CHAPTER 1

ABC, ABM, DPP, CPA and DCP

• Chapter Summary
• Traditional Costing methods
• Activity Based Costing (ABC)
• Activity Based Management (ABM)
• Direct Product Profitability (DPP)
• Customer Profitability Analysis (CPA)
• Distribution Channel Profitability (DCP)
• CGMA Cost Transformational Model
• Pareto Analysis
• Traditional Costing Methods
• Marginal Costing
• Marginal costing is the accounting system in which variable costs are charged to cost
units and fixed costs of the period are written off in full against the aggregate
contribution.
• In marginal costing, closing inventories are valued at marginal (variable) production
cost.
• Absorption Costing
• Absorption Costing is a means of incorporating a fair share of indirect costs incurred
in the production process into the cost of a unit of a product or a service provided in
addition to the variable cost included in a product.
• In absorption costing, closing inventories are valued at full production cost.
 ISSUES IN THE TRADITIONAL COSTING
SYSTEM
1. Not suited for modern environment
When Absorption Costing was developed:
• Direct Material & Direct Labour was fairly large compared to Overheads
• Small number of Products with similar resource requirements
• Labour Centered Manufacturing

But now (With Industrial Revolution)

• More OH compared to Direct Cost
• More Products in the portfolio with different resource requirements
• Machine Centered Manufacturing
• Due to that the OAR‟s would be more than 100 times labour. This questions the applicability of
the traditional costing to the modern environment
2. It doesn’t give a proper understanding of the cost structure of the organization and what drives the cost
Traditional Absorption Costing assumes that all costs are driven by one Cost Driver (Absorption Basis which is
either Machine hours, Labour hours, DM Cost, DL Cost, Prime Cost & Units).

3. Over Costs High Volume Products & Under Costs Low Volume Products
E.g:
Product Volume OH Cost (Rs)
Product 1 200 1000
Product 2 500 1000
Product 3 1000 1000
If Absorption Costing is used the FOAR = 3000/1700 = 1.76 per unit
OH Absorbed Per Unit Actual OH Per Unit
Product 1 1.76 5
Product 2 1.76 2
Product 3 1.76 1
4. Would lead to set prices without considering the actual resource consumption. This
would lead to accepting loss making orders and rejecting profit making orders. Difficult
under competition.

5. Unable to defend prices if challenged by the customers

6. Difficult to identify areas of unnecessary spending and create strategies to act on them

7. Cannot be used for Outsourcing Decisions

With the above problems a more refined technique was developed known as “Activity
Based Costing”
Activity Based Costing
“Any Cost is variable if you can identify the correct cost driver”

• The main purpose of ABC is to allocate the OH based on various activities. It attempts to identify the direct link
between the cost & the product. ABC assigns cost to products or services using the basis of their consumption of
various activities within the organization.

• A cost pool is an activity that consumes resources and for which overhead costs are identified and allocated. For each
cost pool, there should be a cost driver.
• A cost driver is a unit of activity that consumes resources. An alternative definition of a cost driver is a factor
influencing the level of cost. Imagine
Steps of ABC

• Identify the Activities

• Assign Costs Pool to Activities

• Determine the “Cost Driver”

• Cost per Cost Driver

• Charge to Products
• Cost Drivers should be:
1. Relevant
2. Easy to Measure

Identifying Activities:
i. Unit Level – Quality Checking
ii. Batch Level – Machine Set up Cost, Cost of mould (E.g.: Plastic)
iii. Product Level – Product Design, Product Re-engineering
iv. Customer Level – Equipment Installation Cost (E.g.: Cable TV)
v. Region Level – Tower Maintenance (Mobile Industry)
vi. Organization Level – Rent, Electricity etc.
COST POOL COST DRIVER COST PER COST
DRIVER
MACHINE COST POOL MACHINE HOURS MACHINE COST /
MACHINE HOURS
MACHINE SET UP COST POOL NO OF PRODUCTION RUNS SET UP COST/ PROD.
RUN
QUALITY INSPECTION COST POOL NO OF INSPECTIONS QI COST/INSPECTION

ASSEMBLY COST POOL TOTAL ASSEMBLY HOURS ASSEMBLY COST/HOUR

WAREHOUSING COST POOL DELIVERED CUBIC METERS WAREHOUSING

COST/CUBIC METER
CUSTOMER SERVICE COST POOL NUMBER OF CUSTOMERS CUSTOMER SERVICE
COST/ CUSTOMER
FACILITIES COST POOL NUMBER OF EMPLOYEES FACILITIES COST/
EMPLOYEE
QUESTION 1
A company manufactures 2 products L & M, using the same equipment and similar processes. An extract of the production data
for these products in one period is shown below.
. L M
• Quantity Produced (Units) 5,000 7,000
• Direct Labour hours per unit 1 2
• Machine Hours per unit 3 1
• Set ups in a period 10 40
• Orders handled in the period 15 60
Overhead Costs for the period is as follows:
• Relating to machine activity $ 2,200,000
• Relating to production run set ups $ 200,000
• Relating to handling orders $ 450,000
• Required to calculate the production overhead charged to one unit of each product using

1. Traditional Costing method using direct labour hour rate to absorb overheads
2. ABC, using suitable cost drivers to trace OH to
ANSWER 1
Traditional method
OAR=B.O.H/B.A.L=2200000+200000+450000/(1*5000+2*7000)
=$150/LH
L M
Overhead 1hr*150=$150 2hr*150=300
ABC SYSTEM
L M
Machine activity= $2200000/(3*5000+1*7000)
=$100/MH 3*$100=$300 1*100=$100
Production run set up=$200000/(10+40)
=$4000/set up (4000*10/5000)=$8 ( 4000*40/7000 ) =$22.85
Handling order =$450000/15+60
=$6000/order (15*6000/5000)=$18 (60*6000/7000)=$51.43
COST PER UNIT =$326 =$173.28
• A manufacturing business makes a product in two models, model M1and model M2. details of the two products are as follows
QUESTION 2 Model M1 Model M2
• Annual sales 8,000 units 8,000 units
• Number of sales orders 60 250
• Sales price per unit $54 $73
• Direct material cost per unit $11 $21
• Direct labour hours per unit 2.0 hours 2.5 hours
• Direct labour rate per hour $8 $8
• Special parts per unit 2 8
• Production batch size 2,000 units 100 units
• Setups per batch 1 3
 $ Cost driver
• Setup costs 97,600 Number of setups
• Material handling costs 42,000 Number of batches
• Special part handling costs 50,000 Number of special parts
• Invoicing 31,000 Number of sales orders
• Other overheads 108,000 Direct labour hours
A customer has indicated an interest in placing a large order for either model M1 or M2, and the
sales manager wished to try to sell the higher priced model M2.

(a) Calculate the profit per unit for each model, using ABC.
(b) Using the information above identify which product the sales manager should try to sell on the
basis of the information provided by your ABC analysis.
Advantages of ABC
1. More accurate CPU which would improve pricing, sales strategy, decision making, performance management etc
2. It provides a much better insight to what drives the cost
3. Overheads can be controlled by controlling the drivers
4. Unlike absorption costing, it can be used for non-production OH as well
5. Can be used in service organizations
Disadvantages of ABC
1. Expensive to implement
2. Complex process and hard to explain to the stakeholders
3. Difficult to design a system to perfectly capture correct activities and corresponding drivers
• a. Difficult to identify activities to capture overall organization
• b. Difficult to identify the “Cost Pool” corresponding to the activities
• c. Difficult to identify a single correct driver for each activity and collect information on a routine basis for that
driver
4. All overheads may not be allocated to a specific activity.
• Activity Based Budgeting
• • ABB is 'a method of budgeting based on an activity framework and utilizing
cost driver data in the budget setting and variance feedback processes'
• Activity Based Management (ABM)
• Definition
• ‘A System of management which uses activity based cost information for a
variety of purposes including cost reduction, cost modelling and customer
profitability analysis.’ (CIMA Official Terminology).
• Organizations that design and implement ABM has the following information
outputs.
• Facts …
• Support from the top management is mandatory for ABM
• ABM requires investments in the form of both costs and time
• ABM empowers employees and takes a critical step beyond ABC by recognizing the
contribution made as key resources of the organization.
• ABM leads to good team work and enhanced quality control
• ABM only focuses on reducing non-value activities, but exploits methods of eliminating
nonvalue activities. (e.g. In an ideal scenario, customer complaints could be eliminated by
identifying the cause for customer complaints)
• ABM aids high level decisions such as the discontinuation of non-profitable product lines
• ABM provides insights on the effect on the cost structure due to a change in strategy (e.g. the
impact of witching from large scale/batch production to small scale/customized production)
• In depth cost driver analysis enables companies to develop the linkages between cost drivers
and work towards differentiating from competitors
• Direct Product Profitability (DPP)
• Definition
• Direct Product Profitability involves the attribution of both the purchase price and other indirect costs (for
example distribution, warehousing and retailing) to each product line. Thus a net profit, as opposed to a gross
profit, can be identified for each product. The cost attribution process utilizes a variety of measures (for example
warehousing space and transport time) to reflect the resource consumption of individual products'.
• (CIMA Official Terminology)
• Retail organizations traditionally deducted the bought in cost of the good from the selling price to give a gross
margin. The gross margin is a useless measure for controlling the costs of the organization itself or making
decisions about the profitability of different products. This is because none of the costs generated by the retail
organization itself are included in its calculation.
• DPP is one relatively new way of spreading overheads in retail sector.
• In recent years DPP has evolved considerably in parallel with activity based costing. DPP has become much
more sophisticated and is now very similar to activity based costing. One of the reasons for its development
during has been the development of EPOS and EFTPOS (electronic point of sale and electronic funds transfer
point of sale) systems that have enabled access to the detailed data needed for direct product cost and
profitability calculations.
• Direct Product Profitability Computation
Selling price 1.50
Less: bought in price (0.80)
Gross margin 0.70
Less: Direct product costs
Warehouse costs .16

Transport costs .18

Store costs .22

Inventory Financing cost .04 (0.60)

Benefits of DPP

Direct product profit 0.10

• Better cost analysis

• Better pricing decisions

• Better management of store and

warehouse space

• The rationalization of product

ranges

• Better merchandising decisions

• Customer Profitability Analysis (CPA)
• ‘The analysis of revenue streams and service costs associated with specific customers or customer groups'
(CIMA Official Terminology)
• CPA provides important information which allows an organization to determine which classes of customers it
should concentrate on, and, the prices it should charge for customer services. Its use ensures that those customers
contributing sizably to the profitability of the organization receive a comparable amount of attention from the
organization.
• Profitability can vary widely between different customers because various overhead costs are, to some extent,
variable and customer driven. (E.g. Discounts, distribution, sales force, promotions, quality control, financing
cost, merchandising, enquiries)
• Conceptualization
• A hotel may have activities that are provided for specific types of customers, such as well laid out gardens, a
swimming pool and a bar.
• Older guests may appreciate and use the garden, families the swimming pool and business guests the bar.
• If the activities are charged to the relevant guests a correct cost per bed occupied can be calculated for this type
of category. This will show the relative profitability and lead to strategies for encouraging the more profitable
guests.
• Distribution Channel Profitability
• (DPP)
• Distribution Channel Profitability
• Both costs and revenues are driven not only by products but also by distribution channels
chosen. The channels profitability differs due to different cost incurred or different sales
volume. In order to select the right channels entity should understand their profitability
profiles.
• The channel a company selects is therefore a critical driver to business profitability. A
company should not only aim to satisfy the needs of the customer but must also ensure that
the products and services that they are providing are profitable.
• Activity based costing information makes this possible because it creates cost pools for
various activities. Channels will use some activities but not all, and different channels will
have different ‘activity profiles’. This makes channel profitability analysis possible and
allows companies to build up distribution channel profitability profiles.
• Factors to be considered when selecting a channel
• Access to customer base
• Brand awareness
• Competitiveness
• Achieving sales and market targets Direct Channels Indirect Channels

Sales teams Wholesalers

• Speed of payment Telephone Retailers
Internet Agents
Company owned stores Re-sellers
• Pareto Analysis
• Pareto analysis is based on the 80:20 rule that was a phenomenon first observed by Vilfredo Pareto, a
nineteenth century Italian economist. He noticed that 80% of the wealth of Milan was owned by 20% of
its citizens
• Applicability
• The Pareto phenomenon often shows itself in relation to profitability. Often around 80% of an
organization’s contribution is generated by 20% of the revenue.
• Instead of analysing products, customers can be analysed for their relative profitability to the
organisation. Again, it is often found that approximately 20%of customers generate 80% of the profit.
There will always be some customers who are less profitable than others, just as some products are less
profitable than others.
• In inventory control it may be found that only a few of the goods in inventory make up most of the value.
• Another study might relate to activity based costing and overheads. It may show that 20% of an
organisation’s cost drivers are responsible for 80% of the total cost. By analysing, monitoring and
controlling those cost drivers that cause most cost, a better control and understanding of overheads will
be obtained.
CGMA Cost transformation model
The CGMA cost transformation model is designed to help businesses to achieve and
maintain cost competitiveness
THANK YOU