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Chapter 5

Activity-Based Costing and Management

Teaching Notes for Cases

5-1 Blue Ridge Manufacturing (Activity-Based Costing for Marketing Channels)

Case Description:
Blue Ridge Manufacturing produces and sells towels for the U.S. “sport towel” market. A “sport towel” is
a towel that has the promotion of an event or a log printed on it. Most often they are used in connection
with major sporting events such as the Super Bowl.

Case Writers: Paul E. Juras and Paul A. Dierks, Wake Forest University; written for the IMA 1994 Student
Case Competition

Teaching Objectives:
The main teaching objective of the case is to illustrate, with an extensive numerical exercise, the
use of value chain analysis for profitability analysis. The analysis follows an ABC model, in which selling
and administrative costs are allocated to customer groups for the purpose of analyzing customer

Main Points:
Activity-Based Costing
Value Chain Analysis
Customer profitability analysis

Discussion Questions:
1. What is Blue Ridge’s competitive strategy?

The current strategy appears to be a combination of focus (on the southeast states) and cost
leadership. The manufacturing is in a modern plant with upgraded facilities, including the use of ABC
costing for manufacturing costs and the commitment to introducing advanced manufacturing
techniques. This suggests a commitment to efficiency and large volume production, which is
characteristic of cost leadership firms. Because the product is much like a commodity, unless Blue
Ridge has exclusive rights from the sports teams, it is unlikely they are competing on differentiation.
However, with the introduction of new ink that is non-toxic and won’t wash out, the firm appears
to be moving to a differentiation strategy. Further evidence of this is the firm is “going national,” it will
focus more on quality, and is interested in identifying the least profitable customers. All this suggests
efforts to differentiate the firm from its competitors.
The case does not provide sufficient information for a thorough strategic analysis. However, the
student’s should be expected to identify strategic issues, as noted above, and also:
a) Is the new ink patented? How soon are competitors expected to meet this new innovation?
b) Are Blue Ridge’s licenses with the sports teams of unique value, or do competitors have the
same access as Blue Ridge?
c) How strong are Blue Ridge’s ties to its customers, especially the large customers? Are these
ties sufficiently strong to protect against competition for the next few years?
d) Has Blue Ridge integrated the marketing and manufacturing strategies, so that they are
consistent? Given the changes in both manufacturing (new ink) and marketing (going national, seeking
more profitable customers), the integration of these functions is important.

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2. What type of cost system does Blue Ridge use, and is it consistent with their strategy?

The ABC costing system in use is consistent with the cost leadership strategy. It will also assist
the firm in identifying the most profitable customers, as the firm moves to a differentiation strategy
based on quality and innovation.

3. What is Blue Ridge likely to gain from a value chain analysis? What are some of the opportunities for
cost reduction and for value added for the customers?

The value chain analysis can help Blue Ridge better understand its competitive advantage and to
identify opportunities for improving its competitive position.
Blue Ridge occupies the second, third and fourth value activities of a five-activity chain - knitting,
ink-dye-embroidery, and marketing-distribution:

A study of the value chain raises issues for possible cost reduction and value added.

Cost reduction:
- Can Blue Ridge obtain better terms or prices from its suppliers? Materials cost represents a large
share of total manufacturing cost.
- Use profitability analysis (as illustrated in the computer exercise below) to determine the “full”
costs of each product line and customer group as a basis for identifying and focusing on the most profitable
product lines and customers.
- Further analyses to identify the cost drivers in manufacturing, marketing and distribution:
- Customer service requirements
- Order frequency
- Delivery frequency
- Geographic location
- Technical support requirements
(Does Blue Ridge do design or other service for any of the customers, and if so are they properly charged to
the customer?)

Value Added for Customers

- Develop service links with the larger customers, as in the case of Proctor and Gamble and Wal-Mart;
where the retailer and manufacturer share data so that the manufacturer knows when, where and what to
restock at the retailer’s various locations
- Faster delivery, better coordination with all customers, especially the largest ones
- Identify new ways to improve customer satisfaction
- Identify new ways to boost demand at the retail level

Computer Assignment:
Develop a spreadsheet analysis, which can be used to assess the profitability of the three customer groups
of Blue Ridge -- large, medium and small customer account size. Use the information in Tables 1-4 to trace
and allocate the costs necessary for the analysis.

The solution is shown on the attached spreadsheet. The solution process involves three stages:

Stage 1: Allocate SG & A Costs to SG & A Activities.

1. Collect all SG & A costs incurred in each function (Shipping, Sales, Marketing) as showed in
Table 4A of the case.
2. For each function, collect usage % for each activity (Entering P.O., Commissions, Shipping,
Invoicing, Making Sales Calls, Checking Credit, Samples & Catalog Information, Special
Handling, Distribution Management, Marketing by Customer Type, Advertising & Promotion,
Marketing, Administrative Office Support, and Licenses & Fees) as shown in 4A.
3. Then, allocate function costs to activities by usage %.

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Stage 2: Allocate activity costs to Customer Type (Large, Medium, Small).
1. Identify cost drivers (as shown in Table 4) and their consumption statistics for each customer
type (as shown in Table 1).
2. Calculate cost driver consumption % for each customer type.
3. Allocate activity costs to customer type.

Stage 3: Customer Profitability Analysis.

1. Calculate revenues for each customer group (sales quantities from Table 1 and unit prices
from Table 2).
2. Calculate manufacturing cost (Regular, Mid-size, Hand, Special), customizing cost (Inking,
Embroidery, Dyeing), SG & A cost and total costs for each customer group (using data from
Tables 1 & 2).
3. Calculate customer profits ($102,661, $49,742, -$4,828) and profit per customer ($12,833,
$323, -$6) for each customer type.

Note that the analysis makes it clear the group of large customers provide most of the profits for
Blue Ridge. Show how the cost of purchase orders, shipping, the medium and small customer groups
predominantly cause credit checks, advertising, and marketing. The analysis shows clearly that these two
groups, on a per customer basis, are marginally profitable. This analysis indicates that Blue Ridge should
concentrate on its largest customers and/or determines how to make its smaller customers more profitable.
This is especially important if the firm is planning to “go national” and this may bring in an even larger
portion of medium and smaller customers.

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-3 ©McGraw-Hill Companies, Inc., 2008

Blue Ridge Manufacturing
First Stage Allocation: Allocate SG&A Costs to SG&A Activities
First: SG&A Costs Total
Shipping Sales Marketing Other Assigned Source
Administration 17,000 37,400 20,400 56,100 130,900Table 3
Selling 15,500 117,800 9,300 12,400 155,000Table 3
$32,500 $155,200 $29,700 $68,500 $285,900

Percentage of...
Second: SG&A Shipping Sales Marketing Other
Enter P.O. 55% 10% Table 3
Commissions 10% "
Shipping 65% 15% "
Invoicing 20% "
Sales Calls 30% 10% "
Check Credit 10% "
Samples... 5% 10% "
Sp Handling 5% 5% "
Distribution 10% 10% "
Marketing, Customer 5% "
Advertising 30% "
Marketing 15% 50% 5% "
Administrative 20% "
Licenses, fees 0% 5% "
TOTAL 100% 100% 100% 100% "

Third: Allocate Costs to Activities

Shipping Sales Marketing Other Total
Enter P.O. 0 85,360 0 6,850 92,210
Commissions 0 15,520 0 0 15,520
Shipping 21,125 0 0 10,275 31,400
Invoicing 0 0 0 13,700 13,700
Sales Calls 0 46,560 0 6,850 53,410
Check Credit 0 0 0 6,850 6,850
Samples,... 1,625 0 2,970 0 4,595
Sp Handling 1,625 0 0 3,425 5,050
Distribution 3,250 0 2,970 0 6,220
Marketing, Cust 0 7,760 0 0 7,760
Advertising 0 0 8,910 0 8,910
Marketing 4,875 0 14,850 3,425 23,150
Administrative 0 0 0 13,700 13,700
Licenses, fees 0 0 0 3,425 3,425
TOTAL $ 32,500 $155,200 $29,700 $68,500 $285,900Table 3

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Second Stage Allocation: Allocates SA&A Activities to Customer Type (Large, Medium, Small)
First: Identify Cost Driver and Its Consumption Level or Amount
Customer Type...
COST DRIVER Large Medium Small Total
Units sold- w/o specials 99,770 55,118 116,812 271,700
Units sold-Total 100,250 58,544 117,406 276,200 Table 1
Units embroidered 5,959 6,490 29,394 41,843 "
Units dyed 20,536 9,935 12,328 42,799 "
Orders 133 845 5,130 6,108 "
Shipments 147 923 5,431 6,501 "
Invoices 112 754 4,737 5,603 "
%>60days 1 11 122 134 "
Revenues (Sales $308,762 $183,744 $318,024 $810,530 "
Customers 8 154 824 986 "

Second: Calculate Cost Driver Percentage for Each Customer Type

Units sold (excl. Special) 0.367 0.203 0.430 1.000From above
Orders 0.022 0.138 0.840 1.000From above
Shipments 0.023 0.142 0.835 1.000From above
Invoices 0.020 0.135 0.845 1.000From above
%>60days 0.007 0.082 0.910 1.000From above
Revenues 0.381 0.227 0.392 1.000From above
Customers 0.008 0.156 0.836 1.000From above

Third: Allocate Activity Costs to Customer Type Cost Driver/ Allocation Base
ACTIVITIES Total Cost Large Medium Small (Table 4)
Enter P.O. 92,210 2,008 12,757 77,446 Orders
Commissions 15,520 15,520 Revenues (Medium Customers
Shipping 31,400 710 4,458 26,232 only)
Invoicing 13,700 274 1,844 11,583 Invoices
Sales Calls 53,410 53,410 Revenues (Large
Check Credit 6,850 51 562 6,237 Customers only)
Samples... 4,595 1,750 1,042 1,803 Revenues
Sp Handling 5,050 1,010 4,040 Estimate (20% M, 80% S)
Distribution 6,220 2,369 1,410 2,441 Revenues
Marketing, Cust 7,760 2,956 1,759 3,045 Revenues
Advertising 8,910 2,228 6,682 Estimate (25% M, 75% S)
Marketing 23,150 8,501 4,696 9,953 Units sold (Excluding Specials)
Administrative 13,700 5,031 2,779 5,890 Units sold (Excluding Specials)
Licenses, fees 3,425 3,425 Revenues (Medium Customers
TOTAL 285,900 77,060 53,490 155,350 only)

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-5 ©McGraw-Hill Companies, Inc., 2008

Third Stage: Customer Profitability Analysis
First: Get Revenues by Customer Group
Unit Sales Large Medium Small
Regular 27,250 16,600 10,550 54,400 Table 1
Mid-size 36,640 18,552 10,308 65,500 "
Hand 35,880 19,966 95,954 151,800 "
Special 480 3,426 594 4,500 "
Total 100,250 58,544 117,406 276,200

Revenue Price Large Medium Small

Regular $ 3.60 98,100 59,760 37,980 195,840 Table 2
Mid-size $ 3.20 117,248 59,366 32,986 209,600 "
Hand $ 2.55 91,494 50,913 244,683 387,090 "
Special $ 4.00 1,920 13,704 2,376 18,000 "
Total Revenue $308,762 $183,744 $318,024 $810,530BB

Second: Calculate Manufacturing Cost --

(1) Unit Cost
Regular $ 1.19 32,428 19,754 12,554 64,736Table 2 x Table 1
Mid-size $ 1.03 37,739 19,109 10,617 67,465 "
Hand $ 0.89 31,933 17,770 85,399 135,102 "
Special $ 1.44 691 4,933 855 6,480 "
Total $102,791 $61,566 $109,426 $273,783CC

Direct Cost of Unit Cost

Inking (Units x 2) $ 0.0817 16,381 9,566 19,184 45,131Table 2 x Table 1
Embroidery $ 1.2770 7,610 8,288 37,536 53,434
Dyeing $ 0.1100 2,259 1,093 1,356 4,708
$26,249 $18,947 $58,076 $103,272DD

(2) Total Cost

Mfg Cost $102,791 $61,566 $109,426 $273,783From CC above
Customizing $26,249 $18,947 $58,076 $103,272From DD above
SG&A 77,060 53,490 155,350 $285,900From AA above
Total Cost $206,101 $134,002 $322,853 $662,955EE

Third: Calculate Customer Profit --

(1) Total
$102,661 $49,742 $(4,828) $147,575BB-EE
(2) Per Customer $12,833 $323 $(6) $150

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-6 ©McGraw-Hill Companies, Inc., 2008

5-2 Blue Ridge Manufacturing (Using SAS Activity-Based Costing Software)

Overview of the Case

Case 5-2 is based on the same case material as in case 5-1, and has the same solution. The
difference is that the students using Case 5-2 have the experience of using a comprehensive software
system (SAS Institute’s Oros Quick® ABC software) to obtain the solution, in contrast to the Excel-based
approach in Case 5-1. Cases 5-1 and 5-2 can be assigned together to provide the opportunity for the
students to compare and contrast the two solution approaches and to verify that they produce the same
The instructor can download the files shown in TN-1 that are pertinent to the case from the
McGraw-Hill/Irwin textbook website (, under Instructor Center: Solutions to
ABC cases. These files include: A Word files of the teaching note as it appears in this Guide. The Excel file
is the Excel solution for the case that is used in case 5-1 and can also be used as a benchmark for the
solution for case 5-2. The rest of the files those used to solve the case using Oros Quick®, so they
collectively represent the Oros solution. We recommend that you download all of these files into a specific
folder for the case, and access the Excel and Oros solutions from this subdirectory. The folder on my
computer is labeled “Blue Ridge Manufacturing” as seen in TN-1.

The actual Oros Quick® Software and Oros Quick® Tutorial are downloaded separately from the McGraw-
Hill/Irwin website (, under Premium Content. Students and instructors can
download the software and tutorial here as well as a Word file of the case as it appears in the Cases and
Readings Manual.
(For clarity, the system, tutorial, and solutions files are downloaded separately. For example, the next Case
5-3: Sunny View Dairy Farm is also an Oros case, and it will have a similar set of files to those discussed
above for the Blue Ridge Manufacturing case. The Sunny View Dairy Farm files will be in a separate link
to be downloaded to a separate folder. As further Oros cases are added to the web site in the coming
months, they will be set up in the same format.)

The organization of downloads is as follows. The web site will have the following links:
Under Premium Content (students will have access to this section with a passcode packaged with
their text):
1. A link to download the Oros Quick® Software (a 9,095KB Winzip file; “Quick 551”)
2. A link to download the Oros tutorial (a 1,833 KB Adobe Acrobat file; “Oros Tutorial”)
3. A link to the Word file of the Blue Ridge case for use with Oros Quick®
Under the Instructor Center (password protected):
1. A link to download the Blue Ridge Manufacturing Case Solution files (these files are shown in
TN-1)—the teaching note, Excel solution file, and Oros solutions files

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TN-1 Solutions Files for the Blue Ridge Manufacturing Case

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Approach to Teaching the Case

The goal of case 5-2 is to show students how to use a software system for calculating costs using
ABC costing. The use of the Oros system from SAS Software (formerly ABC Technologies Inc) provides
the student an experience using an ABC software system that is used in practice by firms implementing
ABC costing. It is one of the most well-known and widely used systems of this type. The Oros system
used here (Oros Quick®) is a demonstration version which limits the number of accounts and other
elements of the model, but the structure of the model is the same as that used in practice.
A student who has the experience using an actual software system will have a better understanding
of the complexities involved in implanting such systems. They should also have a better appreciation of
what these systems can accomplish in the real world, since they are not working with the complexities
inherent in comprehensive systems. For example, most textbook problems and cases in ABC costing
simplify the application greatly. It is very uncommon, for example, to see a problem or case that requires
the use of resource consumption cost drivers. Generally, the problems and cases available today focus on
the process of assigning activity cost pools to cost objects, thereby ignoring the first half of the “ABC
Cross,” the consumption of resources by activities.
The Blue Ridge Manufacturing case is one of the few cases that allows a consideration of both
resources and activities, and is therefore an excellent example to use in studying ABC costing. It is also a
useful case for illustrating the application of software such as the Oros system, since Oros, like other real-
world ABC systems incorporate all the elements of the ABC Cross (see the cost assignment view of the
ABC Cross on page 6 of the Oros tutorial).

There are a variety of ways the case can be used, from a relatively short exercise to a fairly
extensive and comprehensive case assignment. My suggestions below begin with the short and easy and
progress to the most extensive and demanding.

1. Perhaps the simplest is to assign students to read the Oros tutorial. Then, the tutorial could be discussed
in class period or part thereof. In the class discussion of the tutorial, the instructor can bring out the key
elements of the model (centers, accounts, assignments, etc) and relate these to the Blue Ridge case or to
other ABC-based problems that the instructor might be covering. For example, the instructor could ask
how certain information in a problem assigned from the textbook would be included in the Oros model.
For the Blue Ridge case, the instructor might ask, what are the Oros accounts (or drivers or activities, etc)
that you would use to build an Oros model?
This approach would clearly highlight for example, whether the problem has resources and
resource cost drivers or not, and would reveal the degree of complexity in the activity cost assignment
process (do some activities serve only some of the cost objects, are does each activity serve all cost
objects?). Information from the tutorial could also be used on an exam, for example, by asking “What are
the default cost drivers included in Oros? or, What is the difference between a cost center, and account,
and an activity, in Oros?”

2. A more challenging use of the Oros system would be to provide the students a solution for the Blue
Ridge case (for example, the Excel solution to Case 5-1; see TN-2) and then require them to use the tutorial
and the Oros system to solve the problem using Oros. The students would have the solution as a guide to
building the model and to checking the accuracy of their work. This would be a substantially more
extensive experience for the students and would acquaint them with the details of using a system such as
Oros. We would suggest the student should budget about two hours for reviewing the tutorial prior to
doing the case, and then another two hours, approximately, for completing the case with the solution in
hand. These times could be reduced somewhat if you assign the students to do the work in teams.

Another variation on this approach would be to build a partial Oros solution by for example
entering the accounts, activities, drivers, and cost objects, so that the student would only have to add the
cost driver quantities and assignments to complete the model. See the explanation of the use of the tutorial
in the answer to assignment question 5 below to get an idea of the various phases to completing the Oros

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model as a basis for choosing how much or how little of the model to prepare for the students. With this
approach, the time to complete the model could be reduced to an hour or less.

Yet another variation on this approach would be to have the students build the entire Oros model
but provide some helpful hints about how to complete each step, for example, by including the steps
outlined in the solution key for assignment question 5 below. This should allow the students (or teams) to
complete the project in less than 2 hours.

3. The most extensive use of the Oros model, the one that we prefer, is to have the student complete the
Oros solution for the case without the aid of the solution key. We assign the students to teams to do this
assignment because of the amount of work involved. A reasonable time for the student to budget for this
exercise would be two hours for the tutorial and 3 hours for the solution of the case, when working as
teams. Somewhat more time will be required if working alone.

Teaching Notes for Assignments

1. Students should download and install the Oros Quick® ABC/M program (WinZip file).
The link for this download is on the McGraw-Hill/Irwin text website: under Premium Content. This will require the user to have the WinZip
program. WinZip can be obtained at for a single user fee of
$29 or there is a link on the site for a free trial version of WinZip as well.

2. Students should download the Oros Quick® Tutorial (Adobe Acrobat file)
The link for this download is on the McGraw-Hill/Irwin website: under Premium Content. This will require Adobe Acrobat Reader. Reader can
be obtained free at

3. Work through the Oros Tutorial (you can skip the sections on attributes and on the balanced
The student should expect to spend about 2 hours on this. A student could skim through
it rather quickly or spend several hours. We think the most benefit would be obtained by planning to spend
about 1 ½ to 2 hours, and then go to steps 4 and 5 below.

4. Create a folder on your computer labeled “Blue Ridge.”

This step is added simply to reduce clutter on the student’s computer and to keep the files
in a single convenient location for later reference.

5. Use the information in the Blue Ridge Manufacturing Company Case (Case Number 5-1) and in
the tutorial to complete an ABC costing application using Oros; determine the ABC-based unit
costs for Blue Ridge’s three customer groups.
The students should allow approximately 3 hours for this step working in teams, or a little
longer if working alone. The best way to complete the step is to print out the tutorial and to follow the
tutorial page by page in entering the relevant information from the case, replacing the Tyler case
information in the tutorial with the Blue Ridge Manufacturing information. Some suggestion for using the
tutorial follow (tutorial pages are show in parenthesis):
 Page 24 of the tutorial has a good overview of the structure of the Oros model
 Under Building Resources (pp19-22)
o Under resources, there is only one “center” in the Blue Ridge case, that is,
General and Administrative Costs
o There are four “accounts” in this center: shipping, sales, marketing, and other
 Under Building the Activity Structure (pp 23):
o There are 14 activities in the model, from “Enter Purchase Order” to “Licenses and Fees”
 Under Creating Cost Objects (pp24-25):

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-10 ©McGraw-Hill Companies, Inc., 2008

o There are three cost objects; small, medium and large customers
 Building Drivers (29-31):
o There are two types of drivers in any ABC application and in the Oros system: resource
consumption cost drivers and activity consumption drivers
o There are two default drivers already in the Oros system – “evenly assigned” and
“percentage.” The resource consumption cost drivers for the Blue Ridge case will use
the “percentage” cost driver.
o You will need to add six additional activity consumption cost drivers for the Blue Ridge
case: Number of units sold, orders, shipments, invoices, accounts > 60 days, and
 Creating Assignment Paths (pp 32-43)
o Each resource is linked to the activities that receive costs from that resource
o Each activity is linked to the cost objects that receive costs from that activity
 Tutorial pp 43- 69. Can skip
 Entering Data (pp 70-80):
o This section is used to show you how to enter the costs for each of the resource accounts
and the quantities for the resource drivers; this information is in Table 4A of the case
o Next you enter the activity cost driver quantities, from Table 1 of the case
o Finally, you enter the cost object (“output”) quantities from Table 1 of the case
 Calculating the Model (pp 81-86):
o This section shows how the model is calculate
o Note that the cost object multi-level view now shows the final allocation of resource costs
to activities and then from the activities to the three cost objects, the large, medium, and
small customer groups.
o The assignment question asks for unit costs which is not automatically included in the
cost object multi-level view. This can be added easily by clicking on the command line
that shows “Name,” “ReferenceNumber,” and “Cost,” and then use the dialog box to add
the additional columns: “UserOutputQty,” and “Unit Cost.” The cost analysis is now
 Tutorial pages 87- end; not needed for the Blue Ridge Case.

6. Create and print a unit cost report for Blue Ridge, using the Oros system.
The student prepares a unit cost report. The unit cost report is obtained from the file
menu under “Generate Reports.” You must select Unit Cost Report under “Module Reports” and Cost
Objects under “Select Data.”

Some Screens from the Oros Solution of the Blue Ridge Manufacturing Case are as follows. These screens
are included here as a guide to the instructor as to how the development of the solutions will look on the
computer screen. One teaching strategy for the instructor is to copy and hand out to the students some of
these screens to assist them in the development of their solutions. Note also that the tutorial has screens to
assist in the development of the solution. The difference here is that the screens in the tutorial are for the
case used in the tutorial, while the screens shown below are specific to the Blue Ridge case.

TN-2: Excel Solution for Blue Ridge

TN-3: List of Resources
TN-4: List of Activities Showing Costs after Model is Calculated
TN-5: Resource Driver Assignments to Activities
TN-6: Activity Driver Assignments to Cost Objects
TN-7: Resource Costs
TN-8: Resource Driver Quantities
TN-9: Activity Driver Quantities
TN-10: Cost Object Quantities
TN-11: Cost Allocation to Cost Objects after Model is Calculated, Showing Unit Costs

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-11 ©McGraw-Hill Companies, Inc., 2008

TN-12: Unit Cost Report

TN-2 Excel Solution for the Blue Ridge Manufacturing Case

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TN-3 List of Resources

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TN-4 List of Activities, Showing Costs after Model is Calculated

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TN-5 Resource Driver Assignments to Activities

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TN-6 Activity Driver Assignments to Cost Objects

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TN-7 Resource Costs

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TN-8 Resource Driver Quantities

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TN-9 Activity Cost Driver Quantities

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TN-10 Cost Object Quantities

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TN-11 Cost Allocation to Cost Objects after Model is Calculated

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TN-12 Unit Cost Report for Blue Ridge Manufacturing

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5-3 Columbo Soft-Serve Frozen Yogurt

Purpose of the case:

This case illustrates the application of Activity-based costing to marketing costs in a food
manufacturer. While the purpose of analyzing product costs is to identify costs per unit of
product, the purpose of analyzing marketing costs is to identify costs per customer or customer
group. This case illustrates how cost drivers are identified and used to compare two separate
customer groups based on the channels of distribution. These cost drivers could also be used to
analyze marketing costs for individual customers. This information is very useful for
understanding profitability in the two channels and for decisions about how to service the two

Suggested Strategy for Use:

About 60 to 90 minutes are needed to discuss the case thoroughly. This fits well in a 90 minute
class with some lecture about Activity-based costing. I suggest starting with a short background
about marketing in the food business followed by a discussion of the critical issues in the case.
Then, discuss the activity-based costing analysis of the marketing costs. During this phase,
discuss the development of cost drivers, how the firm might have identified them, whether other
cost drivers might be applicable, how to measure the cost drivers and how to collect data about
the cost drivers. Finally, discuss the suggestions for changes in strategy.

Background for the Case Analysis

Food Industry Structure:

There are two distinct channels of distribution in the food business. Grocery and Foodservice.
Grocery is defined as food purchased for later assembly, preparation and consumption in the local
Grocery store. Foodservice is defined as meals prepared for the consumer away from home.
While most are familiar with the local grocery store, foodservice includes any location a
consumer may venture to purchase or eat a meal such as the corner deli, Red Lobster,
McDonald‘s or the college cafeteria. Foodservice comprises more than 52 percent of consumer‘s
food dollars and is growing at a real rate of 1.5% faster than Grocery
Grocery and Foodservice evolved independently due to three primary factors: Packaging
requirements, Shipping/Logistics requirements and Marketing requirements.

 Packaging. The end use packaging format was the primary determinant of this
separation. Grocery stores sell relatively small package sizes whereas Foodservice uses
either single-serve packages or large, bulk packages. The large manufacturers in
foodservice are generally grocery product suppliers as well due to large capital
requirements to build manufacturing plants and relatively small capital requirements for
unique packaging. Thus, Foodservice is an excellent tool to maximize plant utilization. In
addition, consumer brands built in the Grocery channel have strong appeal in the
Foodservice channel.

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-24 ©McGraw-Hill Companies, Inc., 2008

 Shipping/Logistics. There are six hundred thousand foodservice operators in the United
States and only thirty thousand grocery stores. Given similar channel sizes, the average
foodservice outlet purchases 1/20th the volume of the average grocery store. Furthermore,
foodservice operators generally have little storage room, so they tend to order more often
than grocers do. As a result, Grocery operators deal directly with manufacturers whereas
Foodservice operators deal with foodservice distributors who deal with the
manufacturers. The Foodservice distributors (such as Sysco, Alliant, US Foodservice)
carry the entire line of products their foodservice customers require including cooking
equipment, dry food, fresh food, meats, etc.

In addition, the manufacturer distribution centers differ for each subchannel because
Grocery orders are predominately full cube/full truck orders whereas Foodservice orders
are mostly part cube and less than truckload (LTL) orders. Thus, grocery distribution
centers are highly standardized with significant automation whereas foodservice
distribution centers are highly customized and manually intense operations.

 Marketing. Grocery stores are very active in merchandising consumer products and
usually work in conjunction with the manufacturers to coordinate their advertising
activities. When manufacturers fund these promotions (and they generally do), they can
have tremendous influence over consumer purchase behaviors independent of the grocery
retailer. There is no similar mechanism in the foodservice industry. Instead, the few large
foodservice operators (McDonald‘s, Red Lobster, Marriott, ARAMARK, etc) enjoy
market power over the distributor who in turn wields power over the manufacturer. The
distributors control the street business (small, independent operators) through their sales
force (Distributor Sales Rep œ DSR) but remain beholden to the large foodservice

Since the large foodservice operators are few and powerful, manufacturers have found
it profitable to develop strong business ties to these operators and use those
relationships to pull product into distributor inventories. Once they have the product,
the distributor will encourage their DSR‘s to sell the product on the street in an effort
to maximize inventory turns. Less than half the 600M foodservice operators are
represented by chains, rather they are independently operated. So the decision making
in this market is quite uneven: a relatively few powerful players dominate. Yet a large
number of individual independent buyers purchase large quantities in aggregate. This
creates a window of competitive opportunity for a strong foodservice manufacturer.

General Mills has a large direct sales force of its own who call on the
restaurants and other foodservice operators. The salespeople create
demand with the operators who request the product from the distributors.
General Mills planned to use this sales force to market Colombo yogurt.

This case concentrates only on Foodservice. Within Foodservice, there are two distinct sub-
channels-- Shops and Impulse locations. These sub-channels differ in marketing and shipping
requirements. Shops specialize in frozen yogurt whereas Impulse locations specialize in other
products--yogurt is an add-on

1. General Mills and Colombo Competitive Environment:

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-25 ©McGraw-Hill Companies, Inc., 2008

General Mills focuses on high quality and high sales service. They had a large sales force
already selling to Impulse segment; Colombo offered the advantage of one more product. The
appeal was added profit for little added effort. General Mills had little experience or expertise in
selling to Shops

The market for frozen yogurt changed dramatically in the 1990‘s. In the early 1990‘s, the
market for frozen yogurt was increasing and many shops converted into franchise operations
such as TCBY, ICBY, Freshens, and Yogen-Fruz. These shops purchased their product from
their franchise operator. Meanwhile, Impulse locations started to open up. By late 1990‘s more
than 2/3 of soft-serve sales were at Impulse locations.

Sales of frozen yogurt started to drop and the company wasn‘t exactly sure why. Customers were
dissatisfied and profits were declining. General Mills used the same approach for both Impulse
and Shops. The company sensed that the two channels were different but lacked detailed
information about each channel.

2. Activity-based costing analysis:

Cost of goods sold: - $14,250,000 (same for all cases) = $14,250,000/1,500,000 cases = $9.50 per

 Impulse: 1,200,000 @ $9.50 = $11,400,000

 Shops: 300,000 @ $9.50 = $2,850,000
Shipping: $3,000,000 varies with individual cases ($2.25/case) or with pallets ($75/pallet):
 Impulse:
o Pallets = 60,000/75 = 800 @ $75 = $60,000
o Individual cases = 1,140,000 @ $2.25 = $2,565,000
o Total = $2,625,000
 Shops:
o Pallets = 240,000/75 = 3200 @ $75 = $240,000
o Individual cases = 60,000 @ $2.25 = $135,000
o Total = $375,000
Merchandising: $500 per kit

 Impulse: (3450 - 90) x $500 = 3360 x $500 = $1,680,000

 Shops: 90 x $500 = $45,000
Selling, General and Administrative: (previously allocated based on sales dollars)
 Impulse: 99% x $3,900,000 = $3,861,000
 Shops: 1% x $3,900,000 = $39,000

New Net Income Analysis:

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-26 ©McGraw-Hill Companies, Inc., 2008

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-27 ©McGraw-Hill Companies, Inc., 2008
The following points should come out in the discussion:
 Segment Net income declines because SG&A allocation to segment was too low under
the Sales dollar method.
 Marketing costs (price promotions, merchandising, shipping and SG&A) now total
$13,125,000 - 44% of sales and 530% of net income.
 The Shops segment has 20% of the sales and 71% of the net income.
 The ABC analysis provides information that wasn‘t available with an arbitrary allocation.
It also shows how to determine cost drivers for marketing costs.

3. What recommendations do you suggest based on ABC analysis?

Clearly, Shops and Impulse locations are very different in their costs and needs. Students should
recommend different approaches for Shops and Impulse.

The largest cost issue is SG & A. The discussion should cover several questions. How can you
reduce the time spent on Impulse and increase the time spent on Shops? How much time is spent
on servicing Impulse? How can you alter sales force time? Is this allocation fair? The salespeople
call on the Impulse locations for other products. What is the added cost of their time? Can we
reduce the extra time? For example, some of their time is spent on servicing machines. It would
be preferable to get someone else to do that such as the distributors who supply the machines.
How can the sales force better service the shops?

The second largest cost is shipping. Impulse is getting a lot of product. Is there a more efficient
way to distribute the product? Students are likely to have many suggestions about discounts for
larger orders. They need to understand why the orders are small. There is little storage space in
the Impulse locations and their order patterns are relatively fixed. You need to be much more
creative in order to reduce shipping costs. It‘s better to concentrate on the Sales force time and

Finally, Merchandising œ customers aren‘t happy. Shops want different, more elaborate
support than Impulse. Can support be tailored to shops? Shops are willing to pay for
merchandising. Impulse needs smaller, less costly, merchandising.

Price Promotions are very costly. Do they have to be available to all? Can that be changed now
that they know about them?

Blocher,Stout,Cokins,Chen, Cost Management, 4e 5-28 ©McGraw-Hill Companies, Inc., 2008

What really happened after the analysis?

The ABC analysis showed that the company was inadvertently harvesting the market in shop sales.
Given the new ABC of the two segments, General Mills went to the market with a significantly new

In the impulse segment: General Mills had devoted too much sales time and effort to this segment and
that was driven by the fact that the merchandising required too much field support. The sales people were
being turned into technical service people. General Mills simplified the merchandising and distributed it
via direct mail rather than having sales people deliver it. This simplified kit was much less expensive than
the previous kit and the budget for merchandising in this segment dropped from $1.44 per case to $.96 per
case. The kits were mailed to 10M impulse accounts that were believed to sell soft-serve rather than hand
delivered by sales people to only a few hundred locations. Finally, customers were given the name of soft-
serve equipment dealers to deal with any equipment issues. Sales time in the Impulse segment was
expected drop from $3.22 per case to $1.96 per case. These changes were expected to reduce costs but not

In the Shop Segment: The shop business changes were a bit riskier. General Mills created a special sales
team to cover the market. They identified 1,500 yogurt shops that they wished to rebuild a relationship
with. A nine-person inside sales team with yogurt shop experience (both shop and classroom training)
was created. This sales team phoned each of the 1,500 shops at least once a month. General Mills also
moved three of the strongest soft-serve field sales people (with foodservice operations experience) to
positions where they could make face-to-face calls on accounts on an as-needed basis. General Mills also
introduced a whole new set of merchandising kits to the shops and started to charge for them again. The
kits cost $1,000 and the accounts paid $500. These kits were refreshed two times a year. General Mills
included both recipe variations and consumer/patron promotion tie-ins. They also eliminated the pricing
promotions for this segment of the market. The big three products were reformulated to include a
strongly differentiated offering and the line was extended to include smoothies. The shop business was
removed from the incentive calculations for the rest of the field sales force and they were told that they
were not responsible for the shop business. While the shop changes would decrease shop profitability in
the plan year, General Mills expected to halt volume declines and possibly increase volume with the new

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-29 ©The McGraw-Hill Companies, Inc., 2008
5-4 and 5-5 Wilson Electronics (A) and (B)

Abstract: This case is designed to provide students with an activity-based costing (ABC) capstone experience that
addresses the following topics: (1) applying resource usage and resource spending concepts to support "what-if"
decision making; (2) using ABC product cost information to support strategic product mix decision making; (3)
using ABC process cost information to support process improvement decision making; and (4) using ABC
information in conjunction with the theory of constraints (TOC) to support revenue growth-oriented modes of
analysis when making decisions. The case is partitioned into (A) and (B) versions to enable greater flexibility from a
teaching perspective. More specifically, the (A) case focuses on the resource usage vs. resource spending portion of
the analysis. The (B) case expands the analysis to address the full range of topics mentioned above.

Case Overview
The Wilson Electronics case is designed to provide for students an ABC "capstone" experience that draws upon
ABC product costing, process costing, and "what-if" cost-modeling concepts. The (A) version of the case focuses on
the application of resource usage and resource spending concepts to quantify the cost savings associated with a
product redesign proposal. The resource usage approach is a long-run perspective because it assumes that future
changes in capacity costs will occur as individual proposals are combined with other similar proposals that will
materialize in the future. Conversely, the resource spending approach focuses on the identification of tangible
changes in spending that will materialize from individual proposals in the short-run.
The (B) version of the case expands the analysis from (A) to include issues such as product mix strategy,
process cost management, and revenue growth as an alternative mode of ABC analysis that can be contrasted to the
usual focus on cost reduction. The (A) and (B) versions provide the instructor with the flexibility either to limit
his/her usage of the case to the resource usage vs. resource spending issue that is the focus of the discussion
questions in (A), or to expand the analysis to include the broader range of topics explicitly discussed in the (B) case.
The case is predicated on the assumption that a capacity-based ABC system is a prerequisite to analyzing
business decisions from a resource-usage perspective. This assumption is embedded into the case through the former
controller, Mike Foster, who made the decision to design Wilson's ABC system using a capacity-based approach. In
fact, Foster makes the statement in the case that a capacity-based approach to designing an ABC system is "essential
to managing the business from an activity-oriented perspective." Foster's statement is consistent with the resource
usage model as explained by Cooper and Kaplan (1992) who distinguish between the cost of used and unused
capacity in their article entitled "Activity-Based Systems: Measuring the Cost of Resource Usage." The benefits of
distinguishing between the cost of used and unused capacity include: (1) enabling more competitive pricing when
significant idle capacity exists, (2) providing fairness to current customers who are not responsible for idle capacity,
and (3) putting pressure on management to react to the presence of idle capacity by either reducing spending or
increasing sales.

The (A) Case

In the (A) version of the case, the president of Wilson Electronics, Bill Simms, has asked his controller, Alice
Johnson, to defend the value of Wilson's ABC system. Simms is concerned that Wilson has yet to realize any
benefits from the ABC system that his company has spent a substantial amount of time and money developing.
Simms informs Johnson that she has three weeks until the next management team meeting to organize a presentation
that will explain the merits of ABC in terms of its ability to support management decision making. The outcome of
Johnson's presentation will determine whether Wilson continues to support its ABC system.
Alice Johnson decides to narrow the scope of her presentation to a cost-reduction proposal that calls for the
redesign of the A12 junction box. A competitor has recently announced a $0.40 per unit price reduction on this
product line, thereby necessitating a response from Wilson. The reengineering proposal, prepared by the product
engineering department, calls for reducing the number of different types of parts in the A12 junction box from ten
down to eight, while reducing the total number of parts per unit from 26 to 21. Interestingly, the raw material cost
would increase $1.00 per unit as a result of the product redesign. Johnson believes that she can demonstrate the
potential value of ABC by showing how it can be used to help quantify the savings that Wilson would realize due to
the activity reductions that are associated with this cost-cutting proposal. Johnson is relatively new to the company
and does not have an intimate knowledge and understanding of Wilson's ABC system; therefore, she decides to
solicit the advice and recommendations of her staff and a representative of the industrial engineering department.
Johnson calls a meeting on August 30th that includes Ed Branson from Industrial Engineering, as well as Sally
Jones and Phil Markley from the Finance Department. The purpose of this meeting is to determine how to use ABC

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-30 ©The McGraw-Hill Companies, Inc., 2008
data to quantify the cost-savings opportunity associated with the A12 redesign. Johnson is hoping that a consensus
emerges from this meeting that will give her the confidence in making her presentation to the management team.
However, such a consensus does not emerge from the meeting. The difference of opinion between Sally Jones, the
cost accounting manager, and Ed Branson, the head of industrial engineering, provides the platform for a discussion
of the merits of the resource-usage and resource-spending points of view. Sally supports the resource-usage
approach for estimating the cost savings associated with the A12 redesign, while Ed is a proponent of the resource-
spending point of view. According to the resource-usage-based analysis, the A12 redesign proposal offers a savings
of $0.47 per unit, net of the increase in material cost. However, the resource spending analysis suggests that the
redesign proposal is not cost-beneficial to Wilson.

The (B) Case

The (B) case begins where the (A) case ends. In other words, the (B) case cannot be used as a stand-alone case. In
the (B) case, Johnson's presentation to the management team is fast approaching. She is confident that the $0.47 per
unit savings identified by the ABC system (per the resource-usage approach) will provide Wilson with the
information the team needs to respond to its competitor's price reduction of $0.40 per unit. She believes that this
"proof-of-concept" will be sufficient to sustain the ABC system. However, a few days before the management team
meeting another of Wilson's competitors announces a price reduction of $2.50 per unit on this product line. Alice
becomes keenly aware that her presentation is destined for failure if she remains focused on using ABC to identify a
$0.47 per unit cost reduction on a product being threatened by a $2.50 price reduction.
In need of some advice, she seeks the counsel of Mike Foster, who was the controller whom she replaced.
Foster convinces Johnson that she needs to expand the scope of her presentation beyond the resource-
usage/resource-spending analysis associated with the A12 redesign. Foster's comments provide a platform for
students to consider ABC's role from a product-mix strategy perspective as well as a process cost management point
of view. These applications of ABC are prevalent in practice, as evidenced by the case studies discussed in Player
and Lacerda (1999); therefore, it is beneficial for students to expand the analysis of Wilson to consider these issues.
In addition, Foster offers comments that raise the topic of applying ABC data to decisions from a revenue
growth perspective as compared to the usual cost reduction perspective. Given that Wilson is operating at its
practical capacity, this presents the opportunity to introduce Theory of Constraint (TOC) concepts into the case
(Ruhl 2000).

Suggested Teaching Procedure

This case can be taught to a broad range of audiences. For example, the case is used in the junior-year management
accounting course at Miami University. To the authors' knowledge, the case has also been used in the junior-year
cost accounting course by a professor at the University of Texas at Austin. At the graduate level, the case has been
used in the M.ACC. program by a professor at the University of Virginia and at the M.B.A.-level by a professor at
Wake Forest University.

Background Knowledge
To teach the (A) case effectively, students should have sufficient background in three areas. First, students should be
exposed to at least four weeks of traditional vs. ABC. For example, at Miami we spend two weeks discussing
traditional cost allocation methods. We examine the conceptual underpinnings of traditional cost systems and we
solve practice problems similar to what would be found in undergraduate cost accounting textbooks. We also
analyze case studies, such as Seligram: Electronic Testing Operations (Turney and Ittner 1988) and Camelback
Communications (Cooper 1985), that deal with traditional cost allocation. Similarly, we discuss the conceptual
foundation of ABC and discuss ABC from a design perspective. We solve ABC problems comparable to what would
be found in an undergraduate textbook. In addition, we analyze case studies, such as Siemens Electric Motor Works
(A) (Cooper and Wruck 1990) and Classic Pen Company: Developing an ABC Model (Kaplan 1998), that deal with
ABC from a design and/or a decision-making perspective.
Second, students should have some background in capacity costing. At Miami, we discuss the conceptual
underpinnings of capacity-based denominator volumes and we solve problems comparable to what would be found
in textbooks (for example, see Horngren et al. 1997, problem 14-33). We also analyze the Schulze Waxed
Containers, Inc. (Bernier and Cooper 1988) case study that deals with capacity-based costing. Third, students need
to have familiarity with resource-usage vs. resource-spending concepts. To support a conceptual discussion about
resource usage vs. resource-spending, we solve problems similar to 11-7, 11-13, and 11-14 in Hansen and Mowen
(1997) that highlight the differences between these two terms.

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-31 ©The McGraw-Hill Companies, Inc., 2008
To teach the (B) case, students need a modest background in four areas. From a product-mix-strategy
perspective, students need to understand the sources of product diversity that create cost distortion in traditional
volume-based cost systems. This topic can be covered as part of the background to prepare for the (A) case. From a
process-cost-management perspective, students need a basic understanding of a manufacturing cell and how cellular
manufacturing would eliminate many of the non-value-added activities that are currently a part of Wilson's
manufacturing process. From a revenue-growth perspective, students need a basic understanding of production
bottlenecks, so that they can identify the Assembly Department as the bottleneck in the Wilson case. Finally,
students need a basic understanding of NPV concepts in order to extend the analysis of the A12 proposal into a
multi-period setting.
In addition to the background information already provided, this Teaching Note includes an annotated
bibliography of literature citations that could be assigned to students as supplemental reading.

Teaching Methods
The case can be taught in numerous ways. One approach is to teach the (A) case in one 75-minute class period and
the (B) case in a second 75-minute class period (perhaps separated by one or more weeks). With this approach, the
professor needs to manage the direction of the conversation so that the issues earmarked for the (B) case do not
begin to dominate the discussion during coverage of the (A) case. The professor can explicitly ask the students to
adopt Alice's mindset, which is narrowly focused on analyzing the A12 junction box proposal, as a means of
ensuring that the discussion remains focused on the resource-usage vs. resource-spending debate.

A second method for teaching this case is to teach the (A) case in class and then assign the (B) case as an
outside-of-class group assignment to be handed in for grading at a later date. A third approach is to teach the (A)
case in class and then have groups of students prepare the (B) case and make oral presentations to the class to
explain how they would make their presentation to Wilson's management team if they were Alice Johnson. In
addition, it may be possible, depending upon the background of the students, to teach only the (A) case and rely
upon the students to identify the issues that are explicitly introduced in the (B) case without actually assigning it. For
example, if graduate students have a substantial amount of knowledge of ABM, manufacturing processes, and the
Theory of Constraints, they may be capable of identifying some of the issues implicitly from the (A) case that are
explicitly alluded to in the (B) case.

Wilson Electronics (A) Discussion Questions

The following discussion questions provide a foundation for teaching the (A) case. We have found that discussing
the questions in sequence works well. The most important "time management" issue in the (A) case is allowing
students enough time to complete the resource-spending-based calculations (Question 2). Depending upon the
preference of the professor, it is possible to manage the time students need to commit to the resource spending
calculations. For example, the professor can narrow the scope of the calculations by focusing exclusively on the
"wages and fringes" resource category. Another time-management tactic would be to walk the students through
the "wages and fringes" calculations in the Purchasing Department. Then let the students duplicate the same
methodology in the remaining departments. A final option would be to provide students with a template (similar to
Exhibit TN-3) that includes the appropriate headings to guide their thought process.

Question 1
Sally Jones supports the "what-if" output from Wilson's ABC model, which implies that a long-run-oriented
resource-usage perspective be adopted when analyzing the A12 redesign proposal. The resource usage view is
predicated on the logic that the A12 product redesign proposal is one in a stream of related proposals that will
continue to materialize in the future.
For example, activity #8, "move parts to Assembly," is expected to have a driver count reduction of 533
moves (per Exhibit 7). Since each of these moves requires a standard time of 25 minutes (per Exhibit 3), the activity
reduction will save 222 hours (533 moves at 25 minutes per move). While this results in freed-up material-handling
capacity in the short run, it does not generate enough idle capacity by itself to justify reducing employee headcount,
since each employee provides a capacity of 1,571 hours (per Exhibit 2). However, Sally Jones is contending that a
series of projects implemented over time may provide a substantial release of capacity in activities such as material
handling. This cumulative effect would allow the firm to reduce capacity and spending over time. Thus, each
proposal by itself has the potential to contribute to cost savings in the long run. In other words, if the cumulative
impact of three separate proposals reduced the hours needed to perform activity #8, "move parts to assembly," by
more than 1,571 hours, Wilson could release one of its forklift drivers and eliminate one forklift truck. This decision

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-32 ©The McGraw-Hill Companies, Inc., 2008
to reduce capacity would provide savings in terms of wages, benefits, supplies, utilities, and equipment.
Under the resource-usage approach, the contribution of each proposal to cost savings is measured by the
reduction in activity frequency multiplied by the applicable activity rate for each affected activity. Granted, during
the first several months after activity demands decline, Wilson may realize nothing more than the presence of
additional idle time. However, as the benefits of subsequent improvement projects are realized, management will
eventually be able to react to the creation of excess time by reducing activity capacity or finding new uses for such
freed-up capacity.
Exhibit TN-1 presents a new bill of activities for the revised version of the A12 junction box. The revised per
unit cost is $82.24. Given the original cost of the A12 junction box ($82.72), this represents a per unit savings (net of
the material cost increase) of $0.48. Students can verify the accuracy of their revised bill of activities by comparing
their numbers to the estimated cost savings shown in Exhibit 7 of $147,231, less the material cost increase of
$100,000, for a net savings of $47,231 or $0.47 per unit (the $0.01 difference in estimated savings is due
to rounding).
The capacity-based approach enables the measurement of changes in resource usage because it distinguishes
between the cost of used and unused capacity. This approach to accounting for the cost of resources supplied ensures
that the cost of resources used in production is not confounded by the cost of unused capacity.

Question 2
Ed Branson supports a resource-spending point of view. The resource-spending model is based on the assumption
that management decisions to implement organizational or product changes should be judged as to whether the end
results of such decisions improve the "bottom-line" in the short run. This view recognizes that the majority of the
costs in ABC cost pools are salaries and wages, equipment and space costs. In the short run, these costs are primarily
fixed and represent planned investments in the creation and maintenance of activity capacities. For example, assume
that a material-handling cost pool represents a planned investment in forklift capacity of 2,000 moves. Whether the
actual resource usage is 1,700 moves or 1,800 moves during the year, there will be no difference in the wages and
equipment costs in the pool-at least in the short run. Changes in the cost pool occur only when management
increases or decreases the activity capacity by making changes in future employment levels, or making changes in
the amount of investment in equipment and space allotted to the activity. According to the resource-spending model,
cost changes occur as a result of specific management decisions to hire or fire employees and to buy or sell assets.
Activity reductions within specific departments, if significant, can support staffing change decisions and real cost
The resource-spending viewpoint looks at a single cost-reduction proposal in isolation from other similar
proposals reviewed over time. The single proposal must generate enough activity reduction to lead to employee
headcount reduction if cost savings are to be attributed to the proposal. Usually, some variable cost savings for items
such as supplies and utilities will be realized as a result of activity frequency reductions. However, with respect to
short-term fixed costs such as personnel, activity reductions are often insufficient to create an opportunity to reduce
these larger, step-fixed costs.
In summary, the three major differences between the resource-usage and resource-spending points of view are:
(1) resource usage is more long-run oriented and resource spending is more short-run oriented; (2) resource usage
views each decision within the larger context of an ongoing set of business decisions, while resource spending views
each decision and its cost savings potential in isolation; and (3) resource usage relies upon ABC rates to estimate
cost savings, while resource spending relies on resource-spending profiles in conjunction with estimates
of current idle capacity as the basis for estimating cost savings.
In answering this question, professors can narrow the scope of analysis to focus solely on labor expenses, or
they can expand the scope to consider all the resource categories included in the ABC model. The discussion below
considers all the resource categories in the ABC model. Providing a comprehensive answer to this question requires
labeling the four types of resources shown in Exhibit 4 as variable, step-fixed, or committed-fixed. These resources
are supplies and utilities, wages and fringes, supervision, and equipment. Each is discussed below.
The "supplies and utilities" are variable resources because they can be supplied as needed. The "wages and
fringes" are step-fixed resources that pertain to nonsupervisory labor, such as forklift drivers or assemblers.
Assuming that Wilson does not employ temporary workers, their laborers are employed for 40 hours a week and
their wages are a fairly stable expense for the company. Only long-term, substantial changes in output or activity
driver counts would cause the firm to expand or contract the number of employees hired. Shorter-term fluctuations
in output or driver counts are either handled by overtime or represent idle activity capacity. The cost of
"supervision" is also a step-fixed resource. This category changes with adjustments in number of shifts and large
changes in number of employees. The "equipment" may be a step-fixed cost, when equipment is specific to an

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-33 ©The McGraw-Hill Companies, Inc., 2008
employee, such as a forklift truck driven by a specific driver. When releasing a driver, the expectation would be that
the firm would sell off the forklift truck driven by that employee. Equipment may also be a committed-fixed cost in
cases when: (1) it represents high investment cost; (2) its deployment is essentially permanent; and (3) it is operated
by work crews, compared to individuals. Committed fixed costs do not play a role in quantifying the spending
reduction opportunity associated with the A12 redesign.
Regarding the specific calculations, the instructor can walk the class through the analysis one resource
category at a time. First, calculate the $2,542 of cost savings associated with "supplies and utilities" resources. This
cost savings is estimated by isolating the "supplies and utilities" portion of each ABC rate and multiplying it by the
respective decreases in activity frequency, as shown below:

"Supplies/Utilities" Change in Estimated

Activity # ABC rate Activity Frequency Spending Reduction
3 $0.35 -600 $210
4 0.28 -600 168
5b 0.06 -3,200 192
6b 0.05 -3,200 160
8 0.62 -533 330
13 0.33 -1,550 512
15 0.00034 -500,000 170
16 0.0016 -500,000 800
Total savings $2,542

Second, calculate the $89,973 of cost savings associated with "wages and fringes" resources. This cost savings
is estimated by following a four-step process as shown in Exhibit TN-2. In the first step, calculate idle capacity
existing in each department stated in terms of idle employee hours. The information needed for this calculation is
given in Exhibit 2 and in the text of the case. For example, the Purchasing Manager estimated an idle time for the
department of 0.75 FTE. Multiplying 0.75 FTE by the average capacity of 1,537 hours provided by each Purchasing
employee results in an idle time estimate of 1,153 hours annually. In the second step, estimate the impact of the A12
redesign on idle time. This is added to the pre-existing idle time to provide the projected total idle time available if
the proposal is implemented. The detailed calculation of A12's impact on idle time, on a department-by-department
basis, is shown in Exhibit TN-3. For example, the Purchasing Department would have an estimated savings of 500
hours from the redesign. Since employees perform multiple activities within a department, determining payroll
savings from employee reduction must be done at the department level rather than the activity level. In the third
step, the total idle capacity in each department is translated into potential full-time equivalent (FTE) reductions. For
example, purchasing would have a total idle capacity of 1,653 hours annually if the proposal is implemented. A
typical employee in that department adds 1,537 hours of capacity each year. Therefore, reducing the number of
employees by one would still leave sufficient capacity to handle the demand for purchasing activities. In the fourth
step, translate the reduction in FTEs to dollar savings by multiplying the average annual wages and fringes per
employee, as given in Exhibit 2, by the FTE reduction.
The next consideration is the cost of supervisors. It appears that there is only one supervisor in purchasing,
stores, and crane/forklift operations (this observation is based on the supervision dollars shown in Exhibit 4);
therefore, there are no spending reduction opportunities in these departments. Exhibit TN-2 shows that the
Fabrication Department will not be able to reduce nonsupervisory headcount as a result of the A12 redesign;
therefore, it is reasonable to assume that no spending reduction opportunity exists with respect to fabrication
Finally, it appears as though there are approximately seven supervisors in the assembly department. This
estimate is calculated by taking $370,800 of Assembly supervision salary and fringes from Exhibit 4 and dividing it
by an approximated average supervisor's salary and benefits of $50,000 (this approximation is reasonable given the
$52,000 of supervision in Purchasing, $48,800 in Stores, $37,938 in Material Handling, and $56,000 [$112,000/2]
average supervision in Fabrication per Exhibit 4). At seven supervisors, the span of control is about 15 employees,
which appears to be consistent with the other departments at Wilson. With a span of control of 15 employees, a
headcount reduction of two employees would not provide a spending reduction opportunity in supervision.
Equipment is the final resource cost. Under the resource-spending viewpoint, equipment is generally considered a
sunk fixed cost and not subject to cost savings in the short run. In the case of material handling, elimination of a
forklift driver would also provide the opportunity to eliminate equipment costs by selling or retiring a forklift truck.

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-34 ©The McGraw-Hill Companies, Inc., 2008
Since the A12 redesign did not eliminate a driver, we assume that no equipment savings are available. In the other
departments, the equipment is assumed to be common to all employees and therefore a sunk cost.
In summary, the resource-spending-based cost savings associated with the A12 redesign total $92,515, as
shown below. Of course, in the first year these savings would be reduced by the $15,000 in severance pay for the
three eliminated workers.

Resource Category Spending Reduction

Supplies and Utilities $ 2,542
Wages and Fringes 89,973
Supervision 0
Equipment 0
Total Spending Reduction Opportunity $92,515

Given that the annual savings of $92,515 is less than the annual $100,000 increase in direct materials, the
resource spending view suggests that the A12 redesign would result in an annual net loss of $7,485.

Question 3
At this point, the objective is to generate significant class discussion and debate on the usage vs. spending issue. The
goal of the discussion is to have students identify the strengths and weaknesses of each approach. Many students
initially see the resource-usage-based estimate of long-run cost savings as vague because no specific timetable has
been established for realizing the proclaimed savings in step-fixed and committed-fixed resources. In fact, it is
possible that these savings may never materialize. Conversely, there is strong appeal among many students for the
specific and tangible nature of savings under the resource-spending viewpoint.
To extend the discussion, we present the class with two hypothetical cost-reduction proposals. Each proposal
assumes two departments-Purchasing and Material Handling-with one activity in each department and no idle
capacity. Exhibit TN-4 (Panel A) summarizes the first proposal that was prepared during the month of February and
has an implementation cost of $5,000. The proposal does not produce sufficient capacity reductions in either
department to generate any immediate savings under the resource-spending viewpoint. Students are then asked
whether they would accept or reject the proposal. The majority of students undoubtedly reject the proposal since it
loses money on its own merits. In other words, the proposal merely creates additional idle capacity while costing the
organization $5,000.
Exhibit TN-4 (Panel B) depicts the second cost-reduction proposal, involving the same two departments,
which is assumed to be evaluated two months later. The second proposal has higher costs and again insufficient
activity reduction by itself to generate any headcount reduction and cost savings. Again, we ask the students what
they would do-accept or reject? Applying the resource-spending point of view, students may support rejecting the
second proposal as well because it does not generate any costs savings on its merits. However, some students will
see that we should accept the combined proposals (see Exhibit TN-4, Panel C). The instructor should explain that
when analyzing the first proposal, the decision maker cannot be assured of when the second proposal will be
submitted or how much activity reduction it will generate. The only way to accept the first proposal is to use the
resource-usage method, which places a value on the benefits of any activity reduction and idle capacity creation. The
expectation would exist that future proposals would add to idle capacity sufficiently to support eventual activity
capacity reduction and true cost savings.
Exhibit TN-5 (Panels A and B) shows the resource-usage analysis for each proposal that includes multiplying
the reduction in activity driver counts in the two departments by the appropriate ABC rates. The estimated cost
savings for the first proposal would be a net of $24,500, while the estimated cost savings of the second proposal
would be $25,000. The combined benefits are $49,500, yet the resource-spending model suggests rejecting the
proposals one at a time. Notice, the estimated savings per the resource-usage model of $49,500 exceed the $37,000
of savings due to headcount reductions shown in Exhibit TN-4, Panel C. This is caused by the fact that the ABC rate
would appropriately include other resources besides labor (e.g., equipment, supplies, etc.).

Question 4
From a resource-usage perspective, the A12 redesign proposal does provide enough savings ($0.47 per unit) to
enable Wilson to respond to its competitor's price reduction of $0.40 per unit. In terms of advice, Alice should
mention the following five issues. First, she should emphasize that the ability of the ABC system to link engineering
design changes to the profitability of a product line provides Wilson with an important competitive advantage. The
lessons learned on the A12 product line can be transferred to other product lines. Wilson's management team does

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-35 ©The McGraw-Hill Companies, Inc., 2008
not need to merely react to the actions of its competitors, but rather Wilson's engineers could proactively embark
upon a continuous process of re-evaluating product designs and proposing changes that would reduce unit costs and
increase profit margins.
Second, Alice should emphasize that the resource-usage-based savings are long-run estimates; therefore, the
projected savings of $0.47 per unit will not be realized in next month's income statement. Wilson will need to take
actions in the future that either translate the usage-based savings into spending reductions or sales growth. Third, she
should acknowledge that, while resource usage is broadly applicable in decision contexts where it makes sense to
distinguish between the costs of used and unused capacity, resource-spending analysis has its practical applications
as well. For example, from an operational budgeting perspective, the resource-spending mode of analysis can be
used to make informed resource-planning decisions. Also, if management needs highly certain and targeted cost
savings in the short run, the resource-spending-based measures may be more appropriate than the resource-usage
measures. Fourth, Alice should emphasize that both the resource-usage and resource-spending modes of analysis
offer higher quality information that the estimates provided by the standard-cost system. Finally, she should
acknowledge that the ABC data being relied upon for the cost-savings estimates is more than one year old. To the
extent manufacturing methods have changed or the combination/quantity of resources supplied have changed, the
ABC rates may be subject to some amount of error.
Of course, there are numerous other pieces of advice that would benefit Alice in her ultimate goal of making a
presentation that fully explains the potential applications of ABC to Wilson's business. However, these additional
points are reserved for discussion in the (B) case portion of the teaching notes.
President Simms' response to Alice Johnson's presentation is likely to be positive. Since the ABC system has
shown that the design change will save Wilson $0.47 per unit on a product that is in need of a $0.40 per unit cost
reduction, Simms will likely give his approval to Johnson's request to update the ABC system. However, there is a
strong likelihood that the ABC project will not be successful in the long run. The case points out that Wilson's ABC
project was spearheaded by Mike Foster. With Foster gone, the project stagnated. The implication is clear that the
ABC project did not have strong cross-functional top-management support. Research has shown that ABC
implementations driven by the finance function and unsupported by top-level nonaccounting managers are likely to
fail (Shields 1995). Therefore, it is probable that managers outside the accounting department will never use the
ABC system to support decision making in a meaningful and consistent manner.

Wilson Electronics (B) Discussion Questions

Part A
The ABC cross model illustrates that, generally speaking, ABC adds values from three perspectives-the cost
assignment view, the process view, and the "what-if" cost-modeling view. The conclusions that students reach in this
case may differ, but these three applications of ABC should be apparent to all students.
The purpose of asking students this question is to provide them with an overarching framework for organizing
their presentation. The term "product costing" relates to the cost assignment view of the ABC cross model, whereby
resource costs are assigned to activities and activity costs are assigned to products (Player and Lacerda 1999; Turney
1992). The term "process costing" refers to the process view of the ABC cross model that focuses on costing
activities and processes and identifying their root-cause drivers and performance measures (Player and Lacerda
1999; Turney 1992). The term "cost modeling," in this context, refers to the "what-if" analysis perspective of ABC.
The cost-modeling perspective inverts the cost assignment view in the sense that it estimates the impact of a change
in product mix, product design, or process design on activity demands and resource costs (Brewer and Linderman
1998; Greenwood and Reeve 1994).
The (A) version of the case focuses on the "what-if" cost-modeling perspective. The A12 junction box has
been redesigned and the task at hand is to estimate the potential cost savings. The resource-usage view uses ABC
rates to estimate the long-term impact on resource costs. The resource-spending view uses resource-spending
profiles to estimate the short-run impact on resource costs. The (B) version of the case incorporates the product-
costing and process-costing perspectives of the ABC cross model. It also asks the students to explore the
interrelationship between ABC and TOC.

Part B
At the conclusion of the (B) case, students should have been alerted to Alice's concern that the resource-usage-based
savings of $0.47 per unit is well below the recently announced price reduction of $2.50 per unit. When students are
asked if they are concerned about this $2.03 shortfall, the immediate answer is "yes." However, Wilson's current
view of A12's product cost and profitability is predicated on its direct labor (DL)-based cost accounting system.

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-36 ©The McGraw-Hill Companies, Inc., 2008
Therefore, this question provides students an opportunity to examine the product cost distortion inherent in the DL-
based system and relate the amount of the distortion to the $2.50 price reduction.
Exhibit TN-6 (Panel A) provides an estimated income statement for the current version of the A12 junction
box using the DL-based standard cost system. The estimated DL charge of $416,896 is a function of the number of
labor hours spent on activities #12 and #16 and the average wage rate in the fabrication and assembly departments.
Exhibit 5 shows the 23,333 DL hours in assembly. The 10,000 DL hours in fabrication is found by dividing the
100,000 units produced by the activity time standard of six minutes per unit. Finally, Exhibit 2 shows the average
wage rates of $12.42 and $12.71 per hour for activities 12 and 16, respectively.
The overhead charge is estimated by calculating an overhead rate based on DL hours. The overhead rate is
computed by taking the $7,140,000 of overhead from Exhibit 1 and dividing it by the total labor hours allocated to
activities #12 and #16 of 135,032 (see Exhibit 3), thereby yielding an overhead rate of $52.876 per DL hour.
Multiplying this rate by the DL hours worked of 33,333 results in estimated overhead assigned to A12 of
Exhibit TN-6 (Panel B) provides an estimated income statement for the current version of A12 using the ABC
system. Notice that in the ABC system, DL is lumped in together with the overhead. The ABC charges and other
overhead charges come from Exhibit 6. The bottom of Exhibit TN-6 summarizes the decrease in cost of $3.08 per
unit that results from the ABC data.
This new piece of information usually draws three types of reactions from students. First, some students
contend that Wilson can match the price reduction easily. These students argue that, thanks to ABC, Wilson can meet
the price reduction and increase the A12 profit margins at the same time. At this point, ask students what the income
statement will look like for the coming period if Wilson matches the $2.50 price reduction and does nothing else.
The answer is that profits will shrink by $250,000. Revenue will shrink and the expenses reported on the income
statement will remain unchanged. This quickly gets students to realize that cost reduction must accompany a $2.50
price cut or else profits will decrease.
The second reaction from students is to cut prices more than $2.50 in an attempt to gain market share. If
indeed Wilson's competitors could not match a price reduction greater than $2.50, this argument may have some
merit. However, if Wilson's competitors match any price reduction that it may introduce into the marketplace, it may
not make sense to fuel a price war where nobody gains share and everybody's margins shrink.
Third, some students will suggest that A12 should not be the focus of Wilson's cost reduction efforts. These
students will contend that ABC data should be used to identify the products that are truly unprofitable. The cost
reduction efforts should be directed toward products that are not price- or cost-competitive. These students believe
that the A12 product line seems to be doing okay. Furthermore, they think that Wilson needs to be looking at the
low-volume, complex, custom business that has been growing in recent years. This observation leads to the next

Part C
This question is designed to help students identify the product cost cross-subsidization that results from Wilson's
standard cost system. The average overhead per unit for the custom product lines of $15.94 is calculated by dividing
the total overhead assigned to the custom lines, of $1,092,000 (Exhibit 1) by the 68,500 units produced (found in the
[A] case text). The average overhead per unit for the A12 junction box of $17.63 is calculated by dividing the
overhead assigned to A12 from Exhibit TN-6 of $1,762,527 by the 100,000 units produced. These rates should strike
the students as counter-intuitive. A high-volume product, such as the A12 junction box that is not very complex in its
design, should have a lower overhead rate per unit than custom products that are manufactured in lower volumes to
meet detailed customer specifications.
The primary conclusion inferred from these rates is that the standard cost system is undercosting the custom
business and over-costing the high-volume business. The cross-subsidization problem is probably contributing to
flawed decision making that has in turn resulted in declining profits. Exhibit 1 provides support for this assertion.
First, sales have increased each of the last three years, yet after-tax profits have declined each of the last three years.
Second, sales of the custom lines has increased substantially over the last three years. Third, total overhead has
increased each of the last three years despite what appears to be an effort to reduce DL costs. Fourth, S,G&A
expenses have increased each of the last three years. Although S,G&A was not included in the ABC analysis, it is
reasonable to conclude that the increase in custom sales to buyers outside the normal distribution channels has
probably been a major driving force behind the increase in S,G&A.
This mode of analysis raises the question as to whether the A12 junction box should be the focus of Wilson's
product-cost-reduction efforts. Perhaps Wilson's management should be focusing its attention on reassessing its
long-run product-mix strategy. If the custom business is viewed as supportive of Wilson's strategy, the management

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-37 ©The McGraw-Hill Companies, Inc., 2008
team should revisit its custom business pricing strategy or reduce the costs incurred to serve the custom segment.
One question that Wilson should consider is: where is the competition in the custom niche? If Wilson believes that
the custom niche is highly profitable, why have competitors not challenged this segment of the business? Having
what appears to be a highly profitable niche without the presence of competition is a classic sign of an obsolete cost
system (Cooper 1987).
The $2.50 market-driven price reduction in the A12 line is a genuine issue that warrants a response. Therefore,
the engineers' efforts to reduce costs on this product line are well intended and, indeed, cost reduction of some sort is
a necessity. However, the intent of the (B) case is to alert students to some "bigger picture" issues of which Wilson
should be aware beyond the $0.47 price reduction. If Wilson's engineers can engage in an A12 junction box target-
costing effort that eventually matches the $2.50 price cut, that is good. However, assuming that Wilson's engineers
are constrained by limited time and money, they may want to channel their intellectual capital to larger profit
improvement opportunities. One such opportunity is to consider the product-mix strategy issue and the impact of the
low-volume custom business on overhead and S,G&A costs. Another issue relates to process cost management,
which is the subject of the next question.

Part D
This question should lead into a discussion of value-added vs. non-value-added activities and the process cost view
of ABC. It should raise the students' awareness that the bill of activities for A12 contains numerous charges for
activities that may best be labeled "non-value-added." At a minimum, activities #4-11 and #13-15 could be so
labeled. The activity charges for the A12 junction box that emanate from activities #4-11 and #13-15 total $444,623,
or $4.45 on a per unit basis.
The $0.47 per unit long-run cost savings associated with the A12 redesign is well short of the $2.50 per unit
price reduction announced by one of Wilson's competitors. On the other hand, if Wilson felt that 100,000 units of
A12 were a sufficient volume to warrant creating a manufacturing cell, in the long run Wilson may be able to
eliminate the activity charges associated with activities #4-11 and #13-15, which total $4.45 per unit. These savings
more than offset the competitor's price reduction of $2.50 per unit. Given Wilson's resource constraints, it may make
sense to focus its improvement efforts on a process redesign initiative whereby the payback of $4.45 per unit is more
than nine times greater than the $0.47 per unit savings associated with the product redesign initiative. Exhibit TN-7
shows one approach for estimating an ABC income statement for the original version of A12 in a cellular
environment. This income statement suggests that the A12 profit margin could approach 6.3 percent if Wilson
created a manufacturing cell.
Students could also look at the non-value-added ABC costs in total as opposed to focusing solely on the A12
line. For example, assuming that activities #4-11 and #13-15 are labeled non-value-added, the total dollar value of
resources being committed to support these activities would equal $2,583,202. Stated another way, only 62 percent
of the dollars being committed to the materials procurement and manufacturing processes are adding value.

Part E
The resource-usage analysis vs. resource-spending analysis relates to the "what-if" cost-modeling aspect of the ABC
cross model. The analysis that was the focus of the (A) case definitely should be incorporated into the presentation
because it addresses the role that ABC can play in answering "what-if" questions. The resource-usage and resource-
spending-based savings estimates associated with the A12 proposal should be presented as examples of long-run and
short-run modes of analysis that can be used in particular contexts to support "what-if" decision making. The "what-
if" mode of ABC analysis is more proactive in nature in the sense that it feeds information forward into the
decisionmaking process before the decision has been made.
If the professor so desires, the resource-usage and resource-spending analyses can be expanded by extending
the decision time frame beyond one year and including the up-front costs mentioned in the (A) case. Exhibit TN-8
shows one potential net present value (NPV) analysis that relates to the resource-spending view. The NPV analysis
takes into account the up-front costs associated with the redesign, the increase in raw material costs, and the labor
savings over a three-year time horizon. The NPV is a negative $51,880.
An NPV analysis for the resource-usage view is somewhat more perplexing. The resource-usage view is
meant to provide an estimate of long-term cost savings; however, the translation of these savings to cash flows is not
guaranteed. Given that the value of a firm is measured by the discounted present value of its future cash flows, this
raises the question of how should the $147,231 of resource- usage-based, long-run savings be incorporated into an
NPV analysis? Exhibits TN-9 and TN-10 show two possible solutions that students might suggest. First, Exhibit TN-
9 is based on the most optimistic assumption that all the long-run cost savings will materialize in year one, thereby
resulting in an NPV of $75,170. This is an unlikely scenario. Second, Exhibit TN-10 includes only $92,515 of

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-38 ©The McGraw-Hill Companies, Inc., 2008
savings in year one and then phases in the rest of the savings at years two and three. Using a three-year time horizon,
the NPV is a positive $27,099. If the time horizon is extended to five years, the NPV becomes $79,596.
Of course, these two solutions are predicated on the assumption that all of the potential savings will truly be realized
at some point in the future, which is a debatable point.

Part F
The resource-usage vs. resource-spending debate that was the focus of the (A) case was predicated upon the
assumption that the answers to "what-if" questions need to be presented within the context of "cost reduction
potential" as the decision criterion. However, the freed-up capacity that would result from the A12 redesign does not
have to be translated into spending reductions. Certainly, cost reduction is one way to increase profits; however,
revenue and contribution growth is another way. Therefore, an alternative mode of thinking with respect to the A12
redesign is to analyze the impact of the redesign on the potential for revenue growth.
The (A) case indicates that Wilson is operating at its practical capacity. Furthermore, it mentions that the
constraining resource is the labor hours available in the assembly department. From a constrained optimization
perspective, the (A) case indicates that, on average for Wilson, 59¢ of each sales dollar is raw material cost and 6¢
of each sales dollar is paid out in commissions. This implies that the throughput earned by Wilson in 1996 is 35¢ per
sales dollar or $21,000,000 in total. The throughput per assembly labor hour is $21,000,000/157,220 = $133.57.
Given that the A12 redesign frees up 3,466 labor hours in assembly, a revenue-oriented "what-if" analysis would
suggest that the redesign provides Wilson with the opportunity to earn $462,954 of additional throughput without
having to invest in more people. From this perspective, the A12 redesign appears to be much more appealing than
the cost-reduction point of view.

Bill of Activities for Redesigned Version of A12 Junction Box

Quantity of Activity Total Activity Volume of Activity

Activity# Activity Driver Rate Charge Production Charge/unit
1 300 batches $20.51 $ 6,153 100,000 units $ 0.06
2 300 batches 19.61 5,883 100,000 units 0.06
3 2,400 unique parts 7.67 18,408 100,000 units 0.18
4 2,400 unique parts 11.74 28,176 100,000 units 0.28
5a 1,500 bundles 7.23 10,845 100,000 units 0.11
5b 16,800 containers 1.88 31,584 100,000 units 0.32
6a 1,500 bundles 3.26 4,890 100,000 units 0.05
6b 16,800 containers 0.86 14,448 100,000 units 0.14
7 600 crane moves 38.95 23,370 100,000 units 0.23
8 2,800 forklift moves 10.70 29,960 100,000 units 0.30
9 1,500 forklift moves 21.51 32,265 100,000 units 0.32
10 1,500 forklift moves 15.02 22,530 100,000 units 0.23
11 300 setups 84.72 25,416 100,000 units 0.25
12 100,000 housing units 2.46 246,000 100,000 units 2.46
13 3,000 hours 7.17 21,510 100,000 units 0.22
14 100,000 housing units 0.63 63,000 100,000 units 0.63
15 2,100,000 parts 0.04 84,000 100,000 units 0.84
16 2,100,000 parts 0.18 378,000 100,000 units 3.78
17 100,000 finished units 0.90 90,000 100,000 units 0.90
18 100,000 finished units 0.67 67,000 100,000 units 0.67
Total Activity Charges $1,203,438 $12.03
Overhead from departments not included in ABC study 520,661 5.21
Total Material Costs 6,500,000 65.00
Total Product Cost $8,224,099 $82.24

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-39 ©The McGraw-Hill Companies, Inc., 2008
Resource Spending View of A12 Junction Box Redesign Proposal

Step 1-Transform FTE Idle Capacities from the Text of the Case to Hours

Current Practical
Idle Capacity x Capacity/FTE = Idle Capacity
Purchasing 0.75 persons 1,537 hours 1,153 hours
Stores 0.25 persons 1,490 hours 373 hours
Crane Operators 0.25 persons 1,615 hours 404 hours
Forklift Operators 0.50 persons 1,571 hours 786 hours
Fabrication 0.50 persons 1,590 hours 795 hours
Assembly 0.00 persons 1,526 hours 0 hours

Step 2-Compute Revised Idle Capacity as a Result of Product Redesign

Idle Capacity Decrease Due Revised

in Hours + to Redesign = Idle Capacity
Purchasing 1,153 hours 500 hours 1,653 hours
Stores 373 hours 374 hours 747 hours
Crane Operators 404 hours 0 hours 404 hours
Forklift Operators 786 hours 222 hours 1,008 hours
Fabrication 7 95 hours 258 hours 1,053 hours
Assembly 0 hours 3,466 hours 3,466 hours

Step 3-Quantify Potential Reduction in Terms of FTEs

Revised Practical Potential FTE

Idle Capacity ÷ Capacity/FTE = Reduction
Purchasing 1,653 hours 1,537 hours 1 FTE
Stores 747 hours 1,490 hours 0 FTE
Crane Operators 404 hours 1,615 hours 0 FTE
Forklift Operators 1,008 hours 1,571 hours 0 FTE
Fabrication 1,053 hours 1,590 hours 0 FTE
Assembly 3,466 hours 1,526 hours 2 FTE

Step 4-Translate Potential FTE Reduction to Dollar Savings

Potential FTE Average Wage and Dollar

Reduction x Fringe/Employee = Savings
Purchasing 1 FTE $30,373 $30,373
Stores 0 FTE 24,042 0
Crane Operators 0 FTE 27,300 0
Forklift Operators 0 FTE 18,262 0
Fabrication 0 FTE 24,022 0
Assembly 2 FTE 29,800 59,600
Total Spending Reduction $89,973

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-40 ©The McGraw-Hill Companies, Inc., 2008
The Impact of the A12 Redesign on Idle Timea

Change from
Original Revised Change in Activity Original
Activity Activity Activity Time Activity Time
Activity Activity Driver Frequency Frequency Frequency Standards Forecast (hours)
Process #1: Materials Procurement
Purchasing Department
3. Issue purchase orders for parts # unique parts/batch 3,000 2,400 -600 20 min./count -200
4. Expedite open parts orders # unique parts/batch 3,000 2,400 -600 30 min./count -300
5. Unload materials and put in stores
b. assembly-parts # parts containers 20,000 16,800 -3,200 5 min./container -267
6. Process material requisitions
b. assembly-parts # parts containers 20,000 16,800 -3,200 2 min./container -107

Process #2: Manufacturing

Material Handling
8. Move parts to Assembly # forklift moves 3,333 2,800 -533 25 min./forklift
move -222

13. Rework defective units # of rework hours 4,550 3,000 -1,550 10 min./unit -258

15. Unload parts and hold # parts used 2,600,000 2,100,000 -500,000 0.10 min./part -833
16. Assemble finished products # parts used 2,600,000 2,100,000 -500,000 see Exhibit 5 -2,633
Activity #7 relates to Crane Operators. The A12 redesign has no effect on this activity.

Blocher, Stout, Cokins, Chen: Cost Management 4e 5-41 ©The McGraw-Hill Companies, Inc., 2008
Illustration of Usage vs. Spending Concepts

Panel A: Cost Reduction Proposal #1 Submitted in February 19xx

Average employee wages = $25,000
Implementation costs = $5,000
No idle capacity exists

Activity Activity Time

Frequency Time Savings Employee Headcount
Activity Reduction Activity Driver Standard (in hours) Capacity Reduction
Purchasing 1,600 # purchase orders 30 min. 800 1,500 hours 0
Material moves 1,800 # moves 25 min. 750 1,500 hours 0

According to the resource spending view, what are the potential cost savings?

Panel B: Cost Reduction Proposal #2 Submitted in April 19xx

Average employee wages = $25,000
Implementation costs = $8,000
No idle capacity exists

Activity Activity Time

Frequency Time Savings Employee Headcount
Activity Reduction Activity Driver Standard (in hours) Capacity Reduction
Purchasing 1,800 # purchase orders 30 min. 900 1,500 hours 0
Material moves 2,000 # moves 25 min. 833 1,500 hours 0

According to the resource spending view, what are the potential cost savings?

Panel C: Impact of the Combined Proposals on Spending Reduction

Activity Activity Time

Frequency Time Savings Employee Headcount
Activity Reduction Activity Driver Standard (in hours) Capacity Reduction
Purchasing 3,400 # purchase orders 30 min. 1,700 1,500 hours 1
Material moves 3,800 # moves 25 min. 1,583 1,500 hours 1

Potential savings opportunity = $50,000 - $13,000 = $37,000.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-42 ©The McGraw-Hill Companies, Inc., 2008
Illustration of Usage vs. Spending Concepts

Panel A: Resource Usage View of Cost Reduction Proposal #1 Submitted in February 19xx

Average employee wages = $25,000
Implementation costs = $5,000
No idle capacity exists

Frequency Activity ABC
Activity Reduction Activity Driver Rate Cost Savings
Purchasing 1,600 # purchase orders $10.00 $16,000
Material moves 1,800 # moves $7.50 13,500
Estimated Savings $29,500
Less: Implementation costs 5,000
Net Cost Savings $24,500

Panel B: Resource Usage View of Cost Reduction Proposal #2 Submitted in April 19xx

Average employee wages = $25,000
Implementation costs = $8,000
No idle capacity exists

Frequency Activity ABC
Activity Reduction Activity Driver Rate Cost Savings
Purchasing 1,800 # purchase orders $10.00 $18,000
Material moves 2,000 # moves $7.50 15,000
Estimated Savings $33,000
Less: Implementation costs 8,000
Net Cost Savings $25,000

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-43 ©The McGraw-Hill Companies, Inc., 2008
Comparative Income Statements for the Current Version of the A12 Junction Box

Panel A: Estimated Income Statement for the Current Version of the A12 Junction Box
(Using the Direct-Labor-Based Standard Cost System)

Sales (60,000,000 ??0.185) $11,100,000
Direct materials (see Exhibit 5) 6,400,000
Direct labor (23,333 ??12.42) + (10,000 ??12.71)* 416,896
Overhead (7,140,000/135,032 ??33,333)** 1,762,527
Gross margin $ 2,520,577
S, G & A (11,100,000 ??0.19) 2,109,000
Profit before tax $ 411,577
Tax expense (411,577 ??0.4) 164,631
Profit after tax $ 246,946
Profit margin 2.2%

Panel B: Estimated Income Statement for the Current Version of the A12 Junction Box
(Using the Activity-Based Costing System)

Sales $11,100,000
Direct materials (see Exhibit 5) 6,400,000
ABC charges (includes direct labor) (see Exhibit 6) 1,350,669
Other overhead unrelated to ABC project (see Exhibit 6) 520,661
Gross margin $ 2,828,670
S, G & A (11,100,000 ??0.19) 2,109,000
Profit before tax $ 719,670
Tax expense (719,670 ??0.4) 287,868
Profit after tax $ 431,802
Profit margin 3.9%

Cost Difference between Standard Cost System and ABC

Standard cost Direct labor + overhead $2,179,423

ABC charges (including direct labor) + other overhead 1,871,330
Difference in cost assigned $ 308,093
Number of units produced 100,000
Decrease in cost on a per-unit basis $3.08

* The estimates of direct labor hours (23,333 and 10,000) are based on the hours spent performing activities
12 and 16.
** Overhead can also be estimated by taking direct labor dollars of 416,896 ??4.2 = 1, 750,963.
Either estimate provides a result that approximates the 2.2 percent return reported in the case.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-44 ©The McGraw-Hill Companies, Inc., 2008
ABC Income Statement for the A12 Junction Box
(Original Version of A12 Junction Box in a Cellular Environment)

Sales ($60,000,000 ??0.185) $11,100,000
DM (see Exhibit 5) 6,400,000
ABC charges (1,350,669 - 444,623) 906,046
Other overhead (see Exhibit 6) 520,661
Gross margin $ 3,273,293
S, G & A 2,109,000
Net income before tax $ 1,164,293
Tax expense 465,717
Net income after tax $ 698,576
Profit margin 6.3%

Key Assumptions
1. This income statement assumes that the $444,623 of resources attributable to activities #4-11 and #13-15 could be
productively redeployed and charged to other product lines or, that the resources could be released, thereby resulting
in genuine savings. If a manufacturing cell was created, but the freed-up resources relating to activities #4-11 and
#13-15 remained permanently idle, there would be no savings for Wilson as suggested by the income statement
2. The "Other overhead" of $520,661 is assumed to be unaffected by the switch to cellular production.

Resource Spending View-Discounted Cash Flow Analysis

Discount rate = 14%

0 1 2 3
Product Engineering $ (10,000)
Process Engineering ( 9,500)
Severance Pay (15,000)
Raw Material purchases (232,200) $(100,000) $(100,000) $(100,000)
Cost Savings 214,820 $92,515 $92,515 $92,515
Net Present Value $ (51,880)

Key Assumption
1. This analysis assumes that raw material prices remain constant over the three-year time horizon. Likewise, it assumes
that the savings generated by the redesign ($92,515) remains constant over the three-year time horizon. The analysis
would become more complex if expected increases in raw material prices and average wage rates were factored into
the calculation.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-45 ©The McGraw-Hill Companies, Inc., 2008
Resource Usage View-Discounted Cash Flow Analysis

Discount rate = 14%

0 1 2 3
Product Engineering $ (10,000)
Process Engineering ( 9,500)
Severance Pay (15,000)
Raw Material purchases (232,200) $(100,000) $(100,000) $(100,000)
Cost Savings $ 341,870 $ 147,231 $ 147,231 $ 147,231
Net Present Value $ 75,170

Key Assumption
1. This analysis assumes that raw material prices remain constant over the three-year time horizon. Likewise, it assumes
that the savings generated by the redesign ($147,231) remains constant over the three-year time horizon. The analysis
would become more complex if expected increases in raw material prices and average resource costs were factored
into the calculation.

Resource Usage View-Discounted Cash Flow Analysis

Discount rate = 14%

0 1 2 3
Product Engineering $ (10,000)
Process Engineering (9,500)
Severance Pay (15,000)
Raw Material purchases (232,200) $(100,000) $(100,000) $(100,000)
Cost Savings 293,799 $92,515 $147,231 $147,231
Net Present Value $ 27,099
NPV for five-year time horizon $ 79,596

Key Assumption
1. This analysis assumes that raw material prices remain constant over the three-year time horizon. Likewise, it assumes
that the savings generated by the redesign ($147,231) remains constant over years 2 through 5. The analysis would
become more complex if expected increases in raw material prices and average resource costs were factored into the

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-46 ©The McGraw-Hill Companies, Inc., 2008

Brewer, P., and P. Linderman, 1998. From cost accounting to cost management. Journal of Engineering Valuation and
Cost Analysis 1: 265-276.

This article is a good background reading for the case because it discusses the uses of ABC
from product costing, process costing, and "what-if" cost-modeling perspectives. It relies on
a simple numerical example to illustrate these three applications of ABC. This article
would work best if assigned before the (B) case.

Cooper, R., and R. Kaplan. 1992. Activity-based systems: Measuring the cost of resource usage. Accounting Horizons
(September): 1-13.

This article is good background reading for the case because it explains how ABC systems
are designed to measure the cost of resource usage. It introduces the fundamental equation:
the cost of resources supplied = the cost of resources used + the cost of unused capacity.

Gantt, H. L. 2000. The relation between production and costs. In Readings and Issues in Cost Management, edited by J.
Reeve. Cincinnati, OH: South-Western College Publishing.

This article discusses the merits of capacity costing. It explains how cost-per-unit information
can be dramatically influenced in traditional cost systems by the amount of capacity
being utilized in production. It has some conceptual overlap with the Cooper and Kaplan
(1992) article entitled "Activity-Based Systems: Measuring the Cost of Resource Usage";
however, this article is shorter in length so it provides an attractive alternative if time or
student work load are of concern.

Greenwood, T., and J. Reeve. 1994. Process cost management. Journal of Cost Management (Winter): 4-19.

This reading discusses the concept of resource-spending profiles and explains their role in
estimating the impact of changes in product and process cost drivers on resource spending.
The article provides a useful illustration for demonstrating how changes in product cost
drivers can be linked to their impact on activity demands and resource spending.

Kaplan, R. 1997. Using Activity-Based Costing with Budgeted Expenses and Practical Capacity. Boston, MA: Harvard
Business School Publishing Case No. 9-197-083, 1-12.

This article discusses the use of practical capacity as a basis for calculating denominator
volumes. It also discusses the role capacity-based denominator volumes play in enabling
the accurate measurement of the cost of resources used in production. It introduces the
idea of responding to the presence of unused capacity by either reducing spending or increasing

King, A. 1993. Green dollars and blue dollars: The paradox of cost reduction. Journal of Cost Management (Fall): 44-

This article can be used to contrast the notions of resource usage and resource spending.
The author refers to changes in the level of resource usage as "blue-dollar" savings and
changes in the level of spending as "green-dollar" savings.

Ruhl, J. 2000. An introduction to the theory of constraints. In Readings and Issues in Cost Management, edited by J.
Reeve, Cincinnati, OH: South-Western College Publishing.

This article is a basic introduction to the Theory of Constraints. It is good background reading
for the (B) case given that this portion of the case focuses on the A12 redesign proposal
from not only a cost management perspective, but also a revenue growth perspective.
Turney, P. 1992. What an activity-based cost model looks like. Journal of Cost Management (Winter): 54-60.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-47 ©The McGraw-Hill Companies, Inc., 2008
This article can be used to introduce students to the ABC Cross model. It serves as a good
foundation for organizing the analysis of the (B) case. The visual image of the cross model
enables students to conceptualize the three primary applications of ABC, namely, the product
costing, the process costing, and the "what-if" cost modeling perspectives.


Bernier, M., and R. Cooper. 1988. Schulze Waxed Containers, Inc. Boston, MA: Harvard Business School Publishing
Case No: 9-188-134, 1-22.
Brewer, P., and P. Linderman. 1998. From cost accounting to cost management. Journal of Engineering Valuation and
Cost Analysis 1: 265-276.
Cooper, R. 1985. Camelback Communications. Boston, MA: Harvard Business School Publishing Case No. 9-185-179,
---. 1987. Does your company need a new cost system? Journal of Cost Management (Spring): 45-49.
---, and K. Wruck. 1990. Siemens Electric Motor Works (A). Boston, MA: Harvard Business School Publishing Case
No. 9-191-006, 1-8.
---, and R. Kaplan. 1992. Activity-based systems: Measuring the cost of resource usage. Accounting Horizons
(September): 1-13.
Greenwood, T., and J. Reeve. 1994. Process cost management. Journal of Cost Management (Winter): 4-19.
Hansen, D., and M. Mowen. 1997. Cost Management: Accounting and Control. Cincinnati, OH: South-Western College
Horngren, C., G. Foster, and S. Datar. 1997. Cost Accounting: A Managerial Emphasis. Upper Saddle River, NJ:
Prentice Hall, Inc.
Kaplan, R., 1998. Classic Pen Company: Developing an ABC Model. Boston, MA: Harvard Business School Publishing
Case No. 9-198-117, 1-4.
Player, S., and R. Lacerda. 1999. Arthur Andersen's Global Lessons in Activity-Based Management. New York, NY:
John Wiley & Sons, Inc.
Ruhl, J. 2000. An introduction to the theory of constraints. In Readings and Issues in Cost Management, edited by J.
Reeve. Cincinnati, OH: South-Western College Publishing.
Shields, M. 1995. An empirical analysis of firms' implementation experiences with activity-based costing. Journal of
Management Accounting Research 7: 148-166.
Turney, P., and C. Ittner. 1988. Seligram Inc.: Electronic Testing Operations. Boston, MA: Harvard Business School
Publishing Case No. 9-189-084, 1-11.
---. 1992. What an activity-based cost model looks like. Journal of Cost Management (Winter): 54-60.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-48 ©The McGraw-Hill Companies, Inc., 2008
5-6 The Buckeye National Bank (Activity-Based Costing in the Service Sector)

ABSTRACT: The U.S. Bureau of the Census projects that by 2006, the service sector will employ 74 percent of the
workforce. This case illustrates why a major segment of the service sector—banks—needs accurate cost information to
make strategic decisions, and how more refined accounting systems help fulfill this need.
Buckeye National Bank is a hypothetical bank that has suffered falling profits despite a shift in customer base
toward retail customers, which the current information system reports are more profitable than business customers.
Following a step-by-step approach, you will develop the Bank’s average cost of serving a retail customer account and a
business customer account, under (1) the Bank’s traditional single allocation base system, and (2) a (pilot test) activity-
based costing system. You will analyze these results to determine how and why costs reported by the activity-based
system differ from the costs reported by the traditional system, and what this difference means for the Bank’s business
strategy. Finally, you will consider how the Bank’s managers can use the new, more refined activity-based cost data in
strategic decision making, including controlling costs and developing more profitable business strategies.


Background and Purpose

Textbook illustrations and pedagogical cases on activity-based costing (ABC) typically focus on manufacturing
applications.1 However, the U.S. Bureau of the Census projects approximately 74 percent of the workforce will be
employed in the service sector by 2006 (U.S. Bureau of the Census 1999). Furthermore, ABC and customer costing are
increasingly popular among service organizations such as financial institutions and health care organizations.
This structured case uses a customer-costing context to help instructors introduce ABC to undergraduate
students in the initial sophomore- or junior-level management accounting or cost accounting course (although we have
also successfully used adaptations of the case in introductory M.B.A. courses). First, the case presents a structured and
straightforward ABC illustration that is more comprehensive than examples found in most undergraduate texts.
Structured cases like Buckeye National Bank (BNB) provide an educational bridge between textbook problems and
more in-depth and intentionally ill-structured Harvard Business School-style cases that students may encounter later in
their educational experiences. Second, this case integrates the conceptual advantages of ABC over traditional allocation
systems with the computational steps necessary to implement ABC, and also requires students to consider how
managers use ABC and customer cost information in making strategic decisions (activity-based management). Finally,
the BNB case illustrates ABC and customer costing in a nonmanufacuring environment, focusing on an important
industry in the service sector—banking.
The case provides students with the opportunity to apply their (cost allocation) accounting knowledge to
address real-world problems. The Accounting Education Change Commission’s (AECC) Position Statement Number
One (AECC 1990) lists the ability to apply accounting knowledge in realistic situations as one of the capabilities
accounting students must acquire. Assigning parts or all of the case as group work provides opportunities to apply
problem-solving skills, to work with others, and to better understand how changes evolve in an organization. These
educational opportunities help students develop intellectual, interpersonal, and general business skills (AECC 1990).
The structured flow of the BNB case requirements leads the student through the cost-allocation process, first
under a traditional system, then under ABC. This explicit contrast helps students understand how these two costing
approaches affect strategic corporate decisions, and reinforces the importance of accurate cost information in a
competitive industry. The banking scenario and banking activities are designed to be familiar even to introductory
accounting students.
This case assumes the introduction to ABC occurs early in the cost/managerial course following job costing.
Many students will not have covered capacity considerations at this point. Consequently, the case avoids capacity issues
by stipulating that actual activity levels approximate practical capacity. 2 In addition, because the case focuses on
Pedagogical ABC cases set in the manufacturing sector include Adams (1997), Albright et al. (1992), Tabor and
Stanwick (1996), Wisner and Roth (1998), Brewer et al. (2000), and Platt and Towry (2001).
Cooper and Kaplan (1992) and Kaplan and Cooper (1997) discuss the importance of capacity in ABC. In their teaching
note, Kaplan and Cooper (1997) describe ABC systems as resource usage models in which:
Activity Availability = Activity Usage + Unused Capacity
The left-hand term measures the resources acquired by the firm. The first right-hand term measures the
firm’s usage of its available resources. The difference between resources acquired and resources used is

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-49 ©The McGraw-Hill Companies, Inc., 2008
introducing ABC, consideration of activity-based management (ABM) occurs near the end of the case’s requirements, in
conjunction with a discussion of how managers can use ABC data to make strategic business decisions.

Suggested Teaching Strategy

The BNB case is quite flexible. It can be used as an in-class lecture exercise, as an out-of-class individual or group
assignment, or some combination of these. Table 1 classifies requirements 1–12 by teaching objective. Instructors may
choose to assign only a subset of requirements 7–12, depending on the desired emphasis. The teaching notes for
requirements 2 and 7–12 are intended to facilitate class discussion. Our experience suggests that undergraduate students’
responses to items 2 and 7–12 are less developed than responses of graduate students (enrolled in introductory
management accounting courses) who have the benefit of work experience. However, these requirements prompt
students at all levels to consider how managers actually use accounting information in making strategic business

Case Requirements Classified by Selected Teaching Objectives

Case Traditional ABC Step-by-Step Conceptual Group Limited

Requirement Costing Implementation Requirements Discussion Class Timea
1 X X P
2 X X X
3 X
4 X
5 X
6 X
7 X X X
8 X X A
9 X X A
10 X X A
11 X X A
12 X X A
P = completed prior to class; A = completed after class.

To spark student interest in why banks would use ABC, we suggest assigning the Wall Street Journal article by
Brooks (1999), reprinted as an Appendix to this case, prior to covering the BNB case. The article explains that, in an
effort to attract and retain profitable customers, banks are providing extra services and benefits targeted specifically to
their most profitable customers. However, to identify which customers provide the bank the most profit, the bank must
first assign costs to customers based on their usage of bank services. The BNB case illustrates how banks can design
ABC systems to provide such customer cost information.
The BNB case is specifically designed for undergraduate students early in their accounting education. It has
been used in a number of educational venues, including undergraduate introductory management accounting, junior-
level cost/ managerial accounting, and even introductory M.B.A. management accounting courses. The case has been
used by instructors at four different institutions, ranging from a small private university to large state universities. We
have used the case as an in-class exercise, as an out-of-class assignment, and as part of an examination. Most recently,
we used the case in a junior-level cost/management accounting course as an out-of-class assignment that we then
discussed in class. A survey of the students indicated that they believed the case met its learning objectives. Following
are the mean responses of 81 students on a five-point Likert scale where 1 = strongly disagree, 2 = disagree, 3 = neither
agree nor disagree, 4 = agree, and 5 = strongly agree: “The case helped me understand how a service firm would
implement and then use ABC” (4.2); “The case helped me understand how to compute ABC costs” (4.1); “The case
helped me understand why costs reported by an ABC system may differ substantially from costs reported by traditional
single-allocation base systems” (4.1); “The case helped me understand why service firms need accurate cost

unused capacity. Kaplan and Cooper (1997) suggest that firms set the denominators of activity-cost allocation
rates to activity availability (i.e., the firm’s practical capacity). Since these rates are multiplied by
actual usage, the cost of unused capacity is not assigned to products and customers. This approach highlights
unused capacity costs for future management action (for example, future elimination of unused
capacity or putting the capacity to productive use).

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-50 ©The McGraw-Hill Companies, Inc., 2008
information” (4.2); and “The case helped me understand how managers can use ABC information to control costs and to
develop more profitable business strategies” (4.1). Students also agreed that the case was realistic (3.9).
Other instructors who have used this case indicate that it is more comprehensive than examples in the assigned
textbooks, while the students enjoy the realistic scenario. One instructor commented that “the case helped students to
understand that ‘activities’ could be interpreted broadly and that ABC applies to service institutions. It also helped them
to see that customers have costs, and that organizations can form strategy around the services they offer and the type of
customers they try to attract….These customer cost and strategy issues are seldom discussed in initial accounting
classes, even though they figure significantly in strategy or marketing. So I think this case helped students tie in the
ABC decision effects to issues they considered in other classes.”
The case is designed to efficiently illustrate ABC and customer costing, and their strategic decision
implications, to accounting (and nonaccounting) students who are not sophisticated users of accounting information.
When we use the case in M.B.A. and Executive M.B.A. (introductory) management accounting courses, we typically
make the case less structured and thus more challenging by replacing requirements 1 and 3–8 with the following simple

Compute the profit (loss) per account for: (1) the retail customer line and (2) the business customer line, under
both (a) the original cost system and (b) the ABC system.

The discussion can then rapidly focus on how business decisions depend on accurate cost information and the
advantages of implementing ABM.3


Requirement 1
Requirement 1 reviews indirect cost allocation in a conventional costing system. Students must understand a single
allocation-base system before attempting ABC. Requirement 1 shows students how the original, single-cost-pool system
allocates indirect costs to the retail and business customer lines. The results provide a basis for comparison with the
ABC system in Requirement 3.

A) The indirect cost allocation rate:

$2,850 total indirect costs = $0.03 per dollar processed.

$95,000 total value of checks processed

B) The total indirect cost assigned to (i) the retail customer line, and (ii) the business customer line:

(i) Retail Line (ii) Business Line Total

$ value of checks processed $9,500 $85,500 $95,000
Cost per $ processed × 0.03 × 0.03 × 0.03
Total indirect cost $285 $2,565 $2,850
These allocations are driven by the dollar value of the checks processed.

C) The proportion of the total indirect cost assigned to: (i) the retail customer line, and (ii) the business customer
(i) Retail line $ 285 10%
(ii) Business line 2,565 90%
Total indirect cost $2,850
The original system assumed that indirect costs are incurred in direct proportion to the dollar value of the checks
processed. Since retail customers wrote only 10 percent of the dollar value of the checks ($9,500/$95,000), the
original cost system assigned the retail line only 10 percent of the total indirect costs tabulated in Exhibit B.
Similarly, the original system allocated 90 percent of the indirect costs to the business customer line because
business customers wrote 90 percent of the dollar value of the checks processed. This allocation is
We have also modified the case by adding additional activities (such as ATM transactions and processing
returned checks), and by adding additional cost line items to Exhibit B that require students to split the
cost across activity cost pools. For example, salaries of check-processing personnel might be split across
the “paying checks” activity and a new activity for processing returned checks.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-51 ©The McGraw-Hill Companies, Inc., 2008
approximately accurate only if the indirect costs in Exhibit B are incurred in direct proportion to the dollar value
of the checks each customer line writes.

D) The annual indirect cost per (i) retail account, and (ii) business account:

(i) Retail (ii) Business

Total indirect cost $285 $2,565
÷ Number of accounts ÷ 150 ÷ 50
Indirect cost per account $1.90 $51.30

E) The average annual profit per account for retail customers and for business customers:

Retail Business
Revenue per account $ 10.00 $ 40.00
Cost per account ($ 1.90) ($51.30)
Profit (loss) per account $ 8.10 ($11.30)

The original cost system suggests retail customers are profitable, but business customers are not. This suggests
BNB should pursue a strategy of increasing the retail-customer base (e.g., awarding bonuses for attracting and
retaining new retail customers, pampering retail customers). BNB also should try to make business customers
more profitable, perhaps by increasing fees for services, requiring businesses to hold higher account balances (to
increase the interest revenue the bank earns from the business accounts), or increasing the “interest spread” on
business accounts. This interest spread (as explained in case note 3) is a major source of banks’ profits.
Figure 1 summarizes how the original cost system assigns costs to the retail and business customer
lines. We suggest reproducing Figure 1 on an overhead transparency, handout, or PowerPoint slide, and then
using its visual structure as a benchmark for comparison to the subsequent ABC analysis.

Requirement 2
Broken cars and computers simply stop running. In contrast, “broken” or outdated cost systems continue spewing out
(potentially misleading) costs. Consequently, managers need to recognize clues that the cost system needs refinement.
The original cost system was developed when the bank primarily served business customers. BNB then shifted
its focus to increasing its retail customer base. This shift significantly changed the relative proportions of total bank
resources expended on the two types of customers, with retail customers consuming relatively more resources, and
business customers consuming relatively less. For example, the bank established a customer account inquiry call center,
a service used primarily by retail customers. However, despite the significant change in BNB’s customer mix,
the original cost system remained intact.
Other symptoms that BNB’s original cost system may be “broken” include:
• Profits are declining even though the bank is serving more customers. Use the Income Statement in Exhibit A to
illustrate this point. Although net interest income is growing at a modest rate as a result of the expanding retail
customer base, noninterest expense (largely the indirect costs on which the case focuses) is growing more rapidly.
This is one reason that net income declines from 20x3 to 20x5.
• The original cost system (Requirement 1) suggests retail customers are more profitable than business customers,
but profits are declining despite a shift in the mix of customers toward retail customers. • The cost system is an
old (1985), single-allocation-base system.
• The cost system has not changed since BNB added the new customer account inquiry call center. Retail
customers are more likely than business customers to use the account inquiry call center, so establishment of this
center suggests that BNB’s cost of serving its two customer lines may have changed significantly.
• The manager (Erik Larsen) does not trust the accounting system’s numbers.
• CEO Rob Garrison does not understand the results.
Cooper (1987) provides a straightforward discussion of the symptoms of a “broken” cost system; this reading
can be assigned to advanced undergraduate or graduate classes. However, keep in mind that although the above bulleted
points are often symptoms that the cost system needs refinement, they are not rigid guidelines. For example, profits
could decline even though the number of customers is increasing if the business environment is becoming increasingly
competitive. While none of the symptoms provides conclusive evidence that the cost system is to blame, the pattern of
several symptoms suggests that BNB should consider whether its cost system would benefit from refinement.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-52 ©The McGraw-Hill Companies, Inc., 2008
Blocher, Stout, Cokins, Chen: Cost Management:4e 5-53 ©The McGraw-Hill Companies, Inc., 2008
Requirements 3 and 4
To help students see the big picture, we suggest walking through the case in class to explicitly relate your textbook’s
“steps in performing ABC” to the BNB case. You can easily adapt the following steps to match those in your textbook.
If time is short, simply focus on steps 5 and 7 (computing the indirect cost allocation rates for Requirement 3 and
allocating the costs for Requirement 4).

Step 1: In ABC, the first step is identifying the activities. BNB’s ABC team identified three activities:
1. Paying checks
2. Providing teller services
3. Responding to customer account inquiries

Step 2: The second step in ABC is estimating the aggregate costs, or cost pool, associated with each
activity. The ABC team used activity analysis as explained in the case to identify the personnel,
equipment, and other costs of each of the three activities:
1. Paying checks: $700 + $440 = $1,140
2. Providing teller services: $1,000 + $200 = $1,200
3. Responding to customer account inquiries: $450 + $60 = $510

Steps 3 and 4: The third step in ABC is identifying the cost driver for each activity that will link the cost of that
activity with the customers who use the activity. The fourth step is estimating the total quantity of
each cost driver. The ABC team identified the following cost drivers and estimated quantities for
each of the three activities:4

Activity Activity Cost Driver Total # Units of Cost Driver

Paying checks Checks processed 2,850
Providing teller services Teller transactions 200
Responding to customer Account inquiry calls to customer service
account inquiries call center 100

Because the pilot study is based on last year’s actual data, step 4 uses the total actual number of units of each cost
driver. In the future, however, BNB’s ABC team has decided that the calculation in step 4 will use estimated (budgeted)
activity-level information, so that the activity cost allocation rates can reflect expected changes in each activity (see
Kaplan and Cooper 1997).

Step 5: The fifth step is computing the indirect cost allocation rate for each activity. (Divide activity costs in
step 2 by the quantity of activity cost driver in step 4.)

Paying checks: $700 + $440 = $1,140 = $0.40 per check processed

2,850 2,850
Providing teller services: $1,000 + $200 = $6 per teller transaction
In more advanced classes, you may want to link BNB’s pilot ABC study to the activity-cost hierarchy. Horngren et
al. (1999) describe the following four-level hierarchy:
1. Unit-level activities are performed for each unit of product or service. Erik Larsen considers “paying checks” and
“providing teller services” as unit-level activities.
2. Batch-level activities are performed for groups of products or services rather than for individual units. For
example, setting up machines to produce a batch of a specific product is a batch-level activity. For simplicity,
BNB’s ABC pilot study does not identify any batch-level costs. Thus you may want to provide examples of batch-
level activities from manufacturing (e.g., setups, material handling), and ask whether students would expect to find
more or fewer batch-level activities in service firms (especially where each service represents a unique demand on
resources, such as in this case) or in manufacturing.
3. Product-sustaining activities, service-sustaining activities, and customer-sustaining activities support individual
products, services, or customers. Erik considers “responding to customer account inquiries at the customer service
call center” to be a customer-sustaining activity.
4. Facility-sustaining activities are general activities that support the organization as a whole, but that cannot be
traced to individual products or services, such as the CEO’s activities. Because it is not possible to identify cost
drivers for facility-sustaining costs, many ABC systems exclude these costs, or allocate them using a general
allocation base. For simplicity, the BNB ABC team excluded this type of activity from the pilot study.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-54 ©The McGraw-Hill Companies, Inc., 2008
Customer account inquiry: $450 + $60 = $510 = $5.10 per account inquiry call
100 100

Step 6: The sixth step in ABC is obtaining the actual quantity of the cost driver each cost object uses in
order to estimate the resource demands of each cost object. In this case, the two cost objects are the
retail customer line and the business customer line. The ABC team estimates that each customer line
will use the following quantities of the cost drivers: 5

# of Units of Activity Cost # of Units of Activity Cost Driver Total # Units

Activity Cost Driver Driver Used by Retail Customers Used by Business Customers of Cost Driver
Checks processed 570 2,280 2,850
Teller transactions 160 40 200
Account inquiry calls to
customer service call center 95 5 100

Step 7: The seventh step in ABC is allocating the cost of each activity to the cost object. BNB allocates the
costs to the retail and business customer lines, by multiplying the activity’s indirect cost allocation
rate from step 5 by the number of units of the activity’s cost driver in step 6:

Total Indirect Cost Assigned Total Indirect Cost Assigned

Activity to Retail Customer Line to Business Customer Line
Paying checks [$0.40 × (570; 2,280)] $ 228.00 $ 912.00
Providing teller services [$6 × (160; 40)] 960.00 240.00
Responding to customer account inquiries
[$5.10 × (95; 5)] 484.50 25.50
Total indirect costs $1,672.50 $1,177.50

Figure 2 summarizes how the ABC system assigns costs to the retail and business customer lines.
Compare the visual structure of the ABC system in Figure 2 with the original system in Figure 1.
The ABC team uses the activity analysis described in the case to identify the cost of personnel,
equipment, and other resources required for each of these activities. BNB then assigns the costs of
each activity, for example the “paying checks” activity, to the retail and business customer lines,
based on how much of the “paying checks” activity the customer line actually used. Thus, each
customer line receives three indirect cost allocations, based on its actual usage of each of the three
activities. We use transparencies, handouts, or PowerPoint slides of Figure 2 to trace the flow of
resources to the activities, and then on to the customer line cost objects.

Students may ask whether step 4 is out of order, in that the total quantity of the cost driver is used in step 4, while its
components by customer class are used in step 6. The pilot study is based on historical data, so total costs and
quantities of the cost drivers are already available. If the pilot study succeeds and BNB implements ABC firm-wide,
then BNB’s ABC team has decided that the calculation in step 4 will use data that are budgeted (and therefore
available at the beginning of the period). The advantage of budgeted rates is that they can reflect expected changes in
the costs or activity levels associated with each activity (see Kaplan and Cooper [1997] for a discussion of the use of
budgeted rates in ABC). Step 6 will continue to use the actual amounts of each cost driver consumed by the two
customer classes, which is not known until after the activity has occurred. Therefore, for this particular example, the
two steps are in the proper sequence.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-55 ©The McGraw-Hill Companies, Inc., 2008
Blocher, Stout, Cokins, Chen: Cost Management:4e 5-56 ©The McGraw-Hill Companies, Inc., 2008
Requirement 5
The proportion of each activity that is attributable to: (i) the retail customer line, and (ii) the business customer line:

Requirement 6
The ABC annual indirect cost per retail and business customer account is:

Requirement 7
Use Requirements 1C and 5 to illustrate why costs shifted as they did. The original cost system allocated all indirect
costs based on the dollar value of the checks processed. Retail customers wrote 10 percent of the value of checks
processed and business customers wrote 90 percent of the dollar value of checks processed. Thus, the original cost
system allocated 10 percent of the indirect costs to retail customers and 90 percent to business customers. We use
overhead transparencies, handouts, or PowerPoint slides of Figure 3 to help students visualize the allocation under the
original system.
The ABC analysis shows that retail customers use much more than 10 percent of the three activities: (1) paying
checks, (2) teller services, and (3) responding to customer account inquiry calls. The solution to Requirement 5 shows
that retail customers wrote 20 percent of the (number of) checks processed, made 80 percent of the teller transactions,
and 95 percent of the account inquiry calls to the customer service call center. Whereas the original costing system
suggested that retail customers consumed only 10 percent of these resources, the ABC analysis clearly shows that retail
customers consumed significantly more than 10 percent of these three activities. The new ABC system allocates the
indirect costs to the retail and business customers based on the proportion of each activity’s resources that the customer
line consumed. Because retail customers wrote 20 percent of the checks processed, the ABC system considers these
customers as consuming 20 percent of the bank’s “check paying” resources, so they are allocated 20 percent of the costs
associated with the paying checks activity. Retail customers make 80 percent of the teller transactions, so they are
assigned 80 percent of the costs associated with the teller services activity. Retail customers are assigned 95 percent of
the customer account inquiry costs because they make 95 percent of the account inquiry calls. We use overhead
transparencies, handouts, or PowerPoint slides of Figure 4 to show how this more refined assignment of these activities’
costs allocates 59 percent ($1,672.50/$2,850) of the total indirect costs to retail customers and only 41 percent
($1,177.50/$2,850) to business customers.
Comparing Figures 3 and 4 helps students see why ABC shifts costs out of the business customer line and into
the retail customer line. This shift arises because retail customers use a much greater proportion of the teller transactions
(80 percent) and customer account inquiry (95 percent) activities than of the dollar value of checks processed (10
percent). The original system that allocated all the indirect costs based on the dollar value of checks processed assigned
too little cost to the retail customers (failing to recognize that they make 80 percent of the teller transactions and 95
percent of the calls), and too much cost to the business customers, who write 90 percent of the dollar value of the
checks, but make only 20 percent of the teller transactions and only 5 percent of the customer account inquiry calls. The
more refined ABC system more accurately estimates the costs of serving each type of customer, based on the customer’s
use of BNB’s resources.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-57 ©The McGraw-Hill Companies, Inc., 2008
Blocher, Stout, Cokins, Chen: Cost Management:4e 5-58 ©The McGraw-Hill Companies, Inc., 2008
Requirement 8
Using the ABC data, the average annual profit per account for retail and business customers is:

Retail Business
Revenue per account $10.00 $ 40.00
ABC cost per account (11.15) (23.55)
ABC profit (loss) per account $(1.15) $ 16.45
Original system’s profit (loss) per account $ 8.10 $(11.30)

The ABC customer cost data suggest business customers are profitable, but retail customers are not, which is exactly
opposite the conclusion reached using the original cost data. This example illustrates how ABC can significantly affect
management’s strategy. The ABC data suggest BNB should emphasize business customers (e.g., awarding managers
bonuses for attracting and retaining business customers, pampering business customers). The bank can also try to make
retail customers more profitable, perhaps by increasing fees for services, requiring retail customers to maintain higher
account balances, or increasing the interest spread on retail accounts.

Requirement 9
The ABC customer cost data suggest that management’s strategy to increase the retail customer base rather than the
business customer base was unwise. Management made this decision based on the assumption that the bank’s original
cost system provided accurate cost information. Unfortunately, the ABC data show that the retail customers are not
currently profitable for BNB. Given the existing revenue and cost structure (and assuming the largely labor-related
indirect costs are mostly variable), BNB may want to provide a bonus for attracting and retaining new business
customers only. For retail customers, the bank should consider changing the revenue structure (e.g., increasing the
required minimum balance for retail checking accounts) or the cost structure (e.g., developing methods that deliver the
same level of service at a lower cost, such as encouraging retail customers to use ATMs or online banking rather than
expensive teller services, or possibly cutting back service at the customer account inquiry center).

Requirement 10
ABC provides more accurate cost information that managers can use in making important business decisions. Activity-
based management (ABM) refers to using ABC information to make decisions that increase profits while satisfying
customer needs. Managers use ABC information in making pricing and product or customer mix decisions, in
identifying opportunities to cut costs, and in routine planning and control.
ABC customer cost data can help BNB’s managers develop more effective marketing strategies by more
appropriately pricing their services and assessing the profitability of different mixes of customers and/or services. For
example, after recognizing that attracting and retaining business accounts is the key to profitability (given the existing
cost and revenue structure), BNB may want to add special services for business customers. In a recent Wall Street
Journal article, reprinted as an Appendix to this case, Brooks (1999) highlights new services that banks provide to retain
their most profitable customers—from special expedited toll-free phone lines to waiving certain fees. In contrast, BNB
should be wary of encouraging retail customer growth unless it increases the revenues or reduces the costs of serving
retail customers.
BNB’s managers can also use ABC data to pinpoint opportunities to improve production (or service) processes
and trim costs by reducing: (1) the cost per unit of the activities, or (2) customers’ consumption of the activities. For
example, highlighting the costs of each activity may help BNB find ways to trim the indirect cost per unit of the cost
driver. The bank may train customer account inquiry representatives to handle more calls per hour. This can reduce the
cost per call if the bank can then handle the call load with fewer customer service representatives. To cut the per-check
cost of paying checks, BNB might purchase more efficient check-processing systems. ABM can also help the bank
reduce customers’ consumption of activities that drive costs (while maintaining their business). For example, teller
services, a relatively high-cost activity, provides a promising starting point for managers looking for significant cost
savings. Management may be able to develop creative lower-cost alternatives to reduce customers’ use of expensive
teller services, such as encouraging customers to use Automatic Teller Machines (ATMs) or to switch to Internet
banking. The bank may also develop a web-based account information site that allows customers to access their
accounts through the Internet, thereby answering many of their own questions, and reducing the number of inquiries to
the customer service call center.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-59 ©The McGraw-Hill Companies, Inc., 2008
Requirement 11
For BNB, the benefits are likely to outweigh the costs of ABC. First, BNB operates in a highly competitive
environment. In competitive industries, accurate cost information is essential for setting competitive prices that still
allow the company to earn a profit. Competitors will capitalize on a company’s mispricing, especially by cherry-picking
high-volume profitable products, services, or customers that the company overprices. In this case, BNB is vulnerable to
losing its business customers, whose costs are far less than the revenues they provide BNB. In addition, ABC can
pinpoint opportunities for cost savings, which increase the bank’s profit or are passed on to customers in lower “sale
prices” (for example in this context, by reducing the amount of the minimum required account balances). Second, most
of BNB’s costs are indirect. ABC is most valuable to companies with high indirect costs, because if indirect costs are
low, it does not matter how they are allocated. Third, ABC has a material effect when different customers/products/
services use different amounts of the company’s resources. At BNB, retail and business customer lines use different
amounts of the bank’s resources for paying checks, teller services, and customer account inquiry services. Finally, costs
of ABC include information technology and accounting expertise to implement the system and to record cost driver
data. Given the magnitude of the data processing requirements, banks typically possess advanced information
technology and accounting expertise. All these factors suggest that for BNB, the benefits of ABC are likely to outweigh
the costs.

Requirement 12
ABC is not just an accounting exercise. Managers outside the financial function need to understand ABC so that they
can use the resulting cost information when making important decisions such as setting prices, analyzing product and
customer profitability, and identifying opportunities to trim costs. As requirement 10 briefly discusses, managers
engaged in ABM use ABC information to guide strategic product emphasis, process improvement, and cost-reduction
decisions. Finally, nonaccounting managers need to understand ABC because they often serve on ABC teams. These
cross-functional teams typically include managers actively engaged in the firm’s core operations, in addition to

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-60 ©The McGraw-Hill Companies, Inc., 2008


Banks, Others Base Service On Whether an Account Is Profitable or a Drain

‘Redlining in the Worst Form’

By Rick Brooks
Staff Reporter of The Wall Street Journal

CHARLOTTE, N.C.–Fielding phone calls at First Union Corp.’s huge customer service center here, Amy Hathcock is
surrounded by reminders to deliver the personal touch. Televisions hang from the ceiling so she can glance at the
Weather Channel to see if her latest caller just came in from the rain; a bumper sticker in her cubicle encourages,
“Practice random kindness & senseless acts of beauty.”
But when it comes to answering yes or no to a customer who wants a lower creditcard interest rate or to escape
the bank’s $28 bounced-check fee, there is nothing random about it. The service all depends on the color of a tiny
square—green, yellow or red—that pops up on Ms. Hathcock’s computer screen next to the customer’s name.
For customers who get a red pop-up, Ms. Hathcock rarely budges; these are the ones whose accounts lose
money for the bank. Green means the customers generate hefty profits for First Union and should be granted waivers.
Yellow is for in-between customers: There’s a chance to negotiate. The bank’s computer system, called “Einstein,” takes
just 15 seconds to pull up the ranking on a customer, using a formula that First Union declines to detail of minimum
balances, account activity, branch visits and other variables.

The Non-Egalitarian Approach

“Everyone isn’t all the same anymore,” says Steven G. Boehm, general manager of First Union’s customer-information
center, where agents will handle about 45 million customer calls this year.
After years of casting a wide net to lure as many consumers as possible, banks and many other industries are
becoming increasingly selective, limiting their hunt to “profitable” customers and doing away with loss-leaders.
Wielding ever-more powerful computer systems, they are aggressively mining their vast databases to weed out losers, or
at least to charge them more, and to target the best customers for pampering.
Paging Network Inc., a paging-services provider that for several years essentially gave away its pagers in a
race to build market share, now is trying to chase away heavy users who receive a flurry of messages but often pay only
a rockbottom monthly fee. “The power users are the ones you need to get away from,” a PageNet spokesman says.

Sending Bad News

After bringing in consultants to sift through data on individual customers, PageNet sent letters to marginal subscribers,
telling them their rates were being increased. The company, under new management and in the process of restructuring
most of its operations, also got tougher on companies that resell its pagers.
The results so far are significant: PageNet’s domestic subscriber base shrank by almost 138,000 in the third
quarter of 1998 to about 10.2 million. Last month, the Dallas company said it expected to lose as many as 325,000
additional customers in the fourth quarter.
“There’s just no free lunch anymore,” the PageNet spokesman says. “We’ve done the research now to feel
comfortable walking away with no regrets.”
The story is similar at FedEx. Two years ago, the shipping giant began analyzing the returns on its business for
about 30 large customers that generate about 10% of its total volume. It found that certain customers, including some
requiring lots of residential deliveries, weren’t bringing in as much revenue as they had promised when they first
negotiated discounted rates with FedEx.
So FedEx went on the offensive, demanding that some customers pay higher rates and imposing double-digit
increases in a handful of instances. A couple of big customers who refused to budge were told they could take their
shipping business elsewhere.

‘Suck It Up’
“We were willing to risk a point or two of market share to correct the problem,” says a spokesman for FedEx, a unit of
FDX Corp. “You have to be willing to suck it up and walk away.”
Of course, some industries have a long tradition of favoring “good” customers over less profitable ones.
Airlines, credit-card issuers and mail-order companies have thrown loads of tailored services to so-called platinum and

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-61 ©The McGraw-Hill Companies, Inc., 2008
premier customers. And banks several years ago began charging fees for services they wanted to discourage, like visits
to the teller. But only recently has technology developed to the point where companies can compare profit-and-loss
statements on every customer and weed out the money-losers.
Banks are by far the biggest industry yet to marshal this data-crunching ability. Already, about half of big banks
with more than $1 billion in deposits use profit data to make customer decisions, more than double the percentage just a
year ago, estimates GartnerGroup Mentis Financial Services, a banking-research firm in Durham, N.C.
For banks, a typical “bad” customer makes frequent branch visits, keeps less than $1,000 in the bank and calls
often to check on account balances. The most profitable customers, who keep several thousand dollars in their accounts,
use a teller less than once a month and hardly ever use the call center. And while favored customers generate more than
$1,000 in profits apiece each year, the worst customers often cost the bank money—a minimum of $500 a year.
What’s more, the top 20% of typical bank customers produce as much as 150% of overall profit, while the
bottom 20% of customers drain about 50% from the bank’s bottom line, according to Market Line Associates, an
Atlanta bank-consulting firm.
To help separate the wheat from the chaff, banks have spent about $500 million in the past few years on
software and consultants, according First Manhattan Consulting Group in New York. That number is expected to grow
to at least $500 million per year in the near future, as many more of the nation’s 9,000 or so banks take up the call.
First Union estimates its Einstein system will add at least $100 million in annual revenue, or less than 1% of its
1997 total revenue of about $12 billion. About half of that increase is expected to come from extra fees and other
revenue from unprofitable customers, and from holding on to preferred customers who might otherwise leave the bank
if not for the extra pampering.

Calculating Profits
First Union, the sixth-largest bank in the U.S., acknowledges that it is still figuring out how to track profits generated by
its new strategy. “It’s not so much that it can’t be done, but we need to refine the mechanism,” says Sandy Deem, a First
Union spokeswoman. Part of the problem is that most banks haven’t married their disparate computer systems. While
one database may track how many times a customer visits ATMs, how much the bank spends on marketing to get that
person there might be in another system, with a third system estimating how much interest income an account generates.
The profit obsession, of course, has many risks. For one, future profits are hard to predict. A high-school
student on his way to a Harvard M.B.A. and a plum job on Wall Street might be worth courting. So might an
unprofitable customer who suddenly inherits a lot of money and wants to plunk it in CDs or other products.
“That shabby-looking guy might actually be or become an eccentric billionaire. But as a result of using this
technology, do you give him the bum’s rush?” asks Srikumar S. Rao, chairman of the marketing department at Long
Island University’s C.W. Post campus in Brookville, N.Y.

Bristling Over Bank Policy

Even some customers who fit the favored-customer profile bristle at the notion that bankers are bending over backward
only for their most profitable clients. “I understand that everybody needs to make a profit, and I can’t begrudge them for
that,” says John B. Warnken, a 47-year-old insurance consultant in Tampa, Fla., who banks with Huntington Bancshares
Inc. “To me, this is redlining in the worst form and fashion.”
Nancy Moran, a prison consultant in Baltimore, keeps about $500 in her account at NationsBank, just enough
to avoid paying a monthly fee. She is irritated that her monthly account statement includes a list of each service she
uses, and she fears that the bank, now part of BankAmerica Corp., can track her moves and profitability so closely that
soon “every little interaction between me and the bank will be assessed a fee.”
It doesn’t help matters that the relationship between many banks and their customers is already strained. The
biggest merger boom in the industry’s history has left countless customers to endure longer lines and more bureaucratic
snafus. And there is some customer resistance to the industry’s push toward conducting as many transactions as possible
via ATM or on-line; banking is still a business that operates largely on trust, and many customers want to speak to a
human being when doing important transactions such as depositing large checks or taking out a car loan or mortgage.

Competing for Customers

At the same time, banks, like other businesses, are under attack from all sides. Brokerage firms and mutual-fund
empires in particular are trying to grab traditional bank customers, and highly profitable ones are the most attractive. To
fend off the assault, banks say they need to identify the customers they should fight hardest to keep.
In many places, the line in the sand between preferred and nonpreferred customers has become strikingly
obvious. Bank One Corp., Chicago, the nation’s fifth largest bank, is redesigning its 218 branches in Louisiana so
“Premier One” customers, after presenting a special gold card to the “concierge” near the front door, can be whisked
away to a special teller window with no line or to the desk of a specially trained bank officer.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-62 ©The McGraw-Hill Companies, Inc., 2008
“And if that person has a problem or complaint, we are empowering our people to provide no-questions-asked
refunds” on fees customers think they shouldn’t have to pay, says Ronald Baldwin, Bank One’s president of retail
delivery. Customers qualify by keeping at least $2,500 in a checking account or a total of $25,000 in a combination of
certain bank accounts, loans and investments, or by paying a $17 monthly fee. Bank One estimates the extra attention
will go only to the top 20% of its customers.
Need to dial into your bank’s customer-service center? At Westamerica Bancorp. in San Rafael, Calif., about
5,000 “VIP” customers get a secret toll-free number allowing them to jump ahead of unprofitable callers. BankAmerica,
the second largest U.S. bank, routes calls from preferred and unprofitable customers to different operators; a personal-
identification number entered by each caller allows the bank to determine, among other things, the customer’s
profitability ranking.

‘We Don’t Do That Anymore’

Now, talking to a branch manager can also depend on whether a customer is profitable. Gone are the days at Centura
Banks Inc., Rocky Mount, N.C., where the manager returned phone messages in the order they were received. “We
don’t do that anymore,” says Bob James, group executive for market planning and customer development. He notes that
the bank now rates its 550,000 customers on a scale of one to five, with one being the most lucrative. “I would hope that
all of our branch managers, if they recognized a ‘one’ in there, would call that person first.”
Most banks deny they are trying to get customers to leave. “It’s not that you don’t want to get people as your
customers,” says Jack M. Antonini, a former credit-card executive brought to First Union to ramp up its information-
crunching efforts. “This is just a more efficient model for putting the right product in the hands of the right customer.”
But after First Chicago Corp., now part of Bank One, imposed a $3 teller fee in 1995 on some of its money-
losing customers, 30,000 of them—or close to 3% of the bank’s total customers—closed their accounts. Some
customers became profitable by boosting their account balances high enough to avoid the fee or by visiting ATMs
instead of tellers, the bank says.
Meanwhile, some competitors are making a nice living on the throwaways. David Ness, president of Raymond
James Trust Co. and Sound Trust Co., both units of Raymond James Financial Inc., St. Petersburg, Fla., says “dozens”
of his firm’s 1,177 trust accounts came from traditional banks that told their clients they were too small to merit further
personal attention.
Says Mr. Ness, “Nobody seems to care anymore, and that is a big part of our marketing effort.”

Copyright 1999 by DOW JONES & CO INC. Reproduced with permission of DOW JONES &CO INC from the Wall
Street Journal, January 7, 1999, permission conveyed through Copyright Clearance Center.

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Teaching Strategies for Articles

5-1 Activity-Based Costing and Predatory Pricing: The Case of the Petroleum Retail Industry

1. What are product-cost subsidizations?

Product-cost subsidizations are where excessive costs are charged to one or more products, usually
high-volume products, and insufficient costs are charged to other, usually low-volume, products.

2. What are possible consequences of product-cost subsidizations?

Product-cost subsidizations can lead undercosted—and underpriced—products and overcosted—and

thus overpriced—other products. Product-cost subsidization also may have legal consequences.
Undercosted products can lead to the appearance of predatory pricing where it actually does not exist.

3. List alternative approaches to assign costs in a gasoline service center.

Three approaches can be employed to assign gasoline service center costs to products:
a. Unit-based
b. Product-based
c. ABC approach.

4. Identify cost hierarchy level groups in classifying activities at the retail level of a gasoline service
center and give at least one example each.
 Unit-level activities are undertaken for each gallon of gasoline sold (such as electricity to power
pumps when dispensing gasoline);
 Batch-level activities are the same for each gasoline transaction irrespective of the volume of
gasoline purchased (for example, transactions to process customer payments for gasoline by cash,
check, or debit/credit card);
 Product-level activities are conducted for specific gasoline products such as regular, plus, and
premium gasoline and motor oil (for instance, gasoline tanks that are dedicated to specific gasoline
Customer-level activities are conducted for specific gasoline customers (such as using billboard
advertisements to promote the benefits of premium gasoline); and
 Organizational-supporting activities are for the gasoline dispensing organization as a whole and
cannot be causally identified with units, batches, or individual products (including payroll and
many other centralized activities).

5. What are overheads activity-cost pools pertaining to selling gasoline in a retail gasoline service center
and what is the activity level for each of the cost pools?

Gasoline Sales Attendants (Labor): Attendants are needed to receive payments from customers
who do not pay electronically at the gasoline pump. This is a batch-level activity because payment
transactions occur only once for each purchase of gasoline, regardless of the volume of gasoline
Kiosk Facility and Gasoline-Dispensing Facility: Rental value of the kiosk (retail gasoline facility)
that facilitates the payment transactions for gasoline purchase. This is a batch-level activity, as it
occurs only once for each purchase of gasoline, regardless of the volume of gasoline purchased.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-65 ©The McGraw-Hill Companies, Inc., 2008
Also, it was necessary to determine a “reasonable rental value” for the gasoline-dispensing facility,
which, in general, can be classified as a product-level activity. This activity cost pool includes
assets that are specific to a particular gasoline grade and common gasoline dispensing assets. In a
more comprehensive activity analysis, this cost pool could be divided into two or more activity
cost pools that would be more homogeneous in nature.

6. Identify the activity drivers for overheads activity-cost pools identified in this study and explain the
reasons for the selection?

Gasoline Sales Attendants (Labor): Volume of gasoline sold (a unit-level activity driver).
 The principal responsibility of a kiosk attendant is to receive payments from customers for
gasoline purchases, which is a batch-level activity. Given that the average volume of gasoline sold
to each customer is about the same, regardless of the gasoline grade, the volume of gasoline sold
can be used as a proxy activity driver for these payment transactions.
 The number of gasoline sales transactions is a major factor in determining the number of kiosk
attendants and the hours a gasoline station is open, which directly affect the level of salary and
benefits payments.
Kiosk Facility: Volume of gasoline sold.
 The entire purpose of the kiosk facility is to house the attendants who receive payments from
customers for gasoline purchases.
 The expected volume of gasoline sales determines the size of the kiosk necessary to house the
number of attendants, which directly impacts the imputed rental payments.
The volume of gasoline sales determines the hours a gasoline station is open, which directly
affects the level of repairs and maintenance, utilities costs, and so on.
Gasoline-Dispensing Facility: Number of gasoline grades.
The facilities used for dispensing the three grades of gasoline are identical in size and cost for
each grade of gasoline irrespective of the volume of gasoline sold (for example, the gasoline

7. List examples of gasoline-dispensing facilities for a gasoline service center and identify whether each
of the facilities is a common or a gasoline grade-specific asset.

(Please refer to Table 3 for the answer).

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-66 ©The McGraw-Hill Companies, Inc., 2008
5-2 Activity-Based Benchmarking and Process Management - Managing the Case of
Cardiac Surgery

1. Describe briefly hospital’s costing system.

Generally, the hospital’s costing system begins with the division of each general ledger account
into cost types: variable direct cost, fixed direct cost, and fixed indirect cost.
At the cost center or department level, each indirect cost center is assigned an allocation base (such
as total cost, square feet, or gross revenue) to be used to spread the indirect costs to the direct cost
centers. The departmental direct costs and allocated indirect costs become departmental total costs.
The standard unit cost of the primary product/service is then calculated by first allocating the
departmental total cost based on the relative value units (RVUs) multiplied by the budgeted volumes
of each individual product/service to obtain the budgeted total cost of each basic product/service.
The standard unit cost is calculated by dividing the total cost of the individual product/service by
its budgeted volume. The standard unit costs for primary products/services are then summed up into
intermediate products, such as a surgical procedure and rolled up into final product/service, such as
inpatient days or admissions.

2. Describe steps in activity-based benchmarking for medical-care processes.

Activity-based benchmarking for medical-care processes involves three steps: (1) analyzing process
flow and identifying major activities, (2) choosing the appropriate measurement of resource
consumption for benchmarking, and (3) identifying the best process and practice as benchmarks.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-67 ©The McGraw-Hill Companies, Inc., 2008
5-3 Using ABC to Asses Channel/Customer Profitability

This article explains how ABC was used by a firm (TEC) in the temporary employment industry to better
identify the profitability of its service distribution channels and individual customers.

Discussion Questions:
1. What are the four steps used in implementing ABC costing at TEC?
Step 1. Develop the activity dictionary.
Step 2. Determine how much the organization is spending on each of its activities.
Step 3. Identify the organization’s products, services, and customers.
Step 4. Select activity cost drivers that link activity costs to the organization’s products, services,
and customers.
Step 5. Calculate activity rates for each activity

2. What are the activity consumption drivers that TEC has chosen for each of the three activities: filling
work orders, hiring temporaries, and processing payroll?
From Table 2:
 number of temporaries ordered for filling work orders,
 number of applicants for hiring temporaries, and
 number of hours worked for processing payroll

3. Which customer channel is most profitable, clerical or industrial, and why?

The clerical channel has somewhat higher profitability (Table 3)because the industrial customers
demand lower rates and have significantly higher worker’s compensation rates.

4. Within the industrial channel, which class of customers is most profitable and why?
Per Table 4, the most profitable class is the low workers’ compensation rate (low WS) class. The
High WC class has a low margin because of the high WC rates. The average WC class has a net loss
because the customers in this class require a lot of service time.

5. In the study of the four largest customers, which is the most profitable and why?
The newspaper publisher and the food processing company had negative contributions, while the
trailer manufacturer has a modest contribution. The highest contribution was for the chemical company
because in part this company tended to hire temporaries on a long term basis, so the activity consumption
cost driver, number of temporaries, was relatively small for this company.

Blocher, Stout, Cokins, Chen: Cost Management:4e 5-68 ©The McGraw-Hill Companies, Inc., 2008