Activity Based Management Sail Rite

(Marine tools Industry)

CPM Assignment 1

8/15/2015
IIM INDORE
SOMA BANIK (2014PGP370)

Activity Based Management Industry Implementation

INTRODUCTION TO ABM

Product
ABC allocation
Burger
1000 x 8/10 = 800
Cola
1000 x 2/10 = 200
Cost Driver
Machine runs
Burger
800/50 =Rs 16
Cola
200/50 = Rs 4
takes 8 hours to produce burger and only 2
hours for cola. Thus it does not make sense
to assign overhead costs of Rs 500 each to
burger and cola. This problem mentioned
above is explained diagrammatically to get
clarity on ABC.

[5]

Activity based management is a method

that analyzes how a company incurs costs
from its activities that are driven by cost.
For this purpose, activity based costing
plays a major role in proportionately
distributing the manufacturing overhead
costs over products in a logical manner.
Activity analysis, cost driver analysis and
performance analysis are the key
dimensions of management under ABM.

Hence the unit cost becomes Rs 10 for both

burger and cola. This is not a right way of
splitting overhead costs since we do not
know how much out of the total 10 hours of
machine run activity was given to making
burger and how much to cola. ABC method
defines costs based on activities, machine run
hours in this scenario. There are usually
many activities and cost drivers. So here we
find out that 8 hours are assigned to burger
and 2 hours to cola making. Thus we assign a
higher cost share of 800 to burger and 200 to
cola, making the unit cost for burger as Rs 16
and that of cola as Rs 10. This helps the
shopkeeper to come to a decision making
that burgers need to be sold at a higher price
than cola, since the costs incurred to produce
it are more.

An easy example to first explain the ABC

concept and its importance is the burger
and cola example. If a small shop sells
burger and cola and the total time it takes
to prepare the items is 10 hours daily for
equal quantities of burger and cola, say 50,
then the total cost incurred to produce
these items is say Rs 1000. The traditional
costing method assigns a unit cost of
1000/100 = Rs10 to both burger and
cola(since number of units produced for
both are same). But if we look at the actual
machine run hours devoted to making
burger and cola, we find that the system

By analyzing the relation between

activities and their costs, ABM helps a
companys management to determine
which activities contribute to productive
efficiency and which do not. ABM also
helps
making
decisions
between
profitable and unprofitable product lines,
which ones to be stopped and which ones
to be invested on.

flagship product, sewing machines. It

started in 1969 and slowly began
diversification into not only boats but
also home fabrics.

WHY ABM?
[2]

1. Desire to improve cost accuracy

2. To know the true profitability
3. Desire to know value added and
non value added costs
4. Better analyze the ROI from
different projects
5. Support pricing decisions of final
products

Sail Rite believes the cost of its

manufacturing equipments are costly
and it is essential that they keep a
count on which material is used in
which activity to produce what
product. Hence Sail Rite has recently
dived into ABC costing. Sail Rite has a
5-step methodology to ABM.

[3]

As on 2014, national surveys have

reported that the highest percentage of
companies using ABC is in the
manufacturing
sector
(20-50%)
followed by financial services (25%),
public
sector
(20%)
and
communications. After doing a
literature reading on some of the
existing research papers, it is found
that ABC costing has been the base for
cost calculations in many emerging
industries, the new ones being the
hospital, medicine and airline industry.
Every company has adopted the ABC
and made modifications to it to suit to
their organizational needs and goals.
However, the basic steps of ABC
remain the same, being

Before ABC, Sail Rite was aware that

the total overhead costs in the
company were around $8 million.
After evaluating the balance sheets and
other
financial
statements,
the
company accountant came up with the
following activity list:Step
1:
Identifying
activities
contributing to overhead costs
1.
2.
3.
4.
5.

Purchasing materials
Machine set ups
Machine runs
Assembly of products
Inspecting finished goods

Step 2: Assigning overhead costs to

the activities

1. Identifying the cost object

2. Identifying the direct and overhead
costs
3. Selecting the activities and cost
allocation base for assigning cost
overheads to the cost object
4. Developing the overhead rate per
unit for allocating overhead to the
cost object

Activity

Purchasing
materials
Machine set ups
Machine runs
Product assembly
Finished products
inspection
Total

ABM ANALYSIS OF SAIL RITE

[1]

In this report, I will be discussing the

ABM model of a company called
SailRite. This is owned by Matt and
Hallie Grant and a full stock online
retailer of fabrics, tools, kits and their
3

Estimated
Annual
Overhead cost
$1.2 M
$1.6 M
$2.7 M
$1.5 M
$1 M
=$8M

Activity Based Management Industry Implementation

Step 3: Identifying the cost driver for

each activity in step 2

Step 5: Allocating overhead costs to

products as per their utility

A cost driver is a cause for cost for a

particular activity. It can also be imagined
as the unit of measurement of cost for any
activity. The following cost drivers were
identified for Sail Rite activities:-

The total annual cost driver utilization

calculated in the last column of step 3 is
not used and the total cost is split between
activities that have used it. In this example,
the company had allocated these cost
driver usages to 2 major product lines
Basic Sailboat and Deluxe Sailboat.

Activity

Cost driver

Purchasing
materials
Machine set
ups
Machine runs

Purchase
orders
# setups

Product
assembly
Finished
products
inspection

Machine
hours
Direct labor
hours
Inspection
hours

Annual cost
driver usage
10,000 orders

Activity

2,000 setups

Purchasing
materials
Machine
set ups
Machine
runs
Product
assembly
Finished
products
inspection

90,000 hours
250,000
hours
20,000 hours

The above information table shows an

estimate of level of activity, which is
further used to calculate activity rates in
the next step. We have still not allocated
the overheads to final products.

Overhead Rate = Overhead cost/Level of

cost driver activity

Overhead
costs
Purchasing
materials
Machine set
ups
Machine
runs
Product
assembly
Finished
products
inspection
Total

Overhead Cost driver Overhead rate

costs
activity
$1.2 M
$10,000
120 per order
orders
$1.6 M
2,000 setups 800 per setup

$1.5 M
$1 M

Deluxe
Sailboat
3000
orders
900
setups
40,000
hours
50,000
hours
8,000
hours

Total
10,000
orders
2000 setups
90,000
hours
250,000
hours
20,000
inspection
hours

The overhead costs are now allocated

based on the above table to the respective
products based on the proportion of the
activity they have utilized during
production (step 4 overhead rate x step 5
allocations of cost driver activity)

Step 4: Calculate a pre-determined

overhead rate for each activity

$2.7 M

Basic
Sailboat
7000
orders
1100
setups
50,000
hours
200,000
hours
12,000
hours

90,000 hours 30 per machine

hour
250,000
6 per labor hour
hours
20,000
50 per
hours
inspection hour

Basic
Sailboat
120x7000=
840,000
800x1100=
880,000
30x50000=
1,500,000
6x200,000=
1,200,000
50x12,000=
600,000

Deluxe
Sailboat
360,000
720,000
1,200,000
300,000
400,000

5,020,000
2,980,000
$8,000,000

The overhead cost hence calculated is divided by the total number of units of basic and
deluxe sailboats which are 5000 and 1000 respectively. The overhead unit cost hence comes
out to be
Basic Sailboat = 5.02M/5000 = $1,004
Deluxe Sailboat=2.98mM/1000=$2,980
How is the overhead cost per unit per product used further in the benefit of the company? To
answer this question, we already know that a products cost component is split into 3 parts
Direct Labor, Direct Material and Overhead costs (indirect). The following information about
direct costs is given about Sail rite:-

Sail Rite was initially selling the basic boats at a price of $3,200 gaining a profit of 32002604=$596 and deluxe boats at a price of $4,500 having a loss of 5030 4500 = $(530).
With traditional costing, the step 5 would have looked like the following:Total costs = $8,000,000
#basic units = 5000 ; #deluxe units = 1000; #unit cost = 8,000,000/6,000=$1,333 per unit
The above table of unit production cost would have then looked like :DM + DL costs per unit
Overhead costs per unit
Total

Basic Sailboat
1600
1333
2933

Deluxe Sailboat
2050
1333
3383

By selling Basic at $3500, Sail rite thought it was making a profit of 3500 2933 = $517.
By selling Deluxe at $4500, Sail rite thought it was also making a profit of 4500 3383 =
$1117
Actual profits through ABC costing vs expected profits through traditional costing
Traditional profits
ABC profits (real)

Basic Sailboat
$517
$596

Deluxe Sailboat
$1117
($530) - loss

Hence ABC costing protected the company by helping them decide a price point for deluxe to
make the product profitable, where it had to charge the customer a value greater than $5030.

Activity Based Management Industry Implementation

Recommendations for Sail Rite:[4]

1. Economies of scale are not taken into account in ABC method. For such kind of
industries where there is a possibility of making more production units by utilizing
more resources, a large portion of overhead costs are actually fixed costs which must
be spread proportionately among number of units produced. For example, if 2,000
units of deluxe boats were produced instead of 1000, the product unit cost will vary
accordingly and the new value, say x will now be divided among 2000 units, thereby
reducing the unit production cost. The company then has to dynamically change its
pricing policy since the product can now be sold at a cheaper price with similar or
more profits. Companies must keep this in mind.
2. The number of hours allocated to each activity or product may not lead to efficient
output. Just like if we study for 8 hours a day and achieve some output level, the
same could be achieved in maybe 5 hours if we were more efficient and studied with
more attention. Similarly, actual hours allocated leading to useful production is less
than what is called the expected production level. As a company grows across its
learning curve, it may be able to surpass this disadvantage over time. ABM can
hence take a progressive approach towards this aspect of ABC costing.
3. We should not rely only on numbers only that are derived from ABC techniques. A
strategic goal and vision mission should always be sustained in any solution we
propose. For example, if deluxe boats are currently not profit making and raising the
prices will reduce the demand, we should not simply discard that product line. We
need to find ways to differentiate the deluxe boat so that people are willing to pay a
higher price for it, and simultaneously work on reduction of internal manufacturing
costs over time.

ABM is a strategic approach to

cost management. As the diagram
explains, ABM closes the needs of
short and long range planning in
addition
to
deployment
of
proactive strategy. It is always
aligned to the business model of
the company and sustains the value
proposition explained by the
company. [6]
4. ABM does not give a
holistic view on Economic Value
Added and other opportunity costs
involved in the business. A
scenario planning and analysis
taking each of these costs in
revenue planning could be a
6

Activity Based Management Industry Implementation

recommended option for wider acceptance of ABM. [7]

References:
[1] http://catalog.flatworldknowledge.com/bookhub/reader/4402?e=heisinger_1.0-ch03_s03
[2] http://accountingexplained.com/managerial/cost-allocation/
[3] https://www.business-case-analysis.com/activity-based-costing.html

[4] http://www.brighthub.com/office/finance/articles/78752.aspx
[5] http://www.youtube.com/watch?v=ivlI0HvUPQo
[6]http://www.imanet.org/docs/defaultsource/thought_leadership/internal_measurement_systems/implementing_activity_basedmanagement.pdf?sfvrsn=2
[7]http://www.salient.com/docs/LIT_ABM.pdf