Time-Driven Activity-Based Costing to Consider the situation faced in the 1990s by Carolina Distributors, a Fortune 500 distributor of medical and surgical supplies. Sales had more than tripled in five years (325%) to nearly $3 billion. Yet its selling, general , and administrative (SG&A) expenses, thought by many to be a "fixed" or "semi- fixed" cost, had increased even faster than sales (337%). Despite the tripling in sales, gross margins had declined by one percentage point and the company experienced its first loss in decades. Rather than SG&A costs being fixed or even variable, these costs had become "super-variable." They had increased faster than sales revenue. The experience of this large distributor is hardly unique. Companies, attempting to retain and grow their business with existing customers and also attract new customers from competitors, o often agree provide customers with new value-added services such as the following: Producing and stocking a greater variety of products Customizing products and services to individual customer preferences Supporting more order-entry and order-tracking channels Producing and delivering in smaller order sizes Delivering directly to customers' end-use locations, often in expedited and narrow time windows Providing specialized technical application support . . . . . All these new services create value and loyalty among customers, but none of them comes for free. Like many companies, Carolina had added extensive infrastructure to make the transition from its historic low-cost strategy to its new strategy of providing differentiated and complete solutions to its customers. But it had not modified its pricing formula. It continued to use the traditional cost-plus pricing in which the customer paid the base manufacturer price plus a standard markup for the distributor. No provision was made in the price for any special services performed for customers. The consequences of this pricing policy were highly predictable. First, customers, learning that Carolina's average markup on expensive, low-bulk items, such as cardiovascular sutures, greatly exceeded their cost of handling and distributing them, began to order such items directly from the manufacturer. Carolina was left handling low-price, low-margin, bulky items like boxes of diapers where the flat percentage markup was well below the true cost of storage, handling, and distribution. Second, customers increased their demands for special services such as breakpacks, small order sizes, overnight delivery, and delivery directly to the point of use. After all, customers calculated, if suppliers were willing to deliver small quantities directly to the point of consumption, why incur the extra costs associated with receiving carton and pallet quantities at a receiving dock, moving them into a local storage area, and subsequently distributing them, with internal resources, to its own end-use customers. The demand from customers for specialized services, willingly provided at no additional cost by companies such as Carolina, can be enormous. In general, as a customer's demands for unpriced services increases, the supplier incurs large losses when serving that customer. This was the situation in which Carolina Distributors found itself; it had accommodated customers' increased demands by adding resources whose cost outstripped revenue increases, leading to operating losses. Second, to avoid the losses, the supplier decides not to supply some services requested by the customer. For example, Carolina was beginning to refuse a customer's requests for delivery of small quantities directly to multiple locations at the customer's site. In this case, the market between supplier and customer has broken down. Customers are making excessive demands and the vendor is restricting supply. The lethal combination leads to frustration and confrontation. This conundrum occurs in many companies. A semiconductor manufacturer with nearly $2 billion in annual sales found its profitability eroding. It had increased the scope of its product line to accommodate customers' specialized requests, and had expanded the services it offered, such as express (overnight) delivery of small shipments, consignment warehousing, special packaging and labeling and electronic data interchange (EDI). While EDI is normally thought to be a cost-reducing alternative, the manufacturer found that customer error rates were more than 50% when submitting EDI orders, requiring extensive error correction and data validation processes. The company had no understanding of how the costs of the special products and services varied among its individual customers, consequently it had no basis for recovering these costs. A Solution and a Problem: Activity-Based Costing to Measure "Cost-to-Serve" Companies can remedy the supplier-customer conflict through improved information systems and better aligned incentives. The solution starts when the supplying company builds a new system that reports accurately on its cost to produce products, process orders, distribute to customers, and provide special services to them. Activity-based costing (ABC) provides the conceptual framework for linking financial, production, scheduling, order-entry, marketing and sales data -- from general ledger, ERP, and CRM systems -- into a comprehensive costing and profitability model that reports profitability by individual product, customer, and even, by order. An ABC system gives a clear and accurate picture of a company's gross margins by individual product or SKU, and the company's costs of serving its diverse customer base. This picture provides the basis for companies to take actions on process improvement, pricing and managing customer relationships that transform unprofitable products, orders, and customers into profitable ones. The problem comes when managers attempt to apply activity-based costing to complex enterprises. First, the process of interviewing and surveying employees to get their time allocations to multiple activities can prove time-consuming and costly. At one large money center bank's brokerage operation, the ABC model required 70,000 employees at more than 100 facilities to submit monthly surveys of their time. The company had to provide 14 full-time people just to manage the ABC data collection, processing and reporting. Managers also questioned the accuracy of the system since cost assignments were based on individuals' subjective estimates of how they spend their time. Because of the high cost of continually updating the ABC model, many systems were updated only infrequently, leading to out- of-date activity cost-driver rates, and inaccurate estimates of process, product, and customer costs. A subtler and more serious concern arose from the interview and survey process itself. When people estimated how much time they spend on various activities, they invariably reported percentages that added up to 100%. Few individuals reported that a significant percentage of their time was idle or unused. Therefore, cost-driver rates were calculated assuming that resources were working at full capacity. But, of course, operations at practical capacity are more the exception than the rule. In summary, the process of calculating activity expenses through interviews, observation, and surveys requires a time-consuming and costly process to collect the data, an expensive information system to run the model, and a difficult process to updaty the model in light of changing circumstances. It is also theoretically incorrect, by including the cost of unused capacity when calculating cost-driver rates. Time-Driven Activity-Based Costing: A Simpler, More Powerful Path to Profitability A new approach, which we call time-driven ABC, is far simpler and also much more powerful than the conventional ABC models. The TDABC model requires, for each group of resources, only two parameter estimates: 1. The cost rate of supplying resource capacity; and 2. The consumption of resource capacity (typically unit times) by the activities performed by the resources for products, services, and customers. The model allows all types of complexity to be incorporated within the capacity consumption estimates, Capacity Cost Rate Estimate Time-driven ABC starts by identifying the various groups of resources performing activities. For example, customer administration resources include the front-line employees who receive and respond to customer-related requests, their supervisors, and the support resources they require to perform their functions -space, computers, telecommunications, furniture, and potentially, resources in other support departments (information technology, human resources, utilities, etc.). Consider a customer service department, costing $560,000 per quarter. The department has 28 customer service employees performing the front-line work. For simplicity, assume that all costs are committed for the period. They will not vary based on the actual work performed. During the most recent period, the department performed three types of activities: Processed 49,000 customer orders . . Handled 1,400 customer inquiries Performed 2,500 customer credit checks We already know that the cost of the department totals $560,000, which includes compensation for employees and their supervisors, occupancy and technology costs, and any direct assignment of expenses from support departments such as human resources, information technology, and finance To calculate the practical capacity of the department, assume that each of the 28 front-line employees works an average of 22 days per month, 71/2 hours per day, for a total of about 9,900 minutes per month. Suppose that about one hour per day is unavailable for actual work, due to breaks and training activities. So each employee is available for work about 8,580 minutes per month, approximately, 25,000 minutes per quarter. With 28 employees, the department has a quarterly practical capacity of about 700,000 minutes. The formula and calculations for the capacity cost rate are shown below: Cost of capacity supplied Capacity cost rate Practical capacity of resources supplied $560,000 Capacity cost rate $0.80 per minute 700,000 While most resources measure capacity using time availability, the time-driven approach also recognizes resources whose capacity is measured in other units. For example the capacity of a warehouse, truck, or freight car could be measured by space available, while memory storage would be measured by megabytes supplied. In these cases, the designer calculates the cost rate based on the appropriate capacity measure, such as S/cubic meter or $/megabyte. Unit Time Estimate Next, the time-driven ABC approach requires an estimate of the time required to perform a transactional activity. The time estimates can be obtained either by direct observation or by interviews. Precision is not critical, rough accuracy is sufficient. Returning to the numerical example, suppose that the analyst obtains estimates of the following average unit times for the three customer-related activities: Process customer order 8 minutes Handle customer inquiry 44 minutes Perform credit check 50 minutes Summary Over the past 15 years, activity-based costing has enabled managers to see that not all revenue is good revenue, and not all customers are profitable customers. Unfortunately, the difficulties of implementing and maintaining traditional ABC systems have prevented activity-based cost systems from being an effective, timely, and up-to-date management tool. The time-driven ABC approach has overcome these difficulties. It offers managers a methodology that has the following positive features: 1. Easy and fast to implement 2. Integrates well with data now available from recently installed ERP and CRM systems 3. Inexpensive and fast to maintain and update 4. Ability to scale to enterprise-wide models 5. Easy to incorporate specific features for particular orders, processes, suppliers, and customers 6. More visibility to process efficiencies and capacity utilization 7. Ability to forecast future resource demands based on predicted order quantities and complexity These characteristics enable activity-based costing to move from a complex, expensive financial systems implementation to becoming a tool that provides meaningful and actionable data, quickly and inexpensively, to managers. In a consulting report format (3 page max), analyze and evaluate Timken's Transfer Pricing methods, and performance measures. Recommend changes that will motivate the strategic business units (SBU's) to perform in the best interest of the firm and to help Timken achieve their strategy. These suggestions must work inside the existing responsibility structure of profit/investment center that Timken uses. All case facts are to be considered. Taxes are not a part of the assignment. Required: Your formal report must cover the following (at a minimum) 1. Strategy: Using the annual report, EXPLAIN Timken's strategy and the basis on which they compete. Be specific with regard to cost or differentiation and value proposition 2. Transfer Pricing Policies and Method: Currently Timken uses the "Minimum Rule" and sets the market based transfer price based on Steel's market sell price data. Auto is also precluded from buying steel externally. However, Steel is running 30% below capacity and Timken is considering a negotiated transfer price based on the "General Transfer Pricing Rule that states any price between variable cost and market price should be acceptable to both the buying and selling parties. a. RECOMMEND AND Analyze: Should Timken continue with the current Market Based transfer pricing method or should they adopt a different method? i. Explain the positive and negative motivational issues and the likely behavior between Auto and Steel that could arise with your chosen method. i. Using the Excel Model, show the consolidated profit using your method. b. Timken's "Minimum Rule" and their policy that does not allow Auto to buy steel externally appears to be a problem. Explain if these two policies are in Timken's best interest? Do these policies inhibit overall profits and how should they be applied across the corporation? 3. Performance Measures: Strategic performance measurement is complex in a decentralized firm as the transfer of goods between units affects each SBU's reported profitability. Timken is concerned that the current ROIC measure may be ineffective and not inducing the goal congruent behavior at the SBU level and non-financial measures seem to be non-existent. a. Using your transfer pricing method from question 2. Recommend a set of performance measures should be used to positively motivate manager performance at Steel and Auto and that both protects SBU autonomy while achieving congruence at the corporate level. Time-Driven Activity-Based Costing to Consider the situation faced in the 1990s by Carolina Distributors, a Fortune 500 distributor of medical and surgical supplies. Sales had more than tripled in five years (325%) to nearly $3 billion. Yet its selling, general , and administrative (SG&A) expenses, thought by many to be a "fixed" or "semi- fixed" cost, had increased even faster than sales (337%). Despite the tripling in sales, gross margins had declined by one percentage point and the company experienced its first loss in decades. Rather than SG&A costs being fixed or even variable, these costs had become "super-variable." They had increased faster than sales revenue. The experience of this large distributor is hardly unique. Companies, attempting to retain and grow their business with existing customers and also attract new customers from competitors, o often agree provide customers with new value-added services such as the following: Producing and stocking a greater variety of products Customizing products and services to individual customer preferences Supporting more order-entry and order-tracking channels Producing and delivering in smaller order sizes Delivering directly to customers' end-use locations, often in expedited and narrow time windows Providing specialized technical application support . . . . . All these new services create value and loyalty among customers, but none of them comes for free. Like many companies, Carolina had added extensive infrastructure to make the transition from its historic low-cost strategy to its new strategy of providing differentiated and complete solutions to its customers. But it had not modified its pricing formula. It continued to use the traditional cost-plus pricing in which the customer paid the base manufacturer price plus a standard markup for the distributor. No provision was made in the price for any special services performed for customers. The consequences of this pricing policy were highly predictable. First, customers, learning that Carolina's average markup on expensive, low-bulk items, such as cardiovascular sutures, greatly exceeded their cost of handling and distributing them, began to order such items directly from the manufacturer. Carolina was left handling low-price, low-margin, bulky items like boxes of diapers where the flat percentage markup was well below the true cost of storage, handling, and distribution. Second, customers increased their demands for special services such as breakpacks, small order sizes, overnight delivery, and delivery directly to the point of use. After all, customers calculated, if suppliers were willing to deliver small quantities directly to the point of consumption, why incur the extra costs associated with receiving carton and pallet quantities at a receiving dock, moving them into a local storage area, and subsequently distributing them, with internal resources, to its own end-use customers. The demand from customers for specialized services, willingly provided at no additional cost by companies such as Carolina, can be enormous. In general, as a customer's demands for unpriced services increases, the supplier incurs large losses when serving that customer. This was the situation in which Carolina Distributors found itself; it had accommodated customers' increased demands by adding resources whose cost outstripped revenue increases, leading to operating losses. Second, to avoid the losses, the supplier decides not to supply some services requested by the customer. For example, Carolina was beginning to refuse a customer's requests for delivery of small quantities directly to multiple locations at the customer's site. In this case, the market between supplier and customer has broken down. Customers are making excessive demands and the vendor is restricting supply. The lethal combination leads to frustration and confrontation. This conundrum occurs in many companies. A semiconductor manufacturer with nearly $2 billion in annual sales found its profitability eroding. It had increased the scope of its product line to accommodate customers' specialized requests, and had expanded the services it offered, such as express (overnight) delivery of small shipments, consignment warehousing, special packaging and labeling and electronic data interchange (EDI). While EDI is normally thought to be a cost-reducing alternative, the manufacturer found that customer error rates were more than 50% when submitting EDI orders, requiring extensive error correction and data validation processes. The company had no understanding of how the costs of the special products and services varied among its individual customers, consequently it had no basis for recovering these costs. A Solution and a Problem: Activity-Based Costing to Measure "Cost-to-Serve" Companies can remedy the supplier-customer conflict through improved information systems and better aligned incentives. The solution starts when the supplying company builds a new system that reports accurately on its cost to produce products, process orders, distribute to customers, and provide special services to them. Activity-based costing (ABC) provides the conceptual framework for linking financial, production, scheduling, order-entry, marketing and sales data -- from general ledger, ERP, and CRM systems -- into a comprehensive costing and profitability model that reports profitability by individual product, customer, and even, by order. An ABC system gives a clear and accurate picture of a company's gross margins by individual product or SKU, and the company's costs of serving its diverse customer base. This picture provides the basis for companies to take actions on process improvement, pricing and managing customer relationships that transform unprofitable products, orders, and customers into profitable ones. The problem comes when managers attempt to apply activity-based costing to complex enterprises. First, the process of interviewing and surveying employees to get their time allocations to multiple activities can prove time-consuming and costly. At one large money center bank's brokerage operation, the ABC model required 70,000 employees at more than 100 facilities to submit monthly surveys of their time. The company had to provide 14 full-time people just to manage the ABC data collection, processing and reporting. Managers also questioned the accuracy of the system since cost assignments were based on individuals' subjective estimates of how they spend their time. Because of the high cost of continually updating the ABC model, many systems were updated only infrequently, leading to out- of-date activity cost-driver rates, and inaccurate estimates of process, product, and customer costs. A subtler and more serious concern arose from the interview and survey process itself. When people estimated how much time they spend on various activities, they invariably reported percentages that added up to 100%. Few individuals reported that a significant percentage of their time was idle or unused. Therefore, cost-driver rates were calculated assuming that resources were working at full capacity. But, of course, operations at practical capacity are more the exception than the rule. In summary, the process of calculating activity expenses through interviews, observation, and surveys requires a time-consuming and costly process to collect the data, an expensive information system to run the model, and a difficult process to updaty the model in light of changing circumstances. It is also theoretically incorrect, by including the cost of unused capacity when calculating cost-driver rates. Time-Driven Activity-Based Costing: A Simpler, More Powerful Path to Profitability A new approach, which we call time-driven ABC, is far simpler and also much more powerful than the conventional ABC models. The TDABC model requires, for each group of resources, only two parameter estimates: 1. The cost rate of supplying resource capacity; and 2. The consumption of resource capacity (typically unit times) by the activities performed by the resources for products, services, and customers. The model allows all types of complexity to be incorporated within the capacity consumption estimates, Capacity Cost Rate Estimate Time-driven ABC starts by identifying the various groups of resources performing activities. For example, customer administration resources include the front-line employees who receive and respond to customer-related requests, their supervisors, and the support resources they require to perform their functions -space, computers, telecommunications, furniture, and potentially, resources in other support departments (information technology, human resources, utilities, etc.). Consider a customer service department, costing $560,000 per quarter. The department has 28 customer service employees performing the front-line work. For simplicity, assume that all costs are committed for the period. They will not vary based on the actual work performed. During the most recent period, the department performed three types of activities: Processed 49,000 customer orders . . Handled 1,400 customer inquiries Performed 2,500 customer credit checks We already know that the cost of the department totals $560,000, which includes compensation for employees and their supervisors, occupancy and technology costs, and any direct assignment of expenses from support departments such as human resources, information technology, and finance To calculate the practical capacity of the department, assume that each of the 28 front-line employees works an average of 22 days per month, 71/2 hours per day, for a total of about 9,900 minutes per month. Suppose that about one hour per day is unavailable for actual work, due to breaks and training activities. So each employee is available for work about 8,580 minutes per month, approximately, 25,000 minutes per quarter. With 28 employees, the department has a quarterly practical capacity of about 700,000 minutes. The formula and calculations for the capacity cost rate are shown below: Cost of capacity supplied Capacity cost rate Practical capacity of resources supplied $560,000 Capacity cost rate $0.80 per minute 700,000 While most resources measure capacity using time availability, the time-driven approach also recognizes resources whose capacity is measured in other units. For example the capacity of a warehouse, truck, or freight car could be measured by space available, while memory storage would be measured by megabytes supplied. In these cases, the designer calculates the cost rate based on the appropriate capacity measure, such as S/cubic meter or $/megabyte. Unit Time Estimate Next, the time-driven ABC approach requires an estimate of the time required to perform a transactional activity. The time estimates can be obtained either by direct observation or by interviews. Precision is not critical, rough accuracy is sufficient. Returning to the numerical example, suppose that the analyst obtains estimates of the following average unit times for the three customer-related activities: Process customer order 8 minutes Handle customer inquiry 44 minutes Perform credit check 50 minutes Summary Over the past 15 years, activity-based costing has enabled managers to see that not all revenue is good revenue, and not all customers are profitable customers. Unfortunately, the difficulties of implementing and maintaining traditional ABC systems have prevented activity-based cost systems from being an effective, timely, and up-to-date management tool. The time-driven ABC approach has overcome these difficulties. It offers managers a methodology that has the following positive features: 1. Easy and fast to implement 2. Integrates well with data now available from recently installed ERP and CRM systems 3. Inexpensive and fast to maintain and update 4. Ability to scale to enterprise-wide models 5. Easy to incorporate specific features for particular orders, processes, suppliers, and customers 6. More visibility to process efficiencies and capacity utilization 7. Ability to forecast future resource demands based on predicted order quantities and complexity These characteristics enable activity-based costing to move from a complex, expensive financial systems implementation to becoming a tool that provides meaningful and actionable data, quickly and inexpensively, to managers. In a consulting report format (3 page max), analyze and evaluate Timken's Transfer Pricing methods, and performance measures. Recommend changes that will motivate the strategic business units (SBU's) to perform in the best interest of the firm and to help Timken achieve their strategy. These suggestions must work inside the existing responsibility structure of profit/investment center that Timken uses. All case facts are to be considered. Taxes are not a part of the assignment. Required: Your formal report must cover the following (at a minimum) 1. Strategy: Using the annual report, EXPLAIN Timken's strategy and the basis on which they compete. Be specific with regard to cost or differentiation and value proposition 2. Transfer Pricing Policies and Method: Currently Timken uses the "Minimum Rule" and sets the market based transfer price based on Steel's market sell price data. Auto is also precluded from buying steel externally. However, Steel is running 30% below capacity and Timken is considering a negotiated transfer price based on the "General Transfer Pricing Rule that states any price between variable cost and market price should be acceptable to both the buying and selling parties. a. RECOMMEND AND Analyze: Should Timken continue with the current Market Based transfer pricing method or should they adopt a different method? i. Explain the positive and negative motivational issues and the likely behavior between Auto and Steel that could arise with your chosen method. i. Using the Excel Model, show the consolidated profit using your method. b. Timken's "Minimum Rule" and their policy that does not allow Auto to buy steel externally appears to be a problem. Explain if these two policies are in Timken's best interest? Do these policies inhibit overall profits and how should they be applied across the corporation? 3. Performance Measures: Strategic performance measurement is complex in a decentralized firm as the transfer of goods between units affects each SBU's reported profitability. Timken is concerned that the current ROIC measure may be ineffective and not inducing the goal congruent behavior at the SBU level and non-financial measures seem to be non-existent. a. Using your transfer pricing method from question 2. Recommend a set of performance measures should be used to positively motivate manager performance at Steel and Auto and that both protects SBU autonomy while achieving congruence at the corporate level