Activity Based Costing And Customer Profitability Analysis Essay.

Louise Fairbern operates Interiors by Louise, an interior design consulting and window treatment fabrication business.

Her business is made up of two different distribution channels: a consulting business in which Louise serves two architecture firms (Adams and Betz), and a commercial window treatment business in which Louise designs and constructs window treatments for three commercial clients (Chatham, Dedham and Elm).

Louise wishes to evaluate the profitability of her two architecture-firm clients and three commercial window treatment clients, as well as evaluate the profitability of each of the two channels and the business as a whole. Information relating to the most recent quarter is:

	Adams	Betz	Chatham	Dedham	Elm
Gross revenue	$234 000	$188 800	$357 380	$147 840	$73 200
Direct costs	147 000	117 200	218 400	115 720	57 040

The total overhead costs are $340 400. Louise estimates that 25% of her overhead costs relate directly to her architectural business, 40% directly to her window-treatment business, and the remainder are general in nature.

On the revenues above, Louise gave a 10% discount to Adams to lure this customer from a competitor and gave a 5% discount to Elm for advance payment in cash.

1. Prepare an activity-based customer-cost report, distribution channel cost report and a customer-profitability analysis for the five customers. Ensure that you also include an overall total profitability analysis for the business.

2. Write a report to Louise Fairbern relating customer costs, customer profitability, distribution channel profitability and total profitability. Support the report with the analyses you have prepared and recommend courses of action to Louise. The report excluding the computational analysis should be around 500-1000 words and should include a brief introduction, analysis, recommendation and conclusion. 

The Australian Instrument Company (AIC) consists of the Semiconductor Division and the Process Control Division, each of which operates as an independent profit centre. The Semiconductor Division employs craftspeople who produce two different electronic components: the new high-performance Super-chip and an older product called Okay-chip. These two products have the following cost characteristics:

	Super-chip	Okay-chip
Direct materials	$5	$2
Direct manufacturing labour, 3 hours × $20; 1 hour × $20	60	20

Annual overhead in the Semiconductor Division totals $400 000, all fixed. Due to the high skill

level necessary for the craftspeople, the Semiconductor Division’s capacity is set at 45 000

hours per year.

One customer orders a maximum of 15 000 Super-chips per year, at a price of $80 per chip.

The rest of the Semiconductor Division’s capacity is devoted to the Okay-chip, for which there

is unlimited demand at $26 per chip.

The Process Control Division produces only one product, a process-control unit, with the following cost structure:

• direct materials (circuit board): $70
  

• direct manufacturing labour: $45 (3 hours * $15)

Fixed overhead costs of the Process Control Division are $80 000 per year.

The current market price for the control unit is $132 per unit.

A joint research project has just revealed that a single Super-chip could be substituted for the circuit board currently used to make the process-control unit. Direct labour cost of the process-control unit would not change. The improved process-control unit could be sold for $145.

1. Calculate the contribution margin per hour of selling the Super-chip and the Okay-chip. If no transfers of Super-chip are made to the Process Control Division, how many Super-chips and Okay-chips should the Semiconductor Division manufacture and sell? Show your calculations.

2. The Process Control Division expects to sell 5000 process-control units this year. From the viewpoint of AIC as a whole, should 5000 Super-chips be transferred to the Process Control Division to replace circuit boards? Show your calculations.

3. What transfer price, or range of prices, would ensure goal congruence among the division managers? Show your calculations and provide an explanation.

4. If labour capacity in the Semiconductor Division were 60 000 hours instead of 45 000 hours, would you answer differently to requirement 3 above? Show your calculations and provide an explanation. (5 marks)

ACTIVITY BASED COST REPORT
PARTICULARS	ARCHITECTURE FIRMS			WINDOW TREATMENTS			TOTAL	TOTAL OF BOTH THE OPERATIONS
	ADAMS	BETZ	TOTAL	CHATHAM	DEDHAM	ELM
Direct Costs	147000	117200	264200	218400	115720	57040	391160	655360
Overhead Costs (WN1)			85100				136160	340400
Discount Cost (WN2)	23400		23400			3660	3660	27060
Total Cost	170400	117200	372700	218400	115720	60700	530980	1022820

CUSTOMER & TOTAL PROFITABILITY REPORT
PARTICULARS	ARCHITECTURE FIRMS			WINDOW TREATMENTS			TOTAL	TOTAL
	ADAMS	BETZ	TOTAL	CHATHAM	DEDHAM	ELM
Gross Revenues	234000	188800	422800	357380	147840	73200	578420	1001220
Direct Costs	147000	117200	264200	218400	115720	57040	391160	655360
LESS :
Overhead Costs			85100				136160	340400
Discount	23400		23400			3660	3660	27060
PROFIT	63600	71600	50100	138980	32120	12500	47440	-21600

		DISTRIBUTION CHANNEL COST REPORT
PARTICULARS	ARCHITECTURE FIRMS		WINDOW TREATMENTS	TOTAL
Direct Costs	264200		391160	655360
Overhead Costs	85100		136160	221260
Discounts Given	23400		3660	27060
Total Costs	372700		530980	903680

WN1 :
Overhead basis of Allocation
	($)
OVERHEADS	340400
ARCH	25%
WIND	40%
GENERAL	35%

WN 2: The overheads are allocated on the basis of percentage that is stated above as per activity based costing. Discount is considered to be the cost for the sellers. Therefore, such discount has been added to both the departments.

WN 3:  As per the distribution channel cost report, there are two departments and the cost is allocated to the two departments accordingly. However, the total overhead expense does not appear in the reports.

Louise is famous for the consultation of interior designing and also for window treatment fabrication.  There are two different distribution channels in his business. The first one is the architecture firms and the second one is the commercial window treatments business.  Louise has one client for architecture firms and three clients for commercial window treatments.

The required case study has been provided to us in order to prepare the activity based report, cost report of the different channels and customer profitability also which will help us in assessing the overall profitability that they are able to earn. The cost incurred in the overall business as well as in different departments can be understood with the help of activity cost report.

The customer profitability report is prepared as it helps to understand each customer’s contribution in the profits earned by the company. This report also provides us the information of the total profits of the company. However, the distribution channel report helps us to obtain information about the costs that is incurred in different channel.

On the basis of the calculations made in this assignment, a proper analysis has been carried out and recommendations have been given.

The company has adopted activity based costing as the cost allocation method in which the cost is allocated on the basis of cost that should be allocated to that department. The company does not use traditional costing system but it gives a clearer picture.

On analysis the customer analysis, it is observed that the cost incurred in the windows department is amounting to $ 530980.  But when we look upon the customer profitability report, we observe that the profits that are generated from the architecture department are higher. The analysis shows that more revenues are generated from the windows department when compared with the other department. The company has adopted a strategy in order to attract customers; it gave the customers a discount of 10% which amounted to $23,400. This strategy was adopted by the company to slower down the sales of the competitors. There was also a negative impact because of this which is that the company has to suffer loss or incur extra costs of $23,400.

Customer Profitability Analysis

The company also decided to provide 5% discount to the customers who would make advance payments in cash. This strategy was justified because the cash payments helped the company to shorten the operating cycle. As we know, a shorter operating cycle is considered to be favourable as it beings the company to a good position.

The total profitability of the company is in negative which can be observed in the customer profitability report of the company. Although we can see that the departments of the company are generating profits individually but when it comes to the overall profitability the company is suffering because of the huge overhead costs and the heavy discounts that it is providing to the customers. If the company would not have provided 10% discount to Adams then the profitability of the company would have been positive. It is observed that there are huge overhead costs that are involved in the distribution channel cost report of the company (Atkinson, 2012).

Activity Based Costing is preferred by the company and the reasons for it are as follows:

• Activity based costing helps to allocate costs to the product on the basis of the actual resources that is consumed. Therefore, it helps in allocating the costs correctly.
• It improves the decision making process as the information obtained because of this costing method is true. It helps the firm in deciding whether it should continue producing a particular product or not keeping in mind the profitability.
• The absorption capacity of the individual departments and the department’s contribution helps to know about the cash flows and profits.

Therefore, the company is recommended to use activity based costing in future also.

The company has also provided discount to the customers in order to complete with the competitors which is not appreciable as it has affected the profits. The company incurred losses of $21600 because of this offer but this figure could have been the profit figure if the company would not have adopted such strategy. There were alternative strategies that were available, they were production of market substitutes and own house etc.

The company has a better option which was to shut down the current production of one business, save costs and then invest such money at a place where the cost of production is low and the company is able to generate higher profit.

Conclusion

As we know, market is dynamic in nature and therefore, there is a requirement of certain precise methods in all the fields whether accounting, auditing or costing. The reports that are prepared by the company are used by various users in order to take numerous decisions such as comparison of costs between different competitors and that of the industry rates, investment decisions or raising loan decisions. Therefore, the reports prepared should fulfil the qualitative characteristics of transparency.

In this dynamic environment, the companies loose customers very easily which is highly unfavourable. In the current situation, the companies give more importance to customers than the profits. Customers help the companies to survive in the long run and therefore, customer satisfaction is the main objective of the company. If the primary aim of any company is to earn profits only then it might not survive in the long run. The objectives of the companies should be analysed properly and steps should be taken accordingly. However, preparation and analysis of report is a difficult job but this helps in providing true and fair view about the company which is demanded in the current scenario (Seal, 2012).

This assignment comprises of information about the different approaches that are adopted by the company, its costs and profits from individual customers, department or the entire business. This information is considered to be very important because the management uses this information to take important decisions regarding the business activities.

Particulars	Super Chip	Okay Chip
Sale Price p.u.	80	26
Less :
Direct Materials p.u	5	2
Direct Manufacturing Labour p.u	60	20
Contribution p.u	15	4
Hours Required	3	1
Contribution/hour	5	4

The company should prefer manufacturing Super Chip as it produces $5 per hour. The maximum number of Super Chips and Oky chips that could be produced taking into consideration the maximum units are shown below.

Particulars	Hours p.u.	Maximum Units	Total Hours
Maximum Available			45000
Super Chip	3	15000	45000
	1	-	-
Available Capacity			-

Therefore, the company should manufacture 15000 units of Super chip.

Case 1: when there is no transfer, profit calculation:

Particulars	Super Chip	Okay Chip	Process Control Unit	Total
Sale Price p.u.	80	26	132
Less :
Direct Materials p.u	5	2	70
Direct Manufacturing Labour p.u	60	20	45
Contribution p.u	15	4	17
Units Proposed to be Sold	15000		5000
Total Contribution	225000		85000	310000

Case 2: When there is a transfer of 5000 Super chips to the process control unit:

Particulars	Super Chip	Okay Chip	Process Control Unit	Total
Sale Price p.u.	80	26	145
Less :
Direct Materials p.u	5	2	-
Direct Manufacturing Labour p.u	60	20	45
Transfer Price                       (5000 Super Chips are t/f to Process Unit Cost @80/unit)			80
Contribution p.u	15	4	20
Units Proposed to be Sold	15000		5000
Total Contribution	225000	-	100000	325000

Conclusion: On comparing both the cases, it is found that the profits increased by $15000 and therefore, the company can go for the transferring option.

The transfer price for 5000 Super chips would be $80 per unit which would be considered as sales for the first division and cost for the second division.

Particulars	Super Chip	Process Control Unit	Total
Profit when there is a transfer	2,25,000	1,00,000	3,25,000
Profit when there is no transfer	2,25,000	85,000	3,10,000
Difference			15,000

There is no impact on the profits whether the company has adopted transfer or sale in case of the super chips. But in the case of Process control unit we can see that the profits has increased by $15000.  It is advisable that the company should consider transferring 5000 super chips to the other department and purchase the material at $ 70 per unit. However, the transfer price would be $ 80 per unit.

Case 1: when there is no transfer, profit calculation:

Particulars	Super Chip	Okay Chip	Process Control Unit	Total
Sale Price p.u.	80	26	132
Less :
Direct Materials p.u	5	2	70
Direct Manufacturing Labour p.u	60	20	45
Contribution p.u	15	4	17
Hours Required	3	1	3
Contribution/hour	5	4	5.67
Units Proposed to be Sold	15000	15000	5000
Total Contribution	225000	60000	85000	370000

Case 2: When there is a transfer of 5000 Super chips to the process control unit:

Particulars	Super Chip	Okay Chip	Process Control Unit	Total
Sale Price p.u.	80	26	145
Less :
Direct Materials p.u	5	2	-
Direct Manufacturing Labour p.u	60	20	45
Transfer Price                       (5000 Super Chips are t/f to Process Unit Cost @80/unit)			80
Contribution p.u	15	4	20
Units Proposed to be Sold	15000	15000	5000
Total Contribution	225000	60000	100000	385000

Conclusion:  

15000 hours could be used to produce 15000 oky chips where contribution per hour is $4/hour. The case of transfer and without transfer should be analysed.

Atkinson, A. A. (2012). Management accounting. Upper Saddle River, N.J.: Paerson.

Seal, W. (2012). Management accounting. Maidenhead: McGraw-Hill Higher Education.