# 2.2.1 Tracing of costs to customers

In order to apply the activity-based costing approach it is necessary to identify the cost driver for a particular indirect cost and then establish a cost driver rate for charging the cost to a particular ‘cost object’, be it a product or customer. For example, the cost driver for sales order processing cost might be the number of orders taken. If the total sales order processing cost for a period is £150,000 and the number of orders taken is 1,000, then the cost driver rate will be:

Order processing costs should then be allocated to customers at a rate of £150 for every sales order received from the customer.

## Activity 4 Calculate customer profitability using activity based costing

(This activity is adapted from Glad and Becker, 1995, pp. 57–58.)

Alpha Ltd has three customers: Beta, Gamma and Delta. The management accountant has collected the following data concerning sales, transactions and costs relating to the three customers, as follows:

### Table 3

Beta | Gamma | Delta | |
---|---|---|---|

Sales revenue | £120,000 | £150,000 | £90,000 |

Number of orders placed | 13 | 66 | 39 |

Number of units sold | 300 | 500 | 450 |

Warehouse floor space occupied (square metres) | 30 | 40 | 25 |

### Table 4

Alpha’s indirect costs and cost drivers | |
---|---|

£ | |

Order taking (number of orders taken) | 1,534.00 |

Packing (number of units packed) | 5,250.00 |

Dispatch (number of units dispatched) | 4,312.50 |

Warehousing (cost of floor space occupied by goods) | 1,007.00 |

Account administration (number of orders taken) | 2,242.00 |

The gross profit on sales (based on the standard profit margin) is 30%. The directly traceable service and support costs (consisting of selling, delivery, financing and settlement discounts) for each customer are as follows.

### Table 5

Beta: | £13,120 |

Gamma: | £18,476 |

Delta: | £13,620 |

Using activity based costing, calculate the net profit for each of the three customers.

Note: You can assume that the number of units packed is the same as the number of units dispatched/sold.

### Answer

#### Table 6 Calculation of cost driver rates

Order taking = £1,534/118 | = £13.00 per order |

Packing = £5,250/1,250 | = £4.20 per unit |

Dispatch = £4,312.50/1,250 | = £3.45 per unit |

Warehousing = £1,007/95 | = £10.60 per square metre of floor space |

Account administration = £2,242/118 | = £19.00 per order |

#### Table 7 Customer activity costs

Activity | Beta | Gamma | Delta | |||
---|---|---|---|---|---|---|

£ | £ | £ | ||||

Ord. taking | 13 × £13 = | 169 | 66 × £13 = | 858 | 39 × £13 = | 507 |

Packing | 300 × £4.20 = | 1,260 | 500 × £4.20 = | 2,100 | 450 × £4.20 = | 1,890 |

Dispatch | 300 × £3.45 = | 1,035 | 500 × £3.45 = | 1,725 | 450 × £3.45 = | 1,553 |

W’housing | 30 × £10.60 = | 318 | 40 × £10.60 = | 424 | 25 × £10.60 = | 265 |

Acc. admin | 13 × £19.00 = | Total 247 | 66 × £19.00 = | Total 1,254 | 39 × £19.00 = | Total 741 |

Total act’y traced costs | Total 3,029 | Total 6,361 | Total 4,956 |

#### Table 8 Customer profitability analysis

Beta | Gamma | Delta | |
---|---|---|---|

£ | £ | £ | |

Sales revenue | 120,000 | 150,000 | 90,000 |

Gross profit (30% of sales) | 36,000 | 45,000 | 27,000 |

Directly traceable service/support costs | 13,120 | 18,476 | 13,620 |

Total activity costs (as per above analysis) | 3,029 | 6,361 | 4,956 |

Net profit | Total 19,851 | Total 20,163 | Total 8,424 |

### Discussion

The calculations show that the ranking of customers in terms of total profit is the same as in terms of sales revenue:

#### Table 9

Beta | Gamma | Delta | |
---|---|---|---|

Revenue | 120,000 | 150,000 | 90,000 |

Ranking | 2 | 1 | 3 |

Net profit | 19,851 | 20,163 | 8,424 |

Ranking | 2 | 1 | 3 |

However, if profitability in terms of profit as a percentage of sales revenue is considered, a different picture emerges:

#### Table 10

Beta | Gamma | Delta | |
---|---|---|---|

Revenue | 120,000 | 150,000 | 90,000 |

Ranking | 2 | 1 | 3 |

Net profit as % of revenue | 16.5% | 13.4% | 9.4% |

Ranking | 1 | 2 | 3 |

This is because both indirect costs and directly traceable service and support costs are (proportionately) highest for Delta and lowest for Beta (with Gamma in between):

#### Table 11

Beta | Gamma | Delta | |
---|---|---|---|

Indirect costs as % of revenue | 2.5% | 4.2% | 5.5% |

Direct support as % of revenue | 10.9% | 12.3% | 15.1% |

This analysis indicates that Delta consumes a proportionately (relative to sales revenue) higher amount of indirect and support resources than the other two customers. Gamma consumes significantly more resources than Beta, so that, although sales for Gamma are 25% higher than for Beta, the difference in profit is almost negligible.

It is appropriate at this point to add a cautionary note. Activity based costing has considerable potential for providing more accurate product and customer costing, but it is based on a number of assumptions which may not always hold true in practice. It effectively assumes a linear relationship between activities and costs which may not be realistic due to the existence of fixed costs and joint costs. It also assumes that the costs of individual activities are independent of each other and therefore separable (Noreen, 1991) which may also not always be the case. These assumptions limit the possible application of activity based costing in practice (Bhimani and Bromwich, 2010).