Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
The following points should come out in the discussion:
Segment Net income declines because SG&A allocation to segment was too low under
the Sales dollar method.
Marketing costs (price promotions, merchandising, shipping and SG&A) now total
$13,125,000 – 44% of sales and 530% of net income.
The Shops segment has 20% of the sales and 71% of the net income.
The ABC analysis provides information that wasn‘t available with an arbitrary allocation.
It also shows how to determine cost drivers for marketing costs.
3. What recommendations do you suggest based on ABC analysis?
Clearly, Shops and Impulse locations are very different in their costs and needs. Students should
recommend different approaches for Shops and Impulse.
The largest cost issue is SG & A. The discussion should cover several questions. How can you
reduce the time spent on Impulse and increase the time spent on Shops? How much time is spent
on servicing Impulse? How can you alter sales force time? Is this allocation fair? The salespeople
call on the Impulse locations for other products. What is the added cost of their time? Can we
reduce the extra time? For example, some of their time is spent on servicing machines. It would
be preferable to get someone else to do that such as the distributors who supply the machines.
How can the sales force better service the shops?
The second largest cost is shipping. Impulse is getting a lot of product. Is there a more efficient
Finally, Merchandising œ customers aren‘t happy. Shops want different, more elaborate
support than Impulse. Can support be tailored to shops? Shops are willing to pay for
merchandising. Impulse needs smaller, less costly, merchandising.
Price Promotions are very costly. Do they have to be available to all? Can that be changed now
that they know about them?
What really happened after the analysis?
The ABC analysis showed that the company was inadvertently harvesting the market in
shop sales. Given the new ABC of the two segments, General Mills went to the market
with a significantly new approach.
In the impulse segment: General Mills had devoted too much sales time and effort to this
segment and that was driven by the fact that the merchandising required too much field support.
The sales people were being turned into technical service people. General Mills simplified the
merchandising and distributed it via direct mail rather than having sales people deliver it. This
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impulse accounts that were believed to sell soft-serve rather than hand delivered by sales people
to only a few hundred locations. Finally, customers were given the name of soft-serve
equipment dealers to deal with any equipment issues. Sales time in the Impulse segment was
expected drop from $3.22 per case to $1.96 per case. These changes were expected to reduce
costs but not volumes.
In the Shop Segment: The shop business changes were a bit riskier. General Mills created a
special sales team to cover the market. They identified 1,500 yogurt shops that they wished to
rebuild a relationship with. A nine-person inside sales team with yogurt shop experience (both
shop and classroom training) was created. This sales team phoned each of the 1,500 shops at
least once a month. General Mills also moved three of the strongest soft-serve field sales
people (with foodservice operations experience) to positions where they could make face-to-
include a strongly differentiated offering and the line was extended to include smoothies. The
shop business was removed from the incentive calculations for the rest of the field sales force
and they were told that they were not responsible for the shop business. While the shop
changes would decrease shop profitability in the plan year, General Mills expected to halt
volume declines and possibly increase volume with the new offerings.
Brooks, R. 1999. Unequal treatment: Alienating customers isn’t always a bad idea, many firms discover.
Wall Street Journal (January 7): A1.
Cooper, R. 1987. Does your company need a new cost system? Journal of Cost Management (Spring): 45–
49.
———, and R. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting
Horizons 6 (3): 1–13.
Horngren, C., G. Foster, and S. Datar. 1999. Cost Accounting: A Managerial Emphasis. Upper Saddle
River, NJ: Prentice Hall.
Kaplan, R., and R. Cooper. 1997. Using Activity-based Costing with Budgeted Expenses and Practical
Capacity. Harvard Business School Case 9-197-083. Boston MA: HBS Press.
Platt, D., and K. Towry. 2001. Pecos products: A project introducing complexity into the study of activity-
based costing. Issues in Accounting Education (February): 99–124.
Tabor, R. H., and S. D. Stanwick. 1996. Instructional case: Griffen textile company. The Accounting
Educators’ Journal (Fall): 122–145.
U.S. Bureau of the Census. 1999. Statistical Abstracts of the U.S. 1999. Washington, D.C.: Government
Printing Office.
Wisner, P. S., and H. P. Roth. 1998. Metalworks company. Issues in Accounting Education (November):
1043–1057.
5-3 Alternative Costing Methods: Precision Paint Shop’s Dilemma
Synopsis and guidelines for instruction
Precision Paint Shop is a privately held custom painter of automotive components. Raw
metal parts are received on consignment from the customer, finished with the desired
application(s) of paint, and shipped back to the same customer. The product lines consist of a
large number of combinations of various types of coating, paint finishes, and paint colors. The
company had recently implemented an ABC system because demand had been significantly
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
increasing, especially in the higher-grade coatings, but profits were declining and management
could not understand why.
The labor intensive paint process involves a monorail conveyor line that moves at line
speeds of between 10 and 18 feet per minute, depending on the coating applied and part shape
(complexity). The conveyor is being fully utilized, representing a capacity constraint, and giving
rise to questions about the current ABC costing system for making decisions about the use of this
strategic resource.
This case is not a “number crunching” case, and requires the students to have at least
some basic understanding of the role of strategy in managing an organization. It also requires an
basic understanding of capacity constraints, and different types of decisions that cost information
can support.
The entire case can be covered in one 60-75 minute class session, and can be used in an
undergraduate cost accounting course, in an introductory management accounting course at the
MBA level, or a cost analysis course in an MBA or MSA curriculum. Time constraints during a
semester and the requisite level of background knowledge probably make this case inappropriate
for an introductory managerial accounting course at the undergraduate level.
Objectives:
The value of cost information comes from how management uses it, and the effective use
of costing information is strategically important to an organization. This case is designed to help
students:
Understand strategic cost analysis and the role of costing systems in support of strategic
decision making.
Recognize the existence of alternative costing methods and the need for management to
evaluate these methods in light of a particular type of decision. In this case ABC, TOC,
and RCA are being considered in a job-shop environment.
Recognize strategic resources and use costing information to support decisions to
proactively manage the demands on a constraint to help improve the chances of survival
and success.
Required Questions (from case competition)
1. Distinguish between traditional cost analysis and strategic cost analysis.
2. Management of PPS used activity-based-costing (ABC) to obtain a better understanding the
“true” cost of the products to help make better pricing decisions. Management now wants to be
more proactive in the use of costing information to help develop and implement organizational
strategy in an environment where the demand exceeds current productive capacity. The company
has an ABC system, but throughput costing based on Theory of Constraints (TOC) and Resource
Consumption Accounting (RCA) have been offered as alternatives. Discuss the potential
strategic value of the ABC versus TOC versus RCA cost information in making strategic
decisions in such a capacity constrained environment.
Suggested solution
1. Distinguish between cost analysis and strategic cost analysis.
While traditional cost analysis has been viewed as a process of assessing the financial
impact of alternative managerial decisions, strategic cost analysis (SCA) is a process of
developing cost information that aids managers in making strategic choices. The primary utility
of a strategic cost system is that it can provide valuable insights of the firm’s operations and be
used to help formulate or assess overall business strategies. The utility of a strategic cost system
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difference (value added) between purchases and sales. Also, a conventional costing analysis is
usually volume-based, which means that indirect costs are allocated using a base that is a function
of production volume.
In the case we are told the change to ABC “was made to better understand the costs
associated with painting the various products” and there was no apparent regard for strategic
support. SCA is a process of developing cost information that aids managers in making strategic
choices, with attention directed to maximizing the use of strategic resources. There is an effort to
examine the relationships between the cost of providing a product or service and the value
delivered. SCA relies on a good understanding of the underlying causes of costs. A basic part of
the process is identification of output characteristics that relate to strategy and drive the activities
decisions involve capital equipment investment, hiring of employees of certain skill levels and
pay rates, etc. Structural drivers can be changed, but only with a fundamental change in the way
the organization chooses to compete. Executional drivers, on the other hand, relate to the way
management makes use of the structural components and includes such factors as product/process
design, quality control, and capacity management. Some of the other characteristics of strategic
cost analysis are:
SCA focuses on strategic choices and the costs that are relevant to their analysis. The
1. Increased complexity in manufacturing/production processes (e.g. flexible manufacturing
cells, JIT, TQM) and expanded product lines increase the difficulty of tracing costs to specific
diversity; thus, profits earned on various processes or products can be distorted.
2. With increased competitive pressures, increased accuracy in costing products is required.
Cost analysis is extended beyond traditional product costing to service and support areas
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SUMMARY OF KEYS POINTS FOR QUESTION 1
Traditional cost analysis
oviewed as a process of assessing the financial impact of alternative managerial
decisions
oprimarily focuses on activities within a firm itself in attempting to maximize the
difference (value added) between purchases and sales.
ousually volume-based, which means that indirect costs are allocated using a base that
is a function of production volume.
Strategic cost analysis
oa process of developing cost information that aids managers in making strategic
choices.
oan effort to examine the relationships between the cost of providing a product or
service and the value delivered.
orelies on a good understanding of the underlying causes of costs and identification of
output characteristics that relate to strategy and drive the activities of the
organization.
otakes a long term view of the organization and should look beyond
manufacturing/production costs.
SCA looks at two types of cost drivers
Structural components relate to the scale and scope and technology of the production
environment.
Executional drivers, which relate to the way management makes use of the structural
components.
2. Management of PPS used ABC to obtain a better understanding the “true” cost of the
products to help make better pricing decisions. Management now wants to be more
proactive in the use of costing information to help develop and implement organizational
strategy in an environment where the demand exceeds current productive capacity. The
company has an ABC system, but throughput costing based on Theory of Constraints
(TOC) and Resource Consumption Accounting (RCA) have been offered as alternatives.
Discuss the potential strategic value of the ABC versus TOC versus RCA cost information in
making strategic decisions in such a capacity constrained environment.
In “Finding the Right Mix”, Krumwiede and Charles (Strategic Finance, April 2006)
report on the a survey that matched management practices to firm strategy and concluded that no
management practice is equally suitable to every organizational strategy. The same could be said
for TOC, ABC, and RCA. That being said, one way to address strategic value is to first
understand the focus or emphasis of these alternative costing methods. It would be fair to assume
that the students should be able to provide a brief description of each method.
If we accept that PPS has reached it capacity limit, the objective is to optimize the use of
the constrained conveyor resource by maximizing the profit generated by using the resource.
Drawing of theory of constraints (TOC) concepts, efforts should focus on increasing the capacity
of this constraint, like reducing the already short (5 minute) set-up time or reduce the number of
set-up needed. Another possibility is to hire temporary workers, but there is already idle labor, so
temporary workers will not help solve their problem. Outsourcing some of the work is not an
option since the physical painting would have to be outsourced to another paint vendor, which
would simply support a competitor.
A key point is that effective capacity utilization requires both a short-term and long-term
strategic focus. In the short run, the goal is to make optimal use of the resources currently
available, so management may take the short-term view of maximizing use of constraints on a
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continuous basis. TOC is a way to accomplish this objective by matching the use of the firm’s
resources with market opportunities, but a strictly short-run view of capacity utilization could be
a problem.
In practice, TOC accounting is similar to variable costing, and like variable costing,
“Emphasis is placed on short-run differential or incremental costs rather than on long-run full
costs” (Usry & Calvasina, p. 8) The difference is that TOC accounting treats materials as the only
variable cost, and arbitrary allocations are avoided by not doing any allocations or applying all
operating costs to the constraining resource. TOC emphasizes maximizing throughput per unit of
time. Non-bottleneck resources are allowed to remain idle because excess production creates
unnecessary inventory.
TOC is a short-term focused tool that considers direct materials and energy to be the only
product cost. While this approach promotes greater pricing flexibility, it does not consider fixed
costs to be product costs. This means that TOC is short-term focused and is much like the
contribution per unit of scarce resource model. The problem comes from the fact that so-called
fixed costs have increased as a percentage of total costs because of organizational complexity,
which is a function of product and operational diversity (including logistical and customer
support).
Looking to the facts, the case tells us four factors: shape, size, coatings, and color,
determine job complexity and it is the job complexity that drives up the demand for line capacity.
For example, large parts take up more space on racks, therefore more racks are needed, and fewer
parts can be painted simultaneously. Shape of part to be painted determines loading and
unloading times, space on rack, number of parts on rack and also on the conveyor belt. (E.g. a
bumper is easier to paint than a luggage rack as there is more uniform surface area.) Coatings
(high or low gloss) vary in first pass yield. The production scheduler must consider these factors,
so maybe they could take a more strategic approach to bidding by offering price levels that can
fluctuate based on promised delivery time. Such a bidding approach would have to consider
more than just the variable costs of production, and ABC attempts (ideally) to assign costs
associated to making a product to that product, including fixed costs.
ABC is a full costing model in that all costs of performing an activity are assigned to the
activity, and eventually to a cost object based on the use of selected cost drivers. Through this
process, ABC analysis draws attention to the full cost of a product by estimating the long-term
costs of products over their life. The long-term costs of resources are assigned to cost objects
based on consumption through the use of drivers. So, while TOC may dictate taking any price
that exceeds the cost of direct materials, ABC helps set a price that covers the long-term costs of
the organization.
While the ABC analysis indicates the cost and related profitability of products, the
results of the ABC analysis may cause management to move in the wrong direction. ABC
measures consumption of the cost drivers, which relate to the resources consumed in the
production process. The underlying resources exist in limited quantity (capacity), but the ABC
analysis does not explicitly consider that the quantity of resources demanded and capacity of
resources supplied may not be equal. Since unused capacity is often not identified, its related
cost is assigned to all cost objects that place any demand on the resource with the excess capacity.
Such an approach can re-introduce the death spiral often attributed to traditional costing methods.
The ABC cost information is not irrelevant, however, for the ABC information has
already served two purposes: directing management’s attention to the varying demand products
places on various resources and a refined calculation of the profit each product generates. What
remains is using the information to make strategic decisions.
ABC and TOC can be complementary; while ABC is an accounting model, TOC is a
manufacturing philosophy. TOC may be able to tell you what to make today, but is the day’s
production in line with long-term objectives? Many units pass through booths 3 and 4 but do not
receive and treatment in those booths, which cuts into available capacity because the items stay
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on the conveyor than necessary. TOC does not assign any cost to units. Should PPS try to attract
business that makes use of those booths or get rid of them and shorten the conveyor line modify
the conveyor line into the shape of a “Y” which would allow them to divert some units directly to
the oven and bypass booths 3 and 4? The ABC information may provide the answer.
ABC is a main source of information for ABM, and the identification of cost drivers can
help identify areas to target for improvement – which has a direct relationship to TOC because of
the focus on managing activities. ABC, in conjunction with ABM can effect changes in activity
that can reduce consumption, but there may be a time lag before spending follows usage. Also,
ABC is a model based on consumption rather than spending so it can help analyze the cost of
used versus unused capacity. With its process-improvement focus, TOC can be useful in
identifying waste, which ABC calls non-value-added activities. Identifying and reducing waste at
constrained resources elevates the constraint and reduces costs. (As an aside, in this case we have
only focused on demand for the conveyor line capacity. TOC tells us it is possible to expand the
capacity of a bottleneck to the point where the limiting constraint moves to a different resource.
The ABC information can be combined with capacity information for various resources and a
linear programming model can be developed to maximize the total profit given the various
capacity limitations.)
ABC has the advantage of allocating costs through the use of a wide variety of cost
drivers. Setups, maintenance, and rework are all activities that support the creation of acceptable
products. Over the long-term, the product should be priced to recover these costs. In its
traditional form, however, ABC has not distanced itself from the full costing approach because
the calculations are based on the cost of resources available and does not illuminate hidden waste.
A move to capacity adjusted ABC takes the capacity of the resources into account and can
highlight the cost of unused capacity, but capacity is acquired in lumpy amounts and ABC does
not adequately model this situation. Resource consumption accounting, however, has provided
some new notions to solve these problems.
RCA is a comprehensive, integrated cost system that can provide an identification of cost
affected by decisions at different management levels. Most notably, RCA has a strong planning
emphasis that can be beneficial in a proactive culture, and allows management to integrate
prospective and actual results into the organizational control system.
According to Keys and VadDer Were (1999), RCA provides managers with cost
information for short-term and long-term time horizons and for tactical and strategic decision
making. While drawing a clear distinction between resource cost drivers and activity drivers, a
RCA system can use both types of drivers in tandem. As Van Der Merwe and Keys (2001, pp 31-
32) summarize: RCA effectively addresses some of the shortfalls of the ABC perspectives on
resources by:
1. Providing the resource output measure as a consistent and uniform
measure of resource capacity.
2. Accurately accounting for short- to medium-term fluctuations in capacity
use and delineating the excess or idle capacity variance to ensure that it
is visible and actionable by management.
3. Accurately expressing resource interrelationships by reflecting causal
relationships in resource output quantities.
4. Unambiguously tying the nature of cost to the strategic timeframe and
objectives of the enterprise and accommodating the different demands
for operational, tactical, and strategic decision support effectively by
using a single source of information.
Keys and VanDer Merwe (2002) offer the RCA cube and an alternative to the ABC cross
to overcome their perceived weaknesses of the ABC/M model. The RCA approach explicitly
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
considers the operational information needs of line managers, the tactical information needs of
middle managers, and the strategic information needs of top management.
From a control perspective, RCA provides input-side and output-side variances, which
reflect whether variances are caused by resource acquisition issues (resource cost and quality),
process issues (scrap and quantity variances), and production (lot size and production volume
variances).
From a planning perspective, RCA explicitly accounts for idle capacity while Activity
based budgeting (which uses ABC as its foundation) does not adequately handle idle capacity.
PPS dos not have an idle capacity for its key resource (the conveyor line) so RCA may not offer
any distinct advantage in this regard. RCA does, however, more accurately reflect the underlying
nature of a cost’s behavior and activity-based-budgeting (ABB), which would certainly have
implications for planning purposes.
Keys and VanDer Merwe (2002) point out the following advantages of RCA over ABB.
Accuate projections of monetary equivalents based on activities and outputs
Ability to reconcile supply of resources with their demand
Better information for incremental resource investment decisions
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
Highlights some of the key characteristics of the three methods.
TOC ABC GPK/RCA
A production philosophy that provides
insights into manufacturing process and how
resource consumption and capacity impact
Models the economic aspects of how resources
are transformed into products.
Attributes cost of excess capacity to person
responsible for influencing the level of resource
Ignores cost allocations Aims at allocating all the costs required to
produce and market a product in the long run.
Applies the marginal costing principle and,
accordingly, allocates only variable costs to
products.
Does not explicitly assign responsibility for
Responsibility for costs lies with process
Responsibility for costs lies with cost center
produce be dropped as unprofitable
design and production
an additional order based on contribution
margin information
Information is typically held outside of the
main financial accounting system.
Information is typically held outside of the main
financial accounting system. Activity management and financial
management become one and the same thing
Creates a large number of cost centers and
marginal benefit.
for product design and log-run production
programs, yet long-term investment decisions
decisions, primarily for short-run production
decisions as well as short-run pricing,
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
actually require net present value analysis. particularly for manufacturing companies.
Resource consumption is focal point.
Activity as the locus of control. Does not
identify constraints that lead to delays, excess,
and variations in the production process
analysis; Capacity, consumption, planning, and
control all focus on the organization’s resources
20-26.
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