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Table 1 -  Alpha Ltd Income Statement
1st quarter 2019	Johnson Ltd	Frank Group	Total
Net Sales                   1	2,000,000	1,780,000	3,780,000
Var. Ind. Costs           2	740,000	800,000	1,540,000
Ind. Contr Marg        3	1,260,000	980,000	2,240,000
Industrial Overh.        4	760,000	600,000	1,360,000
CGS              (2+4)   5	1,500,000	1,400,000	2,900,000
Indust Profit   (1-5)   6	500,000	380,000	880,000
Adm/S&M/R&D          7			520,000
Gross Income  (6-7) 8			360,000

 

That's one of the possible Internal Income Statements we use to make the right analysis by customer (similar for market and distribution channel) and to start reasoning on what a right a profitable action could be.

 

It's a simple example where the customers of Alpha Ltd are onyl two, but I prefer malking this way in order to reach the goal of this article.

 

You'll notice that we stop at the industrial expense level but all of us are aware that a customer absorbs a lot of resources by other dpts.

Some of these costs and related activities are considered even value-added ones, that is they are functional to some of the attributes the customers see as important reasons for "striking the bargain" (getting the purchase process done).

 

Without making a breakdown analysis of these activity categories according to their value creation potential, I kick off to descant on this real consumption of resources and the costs incurred.

 

Some of these customer resource-consuming activities are hidden into the Adm, Sales & Mkt dpt and in some cases also into the R&D when a long-term supply contract is in place at particular terms on the features of the products.

Many of these activities bring about the top side of each Income Statement (the industrial expense level), that is the manufacturing/delivery activities and linked costs arise because the "lower" side of the Income Statement (other dpt expenses) has been effective.

 

In making the short-term decisions we rely on the variable costs but when a wider lapse is helpful we cannot stop either at the Contribution Margin or at Throughput Margin and we make our reasoning on the full cost.

 

Nothing new about that.

 

Where does the strategic side lie?

 

In assessing the customer profitability as well as the channel distribution channel one (for instance) many management accountants consider only the respective Industrial Profit calculated by multiplying the Product Unit Industrial Cost by the number of products sold to each customer.

 

In other terms they ignore the costs to serve customers that include all the costs related to the activities that help the business "strike the bargain" (sell the products/services) and match the requests from customers.

Example of these are Advertising, Service calls, Collection, Billing, Travel and so on.

 

As you may understand, these activities are not the same for all the customers and you can evaluate it if you spot the right drivers that is the factors that explain the resource consumption and the related costs of a particular activity.

 

In other words when the drivers vary, the costs for those activities vary as well.

 

If you make the right driver analysis, you make the right Customer Profitability Analysis, achieving as a result further benefits such as:

 

- Giving the decision-making basis for marketing new services and products.

- Choosing the best product/service mix to realize.

- Discouraging the most unprofitable services and products.

- Identifying the best distribution channels.

.........

 

Let's make a step back.

 

If we make use of the traditional volume-based cost allocation techniques we cannot avoid to hide the real consumption of resources and the subject dissertation doesn't make sense.

 

We should resort to the activity approaches that highlight the real cost drivers that show how and why the resource consumption happens in all the activities that help the business acquire the customers, make the deal and satisfy their after-sales needs.

 

Here the steps of the ABC/M methods are not shown because the literature is rich in these topics, but we will limit to show the last part of the process, functional to the purpose of the dissertation.

 

According to the results of table 1 the most profitable customer, by limiting the analysis to the Industrial Profit, is Johnson Ltd and on this basis the business, we call Alpha Ltd, makes its decisions.

 

We can see at the same time there are Adm, Sales & Mkt, R&D expenses not allocated to each customer and we put at issue whether a Customer Cost Analysis can shift the decision basis.

 

Let's guess all of the related costs are previously allocated, on the basis of activity drivers, to the activity and now the last step to take is tracing the activity costs back to the customers.

 

How can we do this?

 

In this regard a preliminary Cost Classification is important.

 

Customer Unit-Level Costs: these costs increase as soon as a product/service unit is sold or delivered to the customers. A good example is the Shipping costs when their amount depends on the number of units shipped.

 

Customer Batch-Level Costs: the cost variation materializes when a  customer transaction is done and  may include more than one unit of product/service. 

The invoicing costs could be a good example as well as in most cases the delivery ones.

 

Individual Customer Costs: the resources in these case are consummed depending on the activities made with reference to a specific customer.

This is the case of the R&D costs when a customer asks for some new product features for the future supplies or of the travel expenses incurred to "pay visit" to the customer.

 

When the analysis shifts its focus to the Distribution Channel or Structural Business costs, other two categories come up:

 

Distribution Channel Costs: they vary according to the number of these channel because the firm pays for operating, running each of them.

For instance, if the company uses great warehouses for distributing its products to smaller sales points, all the related costs come into this category.

 

Structural Sales Costs: these expenses are related to those activities that aren't traceable to the previous categories because concern  the "basic" existence of the Sales dpt, such as the compensation of the Sales Top Management  and  the costs of  commercial cental offices.

 

Having said that and turning our attention to table 1, let's guess to be able, based on the available data, to spot 8 kinds of "activities" to serve customers that are traced to 3 of the above mentioned categories, with the respective costs, their drivers for allocating them to the customers ($ 460,000 out of $ 520,000 of Adm., Sales & Mkt expenses)  

$ 60,000 are not allocated to any customer for any operating and appropriate reason.

 

 

 

Table 2 - Costs to serve customer breakdown by Activity of Alpha Ltd (the numbers are not taken by any real business case)

 

Activity                 Amount      Categ.      Cost Driver (CD)   CD Numb    CD cost     CD Numb for Johnson  $ for Johnson   CD Numb for Frank   $ for Frank

Delivery                  120,000     Batch-Level       Miles                  5,000              24                    3,000                        72,000                  2,000                      48,000

Cust. Visits                70,000      Indiv. Cust.       Visits                      30         2,333                         22                        51,333                         8                      18,667

Order Processing     25,000     Batch-Level      Orders                    300              83.33                    180                      15,000                    120                     10,000

Invoicing                   20,000     Batch-Level      Invoices                  240              83,33                    160                      13,333                     80                         6,667  

Sales Return              15,000     Unit-Level            Units                   500              30                        300                        9,000                    200                        6,000

R&D                          60,000     Indiv. Cust.   Techn. Requests              8         7,500                            6                      45,000                        2                     15,000

Restocking                 20,000      Unit-Level           Units                    250             80                        190                      15,200                        60                     4,800

Shipping                  130,000      Unit-Level           Units                 2,800              46,43                1800                        83,571                     1000                  46,429

TOTAL                    460,000                                                                                                                                          304,437                                             155,563                                                                              

 

In consideration of the results of this Cost Analysis the real Customer Profitabilty table is the following: 

 

Table 3 - Customer Profitability Breakdown

   

1st quarter 2019	Johnson Ltd	Frank Group	Total
Indust Profit	500,000	380,000	880,000
Adm., Sales & Mark.	304,437	155,563	460,000
Customer Profit	195,563	224,437	420,000
Adm., Sales & Mkt not allocated			60,000
Gross Income			360,000

 

   

The basis for any kind od decision concerning the customers has now changed: the most profitable Customer is Frank Group and not Johnson as resulted instead from table 1.

 

Of course the importance of this Activity Analysis goes at the same pace as the degree of the customer orientation of the business.

The higher  the importance the firm puts on the customer satisfaction the higher the costs to serve customer and the higher the usefulness of this cost management technique

 

Other issue is the profitability by Customer in the  "remote" future.

 

There another kind of analysis that should be done and any request may be asked on page Contacts

 

 

 

 

The choice of a cost accounting system is made, most times, just by turning the attention to the highest number possible of the accounts to be considered and/or by increasing the number of the costing centers and focusing on factors that in the eyes of the management accountant/controller improve the accuracy of the product costing and of the department efficiency evaluation.

As a matter of fact, there are other aspects at issue that should be considered with regard to both the decision making support function and the internal factors, such as motivation and fairness, that at the end affect the efficiency of the single business units and of the whole business.

Before to start, a step “back” is needed to make the dissertation more clear and focused.

 

There are three ways of tracing the indirect costs to the products/services/projects (from now on for short product/products):

- Job costing when direct costs by product and the overheads are allocated directly to the products (the latter step on the basis of some cost driver)

- Operation costing when the direct costs are imputed to the products  and the overheads to intermediate objects (departments or activities )to which charging the overheads on the basis of some cost drivers and then imputing the intermediate object costs to the product, here too, on the basis of given drivers.

- Process costing when the allocation phase considers intermediate objects (departments or activities) to which charging both the traditional direct costs and the overheads on the basis of some cost drivers and then imputing the intermediate object costs to the product on the basis of given drivers.

Having said that, the implications mentioned in the lines above are good for the case of the departmental approach in particular  when there are Service (Support) costing centers that deliver their work to the Production (Primary) ones and, even more, this Service centers work also between them, generating the so-called reciprocal flows.

 

What are the reciprocal flows like?

 

As we know, inside a large organization there are the primary units (departments) that manufacture or, in the service industry, work the final output  that goes into the customers’ hands and the secondary units (called in some cases service ones) that  support the formers by giving them their services.

In many cases the latters, for short  Service dpts, work just to the primary units, for short Production dpts., and no issue arises about the accuracy of the allocation phase of their costs to the Production dpts but for the traditional matters about the right cost drivers.

In many other cases the Service dpts give their “output” not only to the Production ones but also to other Service ones of the firm, receiving also the work from the latters.

 

These are the reciprocal flows

 

Right  there we could encounter some important points at issue to be discussed about the most suitable cost allocation method to be made use of.

 

Which points  are we talking about?

 

1. The most accurate product costing method that affects the decision making about some issues such as profitability analyses and operating decisions concerning the product lines to prefer and the pricing in particular when the businesses adopt the mark-up technique on the full cost.

2. Efficiency evaluation of the depatments that are assessed on the basis both of the costs incurred internally and of the costs allocated to them from external sources  and for the services received.

We’ll see how many cost allocation methods are concerned and how the cost amount of the single cost objects varies as a result.

 

Three methods three different results

 

Let’s make the example of a manufacturing firm using the departmental approach for the overheads whilst the direct costs by are traced to the products (that is the Operation costing).

 

Input Data

 

N. 2 Products: A, B

N. 2 Service Dpts: Alfa, Gamma

N. 2 Production Dpts: 1, 2

 

In this structure one of the main characteristics that makes hard the choice of the kind of the departmental cost  allocation method is that the Service dps deliver their output not only to the Production Dpts but as well to each other.

Here is the flow percentage of their services as it is measured with reference to the labor hours worked

 

Table 1 - Percent distribution of the Service dpt Labor Hours

 

	Alfa	Gamma	Prod dpt 1	Prod dpt 2	Total
Serv dpt Alfa	-	30%	35%	35%	100%
Serv dpt Gamma	15%	-	35%	50%	100%

 

 

The first phase is the result from the attribution of the direct costs by dpt (for instance dedicated equipment depreciation, labor..) and of the allocation of the overheads of the whole firm to the dpts concerned.

 

Table 2 - Total overheads by industrial dpts after the first phase – January  2019

 

	Serv dpt Alfa	Serv dpt Gamma	Prod dpt 1	Prod dpt 2	Total
Total Overheads $	70,000	90,000	260,000	290,000	710,000

 

 

The following steps consist of allocating the costs of the Service dpts to the Production ones according to the percentage of the respective Labor hours in proportion to the total Labor Hours worked by the same Service dpts and then attributing the costs of each Production dpt to the Products A and B.

The latter step is made by using, as a cost driver, the Machine Hours for the Production dpt 1 and the Labor Hours for Production dpt 2.

 

Table 3 – Percent allocation of the Production dpt overheads to the Products A and B

 

	Product A	Product B
Product. Dpt 1  - Mach Hours	30%	70%
Product. Dpt 2  - Labor Hours	40%	60%

 

All of these phases following the first one, giving the results of table 2, can be carried out by using three methods, each of them bringing about different distributions of the overheads allocated to departments and products.

 

1) Direct Method

 

According to this method all the costs incurred and allocated to the Service dpts (see table 2) are in their turn allocated to the Production dpts just by taking into account for the calculation the  respective percentage of the cost driver (in our example Labor Hours – see table 1) and ignoring the reciprocal work flows between the Service dpts.

After that the final costs, this way calculated, of the Production dpts are attributed to the Products according to the percentage of the cost driver chosen (see table 3).

The ending step is common to the other two steps remaning (Step Method and Reciprocal one)

 

Without showing the single calculations, in order  to make the dissertation as fluid as possible and since the goal is highlighting the strategic side of the matter and not to be a manual of maths, here are the results concerning each Production dpt and the final products.

 

Table 4  - Direct Method - Total Overheads to the Production Dpts

 

Cost Source	Product. dpt 1	Product. dpt 2	Total
Serv dpt Alpha	35,000	35,000	70,000
Serv dpt Gamma	37,059	52,941	90,000
First Allocation Costs	260,000	290,000	550,000
Total	332,059	377,941	710,000

 

 

Table 5 - Direct Method - Total Overheads to the Product A and B

 

Product dpts	Product A	Product B	Total
Product. dpt 1	99,618	232,441	332,059
Product. dpt 2	151,176	226,765	377,941
Total	250,794	459,206	710,000

 

 

2) Step Method

 

The workings of this way require that the costs of a Service dpt (in our example Service dpt Alpha), resulting from the first phase, to be allocated to the other Service dpts (in our example just one - Gamma) and Production ones on the basis of the respective percentage of the cost driver (in our example Labor Hours – see table 1).

Then the costs this way calculated of the other Service dpts are attributed to the Production ones (by taking into account for the calculation the  respective percentage of the cost driver – see table 1 ) that in their turn are imputed to the products according to the percentage of the cost driver chosen (see table 3).

 

Here are the results concerning each Production dpt and the final Products.

 

Table 6 – Step Method - Total Overheads to the Production Dpts

 

Cost Source	Product. dpt 1	Product. dpt 2	Total
Serv dpt Alpha	24,500	24,500	49,000
Serv dpt Gamma	45,706	65,294	111,000
First Allocation Costs	260,000	290,000	550,000
Total	330,206	379,794	710,000

 

 

 

Table 7 – Step Method - Total Overheads to the Product A and B

 

Product dpts	Product A	Product B	Total
Product. dpt 1	99,062	231,144	330,206
Product. dpt 2	151,918	227,876	379,794
Total	250,980	459,020	710,000

 

Please Notice how the results of both tables differ from those of the Direct Method.

 

 

3) Reciprocal Method

 

Through this method the costs of the Service dpts. resulting from the first phase are calculated again taking into account the percentages of reciprocal work flows ( 30%  from Alpha to Gamma and 15%  from Gamma to Alpha), by an equation system (you can use also some Excel Tools).

The costs this way achieved of the Service dpts are attributed to the Production ones on the basis of the respective percentage of the cost driver (in our example Labor Hours – see table 1) that in their turn are imputed to the products according to the percentageof the cost driver chosen (see table 3).

 

Here are the results concerning each Production dpt and the final Products.

 

 

Table 8 – Reciprocal Method - Total Overheads to the Production Dpts

 

Cost Source	Product. dpt 1	Product. dpt 2	Total
Serv dpt Alpha	30,602	30,602	61,204
Serv dpt Gamma	40,681	58,115	98,796
First Allocation Costs	260,000	290,000	550,000
Total	331,283	378,717	710,000

 

 

Table 9 – Reciprocal Method - Total Overheads to the Product A and B

 

Product dpts	Product A	Product B	Total
Product. dpt 1	99,385	231,898	331,283
Product. dpt 2	151,487	227,230	378,717
Total	250,872	459,128	710,000

 

 

Please Notice how the results of both tables differ from those of the Direct Method and the Step Method

 

For instance, let’s take into consideration the differences between the cost Allocated to the Production Dpts following the application of all of three methods.

 

 Table 10 – Differences in the Total Production dpt Costs

 

Methods	Product dpt 1 - 2
Direct	- 45,882
Step	- 49,588
Reciprocal	- 47,434

 

 

The variances amongst these differences concern only one month and the amount relative small could deceive about the usefulness of the points at issue.

If you consider a larger period or if the costs allocated to the Service dps are higher than our example ones, it’s easily understandable how these questions can cause conflicts between managers when their performances are evaluated on the basis of the full costs absorbed from their production dpts.

Furthermore, when the criteria of allocation aren’t accurate because they don’t consider the real consumption of the Service dpt  work and its direction, achievable only through the most accurate system (the reciprocal method), some disincentives to put under control the requests of the Service work  from the managers that take advantage of this misallocation of the overheads can result.

The difference of the cost allocation concerns also the costing of the Products and as a result all the profitability analyses, above all those involving the long term, are wrong and can lead to erroneous decisions,

Not to say the consequences from an erroneous pricing of the products based on the full cost.

 

For more in-depth analysis about the arguments here dealt with, you can reach out to thestrategiccontroller.com on page Contacts or on carlo.attademo@libero.it

 

 

In the past article, n 31, dedicated to the Capacity I always referred only to the internal capacity of a business.

As a matter of fact  a firm is part of a supply chain and works with upstream and downstream partners to provide products and services to the customers, trying to meet their expectations and requirements.

 

That’s why many decisions should be focused also on the whole

supply chain issues and features.

 

Amongst those decisions, I want to write about Capacity matters and Just-in-Time systems.

 

Let’s start with the formers.

 

In case of an unexpected and great surge in the demand for a product/component/service the most natural reaction could be resorting to an external supplier.

In many cases, above all when a capacity reporting system is in place, the managers can become aware of the idle or non productive capacity within the whole supply chain and verify to be able to manufacture/achieve that missing “part” internally.

 

When is that possible?

 

It’s possible when the whole chain is flexible and the information system is well-integrated so that all the signals concerning the available capacity and where it’s available within the supply chain are highlighted in a fast way.

 

In this context the needed level of inventory could be lowered because of  a faster response time to the customer.

 

The benefits of this aspect are clear and can be embedded for the manufacturing firms also into the issue above highlighted, the JUST-IN-TIME (JIT) manufacturing system, that can be adopted when the supply chain has the features just listed (flexibility and availability of a capacity reporting).

 

The classical benefits resulting from the reduction of the inventory add to the lowering of the risk for the damaged and obsolete goods.

 

In order to make the dissertation more clear and fluid, some JIT concepts are now recalled.

 

 

JIT (Just In Time)

 

It’s the manufacturing system that has as a main feature that no job/productive activity gets started in the manufacturing dpt if  no order is received by the customers.

The latter term includes both internal and external customers.

 

The result of this policy is the low level of the inventory that serves as a buffet for meeting the requests from the customers as fast as possible.

 

The logical consequence is that the quality of the products and processes must be lifted to the maximum level  in order to reduce the risk of the delay of the delivery and the return of defective products.

 

In other terms, the JIT adoption as well as the existence of a supply chain flexible and well-integrated are particularly fit for  the businesses that adopt a differentiation strategy in comparison with its competitors.

 

 

Benefits of the JIT:

 

1) Direct:

 

- Elimination of the investments into fixed assets not required.

All of those assets should be tied up, that is they cannot be used for alternative purposes.

 

- Reduction in the labor costs associated to the holding and recording of the inventory as well as in the information system costs.

 

 

2) Indirect:

 

- All the advantages following the increase in the quality (here is the differentiation strategy) of the products/processes such as a higher profitability because of the increased sales and of the reduction in the manufacturing quality costs like those related to the waste, scrap and spoilage management and reworking of the defective products.

 

- As said before the response time to the customer needs to be strictly monitored producing as a result (when this element is put rigorously in place) a greater customer satisfaction and a following larger market share and sale level.

 

 

Costs of the JIT:

 

1) Training of the personnel involved and settings of a new information-monitoring system that includes also a range of well-suited nonfinancial indicators intended to pinpoint defects, waste, errors and delays.

 

2) Reconfiguration of the physical (tangible) assets (in some cases additional investments are needed) concerned that should have the right layout to allow the best workings of the new system.

 

 

In setting the JIT system of course you should take into account the main features of the industry concerned and the stage that industry is in.

 

For an in-depth analysis in this regard, you can contact www.thestrategiccontroller.com

 

 

Again Capacity Issue

 

Let’s go back to the capacity issue about the supply chain.

 

When we talk about the high quality of the products/processes we refer also to this issue.

In fact, if the products received from an upstream partner are not “good” enough, this creates nonproductive capacity inside the receiving organization in order to deal with the noncompliance related issues.

 

In other terms the real workings of the supply chain can have a negative impact on the best use of the capacity.

 

In the same way the lack of the flexibility of the supply chain has a negative impact also following a decision made by a downstream partner that creates an important surge in demand that the suppliers are not able to meet in due time.

 

What do we mean by due time?

 

The fact that the prior high demand got for the product involved is matched by the output received from the suppliers only when the same demand decreases so that excess stocks have been created.

 

These stocks should be returned to the suppliers that should level their output downwards again, creating as a result nonproductive time when forced to set up the machines and structure once more.

 

That’s just one more example of how the supply chain is a key factor to being considered in many decisions that impact the profitability of each of the firms concerned and of how flexible it should be especially in times and industries of great uncertainty.

 

 

How many times you are held responsible for the decisions that have impact on the medium-long term, such as the investments in asset-related resources, pricing, inventory evaluations, choice of the best customers on which to focus the business efforts and so on....!!

In order to make the best decisions you made use of the traditional profitability analyses that look over each product/service/project/customer and on the basis of their results you choose the best actions.

BUT when you analyse the results, you see that they are different from what you estimated.

Why?

One of the possible explanations on the cost side is that you didn’t consider the very nature of your business indirect activities and the way they consume resources and generate as a result costs.

In fact, when they are so different according to the product/service/project/ customer or whatever cost object, you cannot allocate them always on the basis of some sort of volume measure (mach. hrs, direct labour hrs, output units...) because the factor that impact their costs (cost driver) is of another kind.

In  other terms, in some cases if you persist on using the volume-based costing methods, the profitability order of your cost objects and on which you base your decisions is WRONG!

 

Then, What Better Way to show this concept than numerical examples!!?

 

Let’s guess a manufacturing firm that makes 3 products and uses the Machine Hours as a driver to allocate the Factory Overheads to the products.

 

This firm has the Engineering DPT that works in continuous interaction with the Manufactuting one and for this reason has been considered like an industrial responsibility center.

 

The same settings have been chosen for Part Purchasing One as a result also of the JIT (Just In Time) policy.

 

When it is time to budget the Industrial Profit, the Controlling Manager makes the following steps on the basis of this inputs and calculations.

 

Table 1 - Input Data

	Product A	Product B	Product C
Output Units	10,000	30,000	20,000
Price $	500	350	440
Direct Resources $:
Labour	200	150	180
Materials	100	70	100
Machine Hours per Unit	6	4	5
Total of Machine Hours	60,000	120,000	100,000

 

 

VOLUME-BASED COSTING OVERHEAD RATE

 

Total Budgeted Factory Overheads:  $ 4,750,000

Overhead Rate: 4,750,000/ Total Business Machine Hours = 4,750,000/280,000 =  $ 16.964per MH

 

After Multiplying the Overhead rate by the Mach. Hrs per product as per the table 1 and dividing the results by the Output Units by product , we have the following:

 

Table 2 - Factory Overheads per product as per Volume-Based Costing

	Product A	Product B	Product C
Output Units	10,000	30,000	20,000
Total of Machine Hours	60,000	120,000	100,000
Overheads	1,017,857	2,035,714	1,696,429
Overheads per Unit	101.79	67.86	84.82

 

At this point we can draw up an Industrial Profit Statement that yields this profitability order:

1.       PRODUCT A
2.       PRODUCT B
3.       PRODUCT C

 

Table 3 - Industrial Profit by product unit according to the Volume-Based Costing

	Product A	Product B	Product C
Unit Price	500	350	440
Unit Manufacturing Cost:
Labour	200	150	180
Materials	100	70	100
Factory Overheads	101.79	67.86	84.82
Total Cost per unit	401.79	287.86	364.82
Industrial Profit	98.21	62.14	75.18

 

 

On the other side the Controlling Manager, aware that in the past reference period the results were so different from the forecast, decides to make his calculations based on the Activity Approach and his favour, for a start, goes to the traditional model, that is what isn’t linked to customer-driven value model (whose dissertation is on page Shop of this website).

 

ACTIVITY-BASED COSTING SYSTEM

 

He is able with the help of the technical staff to understand that not all the activities change their costs when the volume measure chosen previously changes, the number of the machine hours.

To be more precise, he realizes that some of them change their costs (linked to the resource consumption they measure) at some product group change.

For instance, the setup activities are carried out without a direct  proportion to the number of the output units or machine hrs to be worked and, as a result, the factor that affects their costs is the number of setups.

This kind of activities are called either Group-Level ones or Batch-level Activities.

He becomes aware also that the Purchasing activity of Parts is linked to the models per each product not to any of the volume measures and that the cost driver is the number of models.

In other terms, the overhead rate for these kind of activities must be calculated with reference to the setup and model number and then allocated to the different products according to the respective number (table 6).

There are also other activities that concern the whole business and are related just to its “existence”, called Facility ones, that shouldn’t be allocated to the products.

Here are the most important steps.

 

Table 4 - Budgeted overheads by Activity, Activity Cost Drivers

	Costs $	Activity Cost Driver	Activ Cost Driver: Prod.  A	Activ Cost Driver: Prod. B	Activ Cost Driver: Prod. C	Total of Activ. Cost Drivers
Engineering	450,000	Engin. hrs	10,000	15,000	11,000	36,000
Part Puchasing	500,000	Num. of  models	6	5	4	15
Setups	800,000	Num. of setups	400	120	130	650
Manufact.	3,000,000	Mach Hrs	60,000	120,000	100,000	280,000
Total	4,750,000

 

 

Table 5 - Calculation Overhead rate by Activity

	Costs $	Total of Activ. Cost Drivers	Overhead rate by Activity
Engineering	450,000	36,000	12,5
Part Puchasing	500,000	15	33,333,33
Setups	800,000	650	1,230,77
Manufacturing	3,000,000	280,000	10,7143
Total	4,750,000

 

 

After Multiplying the Activity Overhead rates by the Activity cost driver level per product as per the table 5, we have the following:

 

Table 6 - Overheads by Product according to ABC

	Overhead rate by Activity	Product A	Product B	Product C
Engineering	12,5	125,000	187,500	137,500
Part Puchasing	33,333,33	200,000	166,667	133,333
Setups	1230,77	492,308	147,692	160,000
Manufacturing	10,714	642,856	1,285,714	1,071,430
Total overh. Per Product		1,460,164	1,787,573	1,502,263
Ouput Units		10,000	30,000	20,000
Eng. Costs per Unit		12,50	6,25	6,88
Part Purch. Costs per Unit		20,00	5,56	6,67
Setup Costs per Unit		49,23	4,92	8,00
Manuf. Cost per Unit		64,29	42,86	53,57
Overheads per unit		146,02	59,59	75,12

 

Before to make a comparison between Volume-Based and Activity Based Full Costing, I find it useful to point out  two aspects of the ABC, to make this dissertation more clear:

1) The costs of the Activities are calculated by allocating the resource costs by using the most suitable drivers that express the demand for the resource from the activities,

This step has been omitted to make the article more fast and clear and because the description of all the steps of the ABC is not the purpose of this article, whose goal is highlighting the strategic aspects.

 

2) The “inventors” of the ABC assign the resource costs directly to the activities through a cross-departmental approach, by identifying some activity pools, each of them  having the same cost driver for the activities included and whose costs are then allocated to the cost objects.

That is a different way from the Volume-Based Costing that as a first step of the overhead allocation passes through each costing center.

In my opinion, the mapping and the evaluation of the activities per costing center is in any case important to holding the respective manager accountable for the center efficiency and for a fairer allocation of the indirect costs that should express a better basis to the manager performance evaluation purposes.

 

Now we can proceed to the comparison between the costing methods.

 

Table 7 – Comparison between the two Industrial Profits by product unit

	Volume-Based Full Costing			ABC
	Product A	Product B	Product C	Product A	Product B	Product C
Price	500	350	440	500	350	440
Unit Manufacturing Cost:
Labour	200	150	180	200	150	180
Materials	100	70	100	100	70	100
Factory Overheads	101,79	67,86	84,82	146,02	59,59	75,12
Total Cost per unit	401,79	287,86	364,82	446,02	279,59	355,12
Industrial Profit	98,21	62,14	75,18	53,98	70,41	84,88

 

 

At this point we see the profitability order has been nearly inverted by the ABC evaluation.

1.       PRODUCT C
2.       PRODUCT B
3.       PRODUCT A 

 

WHY?

 

Because of the change to the criteria  that apply the causality principle on the basis of which the real causes of the resource absorption are considered when attributing the overheads to the product families via activities.

With the Volume-Based method the overheads are allocated through a single cost driver, the mach. hrs in this case, and this brings about the so-called cross subsidization, that is the product that recorded the higher number of that volume measure is charged with the heaviest burden of indirect costs.

In other terms, no realistic difference in the resource consumption by the activities and then in the activity consumption by the products is considered, differently from the ABC.

 

What are the implications of the use of the Volume-Based Costing when the activities vary largely according to the product?

 

Here are some examples:

- Investment decisions into products that, by using Volume-Based costing, are considered erroneously the most profitable or to an extent not true at all.

- Erroneous pricing and that is vital because you set a price not assuring a good margin to cover as you want all the costs estimated.

In both the cases, you achieve a smaller area of profit for the firm.

- Erroneous Inventory evaluation.

- Other internal consequencies are the behaviour of some managers that aren’t very motivated to control some kind of costs because they are held responsible  just on the basis of a volume measure and the result is an increase in the whole business overheads

Just as an example, a dpt manager could require several maintenance interventions  and not caring about the respective costs  charged to him because in any case the allocation is  made on the basis of the mch. hrs or labour hours over which he has  not much influence.

On the other side, there could be some other dpt managers requiring very few maintenance interventions charged with a similar amount of those costs!

 

Are there ways to see misleading overhead allocation prior to implementing the ABC?

 

Yes, there are some methods based on the deep knowledge of the internal and external activities and in particular on the verification of the presence of specific categories of business activities and of their extent that pave the way to the ABC application.

 

 

Which are those activity categories?

 

if you are interested to know more about it, Page Contacts on  www.thestrategiccontroller.com

 

One of the next publications on this website is due to be “The Way to spot the real profitability by customer”.