ACFI2003 MANAGEMENT ACCOUNTING
WEEK 9: OVERHEAD ALLOCATION, ACTIVITY BASED
COSTING AND CUSTOMER PROFITABILITY ANALYSIS II

overhead allocation.

Most of you would be aware of the increasing importance placed on the delivery of ‘customer value’ in contemporary business. Organisations are becoming more conscious of the ‘value proposition’ that they offer in the marketplace (appropriate blend of various components of customer value). The provision of customer value is seen as a central issue in retaining existing customers and acquiring new ones. Moreover, customers are becoming increasingly demanding in their relationships with organisations. The internet, for example, has enabled widespread and rapid comparison of product features and price.

In addition to providing value to customers, the firm also needs to derive value from customers. Generally speaking, a profitable customer is one who purchases profitable products and is low “cost to serve”.

Investments in product/service quality and the accommodation of requests for customisation etc. are resource intensive activities. The fundamental issue that organisations confront is whether these customer-focused outlays are being recouped in the prices paid by customers and/or a commensurate growth in their sales and customer base.

In weeks 8 + 9, we have turned our attention to a relatively new management accounting technology referred to as Customer Profitability Analysis, which attempts to address such issues, as well as certain costing techniques such as Activity Based Costing. 2

We first considered the importance of overhead allocation in the costing process and examine two methods that are commonly used to cost products and services: traditional job costing and Activity Based Costing (ABC). ABC costing not only provides a more accurate method of costing but also can be useful for cost cutting and it shows the costs of various activities within the organisation allowing a cost/benefit analysis on non-essential activities. We spentd last week introducing you to these two different techniques for allocating overheads.

In this second week, we focus more specifically on Customer Profitability Analysis (CPA) and how to accurately trace selling, general and administrative costs (SG&A) to particular customers or customer segments. (SG&A are expenses that are found in the Statement of Financial Performance, below the gross margin tabulation.) CPA derives from Activity Based Costing.

CPA is now possible given the significant advances in information processing technology and the large data warehouses that many organisations now maintain. Previously, accountants would allocate these costs to customers or segments based on relative sales volume/value. So large customers would receive the largest allocation of SG&A costs. However, the cost to serve is driven by the nature of a customer relationship and not necessarily by customer size. For example, small customers may make many profit-decreasing demands on an organisation (customised features, non standard lot sizes, particular forms of packaging and so-on).

As such, this course adopts the Activity Based Costing approach to assign selling, general and administrative costs (SG&A) to particular customers or customer segments in the customer profitability analysis. Although sales volume is traditionally used to allocate costs to customers, the cost to serve is often driven by the behaviour or needs of each customer. CPA thus enables organisations to better able to understand their financial performance, and to identify the profitable and unprofitable customers.

CPA also provides insight into what makes the customer profitable or otherwise. This allows organizations to consider alternative pricing strategies, the re-engineering of their relationships with particular customers, and the overall composition of their customer portfolio.

Increased profit margins result in higher return on assets and consequently increased shareholder value. This can therefore be achieved by focusing on the customer and the cost of providing this product to them.

 Describe the purpose of Customer Profitability Analysis.

 Calculate customer profitability and apply the CPA technique in an organisational context.

 Propose strategies for maximising customer profitability.3

 Mittal V., Sarkees M. and Murshed F. 2008. “The right way to manage unprofitable customers”. Harvard Business Review, April, pp. 95-102.

 Week 8: Chapter 12: Activity Analysis, Costing and Management

 Week 8: Chapter 16: The Strategic Management of Costs and Revenues

 Atkinson, A.A., Kaplan, R.S., Matsumura, E.M., and Young, S.M. 2012. Management Accounting: Information for Decision-making and Strategy Execution. (6th ed.). Pearson Education, Inc., Upper Saddle River, NJ, pp. 218- 240.

Question 1: Customer Profitability Analysis at Funcorp

Funcorp manufactures water pistols for sale in leading toy retailers. By far their most popular model is the ‘Terminator’. The product features of this model include a ten litre water storage capacity (this is strapped to the user’s back) and automatic rapid fire option for pure soaking power. Funcorp also produces a second model, the ‘Assassin’, which is reputed to be the longest shooting water pistol on the market. Recently, Giorgio Lawless, the CFO of Funcorp, decides to conduct a thorough customer profitability analysis. Giorgio has provided you with the following information:

 You need to do the following exercises prior to coming to class.

 Your answers will be collected at random in class twice during the semester and count for 20% of your overall course mark.

 Students who fail to hand in the exercises will be given a mark of 0.4

In addition, the company incurs selling, general and administrative (SG&A) expenses of $500,000, which is related to three customer-driven activities: sales calls (salespeople conducting regular customer visits), sales orders processing (the retailers manually order stock as and when they require it), and advertising support (in the form of Funcorp placing ads to support the retailer’s further sale of Funcorp products to consumers). The resource driver, the number of full-time equivalent staff (FTE), and the activity drivers associated with these customer-driven activities are listed as follows:

a) Calculate customer profitability for Funcorp using the net revenue approach (i.e., revenue minus discounts given). Prepare a customer profitability statement. (Hint: Using this approach, a customer who contributes 30% of total net sales revenue received by the firm will be allocated 30% of SG&A expenses).

b) After studying your lecture slides and required readings carefully, you decided that the activity-based costing (ABC) approach to analyse customer profitability is more appropriate. Prepare a customer profitability statement.

c) Which of the two approaches is more accurate in allocating SGA costs to the three customer groups? Justify your answer.

d) Based on your answers in part (b), construct a “2X2” matrix graph using the two components of customer profitability. Label the y-axis and x-axis of your graph clearly. Classify these customers either as aggressive customers, cheap customers, passive customers, or savvy customers.Hint: Before you construct the matrix, start by transforming the relevant calculations from CPA into relative percentages.

e) Based on your classification in part (e) and using CPA information, provide recommendations to Funcorp on how it should manage each customer.