Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
The following questions were not part of the requirements in the case competition. The questions
could serve as the basis for the final question in the live presentations at the Annual Meeting. Also,
the suggested solutions might give you ideas as to what represents a more in-depth or insightful
analysis of the case, which may help judges evaluate the teams.
Additional possible questions
Question 2 could be revised to give a more directed focus by changing the wording as follows:
“Management of Customer Paint Shop used ABC to obtain a better understanding the “true” cost of the
products. Management is now working toward a more proactive approach to capacity utilization, and
TOC costing has been suggested and some additional cost analysis was done. Discuss the potential
strategic value of the ABC versus TOC cost information in making decisions about the use of existing
capacity.” This wording offers the opportunity to spend time focusing on ABC and TOC would allow the
instructor to avoid or delay dealing with RCA if desired.
Possible solution: TOC promotes focusing on the contribution margin per unit of scare
resource, but this approach to managing a scarce resource would be a short-term approach to developing a
Also, TOC is not a panacea. For example, TOC looks at the constrained resource while a technique like
JIT looks to improve all processes, not just the process related to the constrained resource. The JIT
approach allows for a deeper understanding of all processes and their interrelationships that may not be
gained from a strict TOC approach. Thus potentials for uncovering opportunities may also be missed
from a strict TOC approach. Also, TOC takes only a short-term view of capacity utilization, whereas a
process like activity-based costing takes a longer-term perspective.
Other possible questions:
The case states the change to ABC “was made to better understand the costs associated with
painting the various products.” How effective is ABC in supporting such an objective as compared to
TOC and RCA. This question changes the context of the comparison to highlight that different tools
might be preferred for different purposes and reinforce the need to understand more than one costing
concept in order to be able to decide when a tool might be most effective.
The instructor could ask the students to identify the characteristics that make an organization’s
processes a candidate for the use of RCA and comment on whether PPS meets each of those
characteristics.
Possible solution: Grasso (2005, p.16)
The approach assigns resource elements to resource centers using the following criteria
1. The center must have an identifiable, measurable output and identifiable, separable costs specific
The paint booths along the conveyor line display these characteristics, making PPS a candidate for RCA.
References
Grasso, LawrenceP., 2005, Are ABC and RCA Accounting Systems Compatible with Lean Management?,
Management Accounting Quarterly, Fall, 2005, Vol. 7, No. 1, pp.12-27
Johnson, H. Thomas, Relevance Regained: From Top-down Control to Bottom-up Empowerment, Free
Press, New York, NY, 1992, p.139.
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
Keys, D. E., and A. Van der Merwe. (2002). Gaining Effective Organizational Control with RCA.
Strategic Finance. May 2002, pp. 41-47.
Keys, D. E., and A. Van der Merwe. (1999). German vs. United States Cost Management. Management
Accounting Quarterly. Fall 1999, pp. 19-26.
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-4 Forest Hill Paper Company
1. What is the competitive environment facing FHPC? What is and/or should be FHPC’s
competitive strategy?
Questions to generate discussion:
1. What is the competitive strategy of the company? What should it be? (Of the industry?)
2. How would you change the competitive strategy of the company? What is the role of cost
information in determining the strategy of the company?
GO TO QUESTION 2 and come back to this…..
Reduce product variety
Batch size
Slitting, or charge appropriately for it
Reduce the number of grades
The industry
Paper products, generally a commodity cost leadership
“Capital intensive, mature industry” cost leadership
overhead is 105% of materials cost
Very cyclical; down in the 1980s and early 1990s, at present demand exceeds supply
Effect on customer order pattern; exaggerates swings in demand
Importance of the cost/management of unused capacity
Firms in the industry do not readily increase capacity
FHPC market share down from 35 to 25%
Customers move to plastic and environmentally sound products (where is FHPC
In these products??) cost leadership
Paperboard manufacturing is a continuous process; hard to trace costs to individual
units of output; also this points up speed (cycle time) as a key cost driver
Producers cannot control prices; “selling price reflect spot market prices,”
cost leadership
The company
Focus on full range of products – 19 different grades of paperboard; also
widths (slitting) and coatings.
Focus on offering special services (slitting) differentiation???
Wide range of batch sizes
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2. Describe FHPC’s current costing system, and explain the type of costing system you would
recommend for FHPC and why. For products A, B, C and D shown in the case, what are product
costs using the current and your recommended costs system?
Overall cost problem: We have 4 batches, one each of products A,B,C and D; there are several
reels of product in each batch. What is the cost per reel, cost per batch and total production cost?
Gross margin per batch?
Note, you cannot focus your costing on reels only, because you would miss the importance of batch
level costs (grade change and slitting) and the influence of these batch related costs on total costs.
Good starting questions:
1. What are the cost drivers in this case
2. Just looking at Exhibits 1 and 2, which products do you think will be over costed with the current
costing system and why?
Product B has so few reels, so batch costs of grade change will strongly effect it
Product D has a large number of reels per batch, and no slitting, it is over costed.
3. How would you describe the current cost system
4. Show the current cost per reel and per batch of the current cost system
5. What are the activities in the ABC system
6. Show the costs under the ABC system
Cost Drivers
Volume: how do we measure it??? The firm uses tons of materials in costing, feet in
pricing
Tons of materials, or
Linear feet of paperboard produced
Grade; a combination of both:
Slitting
Not included in the case….
Cycle time (because it is a continuous process industry and there is now excess demand)
Quality of raw materials
Effectiveness of scheduling so as to reduce the cost impact of grade changes
Current Cost System
Slitting cost is shared among all grades of paperboard; customers are charged a small
amount for slitting (presumably not enough to recover the cost of slitting)
Volume based drivers are used – materials cost, with the idea that thicker material takes
longer to process (slower machine rate) and longer to dry
overhead rate = 105% x materials cost
Note however (not in case) that while tons of materials produced drives costs, the
industry practice is to set price by linear foot
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Calculating the FHPC Overhead Rate (One Step)
First, total materials cost
• Product A 50 x $4,800 = $240,000
• Product B 2 x $5,200 = 10,400
• Product C 35 x $5,600 = 196,000
• Product D 175 x $7,400 = 1,295,000
Total $1,741,400
Second, the overhead rate
Total Overhead Costs $ 1,828,470
Total Materials Costs $ 1,741,400
= $1.05 per dollar of materials cost
(or 105% of materials cost)
Third, Overhead Cost for Product A per reel:
$4,800 x 1.05 = $5,040
Total Cost for Product A per reel
$4,800 + $5,040 = $9,840
One Step Cost per Batch = 50 x $9,840 = $ 492,000
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ABC Costing – Product A
First, Overhead rate for Other Overhead:
Total Other Overhead Costs $1,586,470
Total Materials Costs 1,741,400
= .911 per $ of direct material
Second, Overhead for the Two Activities, per reel
• Slitting $2,294
• Grade Change $11,750/50 235
Third, Total Cost for Product A per reel
• Materials $4,800
• Overhead
• Other OH $4,800 x .911= 4,373
• Slitting 2,294
• Grade Change $11,750/50 235
• Total Overhead 6,902
Total $11,702
Compare to One Step solution of $9,840
Also,
ABC cost per batch = $11,702 x 50 = $585,100
ABC Cost per Batch of Product A, figured directly
Materials $4,800 x 50 $240,000
Overhead
Other $240,000 x .911 218,640
Grade Change 11,750
Slitting $2,294 x 50 114,700
Total Cost per batch $585,090
(small difference due to rounding)
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
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Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
Key points from ABC Analysis
1. Products A,B, and C are more costly than thought, because of the high cost of grade change (has to
be averaged over the number of reels, smaller for A,B, and C) and the high cost of slitting (for A and
C). Note that the grade changes are made between batches, while slitting is done for each reel,
so the effect of the slitting is potentially much greater than the effect of grade change. This does not
2. Gross margins after ABC are much smaller for A, B and C, and B’s gross margin is negative. Need
to consider the pricing issues for B and whether we can make this product more profitable.
3. How should we use the ABC information in pricing, in planning, and in performance evaluation?
Increase the price of B
ABC information is better for planning which products to drop, keep or add
ABC information is better for performance evaluation
4 How would you change the competitive strategy of the company? What is the role of cost
information in determining the strategy of the company?
Reduce product variety
Batch size
Slitting, or charge appropriately for it
5. How would analysis of the value chain help FHPC meet its strategic goals?
Look for ways to add value and reduce costs
Are shipping costs high; how to reduce them?
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