Activity-based management (ABM) uses activity-based costs to make decisions that increase profits while meeting customer needs. In this section, we show how Smart Touch Learning can use ABM in making two kinds of decisions:
• Pricing and product mix
• Cost management
Pricing and Product Mix Decisions
Smart Touch Learning now knows the ABC manufacturing overhead cost per tablet. To determine which products are the most profitable, the company controller recomputes each product’s total manufacturing cost and gross profit. Last year, the manufacturing cost of the standard model tablet was $300 and the item sold for $500.
Standard Model Last Year
Standard Model This Year, Traditional
Allocation
Standard Model This Year, ABC
Allocation
Net Sales Revenue $ 500.00 $ 500.00 $ 500.00
Cost of Goods Sold 300.00 273.20 276.75
Gross Profit $ 200.00 $ 226.80 $ 223.25
Gross Profit Percentage 40.00% 45.36% 44.65%
Learning Objective 3 Use activity-based management
(ABM) to make decisions
Try It!
Newton Company has analyzed its production process and identified two primary activities. These activities, their allocation bases, and their estimated costs are listed below.
Activity Allocation Base Estimated Activity Estimated Costs Purchasing Number of purchase orders 200 purchase orders $ 10,000
Materials handling Number of parts 15,000 parts $ 7,500
The company manufactures two products: Regular and Super. The products use the following resources in March:
Regular Super
Number of purchase orders 5 purchase orders 7 purchase orders
Number of parts 600 parts 750 parts
5. Compute the predetermined overhead allocation rates using activity-based costing.
6. Determine the amount of overhead allocated to Regular products in March.
7. Determine the amount of overhead allocated to Super products in March.
Check your answers online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercises S19-3 through S19-8. MyAccountingLab
Compared with last year’s production, Smart Touch Learning has predicted costs will decrease by $26.80 per unit this year using a traditional allocation method (from $300.00 to $273.20). The refinement of the costing system with ABC shows actual costs to be slightly higher than calculated with the traditional allocation method, but the company has still increased the gross profit margin by $23.25 per unit ($223.25 as compared with
$200.00). If the company sells 2,000 units as expected, gross profits will increase by $46,500 (2,000 units * $23.25 per unit).
With the decrease in costs, Smart Touch Learning could consider lowering the sales price. With costs of $276.75, to maintain a 40.00% gross profit percentage (which means COGS is 60%), the sales price could drop to $461.25 ($276.75 / 60%). The decrease in sales price could lead to an increase in sales volume.
Now let’s look at the premium model. Based on research conducted by the marketing department, the company expects the premium model to sell for $600.
Premium Model, Traditional Allocation
Premium Model, ABC Allocation
Net Sales Revenue $ 600.00 $ 600.00
Cost of Goods Sold 407.20 393.00
Gross Profit $ 192.80 $ 207.00
Gross Profit Percentage 32.13% 34.50%
More accurate cost allocations using ABC indicate that the premium model will be more profitable than originally thought. The increase in gross profit from $192.80 to $207.00 is a difference of $14.20. When multiplied by the expected sales of 500 units, gross profit increases by $7,100 ($14.20 per unit * 500 units).
By comparing the expected gross profit of the two products, it is clear that the stan- dard model is more profitable than the premium model. Therefore, to maximize profits, the company should continue to sell as many of the standard models as possible. This is a product mix decision. Product mix considers overall production capacity and focuses on producing the mix of products that is most profitable, considering limited production capabilities.
Cost Management Decisions
Most companies adopt ABC to get more accurate product costs for pricing and product mix decisions. However, they often benefit more by cutting costs. ABC and value engineer- ing can work together. Value engineering means reevaluating activities to reduce costs while still meeting customer needs. It requires cross-functional teams that include the following:
• Marketers to identify customer needs
• Engineers to design products that can be produced more efficiently
• Production personnel to help improve manufacturing processes
• Accountants to estimate costs
Why are managers turning to value engineering? Because it gets results! Companies set
Value Engineering
Reevaluating activities to reduce costs while satisfying customer needs.
Cost-based pricing (left column) starts with the full product cost, the cost to develop, produce, and deliver the product or service. The full product cost is added to the desired net profit to determine the sales price. Target pricing (right column) does just the opposite. Target pricing starts with the sales price that customers are willing to pay and then subtracts the com- pany’s desired net profit to determine the target cost, the maximum cost to develop, produce, and deliver the product or service and earn the desired net profit. Notice that the target cost includes all costs, not just manufacturing costs. Then the company works backward to develop the product at the target cost. The company’s goal is to achieve the target cost.
Let’s return to our Smart Touch Learning illustration. The ABC analysis shows the premium model has a gross profit percentage of only 34.50%, compared with the standard model gross profit percentage of 44.65%. This analysis prompts the sales team to focus its efforts on selling the standard model. Smart Touch Learning can use value engineering to look for ways to decrease the cost of producing the premium model, which will increase profits.
Target pricing considers full product costs in the analysis. Full product costs consider all production costs (direct materials, direct labor, and allocated manufacturing overhead) plus all nonmanufacturing costs (operating expenses, such as administrative and selling expenses). Smart Touch Learning desires a 20% net profit margin on its products. What is the company’s target full product cost per premium model tablet? The following is the computation:
Target sales price per premium model tablet $ 600.00 - Desired net profit (+600.00 * 20%) (120.00) Target cost per premium model tablet $ 480.00
Notice that we used net profit here, not gross profit. Gross profit is net sales minus cost of goods sold. Net profit is gross profit less the period costs. Remember that period costs are also called selling and
administrative expenses.
Does Smart Touch Learning’s current full product cost meet this target? Assuming nonmanufacturing costs related to the premium model tablet are $120 per unit, the current full product cost per premium model tablet is:
Current total manufacturing cost per premium model tablet $ 393.00 + Nonmanufacturing costs (operating expenses) 120.00 Current full product cost per premium model tablet $ 513.00
Smart Touch Learning’s current full product cost does not meet the target cost.
Full Product Cost The cost to develop, produce, and
deliver the product or service.
Target Cost The maximum cost to develop, produce, and deliver the product or service and earn the desired net profit. Target sales price minus desired net profit.
Exhibit19-6 | Cost-Based Pricing Versus Target Pricing
Cost-Based Pricing Target Pricing Full Product Cost Target Sales Price + Desired Net Profit – Desired Net Profit
Sales Price Target Cost
Because Smart Touch Learning’s current full product cost, $513, exceeds the target cost of $480, CEO Sheena Bright can assemble a value engineering team to identify ways to cut costs. This team analyzes each production activity and considers how to do one or both of the following:
• Cut costs, given Smart Touch Learning’s current production process.
• Redesign the production process to further cut costs.
If the team can find a way to reduce costs by $33 per unit, the difference between the target cost and the actual cost, the company will make its desired net profit.
Try It!
8. Goodwin, Inc. manufactures children’s sandals. Similar sandals manufactured by competitors sell for $12.50 per pair.
Goodwin desires a 20% net profit margin. What is Goodwin’s target cost?
Check your answer online in MyAccountingLab or at http://www.pearsonhighered.com/Horngren.
For more practice, see Short Exercise S19-9. MyAccountingLab
to do is fudge the numbers to make it look like he takes longer to make the product than he actually does. Should Clayton report his actual time or adjust it? What would you do?
Solution
Clayton has the responsibility to his employer to work effi- ciently and effectively in return for his pay. Failure to do so violates the ethical practice of integrity. Falsifying the data submitted to the accounting department could cause manage- ment to make pricing and product mix decisions that will have a negative impact on profits which could result in layoffs. On the other hand, presenting the accurate information may pro- vide management with enough information to give him a raise and help the business improve processes for other employees.
Why can’t “they” leave me alone?
“Why do we have to change things?” mumbled Clayton Huff. “We’ve always done it this way. No need to change now.” Clayton is returning to his workstation after a depart- ment meeting where the controller explained how an ABC system works. The controller wants all employees to help develop the system by documenting their activities and the time spent on each activity. Then the accounting department will determine cost drivers and create cost pools and compute allocation rates.
Clayton enjoys his job in production and is quite good at it. In fact, he is so efficient he can get as many units completed in a shift as the other workers and not work nearly as hard.
Clayton is also smart enough to realize that if he reports his actual time spent on activities, management will find out how much he has been goofing off. Clayton decides the best thing