Week 3

Activity-based management Implementation Model
1
ABM Model
Systems Planning
Identify, Define, and
Classify Activities
Reduce
Costs
Improve
Decisions
Increase Profitability
ABC
1. Continuous improvement (PVA)
2. Product design (eg complexity drivers)
3. Improved decision making
4. Accurate cost info (VCA)(ABC)
a. Products (MA1)
b. Customers (eg setup drivers)
c. Suppliers
PVA
Assess Value Content of
Activities
Define Root Causes of
Each Activity
Establish Activity
Performance Measures
Search for Improvement
Opportunities
Part 1 – Week 2 Part 2 – Week 3
Assign Resource Cost to
Activities
Identify Cost Objects and
Define Activity Drivers
Calculate Activity Rates
Assign Costs to Cost
objects
Product design
Value engineering
Design
analysis
Functional
analysis
Cost Allocation Value Chain Analysis Sales Profitability AnalysisVCA-Customer linkages
1

Week 3
Cost Allocation, Customer-
Profitability Analysis, and
Sales-Variance Analysis
http://www.youtube.com/watch?v=qS7nqwGt4-I 2

3
 Cost Allocation
 Learning Objective 4: Understand criteria to guide cost-allocation decisions
 Value Chain Analysis
 VCA-Customer linkages
 Learning Objective 1: Discuss why a company’s revenues and costs differ across customers
 Learning Objective 2: Identify the importance of customer-profitability profiles
 Learning Objective 3: Understand the cost-hierarchy-based operating income statement
 Learning Objective 5: Discuss decision faced when collecting and allocating indirect costs to
customers
 Sales Profitability Analysis
 Learning Objective 6: Subdivide the sales-variance into the sales-mix variance and the sales-quantity
variance into the market share variance and the market size variance
Week 3: Learning objective summary
Cost Allocation Value Chain Analysis Sales Profitability Analysis

5
ABM Model
Systems Planning
Classify Activities
Reduce
Costs
Improve
Decisions
ABC
a. Products (MA1)
c. Suppliers
PVA
Activities
Each Activity
Establish Activity
Opportunities
Activities
objects
Product design
Value engineering
Design
analysis
Functional
analysis
5

6
1. What is Cost Allocation?
 Assigning indirect costs to cost objects
 These costs are not traced
 Indirect costs often comprise a large percentage of Total Overall Costs
Learning Objective 1:
Understand the criteria to guide cost-
allocation decisions. Identify four
purposes for allocating costs to cost
objectives
4(1&2)

7
2. What are the purposes of cost allocation?
 1
 2
 3
 4

Purposes of Cost Allocation
8

9
3. What are the criteria for cost allocations?
 1
 2
 3
 4

10
Exercise: Criteria for Cost-allocation decisions
 Cause and Effect
 Benefits Received
 Fairness (Equity)
 Ability to Bear

11
 The basis for establishing a price satisfactory to the government and
its suppliers
 Most credible to operating managers
 costs are allocated in proportion to the cost object’s ability to bear
them
 Integral part of ABC
 Generally, larger or more profitable objects receive proportionally more
of the allocated costs
 Cost allocation here is viewed as a “reasonable” or “fair” means of
establishing selling price
 the beneficiaries of the outputs of the cost object are charged with
costs in proportion to the benefits received
 variables are identified that cause resources to be consumed

12
 Cause and Effect
 variables are identified that cause resources to be consumed
 Most credible to operating managers
 Integral part of ABC
 Benefits Received
 the beneficiaries of the outputs of the cost object are charged with costs in proportion
to the benefits received
 Fairness (Equity)
 the basis for establishing a price satisfactory to the government and its suppliers
 Cost allocation here is viewed as a “reasonable” or “fair” means of establishing selling
price
 Ability to Bear
 costs are allocated in proportion to the cost object’s ability to bear them
 Generally, larger or more profitable objects receive proportionally more of the
allocated costs

Example: Cost Allocation
13

14
Value Chain Analysis - Product Costing Definitions
Long-Term Pricing Decisions
Product-Mix Decisions
Life cycle product costing
Strategic Profitability Analysis
Short-Term Pricing Decisions
Product-Mix Decisions
Strategic Design Decisions
Tactical Profitability Analysis
Short-Term Pricing
Decisions
External Financial
Reporting
Production
Value-Chain Product Costs Operating Product Costs Traditional Product Costs
Production
Research &
Development
Production
Marketing
Distribution
Outsourcing/suppliers
Customer service
Warranty claims
Design
Lawsuits
Understand the broader relevant costs
across the value chain and the
decisions impacted
(3)

15
Profit and Loss Statement
 Sales
 Cost of Goods Sold
 Begin Inventory
 Cost of Goods Manufactured
 Begin WIP
 Total Manufacturing costs
 Direct materials
 Direct labor
 Manufacturing overhead
 Ending WIP
 End Inventory
 Gross Profit on Sales
 Operating (period) expenses
 Selling
 Administration
 Financing
 Net Profit on Sales

16
Customer
Profitability
Analysis
Customer
Revenue Analysis
Customer
Cost Analysis
Discuss why a
company’s revenues
and costs differ
across customers
… revenues can differ
because of differences in
the quantity purchased
and the price discounts
while costs differ
because of different
demands placed on a
company’s resources
(P.572)
1(4)

17
Customer Profitability Analysis
 ABC/ABM product costing can be extended to customer profitability
analysis to identify the best customers
 Customer profitability analysis focuses on selling, general, and
administrative costs
 Customer profitability analysis analyzes activities, identifies proper cost
drivers, and determines realized profits from customers

18
Customer Profitability Matrix
Companies do not have to target all types of customers in order to be successful. One way to think
about which customers to target is by using a customer profitability matrix.
Insert Exhibit 5.16
(Profitability Matrix)
Here
18

19
Managers are increasingly finding it important to:
https://www.youtube.com/watch?v=_IznwZYvrAE (Equation)
https://www.youtube.com/watch?v=EYboh3f6gsU (SAP)
The banking industry is changing and financial institutions are suffering
increasing pressures. To survive in an increasingly competitive market,
banks are forced to become more flexible, they must innovate to meet
customers' needs whose behaviors and expectations are changing.
Want to stay competitive in the eyes of your customer? How to
customize your service offerings to meet the changing needs of your
customers? By implementing a relationship-based and a la carte
pricing! Discover how a predictive analysis of your customer combined
with a flexible pricing engine allows you to set up the appropriate
service offerings and to reward customer's loyalty while maintaining
your profitability.

20
1. E.g. raise prices for “demanders” or discount to gain more volume with low
“cost-to-serve” customers
2. Identify the most profitable customers
3. Providing better services to highly profitable customers (e.g. offer the
customer profit-positives service level options)
4. Securing highly profitable customers from competitors
5. Establish a surcharge for or re-pricing of expensive activities
6. Negotiating with customers to reach mutually beneficial levels of service
7. Choose various kinds of after-sale services to provide)
8. Abandon (reduce) products, services, or customers (e.g. conceding
permanent “loss customers” to competitors
9. Introduce new products and services
10. Manage each customer’s “costs-to-serve” to a lower level (e.g. Improve
their processes)
11. select the customer mix (e.g. shift the customer’s purchase mix toward
richer, higher-margin products and service lines)
Managers are increasingly finding it important to:

21
Customer Profitability Analysis – Task 1
 Customer profitability analysis allows managers to:
1. Strategic customer acquisition
2. Continuous improvement
3. Setting prices based on the cost to serve
4. Value added service management

22
Customer Profitability Analysis – Task 1
 Customer profitability analysis allows managers to:
1. Strategic customer acquisition
1. Identify the most profitable customers
2. Securing highly profitable customers from competitors
3. Abandon (reduce) products, services, or customers (e.g. conceding permanent “loss customers” to
competitors
2. Continuous improvement
1. Manage each customer’s “costs-to-serve” to a lower level (e.g. Improve their processes)
3. Setting prices based on the cost to serve
1. E.g. raise prices for “demanders” or discount to gain more volume with low “cost-to-serve” customers
2. Establish a surcharge for or re-pricing of expensive activities
4. Value added service management (i.e. choose various kinds of after-sale services to provide)
1. Select the customer mix (e.g. shift the customer’s purchase mix toward richer, higher-margin products and
service lines)
2. Introduce new products and services
3. Providing better services to highly profitable customers (e.g. offer the customer profit-positives service level
options)
4. Negotiating with customers to reach mutually beneficial levels of service

In practice #1: Banks - U.S. Millionaires Told
Go Away as Tax Evasion Rule Looms
 “I don’t open U.S. accounts, period,” said Su Shan Tan, head
of private banking at Singapore-based DBS, Southeast Asia’s
largest lender, who described reg attitudes toward U.S.
clients as “Draconian.”
 Bank of Singapore, the private-banking arm of Oversea-
Chinese Banking Corp. (OCBC), ranked strongest in the
world for the last two years by Bloomberg Markets magazine,
has turned away millions of dollars from Americans because
it doesn’t want to deal with the regulatory hassle, according
to Chief Executive Officer Renato de Guzman. The bank had
$32 billion under management as of the beginning of the
year.
 http://www.bloomberg.com/news/2012-05-08/u-s-millionaires-told-go-away-as-
tax-evasion-rule-looms.html 23

25
In practice #1: Customer stop light feedback indicators
Companies use stop lights to give instant feedback to service operators (phone operators) so as to
help them deal with the type of customer in the appropriate way.

26
In practice #2: Oops, what happened here?

27
In practice #2: Customer profitability in an Insurance company
 Figure 1 occurs in virtually every customer profitability study ever done,
in which:
 15 percent to 20 percent of the customers generate 100 percent (or
more) of the profits.
 In this case,
1. the most profitable 40 percent of customers generate 130 percent of annual
profits;
2. the middle 55 percent of customers break even, and
3. the least profitable 5 percent of customers incur losses equal to 30 percent
of annual profits.

28
In practice #2: Customer Profitability in an Insurance Company

29
In practice #2: Customer profitability in an Insurance company –
decisions made
1. With its most profitable customers, the company worked harder to
ensure their continued loyalty and to generate more business from them.
2. For customers in the middle break-even group, it would improve its
processes to lower its cost of serving them.
3. It focused most of its attention on the 5 percent-loss customers, taking
actions to re-price services and asking them for more business in
higher-margin product lines. If the company could not transform these
customers into profitable ones by these actions, it was prepared to drop
the accounts.

30
Customer
Profitability
Analysis
Customer
Revenue Analysis
Customer
Cost Analysis
EXAMPLE FROM 14th edition

Example 1: Customer Profitability Analysis –
Spring Distribution Co – Retail Channel (14th ed Exb14-5)
31

Example 1: Customer Profitability Analysis
Spring Distribution Co – Retail & Wholesale Channel
(14th ed Exb14-6)
32

Example 1: Customer Profitability Analysis Spring
Distribution Co – Retail Channel (14th ed Exb14-7)
33

Example 1: Customer Profitability Analysis
(14th ed Exb14-8)
34

35
Customer
Profitability
Analysis
Customer
Revenue Analysis
Customer
Cost Analysis
EXAMPLE FROM 15th edition

36
Customer Revenue Analysis
 Customer revenue analysis considers all activities that affect the net
amount received from the customers
 Customer revenue analysis traces prices and discounts (including sales
and cash discounts) to customers and identifies financing costs
associated with customer revenues

Astel Computers
37

Astel Computers
38

39
 Not all customers require the same type of activities. Examples
of customer-specific activities include:
 order processing costs
 billing, collection and payment processing costs
 accounts receivable and carrying costs
 customer service costs
 return or allowance processing costs
 restocking costs
 selling and marketing costs
Customer Cost Analysis

40
 Customer cost analysis identifies activities and cost drivers to
service customers
 Traditionally, these costs are hidden in the customer support,
marketing, and sales function
 Customer cost can be classified into the following categories:
1. customer unit-level cost
2. customer batch-level cost (e.g. order size)
3. customer-sustaining cost (e.g. visits)
4. distribution-channel cost (e.g. commercial vs. retail)
5. sales-sustaining costs (e.g. maintaining firm sales capability)

Astel Computers
Provalue division cost and cost driver information
(Exhibit 14-2)
41

Astel Computers
Provalue quantity of cost drivers, select customers
Next, we must determine how much of each resource the various
customers consumed. That information is reported here.
42

Astel Computers
Customer-profitability analysis for provalue-
wholesale customers
Now that we’ve identified the activities that drive
costs and determined the usage for those
activities for our select customers, we can
calculate profitability by customer.
In this example, we’ll look at Provalue’s 4
wholesale customers and compare profitability.
14-43

Astel Computers
Looking at this chart, if you were the manager, what would you do?
(Exhibit 14-3)
44

 Customer profitability profiles are a useful tool for
managers.
 Cumulative customer profitability profiles provide
information that shows what percentage of operating
income each additional customer contributes.
 Customers are presented in order of contribution to
operating income so any customers in a loss position are
highlighted at the bottom of the analysis.
14-45
Example 2: Customer Profitability
Analysis – Astel Computers
Customer Profitability Profiles
2
Identify the importance
of customer-
profitability profiles

Astel Computers
Customer profitability profiles, cont’d
 Customer profitability profiles can be presented in
graphical form as well as table form.
14-46

Real World Example : Sanyo Ltd – Can Activity-based
Costing Improve Sanyo’s Management Decision
Making?
Customer Profitability for Selected Customers
-400
-300
-200
-100
0
100
200
300
400
500
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20
Selected Customers
CustomerProfit('000)
47

48
What other factors need to be considered in evaluating
customer profitability?
 1.
 2.
 3.
 4.
 5.
 6.

49
Other Factors in Evaluating Customer Profitability
 Likelihood of customer retention
 Potential for sales growth
 Importance of having the firm as a customer for future sales
references
 Long-run customer profitability
 Increases in overall demand from having well-known customers
 Ability to learn from customers

Astel Computers
Customer profitability profiles, concluded
 Managers must explore ways to make unprofitable
customers profitable. When doing so, they should
include factors other than the current profitability level
including:
 Likelihood of customer retention.
 Potential for sales growth.
 Long-run customer profitability.
 Increases in overall demand from having well-known customers
(if applicable).
 Ability to learn from customers.
14-50

51
External Linkages - Issues to consider
 Reward loyalty – Longer term customers are loyal customers
 Growth opportunities – Small customers can grow into large customers
 Reputation – Must judge the impact on firm reputation among community (e.g.
Citibank versus Hang Seng Bank in Hong Kong.)

Cost hierarchy-based
operating income statement
 We’ve assigned customer-level costs to customers
but what about corporate costs, R&D and design
costs, etc.
 Customer actions do not influence these costs which
raises two important questions:
1. Should these costs be allocated to customers when
calculating customer profitability, and
2. If they are allocated, on what basis should they be allocated
given the weak cause-and-effect relationship between these
costs and customer actions?
14-52
3(6)
Apply the concept of
cost hierarchy to
customer costing

Cost hierarchy-based operating
income statement, concluded
 Some managers and management accountants advocate
fully allocating all costs to customers and distribution
channels because all costs are incurred to support the
sales of products to customers.
 Sometimes only those corporate and other costs that are
widely perceived as causally related to customer actions
or that provide explicit benefits to customer profitability
are allocated.
 Let’s take a look at some criteria to guide cost
allocations.
14-53

Cost hierarchy-based operating income statement
Example 3: Astel Computers (Exhibit 14-6)
54

Cost hierarchy-based operating income statement
Example 3: Astel Computers (Exhibit 14-7)
55

Fully allocated customer profitability
 Recall that the first purpose of cost allocation is
to provide information for economic decisions,
such as pricing, by measuring the full costs of
delivering products to different customers
based on an ABC system.
 Cost categories can be summarized into:
 Corporate costs
 Division costs
 Channel costs.
14-56
5
Discuss decisions
faced when collecting
and allocating indirect
costs to customers

Overview diagram for allocation of corporate,
division and channel costs
Follow the arrows to determine how the costs are allocated:
14-57

Beginning with the last row in the prior screen, we continue
with the allocation.
14-58
Overview diagram for allocation of corporate,
division and channel costs, concluded
What issues, if any, should Astel’s management consider
as they accumulate and allocation these costs?

Issues in allocating corporate costs to
divisions/customers
Let’s take a look at two questions, then we’ll
contemplate the better answers:
1. When allocating corporate costs to divisions, should
a company allocate only costs that vary with division
activity or assign fixed costs as well?
2. When allocating costs to divisions, channels and
customers, how many cost pools should be used?
14-59

Issues in allocating corporate costs to
divisions/customers, concluded
Companies should look to their particular situations, but
the probable best answers to these questions are:
1. To make good long-run decisions, managers need
to know the cost of all resources (variable or fixed
in the short-run) required to sell products to
customers, taking into account only relevant costs
for the specific decision.
2. Managers must balance the benefit of using a
multiple cost-pool system against the cost of
implementing it. Advances in IT technology make it
more likely that a multiple cost-pool system will
pass the cost-benefit test.
14-60

What type of decision?
Sales Variance Analysis
61
Learning outcome 6: Discuss why customer level costs differ across customers
6 (7&8)
SMA

62
 Level 1: Static-budget variance – the difference between an actual result
and the static-budgeted amount - Ouch!
– What happened?
– How much did we make vs. expected (budget)?
 Level 2: Flexible-budget variance – the difference between an actual result
and the flexible-budgeted amount - Ouch!
– what happened?
- How much was due to change in contribution margin (rev – costs)?
 Level 2: Sales-volume variance
- How much was due to change in volume?
 Level 3: Sales Quantity variance
- How much was due to change in quantity?
 Level 3: Sales Mix variance
- How much was due to change in mix?
 Level 4: Market Size variance
- How much was due to change in market size?
 Level 4: Market Share variance
- How much was due to change in market share?
MA

63
 Measures shifts between selling more or less of higher or lower
profitable products
Budgeted
Sales-Mix
Percentage
Actual
Sales-Mix
Percentage
X
Budgeted
Contribution
Margin per Unit
Sales-Mix
Variance =
Actual
Units of
All
Products
Sold
X
Subdivide the sales-volume variance into the sales-mix
variance
…the variance arises because actual sales mix differs from
budgeted sales mix
and the sales-quantity variance
… this variance arises because actual total unit sales differ from
budgeted total unit sales (P.591)
7

64
Budgeted
Units of all
Products
Sold
Actual
Units of All
Products
Sold
Budgeted
Contribution
Margin per Unit
Sales-
Quantity
Variance
=
Budgeted
Sales-Mix
Percentage
X X

Level 2: Change in margin
Change in volume
Example: Flexible-budget and sales-volume variances
65
MA1

Level 3: Change in mix – Which product makes you more money? Did you
sell a higher or lower proportion of this product?
Change in volume
Example: Sales-mix and sales-quantity variances
66
7

67
7
8
MA1

68
Budgeted
Market
Share
Actual
Market
Share
X
Budgeted
Contribution
Margin per
Composite Unit
for Budgeted
Mix
Market-
Share
Variance
=
Actual
Market
Size in
Units
X
Do you have control over this?
Market-share variance
Subdivide the sales-
quantity variance into
the market-share
variance
…the variance arises
because actual market
share differs from
budgeted market share
and the market-size
variance
… this variance arises
because actual market
size differ from budgeted
market size
(P.591)
8

69
Budgeted
Market
Size
Actual
Market
Size
Budgeted
Contribution
Margin per
Composite Unit
for Budgeted
Mix
Market-Size
Variance =
Budgeted
Market
Share
X X
1. Management can only change what they can control?
2. So the value of information is dependent on how well you separate out those
uncontrollable.
3. Do you have control over this?
Market-size variance

Which variance can you control?
Example: Market-share and Market-size variance
70
8

71
7
8
MA1

72
 Cost Allocation
 Learning Objective 4: Understand criteria to guide cost-allocation decisions
 Value Chain Analysis
 VCA-Customer linkages
 Learning Objective 1: Discuss why a company’s revenues and costs differ across customers
 Learning Objective 2: Identify the importance of customer-profitability profiles
 Learning Objective 3: Understand the cost-hierarchy-based operating income statement
 Learning Objective 5: Discuss decision faced when collecting and allocating indirect costs to
customers
 Sales Profitability Analysis
 Learning Objective 6: Subdivide the sales-variance into the sales-mix variance and the sales-quantity
variance into the market share variance and the market size variance
Week 3: Learning objective summary
Cost Allocation Value Chain Analysis Sales Profitability Analysis

Additional Example
Customer Profitability Analysis
73

74
ABM Model
Systems Planning
Classify Activities
Reduce
Costs
Improve
Decisions
ABC
a. Products (MA1)
c. Suppliers
PVA
Activities
Each Activity
Establish Activity
Opportunities
Activities
objects
Product design
Value engineering
Design
analysis
Functional
analysis
74

75
Customer
Profitability
Analysis
Customer
Revenue Analysis
Customer
Cost Analysis
Additional Example

76
Customer
Profitability
Analysis
Customer
Revenue Analysis
Customer
Cost Analysis

77
Customer Revenue Analysis
 Customer revenue analysis considers all activities that affect
the net amount received from the customers
 Customer revenue analysis traces prices and discounts
(including sales and cash discounts) to customers and identifies
financing costs associated with customer revenues

78
Example 3: Customer Revenue Analysis

79
Example 3: Customer Revenue Analysis
Insert Exhibit 5.18

80
Customer
Profitability
Analysis
Customer
Revenue Analysis
Customer
Cost Analysis

81
 Not all customers require the same type of activities. Examples
of customer-specific activities include:
 order processing costs
 billing, collection and payment processing costs
 accounts receivable and carrying costs
 customer service costs
 return or allowance processing costs
 restocking costs
 selling and marketing costs

82
 Customer cost analysis identifies activities and cost drivers to service
customers
 Traditionally, these costs are hidden in the customer support, marketing,
and sales function
 Customer cost can be classified into the following categories:
1. customer unit-level cost
2. customer batch-level cost (e.g. order size)
3. customer-sustaining cost (e.g. visits)
4. distribution-channel cost (e.g. com vs. retail)
5. sales-sustaining costs (e.g. maintaining firm sales capability)

83
Example 3: Customer Cost Analysis
Insert Exhibit 5.19
(Customer-Related Activity)
Here

84
Insert Exhibit 5.20
Which customer has higher batch level (order) activity costs?
Which customer has higher customer sustaining level (visits) activity costs?

85
Insert Exhibit 5.21

86
Customer
Profitability
Analysis
Customer
Revenue Analysis
Customer
Cost Analysis

87
Insert Exhibit 5.22
Example 3: Customer Revenue + Customer Cost
= Customer Profitability Analysis

88
ABM Model
Systems Planning
Classify Activities
Reduce
Costs
Improve
Decisions
ABC
a. Products (MA1)
c. Suppliers
PVA
Activities
Each Activity
Establish Activity
Opportunities
Activities
objects
Product design
Value engineering
Design
analysis
Functional
analysis
88

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