198 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS

Illustration of Activity-Based Costing 4

Con sider th e Billin g Departm en t at Pacific Power Com pan y (PPC), an electric u tility. Th e Billin g Departm en t (BD) at PPC provides accou n t in qu iry an d bill prin tin g services for two m ajor classes of cu stom ers—residen tial an d com m ercial. Cu rren tly, th e Billin g Departm en t services 120,000 residen tial an d 20,000 com - m ercial cu stom er accou n ts.

Two factors are h avin g a sign ifican t im pact on PPC’s profitability. First, deregu lation of th e power in du stry h as led to in creased com petition an d lower rates, so PPC m u st fin d ways of redu cin g its operatin g costs. Secon d, th e dem an d for power in PPC’s area will in crease du e to th e addition of a large h ou sin g devel- opm en t an d a sh oppin g cen tre. Th e m arketin g departm en t estim ates th at residen tial dem an d will in crease by alm ost 50 percen t an d com m ercial dem an d will in crease by 10 percen t du rin g th e n ext year. Sin ce th e BD is cu rren tly operatin g at fu ll capacity, it n eeds to fin d ways to create capacity to service th e expected in crease in dem an d. A local service bu reau h as offered to take over th e BD fu n c- tion s at an attractive lower cost (com pared to th e cu rren t cost). Th e service bu reau ’s proposal is to provide all th e fu n ction s of th e BD at $3.50 per residen - tial accou n t an d $8.50 per com m ercial accou n t.

Exh ibit 5-7 depicts th e residen tial an d com m ercial cu stom er classes (cost objects) an d th e resou rces u sed to su pport th e BD. Th e costs associated w ith th e BD are all in direct—th ey can n ot be iden tified specifically an d exclu sively w ith eith er cu stom er class in an econ om ically feasible w ay. Th e BD u sed a tradition al costin g system th at allocated all su pport costs based on th e n u m ber of accou n t in qu iries of th e tw o cu stom er classes. Exh ibit 5-7 sh ow s th at th e cost of th e resou rces u sed in th e BD last m on th w as $565,340. BC received 23,000 accou n t in qu iries du rin g th e m on th , so th e in direct cost per in qu iry w as $565,340 ÷ 23,000 = $24.58. Th ere were 18,000 residen tial accou n t in qu iries, abou t 78 percen t of th e total. Th u s, residen tial accou n ts were ch arged with

78 percen t of th e su pport costs wh ile com m ercial accou n ts were ch arged with

22 percen t. Th e resu ltin g cost per accou n t is $3.69 an d $6.15 for residen tial an d com m ercial accou n ts, respectively.

Based on th e costs provided by th e tradition al cost system , th e BD m an - agem en t wou ld be m otivated to accept th e service bu reau ’s proposal to service all residen tial accou n ts becau se of th e apparen t savin gs of $.19 ($3.69 2 $3.50) per accou n t. Th e BD wou ld con tin u e to service its com m ercial accou n ts becau se its costs are $2.35 ($8.50 2 $6.15), less th an th e service bu reau ’s bid.

However, m an agem en t believed th at th e actu al con su m ption of su pport resou rces was m u ch greater th an 22 percen t for com m ercial accou n ts becau se of th eir com plexity. For exam ple, com m ercial accou n ts average 50 lin es per bill com pared with on ly 12 for residen tial accou n ts. Man agem en t was also con - cern ed abou t activities su ch as correspon den ce (an d su pportin g labou r) resu ltin g from cu stom er in qu iries becau se th ese activities are costly bu t do n ot add valu e to PPC’s services from th e cu stom er’s perspective. However, m an agem en t wan ted

a m ore th orou gh u n derstan din g of key BD activities an d th eir in terrelation sh ips

4 Much of the discussion in this section is based on an illustration used in Implementing Activity- Based Costin g—Th e Model Approach , a worksh op spon sored by th e In stitu te of Man agemen t

Accounting and Sapling Corporation.

Chapter 5 Cost Allocation and Activity-Based Costing Systems

O BJECTI V E 9

before m akin g im portan t decision s th at wou ld affect PPC’s profitability. Th e com - pan y decided to perform a stu dy of th e BD, u sin g activity-based costin g. Th e fol-

Step 1. Determine

lowin g is a description of th e stu dy an d its resu lts.

cost objectives, key

Th e activity-based-costin g stu dy was perform ed by a team of m an agers

activities centres,

from th e BD an d th e ch ief fin an cial officer from PPC. Th e team followed a fou r-

resources, and related

step procedu re to con du ct th e stu dy.

cost drivers.

Step 1. Determine cost objectives, key activities centres, resources, and related cost

Step 2. Develop a

drivers . Man agem en t h ad set th e objective for th e stu dy—determ in e th e BD cost

process-based map

per accou n t for each cu stom er class. Th e team iden tified th e followin g activities,

representing the flow

resou rces, an d related cost drivers for th e BD th rou gh in terviews with appropri-

of activities, resources, and their

ate person n el.

interrelationships. Step 3. Collect

ACTIVITY CEN TRES

CO ST D RIVERS

relevant data concerning costs and

Number of Lines the physical flow of

Account Billing

Number of Accounts cost-driver units

Account Verification

Number of Labour Hours among activities.

Account Inquiry

Number of Letters Step 4. Calculate and interpret the new

Correspondence

The four key BD activity centres are account billing, bill verification, account

activity-based information.

inquiry, and correspondence. The resources shown in Exhibit 5-7 support these major activity centres. Cost drivers were selected based on two criteria.

1. Th ere h ad to be a reason able assu m ption of a cau se-effect relation sh ip between th e driver u n it an d th e con su m ption of resou rces an d/ or th e occu rren ce of su pportin g activities.

2. Data on th e cost-driver u n its h ad to be available.

Develop a process-based map representing the flow of activities, resources, and their interrelationships . An im portan t ph ase of an y activity-based an alysis is iden tifyin g th e in terrelation sh ips between key activities an d th e resou rces con - su m ed. Th is is typically don e by in terviewin g key person n el. On ce th e lin kage between activities an d resou rces is iden tified, a process m ap is drawn th at provides a visu al represen tation of th e operation s of th e BD.

Step 2.

Exhibit 5-8 is a process map that depicts the flow of activities and resources at the BD. 5 Note that there are no costs on Exhibit 5-8. BD first focused on under- standing business processes. Costs were not considered u n til Step 3, after th e key in terrelation sh ips of th e bu sin ess are u n derstood.

Con sider residen tial accou n ts. Th ree key activities su pport th ese accou n ts— accou n t billin g, accou n t in qu iry, an d correspon den ce. Bill prin tin g activity con - su m es prin tin g m ach in e tim e, paper, com pu ter tran saction tim e, billin g labou r tim e, an d su pervisory tim e. Th is activity also takes u p sign ifican t occu pan cy space. Accou n t in qu iry activity con su m es labou r tim e an d requ ires correspon - den ce for som e in qu iries. Accou n t in qu iry labou r, in tu rn , u ses th e telecom m u - n ication , com pu ter, su pervisory resou rces, an d also occu pies a sign ifican t am ou n t of occu pan cy space. Fin ally, th e correspon den ce activity requ ires su pervision an d in qu iry labou r. Th e costs of each of th e resou rces con su m ed were determ in ed du rin g Step 3—data collection .

5 This example illustrates the process-based modelling approach to activity-based costing. For a more detailed description of the process modelling approach, see Raef A. Lawson, “Beyond ABC: Process-Based Costing,” Journal of Cost Management , Volume 8, No. 3

(Fall 1994), pp. 33–43. Also, for a discussion of how one major firm used process-based costing to implement ABC in its billing centre, see T. Hobdy, J. Thomson, and P. Sharman, “Activity-Based Management at AT&T,” Management Accounting (April 1994), pp. 35–39.

198 PART ONE MANAGEMENT ACCOUNTING, INFORMATION AND DECISONS