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Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
5-16
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
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
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 on the conveyor than
identify areas to target for improvement - which has a direct relationship to TOC because of the focus on
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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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
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
information.
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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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 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
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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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
production decisions
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
available, but does not allocate it to products
Tactical
Strategic/tactical – depending on its focus on
resource usage.
Strategic
Ignores cost of fixed resources
Uses historical cost
Uses replacement cost depreciation
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
costs
Responsibility for costs lies with process
owners across cost centers
Responsibility for costs lies with cost center
managers
Generally considers direct materials to be the
only truly variable cost
Tends to treat all costs as variable
Identifies and assigns costs as fixed or variable
Leads to setting low prices and rarely would a
produce be dropped as unprofitable
Focuses on long-term decisions such as product
design and production
Provides adequate information for short-term
decisions, such as a decision to accept or reject
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
Ignores cost centers
Attempts to handle multiple activities in a
single cost center.
Creates a large number of cost centers and
splitting and segmenting costs and activities
down to their primary elements.
Short-term perspective to obtain greatest
marginal benefit.
Long-term perspective gives recommendations
for product design and log-run production
Superior to ABC for making short-term
decisions, primarily for short-run production
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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programs, yet long-term investment decisions
actually require net present value analysis.
decisions as well as short-run pricing,
particularly for manufacturing companies.
Uses expected consumption of a limited
amount of capacity
Traditionally uses expected consumption, but
can use some capacity measure
Supports capacity analysis through the use of
theoretical volume cost rates
Tends to focus on subset of a process (the
bottleneck resource)
Addresses process owners across functions
Focuses on cost centers
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
Resources consumed are the focal point of the
analysis; Capacity, consumption, planning, and
control all focus on the organization’s
resources – not the activities performed.
Some of the material in this table was taken from Clinton, B. D., and S. A. Webber. (2004) RCA at Clopay. Strategic Finance. October 2004, pp.
20-26.
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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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,
given the production environment that management has put into place.
TOC may not be appropriate for all organizations, but there are some conditions that indicate
TOC may be useful: 1) frequent expediting and 2) large WIP inventory in terms of number of days sales.
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
4. The cost center’s size should be limited, and it should be geographically compact.
The paint booths along the conveyor line display these characteristics, making PPS a candidate for RCA.
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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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.
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.
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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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
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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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:
Caliper (thickness)
Coated/uncoated
Grade changes (see below re: scheduling) – scrap; almost ½ reel is lost after
each grade change (process instability); partially offset by recycling the
scrap paper
Scheduling; sequence runs for minor changes in grade
Batch size
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
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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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
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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ABC Costing - Product A
First, Overhead rate for Other Overhead:
Total Other Overhead Costs $1,586,470
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 $240,000 x .911 218,640
(small difference due to rounding)
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
One Step
Materials Applied Total Total Batch Batch
Average No. cost per Price per Total Direct Overhead Cost Cost Total Gross
Product Slit Reels/Batch Reel Reel Materials Labor* per Reel per Reel per Batch Revenues Margin
A y 50 4,800$ 12,600$ 240,000$ 5,040$ 9,840$ 492,000$ 630,000$ 138,000$
B n 2 5,200 13,500 10,400 5,460 10,660 21,320 27,000 5,680
C y 35 5,600 14,200 196,000 5,880 11,480 401,800 497,000 95,200
D n 175 7,400 19,500 1,295,000 7,770 15,170 2,654,750 3,412,500 757,750
1,741,400$ 3,569,870$ 4,566,500$ 996,630$
Overhead Total Grade Change Slitting Net
Depreciation 800,000$ 8,000$ 70,000$ 722,000$
Indirect Labor 300,000 3,000 25,000 272,000
Energy 500,000 5,000 80,000 415,000
Other 198,470 1,000 20,000 177,470
Unrecoverable Clay,.. 30,000 30,000 -
Total 1,828,470$ 47,000$ 195,000$ 1,586,470$
Overhead Rate 1.05 = Total overhead divided by total materials
*little or no direct labor, omitted from cost calculations
Chapter 5 - Activity-Based Costing and Customer Profitability Analysis
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ABC
Materials Total Total Batch Batch
Average No. cost per Price per Total Direct Grade Other Cost Cost Total Gross
Product Slit Reels/Batch Reel Reel Materials Labor* Change Slitting Overhead per Reel per Batch Revenues Margin
A y 50 4,800$ 12,600$ 240,000$ 235$ 2,294$ 4,373$ 11,702$ 585,103$ 630,000$ 44,897$
B n 2 5,200 13,500 10,400 5875 4,737 15,812 31,625 27,000 (4,625)
C y 35 5,600 14,200 196,000 335.71 2,294$ 5,102 13,332 466,606 497,000 30,394
D n 175 7,400 19,500 1,295,000 67.14 6,742 14,209 2,486,536 3,412,500 925,964
1,741,400$ 3,569,870$ 4,566,500$ 996,630$
Overhead Total Grade Change Slitting Net
Depreciation 800,000$ 8,000$ 70,000$ 722,000$
Indirect Labor 300,000 3,000 25,000 272,000
Energy 500,000 5,000 80,000 415,000
Other 198,470 1,000 20,000 177,470
Unrecoverable Clay,.. 30,000 30,000 -
Total 1,828,470$ 47,000$ 195,000$ 1,586,470$
ABC driver quantity 4 85 1,741,400$
ABC overhead rate 11,750$ 2,294$ 0.9110$
ABC Cost Drivers
Overhead Applied,per Reel
