materials costs
$ 1,600
Activity costs:
Placing purchase order $
Verifying purchase order
4.40
Unloading/unpacking/inspecting
($0.074 × $1,600)
118.40
Costs assigned to cost objective
$214.55
Total cost of materials on PO 1
$1,814.55

7. ABC Implementation ABC is expensive to implement
After switching to ABC, companies may find that only 10 to 15% of their products are profitable
Causes management to alter the product mix by minimizing unprofitable products which causes profits to increase

8. Customer Profitability
ABC may be used for customer profitability analysis.
Customer costs to be analyzed
Cost incurred to sell the goods or services
Cost incurred to provide service
Actions possible from analysis
Convert customers to profitability or increase profitability
Seek to terminate unprofitable customer relationships

9. ABC Customer Profitability Analysis Example
What activities are required to serve customers?
Activity
Activity Cost Driver
Cost per Unit of Activity
Visits to customers
Visits
$ 400
Remote contact
Number of contacts 30
Processing and shipping
Customer orders
150
Packaging
Number of requests
120
Billing and collection
Invoices 40
Customer activity costs for Haskell Construction:
Activity Cost
Driver Data
Cost per Unit of Driver Activity
Customer Activity Cost
Visits to customers 4
$400
$1,600
Remote contact 3 30 90
Processing and shipping 6
150
900
Packaging 2
120
240
Billing and collection 5 40
200
Total customer activity cost
$3,030
Continued

10. ABC Customer Profitability Analysis Example
Customer sales
$79,000.
Less cost of goods sold
62,000.
Gross profit on sales
17,000.
Less activity costs
(3,030)
Customer profitability
$13,970.
Customer profitability ratio:
$13,970 ÷ $79,000 = 17.7%
Customers found to generate losses should be flagged and efforts made to correct the situation or terminate the customer.

11. Activity-Based Management
Identification and selection of activities to maximize the value of activities while minimizing their cost from the perspective of the final consumer
From the perspective of the final customer, what adds value to the product?

12. Activity-Based Management
Value Added: Required activities to produce a product and serve customers.
Examples: Produce product, fill customer order
Non-Value Added: Not required to produce a product or serve customers well.
Examples: Inspections, waiting, customer returns, storage, downtime for repairs, redoing anything