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CHAPTER 5 Activity-Based Costing and Management Teaching Notes for Cases and Articles from the Cases and

Readings Manual
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 profitability. Main Points: Activity-Based Costing Value Chain Analysis Customer profitability analysis Discussion Questions: 1. What is Blue Ridges 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 wont 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 students 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 Ridges licenses with the sports teams of unique value, or do competitors have the same access as Blue Ridge? c) How strong are Blue Ridges 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-dyeembroidery, 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 retailers 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 %. Stage 2: Allocate activity costs to Customer Type (Large, Medium, Small).

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1. 2. 3.

Identify cost drivers (as shown in Table 4) and their consumption statistics for each customer type (as shown in Table 1). Calculate cost driver consumption % for each customer type. 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.

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Blue Ridge Manufacturing First Stage Allocation: Allocate SG&A Costs to SG&A Activities
First: SG&A Costs Administration Selling Shipping 17,000 15,500 $32,500 Shipping Sales 37,400 117,800 $155,200 Marketing 20,400 9,300 $29,700 Other 56,100 12,400 $68,500 Other 10% 15% 20% 10% 10% 10% 5% 10% 5% 15% 0% 100% 30% 50% 5% 20% 5% 100% Table 3 " " " " " " " " " " " " " " Total Assigned Source 130,900Table 3 155,000Table 3 $285,900

Second: SG&A ACTIVITIES Enter P.O. Commissions Shipping Invoicing Sales Calls Check Credit Samples... Sp Handling Distribution Marketing, Customer Advertising Marketing Administrative Licenses, fees TOTAL

Percentage of... Sales Marketing 55% 10%

65% 30% 5% 5% 10%

100%

100%

Third: Allocate Costs to Activities Shipping ACTIVITIES Enter P.O. 0 Commissions 0 Shipping 21,125 Invoicing 0 Sales Calls 0 Check Credit 0 Samples,... 1,625 Sp Handling 1,625 Distribution 3,250 Marketing, Cust 0 Advertising 0 Marketing 4,875 Administrative 0 Licenses, fees 0 TOTAL $ 32,500

Sales 85,360 15,520 0 0 46,560 0 0 0 0 7,760 0 0 0 0 $155,200

Marketing 0 0 0 0 0 0 2,970 0 2,970 0 8,910 14,850 0 0 $29,700

Other 6,850 0 10,275 13,700 6,850 6,850 0 3,425 0 0 0 3,425 13,700 3,425 $68,500

Total Assigned 92,210 15,520 31,400 13,700 53,410 6,850 4,595 5,050 6,220 7,760 8,910 23,150 13,700 3,425 $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 Units sold- w/o specials 99,770 55,118 116,812 Units sold-Total 100,250 58,544 117,406 Units embroidered 5,959 6,490 29,394 Units dyed 20,536 9,935 12,328 Orders 133 845 5,130 Shipments 147 923 5,431 Invoices 112 754 4,737 %>60days 1 11 122 Revenues (Sales $308,762 $183,744 $318,024 Value) Customers 8 154 824 Second: Calculate Cost Driver Percentage for Each Customer Type Units sold (excl. Special) 0.367 0.203 Orders 0.022 0.138 Shipments 0.023 0.142 Invoices 0.020 0.135 %>60days 0.007 0.082 Revenues 0.381 0.227 Customers 0.008 0.156 Total 271,700 276,200 Table 1 41,843 " 42,799 " 6,108 " 6,501 " 5,603 " 134 " $810,530 " 986 "

0.430 0.840 0.835 0.845 0.910 0.392 0.836

1.000From above 1.000From above 1.000From above 1.000From above 1.000From above 1.000From above 1.000From above Cost Driver/ Allocation Base (Table 4) Orders Revenues (Medium Customers only) Shipments Invoices Revenues (Large Customers only) %>60days Revenues Estimate (20% M, 80% S) Revenues Revenues Estimate (25% M, 75% S) Units sold (Excluding Specials) Units sold (Excluding Specials) Revenues (Medium Customers only) AA

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

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Third Stage: Customer Profitability Analysis


First: Get Revenues by Customer Group Unit Sales Large Regular 27,250 Mid-size 36,640 Hand 35,880 Special 480 Total 100,250 Revenue Regular Mid-size Hand Special Total Revenue Price $ $ $ $ 3.60 3.20 2.55 4.00 Large 98,100 117,248 91,494 1,920 $308,762 Medium 16,600 18,552 19,966 3,426 58,544 Small 10,550 10,308 95,954 594 117,406

54,400 Table 1 65,500 " 151,800 " 4,500 " 276,200

Medium Small 59,760 37,980 59,366 32,986 50,913 244,683 13,704 2,376 $183,744 $318,024

195,840 Table 2 209,600 " 387,090 " 18,000 " $810,530BB

Second: Calculate Manufacturing Cost -(1) Unit Cost Regular $ 1.19 32,428 Mid-size $ 1.03 37,739 Hand $ 0.89 31,933 Special $ 1.44 691 Total $102,791 Direct Cost of Unit Cost Customizing Inking (Units x 2) $ 0.0817 Embroidery Dyeing $ $ 1.2770 0.1100

19,754 12,554 19,109 10,617 17,770 85,399 4,933 855 $61,566 $109,426

64,736Table 2 x Table 1 67,465 " 135,102 " 6,480 " $273,783CC

16,381 7,610 2,259 $26,249

9,566 8,288 1,093 $18,947

19,184 37,536 1,356 $58,076

45,131Table 2 x Table 1 53,434 4,708 $103,272DD

(2) Total Cost Mfg Cost Customizing SG&A Total Cost Third: Calculate Customer Profit -(1) Total (2) Per Customer

$102,791 $26,249 77,060 $206,101

$61,566 $109,426 $18,947 $58,076 53,490 155,350 $134,002 $322,853

$273,783From CC above $103,272From DD above $285,900From AA above $662,955EE

$102,661 $12,833

$49,742 $323

$(4,828) $(6)

$147,575BB-EE $150

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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 Institutes 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 answer. The instructor can download the files shown in TN-1 that are pertinent to the case from the McGrawHill/Irwin textbook website (www.mhhe.com/blocher3e), 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 TN1. The actual Oros Quick Software and Oros Quick Tutorial are downloaded separately from the McGrawHill/Irwin website (www.mhhe.com/blocher3e), 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 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.

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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 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: www.mhhe.com/blocher3e under Premium Content. This will require the user to have the WinZip program. WinZip can be obtained at https://secure.safesite.com/cgi-bin/wzc1?PWR for a single user fee of $29 or there is a link on the site for a free trial version of WinZip as well. Students should download the Oros Quick Tutorial (Adobe Acrobat file) The link for this download is on the McGraw-Hill/Irwin website: www.mhhe.com/blocher3e under Premium Content. This will require Adobe Acrobat Reader. Reader can be obtained free at http://www.adobe.com/products/acrobat/readstep2.html Work through the Oros Tutorial (you can skip the sections on attributes and on the balanced scorecard) 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 to 2 hours, and then go to steps 4 and 5 below. Create a folder on your computer labeled Blue Ridge. This step is added simply to reduce clutter on the students computer and to keep the files in a single convenient location for later reference. 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 Ridges 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): 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 5. 4. 3. 2. 1.

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6.

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 revenues 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 complete Tutorial pages 87- end; not needed for the Blue Ridge Case. o

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 TN-12: Unit Cost Report

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TN-2 Excel Solution for the Blue Ridge Manufacturing Case

First Stage Allocation: Alloca First: SG&A Costs Ship Administration Selling $ Second: Resource Drivers

Ship ACTIVITIES Enter P.O. Commissions Shipping

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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 Implementation of Activity Based Costing for Sunny View Dairy Farm Using SAS Activity-Based Costing Software
Overview of the Case Case 5-3 is based on a hypothetical dairy farm that produces a variety of dairy products. The case involves both resources and activities, and related resource consumption drivers and activity drivers. The instructor can download the files shown in TN-1 which are pertinent to the case from the McGrawHill/Irwin text website (www.mhhe.com/blocher3e), under Instructor Center: Solutions to ABC cases. These files include a Word file for the teaching note as it appears in the Guide. The Excel file is the Excel solution for the case. The remaining files are the files that are created 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 Sunny View Diary Farm Case as seen in TN-1. The actual Oros Quick Software and Oros Quick Tutorial are downloaded separately from the McGrawHill/Irwin website (www.mhhe.com/blocher3e), 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 previous Case 5-2: Blue Ridge Manufacturing is also an Oros case, and it will have a similar set of files to those discussed for the Sunny View Dairy Farm case. The Blue Ridge Manufacturing 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 the same format.) The organization of downloads is thus 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): 3. A link to download the Oros Quick Software (a 9,095KB Winzip file; Quick 551) 4. 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 Sunny View Dairy Farm case for use with Quick Under the Instructor Center (password protected): 1. A link to download the Sunny View Dairy Farm 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 Sunny View Dairy Farm Case

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Approach to Teaching the Case


Goals for Teaching the Case The goals of case 5-3 (Sunny View) are the same as that for Case 5-2 (Blue Ridge). Please see the discussion of Goals under the Teaching note for Case 5-2. Teaching Notes for Assignments Download and install the Oros Quick ABC/M program (WinZip file). The link for this download is on the McGraw-Hill/Irwin text website: www.mhhe.com/blocher3e, Premium Content). This will require the user to have the WinZip program. WinZip can be obtained at https://secure.safesite.com/cgi-bin/wzc1?PWR for a single user fee of $29 or there is a link on the site for a free trial version of WinZip as well. Students should download the Oros Quick Tutorial (Adobe Acrobat file) The link for this download is on the McGraw-Hill/Irwin website: www.mhhe.com/blocher3e under Premium Content. This will require Adobe Acrobat Reader. Reader can be obtained free at http://www.adobe.com/products/acrobat/readstep2.html Work through the Oros tutorial (you can skip the sections on attributes and on the balanced scorecard) 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 to 2 hours, and then go to steps 4 and 5 below. 4. 5. Create a folder on your computer labeled Sunny View. This step is added simply to reduce clutter on the students computer and to keep the files in a convenient location for later reference. 3. 2. 1.

Use the information in the Sunny View Dairy Farm Case and in the tutorial to complete an ABC costing application using Oros; determine the ABC-based unit costs for the Farms products The students should require approximately 3 hours for this step working in teams, or a little longer 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 Sunny View 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 are four centers in the Sunny View case, that is, Processing, Materials, G&A, and Facilities o The accounts in each center are shown in TN-3 Under Building the Activity Structure (pp 23): o There are 8 activities in the model, shown in TN-4 Under Creating Cost Objects (pp24-25): o There are five cost objects; whole milk, low-fat milk, skim milk, chocolate milk, and eggnog 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 Sunny View case will use the percentage cost driver. o You will need to add eight additional activity consumption cost drivers for the Sunny View case: See the right hand panel of TN-5

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Creating Assignment Paths (pp 32-43) o Each resource is linked to the activities that receive costs from that resource (TN-5) o Each activity is linked to the cost objects that receive costs from that activity (TN-6) Tutorial pp 43- 61. Can skip Adding Bills of Costs (pp 62-69) o The Sunny View Case incorporates direct costs (the tutorial calls them external costs) in addition to the activity-based costs; these costs include, for example, the cost of chocolate used in chocolate milk; TN-7) 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 (TN-8, TN-9) o Next you enter the activity cost driver quantities the case (TN-10) o Finally, you enter the cost object (output) quantities from the case (TN-11) Calculating the Model (pp 81-86): o This section shows how the model is calculated 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 cost objects. o The assignment question asks for unit cost 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 complete (TN-12) Tutorial pages 87 and beyond are not needed for the Sunny View 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. This report can be saved to a text file or shown on the screen. (TN-13) Select Screens from the Oros Solution of the Blue Ridge Manufacturing Case: Some Screens from the Oros Solution of the Sunny View Dairy Farm 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 Sunny View Dairy Farm case. TN-2: Excel Solution for Sunny View 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 Entering Direct Costs (Bills of Costs) TN-8: Resource Costs TN-9: Resource Driver Quantities TN-10: Activity Driver Quantities TN-11: Cost Object Quantities TN-12: Cost Allocation to Cost Objects after Model is Calculated, Showing Unit Costs TN-13: Unit Cost Report

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TN-2 Excel Solution for Sunny View Case

Sunny View Dairy Farm First Stage Allocation: All

First: Resource Consumption ACTIVITIES Milking Separating/Past Mixing Bottling Warehousing General and Administrative
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TN-3 List of Resources and Accounts

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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 Entering Direct Costs (Bills of Costs)

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TN-8 Entering Resource Costs

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TN-9 Entering Resource Driver Quantities

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TN-10 Entering Activity Cost Driver Quantities

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TN-11 Entering Cost Object Quantities

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TN-12 Cost Allocation to Cost Objects after Model is Calculated

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TN-13 Unit Cost Report for Sunny View Dairy Farm

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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

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ABC 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 resourceusage/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.

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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

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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 savings. 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

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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: Activity # 3 4 5b 6b 8 13 15 16 Total savings "Supplies/Utilities" ABC rate $0.35 0.28 0.06 0.05 0.62 0.33 0.00034 0.0016 Change in Activity Frequency -600 -600 -3,200 -3,200 -533 -1,550 -500,000 -500,000 Estimated Spending Reduction $210 168 192 160 330 512 170 800 $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 supervision. 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.

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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

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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 productcosting 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.

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Therefore, this question provides students an opportunity to examine the product cost distortion inherent in the DLbased 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 $1,762,527. 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 question. 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

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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 resourcespending-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 "whatif" 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

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of 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. EXHIBIT TN-1 Bill of Activities for Redesigned Version of A12 Junction Box Quantity of Activity Activity# Activity Driver Rate 1 300 batches $20.51 2 300 batches 19.61 3 2,400 unique parts 7.67 4 2,400 unique parts 11.74 5a 1,500 bundles 7.23 5b 16,800 containers 1.88 6a 1,500 bundles 3.26 6b 16,800 containers 0.86 7 600 crane moves 38.95 8 2,800 forklift moves 10.70 9 1,500 forklift moves 21.51 10 1,500 forklift moves 15.02 11 300 setups 84.72 12 100,000 housing units 2.46 13 3,000 hours 7.17 14 100,000 housing units 0.63 15 2,100,000 parts 0.04 16 2,100,000 parts 0.18 17 100,000 finished units 0.90 18 100,000 finished units 0.67 Total Activity Charges Overhead from departments not included in ABC study Total Material Costs Total Product Cost Total Activity Charge $ 6,153 5,883 18,408 28,176 10,845 31,584 4,890 14,448 23,370 29,960 32,265 22,530 25,416 246,000 21,510 63,000 84,000 378,000 90,000 67,000 $1,203,438 520,661 6,500,000 $8,224,099 Volume of Production 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units 100,000 units Activity Charge/unit $ 0.06 0.06 0.18 0.28 0.11 0.32 0.05 0.14 0.23 0.30 0.32 0.23 0.25 2.46 0.22 0.63 0.84 3.78 0.90 0.67 $12.03 5.21 65.00 $82.24

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EXHIBIT TN-2 Resource Spending View of A12 Junction Box Redesign Proposal Step 1-Transform FTE Idle Capacities from the Text of the Case to Hours Current Idle Capacity 0.75 persons 0.25 persons 0.25 persons 0.50 persons 0.50 persons 0.00 persons x Practical Capacity/FTE 1,537 hours 1,490 hours 1,615 hours 1,571 hours 1,590 hours 1,526 hours = Idle Capacity 1,153 hours 373 hours 404 hours 786 hours 795 hours 0 hours

Purchasing Stores Crane Operators Forklift Operators Fabrication Assembly

Step 2-Compute Revised Idle Capacity as a Result of Product Redesign Idle Capacity in Hours 1,153 hours 373 hours 404 hours 786 hours 95 hours 0 hours + Decrease Due to Redesign 500 hours 374 hours 0 hours 222 hours 258 hours 3,466 hours = Revised Idle Capacity 1,653 hours 747 hours 404 hours 1,008 hours 1,053 hours 3,466 hours

Purchasing Stores Crane Operators Forklift Operators Fabrication 7 Assembly

Step 3-Quantify Potential Reduction in Terms of FTEs Revised Idle Capacity 1,653 hours 747 hours 404 hours 1,008 hours 1,053 hours 3,466 hours Practical Capacity/FTE 1,537 hours 1,490 hours 1,615 hours 1,571 hours 1,590 hours 1,526 hours = Potential FTE Reduction 1 FTE 0 FTE 0 FTE 0 FTE 0 FTE 2 FTE

Purchasing Stores Crane Operators Forklift Operators Fabrication Assembly

Step 4-Translate Potential FTE Reduction to Dollar Savings Potential FTE Reduction Purchasing 1 FTE Stores 0 FTE Crane Operators 0 FTE Forklift Operators 0 FTE Fabrication 0 FTE Assembly 2 FTE Total Spending Reduction x Average Wage and Fringe/Employee $30,373 24,042 27,300 18,262 24,022 29,800 = Dollar Savings $30,373 0 0 0 0 59,600 $89,973

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EXHIBIT TN-3 The Impact of the A12 Redesign on Idle Timea Original Activity Frequency 3,000 3,000 Revised Activity Frequency 2,400 2,400 Change in Activity Frequency -600 -600 Activity Time Standards 20 min./count 30 min./count Change from Original Activity Time Forecast (hours) -200 -300 -500 -267 -107 -374

Activity Process #1: Materials Procurement Purchasing Department 3. Issue purchase orders for parts 4. Expedite open parts orders Stores 5. Unload materials and put in stores b. assembly-parts 6. Process material requisitions b. assembly-parts

Activity Driver # unique parts/batch # unique parts/batch

# parts containers # parts containers

20,000 20,000

16,800 16,800

-3,200 -3,200

5 min./container 2 min./container

Process #2: Manufacturing Material Handling 8. Move parts to Assembly

# forklift moves

3,333

2,800

-533

25 min./forklift move

-222 -222 -258 -258 -833 -2,633 -3,466

Fabrication 13. Rework defective units Assembly 15. Unload parts and hold 16. Assemble finished products
a

# of rework hours

4,550

3,000

-1,550

10 min./unit

# parts used # parts used

2,600,000 2,600,000

2,100,000 2,100,000

-500,000 -500,000

0.10 min./part see Exhibit 5

Activity #7 relates to Crane Operators. The A12 redesign has no effect on this activity.

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EXHIBIT TN-4 Illustration of Usage vs. Spending Concepts Panel A: Cost Reduction Proposal #1 Submitted in February 19xx Assumptions Average employee wages = $25,000 Implementation costs = $5,000 No idle capacity exists Activity Frequency Activity Reduction Purchasing 1,600 Material moves 1,800 Activity Time Standard 30 min. 25 min. Time Savings (in hours) 800 750 Employee Capacity 1,500 hours 1,500 hours Headcount Reduction 0 0

Activity Driver # purchase orders # moves

According to the resource spending view, what are the potential cost savings? Panel B: Cost Reduction Proposal #2 Submitted in April 19xx Assumptions Average employee wages = $25,000 Implementation costs = $8,000 No idle capacity exists Activity Frequency Activity Reduction Purchasing 1,800 Material moves 2,000 Activity Time Standard 30 min. 25 min. Time Savings (in hours) 900 833 Employee Capacity 1,500 hours 1,500 hours Headcount Reduction 0 0

Activity Driver # purchase orders # moves

According to the resource spending view, what are the potential cost savings? Panel C: Impact of the Combined Proposals on Spending Reduction Activity Frequency Activity Reduction Purchasing 3,400 Material moves 3,800 Activity Time Standard 30 min. 25 min. Time Savings (in hours) 1,700 1,583 Employee Capacity 1,500 hours 1,500 hours Headcount Reduction 1 1

Activity Driver # purchase orders # moves

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

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EXHIBIT TN-5 Illustration of Usage vs. Spending Concepts Panel A: Resource Usage View of Cost Reduction Proposal #1 Submitted in February 19xx Assumptions Average employee wages = $25,000 Implementation costs = $5,000 No idle capacity exists Activity Frequency Reduction 1,600 1,800 Activity Rate $10.00 $7.50 ABC Cost Savings $16,000 13,500 $29,500 5,000 $24,500

Activity Purchasing Material moves Estimated Savings Less: Implementation costs Net Cost Savings

Activity Driver # purchase orders # moves

Panel B: Resource Usage View of Cost Reduction Proposal #2 Submitted in April 19xx Assumptions Average employee wages = $25,000 Implementation costs = $8,000 No idle capacity exists Activity Frequency Reduction 1,800 2,000 Activity Rate $10.00 $7.50 ABC Cost Savings $18,000 15,000 $33,000 8,000 $25,000

Activity Purchasing Material moves Estimated Savings Less: Implementation costs Net Cost Savings

Activity Driver # purchase orders # moves

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EXHIBIT TN-6 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 Direct materials Direct labor Overhead Gross margin S, G & A Profit before tax Tax expense Profit after tax Profit margin (60,000,000 ??0.185) (see Exhibit 5) (23,333 ??12.42) + (10,000 ??12.71)* (7,140,000/135,032 ??33,333)** (11,100,000 ??0.19) (411,577 ??0.4) 1999 $11,100,000 6,400,000 416,896 1,762,527 $ 2,520,577 2,109,000 $ 411,577 164,631 $ 246,946 2.2%

Panel B: Estimated Income Statement for the Current Version of the A12 Junction Box (Using the Activity-Based Costing System) Sales Direct materials (see Exhibit 5) ABC charges (includes direct labor) (see Exhibit 6) Other overhead unrelated to ABC project (see Exhibit 6) Gross margin S, G & A (11,100,000 ??0.19) Profit before tax Tax expense (719,670 ??0.4) Profit after tax Profit margin 1999 $11,100,000 6,400,000 1,350,669 520,661 $ 2,828,670 2,109,000 $ 719,670 287,868 $ 431,802 3.9%

Cost Difference between Standard Cost System and ABC Standard cost Direct labor + overhead ABC charges (including direct labor) + other overhead Difference in cost assigned Number of units produced Decrease in cost on a per-unit basis * $2,179,423 1,871,330 $ 308,093 100,000 $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.

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EXHIBIT TN-7 ABC Income Statement for the A12 Junction Box (Original Version of A12 Junction Box in a Cellular Environment) Sales ($60,000,000 ??0.185) DM (see Exhibit 5) ABC charges (1,350,669 - 444,623) Other overhead (see Exhibit 6) Gross margin S, G & A Net income before tax Tax expense Net income after tax Profit margin 1999 $11,100,000 6,400,000 906,046 520,661 $ 3,273,293 2,109,000 $ 1,164,293 465,717 $ 698,576 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 above. 2. The "Other overhead" of $520,661 is assumed to be unaffected by the switch to cellular production.

EXHIBIT TN-8 Resource Spending View-Discounted Cash Flow Analysis Discount rate = 14% Product Engineering Process Engineering Severance Pay Raw Material purchases Cost Savings Net Present Value 0 $ (10,000) ( 9,500) (15,000) (232,200) 214,820 $ (51,880) 1 2 3

$(100,000) $92,515

$(100,000) $92,515

$(100,000) $92,515

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.

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EXHIBIT TN-9 Resource Usage View-Discounted Cash Flow Analysis Discount rate = 14% Product Engineering Process Engineering Severance Pay Raw Material purchases Cost Savings Net Present Value 0 $ (10,000) ( 9,500) (15,000) (232,200) $ 341,870 $ 75,170 1 2 3

$(100,000) $ 147,231

$(100,000) $ 147,231

$(100,000) $ 147,231

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.

EXHIBIT TN-10 Resource Usage View-Discounted Cash Flow Analysis Discount rate = 14% 0 Product Engineering $ (10,000) Process Engineering (9,500) Severance Pay (15,000) Raw Material purchases (232,200) Cost Savings 293,799 Net Present Value $ 27,099 NPV for five-year time horizon $ 79,596 1 2 3

$(100,000) $92,515

$(100,000) $147,231

$(100,000) $147,231

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 calculation.

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ANNOTATED BIBLIOGRAPHY 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 output. King, A. 1993. Green dollars and blue dollars: The paradox of cost reduction. Journal of Cost Management (Fall): 44-52. 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.

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Turney, P. 1992. What an activity-based cost model looks like. Journal of Cost Management (Winter): 54-60. 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.

REFERENCES 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. 9-185179, 1-5. ---. 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 Publishing. 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.

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5-6 Pecos Products (Complexity into the Study of Activity-Based Costing)


ABSTRACT: This case is designed to help students gain a more thorough understanding of activity-based costing (ABC) than is usually obtained in introductory managerial accounting courses. If you have taken such a course, you have probably seen, in general, simple examples of activity-based costing. However, ABC can be more complex than these examples indicate for three reasons: (1) the mechanics of ABC are far more complex than these simple examples indicate; (2) many of the design choices required in an ABC system, which are critical to the cost-benefit decision, are omitted from the simple examples; and (3) without adequate detail, it is hard to see how economic consequences arise from the choice of costing systems. The Pecos Products ABC Design Project (the project) addresses these issues by providing a hypothetical company with a detailed business scenario and asking you to help with the cost-system-design decision. To accomplish this, you will have to think about traditional cost system and ABC design issues, delve deeply into the cost system mechanics, and evaluate the benefits (economic consequences) of an ABC system in light of the cost and effort required to create it. TEACHING NOTES Learning Objectives and Target Audience Accounting students are generally introduced to ABC using simple examples, where the data provided force a one-to-one mapping of pre-pooled costs with cost drivers (see, for example, Hilton [1999, 155169] and Horngren et al. [2000, 140 150]). In this highly abstracted setting, students learn the absorption-costing mechanics of the technique, are confronted with the fact that reported costs can differ substantially between different cost-allocation systems,5 and are presented with an example of the economic consequences of these differences in reported costs. We have found these simple examples to be an effective introduction to the topic of ABC, but inadequate to provide a full understanding of the topic for three reasons: (1) the mechanics of ABC are far more complex than these simple examples indi-cate; (2) the design choices required in an ABC system, which are critical to the cost-benefit decision, are omitted from the simple examples; and (3) in our experience, the notion of economic consequences remains too highly abstract for students to understand and retain. We believe that the learning objectives for a professional accounting student should incorporate these issues. We use the traditional term professional accounting student to indicate that the project is targeted at accounting majors or others who may view themselves as future professionals in business measurement, and not at all undergraduate business students (as in an introductory management accounting course) or at M.B.A. students (where the information-user perspective is generally emphasized and mechanics de-emphasized).6 Our project promotes discussion of the benefits (economic consequences) of the ABC system in light of the costs (here, effort) required to create such a system, and it supports the following four ABC learning objectives, consistent with the discussion above: 1. Students will understand the importance of associating cost-system design with economic consequences for the firm and will know the likely economic consequences of a change in cost reporting. 2. Students will learn in detail how ABC systems work by following the flow of costs from resource costs recorded in the general ledger, through association of resource costs with activities, pooling of activity costs, selection of pool allocation bases from a broad set of potential cost drivers, and allocation of activity pool costs to cost objects.
5

Some ABC advocates refer to ABC as a cost assignment system. As this project reinforces for students, a practical (i.e., cost effective) implementation of ABC remains substantively a cost allocation system, though ideally a less noisy one than is traditionally observed. 6 We designed this project to fill a perceived gap in the curriculum (and in available teaching materials) for a junior-level undergraduate cost accounting and cost management course that is required of all students who have been accepted into our five-year combined bachelors/masters degree (150-hour) program in accounting. 3. Students will realize that ABC system design is an imprecise process and not one of idealized measurement (as in the simple introductory examples). 4. Students will gain intuition about the measurement and reporting costs associated with cost-system-design choices leading to the realization that increases in cost-system accuracy must be weighed against increased

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system operating costs. The next section of this teaching note distinguishes this project from available Harvard teaching cases. The following two sections discuss our experiences teaching the project and the main design issues that arise in the project. The final section discusses the project assignments, and commonly encountered issues. Published ABC Cases This project provides an intensive learning experience that addresses ABC issues in a manner different from that of other cases available to educators. We summarize in Exhibit TN-1 a number of the readily available Harvard Business School cases related to ABC.7 A comparison of the Pecos project to the other cases points out two primary ways in which the case makes an incremental contribution. First, Pecos is the only case to place a major focus on mechanics. While the Schrader Bellows case series provides more practice in the mechanics of an ABC cost system than the other Harvard cases, a number of factors distinguish the Pecos project from Schrader Bellows. For example, Schrader Bellows focuses entirely on supportdepartment costs, whereas Pecos provides an all-inclusive exercise in product costing, including calculations of direct materials, direct labor, and total overhead. Also, while students are required to design their own allocation routines in the Schrader Bellows case, a computer module performs the laborious calculations associated with product costing. On the other hand, the data provided in the Pecos project are complex enough to provide a rich and realistic setting but simplified enough to allow students to go through the detailed product-costing calculations. A second contribution of the Pecos project is its breadth of scope. This project provides some level of coverage of most of the seven topics listed in Exhibit TN-1, beginning with ABC theory and culminating in decision making. Implementation Guidelines Integration with Course Content By design, the Pecos project is an immersion experience that requires a significant investment of time by students.8, 9 We teach the project over a four-week period corresponding to the course time dedicated to teaching ABC and activity-based management (ABM). The project is introduced as the transition from discussing cost system design and traditional single-pool, volume-based absorption-costing
7

Given the wide usage of the Harvard Business School cases, we elected to review these cases as representative of the general population of business cases available. While other extensive ABC projects may exist, especially among consulting firms, we are aware of no other readily available cases or projects similar to this one. As discussed in this section and throughout these teaching notes, this project is designed to be an intensive experience of long duration. Complexity is its raison dtre. Accordingly, we do not recommend that it be used simply as the basis for a one-class discussion or a one-time student presentation. If it were necessary to use the case in this way, we would advise (1) concentrating on Assignment 3; (2) providing students with the ABC system design and cost/profit results (Exhibits TN-3 and TN-4); (3) asking students to explain and critique the design; and (4) focusing discussion on questions [3(c) to 3(f)]. Students have reported spending 4050 hours per student (in teams of four to five students) over the course of this project. While we cannot vouch for the accuracy of this estimate, we find it credible: it took us six hours, working together, the first time we designed the ABC system and computed ABC-based costs and profits. We had the advantage of knowing exactly how to approach the problem we had constructed, and this six hours did not include downloading and exploring the data, developing traditional costing systems, preparing and delivering the in-class presentation, developing answers to the decision-making questions, or writing the papers for Assignments 2 and 3.

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EXHIBIT TN-1 Comparison of Pecos Products and Harvard Business School ABC Cases

Examples of topics covered in each of the categories:


ABC Theory/Conceptual Design The basic concepts that distinguish ABC from traditional volume-based costing Choice of cost pools (including tradeoffs between accuracy & system costs) Choice of cost drivers (including correlation and regression using historical data) System design for strategic vs. operational decision making Integration of financial and managerial cost systems Issues involved in measuring costs of activities Use of general ledger (resource costs) to infer activity costs Interviewing strategies Actual calculation of cost driver volumes/cost pool rates/product costs Aggregation issues (e.g., multiple cost centers) Comparison of ABC results to results from traditional volume-based system Analysis of factors leading to differences in costs between different systems Product mix Pricing Product design Strategy development Customer focus Activity-Based Management Other Analysis of activities Continuous improvement Performance measurement Variance analysis Implementation issues Behavioral consequences

Measurement Mechanics Outcomes Economic Consequences & Decision Making

Legend: Topic is a major focus of case. Topic is covered in some substantial manner.

systems into generalized multiple-pool, or ABC, systems. The project and its assignments support this multiweek teaching model. Students begin by designing a traditional costing system for Pecos. They then design and defend an ABC system and conclude by analyzing the new systems economic consequences and cost-benefit issues. In addition to allowing adequate time for students to work through the complexities of the project, the staged

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approach also provides opportunities for the instructor to provide feedback as the project progresses. For example, during the first iteration of ABC system design many students will create designs that fail to allocate all costs (notwithstanding the warning included in the case questions). Not only does this provide an opportunity to correct a fundamental conceptual misunderstanding for those students, but the problem also must be corrected in order for the students to draw valid inferences from the systems reported costs during the next stage of the project. Use of Teams This project provides an excellent opportunity to give students experience working in teams, as well as an opportunity to instruct students about the difficult issues of group dynamics that can arise. We divide the class into teams of four or five students each. The team members must achieve consensus on and present a solution to the project. All team members receive the same grade for the project, but they are warned in advance that individual grades may be modified after peer evaluations. Because the project is intended to serve as a learning supplement for several weeks of course material, students will be expected to continue concurrently with their normal course preparation, i.e., reading the text, doing problems, and preparing for class discussions. Allowing students to work on the project in teams keeps the workload during this period from being overwhelming and overshadowing the interesting aspects of the project. Student Outputs and the Pedagogical Process To provide opportunities for the development of communication skills by our undergraduate students, we require written and oral team presentations in the Pecos project. One week prior to submitting their final project report, the student teams present their preliminary ABC system designs to the rest of the class, justifying their choice of cost pools and cost drivers. At this presentation, we encourage teams to assess their design solutions against those of their classmates and to ask questions about design choices. The teams are encouraged to adopt features of other teams designs for their final written design and report. Other than asking a number of focusing questions during the design presentations, we do not publicly evaluate the designs until the end of the project so that teams will not be swayed in their continuing exploration to a final design. The final written project report is submitted one week later, documenting and supporting a final cost-system design. We ask the students to respond to the case assignments as if they were preparing a written report for the controller of the CAMP-1 facility. This provides an opportunity to give feedback on business writing skills and to emphasize succinct analysis. Use of Technology The project also provides practice in using technology. First, students must develop and use spreadsheet skills to perform their analyses. The skills needed are not particularly advanced (e.g., no macro writing is required), but a great deal of formula writing and manipulation of fairly extensive spreadsheet data is required, since an efficient solution is best achieved by linking spreadsheets across worksheets and workbooks.10 Second, the project provides practice in the use of electronic communication skills. Data are distributed to students using the Internet, following the download instructions given in the case, and part of the solution is submitted via email.
10

It is worth pointing out to the students that their results in this project are achieved using a relatively modest approach to technologyonly the simplest of computers and software are requiredand that such low-tech approaches can often provide powerful results.

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ASSIGNMENTSRECOMMENDED SOLUTIONS The assignments listed at the end of the case reinforce the learning objectives listed above. Exhibit TN-2 links various aspects of the assignments with the learning objectives they most closely support. We discuss below several of the main points relating to ABC that can be taught and reinforced through the project. EXHIBIT TN-2 Mapping Pecos Products Learning Objectives to Project Assignments Project Learning Objectives Project Requirementsa Assignment 2: Volume-Based System Design Assignment 2: Questions 2(a) to 2(c) Assignment 3: ABC System Design Assignment 3: Questions 3(a) to 3(f) Assignment 3: Questions 3(g) to 3(i) 1 2 3 4

Summary of Project Learning Objectives


1. Students will understand the importance of associating cost system design with economic consequences for the firm and will know the likely economic consequences of a change in cost reporting. 2. Students will learn in detail how ABC systems work, by following the flow of costs from resource costs recorded in the general ledger, through association of resource costs with activities, pooling of activity costs, selection of pool allocation bases from a broad set of potential cost drivers, and allocation of activity pool costs to cost objects. 3. Students will realize that ABC system design is an imprecise process and not one of idealized measurement (as in the simple introductory examples). 4. Students will gain intuition about the measurement and reporting costs associated with cost system design choices and will realize that increases in cost system accuracy must be weighed against increased system operating costs. a Note that Assignment 1 (Download and Exploration) serves primarily to familiarize students with the project data, in preparation for Assignments 2 and 3. Assignment 1: Download and Exploration Assignment 1 simply asks students to download and review the project data. As part of this orientation, the instructor may wish to assign supplemental questions to force exploration. Such questions can ask students to look for trends in the data, assess seasonality, or explore and speculate on issues of causality. Above all, however, the purpose of this assignment is to make students familiar with the data included in the project so that the second and third assignments can proceed smoothly. Assignment 2: Volume-Based Costing Systems Assignment 2 asks students to design two traditional (single overhead pool) costing systems, each with a different volume-based cost driver. This serves as an introduction to the case and requires straightforward costallocation computations (total overhead divided by total allocation base). These systems also provide benchmarks that will later be used to assess the ABC design. Through this exercise, students are generally challenged to think across multiple cost centers and multiple products in a way they probably have not encountered before. (For example, a student commented that Before this project I never realized that machine hours meant combining hours from different kinds of machines. The problems usually just have one machine. This led her to further insights about the concept of cost-driver correlation. One of the benefits of complex projects is the possibility of generating such teachable moments.) There is only one possible solution to the assignment (for each of the given volume-based cost drivers) and it is given in the Volume-Based Costing Systems columns of Exhibit TN-4. In writing a paper that addresses questions 2(a), 2(b), and 2(c), students are forced to focus on the effects of reported costs on managerial decision making and economic consequences. In addition to reinforcing the economic perspective, the students conclusions about product pricing and profitability become benchmark references for subsequent comparison with ABC results in Assignment 3.

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Assignment 3: ABC System Design Process Assignment 3 requires students to design an ABC system for Pecos and then guides them through the complex mechanics of ABC. As a first step in the design process, students must assign the costs of resources (general ledger categories) to pre-defined activities.11 This step requires a great familiarity with all the case workbooks, as well as the use of educated judgments and intuition. Students are often quite uncomfortable with this process, commenting that their choices are arbitrary. We emphasize that good intuition is not arbitrary, and is likely to be highly consistent from group to group. This point is reinforced when teams present their preliminary solutions: the cost by activity is usually similar across teams. The general ledger resources vary in the amount of judgment required for the activity-assignment process. Indirect salaries, wages, and benefits can be based almost entirely on the detailed information (how indirect time is spent) in the CCINFO workbook. Indirect materials and supplies require a bit more judgment. The CCINFO workbook lists the main supplies used. Students must judge which activities are most likely to use those supplies and in what proportions. For example: Much of the cost of Office Supplies would logically go to the supervising activity, but some might also be assigned to other support activities, and very little would go to the main production activities. The exact apportioning would be subjective (but not, as the students say, arbitrary). Safety Equipment costs are usually allocated mainly to the primary activity of the cost center (e.g., cutting in the Cutting cost center), with much smaller amounts allocated to reworking, training, and moving materials. Repairs and Maintenance and Depreciation are related to machines; hence these costs are allocated to all activities that require machines, with most of the costs going to the primary activity of the cost center. (In Receiving, Logistics, and Shipping there are no machine hours, but these cost centers are likely to have a number of forklifts, and these are the machines to which Repairs and Maintenance and Depreciation are related for these cost centers.) In assigning Scrap Disposal costs, students are encouraged to infer which activities are most likely to produce scrap. Most costs should be assigned to the primary activity of the cost center, but with significant amounts to reworking and setting up. There are a number of general ledger categories for headquarters allocations (e.g., lease, insurance, etc.). These facility-level costs are particularly difficult to assign, and we feel the most appropriate solution is to assign them based on the average of all other resource assignments. As we point out to the students, even in ABC we cannot entirely escape the need for allocation.
11

As discussed in the case, activity identification is a major step in the system design process, which in this case has already been performed for the students. This provides a certain degree of standardization, which facilitates classroom discussions and eases the grading burden. To provide the students with some experience in this task (albeit quite limited), we encourage students to suggest improvements to the activity list.

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Design Challenges In providing guidance to students working in the ABC design phase of the project, our primary goal is to help them fully analyze the implications of their design choices. In their preliminary designs, students often make decisions that sound reasonable on the surface, but are found to be flawed under a more thorough analysis. For example, students often decide to combine the pad-pressing activity with other activities in one cost pool. They note (correctly) that the cost of the pad-pressing activity is quite low, and suggest that the increased accuracy would not be worth the cost of maintaining a separate cost pool for this activity. However, this logic fails to recognize that costs of this activity ideally should be allocated entirely to sleeping pads. While the costs of the activity are not significant for the plant as a whole, they are highly significant for the sleeping pad product line. Because this is a low-volume product, the choice to allocate these costs to all the products instead of just sleeping pads can seriously underestimate the cost of sleeping pads. Another common preliminary design that is subtly flawed combines all labor intensive activities into one cost pool and allocates this cost pool to products based on their direct-labor hours. Once again, on the surface this seems a reasonable approach. However, the flaw with this approach is that it assumes that direct labor and labor intensive overhead are consumed by products in the same proportions. For example, students often include the costs of the seam-sealing activity in this labor-driven cost pool, because seam-sealing is a labor-intensive process. This choice is usually indicative of a fundamental misunderstanding of the distinction between direct and indirect costs that needs to be corrected. Students who make this design mistake are reminded that any direct labor associated with seam-sealing is a direct cost and not included in overhead. The primary indirect costs associated with seam sealing are indirect materials (sealant) and the cost of keeping the machines running. When students are reminded of this fact, they usually conclude that a better cost driver for the seam-sealing activity is seam-sealing machine hours. To confirm their hypotheses about the relationships between activities and potential cost drivers, students are encouraged to perform regressions using the historical data provided in the project spreadsheets.12 Through this process, students are able to refine their reasoning, and gain a deeper understanding of ABC fundamentals. Good Designs For this project, the best designs generally include between six and eight cost pools. While utilization of more cost pools would certainly improve the accuracy of the solution, we find that the differences in results are minimal, suggesting that the costs of more cost pools may outweigh the benefits. We propose that a good solution will include at least one cost pool in each of the following categories: Labor-related costs: Includes supervising and training, which both vary with the number of employees. Machine-related costs: Cutting, sewing, and reworking. It is generally preferable to keep these each in a separate cost pool. The main product affected by the choice to combine these activities is sleeping pads, which are not sewn at all. Batch-related costs: Setting up, scheduling, and inspecting. A case can be made for putting setups into a separate cost pool, because setup time depends on the product. Similarly, inspecting can be put into a separate pool, allocated based on number of inspection batches. Students are encouraged to do sensitivity analysis to analyze the implications of these choices. Seam-sealing: Discussed above. Pad-pressing: Discussed above. Material-related costs: Tracking inventory, packing, and moving materials. Building on these groupings, our reference (preferred) design solution is included as Exhibit TN-3. Note the role of the Cooper hierarchy of costs in this solution. Most of the cost pools consist of volume-based costs, with batch-level costs also represented in the solution. No product-level costs are present, and the facil-ity-level costs are included among the general ledger costs that are mapped to the activities using percentage allocations (as described in the first step of the ABC design guidelines in Assignment 3). There are three important lessons in this for students. First, volume-based costs and their associated cost drivers are not evil. They will still play a very important role in any costing-system design. Second,
12

As discussed earlier, some information (how indirect labor time was spent and use of indirect materials/ supplies) is provided as a yearly average instead of on a quarterly basis. For this reason, we suggest that regressions be run on yearly data only.

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EXHIBIT TN-3 Pecos Products Reference SolutionABC System Design Cost Pool 1 2 3 4 5 Pooled Activities Cutting Sewing Pad Pressing Seam Sealing Scheduling Inspecting Setting Up Moving Materials Tracking Inventory Packing Reworking Training Supervising Cost Driver Cutting Machine Hours Sewing Machine Hours Number of Pads (units) Sealing Machine Hours Number of Batches

6 7 8

Pounds of Assembled Product Total Machine Hours (all machines) Direct Labor Hours

the benefit of an ABC system does not depend entirely on the use of non-volume-based cost drivers. Several of the cost pools identified above are essentially volume-based, but they are constructed from activity-cost data provided only by the ABC system. Third, facility-level costs can be significant, but they must still be allocated if full-costing of products is desired. Design Costs of ABC Systems In a closed-end teaching exercise it is very challenging to convey a sense of the costs of gathering and maintaining data in an ongoing cost system. As noted above, we discuss this topic in class with the intention of sensitizing students to the importance of focusing their efforts only where the potential increase in the return to management will exceed the costs. And as noted in the ABC design instructions in Assignment 3 (particularly the third step), we expect students to be aware of and sensitive to the costs of collecting and updating data. However, the value of the Pecos project in support of Learning Objective #4 (Students will gain intuition about the measurement and reporting costs associated with cost system design choices) comes from the effort required of students to manage and manipulate the extensive project data (in contrast to that required for the traditional system). The students thus become aware of the burdens of complexity. We find that their efforts make the cost-ofdata concept resonate strongly (to the point that on a recent final examination essay, almost every student in the class raised and discussed [unsolicited] the issue of cost-benefit). We reinforce the idea that data measurement is expensive and itself a potential non-value-adding cost by informing students that we will be explicitly weighing their proposed ABC systems ability to represent the consumption of resources by products in light of its costs. We compare their proposed ABC systems with the reference solution presented in Exhibit TN-3. In comparison to the reference solution, systems that require greater data costs by proposing more cost pools and/or more complicated cost drivers generally do not result in significantly different reported costs, and hence are strictly inferior to it. More interesting are the solutions that employ fewer and/or simpler cost pools and drivers, while still reporting product costs that do not deviate too far from those of the reference solution. These require more careful review and some solutions may in fact be quite satisfactory. However, we generally find the intuition or logic behind the costpool groupings or the chosen cost drivers to be inferior to the reference solution. For example, students will sometimes combine the cutting and sewing activities into one cost pool and use combined cutting/sewing machine hours as the cost driver. This results in a less costly system whose reported product costs are not very different from the reference solution. The drawback of such a solution, however, is that these are both very large activities and demand for them is not necessarily correlated (for example, sleeping pads require cutting but no sewing), so we do not have great confidence that such a design will continue to provide accurate costs into the future.

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Questions In questions 3(a) through 3(f) students are asked to consider the economic consequences of using their ABC system rather than a traditional system, revisiting the questions asked about the traditional systems in Assignment 2 and extending to a consideration of strategic issues.13 A comparison of the cost- and profit-per-unit results for our reference ABC system and two of the possible traditional systems is included as Exhibit TN-4.14 Several interesting points derive from this comparison. First, costs and profitability differ quite dramatically among the three cost systems. Indirect costs reported by product for the direct-labor-based system differ from those of the ABC solution by (in absolute value) between 1 percent and 60 percent, and for the machine-hours based system this range increases to 19 percent and 1093 percent. Questions 3(a) to 3(f) force students to interpret these swings in terms of their economic effects and the effects that the associated changes in profitability might have on managers decisions and Pecos strategy. Examples of economic consequences reported by students in response to the case questions have included:

13

Even greater economic consequences are likely to arise from using the activity data to perform ABM. This is a logical extension of this project and will be addressed in the future. As presently written, the case supports the analysis needed for ABC, but does not provide the detailed information about processes and activities that will be required to effectively address ABM. 14 Using the ABC system design from Exhibit TN-3, the instructor should have little difficulty approximat ing our ABC systems reported costs. However, an exact replication would require using the same percent ages in the allocation of general ledger accounts to activities. The complete Excel workbook containing the percentages and the results of our solution is available on request via email from the authors. Because a percentage allocation of general ledger costs to activities is required for each of the six cost centers, the complete solution is too long to be incorporated into these teaching notes.

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EXHIBIT TN-4 Comparison of Pecos Products Costs Reference Solution (TN-3) vs. Traditional Costing Systemsa Volume-Based Costing Systems ABC System Computed Cost Direct Labor Hours Computed % Cost from ABC $112.00 44.80 5.17 32.11 82.08 $ 29.92 $58.00 16.66 4.76 29.19 50.61 $ 7.39 $53.00 8.44 4.46 27.24 40.14 $12.86 $25.00 12.55 3.66 23.35 39.56 ($14.56) Machine Hours Computed % Cost from ABC

Product Tents Price per Unit Direct Material Direct Labor Indirect Costs Cost per Unit Profit per Unit Backpacks Price per Unit Direct Material Direct Labor Indirect Costs Cost per Unit Profit per Unit Sleeping Bags Price per Unit Direct Material Direct Labor Indirect Costs Cost per Unit Profit per Unit Sleeping Pads Price per Unit Direct Material Direct Labor Indirect Costs Cost per Unit Profit per Unit
a

$112.00 44.80 5.17 39.07 89.04 $ 22.96 $58.00 16.66 4.76 29.54 50.96 $ 7.04 $53.00 8.44 4.46 25.64 38.54 $14.46 $25.00 12.55 3.66 14.55 30.76 ($5.74)

18 8 30

$112.00 44.80 5.17 46.49 96.46 $ 15.54 $58.00 16.66 4.76 4.81 26.23 $31.77 $53.00 8.44 4.46 33.25 46.15 $ 6.85 $25.00 12.55 3.66 1.22 17.43 $ 7.57

19 8 32

1 1 5

84 49 351

6 4 11

30 20 53

60 29 153

1093 43 232

The ABC System solution reflects the design shown in Exhibit TN-3. As discussed in the section entitled Good Designs, this is only one of many possible ABC solutions. The Volume-Based Costing System solutions are unique for the given volume-based cost drivers.

Resource allocation example: Should we continue investing in sleeping pads? The $5.74-per-unit loss reported by ABC is sobering in comparison with the $7.57 profit reported by the machine-hours system, but is considerably more palatable in the short run for a new product than the $14.56 loss reported by the direct-labor system. Pricing example: Are we pricing sleeping bags at their optimal level, given elasticity of demand? Although we dont know the demand elasticity, the fact that profit is understated (relative to ABC) by almost $2/unit in the direct-labor system and by more than $7.50/unit in the machine-hours system hints at opportunities for more aggressive pricing and different special-order decisions. Production example: Should we continue to outsource production of stuff sacks? Under the ABC system, we know the cost of the cutting and sewing activities, so we can use this information to make an effective make-or-buy decision.

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A second point relating to the costing results in Exhibit TN-4 can help to instill a deeper understanding of costpool/cost-driver relationships. We can observe that although several of the ABC systems cost drivers comprise various measures of machine hours, using machine hours as the sole cost driver in a traditional system provides a poor measure of product costs (if ABC is accepted as the standard). We similarly observe that although direct labor serves as the cost driver for only one (relatively unimportant) ABC cost pool, the direct-labor-hour traditional system reports results much closer to the ABC systems results. The only way to make sense of this result is to understand the role of product cross-subsidization in volume-based costing. Cross-subsidization (which occurs when one product is assigned costs actually caused by activities incurred in support of another product) is most easily seen in the case of sleeping pads. This product is machine-intensive, so we might expect the ABC system, with its many machine-related pools, to report costs similar to those of the machinehours-based system. However, the ABC methodology allows us to associate the costs of the pad-pressing machines exclusively with the pad-pressing activity, all costs of which are assigned to sleeping pads. In contrast, in the machine-hour system the pad-pressing machine costs are combined with all other indirect costs in the single overhead cost pool and then divided among all machine hours, including sewing, cutting, and seam-sealing machines, so that much of the pad-pressing machine cost ends up absorbed by the tents, backpacks, and sleeping bags that dominate the cutting, sewing, and seam-sealing activities. A third point regarding the economic consequences of ABC relates to the magnitude of the changes in indirect cost allocation between costing systems in Exhibit TN-4. The difference between costing systems is likely to be understated if we consider only the change in indirect-cost allocation, as students are prone to do. Rather, it is the change in the perceived profitability of different cost objects that is likely to cause a change in managerial behavior. Any change in indirect costs assigned to a product as a result of changing cost-allocation systems flows directly to the profit line, because direct costs will not vary between costing systems. Nevertheless, students are likely to express concern or disappointment at the similarity in product costs between the direct-labor and ABC systems because they are so primed by this point in the course for a big ABC message. This concern provides the motivation for a great discussion about the effects of costing. Generally, there are three aspects of this discussion: 1. Why are costs between the ABC and direct-labor systems so similar? While the reported cost differences between these systems may not be as dramatic as students are accustomed to seeing in the textbook examples, a change in costs of a few percent is a highly significant event in the real world. As discussed above, this is especially true for a change in overhead allocation where the full effect flows straight to the bottom line. 2. Because the costs are similar now, does it mean they will remain that way in the future? We lead a discussion on the differences in the systems and how changes in resource costs would flow differently to products. We also emphasize the need to monitor system design in the future, and how having a well-designed system will direct our attention more effectively to changes in the relationships among resources, activities, and products. Finally, we point out that we didnt really know ahead of time that the direct-labor-based system was giving us cost data similar to that produced by the ABC system. Why, when there is so much machine time in this process, are machine-hours-based costs so different from ABC-based costs? We point out that the total machine hours are composed of hours from four different types of machines. The products do not use proportional amounts of machine time from the four machine types. Further, the costs associated with each of the machine types differ greatly. Therefore, it is not surprising that the ABC solution is not similar to the machine hours solution.

3.

Project requirements 3(g) to 3(i) provide a larger context for the question of cost system design, raising issues of implementation and the role of the cost system. Questions 3(g) and 3(h) ask about alternative approaches for obtaining and organizing expenditure data. If an ABC system were integral to the general ledger, then expenditures theoretically could be charged to accounts that would reflect the activity center as well as the expenditure type. In this case, the first ABC design step in Assignment 3 would be unnecessary and activity costs could be totaled directly from the general ledger.

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In reality, of course, ABC systems are quite structurally complex (see, for example, Cokins 1999) and, despite calls for full integration of ABC systems (IMA 1998; Keegan and Eiler 1994), most systems remain as stand-alone analysis tools (Krumweide 1998). These stand-alone models generally begin with resource-based, not activitybased, data fed from the general ledger system, so this projects design (beginning with percentage allocations of general ledger accounts to activities) represents a reasonable approach to teaching the ABC design process. Question 3(i) asks students to discuss issues of ABC system implementation. This allows students to summarize the costs associated with complex costing systems, including issues of data collection, project management, and sponsorship, all of which are quite complex for an ABC system.

REFERENCES Cokins, G. 1999. Avoiding ABC implementation mistakes. In Handbook of Cost Management, 1999 edition, edited by J. B. Edwards, Section B9. New York, NY: RIA Group/WG&L. Hilton, R. W. 1999. Managerial Accounting. Fourth edition. Boston, MA: Irwin McGraw-Hill. Horngren, C. T., G. Foster, and S. M. Datar. 2000. Cost Accounting: A Managerial Emphasis. Tenth edition. Upper Saddle River, NJ: Prentice Hall. Institute of Management Accountants (IMA). 1998. Practices and Techniques: Implementing Activity-Based Management: Avoiding the Pitfalls. Statement on Management Accounting No. 4CC. Montvale, NJ: IMA and Arthur Andersen LLP. Keegan, D. P., and R. G. Eiler. 1994. Lets reengineer cost accounting. Management Accounting (August): 2631. Krumweide, K. R. 1998. The implementation stages of activity-based costing and the impact of contextual and organizational factors. Journal of Management Accounting Research 10: 239277.

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5-7 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 sectorbanksneeds 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 Banks average cost of serving a retail customer account and a business customer account, under (1) the Banks traditional single allocation base system, and (2) a (pilot test) activitybased 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 Banks business strategy. Finally, you will consider how the Banks managers can use the new, more refined activity-based cost data in strategic decision making, including controlling costs and developing more profitable business strategies.

TEACHING NOTES
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 sectorbanking. The case provides students with the opportunity to apply their (cost allocation) accounting knowledge to address real-world problems. The Accounting Education Change Commissions (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
1

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). 2 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 firms usage of its available resources. The difference between resources acquired and resources used is

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introducing ABC, consideration of activity-based management (ABM) occurs near the end of the cases 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 112 by teaching objective. Instructors may choose to assign only a subset of requirements 712, depending on the desired emphasis. The teaching notes for requirements 2 and 712 are intended to facilitate class discussion. Our experience suggests that undergraduate students responses to items 2 and 712 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 decisions. TABLE 1 Case Requirements Classified by Selected Teaching Objectives Case Requirement 1 2 3 4 5 6 7 8 9 10 11 12
a

Traditional Costing X X

ABC Step-by-Step Implementation X X X X X

Conceptual Requirements X

Group Discussion X X

Limited Class Timea P

X X X X X X

X X X X X X

A A A A 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, juniorlevel 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 firms 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).

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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 38 with the following simple instruction: 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 RECOMMENDED SOLUTIONS 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 $95,000 total value of checks processed = $0.03 per dollar 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 $ value of checks processed $9,500 $85,500 Cost per $ processed 0.03 0.03 Total indirect cost $285 $2,565 These allocations are driven by the dollar value of the checks processed. Total $95,000 0.03 $2,850

C) The proportion of the total indirect cost assigned to: (i) the retail customer line, and (ii) the business customer line: (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
3

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.

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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: Total indirect cost Number of accounts Indirect cost per account (i) Retail $285 150 $1.90 (ii) Business $2,565 50 $51.30

E) The average annual profit per account for retail customers and for business customers: Revenue per account Cost per account Profit (loss) per account Retail $ 10.00 ($ 1.90) $ 8.10 Business $ 40.00 ($51.30) ($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 BNBs customer mix, the original cost system remained intact. Other symptoms that BNBs 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 BNBs cost of serving its two customer lines may have changed significantly. The manager (Erik Larsen) does not trust the accounting systems 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.

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Requirements 3 and 4 To help students see the big picture, we suggest walking through the case in class to explicitly relate your textbooks 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. BNBs ABC team identified three activities: 1. Paying checks 2. Providing teller services 3. Responding to customer account inquiries 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

Step 2:

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 Paying checks Providing teller services Responding to customer account inquiries Activity Cost Driver Checks processed Teller transactions Account inquiry calls to customer service call center Total # Units of Cost Driver 2,850 200 100

Because the pilot study is based on last years actual data, step 4 uses the total actual number of units of each cost driver. In the future, however, BNBs 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
4

In more advanced classes, you may want to link BNBs 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, BNBs ABC pilot study does not identify any batch-level costs. Thus you may want to provide examples of batchlevel 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 CEOs 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.

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200 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 Total # Units of Cost Driver 2,850 200 100

# of Units of Activity Cost # of Units of Activity Cost Driver Activity Cost Driver Driver Used by Retail Customers Used by Business Customers Checks processed 570 2,280 Teller transactions 160 40 Account inquiry calls to customer service call center 95 5 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 activitys indirect cost allocation rate from step 5 by the number of units of the activitys cost driver in step 6: Total Indirect Cost Assigned to Retail Customer Line $ 228.00 960.00 484.50 $1,672.50 Total Indirect Cost Assigned to Business Customer Line $ 912.00 240.00 25.50 $1,177.50

Activity Paying checks [$0.40 (570; 2,280)] Providing teller services [$6 (160; 40)] Responding to customer account inquiries [$5.10 (95; 5)] Total indirect costs

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 BNBs 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.

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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 activitys 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 banks 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 customers use of BNBs resources.

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Requirement 8 Using the ABC data, the average annual profit per account for retail and business customers is: Revenue per account ABC cost per account ABC profit (loss) per account Original systems profit (loss) per account Retail $10.00 (11.15) $(1.15) $ 8.10 Business $ 40.00 (23.55) $ 16.45 $(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 managements 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 managements 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 banks 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. Activitybased 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 BNBs 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 customersfrom 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. BNBs 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.

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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 companys 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 banks 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 BNBs 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 companys resources. At BNB, retail and business customer lines use different amounts of the banks 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 firms core operations, in addition to accountants.

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