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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
The controller of Cooper Pen was disappointed with the most recent quarters 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
Total 100,000
451,800
Gross Margin
G.M. %
Last years new computer system helped to reduce some of the confusion
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
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
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
A complex factory generally also operates with higher levels of idle time, setup time, overtime, inventory, rework, and scrap
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
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
BATCH LEVEL
BATCH LEVEL 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
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
RUN MACHINES
PROVIDE FRINGE BENEFITS
MACHINE HOURS
LABOR DOLLARS
DL hr/unit
Mch. hr/unit Prod. runs Setup time/run Total setup hr # of products **Total = per unit X quantity
0.02
0.1 70 4 280 1
0.02
0.1 65 2.4 156 1
0.02
0.1 50 5.6 280 1
0.02
0.1 15 5.6 84 1
2,000
10,000 200 -800 4
50,000
40,000
9,000
1,000
ACDR
66,000
33,600
200
800
330 per
run
42 per
setup hr
14,400
42,000 156,000
4
10,000
3,600 per
product
4.20 per
machine hr
59,460
48,402
35,640
12,498
156,000
Black
180,000
Red
41,850
Purple
4,950
Total
451,800
Material Labor
40% fringe on DL
Support
Total Mfg. Expenses
Gross Margin
48,540
21.6%
37,998
21.1%
(15,390)
-36.8%
(10,038)
-202.8%
61,110
13.5%
G.M. %
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
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
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
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
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
Such an assignment is done on a lump-sum basis; it will be treated as a sustaining, not a unit-level, expense.
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
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
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
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
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
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
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
CGS
Gross Margin MSDA expenses (@35% of Sales) Operating profit Profit percentage
154,000
166,000 112,000 54,000 16.9%
156,000
159,000 110,250 48,750 15.5%
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 companys marketing, selling, distribution, and administrative costs
Duration drivers
Estimated time and effort
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
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 companys most profitable or its most unprofitable They are rarely in the middle
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
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
Managing Relationships
Companies can transform unprofitable customers into profitable ones by persuading the customer to use a greater scope of the companys 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
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
Implementation Issues (2 of 2)
Delegating the project to consultants
Consultants are usually not familiar enough with the businesss organization and problems and may not be able to build management consensus
If you have any comments or suggestions concerning this PowerPoint presentation, please contact: Rishiraj Dasgupta (dasgupta.rishraj@gmail.com)