Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-42
5-47 (continued –1)
2. The additional business with AS would leave very little unused
capacity(less than 3%) as shown below:
Total Calls
Answered
Avg. No. of
Minutes/
Call
Total Time (minutes)
Inquiries
Autos
Trucks
Total
Inquire re: Rates and
Terms
Autos
96,000
5
480,000
Trucks
32,000
7
224,000
Inquire re: Loan App Status
Autos
37,500
6
225,000
Trucks
6,750
11
74,250
Inquire re: Payment Status
Autos
39,000
3
117,000
Trucks
12,000
4
48,000
Inquire re: Other Matter
Autos
29,000
11
319,000
Trucks
8,500
15
127,500
Total
1,141,000
473,750
1,614,750
Processing Credit Checks
Auto
45,600
10
456,000
Truck
12,500
18
225,000
Total Processing Minutes
456,000
225,000
681,000
Total Minutes for the Combined
Engagement
2,295750
9,499,421
11,795,171
249,829
12,045,000
The cost of the unused capacity could be determined as follows:
$.78/min × 249,829 minutes = $194,867
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-43
5-48 Personnel Planning; TDABC(30 min)
1. Unlike a manufacturing company, almost all costs for a service company
are indirect in nature. Almost all of these costs are supplied in advance;
short-term spending is generally not affected by fluctuations in demand or
produce/service mix. Thus, traditional accounting practice is to view such
2. As indicated in the text, two items need to be estimated for each
department or process in conjunction with a TDABC model: (1) the unit
cost of supplying capacity for the department or process in question (this
is also referred to as the capacity cost rate), and (2) the consumption of
capacity (i.e., an estimate of how much capacity (measured, generally
speaking, in terms of time) by activities performed. As to item (1), we
3. and 4.
Claim information
Remote
Processing
On-site
Processing
Total
Processing time/claim
0.50
1.00
Customer record maintenance/claim
0.20
0.20
Total time per claim
0.70
1.20
× Number of claims
1,900
2,900
4,800
Total hours needed
1,330
3,480
4,810
× Capacity cost per hour
$ 51
$ 51
Budgeted support costs
$ 67,830
$ 177,480
$ 245,310
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-44
5-48 (continued –1)
5.
Claim information
Remote
Processing
On-site
Processing
Total
Processing time/claim
0.50
1.00
Customer record maintenance/claim
0.20
0.20
Total time per claim
0.70
1.20
× Number of claims
2,700
2,000
4,700
Total hours needed
1,890
2,400
4,290
× Capacity cost per hour
$ 51
$ 51
Budgeted support costs
$ 96,390
$ 122,400
$ 218,790
Note that the capacity cost per hour is unchanged because 3 workers are still needed to handle the
demand. (1 worker has about 1,667 hours of capacity, which is 5,000 hours ÷ 3 workers, so 4,290 hours
needed ÷ 1,667 = 2.6 workers).
6. As noted above in response to Requirement 1, many support costs are
short-term fixed costs, related to the supply of capacity/service. Thus, after
companies institute cost-saving measures or process improvements in
response to ABC-based data, there might not be immediate financial
7. The underlying theory is that when cost-allocation rates are estimated in
conjunction with an ABC system the denominator volume level should be
consistent with the numerator (resource spending). That is, the numerator
represents the dollar amount of resource cost for a given activity (e.g.,
claims processing). The denominator should logically be measured as the
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-45
5-48 (continued –2)
terms of bringing the demand for and supply of resources in each
support area (process).
5-49 Assessing Customer Lifetime Value (45 min)
1. The primary issue addressed in the article is the effort to boost the
total value of each of the firm’s customers.
2. Customer lifetime value is the estimate of how much a customer is
expected to spend on a company’s products and/or services for some
designated time, less the cost of marketing to that customer. Customer
referral value is an estimate of the lifetime value of a customer that
would not otherwise have become a customer if the referral had not
exceed the spending of any one customer that made the referrals.
3. Customer referral value is more difficult to estimate because of the
number of variables involved. In addition to estimating the expected
lifetime value of each referral, the number of successful referrals must
also be estimated. This entails estimating how many new customers
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-46
5-49 (continued –1)
4. The customer value matrix is a method of categorizing the
organization’s customers based on their value to the firm. Since the
authors found that CLV is not a good predictor of CRV, it became
necessary to capture these two different dimensions of a customer’s
5. The determination of CLV and CRV both require the ability to identify the
resources directed toward the acquisition and retention of customers.
This fundamental requirement matches up with the underlying theme of
5-47
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5-50 Volume-Based Costing vs. ABC (30 min)
1. Current Costing System – Direct-Labor-Hour Based
Overhead rate = Budgeted overhead ÷ Budgeted direct labor hours
Overhead cost allocation:
Cost per capsule:
Diomycin
Homycin
Addolin
Direct labor-hours
7,200
6,800
2,000
Overhead rate
$12.50
$12.50
$12.50
Total overhead
$90,000
$85,000
$25,000
Diomycin
Homycin
Addolin
Direct Materials
$205,000
$265,000
$258,000
Direct Labor
250,000
234,000
263,000
Overhead:
90,000
85,000
25,000
Total Cost
$545,000
$584,000
$546,000
Packets produced
1,000,000
500,000
300,000
Cost per capsule
$0.545
$1.168
$1.820
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
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5-50 (continued-1)
2. Overhead rates for Activity-Based Costing:
Activity
Cost Driver
Budgeted
Overhead
Cost
Budgeted
Cost Driver
Volume
Overhead
Rate
Machine setup
Setup hours
$ 16,000
1,600
$10.00
Plant management
Workers
36,000
1,200
$30.00
Supervision of
Direct labor–
46,000
1,150
$40.00
Quality inspection
Inspection–
50,400
1,050
$48.00
Expediting orders
Customers
51,600
645
$80.00
Total overhead
$200,000
Overhead Costs Assigned to Products Using Activity-Based Costing:
Overhead
Rate
Diomycin
Homycin
Addolin
Driver
Volume
Applied
Overhead
Driver
Volume
Applied
Overhead
Driver
Volume
Applied
Overhead
Machine
setup
$10
200
$2,000
600
$6,000
800
$8,000
Plant
management
$30
200
$6,000
400
$12,000
600
$18,000
Supervision
of direct labor
$40
200
$8,000
300
$12,000
650
$26,000
Quality
inspection
$48
150
$7,200
200
$9,600
700
$33,600
Expediting
production
orders
$80
45
$3,600
100
$8,000
500
$40,000
Total
$26,800
$47,600
$125,600
5-49
5-50 (continued-2)
Cost per capsule under Activity-Based Costing:
Diomycin
Homycin
Addolin
Direct Materials
$205,000
$265,000
$258,000
Direct Labor
250,000
234,000
263,000
Overhead
26,800
47,600
125,600
Total Cost
$481,800
$546,600
$646,600
Packets produced
1,000,000
500,000
300,000
Cost per capsule
$0.4818
$1.0932
$2.1553
3. Comparison of Product Costs Using Current Costing and ABC Costing:
Diomycin
Homycin
Addolin
Current Costing System
Overhead
$90,000
$85,000
$25,000
Cost per capsule
$0.5450
$1.1680
$1.8200
Activity-Based Costing system
Overhead
$26,800
$47,600
$125,600
Cost per capsule
$0.4818
$1.0932
$2.1553
products “subsidize” low-volume products in this case. Because of lack of
detailed costing information, ADA ends up undercosting Addolin ($1.82
under the current costing) and overcosting Diomycin ($0.545 under the
current costing).
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-50
5-50 (continued-3)
Activity-based costing provides ADA with more detailed and better
estimates of product costs. For example by using ABC, ADA becomes
aware that the cost of Diomycin is lower ($0.4818 per capsule compared
to $0.545 under current costing), meaning that it can set the price of
Diomycin lower and be more competitive. Also, ABC revealed how costly
Addolin is ($2.1553 per capsule compared to $1.82 under the current
costing). Thus, this opportunity would allow ADA to properly price Addolin
or if it is not profitable, stop producing.
From the schedule, activity-based costing assigns more overhead to
the lower-volume Addolin because the production of Addolin requires
more setups, inspection, supervision, formulation and management. The
current direct-labor-hours based costing system failed to assign costs of
all activities. As a result, Diomycin and Homycin subsidized Addolin.
The production department at ADA also benefits under ABC. ABC
profits by focusing on the high-volume products.
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
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5-50 (continued-4)
4. Among major uses of ABC in the Pharmaceutical Industry are:
a. Strategic Use of ABC to Reduce Costs
One of the important ways companies develop competitive advantages
is to become a low-cost producer. Many companies in the
pharmaceutical industry have learned to use the information they have
gained from their costing systems to make substantial price cuts to
increase market share.
b. Use of ABC to Eliminate Low-Value-Added Costs
ABC can be used to identify and eliminate activities that add costs but
not value to the products in the pharmaceutical industry. A company
can eliminate low-value added activities and costs without reducing
can be computed and the information used in making informed
decisions. For example, some of the different channels of distribution
in the pharmaceutical industry are: grocery stores, convenience stores,
pharmacy shops, each having different activities. The cost of
alternative channels of distribution is useful to marketing managers
who make decisions about which channel to use.
d. Use of ABC to Make Better Pricing Decisions
ABC enables managers to make better pricing decisions by providing
Chapter 5 – Activity-Based Costing and Customer Profitability Analysis
5-52
5-51 Environmental Costing (30 minutes)
1. Social and customer pressures, along with regulatory requirements have
caused organizations’ environmental costs to rise over the past few decades.
Environmental cost accounting or just environmental accounting addresses
the limitations of conventional accounting methods by incorporating both direct
and less obvious costs associated with environmental sustainability.
2. Some of the obvious environmental costs include:
Materials, equipment, and labor costs that can be readily identified from the
general ledger of an organization.
Some of the “hidden” or less obvious costs include:
investors
3. Both ABC and ABM require a clear understanding of processes. Therefore,
the process analysis step will help managers better understand the scope of
an environmental sustainability initiative. Once the process is understood, the