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How ABC Improves Understanding of
Product and Customer Profitability
Traditional cost accounting assumes that
products and services cause costs to occur.
Therefore, direct labor, direct material and
other direct costs are traced directly to prod-
ucts. All other costs are considered indirect
costs and allocated to products on arbitrary
bases, such as product volume or direct labor
hours. This costing system can work well as
long as indirect costs and product diversity
are minimal. As the product mix becomes
more diverse, it becomes more difficult to
accurately allocate overhead costs.
Activity-based costing assumes that activ-
ities cause costs and that product, services
and customers are the reasons for the activ-
ities. ABC focuses on determining what
causes costs to occur rather than on merely
allocating what has been spent. ABC traces
costs to activities in the production process
using resource drivers and activity drivers
based on cause and effect. There are five
primary steps in the ABC costing process:
i) identify activities;
ii) identify resource measures (inputs) from
the consumption of resources by the
iii) identify activity measures (outputs) by
which the costs of a process vary most
iv) calculate the driver rate; and
v) trace activity costs to cost objects such
as products, processes and customers
based on the usage of activities.
ABC has developed into a broad-based
tool that provides information on many
aspects of company functions in addition
to product cost data. ABC can show how
products, brands, customers, customer
groups, facilities, regions or distribution
channels both generate revenue and use
company resources (Cooper and Kaplan
1991:130). Though not a complete solution
to all business problems, a good ABC system
provides useful information that, in conjunc-
tion with other management information,
can facilitate improved business decision
ABC offers a new way to analyze the allo-
cation of costs to non-production activities
such as marketing, selling, distribution and
administration. Customer profitability is
more easily determined through the use of
ABC, since the costs can be driven directly
to individual customers, some of whom
place more demands on the company than
others. Some may require special orders,
purchase just-in-time inventory, or have
special delivery requirements; each of these
has a cost that can be allocated to the spe-
cific customer using activity-based drivers.
Understanding the needs and costs of each
client, and how each impacts corporate
profitability, can help to determine the level
of customer service that will benefit both
the customer and the company. The special
needs of both large and small customers can
be accommodated through a better under-
standing of the drivers of both the revenues
and the costs associated with each customer
(Kaplan and Cooper 1998:181).
Customer Profitability Analysis
Typically traditional cost accounting is not
able to identify product and service costs or
distribution and delivery costs for individual
customers. ABC can help identify customer
activities and track those costs that are allo-
cated to specific customers. This can provide
management with unique information about
customers and customer segments. The
benefits include:
•protecting existing highly profitable
•repricing expensive services, based on
discounting to gain business with low
cost-to-serve customers;
negotiating win-win relationships that
lower service costs to cooperative
conceding permanent loss customers to
competitors; and
attempting to capture high-profit cus-
tomers from competitors (Kaplan and
Cooper, 1998:181).
Customer profitability analysis has become
an important new management accounting
tool based on a recognition that each cus-
tomer is different and that each dollar of
revenue does not contribute equally to the
firm’s profitability. Customers utilize com-
pany resources differently; thus customer
costs vary from one customer to another.
The following issues should be considered
when analyzing customer profitability:
•how to develop reliable customer rev-
enue and customer cost information.
•how to recognize future downstream
costs of customers.
•how to incorporate a multiperiod hori-
zon in the analysis.
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