Principles of Mgmt Accounting Class 2 PDF

Principles of MANAGEMENT ACCOUNTING Class 2 : Traditional vs Activity Based Costing (ABC) & Customer Profitability Analysis 1  Cost allocation: practical example (1/3) A. The case of a bakery that sells only bread and has the follo...

Principles of MANAGEMENT ACCOUNTING Class 2 : Traditional vs Activity Based Costing (ABC) & Customer Profitability Analysis 1  Cost allocation: practical example (1/3) A. The case of a bakery that sells only bread and has the following cost: 1. Bread’s ingredients: €1.000/month 2. Salary of shop employee: €1.500/month 3. Number of breads per month: 2000 breads => Cost per bread: 1. Ingredients: €1.000 / 2.000 breads = €0,5/bread 2. Salary of shop employee: €1.500 / 2.000 breads = €0,75/bread => Total cost per bread: €1,25 B. Now, the bakery starts selling cake as well, the cost of the ingredient are the following: => Cake ingredient: €1.500/month => Number of cakes per month: 1.000 cakes => Cost per cake: 1. Ingredients: €1.500 / 1.000 cakes = €1,5/cake 2. Quid salary cost of the shop employee? 2  Cost allocation: practical example (2/3) A. Shared based method In this method we look for an allocation key to divide proportionally the salary of the shop employee over the number of breads & cakes sold. For example, the number of units sold. => Division of salary of shop employee = 1.500/(2.000 breads + 1.000 cakes) = €0,5 per unit sold => Cost per bread = €1 & cost per cake = €2 B. Incremental method 1. Head activity = sell bread, salary of shop employee needs to be allocated to bread => Then, the cost of one bread is: 1. Ingredients: €1.000 / 2.000 breads = €0,5/bread 2. Salary of shop employee: €1.500 / 2.000 breads = €0,75/bread => Total cost per bread: €1,25 Additional activity = Sell cake, only the incremental cost need to be allocated => Cost per bread = €1,25 & cost per cake (only ingredients) = €1,5 2. Head activity = Sell cake, salary of shop employee needs to be allocated to cakes => Then, the cost of one cake: 1. Ingredients: €1.500 / 1.000 cakes = €1,5/cake 2. Salary of shop employee: €1.500 / 1.000 cakes = €1,5/cake => Total cost per cake: €3 Additional activity = sell bread, only the incremental cost need to be allocated => Cost per cake = €3 & cost per bread (only ingredients) = €0,5 3  Cost allocation: practical example (3/3) Example Situation Cost of bread Cost of cupcake Shared based method Labor costs allocated by turnover 1€ 2€ Incremental method Bread primary activity 1,25 € 1,5 € Cupcake primary activity 0,5 € 3€ As shown in the table above, the cost calculation method has a significant influence on the cost of the different products. When someone is selling only one product, the common costs have to be fully allocated to this product Shared based method: The common costs will be allocated to both products using an allocation key. Each product carries, besides its directly attributable costs, a share of the common costs. The hierarchy of the products (meaning which is the main product and which is the side product) is not important because of the use of allocation keys. Incremental cost calculation method: An incremental cost is an additional cost that is caused by offering an additional product or service. The existing and the new product are respectively called the primary and the secondary product. When calculating the incremental cost, the hierarchy plays an essential role. What will be the primary product that will be used to determine the incremental costs? All common costs will be allocated to this primary product. The incremental cost of the secondary product is thus composed entirely out of costs that can be directly allocated, both fixed as well as variable. 4 Costing in a changing competitive environment: Activity-based costing Traditional cost accounting Focus on calculating full cost per unit for stock valuation Use of a volume-related allocation base Low level of overheads relative to direct costs Relatively uncompetitive market Changing competitive environment Higher level of overheads relative to direct costs Highly competitive international market Focus on customer satisfaction 5  Traditional vs. ABC The Past The Present Small number of products Numerous products with which did not differ much in more and complicated required manufacturing production requirements. support. Labour is becoming an ever Labour was the dominant smaller part component of element in the cost structure. total production costs. 6  Traditional vs. ABC: Example Two clients require an equal number of consulting hours. Customer 2 is using more overhead such as phone calls, site visits, … If we allocate overhead based on number of consulting hours (traditionally), both clients are allocated half of the total overhead, whereas actually customer 2 uses up much more resources. 7 Traditional vs. ABC : Example (2) Required special packaging. Demand Orders fast small service. quantities. Often Orders changes frequently. orders. A costly customer 8  Traditional vs. ABC (2) Volume-Based Costing Activity-Based Costing All production costs except An effort is made to direct materials and direct account for as many costs labour are lumped together as possible as direct costs in one overhead cost pool. of production. Indirect Costs 9  Activity Based Costing System (ABC) Assigning overhead to products is a ABC systems follow difficult process. I agree! a two-stage procedure to assign overhead costs to products. 10 Activity-Based Costing System (ABC) (2) In the ABC method, we recognize that many activities within a department drive overhead costs. 11  Activity Based Costing System (ABC) (3) Let’s begin ABC systems follow a by identifying two-stage our major activities. procedure to assign overhead costs to products. Stage One Identify significant activities and assign overhead costs to each activity in proportion to resources used. 12  Activity Based Costing System (ABC) (4) ABC systems follow a Overhead assigned to activities are called two-stage “activity cost pools.” procedure to assign overhead costs to products. Stage Two Identify cost drivers appropriate to each activity and allocate overhead to the products. 13  Activity Based Costing System (ABC) (5) Traditional Costing Activity Based Costing RESOURCES RESOURCES Resource driver Allocation base ACTIVITIES Activity driver COST OBJECTS COST OBJECTS 14 Activities - production - product design PROCESS - customer service - helpdesk ACTIVITY - technical support - handling complaints - answer telephone TASK - take notes - pass information 15 Levels of activities Unit level: For each item produced Assembly, adding materials, … Batch level: For each batch of items produced or for each order Machine set-up, ordering materials,… Product-sustaining level: For each product (but not depending on number of items produced) Product design, product testing,… Facility-sustaining level: For the whole business General management, accounting, … Customer-level 16 Cost objects Products Product range Product One unit of a product Customers Market or region Distribution channel Individual customer Process Specific questions 17 Cost Drivers A characteristic of an event or activity that results in the incurrence of costs. In selecting a cost driver, we must consider... Degree of Behavioral Correlation Effects Cost of Measurement 18 Resource drivers Relation between activities and resource consumption Examples: Labour time spent on each activity Machine time Floor space occupied by activity … Some costs that are indirect to the cost objects may be direct to an activity Example: a car specifically used to visit customers 19 Activity drivers Transaction drivers: Number of times an activity is performed Examples: number of internal transports, number of orders, … Duration drivers: Time spent on each cost object Examples: internal transportation time, machine hours,… Intensity drivers: Specific registration of resources used Example: set-up activity for simple versus complex products 20  Indicators of Need for ABC Direct labour is a Product-line profit small percentage margins are hard of total costs to explain Line managers do not Sales are increasing, believe the product but profits are declining. costs reports Some products that Marketing does not have reported high use costs reports for profit margins are not pricing decisions sold by competitors 21  Activity Based Costing: Example Identification Overhead Costs Total budgeted cost = $2.423.000 of Activity Cost Pools Activity Cost Pools Product- Unit Batch Sustaining Facility Level Level Level Level Machinery Setup Engineering Facility cost pool cost pool cost pool cost pool $1.212.600 $3.000 $700.000 $507.400 22  STAGE ONE Maintenance Lubrication Various overhead costs related Depreciation Electricity to machinery Computer Support Calibration Activity cost Machinery Cost Pool pool Total budgeted cost = $1.212.600 23  STAGE TWO Calculate Budgeted Machinery Costs $1.212.600 the pool Budgeted Machine Hours 43.000 rate $28,20/hour Mode I: Mode II: $28,20 per hr. $28,20 per hr. 1 hr. per unit 1,25 hr. per unit $28,20 per unit $35,25 per unit Cost Assignment Mode III: $28,20 per hr. 2 hr. per unit $56,40 per unit 24  STAGE ONE Total budgeted setup cost Calculation of $20 per hour 10 hr. per setup total setup cost $200 cost per setup 15 production runs $ 3.000 Total Activity cost Setup Cost Pool pool Total budgeted cost = $3.000 25  STAGE TWO Calculate Budgeted Setup Costs $3.000 the pool Planned Production Runs 15 runs rate $200 per run Mode I: (1 Run) Mode II: (4 Runs) $200 per run $200 per run 10.000 units per run 5.000 units per run = $0,02 per unit = $0,04 per unit Cost Assignment Mode III: (10 Runs) $200 per run 400 units per run = $0,50 per unit 26  STAGE ONE Various overhead Engineering salaries Engineering software costs related to engineering Engineering supplies Depreciation Activity cost Engineering Cost Pool pool Total budgeted cost = $700.000 27  STAGE TWO Allocate based Engineering Cost Pool on engineering Total budgeted cost = $700.000 transactions Mode I: Mode II: 25% × $700.000 45% × $700.000 10.000 units 20.000 units Cost = $17,50 per unit = $15,75 per unit Assignment Mode III: 30% × $700.000 4.000 units = $52,50 per unit 28  STAGE ONE Various overhead Plant depr. Property taxes costs related Plant mgmt. Insurance to general operations Plant maint. Security Activity cost Facility Cost Pool pool Total budgeted cost = $507.400 29  STAGE TWO Calculate Budgeted Facilities Cost $507.400 the pool Budgeted Direct-Labour Hours 118.000 rate $4,30/hour Mode I: Mode II: $4,30 per hr. $4,30 per hr. × 3 hr. per unit × 4 hr. per unit $12,90 per unit $17,20 per unit Cost Assignment Mode III: $4,30 per hr. × 2 hr. per unit $8,60 per unit 30  Product Cost from ABC Here are the new product costs so far... Mode I Mode II Mode III Direct materials $ 50,00 $ 90,00 $ 20,00 Direct labor 60,00 80,00 40,00 Machinery 28,20 35,25 56,40 Setup 0,02 0,04 0,50 Engineering 17,50 15,75 52,50 Facilities 12,90 17,20 8,60 Total ABC 168,62 238,24 178,00 31  Product cost of ABC: Example Total overhead: €100.000 Inspection cost = 10% of total overhead => Inspection cost =.............. 3 products: X, Y, Z # of inspections: 0,2 (X); 0,3 (Y); 0,25 (Z) Production level: 1.000 (X), 2.000 (Y), 800 (Z) => Please calculate the inspection cost for each unit of X, Y, Z 32  ABC: cost / benefits? Costs high measurement costs failure costs low low Optimal high Level of detail system 33  ABC: cost / benefits? (2) Keeping track of the time an employee spends on every activity could prove to be inefficient, if done with too much detail One needs to determine the optimal level of detail Measurement costs tend to decrease as (information) technology advances 34 Advantages of ABC Better, and more accurate, overview of cost objects’ cost structure Base for improved management decisions f.in. Non-profitable customers could be rejected Adapted to contemporary complex competitive business environment Allows more efficient cost controlling and identification of possible cost savings 35  Drawbacks of ABC Complex method Measurement costs of data gathering & processing could be high Difficult integration with financial statements 36  Application area High overhead costs Product diversity Complex production process Little confidence in existing cost management systems Remark: not all companies tend to benefit from the application of ABC f.in. Companies with standard production process where overhead is related to one single cost driver 37  ABC in the Service Industry Activities tend to be non-repetitive Implementation human tasks. Problems High proportion of facility-level costs 38 Customer profitability analysis (CPA) Focus : Customer as cost object Extended value chain : do not forget pre- & post production costs Strongly related to marketing function 20-80 rule of Cooper and Kaplan CPA as management and action tool Differences in revenues and costs  Illustration 20-80 rule 150% 100% Cumulativ e % of profit 20% cumulative 100% Source : Cooper and Kaplan % of Customer profitability analysis (2) What can be improved ? Indirect costs such as marketing, sales, administration… continue to increase (increasing % of sales) Those indirect costs are often caused by the customer How to allocate these costs to individual customers ? (f.in. ABC) So as to be able to : Identify profitable customers Allocate resources effectively and efficiently  1. Customer profitability analysis : Actions Positive contribution Volume discount Promotions Extend product 2 1 Encourage or service range Protect Potential Winners Protect Special service Low volume High volume 4 3 Increase price Increase price Reduce Diminish service Losers Problems costs Negative contribution 1. Customer profitability analysis (4) Required special packaging. Orders Demand small fast quantities. service. Often Orders changes frequently. orders. A costly customer