We've spent a lot of time talking about allocating manufacturing overhead to products.
But why did we do that?
Well, recall that manufacturing companies
must allocate the manufacturing costs to its products,
to place an inventory for financial accounting purposes.
So naturally, that's a good place to illustrate concepts in cost allocation.
But, it's important to realize that the concepts we discussed and
the techniques that we used are equally applicable to some other settings.
And I'd like to talk about three of these: non-manufacturing cost,
service organizations, and cost
objects other than products and services such as customers.
Let's start with non-manufacturing cost.
We'll return again to our T-shirt maker.
In addition to the manufacturing overhead costs
we've addressed in our allocation system thus far,
suppose that the company incurs non-manufacturing overhead cost as well.
Examples can include selling,
administrative or other general costs.
It could be the case that some products cause more of
these non-manufacturing overhead cost to be incurred.
And if so, then knowing that may affect some of
the management decisions we make regarding our products,
in this case, the two T-shirt models.
Let's take a look.
Let's assume that the company incurs $7,800 of selling
costs and that those costs seem to be driven by customer orders.
The sales rep visits the customer to generate orders and then does the paper work
necessary to get those orders into
the company's system so the process of making them can begin.
And let's assume that the company incurs $5,200 of
other general and administrative costs that are primarily related to
human resource type functions like administering benefit plans,
performance reviews, and the like.
So it seems natural to separate those costs into two different pools.
And we would allocate the $7,800 of
selling cost based on customer orders because that's what drives
that cost and the $5,200 cost based
on something like direct labor cost because that's what drives those costs.
Doing so results in an allocation of selling cost of ¢30 per shirt to
basic T-shirts and $2.40 per shirt to deluxe t-shirts.
Remember how many orders the deluxe T-shirts require compared to the basic T-shirts.
And it results in an allocation of general and administrative cost of ¢40 per
shirt for the basic shirts and ¢60 per shirt to the deluxe T-shirts.
Notice that after considering just the manufacturing costs,
deluxe T-shirts seemed quite a bit more costly to make than basic T-shirts.
Well, that difference is even more striking when we consider
the additional non-manufacturing overhead costs associated with those shirts.
This may be an important decision when pricing the two models.
The company should ensure that it prices
the deluxe shirt high enough to cover those higher costs.
Now let's consider the applicability of activity-based costing to service firms.
Let's take as an example an accounting firm that provides
three basic types of services: filing tax returns for businesses,
performing audit of financial statements for businesses,
and doing basic bookkeeping work like accounting and
payroll and the like on an ongoing basis for businesses.
It might want to assess the profitability of each of those types of services and
assess the cost of each as it considers pricing decisions with new clients.
Each of these types of services will have direct costs associated with them.
For example, the firm may assign
an accountant team service that works only on that particular service.
You know, accountants often specialize in tax,
audit, or general accounting.
And it may be able to trace supplies used directly to those services and luckily,
there are some other direct costs as well.
But then there will be indirect costs that are not easily traced to each type of service.
They may include the cost of management to the extent that
management doesn't focus solely on one type of service and of course,
the general and administrative cost fall here as well.
As a final extension,
let's consider the application of activity-based
costing to the assessment of customer profitability.
Many of you have experience working with a wide variety of customers.
Some are easier to work with than others I bet.
Some require less time,
less special orders, less expediting,
less revision to orders placed,
they'll accept more product and fewer shipments or deliveries,
or they're closer to your location so delivery costs
may be lower and I could just go on and on and on.
But an activity-based costing approach to understanding what it
costs to service each of your customers can be extremely valuable.
Take as an example a wholesale distributor.
That distributor has many customers,
many of whom purchase virtually identical products from the distributor.
If the company compared the revenues it
receives and the cost of the products that the customers purchase,
many of its customers may appear to be roughly equally profitable.
However, extending its review to include customer service,
delivery, and other similar costs may tell a different picture.
Understanding which customers are more resource intensive and how much
more resource intensive they are will allow
you to make better decisions as you work with them.
You may decide to charge more for expedited deliveries,
or to charge for those expedited situations
if you've never been charging for them before,
or you may realize a need to refine
customer service processes to make them more efficient.
You may even realize that there are
some customers you would prefer to discontinue a relationship with.
Either way, applying the activity-based costing concept to assess
customer profitability will undoubtedly ensure
you're making more informed decisions in relating to your customers.
Luann J. LynchAlmand R. Coleman Professor of Business Administration
