Case 4

2008 Betty W. Steadman 135

IMPLEMENTING THE ACTIVITY BASE COSTING
SYSTEM: A CASE STUDY ON DAKOTA OFFICE
SUPPLY
By Betty W. Steadman

Overview Situational Analysis

Activity Based Costing (ABC) is an DOP is a regional office supply
accounting method that allows an company with a strong reputation for
organization to determine actual costs customer service and quality supplies.
associated with each product and/or Additionally, DOP is unafraid to adopt
service produced by the organization new service operations such as its “desk
without regard to the organizational top” delivery option which delivered
structure or other extraneous function. For smaller orders directly to individual sites
Dakota Office Products (DOP), its existing as we all as its traditional commercially
costing system was inadequate because it delivered mass orders to customer
is incapable of accounting for even all of distribution sites (Kaplan, 2003, pp.1-2).
the known costs such as the desktop Additionally DOP deployed an Electronic
delivery service as well as hidden costs Data Interchange (EDI) solution in order
such as the 10% DOP paid to maintain its to ease data and payment transfer from and
working capital line of credit for accounts to customers as well as building a
receivable (Kaplan, 2003, p.4). Since ABC customer website that acts an order and
is a powerful tool for measuring account interface for its customers.
performance, identifying, describing, and Together these initiatives all expanded
assigning costs to, and reporting on an DOP’s customer service and quality
organization’s operations it could solve metrics but also came with a cost which
much of DOP’s critical cost oversights the company had difficulty identifying.
(Caplan, Melumad & Ziv, 2005). Used While exact costs were difficult to
holistically ABC can be utilized to also ascertain for DOP it is clear that the
improve processes and identify company is incurring expenses in a
opportunities to improve business manner that it previously had not since its
effectiveness and efficiency by EBIT (earnings before interest & taxes) for
determining the true or real costs of a fiscal year 2000 revealed a -1.3% loss
given product or service. ABC principles (Kaplan, 2003, p.4). Since the company
are used to focus management’s attention did not actually break down costs in order
on the total cost to produce a product or to arrive at a more accurate pricing
service, and as a basis for full cost schedule but instead relied only on a
recovery of a production or service universal 15% markup over basic material
process. costs, DOP had absolutely no way of being

Steadman, B.W. - Case Study 4: Implementing the Activity Base Costing System: A Case Study on Dakota Office Supply

136 Business Intelligence Journal July

able to identify where the cost would be divided by the number of cost-
inefficiencies were in its operations. drivers such as order set-up, order entry,
order validation, receiving, handling,
Activity Based Costing packaging, loading, and delivery and the
result would be the cost per occurrence of
Traditional product costing such as the cost-driver rate: $550k. This figure is
DOP employs was designed for an then divided by the total number of
industry comprised of companies having instances these actions occurred which, as
one-type (homogenous) of product, large reported by DOP was 80k during 2000 and
direct (fixed) costs, very few data so the cost-driver the year would be $6.87
collection techniques and fewer data per activity on average. This figure would
analysis tools, and low below line costs. be used to identify unprofitable accounts
By contrast, contemporary industry such as the customer A and B mentioned
exhibits a highly diversified in the case where customer A and B both
product/service mix as evidenced by generated approximately $100k in annual
DOP’s employment of both commercial revenues and based on customer A’s
delivery methods and its new customized 21.2% markup this would mean that
individually oriented delivery model $78,800 represented the COGS (cost of
accompanied by high overhead costs as goods sold) while the cost-driver would
compared to fixed labor costs, a mass indicate that $10,992 went towards the
amount of data with countless ways to associated activity costs which would
analyze it, and considerable non-product, mean that customer A’s profitability is
indirect, or hidden costs affecting overall $10,208. By contrast, customer B’s
pricing, costs and expenditures. profitability is lower. Based on the same
ABC is a system of accounting based assumptions customer B’s COGS is
on the allocation of resources and $77,600 while the cost-driver would be
accounting for the value of those resources factored with an extra activity per carton
in relation to a specific task or activity. In and thus would be $12,366 plus the $3,000
this sense, labor and direct material costs to carry its accounts receivable balance
lose the prominence that they are given in resulting in a profitability of $7,034.
traditional costing systems and are Because of the additional activities
accounted for as any other resource is associated with customer B and the hidden
accounted for. Activities such as sales, cost of carrying its accounts receivable
support, or other business processes are balance, customer B is less profitable with
largely excluded. This is not the case in the same overall revenues as customer A.
ABC because all the various functions, While it is difficult to identify limitations
activities, and support processes of a in this ABC methodology with respect to
company are broken down into pools of these particular customers it could be
resources with a particular value attached argued that the goodwill created by the
to them. For example, developing a cost- additional services for customer B will
driver rate for DOP would involve basing result in longer service and greater orders
an estimate on an approximate 80% in the future.
capacity rate to employees. For example, a Recommended Application at DOP
cost-driver for DOP related to warehouse
operations is 4,400,000 annually which


2008 Betty W. Steadman 137

ABC in Practice at Dakota ABC that reduces overall expenditures of
the company.
Before performing ABC, a baseline or a
starting point is needed for business Procedural Steps of ABC
process improvement and a baseline can
be expressed in some form of model. This Some typical steps in implementing an
baseline is critical for DOP because in ABC program are often defined as five
order to establish this baseline metric the activities that must occur if a true cost
analytics just performed must be done for accounting is to take place within the
each individual account. If DOP performs confines of an ABC operation. These five
this activity on each customer the strategic activities are typically listed as (Latshaw
management benefits would be substantial & Cortese-Danile, 2002): 1) Analysis of
because all the excess cost-drivers could activities, 2) Cost gathering, 3)
be eliminated resulting in much wider Associating costs with activities, 4) Base-
operating margins and thus profitability lining output metrics, and 5) Cost analysis.
without increasing costs or committing These steps should be performed by an
resources to gain this efficiency. integrated team of cost accountants, floor
Therefore, a baseline is a documentation managers, and project managers that have
of the organization's policies, practices, been committed by top management to
methods, measures, costs and their work on the ABC project within DOP.
interrelationships at a particular location at Yet, the cost savings could be enormous.
a particular point in time (Maiga & Jacobs, For example, by identifying the previous
2003). Through base-lining, activity inputs cost-drivers it is apparent that a simple
and outputs across functional lines of migration of all customers over to the
business can be identified. ABC is the only internet based ordering and billing system
improvement methodology that provides approximately 9,500 man hours can be
output or unit costs. Value added activities removed from the current order fulfillment
are those for which the customers are process resulting in a cost savings of at
usually willing to pay in some fashion for least $142,500 in labor alone not to
the product or service. Non-value added mention efficiencies gained in the order
are activities that create waste, result in a fulfillment process where the cost-driver
delay of some sort, and potentially adds rate could be reduced by the removal of an
costs to the products or services. activity which would amount to
Resources are assigned to activities so that approximately $515,250 or a total cost
the activities can be performed in the first savings of $657,750 annually. Considering
place. Some of Pilgrims’ resources are DOP missed its earnings target by
measured in man-hours, machine hours as (470,000) this cost savings would actually
well as machine maintenance and return the company to profitability as the
operational overhead. It is through ABC following chart reveals:
that an organization can begin to see actual The straight blue line is revenue while
dollar costs against individual activities, the green line represents the direction
and find opportunities to streamline or profits are currently moving without ABC
reduce those costs, or even eliminate the and the yellow line represents the direction
entire activity thus removing the cost it will move following the implementation
altogether. This is the process inherent in of ABC. The pink line represents profits


138 Business Intelligence Journal July

should the company only cut costs without Products. Harvard Business School, 9-
improving its cost-accounting 102-021.
methodology.
Latshaw, C. A., & Cortese-Danile, T. M.
References (2002). Activity-Based Costing:
Usage and Pitfalls. Review of Business,
Caplan, D., Melumad, N. D., & Ziv, A. 23(1), 30+.
(2005). Activity-Based Costing and
Cost Interdependencies among Products: Maiga, A. S., & Jacobs, F. A. (2003).
The Denim Finishing Company. Issues Balanced Scorecard, Activity-Based
in Accounting Education, 20(1), 51+. Costing and Company Performance: An
Empirical Analysis. Journal of
Kaplan, R. (2003). Dakota Office Managerial Issues, 15(3), 283+.


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