Activity Base Costing Management by reh12199

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									MBA 710
Strategic Cost Management
Winter 2010
Dr. Dave Bukovinsky

ACTIVITY-BASED COSTING EXERCISE

PURPOSE:

The purpose of this exercise is to familiarize students with the application of ABC in non-manufacturing settings.
Specifically, this exercise involves applying ABC concepts to the analysis of customer profitability to allow managers to
make better-informed decisions regarding customer acquisition, retention, charging, etc.

REQUIREMENTS:

The following pages contain operating information for Tyler Industries, Inc., a fictitious distributor of industrial supplies.
Students are required to perform an activity-based costing analysis on the information and determine the profitability of
three of TII’s customers. Students will also respond to the following items:

1. In general terms, describe how ABC links costs with cost objects. What does this suggest about effective methods to
control costs?

2. Analyze each of the individual customers and make recommendations for how TII should deal with the customer.

3. In general, what steps could a company take to turn one of their customers who is not profitable to them into a
profitable customer? Do not confine your answer to the customers in this exercise.

4. In the Indianapolis case, the city used activity-based costing to streamline the process of patching potholes. Assume
the city also provides garbage collection services to businesses within the city limits and intends to begin billing
customers for the service based on the cost incurred to service each individual customer. Pick three activities or
measures that you think would be useful as second-stage cost drivers to determine the costs incurred to service
individual customers. Explain why your choices would be appropriate.


GRADING:

This project is worth 25 points. Grading will be based on the accuracy of calculations and the quality of the answers to
the analysis questions.

A NOTE ON EXCEL:

I have provided you with Excel templates to use in this assignment. Use them as Excel is meant to be used - enter your
formulas, etc. DO NOT download the templates and complete them in pencil or pen. You will not receive any points for
your calculations. You should not do the calculations on a calculator and enter the results in the templates, either. You
will undoubtedly be using Excel on the job, so if you don't know how to use it, now is a good time to learn.

DUE DATE:

Monday/Wednesday class - Monday, February 15th.
Friday class - Friday, February 19th.

BACKGROUND:
Tyler Industries, Inc. is a distributor of industrial supplies. The company has been in business since 1968 and has
experienced various levels of profitability throughout its history. The company has recently struggled through a couple of
unprofitable years despite having increased its customer base by 30% over the previous three years. Management is
concerned that the company may be “giving away the store” to attract new customers and increase its market share.
Consequently, management is interested in instituting an activity-based costing system to assist in the analysis of
individual customer profitability.

CURRENT PRACTICE:

TII currently sells its products at a standard markup of 50% over the cost of the items. Annual operating expenses have
been trending upwards, from approximately 25% of revenues eight years ago to approximately 35% currently. No
attempt is made to allocate these expenses to customers. Tyler’s condensed statement of operating income is
MOTIVATION FOR ACTIVITY-BASED COSTING:

TII’s management has recognizes that the standard 50% markup over cost of goods sold is no longer adequate to cover
the increasing operating expenses. Management has rejected the idea of increasing the markup percentage to cover
expenses. This decision is predicated on the belief that higher prices would drive away some customers and would
simply hide the fact that some customers are profitable to TII and others are not profitable. Management does not want
to risk driving away profitable accounts. Management’s gut instinct (and dealings with the customers) suggests that not
all customers should have the same profit percentages. Some customers are very “high maintenance” while others are
relatively easy to service. It is these inherent differences in the customers that motivated management to initiate an
activity-based costing system for profitability analysis.

DESIGN AND ASSUMPTIONS OF THE ACTIVITY-BASED SYSTEM:

Exhibit 2 provides a breakdown of TII’s operating expenses. Analysis revealed that merchandise costs could be (and
are) directly chargeable to individual customers. All other costs are service and operations support costs that cannot be
directly charged to customers. Discussions with employees and a review of operating activities identified nine major
activities which account for 5% or more of the employees’ time. All remaining activities are minor in nature and
consolidated into an “other” category.

Exhibit 3 presents the first stage allocation rates for the nine activity center costs. Employees were asked to estimate
how their time was spent, in increments of 5%. The results of the survey indicated that the sales staff spent 65% of their
time making sales calls, 5% negotiating contracts, etc. Allocation of wages was based on these percentages. Other
expenses were allocated to the various activities based on estimates of the amount of the expenses related to or
consumed by the activities. The “other” expenses were deemed to insignificant to allocate to individual activities and
were consequently charged to the “other” activity category.

The operating expenses from Exhibit 2 activity analysis percentages from Exhibit 3 are used to complete the first stage
allocation in Exhibit 4 (the first part of your assignment).

The allocation of the activity costs to individual customers is achieved through the use of cost driver rates which are
based on drivers believed to have the best causal relationship to the particular activity cost. Exhibit 5 begins with the ten
activity costs (which you calculated in Exhibit 4) and the allocation base used to derive the rate for each cost. Allocation
base amounts were taken from TII’s accounting and operational records. Once the rates are calculated for each of the
ten activity costs, individual customer profitability analyses may be performed.

Exhibit 6 presents customer profitability reports to be completed for three of TII’s many customers. The figures in the
“driver quantity” column represent sales calls made to the individual customer, number of orders placed by the customer
during the year, etc. These figures are taken from TII’s accounting records. Completion of the customer profitability
analysis involves multiplying the driver quantity by the appropriate rate from Exhibit 5 to determine the amount of the
particular cost to be charged to the customer. Note that Slidell Company is a new customer acquired by TII this year,
while the other two are continuing customers. The total operating expenses are then subtracted from the gross margin to
determine how much the customer contributed toward TII’s profits. Finally, the profits are expressed as percentages of
the sales made to the individual customers.
                                                     Exhibit 1

                                              Tyler Industries, Inc.
                                         Operating income statements
                             For the years ended December 31, 2004 through 2009


                         2009             2008            2007            2006            2005            2004
Sales                $   2,100,000   $   1,980,000   $    1,920,000   $   1,687,500   $   1,560,000   $   1,455,000
Cost of goods sold       1,400,000       1,320,000        1,280,000       1,125,000       1,040,000        970,000
Gross margin         $    700,000    $     660,000   $     640,000    $    562,500    $    520,000    $    485,000
Operating expenses        770,000          680,000         600,000         490,000         410,000         380,000
Operating income     $     (70,000) $      (20,000) $        40,000   $     72,500    $    110,000    $    105,000




                                                         Exhibit 2

                                                   Tyler Industries, Inc.
                                                   Operating expenses
                                         For the year ended December 31, 2009


                                     Sales staff wages                $    400,000
                                     Administrative wages                  120,000
                                     Warehouse wages                        75,000
                                     Printed materials and supplies         14,000
                                     Shipping                               23,000
                                     Utilities and fuel                     32,000
                                     Maintenance                            16,000
                                     Taxes and insurance                    14,000
                                     Vehicle leasing                        25,000
                                     Office equipment depreciation           8,000
                                     Building depreciation                  35,000
                                     Other                                   8,000
                                     Total                            $    770,000
                                                                                             Exhibit 3

                                                                                       Tyler Industries, Inc.
                                                                                    First stage allocation rates


                                                                                                              Activity
                                                Contract        Order      Warehousing                         New                  Customer    Post-sale
              Cost               Sales calls   negotiations   processing    activities     Order picking     customer    Shipping    training    support    Other   Total
Sales staff wages                   65%            5%                                                              10%                 5%         15%               100%
Administrative wages                              15%            30%                                               5%                 10%          5%       35%     100%
Warehouse wages                                                  5%           65%               25%                                                          5%     100%
Printed materials and supplies      25%            5%            5%                                                10%                20%         15%       20%     100%
Shipping                                                                                                                  100%                                      100%
Utilities and fuel                  20%            5%                         35%               5%                 5%      10%         5%         10%        5%     100%
Maintenance                                                                   75%                                                                           25%     100%
Taxes and insurance                                                           65%                                          5%                               30%     100%
Vehicle leasing                     50%            5%                                                                      10%        10%         25%               100%
Office equipment depreciation       10%            5%            30%          15%                                                      5%          5%       30%     100%
Building depreciation                                                         75%                                                                           25%     100%
Other                                                                                                                                                       100%    100%
                                                                                                       Exhibit 4

                                                                                                 Tyler Industries, Inc.
                                                                                                 First stage allocation



                                                                                                                                   Activity
                                                                  Contract        Order      Warehousing                            New                          Customer        Post-sale
                        Cost                       Sales calls   negotiations   processing    activities     Order picking        customer        Shipping        training        support        Other           Total
Sales staff wages                $   400,000                                                                                                                                                                 $           -
Administrative wages             $   120,000                                                                                                                                                                             -
Warehouse wages                  $    75,000                                                                                                                                                                             -
Printed materials and supplies   $    14,000                                                                                                                                                                             -
Shipping                         $    23,000                                                                                                                                                                             -
Utilities and fuel               $    32,000                                                                                                                                                                             -
Maintenance                      $    16,000                                                                                                                                                                             -
Taxes and insurance              $    14,000                                                                                                                                                                             -
Vehicle leasing                  $    25,000                                                                                                                                                                             -
Office equipment depreciation    $     8,000                                                                                                                                                                             -
Building depreciation            $    35,000                                                                                                                                                                             -
Other                            $     8,000                                                                                                                                                                             -
Total                            $   770,000   $           -     $        -     $       -    $         -     $            -   $           -   $          -   $          -    $           -   $           -   $           -
                                           Exhibit 5

                                   Tyler Industries, Inc.
                           2nd stage allocation rates calculation


                                                                    Driver base       Rate per unit
              Activity     Activity cost        Driver base           quantity        of driver base
Sales calls                                # of sales calls                 450
Contract negotiations                      Negotiation hours                120
Order processing                           # of orders                      315
Warehousing activities                     Cost of goods sold       $ 1,400,000
Order picking                              # of line items                4,280
New customer development                   # of new customers                     7
Shipping                                   Pounds shipped                91,400
Customer training                          Training hours                   150
Post-sale support                          Support hours                    380
Other                                      Sales dollars            $ 2,100,000
Total
                                                               Exhibit 6

                                                       Tyler Industries, Inc.
                                                   Customer profitability analysis


                                             Kendall Manufacturing                Slidell Company              Murdoch Enterprises
Sales                                                      $   322,500                       $   129,000                     $   54,000
Cost of goods sold                                             215,000                            86,000                         36,000
Gross margin                                               $   107,500                       $    43,000                     $   18,000
Operating expenses


           Driver          Driver rate   Driver quantity                   Driver quantity                 Driver quantity
# of sales calls                                    12                                14                              10
Negotiation hours                                     8                               10                              10
# of orders                                           8                                 3                               3
Cost of goods sold                       $    215,000                      $      86,000                   $      36,000
# of line items                                     20                                  6                             12
# of new customers                                    0                                 1                               0
Pounds shipped                                  14,210                             4,780                           1,870
Training hours                                        8                               28                                3
Support hours                                       36                                54                              10
Sales dollars                                 322,500                           129,000                           54,000
Total operating expenses
Operating income


Operating income as a
percentage of sales

								
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