Funny story about Activity Based Costing.

I confess, I did not write the following. If whoever did sees this and contacts me I will give full credit to that person.


Nevertheless it is a good story and illustrates very well the issues with product costing and the like. I don't hear much about activity based costing these days, but product costing is alive and well. The problems described below are real no matter what you call the method to arrive at a product cost.

In discussing the costs incident to various types of operations, the analogy was drawn of the restaurant, which adds a rack of peanuts to the counter, intending to pick up a little additional profit in the usual course of business. However, the accuracy of the analogy is evident when one considers the actual problem faced by the Restaurateur (Joe) as revealed by his Accountant-Efficiency Expert (Eff. Ex.)

EFF. EX. Joe, you said you put in these peanuts because some people ask for them, but do you realize what this rack of peanuts is costing you?

JOE It ain't gonna cost. 'Sgonna be a profit. Sure, I hadda pay $25 for a fancy rack to holda bags, but the peanuts cost 6 cents and I sell 'em for 10 cents. Figger I sell 50 bags a week to start. It'll take 12 weeks to cover the cost of the rack. After that, I gotta clear profit of 4 cents a bag. The more I sell, the more I make.

EFF. EX. That is an antiquated and completely unrealistic approach, Joe. Fortunately, modern accounting procedures permit a more accurate picture which reveals the complexities involved.

JOE Huh?

EFF. EX. To be precise, those peanuts must be integrated into your entire operation and be allocated their appropriate share of business overhead. They must share a proportionate part of your expenditures for rent, heat, light, equipment depreciation, decorating, salaries for your waitresses, cook,...

JOE The cook? What'sa he gotta do wit'a peanuts? He don' even know I got'em!

EFF. EX. Look, Joe, the cook is in the kitchen, the kitchen prepares the food, the food is what brings people in here, and the people ask to buy peanuts. That's why you must charge a portion of the cook's wages, as well as a part of your own salary to peanut sales. This sheet contains a carefully calculated cost analysis which indicates the peanut operation should pay exactly $1,278 per year toward these general overhead costs.

JOE The peanuts? $1,278 a year for overhead? The nuts?

EFF. EX. It's really a little more than that. You also spend money each week to have the windows washed, to have the place swept out in the mornings, and to keep soap in the washroom. That raises the total to $1,313 per year.

JOE (Thoughtfully) But the peanut salesman said I'd make money -- put'em on the end of the counter, he said -- and get 4 cents a bag profit.

EFF. EX. (With a sniff) He's not an accountant. Do you actually know what the portion of the counter occupied by the peanut rack is worth to you?

JOE Ain't worth nothing - no stool there - just a dead spot at the end.

EFF. EX. The modern cost picture permits no dead spots. Your counter contains 60 square feet and your counter business grosses $15,000 a year. Consequently, the square foot of space occupied by the present rack is worth $250 a year. Since you have taken that area away from general counter use, you must charge the value of the space to the occupant.

JOE You mean I gotta add $250 a year more to the peanuts?

EFF. EX. Right. That raises their share of the general operating costs to a grand total of $1,563 per year. Now then, if you sell 50 bags of peanuts per week, these allocated costs will amount to 60 cents per bag.

JOE What?

EFF. EX. Obviously, to that must be added your purchase price of 6 cents per bag, which brings the total to 66 cents. So you see, by selling peanuts at 10 cents per bag, you are losing 56 cents on every sale.

JOE Something's crazy.

EFF. EX. Not at all. Here are the figures. They prove your peanut operation cannot stand on its own feet.

JOE (Brightening) Suppose I sell lotsa peanuts - thousand bags a week 'stead a fifty?

EFF. EX. (Tolerantly) Joe, you don't understand the problem. If the volume of peanut sales increases, your operating costs will go up. You'll have to handle more bags, with more time, more depreciation, more everything. The basic principle of accounting is firm on that subject: "The Bigger the Operation, the More General Overhead Costs that Must be Allocated." No, increasing the volume of sales won't help.

JOE Okay, you're so smart, you tell me what I gotta do.

EFF. EX. (Condescendingly) Well -- you could first reduce the operating expenses.

JOE How?

EFF. EX. Move to a building with cheaper rent. Cut salaries. Wash the windows bi-weekly. Have the floor swept only on Thursday. Remove the soap from the washrooms. Decrease the square foot value of your counter. For example, if you can cut your expenses 50%, that will reduce the amount allocated to peanuts from $1,563 down to $781.50 per year, reducing the cost to 35 cents per bag.

JOE (Slowly) That's better.

EFF. EX. Much, much better. However, even then you would lose 26 cents per bag if you charge only 10 cents. Therefore, you must also raise your selling price. If you want a net profit of 4 cents per bag, you would have to charge 40 cents.

JOE (Flabbergasted) You mean after I cut operating costs 50%, I still gotta charge 40 cents for a 10 cent bag of peanuts? Nobody's that nuts about nuts. Who'd buy 'em?

EFF. EX. That's a secondary consideration. The point is at 40 cents, you'd be selling at a price based upon a true and proper evaluation of your then reduced costs.

JOE (Eagerly) Look! I got a better idea. Why don't I just throw the nuts out -- put 'em in a trash can?

EFF. EX. Can you afford it?

JOE Sure. All I got is about 50 bags of peanuts -- cost about three bucks -- so I lose $25 on the rack, but I'm outa this nutsy business and no more grief.

EFF. EX. (Shaking head) Joe, it isn't quite that simple. You are in the peanut business! The minute you throw those peanuts out, you are adding $1,563 of annual overhead to the rest of your operation. Joe, be realistic -- can you afford to do that?

JOE (Completely crushed) It'sa unbelievable! Last week, I was gonna make money. Now, I'm in a trouble -- justa because I think peanuts on a counter is a gonna bring me some extra profit -- justa because I believe 50 bags of peanuts a week is a easy.

EFF. EX. (With raised eyebrow) That is the object of modern cost studies, Joe, to dispel false illusions

Technorati Tags: ABC, Accounting, Cost, Cost Accounting, Costing, Efficiency, Finance, Full Absorption Costing, Shareholder Value Add, SVA, Theory of Constraints, TOC

THE FUNDAMENTALLY FLAWED THINKING BEHIND activity based costing II

"We would stand a better chance of success if we gutted a farm animal and read its entrails."

Prof Caspari responds to Tony's article and checks (including through a simulation) whether or not Tony's claim is correct. Read the post, the answer comes towards the end.

OF FARM ANIMALS AND abc

Copyright (c) John A. Caspari, 1998; All rights reserved

PREFACE

John Caspari was an independent educator focused on the accounting measurement issues associated with implementing the Theory of Constraints (TOC). He died about 4 years ago (2007). Prior to focusing on TOC, he taught cost and management accounting and accounting information systems on the undergraduate and graduate levels. He has been a consultant in databased application systems since 1981. In addition to administrative experience as a university

department chair of an accredited accounting program, John served as an administrative contracting officer and has experience as a corporate controller.

John majored in Philosophy, emphasizing logical applications, at Washington University in St. Louis and then pursued graduate studies in accounting, receiving both masters and doctoral degrees in accountancy from the University of Missouri at Columbia. He is a Certified Management Accountant (CMA) and a "Jonahs’ Jonah".

The Theory of Constraints first attracted John’s interest in 1985 when Eli Goldratt made his famous "Cost Accounting: Public Enemy Number One of Productivity" presentation at the IMA convention. This was a time when academic and cost accountants were just realizing that their product costing systems were so flawed as to be causing devastating results in "the new manufacturing environment." After detailed study of the Theory of Constraints, he concluded that a great deal of what he was teaching was fatally flawed – for reasons that had never entered his mind!

He was concerned by the fact that most TOC implementations do not even come close to realizing the potential benefits of the philosophy. For many years he felt that the best thing that the accountants could do for a TOC implementation was to provide a "direct costing" type of information and otherwise keep out of the way.

"... clearly placed the management accountant in TOC as a necessary condition for success*. - Finance and Administration Manager
* for success are the blog owners editing. 

John believed that the full participation of the financial reporting function is a requirement for a successful TOC implementation. His Constraints Accounting seminar provides the opportunity for financial managers to accelerate the process of overcoming the inertia of traditional management accounting thinking. His POOGI Bonus seminar shows how individual goals can be aligned throughout the organization to support a process of ongoing improvement.

John's excellent book (written together with Pamela Caspari), "Management Dynamics; Merging Constraints Accounting to Drive Improvement" is a valuable addition to every manager's library. (ISBN 0-471-67231-9). Chapter 6 of John and Pamela's book goes into the question of pricing, probably a place to go to in order to  understand pricing and the possibilities better.

The article below asks several questions that were asked as a result of Tony Rizzo's article of the same title. The questions are repeated in John's text. Tony Rizzo's article resulted in considerable discussion. The complete discussion can be found here: http://casparija.home.comcast.net/~casparija/dweb/l118.htm

Enjoy!

INTRODUCTION

The issues associated with cost accounting have been an ongoing topic for the TOC discussion group. Three aspects of these discussions are activity based costing (represented by Tony Rizzo's paper entitled "THE FUNDAMENTALLY FLAWED THINKING BEHIND activity based costing"), cost based pricing illustrated by Stephane Mercier's queries), and cost allocation in general (exemplified by Tom McMullen's Detective Columbo and his chorus).

Tony's paper made the recommendation (or perhaps it was a 'speculation' or an 'hypothesis') that "it would be better to slaughter a farm animal and read its entrails than to use activity based costing" for decision-making. This resulted in a few folks saying "Great paper, Tony!" and others suggesting that Tony tone down his language. But NOBODY responded directly to the substance of Tony's recommendation. Neither confirming nor disconfirming instances have been presented.

Thus, there is a need to test Tony's hypothesis, respond to Stephane, and educate Columbo.

So, this post first addresses Detective Columbo's question: Why do we allocate costs to some product -- even when there is no volume linkage between the costs and the product?

“Crap” Pricing

“Crap” means rock in Rumantsch the 4th national language of Switzerland

To set a product’s price is a difficult job. The manager doing the job is expected to consider many parameters for a successful price. He should include the expected demand in targeted market segments, competition, the products value, product cost and the expected profits from the product. This an easy list to write, but very difficult to deal with since each parameter influences the rest and since profit depends not only on price, but also the volume sold. How should prices be set?

"We would stand a better chance of success if we gutted a farm animal and read its entrails."

Tony Rizzo wrote this article in 1997 and you can find it here on John Caspari's site: http://casparija.home.comcast.net/~casparija/dweb/l118.htm.
I thought it would be worthwhile to reproduce this article here. It caused a lot of discussion way back then (in 1997) and maybe it will again. Tony is an engineer but he understands systems very well!
John Caspari ran simulations to test Tony's theory about farm animals and reading entrails. That will make an interesting post too.

THE FUNDAMENTALLY FLAWED THINKING BEHIND activity based costing

By: Tony Rizzo
tocguy@lucent.m
tocguy@home.com

(C) Tony Rizzo, 1997

I want to begin not by discussing activity based costing (please note that the very name of it is unworthy of capital letters) but by discussing a technical subject, Design Of Experiments (DOE). If your educational background is not in a technical field, and if you feel that this discussion is likely to be too technical and too difficult for you to understand, then you're probably correct. Stop reading now, and expose your organization to the debilitating effects of serious, random mistakes. However, if you want to really understand why every company that is managed according to the philosophy of activity based costing can never achieve performance levels beyond the mediocre, then please keep reading.

Retail – Is Shelf Space Wasted?

Every shop selling items to consumers has the same set of problems. The visible problem is surpluses of products clients apparently don’t really want. These will sooner or later result in steep discounts and write-offs. The invisible one is shortages of products that clients do want but have to find in a competitor’s shop. Both problems send consumers consciously or unconsciously to those shops where consumers have the highest chance to find what they desire.

The Retailer’s Limiting Factor (Constraint)

The number of clients that want to buy products from the retailer’s shop determine his sales and income. The limiting factor or constraint of every retailer is the number of clients he manages to entice into his store.

The more potential clients, in other words the higher the traffic, a shop has the higher sales and profits will be. Store traffic is what drives profits and every store manager and retailer’s primary concern is how to get more people into his store(s). The choice of products, the best possible location, promotions, advertising and window dressing are all designed to entice consumers into the shop. Every one of these tactics is a way to “exploit” the constraint – the number of customers that enter the store.

The limiting factor (constraint) of every retailer and shop is therefore the consumer traffic in the store(s).

Get the Most from Consumer Traffic in your Shop

Merchandisers spend a great deal of time and effort developing what the hope will be attractive products and offers for consumers. Since they have to decide well in advance they must forecast or guess what will actually attract the consumer – what products, what prices, what colours what sizes and many other parameters. Particularly fashion products (those that change from season to season) are difficult to forecast. Orders for fashion products are placed well before the first sale will be made. A good merchandiser, one that makes good decisions year in and year out is worth his or her weight in gold.

Most retailers and their merchandisers are not fully aware of the penalties of product surpluses and product shortages.

Surpluses take away shelf space from popular items, which damages sales. Surpluses must be discounted to recoup at least the investment made in the stock. Discounting blocks full price sales in three ways – a discounted sale removes the need for the article, discounts and the associated promotions tend to block popular items from view and consumers learn from experience that it is worth it to wait until discounting begins.

Shortages are not usually measured – a sold out item is celebrated as a success while the associated missed sales are often forgotten.  Every extra 100€ of full price sales brings around 50€ to the bottom line. If shortages are about the same quantity as surpluses (say 30% of sales) they represent an enormous loss to the retailer and, at the same time, an enormous potential for bottom line improvement.

Decisions on product, style, price etc. will all remain very important. The decision to have the right products in the right place has already been made by every retailer. How to do this is the concern of every retailer and their merchandisers. So far, from all the evidence of discounts and factory outlets the problem has not been solved. It looks as big a problem as it always was.

Subordinate the Organisation to the above Decision

(The decision is: to have the right products in the right place has already been made by every retailer)

The retailer’s organization, including their suppliers, should take those actions necessary to ensure the right products are in the right place at the right time. This is where most retailers seem to get it wrong. Local optimisation is the culprit. Merchandisers are measured by the prices they achieve. The supply chain is measured by the cost of shipping. Suppliers are under pressure to deliver at the lowest possible cost. It is easy to see how operating decisions are based on cost leading the biggest possible production and shipping batches. Products are often bought to cover the entire season in order to achieve the lowest possible delivered cost. This thinking forgets all about the cost of surpluses and shortages.

This focus on delivered cost is the source of the huge penalties in shortages and surpluses. These penalties are a big multiple of the costs savings due to big batches.

Shouldn’t the supply chain must be charged with minimizing shortages and surpluses first and production and shipping costs second.

Expand

Once the supply chain has reduced shortages and surpluses customers will soon learn that the retailer’s shop is a good place to visit. There is a high chance the consumer will find what he is looking for. Customer loyalty will increase – more clients will be gained than lost. Traffic in shops increases.

Consumers talk to each other. If performance is maintained word of mouth will bring more and more clients to the store. The shop has exploited and expanded its constraint – traffic in the store.

Since profits are so dependent on store traffic the retailer’s returns should soon be far beyond the usual industry returns.

Will the Limiting factor (Constraint) Ever Move?

It is unlikely the supply chain will ever become the constraint. The retailer’s job remains the same – what should be the next step to draw even more clients into his shops.

Maybe a closer partnership with his suppliers – to be able to decide production plans much later and much closer to the real consumer demand.

A shop’s space is limited. It can stock only whatever actually fits comfortably into that space. It is essential that every meter of space produce the highest possible turnover (or sales). Is there a way to partner with suppliers to make sure every shelf has only fast moving popular items on it? How close can a shop get to such an ideal?

How much can shelf returns be improved by thinking just a little bit differently?

 

 

Technorati Tags: Consumer, Cost, Costing, Distribution, Inventory, Make to Stock, Management, MTS, Production, Replenishment, Retail, Sales, Strategy and Tactics, Supply Chain, Theory of Constraints, TOC