Extending and Applying ABC concepts

Activity Based Costing-Review

Mechanism for cost allocation Single cost pool to Multiple Cost Pool Single Cost Driver to Multiple activity based drivers Better Costing of Products

Over and Undercosting

Overcostinga product consumes a low level of

resources but is allocated high costs per unit. Undercostinga product consumes a high level of resources but is allocated low costs per unit.

Cross-subsidization
The results of overcosting one product and

undercosting another. The overcosted product absorbs too much cost, making it seem less profitable than it really is. The undercosted product is left with too little cost, making it seem more profitable than it really is.

When is ABC most useful

When Increase in product diversity Increase in indirect costs Advances in information technology Competition in foreign markets Decision Making Product pricing Activity based management

Customer Profitability Analysis

Activity-Based Management
A method of management that uses ABC as an integral

part in critical decision-making situations, including:

Pricing and product-mix decisions Cost reduction and process improvement decisions Design decisions Planning and managing activities

ABC vs. ABM

Activity Based Management: Customer Profitability Analysis

Customer-Profitability Analysis is the reporting and

analysis of
revenues earned from customers and costs incurred to earn those revenues

An analysis of cross-customer differences in revenues

and costs can provide insight into

why differences exist in the operating income earned

from different customers

Customer Cost Analysis

Customer Cost Hierarchy categorizes costs related to

customers into different cost pools on the basis of different:

types of drivers cost-allocation bases degrees of difficulty in determining cause-and-effect or

benefits-received relationships

Example: Freedom Card at Bank of Bodega Bay

The Freedom Card is a credit card that competes with

national credit cards such as Visa and Master card. It is marketed by the Bank of Bodega Bay. Tommy Lee Zhang is the manager of the Freedom Card Division and wishes to develop a customer profitability reporting system.

Four Representative Users

A Annual purchase at retail merchants $80,000 B $26,000 C $34,000 D $8,000

Number of retail transactions Annual fee Average annual balance on which interest is paid Number of customer inquiries Number of replacements (loss/theft)

800 $50 $6,000

520 $0 $0

272 $50 $2,000

200 $0 $100

6 0

12 2

8 1

2 0

Example contnued
Customer B card issued under special promotion of

no lifetime fee with minimum of one transaction per year. Customer D is currently a student no fee program at select Universities. Activity based costing shows
Customer transaction at retail merchants costs $0.50 to

process. Customer inquiry costs $5 per inquiry. Replacing a lost or stolen card costs @120. Annual cost to bank for account (including account maintenance and statement mailing) is $108.

Additional Facts
BOB receives 2% of purchase amount from retail

merchants per usage. 2006 bad debts were 0.5% of total purchases. Thus, net amount =2.0-0.5=1.5% Interest spread (rate for customers less BOBs cost of borrowing)=9% on average balance.

Customer Profitability Analysis

Customer A B C Customer revenues Annual fee Merchant paymentsa Interest spreadb Total Customer costs Annual maintenance costs Bad debt provisionc Transaction costsd Customer inquiriese Card replacementsf Total Customer operating income
a

D $ 0 160 9 169 108 40 100 10 0 258 $ (89)

$ 50 1,600 540 2,190 108 400 400 30 0 938 $1,252

d e

$ 0 520 0 520 108 130 260 60 240 798 $(278)

$ 50 680 180 910 108 170 136 40 120 574 $336

2% $80,000; $26,000; $34,000; $8,000 b 9% $6,000; $0; $2,000; $100 c 0.5% $80,000; $26,000; $34,000; $8,000

$0.50 800; 520; 272; 200 $5 6; 12; 8; 2 f $120 0; 2; 1; 0

Note: The above analysis uses the average 0.5% bad debt provision. Bay Bank may want to adjust individual customer-profitability reports at a subsequent date to reflect actual bad debt experience.

Develop profiles of Profitable and Unprofitable Customers

2. Revenues Fees Merchant payments Interest spread Costs Bad debt provision Transaction costs Profitable Customers Unprofitable Customers Pays fee Fee waived High billings and high billings Low billings and low billings per transaction per transaction High outstanding balance Pays on time and has no outstanding balance Pays account Low number of transactions & high billings per transaction Zero or few inquiries No replacements Defaults on account High number of transactions & low billings per transaction Many inquiries Multiple replacements

Customer inquiries Card replacement

Should BOB charge its card holders for making inquiries (outstanding balance/ disputed charges) and Replacement of lost or stolen cards?
The pros of charging for individual services include: Additional source of revenues. If BOB is able to charge more than the cost of each service, it may prefer that customers be prolific users of its services. If BOB is not able to charge the full cost" for each service, the charge may reduce customer usage (thus reducing the losses associated with providing services at below cost). For example, Customer B may make fewer inquiries about his or her balance. The cons of charging for individual services include: May cause customers to drop card or decrease its usage vis--vis competitors cards that have zero or minimal charges. May attract negative publicity from consumer groups who target companies such as banks and credit card companies.

Proposal: discontinue the sizable number of low-volume customers

Factors to consider include: The growth potential of individual customers. Some low-volume credit customers (such as students) may be high-volume users in the medium run. The costs saved by discontinuing low-volume credit card customers. Many costs may be relatively fixed and may not be eliminated by dropping customers. The publicity BOB may attract from discontinuing these customers. There is the potential for much negative publicity from such decisions. Alternatives available to discontinuance, e.g., adopt individual service charges.

Branch Teller Service

Customers who visit branch offices cost the bank considerable

money. It is much more economical for customers to use an ATM, mail, or PC banking. Some banks have tried to discourage branch visits by charging a fee. Profitability analysis shows that such policies may be a serious mistake. In most bank es, branches are visited most by two groups: the most profitable and the least profitable. Policies that turn away unprofitable customers may also turn off Gold customers.

Grouping Customers by Profitability

Group I Group 2 High revenue, High revenue, low cost most high cost profitable group

Group 3 Low revenue, low cost

Group 4 Low revenue, high cost-least profitable group

Measuring and Managing Customer Profitability

Profits
Hi

Types of Customers Passive: Product is crucial Good supplier match

Costly to service, but pay top dollar

Customers that are above the costplus diagonal are more profitable

Net (ABC) Margin Realized

Price-sensitive and few special demands

Low

Aggressive: Leverage their buying power Low price and lots of customized service and features

Cost to Serve
Low

Losses
Hi

Problem 6-38/41: Fresno Fiber Optics

Customer Activity Sales Order taking Special Handling Special shipping Cost Driver Sales visits Purchase orders Units handled Shipments Cost Rate $1000 $200 50 500

Fresno Fiber Optics: Customer Info I

Customer Activity Sales Order taking Special Handling Special shipping Trace Telecom 8 visits 15 orders 800 units handled 18 Shipments Caltex Computer 6 visits 20 orders 600 units 20 shipments

Fresno Fiber Optics: Customer Info II

Customer Activity Sales revenue Cost of goods sold General selling Costs General administration costs Trace Telecom $190,000 $80,000 $24,000 $19,000 Caltex Computer $123,800 $62,000 $18,000 $16,000