5.3. ABC for a retail firm (2)

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From the course by Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

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Moscow Institute of Physics and Technology

Core Concepts of Accounting – Numbers and People

1 оценка

Course 3 of 5 in the Specialization Understanding Modern Finance

Whenever the word “accounting” is pronounced, it is immediately associated with the need to memorize endless boring numbers. However, it is the common financial statements that contain important information that provides inputs for valuation of investment projects. The only challenge is how to properly extract them. Accounting and finance are indeed intertwined. Sometimes people that are not experienced in the area even mix them up. But most often emphasis in accounting is on numbers. Still, the deep understanding of key accounting concepts helps reveal the interests and actions of people behind these numbers. And the human dimension of accounting adds invaluable insight in the potential of successful project implementation. This Course discusses core ideas and concepts of both financial and managerial accounting. It by no means pretends to be comprehensive to any extent. But, being rather an accounting overview, it focuses on the issues that are most relevant and important for effective valuation of investment projects. The learners will gain insight into the essence of accounting. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses. To pursue a career in accounting, a more detailed study is strongly recommended.

From the lesson

Activity-Based Costing (ABC). Relevant Costs

In Week 5 we will study the more advanced approaches to costing – activity-based costing (ABC) and relevant costs – that provide for the more accurate costing of products, projects, and divisions, and allow to reveal actual relationship between numbers and people. We start with the analysis of ABC on an example of a small retail firm. Then we move on to the more detailed example of the use of ABC in manufacturing. Both examples will help us gain insight in the role of ABC in identifying ways to improve performance. Finally, we analyze the idea of relevant costs and its application to managerial actions –make-or-buy decisions, product mix under capacity constraints, customer profit analysis. Of special attention will be the role of relevant and opportunity costs in valuation.

5.1. Activity-based costing (ABC) – an overview8:38

5.2. ABC for a retail firm (1)9:01

5.3. ABC for a retail firm (2)13:21

5.4. ABC in manufacturing (1)13:37

5.5. ABC in manufacturing (2)13:21

5.6. Insights provided by ABC8:30

5.7. Relevant costs – an idea10:53

5.8. Make-or-buy decisions (1)6:04

5.9. Make-or-buy decisions (2)10:30

5.10. Product mix under capacity constraints8:33

5.11. Customer profit, ABC, and relevant costs7:32

5.12. Irrelevance of past costs10:43

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Now, let's proceed.

The store owner started to think that maybe our cost system is sort of wrong.

Now, the important thing is that

the overall amount of costs wouldn't change regardless of the system.

Remember, these numbers of 6.11% of the total.

This we will not be able to change,

unless we start buying these products cheaper,

or selling them at a higher price.

So, now, we're just talking about redistributing parts of these indirect costs over

product lines that seem to be more consistent

with the amount of resources that we use for that.

So, this is ABC for

a retail store two.

And, first of all,

we have a refined cost system that includes,

first of all, we rethink our direct costs.

We can say, well,

the idea of cost of goods sold,

as a maintenance cost, clearly stays.

But after a further analysis,

they notice that oftentimes there is some bottle returns that also comes as a cost,

but clearly, it should be put only over the sub drink product line,

because that has nothing to do with fresh produce or packaged food.

And before, it would be just spread out over all products of the store.

So, that was the number one thing. So, bottle return.

But a much more serious refinement was in indirect costs.

So, indirect cost pools.

Remember, before we had just one pool and that pool was store support.

Now they said, "Why wouldn't we break this down by activities?"

And therefore, they use the ABC.

So, activity now, this is the cost driver,

and they found the following system.

Now, these are pools,

then these are cost allocation bases,

and again, these are direct costs.

Here, we have the following activities.

We have ordering.

So someone calls from the store and makes an order.

Then, this order is delivered.

So here we have deliveries.

Then, when it arrives,

you have to do shelf stocking.

And finally, everything else,

they put as customer support.

Well, that includes, for example, cashier.

But the important thing is that for these kinds of activities,

there are various cost allocation bases.

For example, for orders, what is that?

The number of orders.

Here, this is the number of deliveries.

Here, this is the number of hours spent for that.

And for customer support,

it is actual items sold.

So this is a more fine tuned system.

So these four pools,

they all contribute to the overall indirect cost.

So here, we have product line as an object.

This is the same diagram that they had before.

So, the top part here is indirect,

and the bottom part is direct.

And before, it was just one.

This is cost of goods sold that is still

here and stays as the more important than the basic one.

For all product lines here,

it's also bottle return.

So now, you can see that this is a much more cumbersome system.

And the question is,

why are we spending our time to do that in such seems to be a turn around the way?

Well, wait just a little bit.

You will see how the system actually results in important findings about that.

Now, the key story is not only to identify these activities,

but also to identify these cost allocation bases.

And then we have just the amount of the cost driver used, for example, ordering.

If we had 10 orders,

then we calculate what is the cost of one order,

and then just multiply by this number.

So, see how this goes.

This is a very important table that we come here.

So this is activity,

or cost driver, or as a cost allocation base that is used.

So, now, this is actual the cost allocation base,

or you can say,

this cost allocation array.

This is per order, per something,

and this is the amount of driver used.

And that is what we do looking at the historical costs.

Now, here we have soft drinks,

fresh produce, and packaged food.

And here like I said,

where I identified ordering,

deliveries, shelf stocking,

and then customer support.

And then, compared to what we did over the last year,

we have calculated like how many orders we had,

how much were paid for that.

And then, we realize that actually this is $120 per order.

This is $100 per delivery.

This is $25 per hour of work.

And this is $0.15 per item sold.

We take these numbers from a past activity.

And now, we'll just see how many of these go to what line.

So we have 18 orders for soft drinks,

30 orders for fresh produce,

and 20 orders for packaged food.

Deliveries, here we had 15,

here we had 90. Well, why is that?

Because fresh produce must be delivered more often because otherwise it just gets rotten,

and you throw it away.

Here, we had 28 shelf stockings,

28 here, 220 here.

Why such a huge amount?

Because you got these strawberries.

Not only do we have to put them on the shelf,

but also keep checking.

If one of the strawberries goes rotten,

you have to remove that and replace by another one,

or otherwise you have to really fix

the price label if there are few strawberries in this basket.

Here, it's 94.

And for customer support,

5,000 items sold here,

41,200 items sold here,

and 12,400 items sold here.

So that's an important thing.

And all that was done in the process of refinement.

To the extent, we identified these activities,

then we started to associate which of these activities they go to these product lines.

And then, with the use of this table,

we can actually refine the cost approach,

and then I did that specifically for you just before.

See what happens here. Now, I put all the numbers in thousands,

because some of them are not round.

So, revenue stays the same for 40,000, 85, 55.

The totals, they don't change.

But see what happens here.

Bottle return goes on for soft drinks,

but this is a small amount.

But ordering, these other numbers, delivery, you can see it.

Ordering, delivery, and shelf stocking,

and customer support for fresh produce they are huge compared to others.

And the total indirect costs,

they happen to be 5,310, 24,280, 9,410.

And in red, I show to you the operating income. See what happened.

Now, the operating income dropped fundamentally for

fresh produce and jumped up for soft drinks.

So now, we see that actually soft drinks and packaged food,

they contribute most to our profitability.

And fresh produce, although has almost half of overall sales,

but look at the contribution to the bottom line,

is just a minor 0.84%.

Why is that so?

Because fresh produce is difficult to deal with.

We spend a lot of time ordering frequently,

delivery very frequently, and then just also dealing with that in the store.

And then maybe for fresh produce,

you have to put them on the balance and weigh them,

and the customer support also take some more time.

Now, see what happens,

looking at these numbers.

Before, our idea, or our advice to the store owner would be,

why wouldn't you order more strawberries?

But now, we can see that it's much better to order

more coke and more order packaged food.

So, you can say, "Well,

maybe these numbers give you an idea that you could do without fresh produce altogether."

But here comes the point that doesn't deal with costs.

Maybe the people who get used to come to this store,

they would also like to pick up a basket of strawberries or blueberries here.

So, you may still have to keep

that fresh produce in

your store to make sure that the people who got used to that still keep coming.

But, unfortunately, this is just to keep your customers,

because you basically don't make money on fresh produce,

just a meager 0.84%.

So, see what happen.

Like I said, this number hasn't changed.

But after having redistributed indirect costs

with respect to these product lines based on activities,

we've been able to reveal the actual contribution of these lines to the bottom line.

And this is a much more realistic thing.

And if for example,

look at that, you could say, "Well,

in order to start making a little bit of money on fresh produce,

we have to probably become pickier in our ordering.

We have to bargain more actively to make sure that this number goes up."

Because, like I said,

we cannot close this line altogether,

but clearly with these numbers we are not very much satisfied.

So, that are the findings of ABC on an example of a retail store.

In the next two episodes,

we will take a look at what happens in a manufacturing company.

That also is not only important,

but sort of even more important,

because this store was sort of a minor thing,

and here you can go without the system or maybe it's sort of cumbersome to come up with.

But in a manufacturing company,

you cannot go without that at all.

So, in the next two episodes we will see how that goes.

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