Activity Based Costing

Case: Sippican Corporation (A)

Volume Based Two Stage Producer
Activity Based Two Stage Producer
Activity Analysis – Example
 Merits and Demerits of ABC
• Merits..,
• Better profitability measure
• Better decision making
• Process improvement
• Cost estimation
• Cost of unused capacity
• Demerits..,
• All costs cannot be allocated over activity
• Omission of costs
• Expensive and time consuming process
 Robert Parker, President of Sippican
Corporation
• The decline in our profits has become intolerable
• The severe price cutting in pumps has dropped
our pre-tax margin to less than 2%, far below our
historical 15% margins
• Fortunately, our competitors are overlooking the
opportunities for profit in flow controllers
• Our recent 10% price increase in that line has
been implemented without losing any business
 Robert
Parker,
Presiden
t

Meetin
g
among
Three
Peggy
John Scott, Knight,
Manufacturing
Manager Controlle
r
 Pumps
• Competitors had been reducing prices • Recently, it seemed as though each
on pumps, which were a major product month brought new reports of reduced
line prices for pumps
• Since pumps were a commodity • Sippican had matched the lower prices
product, Parker had seen no alternative so that it would not give up its place as
but to match the reduced prices to a major pump supplier
maintain volume • Gross margins on pump sales in the
• But the price cuts had led to declining latest month had fallen to about 5%,
company profits, especially in the well below the company's planned
pump line gross margin of 35%
• The manufacturing process for pumps
was practically identical to that for
valves
• Five components were machined and
then assembled into the final product
• The pumps were shipped to industrial
product distributors after assembly
 Sippican Corporation
• Sippican supplied products to • It machined these parts to the required
manufacturers of water purification tolerances and assembled them in the
equipment company's modern manufacturing
• Company had started with a unique facility
design for valves which allowed it to • The same equipment and labor were
produce to tolerances that were better used for all three product lines, and
than any in the industry production runs were scheduled to
• Parker quickly established a loyal match customer shipping requirements
customer base because of the high • Suppliers and customers had agreed to
quality of his company’s manufactured just-in-time deliveries, and products
valves were packed and shipped as completed
• He and Scott realized that Sippican’s
existing labor skills and machining
equipment could also be used to
produce pumps and flow controllers,
which their customers also purchased
• They soon established a major
presence in the high-volume pump
product line and the more customized
flow controller line
• Sippican’s production process started
 Valves
• Valves were produced by assembling four • Although Scott felt several competitors
different machined components could now match Parker's quality in valves,
• Scott had designed machines that held none had tried to gain market share by
components in fixtures so that they could cutting price, and gross margins had been
be machined automatically maintained at a standard 35%
• The valves were standard products and
could be produced and shipped in large
lots
Ex. 1
Ex. 2
 Flow Controllers
• Flow controllers were • Sippican had recently raised
devices that controlled the flow controller prices by
rate and direction of flow of more than 10% with no
chemicals apparent effect on demand
• They required more
components and more
labor, for each finished unit,
than pumps or valves
• Also, there was much more
variety in the types of flow
controllers used in industry,
so many more production
runs and shipments were
performed for this product
line than for valves
 Cost Accounting System
• Sippican had always used a simple cost
accounting system
• Each unit of product was charged for direct
material and labor cost
• Material cost was based on the prices paid for
components under annual purchasing
agreements
• Labor rates, including fringe benefits, were
$32.50 per hour,and were charged to products
based on the standard run times for each product
• The full compensation, including fringe benefits,
for direct and indirect employees (other than
engineers) was $3,900 per month
• Employees worked an average of 20 days per
month (holidays and vacations accounted for the
remaining 2–3 business days per month)
• The company had only one producing
department, in which components were both
machined and assembled into finished products
• The overhead costs in this department were
allocated to products as a percentage of
production-run direct labor cost
• Currently, the rate was 185%
• Since direct labor cost had to be recorded anyway
to prepare factory payroll, this was an
inexpensive way to allocate overhead costs to
products
• Knight noted that some companies did not
allocate any overhead costs to products, treating
them as period, not product, expenses
• For these companies, product profitability was
measured at the contribution margin level—price
less all variable costs
• Sippican’s variable costs were only its direct
material and direct labor costs
• On that basis, all products, including pumps,
would be generating substantial contribution to
overhead and profits
• Knight thought that perhaps some of Sippican’s
competitors were following this procedure and
thus pricing to cover variable costs
Exhibit 3
 Task Force on OH Costs
• Their assembly time per product was
included in the direct labor-hour estimates
for each product
• Knight had recently led a small task force to
study Sippican’s overhead costs since they •
had now become much larger than the direct • Sippican operated two 71⁄2 hour shifts each
labor expenses weekday
• Each shift employed 45 production and
assembly workers, plus 15 setup workers
• A setup had to be performed each time a • Workers received two 15 minute breaks each
batch of components was machined in a day
production run
• They received an average of 30 minutes per
• Each component in a product required a day for training and education activities, and
separate production run to machine the raw all the workers—production, assembly, and
material or purchased part to the setup—spent 30 minutes each shift for
specifications for the product preventive maintenance and minor repair of
• Workers often operated several of the the machines
machines simultaneously once they had set
up the machine
• Because of the large number of setups,
Sippican had dedicated about 25% of its
production workforce to focus exclusively on
setups
• Some production workers did not operate
any machines; they performed only manual
 Task Force on OH Costs
• The company had 62 machines for
component processing
• These machines were generally available
for the six hours per shift that production
workers were actively engaged in
production or setup activities on the
machines
• Sippican leased the machines
• Each machine’s operating expenses were
about $5,400 per month, including lease
payments, supplies, utilities, and
maintenance and repairs
• The receiving and production control
departments employed four people over
the two shifts
• These personnel ordered, processed,
inspected, and moved each batch of
components for a production run
• It took a total of 75 minutes for all the
activities required to get one batch of
components ordered, received, and moved
to a machine for processing
• This time was independent of whether the
components were for a long or a short
production run, or whether the
components were expensive or inexpensive
 Task Force on OH Costs
• The work in the packaging and shipping area • Much of their time was spent modifying flow
had increased during the past couple of years control products to conform to customer
as Sippican increased the number of requests
customers it served
• Engineers worked 71⁄2 hour shifts
• Each shipment took 50 minutes to prepare
• After breaks, training, education, and
the packages and labels, independent of the professional activities, engineers supplied
number or types of items in the shipment, about 6 hours of productive work per shift
plus eight minutes per item to bubble wrap
and pack in the carton, whether the item was
a valve, pump, or flow controller
• The packaging and shipping area employed • Knight’s team had collected the data shown
14 people in each of the two shifts (28 in in Exhibit 4 based on operations in March
total) 2006
• The team felt that this month was typical of
ongoing operations
• Like the employees in production and
assembly, employees in the receiving,
production control, packaging, and shipping
departments worked a 71⁄2-hour shift that
included two 15- minute breaks per day, and
30 minutes, on average, for training and
education
Ex. 4
 Time-Driven Activity-Based Costing
The time-driven ABC budgeting
Simple and powerful approach approach enables companies to
for accurate estimation of the replace their arduous and
cost and profitability of an controversial line-item
organization’s orders, products budgeting process with a
and customers transparent and rigorous
analytic model

Building a TDABC model,

especially in the face of
resistance from finance people
who claim that ABC is too
complex to implement
 Why TDABC?
Actions managers can take Forecast the demand for
to enhance product resource capacity as a
profitability once they company forecasts changes
understand the high costs in volume and mix of sales
of certain processes and as well as process
products efficiencies

Adjust resource capacity up

or down, in response to
Using practical capacity for
changing demands,
establishing cost driver
transforms what many
rates
erroneously call “fixed
costs” into variable ones
 Given some of the apparent problems with Sippican’s cost
system, should executives abandon overhead assignment to
products entirely and adopt a contribution margin approach
in which manufacturing overhead is treated as a period
expense? Why or why not?
 How to calculate the practical capacity and the
capacity cost rates for each of Sippican’s resources:
(1) Production and setup employees
(2) Machines
(3) Receiving and production control employees
(4) Shipping and packaging employees
(5) Engineers
Use capacity cost rates and the production data in
Exhibits 3 and 4 to calculate revised costs and
profits for Sippican’s three product lines.

What difference does your cost assignment have on

reported product costs and profitability?

What causes the shifts in cost and profitability?

 Based on the revised cost and profitability
estimates, what actions should Sippican’s
management team take to improve the company’s
profitability?
Prepare a pro forma product line income
statement based on the new plan
What is the competitive situation
faced by Sippican?
Competitive Situation faced by Sippican

Sippican’s products are mature and the company is experiencing

declining profits.

Company is unable to explain the pricing actions in the

marketplace

It faces severe pricing pressure in one product line (pumps) while

able to raise prices without competitive reaction in another product
line (flow controllers)
Why Peggy Knight chooses to focus the new cost
system on analyzing Sippican’s overhead costs?
 Need for New Costing System

The Willie
●
Look for areas with large expenses in indirect and support resources, especially where such
expenses have been growing over time
●
For Sippican, manufacturing overhead costs of $654,600 are higher than either direct labor or
direct materials costs
●
The current system, which allocates overhead based on a percentage (185%) of direct labor dollars,

Sutton Rule clearly distorts the assignment of these indirect and support costs to individual products and
product lines

High Sippican currently produces valves in high production volumes (an average batch size
●

of 375 per production run) and flow controllers in small production runs (average batch
size of about 18)
●
Valves are mature products that require little engineering support

Diversity Flow controllers are new and frequently customized to individual customer demands,
●

requiring high degrees of engineering support

In an environment with large and growing indirect and support expenses as well as high diversity
in products and customers, traditional cost systems are guaranteed to produce large distortions in
measuring the cost of producing products, delivering them, and serving customers

With Sippican, the demand for small batches of flow controllers has led to an increased supply of
support resources for setups, packaging, shipping, and engineering
How to assign the $350,000 in general, selling
and administrative costs?

No clear way to accurately assign GS&A

costs to products based on facts
presented in the Sippican case
GS&A cost analysis requires a separate
study
Many GS&A costs likely relate to
customers, not products
 Goal of ABC System

Goal of an ABC system is not to

allocate all costs; it is to assign costs
based on the clear causal linkages that
emerge from analysis of the demands
for resources from individual
products, transactions, and customers
 Differentiation
Products, such as pumps or flow
controllers may be commodities; These special services
but how they are produced (e.g.,
small lots, custom designs) and create a basis for
delivered (direct, expedited) is not differentiation
a commodity

But differentiation is a
successful strategy only when
Δ Revenues (from The higher revenues from increased prices and perhaps volume are easy to measure
●

the increased value created Not nearly so obvious are the increased costs associated with creating the
●

higher prices, differentiation in the eyes of the customer

by differentiation exceeds the
Companies need an accurate cost system to measure and trace to specific products,
●

orders, and customers, all the costs associated with a company’s differentiation
higher sales
cost to differentiate strategy
Of course, if a company is following a low cost strategy, it needs an accurate cost
●

volumes) > Δ Costs system to measure all the components of its total product and customer costs
Does Sippican really need a new cost system? Why
not just calculate variable costs and make pricing,
product mix, and order acceptance decisions based
only on variable costs, which Sippican has already
calculated well?
 Need for New Costing System
• Sippican’s executives should not abandon
overhead assignment to products
• Contribution margin equals revenues
minus variable costs
• Analysis based on unit contribution
margins can be useful for short-term
decisions, such as whether to accept a one-
time order when operating with excess
capacity
• In the Sippican case, however,
management is concerned about recurring
sales
• Moreover, overhead costs are substantial
($654,600, exceeding both direct labor and
direct material costs)
• Management needs to understand the
impact of variety in the use of overhead
resources by individual products
• The contribution margin approach, by
definition, does not reveal the different
demands that individual products make on
overhead resources (machines as well as
the personnel doing engineering design,
setups, receiving, packaging and shipping)
• Companies that cut prices based on
contribution margin to get new business
should be cautious about (i) competitive
reactions, (ii) having to lower prices to
existing customers, and (iii) filling up
capacity with business that does not pay
for capacity costs
• If a company cuts prices when near
capacity, demand could increase beyond
existing capacity
• Consequently, the company may end up
having to supply more capacity for support
resources to handle the work, without
being paid for supplying these capacity
resources
 Fundamental Parameters Required for TDABC

The time (or other capacity

Capacity cost rates measure, if not time)
for each department required by products, orders,
services, and customers in
or process each department or process

TDABC works by cross-

multiplying the two Cost/product =
parameters (an approach Cost/unit time *
that engineers call
dimensional analysis) unit time/product
TN 1
 Times Required, in Each Department (or resource), to
Produce the Flow Controllers
• Packaging and shipping time calculation uses a simple time equation (shown in the table
above) since the time is a linear function of the number of items packaged and shipped
• In more complex settings, companies require elaborate time equations to capture how
processing times vary with order characteristics
• Before turning to the assignment of costs to product lines via the time estimates in TN Exhibit
2, instructors may want to show the data in TN Exhibit 3, which compares the time (capacity)
available from each resource with the time demanded (from TN Exhibit 2) to produce the
three product lines. This exhibit provides data that are not available from a conventional ABC
model. The second numeric column, hours available, is calculated by multiplying the number
of resource units by the number of hours available each month per resource unit. The third
numeric column comes from TN Exhibit 2, the derived demand for resource time. The final
column shows the capacity utilization for each department for the month. Since all
departments are apparently at or near capacity, Sippican’s profit problems are not caused by
under-utilization of its labor and capital resources. The capacity analysis leads to the next
calculation of the price-cost relationships for all three product lines.
• Ask a student to present the calculations of the product costs for the flow controller line, as
shown in TN Exhibit 4. TN Exhibit 5 provides a graphical comparison between the cost of flow
controllers calculated by Sippican’s previous cost system and the cost calculated using TDABC.
Unit costs provide an easy-to-see comparison between the two systems, though I don’t
encourage their use beyond visualizing differences as shown in TN Exhibit 5. A main teaching
principle of the case is that many costs are not driven by the number of units produced.
TN 2
TN 3
• The big surprise is the flow controller line. Previously thought to be the most profitable, it now is shown to be losing money. The loss is
caused by the high cost of setups (both labor and machine time), which is higher than direct labor and direct materials combined. The time-
driven ABC model reveals the high costs of producing the flow controller line in small production batches. In addition, flow controllers
require extensive engineering time to customize the product to customer specifications.
• A student may fall into a conventional error by claiming that flow controllers are profitable on a contribution margin basis, and that the
TDABC model is just allocating fixed costs. If this comment arises, ask the student how many setup people and machines Sippican has. With
30 people and nearly 25% of the time of the 62 machines being devoted to setups, Sippican has provided many resources, at high cost, to
handle the demands of the flow controller line.
• With the product line P&Ls understood, the discussion of the (A) case can conclude with the possible actions that Sippican management can
take to increase profitability.
• Q: What does this information mean to Sippican’ s management? What actions can they contemplate?
• The company could reconsider its product strategy and focus on its core products—valves and pumps. Sippican might attempt to increase
market share in valves by offering discounts for large orders of valves. Furthermore, Sippican could reduce discounting for pumps, especially
for small orders. Finally, Sippican should aggressively raise prices for flow controllers or accept orders to produce flow controllers only when
the pricing and order size indicate that they can be sold at a profit. It could consider establishing a minimum order size so that the cost of
setups does not overwhelm the cost of producing the number of products ordered.
• Sippican should focus on process improvements to reduce setup times and schedule production of components for multiple product orders
so the costs of setups for components can be shared by multiple batches. It can attempt to redesign the flow controller product so that it
has fewer components, and perhaps share parts also used by valves or pumps so that production runs for some components can be grouped
together.
• The instructor does not have to spend too much time on the action items since there is really not enough market information to suggest that
one course of action is preferable than others. The main point is to indicate how the TDABC profit information motivates managers to
consider a wide variety of pricing, process improvement, and product mix actions that can generate substantial improvements in
profitability.
• Discussion can now transit to the “Sippican (B)” case.