Kronecker Company, a growing mail order clothing and accessory company, is concerned about its growing marketing, distribution, selling and administration expenses. It therefore examined its customer ordering patterns for the past year and identified four different types of customers, as illustrated in the following table. Kronecker sends catalogs and flyers to all its customers several times a year. Orders are taken by mail or over the phone by the toll free number. Kronecker prides it self on the personal attention it provides shoppers who order over the phone. All purchases are paid for by check or credit card. It also maintains a very generous return policy if customers are not satisfied with the product. Customers must pay return shipping charges, but their purchase price is then fully refunded. Customer 1 Customer 2 Customer 3 Customer 4 Initial Sales Rs. 1000 Rs. 1000 Rs. 2,500 Rs. 3,000 Number of items returned 0 4 2 24 Dollar value of items returned 0 Rs. 200 Rs. 500 Rs. 1,500 Number of orders per year 1 6 4 12 Number of phone orders per year 1 0 0 12 Time spent on phone placing orders 0.25 hour 0 0 1 hour Number of overnight delivery 1 0 0 12 Number of regular delivery 0 6 4 0 Prices are set so that cost of goods sold is on average about 75% of the sales price. Customers pay actual shipping charges, but extra processing is required for overnight delivery. The company has developed the following activity cost driver rates for its support costs.
What advice will you give to the company. Activity Activity Cost Driver Rate (Rs.) Process mail orders 5 Process phone orders 80 Process returns 5 Process over night delivery request 4 Maintain customer relations 50 200 500 1,500 Net sales $1,000 $800 $2,000 $1,500 Cost of goods sold, 75% of sales 750 600 1,500 1,125 Processing mail orders, $5 per nonphone order 0 30 20 0 Process phone orders, $80 per hour 20 0 0 80 Process returns, $5 per item returned 0 20 10 120 Process overnight delivery requests, $4 per request Maintain customer relations Customer 1 Customer 2 Customer 3 Customer-4 Sales $1,000 $1,000 $2,500 $3,000 Less returns 0 Customer 4 is the most expensive Customer 1 is fairly low-cost to serve Profit $176 $100 $420 $77 Profit Sales 0.18 0.10 0.17 0.03 11 4 0 0 48 50 50 50 50 Class Assignment Contributions-Section A G Findings Comments Suggestions 2 Loss for customer 4 Is -1944. Company incurs a loss when transacting with Customer 2 and Customer 4. The cost of goods has been set to 75 percent to that of the sales. This is not appropriate from a managerial point of view as it gives poor estimates when calculating returns from a particular customer. 3 Profits for customer 3 Is 69.33. Profit to sales ratio is 25%. In absolute monetary terms, customer 4 is the most profitable. Customer Relations should be higher for customers placing fewer orders and returning more number of units as compared to other customers. 4 Profitability (Profit/Net Sales) for customer 4 is 0.03% And Customer 3 is 0.17%. C-1 is 18% Although customer type 4 has the highest sales, it has the highest monetary returns and the lowest profit. Customer type 3 is by far the most profitable To reduce the service activity usage or improve efficiency to reduce the cost of providing services. The reason for returns, and follow up with ways to reduce problems that caused the returns. To make phone ordering more efficient, to reduce the time spent on the phone. Kronecker may also charge fees to handle overnight delivery requests. 5 Customer type 1 is fairly low-cost to serve in spite of ordering by phone and requesting overnight delivery because this customer type orders only once a year. The Company must spend resources and labour to advertise the advantages of placing orders by mail instead of phones. The company should introduce some cap on returning of the placed orders. This will reduce the cost in process returns. 6 Profitability (Profit/Net Sales) for customer 4 is 0.05% And Customer 3 is 0.21%. Customer 3 is by far the most profitable in terms of Gross Profit margin %, even though its sales are less than customer 4s. Customer 1 and 2 are more profitable than customer type 4 in terms of profit margin to sales %. The company might also explore ways to make phone ordering more efficient, to reduce the time spent on the phone. Kronecker may also charge higher fees (than Rs. 4) to handle overnight delivery requests. 7 Customer 2 most of the order are placed over mail but since they have 20% of the sale items returned inwards the net sale decrease. Customer 3 and Customer 1 both of them has almost similar profit to sales ratio i.e (17-18%) but the differnce between the two is the sales ratio among them themselves which is 1:2.5(Customer 1 to Customer 3. We would suggest company to increase business activities as like Customer 3 where profit-sales margin is good for all the customer and since the sales are larger they will retain larger profit.
9 Customer 3 has the highest profitability while the customer 4 has the lowest. Customer 4 places orders in a costlier manner as it spends 1 hour on phone and it has the requests of more overnight deliveries. Company can impose charge for the overnight delivery requests. Company can change their way to increase efficiency for phone orders. Company can reduce the servicing cost for the customers. 11 Profitability (Profit/Net Sales) for customer 4 is 0.05% And Customer 3 is 0.21%. Profitability ratio is highest for the customer 3 while it is lowest for the customer 4. Customer 2 and 3 are easy to serve since they do not use phone to order Company can reduce the servicing cost for the customers. Company can ask the customer for the return of goods. Company can change their way to increase efficiency for phone orders. Group-5 KRONECKER COMPANY Customer 1 Customer 2 Customer 3 Customer 4 Sales 1000 1000 2500 3000 Return Inwards 200 500 1500 Net Sales 1000 800 2000 1500 Cost of Goods Sold 750 600 1500 1125 Gross Margin 250 200 500 375 Add Selling Overheads 74 100 80 1178 Profit Margin 176 100 420 -803 Overheads Customer 1 Customer 2 Customer 3 Customer 4 Rate Orders Total Orders Total Orders Total Orders Total
Process Mail Orders 5 0 0 6 30 4 20 0 0 Process Phone Orders 80 1 20 0 0 0 0 12 960 Process Returns 5 0 0 4 20 2 10 24 120 Process Over-night Delivery Request 4 1 4 0 0 0 0 12 48 Maintain Customer Relation 50 1 50 1 50 1 50 1 50 Total 74 100 80 1178 Activity-Based Costing Traditional allocation method Activity-based allocation method Costs Products Costs Products Activities First stage 7 Second stage Conventional Costing Expenses Cost Objects AB Costing Resources Activities Cost Objects Economic Element Work Performed Product or service 8 Traditional Costing Systems Product Costs Direct labor Direct materials Factory Overhead Period Costs Administrative expense Sales expense Direct labor and direct materials are easy to trace to products.
The problem comes with factory overhead. 9 Todays businesses are working in an increasingly complex environment. Use of Advanced Technology Product Life Cycle Product Complexity Channels of Distribution Quality Requirements 10 Product Diversity ABC systems addresses the 13 following Questions: What activities are being performed by the organisational resources? How much does it cost to perform activities? Why does the oranisation need to perform those activities? How much of each activity is required for the organisations products, services, and customers? Basics of A B C : How? Steps: 1. Form cost pools 2. Identify activities 3. Map resource costs to activities 4. Define activity cost drivers 5. Calculate cost Cost pools are groups or categories of individual 14 expense items Levels of Cost Incurrence 15 Not all costs are volume-related Unit level Batch level Product level Facility level Activities: Types 16 Unit level: Performed each time a unit is produced Batch level: Performed each time a batch is produced Product level: Performed to support production of different type of product Customer Level: Performed to support servicing customers Facility level:Residuary head Map resource costs to activities 17 Financial accounting categorises expenses by spending code; salaries, fringe benefits, utilities, travel, communication, computing, depreciation etc. ABC collects expenses from this financial system and drive them to the activities performed. 18 Mapping Accounting Records Salaries 313,000 Depreciation 155,000 Electricity 132,000 Supplies 25,000 Travel 100,000 Total 725,000 ABC Records Activities Salaries Depreciati Electricity Supplies Travel Total Business Development 20,000 25000 5000 5000 55,000 Maintianing Present Business 80,000 60000 50000 5000 10000 205,000 Purhcasing Material 125,000 50000 20000 20000 60000 275,000 Set up Machines 25,000 10000 2000 37,000 Running Machines 50,000 10000 50000 110,000 Resolve Quality Problems 13,000 5000 25000 43,000 Total 313,000 155000 132000 25000 100000 725,000 Define activity drivers 19 The linkage between activities and cost objects, such as products, customers,, is accomplished by using activity drivers. An activity driver is a quantitative measure of the output of an activity. The selection of an activity driver reflects a subjective trade-off between accuracy and cost of measurement. 20 d n Activities Drivers Unit Level Acquire and Use material for containers No. of Containers Acquire and Use material for baby-care p No. of products Batch Level Set up manually controlled machines No. of batches of con Set up computer controlled machines No. of batches of B. Product Level Design and manufacture moulds No.of moulds require Use manually controlled machines Product type (contai Use conputer controlled machines Product type (B.Prod Custome r Level Consult customers No. of consultations Provide warehousing for customers No. of cubit feet Faciltiy Level Manage workers Salaries 21 Activities Drivers Activity Cost Activity Volum Activity R Unit Level Acquire and Use material for containers No. of Containers 40,000 1,000,000 0.04 Acquire and Use material for baby-care products No. of products 80,000 8,000 10 Batch Level Set up manually controlled machines No. of batches of containers 3,000 10 300 Set up computer controlled machines No. of batches of B. Produst 12,000 20 600 Product Level Design and manufacture moulds No.of moulds required 5,000 5 1000 Use manually controlled machines Product type (containers) 15,000 1 15000 Use conputer controlled machines Product type (B.Products) 40,000 1 40000 Customer Level Consult customers No. of consultations 4,000 40 100 Provide warehousing for customers No. of cubit feet 2,000 10,000 0.2 Faciltiy Level Manage workers Salaries 3,000 15,000 0.2 Use main building Square feet 48,000 16,000 3 22 Ascertaining Cost Activities A. Rate A.Volume Containers Baby Product Unit Level Acquire and Use material for containers 0.04 1,200,000 48,000 Acquire and Use material for baby-care products 10 7,000 70000 Batch Level Set up manually controlled machines 300 12 3,600 Set up computer controlled machines 600 16 9600 Product Level Design and manufacture moulds 1000 1 1,000 4 4000 Use manually controlled machines 15000 1 15,000 Use conputer controlled machines 40000 1 40000 Customer Level Consult customers 100 Containers 2 200 B.products 40 4000 Provide warehousing for customers 0.2 Containers 8,000 1,600 B.products 2,000 400 Faciltiy Level Manage workers 0.2 Containers 4,000 800 B.products 10,000 2000 Use main building 3 Containers 5,000 15,000 B.products 7,000 21000 Total Cost 85,200 151,000 Lets work an example . . . 23 Assume that a company makes widgets Management decides to install an ABC system Remember ABC Steps Overhead cost drivers are determined. Activity cost pools are created. A activity cost pool is a pool of individual costs that all have the same cost driver. All overhead costs are then allocated to one of the activity cost pools.
An overhead rate is then calculated for each cost pool using the following formula: Costs in activity cost pool/base The base is, of course, the cost driver Overhead costs are then allocated to each product according to how much of each base the product uses. Overhead Cost Drivers are 24 Determined: Management decides that all overhead costs only have three cost driverssometimes called activities (obviously a simplification of the real world) Direct labor hours Machine hours Number of purchase orders All overhead costs are then allocated to one of the activity cost pools. Direct Labor Machine Hours # of Purchase Orders Which overhead costs do you think are driven by direct labor 25 hours? General Ledger Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 All overhead costs are then allocated to one of the activity cost pools. Direct Labor
$1,000 2,000 1,500 $4,500 Machine Hours # of Purchase Orders Overhead driver by direct labor hours 35 General Ledger Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 All overhead costs are then allocated to one of the activity cost pools. Direct Labor
$1,000 2,000 1,500 $4,500 Machine Hours
$ 500 750 1,250 $2,500 # of Purchase Orders 36 General Ledger Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 U W ne h m ic p h lo o y v m e e r n h t ead cost indsruivreanncbey machine h s ar $ e 1,500 ours? All overhead costs are then allocated to one of the activity cost pools. Direct Labor
$1,000 2,000 1,500 $4,500 Machine Hours
$ 500 750 1,250 $2,500 # of Purchase Orders
$4,000 250 $4,250 And finally, which overhead costs are driven by # of purchase orders? 37 General Ledger Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 An overhead rate is then calculated for each cost pool: Direct Labor Again the formulas is: 29 Machine Hours # of Purchase Orders $1,000 2,000 1,500 $4,500 $ 500 750 1,250 $2,500 $4,000 250 $4,250 Costs in Activity Cost Pool/Base = rate Assume the following bases: Direct labor hours = 1,000 Machine hours = 250 Purchase orders = 100 The ABC rates are: $4,500/1,000 = $4.50 per direct labor hour $2,500/250 = $10 per machine hour $4,250/100 = $42.50 per purchase order Overhead costs are then allocated to each product according to how much of each base uses.
$4,500/1,000 = $4.50 per direct labor hour $2,500/250 = $10 per machine hour $4,250/100 = $42.50 per purchase order
Lets assume the company makes two products, Widget A and Widget B:
Lets also assume that each product uses the following activity of overhead cost drivers:
Notice that all base units are accounted for. 30 Base Widget A Widget B Total Direct labor hours 400 600 1,000 Machine hours 100 150 250 Purchase orders 50 50 100 Now lets allocate overhead to Widget A: In this case, 400 hours used to make Widget A is multiplied by the rate of $4.50. This gives total overhead applied for this activity cost pool of $1,800 to Widget A. 31 Base A Rate Allocated Direct labor hours 400 $ 4.5 0 $ 1,800.00 Continuing the calculation: Lets do the sae thig fo the othetwo ates, to get the total aout of overhead applied to Widget A: 32 Widget A Base Rate Allocated Direct labor hours 400 $ 4.50 $ 1,800.00 Machine hours 100 $ 10.00 $ 1,000.00 Purchase orders 50 $ 42.50 $ 2,125.00 Total $ 4,925.00 Now lets allocate overhead to Widget B: Lets do the same thing for the other two rates, to get the total of overhead applied. The original overhead to be applied was $4,500 of direct labor driven overhead + $2,500 of machine hour driven overhead + $4,250 of purchase order driven overhead = $11,250 total overhead to apply.
The actual overhead allocated was $4,925 for Widget A + $6,350 = $11,250 overhead applied. 33 Widget B Base Rate Allocated Direct labor hours 600 $ 4.50 $ 2,700.00 Machine hours 150 $ 10.00 $ 1,500.00 Purchase orders 50 $ 42.50 $ 2,125.00 Total $ 6,325.00 Same Problems Traditional 34 Method Okay, so what if we had allocated the overhead in this company using traditional cost accounting allocation. Lets assume the base is direct labor hours. What would be the amount allocated to each product? Calculation General Ledger This the total overhead we were given, the total amount is $11,250 as explained on the previous slide. Base Widget A Widget B Tota Direct labor hours 400 600 1,000 Machine hours 100 150 250 Purchase orders 40 60 100 Total direct labor hours are 1,000, also given earlier. 44 Payroll taxes $1,000 Machine maintenance $500 Purchasing Dept. labor $4,000 Fringe benefits $2,000 Purchasing Dept. Supplies $250 Equipment depreciation $750 Electricity $1,250 Unemployment insurance $1,500 Calculation 36 The rate would be: OH Rate = Overhead/Direct Labor Hours $11,250/1,000 = $11.25 per hour. Applying overhead using this rate: Widget A: 400 hours x $11.25 = $4,500 Widget B: 600 hours x $11.25 = $6,750 Total overhead applied = $11,250 Comparison 37 Which is more accurate? ABC Costing! Note these are total costs. To get per-unit costs we would divide by the number of units produced. Widget A Widget B Total Traditional Method $4,500 $6,750 $11,250 Activity Based Costing $4,925 $6,325 $11,250 Difference -$425 $425 -0- Production Department Indirect factory wages Factory equipment depreciation Factory utilities Factory building lease $ 500,000 300,000 120,000 80,000 $ 1,000,000 40,000 Shipping costs traced to customer orders General Administrative Department Administrative wages and salaries Office equipment depreciation 400,000 50,000 Administrative building lease Marketing Department 60,000 510,000 Overhead Costs at Classic Brass (Manufacturing and NonManufacturing) Marketing wages and salaries 250,000 Selling expenses 50,000 300,000 Total overhead costs $ 1,850,000 Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Overhead Costs Traced $/DLH Traced Products or Customers Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Customer Orders (# of Orders) Order Size (Mach Hrs) Product Design Customer Relations (# of Customers) Other Overhead Costs First-Stage Allocation Products or Customers Activity-Based Costing at Classic Brass Direct Materials Direct Labor Shipping Costs Customer Orders Product Design Order Size Customer Relations Other Overhead Costs First-Stage Allocation Second-Stage Allocations $/MH $/Order $/Design $/Customer Products or Customers Unallocated Indirect Costs 60 Not easily and conveniently traceable to cost objects Cost element is shared among cost objects Physically impossible to trace Not cost effective to trace Indirect Costs 61 Need for allocation Estimate product or activity cost What does it really cost? Increase awareness of indirect costs Activities are not free Plan more cost efficient operations Now that we know what it costs, what should we do? Allocation of Indirect Costs 62 Typical allocation methods Ability to bear Fairness or equity Benefits received Cause and effect Traditional Allocation Method 63 Indirect costs allocated to cost object based on the cost objects consumption of some measure of activity, usually labor hours $10,000,000 total indirect cost 400,000 total labor hours = $25 per hour rate A product consuming 6 labor hours would be charged $150 ($25 x 6) of indirect costs Criticisms of Traditional Overhead 64 Allocation
Assumes all overhead is volume-related Factory-wide or departmental rates All related to single activity measure Departmental focus, not process focus Focus on costs incurred, not cause of costs Conventional Costing 65 Total Cost = Material + Labour+ Overheads Overheads are allocated to the products on volume based measures e.g. labour hours, machine hours, units produced
Will this not distort the costing in the new environment?
ABC provides an Alternative. Activity-Based Costing (ABC) 66 Purpose Allocation of indirect costs based on causal activities Attempts to identify direct link between cost and cost object Results in better allocation Does not provide true cost ABC Definitions 67 Activity based costing is an approach for allocating overhead costs. An activity is an event that incurs costs. A cost driver is any factor or activity that has a direct cause and effect relationship with the resources consumed. Overview of ABC 68 Identifies activities required to produce the product or service Determines the cost of the activities Allocates costs to the cost object based on the objects consumption of activities Basics of A B C 69 Cost of a product is the sum of the costs of all activities required to manufacture and deliver the product. Products do not consume costs directly Money is spent on activities Activities are consumed by product/services Basics of A B C (contd.) 70 ABC assigns Costs to Products by tracing expenses to activities. Each Product is charged based on the extent to which it used an activity
The primary objective of ABC is to assign costs that reflect/mirror the physical dynamics of the business Basics of A B C (contd.) 71 Provides ways of assigning the costs of indirect support resources to activities, business processes, customers, products. It recognises that many organisational resources are required not for physical production of units of product but to provide a broad array of support activities. Building an ABC Model Identify Resources Identify Activities Identify Cost Objects Define Resource Drivers Define Activity Drivers Enter Resource Costs Enter Resource Driver Qty. Enter Activity Driver Qty. Calculate Costs 72 Thank you.