“The right numbers on the right places”
Product cost calculated through an Activity Based Costing method
Public Version Graduate Thesis February, 2005
J. Verheijden University of Groningen
Faculty of Management and Organization
Public Version
“The right numbers on the right places”
Product cost calculated through an Activity Based Costing method
February, 2005
University of Groningen
Faculty of Management and Organization Financial Value Management
Author:
J. Verheijden
Studentnumber 1065130
Supervisor ABN AMRO Bank Poland:
Frank Hazeu
Supervisors University of Groningen:
Dr. B.J.W. Pennink
Drs. M.P. van der Steen
‘The author is responsible for the content of the thesis, the copyright of the thesis rest with the author’ © 2005
Preface
This is the result of a research conducted for the University of Groningen, faculty of Business Administration. With the completion of this thesis the Financial Value Management major is completed. The research is performed within an investment banking subsidiary of the ABN AMRO Bank in Warsaw, Poland. The subject of this research is the cost accounting model of the bank.
This thesis is a result of the theories and practices learnt at the university. Subjects thoroughly discussed in my courses of Corporate finance, Capital Budgeting and Management Accounting came to life during my internship. In addition the internship provided me with insights and experiences into the dynamics of a multinational company a valuable introduction in the world of business.
The research could not have been completed without the help op several persons. First of all I would like to thank Frank Hazeu of the ABN AMRO Bank and all his colleagues for the opportunity of conducting this research. The research made me get acquainted with the wide variety of products and processes within Working Capital and Financial Markets. In addition it gave me the opportunity to have a good look at deals closed within Corporate Finance.
Second of all the critical feedback of Bart Jan Pennink and Martijn van der Steen inspired me to take small steps and sometimes a big leap, resulting in this thesis. Finally the support of my parents and friends were very much appreciated.
What an interesting experience it was to see work in progress at a foreign investment bank.
Although the mid winter transfer from the University of Barcelona to an investment bank in Warsaw was quite large especially on the scale of Celsius, the steep learning curve however compensated everything and made it all worth it.
Jeroen Verheijden
Meerssen, February 2005
Management Summary
This report is the result of a graduation assignment from a six month internship at the ABN AMRO Bank in Poland. Within the investment bank there are two business units; Financial Markets and Working Capital which serve the corporate market and are the subject of this research. Their products include subsequently interest and risk instruments such as T-bills, derivates, options and payments collections and processing. These products are serviced through six support departments and six operations department. In addition the products and services get support from Group Shared Services which is located outside the business units at the head office.
The management accounting system does not have information which products of the current portfolio generates value for the bank because it has no product cost to perform a calculation with. It is known that the company makes a healthy profit as a whole, however the extent to which the different products contribute to this is not known.
The main research goal of this thesis is formulated as:
To provide management of the ABN AMRO Bank Poland with a suitable* cost allocation model, through which the unit cost of its products can be established in order to evaluate the sales prices.
*Suitable means a cost allocation method through which cost prices are calculated with a minimum of cost price distortion.
This result in a main question focused on generating knowledge to support policy making:
Which products of the bank create value, based upon the comparison of their sales price and the calculated unit product costs?
In order to answer this question the research proceeds by selecting a suitable method for the bank which is able to handle the deficiencies the current method has. Three methods are presented which are able to generate product unit cost;
•
The Direct method
•
The Traditional method
•
The Activity Based Costing method
A comparison reveals the main differences of the methods are the way these allocate indirect cost to a unit product cost. The Activity Based Costing method is selected as the most suitable method to perform the calculation to generate unit product cost because it uses more sophisticated cost drivers which are based upon non- and production volumes. Therefore it is able to allocate cost with relatively less distortions in the environment of the bank which is typified as:
•
Having a complex production process.
•
A high proportion of indirect cost versus direct cost.
•
A high diversity of products
The cost allocation method is applied within the bank and generates product cost through
allocating resources through activities to its products and services through weighted cost
drivers based upon non- and productive drivers. The method distorts cost calculation in two ways which is important to know when using the results. First of all by not including the cost of the customer level to the ABC hierarchy to the scope of the research. Secondly by the process of measuring which is based upon an estimate method of measuring the cost drivers instead of a direct, in order to keep the cost of measuring down?
Conclusions
Insight is derived by the bank by looking at how activities contribute to the final cost price.
The results of the ABC calculation show that products with a high sales volume which need few activities with a low duration driver have low cost because these costs are allocated over a large number of products such as the 1.8 million electronic payments which cost 0.10 zloty each. Products which have a low sales volume and have a high duration driver such as a cheque payment have high unit cost of 109 zloty. In addition all activities within the bank come at a cost. Therefore when products are not charged directly to a client, the bank ends up with resources consumed without cash flow to show for. As is seen in two categories of the four which are distinguished, the insights into the level of cost of products have not yet entered the pricing strategies. In confronting the banks sales prices with the calculated cost prices four different categories of products generating value are distinguished.
The first category is based upon the value destroying products which cost price is above the sales price because the services provided are free of charge. These products include incoming and internal payments which are free of charge. In addition the administrative activities of the accounts are costly but are not charged to the clients. Opening, closing and maintaining an account are examples of cost which every client has but which are not charged directly to the client.
Second category includes products that generate value only above a certain transaction volume, which means that their initial cost price is higher than the sales price at low transaction volume. Transactions which require high manual activities such as fax, cheques and paper based payments are examples of this group which product cost are not entirely reflected in the sales price. In addition Global Trade and Advisory products which have high activity drivers have a higher cost price than initial sales price.
The third category is all products that generate value in all sales scenarios for the bank at any sales volume. High volume electronic payments are the most profitable for the bank for they have low cost and relatively high sales prices. In addition all the Treasury products are priced above their unit cost price.
Finally there are products which have negotiated sales prices which thus need to be priced
above the calculated cost price. Based on the direction of the numbers a strategy can be
formulated for re-pricing the products in order to prevent further value destruction for the
bank from selling these products.
Table of contents
Preface ... 3
Introduction to the research... 8
Chapter 1 The ABN AMRO Bank Poland... 9
1.1 The nature of the ABN AMRO Bank N.V. ... 9
1.2 ABN AMRO Poland ... 9
1.3 Characteristics of the market ... 10
1.4 Organisational scope of the research ... 11
1.5 Costs within the bank... 14
1.6 Motive ... 15
Chapter 2 Research set-up ... 16
2.1 Problem situation ... 16
2.2 Research set-up ... 16
2.3 The main Question ... 17
2.4 Conceptual model of the research ... 17
2.5 Definitions... 19
2.6 Research to support policy making... 19
2.7 Restrictions ... 20
2.8 Information sources ... 20
Chapter 3 Cost allocation methods... 23
3.1 Basic cost terms ... 23
3.3 Three cost allocation methods ... 24
3.3.1 Direct Costing ... 25
3.3.2 The traditional method ... 25
3.3.4 Activity Based Costing method ... 27
3.4 Strengths and weaknesses ... 28
3.5 Conclusion ... 29
Chapter 4: Cost allocation ... 31
4.1 The current cost information... 31
4.2 Defining desired model... 35
4.3 Comparison current with desired ... 36
4.4 Selection of most suitable cost allocation method ... 37
4.5 Conclusion ... 37
Chapter 5 The Activity Based Costing method ... 39
5.1 Design frame ... 39
5.2 Identifying Activities ... 40
5.3 Grouping of Cost Pools... 41
5.4 Cost Assignments... 42
5.5 Assigning activities ... 43
5.6 The ABC concepts ... 43
5.7 Level of suitability ... 44
5.8 Conclusion ... 45
Chapter 6 Product prices... 47
6.1 Selecting Activities ... 47
6.1.1 Operations processes ... 48
6.1.2 Infrastructure processes ... 48
6.2 Cost Pools ... 48
6.3 Cost assignments... 49
6.3.1 Direct cost to activities ... 49
6.3.2 Indirect cost to core activities ... 50
6.4 Activity assignments ... 51
6.5 Calculated product cost... Error! Bookmark not defined. 6.6 Cost price distortions ... 53
6.7 Sales prices... 54
6.8 Conclusion ... 55
Chapter 7: Conclusions and Recommendations... 56
7.1 Conclusion ... 56
7.2 Recommendations... 58
7.3 Reflection ... 59
List of used Literature ... 61
Attachment 1
Sales price list (Left out in public version) Attachment 2
Interview Sheet (Left out in public version)
Calculated Cost Prices (Left out in public version)
Introduction to the research
This thesis is the result of the final phase of the specialization of Financial Value Management of the faculty Business Administration at the University of Groningen. The research was executed at an investment bank subsidiary of the ABN AMRO Bank in Poland during a six month internship. During this internship an Activity Based Costing model has been implemented within the cost accounting model of the bank. ABC enables to generate unit product cost through relating cost to products in a traceable way. This thesis explains why and how this model has evolved, by providing insight into the important decisions made during the process which lead to its implementation.
The bank has a large operations section to support the business units Working Capital and the Financial Markets. Products of these units are serviced through six support departments and six Operations departments. In addition the products and services get support from Group Shared Services which is located outside the business units at the head office. Working Capital generates products such as cash and payments, guarantees and letters of credit products. Financial markets trade interest rate and risk instruments on the stock exchange, such as options, derivates and T-bills.
In order to evaluate the current sales prices a need has arisen for information on products
costs of the services and products generated. For these products and processes the bank wants
a suitable cost allocation method that is able to generate product cost. In order to provide
insight into which of the banks products generate value and which do not, this thesis presents
its results and findings in the following way. Chapter one describes the environment in which
the research takes place. Chapter two presents a set-up in which the research goal is translated
into the main questions and a skeleton of the research. In chapter three theories of cost
allocation methods are explained. Chapter four provides insight into the how the current cost
accounting model relates to the desired model. A selection is made of the most suitable cost
allocation method which is able to deal with the problem situation. Chapter five provides the
reader with insight into the process of creating an accurate cost allocation model according to
literature. Chapter six explains how the model is used within the bank to generate product unit
cost and what its sales prices are. In the final chapter conclusions and recommendations are
given based upon a comparison of the sales prices and the cost prices.
Chapter 1 The ABN AMRO Bank Poland.
This chapter presents the environment in which the research takes place as mentioned in the introduction in the previous page. The investment banking practice of the ABN AMRO Bank in Poland is described and the characteristics of the Polish market are explained. Departments subject to this research are described by their structure and products generated. The chapter ends with a motive which forms the input for the following chapter. The next chapter deals in- depth with the research set-up. Therefore the problem diagnosis, main question, restrictions and theoretical basis of this thesis is discussed in the following chapter.
1.1 The nature of the ABN AMRO Bank N.V.
ABN AMRO is a prominent international bank, its origins going back to 1824. ABN AMRO ranks 11th in Europe and 23rd in the world based on tier 1 capital
1, with over 3,000 branches in more than 60 countries, a staff of about 110,000 full-time equivalents and total assets of EUR 639.9 billion (as at 31 March 2004). ABN AMRO is listed on the Euronext, London and New York stock exchanges
2.
ABN AMRO operates through three Strategic Business Units, each responsible for managing a distinct client segment.
•
Wholesale Clients provides integrated corporate and investment banking services to corporate, institutional and public sector clients worldwide.
•
Consumer & Commercial Clients focuses on retail and Small Medium Entreprise clients in three home markets - the Netherlands, the US and Brazil and in a number of selected growth markets.
•
Private Clients & Asset Management provides private banking services to wealthy clients and investment products to financial intermediaries and institutional clients.
The Wholesale Clients Business Unit is being served in the Polish organization. This is one of the largest Europe-based wholesale banking businesses with operations in about 50 countries.
With a global network, specialists in all major industry sectors and a broad range of products, ABN AMRO provides local and global expertise for complex cross-border deals.
Clients are served through three business units; Corporate Finance, Financial Markets and Working Capital
1.2 ABN AMRO Poland
ABN AMRO started in Poland in 1992 through a minority participation in the International Bank in Poland, a joint-venture bank. As part of its international expansion, ABN AMRO decided to set up its own operations in Poland and received a full banking license in 1994
3. At the end of 1994 ABN AMRO bought the very small Interbank, which was renamed ABN AMRO Bank (Polska) S.A. In 1996 ABN AMRO acquired Dom Maklerski Leonard, which was then renamed ABN AMRO Securities (Polska) S.A. In the beginning of 2003, it was decided to stop the Equities business in Poland. ABN AMRO Polska is wholly owned by
1 Tier 1 capital; is used to describe the capital adequacy of a bank. Tier 1 Capital includes equity capital and disclosed reserves.
2 See www.abnamro.com
3 See www.abnamro.pl
ABN AMRO N.V. and focuses on the corporate market. At present the bank employs one hundred fifty nine full time employees. A single office marks the presence in Poland where the investment bank is located in the capital Warsaw. The bank employs currently approximately 180 full time employees.
1.3 Characteristics of the market
Since Poland joined the EU enlargement in May 2004 a lot has changed for the nearly 40 million Poles. With a GDP per person of approximately 400 dollar, and a growth rate of 3.0%
4the country is climbing up the economic ladder. Unemployment figures of nearly 20%
however show that a large part of the country is not benefiting from this growth.
Within Poland there are several banks active such as the ABN AMRO Bank Poland.
The Polish banking market overview:
Banking sector results in mlns euro Q3 2002
Bank Own funds Net profit Net profitability
1 Lukas Bank 244.00 82.80 33.9%
2 Bank
Gospodarstwa Krajowego
264.70 89.70 33.9%
3 PKO BP 4,070.80 992.80 24.4%
4 Volkswagen Bank 111.20 26.20 23.6%
5 BS Katowice 21.20 4.50 21.2%
6 GE Capital Bank 289.00 60.20 20.8%
7 Krakowski BS 35.70 6.80 19.0%
8 Górno l ski Bank Gospodarczy
174.40 29.60 17.0%
9 GMAC Bank 74.90 12.00 16.0%
10 ABN Amro 248.60 39.70 16.0%
11 BSR Kraków 27.10 3.70 13.7%
12 Fiat Bank 184.80 24.80 13.4%
13 BIG Bank
Gda ski
1,848.80 247.20 13.4%
14 BS Grójec 18.40 2.20 12.0%
15 BZ WBK – AIB 2,281.70 207.30 9.1%
16 BNP Parisbas 280.10 24.20 8.6%
17 Deutsche Bank 524.60 42.80 8.2%
18 PKO SA –
UniCrdo
6,214.20 456.10 7.3%
19 ING Bank l ski 2,589.60 183.30 7.1%
Figure 1.1: ABN its environment 20025
In total there are over 60 banks active in the Polish market. Roughly the market consists out of two parts, a corporate and a consumer market. The ABN distinguishes itself by its focus on the corporate market. It serves multinational corporations and major polish organizations
6. As the asset base is not high, compared to the competitors, returns however show that it is among the top ten in the highly competitive polish banking business.
4 See http://www.economist.com/countries/Poland/profile.cfm?folder=Profile-FactSheet
5 Internal report ABN AMRO Bank (Polska) S.A. ‘Polish banking market profitability 2002’
6 See www.abnamro.pl
1.4 Organisational scope of the research
The Polish organization serves its clients through three different product generating business units as figure two shows. There is a Corporate Finance Department, a Global Financial Markets department and a Working Capital department. The latter two are taken into account in this research. The departments shown in the figure below are explained in the following paragraphs.
Figure 1.2 Organizational scope of the research Infrastructure
Departments
Legal and Compliance
Human Resources
IT
Facility Management
Working Capital
Business Unit Financial Markets
Business Unit
Cash and Payments Operations
Global Trade and
Advisory Operations Treasury Operations Group Shared Services
Departments
Finance
Risk Management
Group Shared Services
Group Shared Services (GSS) was established as of 1 January 2004 to create cost savings through consolidation and standardisation. GSS focuses on further exploiting new market solutions for support services with the aim to achieve better products and services for clients at lower costs. In essence the group is the support unit for all the business units within the bank.
Infrastructure departments
In order to generate products there are six supporting departments within the bank. The infrastructure departments reflect a basic structure of the organisation. Within this basic structure the management and support is responsible for the processes within the organisation.
These include the Facility management, responsible for servicing and maintaining the property of the bank. In addition there is an Information and Technology department. IT services maintains and develops software, plus it keeps the hardware updated. The Risk Management department takes care of dealing with operational and market risk exposure within the bank. Human Resources are responsible for managing the staff currently employed.
Finally Finance deals with all payments to be made and makes monthly profit and loss reports for the organisation.
Financial Markets Business Unit
Financial Markets is serviced by Treasury Back Office (TBO). Global Financial Markets Operations generates products, which are supported by administrative transactions of Treasury Back Office and deals mainly with Securities
7. These mainly contain Foreign Exchange products designed to level interest rate risk exposure. Treasury offers a wide range of solutions to manage currency and interest rate risks exposures of the clients with instruments such as Fixed Income (FI), Foreign Exchange Currency Swap, and Forward Contracts. These products are specially designed for corporate businesses to align their profile to the desired exposure of the markets volatility. The value-added activities are mainly focused on the positioning of the trading products on the Warsaw stock exchange. The FX positions are maintained and reconciled and new deals are entered into the system. Main products generated within Treasury Back Office:
•
Commercial Bonds
•
T-Bills
•
Derivates
•
Foreign Exchange instruments (FX)
Working Capital Business Unit
The Working Capital (WoCa) specializes in providing a comprehensive service to companies by offering banking products that support liquidity management, methods for servicing payments and receivables and interest rate exposure
8. The operational part of the WoCa organisation can be divided into a client facing part and product processing. First of all there are the directly client related support teams that deal with the implementation of web based products and questions of clients. In addition to the client facing parts such as Business
7 ‘An investment instrument, other than an insurance policy or fixed annuity, issued by a corporation, government, or other organisation which offers evidence of debt or equity’ thus www.inverstorwords.com describes it
8 See www.abnamro.pl
Management, Local Client Services and sales, there is a product processing part of the organisation. WoCa Operations products are generated by three different departments Custody, GT&A and Cash and Payments. Custody however is not included the research.
Working Capital has the following Organisational chart:
Figure 1.3: Organisation Chart Working Capital
Cash and Payments
Cash and Payments are divided into Account Management, Domestic and Foreign Payments part. The latter two departments are responsible for the collection, delivery, processing and execution of cash and payments and cheques. Account Services is in charge of a Cash Desk where manual cash transactions take place, such as depositing money and picking up visa cards. Main products generated within Cash and Payments:
•
Electronic Payments
•
Manual Payments
•
Cheques
•
Accounts opened
•
Visa Card Serviced, opened and closed
•
Deposits
•
Withdrawals
Global Trade and Advisory
Global Trade and Advisory (GT&A) provides trade finance products and services to corporate and institutional clients of the Wholesale clients
9. Trade finance’s main products are documentary administration products which include Letter of Credit and trade related guarantees. These are trade products issued by the bank, used to guarantee payments for a
9 See note 9
Global Trade and Advisory
Cash Desk Foreign
Payments Domestic
Payments Account
management Cash and Payments Working capital
customer for a specific period and up to a specific amount. The custody department is not taken into account. Main products generated within GT&A:
•
Letter of Credit
•
Guarantees
•
Factoring
10Operations Facts numbers per month
Electronic Payments 2.500.000
Manual Payments11 10.000
Accounts serviced 600
Documentary administration12 10.000
Treasury Products13 2500
Total FTE's 130
Figure 1.4 Operations facts and figure
1.5 Costs within the bank
Producing these products takes a sophisticated operations service center supported by the brain of the organization the Group Shared Services. In addition the infrastructure departments provide the support to the organization as a whole. The products are sold through the client facing departments. Costs made by the support organization to generate these products are spread out over the departments as indicated in the figure below.
Departments Stake in % of total cost per Annum
Group Shared Services Cost 15%
Infrastructure departments cost 35%
Operations departments cost 40%
Client Facing 10%
Figure 1.5 Spread of total cost over departments14
There are four different types of cost identified by the ABN
15direct and indirect, fixed and variable. Direct costs have a direct relationship to products generated and can therefore be attributed to the department. Indirect costs or overhead can not be traced to a given product or service. Fixed costs do not vary within a timeframe of a reporting year. Variable cost varies with respect to the changes in volume. In the figure the total cost are spread over the departments which are responsible for incurring them. As can be seen the cost created to support the production of a product or service are far higher according to the Chief Financial
10 Factoring enables banks to process the receivables for its customers
11 These are payments to be inputted into the system manually
12 Documentary administration represents Global Trade and Advisory products such as Letter of Credits and Guarantees.
13 Instruments based on Interest rates and Foreign Currency Exchange, T-Bills, Derivates.
14 Based on estimation made by the Chief Financial Officer
15Based on Intranet information
Officer than the direct cost incurred. Thus support cost make up the biggest part of the total cost to generate a product. These costs occur within the Profit and Loss accounts of the departments each month in addition to the departments own cost. Information is generated through the management and accounting system about direct cost generated and the indirect cost allocated.
1.6 Motive
The market is becoming more competitive and margins on products are getting smaller. In addition the organization is getting more complex with many diverse products and services being generated especially for clients needs. These products are produced within an organization that is characterized as having more indirect than direct cost produced. Meaning that support departments attribute more cost to its products than the operating departments do.
At the moment there is no system which is able to produce cost information per product.
Therefore products are priced against market prices without knowing whether or not a profit
is made on the sales of these products. In order to keep the banks revenues up it is necessary
that insight is provided into the products cost and that these can be measure against products
market price. Therefore a cost allocation method needs to facilitate generating unit cost for
cost pricing of the products. Through these cost prices the organization’s profitability,
investment and strategic business planning scheme’s can be initiated. This information needs
to be suitable for strategic cost pricing for the client facing part of the organization. The next
chapter performs an in depth diagnose on the data and forms it into a research framework.
Chapter 2 Research set-up
Having described the organization in the previous chapter, the thesis focuses on the research approach in this chapter. This perspective directs attention towards the origin of this research;
the problem situation. Subsequently the main goal, the main research questions and sub- questions are dealt with. These concepts used in this research are shown in a conceptual research model. Followed by the restrictions and methods of data gathering applicable to this research. The chapter ends with an overview of the chapters and the way these contribute to the solution of the research. In the next chapter the characteristics of cost allocation methods are described.
2.1 Problem situation
The scope of the system includes the management accounting information produced for Operations, which includes the products of the business units of Working Capital and Financial Markets. The main problem can be characterized as a lack of accurate information on the management cost accounting subject. The problem can be divided in two cost management issues. First of all the cost information generated is not accurate enough to provide unit cost prices to the client facing department upon which they can form strategic cost prices. Second there is a lack of tools to manage cost within the organization.
The client facing departments of these two business units do not have enough information for a strategic price setting. At the moment prices for products are set based upon the market prices while no knowledge is available on which products generate a profit or a loss. Business Management within the client facing departments is responsible for pricing the products.
Their aim is to price the products in such a way that they generate a maximum of profit while priced at a competitive level. Products are generated by activities of different departments before they are sold to the client. At the moment it is not clear which activities add value and to what level. Pricing of the products and services is done based on the market prices.
Thus the main problem consist of the lack of insight in the build up of up to date strategic cost prices to evaluate processes and product portfolio’s profitability to make sure the company creates value in the long run. A new cost allocation model needs to be created which is more focused on cost. This motive sum up the initiative for the following research set up.
2.2 Research set-up
De Leeuw (1996, p81) states that a research framework exist of a main objective, its restrictions, and a main question. Verschuren (1995) adds a conceptual model to the list in order to enable the reader to grasp the conceptual solution to the problem situation.
The main objective of this research, given by Management:
To provide management of the ABN AMRO Bank Poland with a suitable* cost allocation model, through which the unit cost of its products can be established in order to evaluate the sales prices.
It is not clear which product of the current portfolio generates value for the bank
considering there are no product cost to initiate the calculation.
*Suitable means a cost allocation method through which cost prices are calculated with a minimum of cost price distortion.
2.3 The main Question
The quality of the main question can, according to De Leeuw (1996, p123), be measured by level of addressing three topics. The first is about its relevance, secondly the way it can be fit into a research and finally the way it fits with the goal. Therefore the research question of this thesis is:
These sub questions are answered in this research to answer main question:
1. Which cost allocation methods generate unit cost according to literature?
a. What different types of cost exist?
b. How are cost assigned?
c. What cost allocation methods are applicable?
d. What are their strengths and weaknesses?
2. How does the current cost accounting method of operations measure up to generating product unit cost?
a. What goal, scope, users and reports does the current method includes?
b. What goal, scope, users and reports does the desired method need?
c. What are their similarities and differences?
3. Which cost allocation method is suitable to create accurate product unit cost?
4. How can unit product cost be generated from the cost allocation method according to literature?
a. How are cost assigned within the method?
b. What influences distortions of the cost allocation method?
5. What are the calculated cost prices and the sales prices of the products?
a. How are cost allocated within the organisation?
b. What distortions does the calculated product cost have?
c. How are sales prices established within the bank?
6. Which products generate value for the bank?
2.4 Conceptual model of the research
According to Verschuren (1995, p4) in order to gain insight in the knowledge needed to accomplish the goal of this research, the situation of the problem needs to be analysed conform this thesis its conceptual research model. The concepts need to be interpreted according to the direction of the arrows.
Which products of the bank create value, based upon the comparison of their sales
price and the calculated unit product costs?
Figure 2.1 Conceptual model of the research
Information resources Objects of analysis Direction of the research Goal of the research
The model’s restriction
The model’s arrows represent the direction of which the problem at hand is solved. The model’s information resources provide insight to the way the research framework is constructed and provide data from the objects of analysis. The main goal is addressed through three research phases from the problem situation. The first phase of the research focuses on generating knowledge to answer sub question one until three; selecting a suitable cost allocation method. This is started by performing a literature study about cost accounting models and their cost allocation methods through desk research as reflected in sub question one. After which the selection phase focuses on the most suitable method for Operations to generate unit product cost. The current cost management information is mapped through analysing the models goal, scope, its users and its reports generated. Through using interviews and internal documents this information is gathered. Thereby the current cost accounting model is confronted with the information needed in sub question two. Confronting the
Cost Accounting Theories
Internal Documents
Interviews
Calculated Unit Product Cost
Current Cost Allocation information
Desired
Cost allocation information
Sales Price per Product
Value of product
Users
Goal
Reports
Scope
Users
Goal
Reports
Scope Suitable method
for Cost Allocation
outcome of the comparison of the theoretical approaches, with the deficiencies of the current method, provide an answer to selecting a calculation method best applied within Operations.
A selection of the most suitable cost calculation method is made based upon the results from answering sub question one and two thereby answering sub question three.
The second phase of the research focuses on answering sub question four, five and six through generating an image of the value creation characteristics of the products of the bank.
For this purpose the research takes on a literature study to answer sub question four to provide insight into the way the selected cost allocation method is applied in order to generate accurate product cost. The method is applied within the bank in answering the first part of sub question five. By using an interview sheet, cost calculation data from the bank which serves as an input for the method is collected. The results of the cost calculation method are calculated product unit cost.
The final phase answers the sub question six and thereby the main question, by comparing the sales price sheet with the calculated unit product cost sheet. Resulting in an analysis of which product create value for the bank.
2.5 Definitions
Cost is a sacrifice of a resource.
Product cost prices are a quantities expression of the resources sacrificed by the producer of the products (Kaplan, 1996)
Cost accounting model is part of the management accounting system and responsible for the determining the cost of a cost object such as a products or service for this research. (Kaplan 1996)
Cost driver quantifies the relationship between a cost and an activity, it reflects thereby how much of a resource is used. (Kaplan 1996)
Cost Pool groups cost together which reflect homogeneous cost behaviour (Kaplan and Cooper, 1999)
Scope of the model consists of the products which need a unit cost price of the business units of Working Capital and Financial Markets.
2.6 Research to support policy making
This research aims to provide the management of the ABN AMRO bank with insight into which products add value to the bank, based upon their cost and sales prices, in order to initiate a strategic cost pricing. De Leeuw (1996) categorizes this type of research as a support research for policy making, because it needs to generating specific knowledge for policy makers. The type generates knowledge which is useful in a defined problem situation and solves part of the need for knowledge by an empiric statement. The demands on quality of an empiric statement are as followed:
Usability; measured by
•
Relevance of the relation between the management problem situation and the produced knowledge.
•
Level of correctness which means that the results need to be precise and testable and statements need to be informative.
Appropriate statements; this means the statements should be formulated with clarity and in a comprehendible way.
In the reflection paragraph in chapter seven the quality of the empiric statements are discussed. The methodological way which leads to the empiric statement dictates the quality of the statement within this research. The policy makers in this case are the management of the bank. The knowledge needed is defined by the problem statement and involves the product cost generated by suitable cost allocations. Answering this question is relevant to the management of the bank whom provided the assignment of this research. The research results prove to be relevant when a clear image for management appears in which their products value creating abilities are exposed, based on a comparison of the cost price and their sales prices.
2.7 Restrictions
Restrictions on the model
•
The cost allocation model does not include the client facing departments.
•
The field research is conducted throughout the six months period the internship has lasted.
•
In determining the value of the products, only value generated by the sales prices is included in this research.
Restrictions on the exposure of results:
•
The software used in which the cost allocation method is composed, is not to be exposed in this research.
•
Sensitive information about the price setting and the cost of the products is not presented in the public version of this thesis.
2.8 Information sources
Desk Research
In order to create knowledge about cost accounting systems, literature research is used.
Several information sources are used in creating this thesis. Such as internet sources, literature research, internal documents from the intranet of the ABN AMRO Bank (Polska) S.A. At the Intranet guidelines and instructions of the organization can be found in ABN AMRO’s Instruction Manual (A.I.M.). The sub questions each have their information sources, resulting in the following approach:
Sub question Reference Method of data gathering
1. Which cost allocation methods
generate unit cost according to literature? Chapter 3 Theory Desk research; literature
2. How does the current cost accounting method of operations measure up
to generating product unit cost? Chapter 4 Analysis
Desk research; internal documents on the profit and loss and cost categories Interview on scope of the research,
and products.
3. Which cost allocation method is
suitable to create accurate product unit cost? Chapter 4 Analysis Desk research
4. How can unit product cost be generated from the cost accounting method
according to literature? Chapter 5 Theory Desk Research; literature.
5. What are the calculated cost
prices and the sales prices of the products? Chapter 6 Analysis Literature, internal documents on cost allocation, Interview sheet, Calculated
Product cost price report.
6. Which products generate value for
the bank? Chapter 7 Conclusion and
Recommendation
Commission and charges sheet, Conclusions and Recommendation based upon results and literature into
further research possibilities.
Figure 2.2 data collection
Interviews
As a data collection method interviews are conducted because these enable the interviewer to obtain information about knowledge, attitudes, opinions and views on certain topics (Baarda en De Goede, 1998) of the interviewee. Interviews can be conducted in a structured and unstructured way. When performing a structured interview the interviewer knows exactly what information he needs and is able to design questions to obtain this. In the unstructured way however the information to be gathered is not known beforehand. Interviewing was used in sub question two to identify the scope and the products subject to this research. Structured interviews with the department heads of Working Capital and Financial Markets are conducted in order to define the users, scope and goals of the desired cost accounting model for sub question two.
Interview sheet
Interviews are conducted as a data gathering technique in establishing information to input into the cost accounting system to answer part of sub question five. The data input is determined based upon interviews with department heads
16of Working Capital and Financial Markets. Interviews are conducted on which activities are performed within the bank, how these activities relate to the products in the core activity sheet. In the support activity sheet the relation between support cost and activities is determined. Weighted cost drivers are established for direct and indirect cost allocation purposes. These two sheets result in cost drivers which determine how costs relate to products and services.
Calculated Unit Product Report
This sheet is the result of a report from the calculation method used to establish the cost of the products. The sheet contains of the products which are subject to this research with
16 See Appendix on “Interview Sheet”
information on volumes and prices. These costs serve as an outcome of the cost allocation model and serve as an input of the product value analysis at sub question five.
Commission and charges sheet
In this sheet the sales prices of all products which are used by the bank are established by the management board.
The research is presented as followed throughout the chapters:
Figure 2.3 Overview chapters
Analysis Theory
Chapter 1&2
Insight is gained into the context and design of the research.
Chapter 3:
Sub questions 1
Provide insight into the characteristics of methods of cost accounting
Chapter 4
Sub questions 2&3
Analyze current with desired information and select suitable cost allocation method.
Chapter 5
Sub questions 4
Gain insight into the process of applying the cost allocation
method.
Chapter 6
Sub questions 5
Allocate cost to products and establish product unit cost and their sales prices.
Goal: To provide Operations management of the ABN AMRO Bank Poland with a suitable cost calculation model, through which the unit cost of its products can be established in order to evaluate the sales prices.
Chapter 7 Conclusion
Subquestion 6
Interpret data on which products create value through comparing its cost
prices to its sales prices.
Chapter 3 Cost allocation methods
Chapter three is based on a literature study on the subject of methods for allocating cost from Cooper and Kaplan. Cooper and Kaplan (1998) have performed several studies on the subject of cost accounting techniques and how these distort management information. Important for this research to take these into account into account when selecting a suitable cost allocation method for the bank. The knowledge gained from this chapter is applied to the following chapters in two ways. First of all it provides the research with definitions used to analyze the current and future cost allocation methods. Second it is used to decide which cost allocation method is suitable in order to gain the desired information for operations management. It provides a background for this analysis based on answering the first sub question:
Which cost allocation methods generate unit cost according to literature?
a. What different types of cost exist?
b. How are cost assigned?
c. What cost allocation methods are applicable?
d. What are their strengths and weaknesses?
This chapter starts with defining the various cost terms, after which methods to allocate cost on support and operations departments are discussed. From paragraph 3.3 until 3.5, three basic methods are explained to allocate cost. Direct, traditional and Activity Based Costing are analysed through comparing their strength and weaknesses.
The chapter provides insight into the characteristics of the cost accounting methods applicable to generating unit costs within an organization as the ABN AMRO Bank. Cost allocation is an important topic because many of the costs associated with designing, producing and distributing products and services are not easily identified with the products and services that are created. The purpose of this chapter is to explain the concepts underlying cost allocations as well as a variety of methods for assigning costs to the various products and services produced. Three cost allocation methods have been selected who are able to fulfill these demands. These are direct costing, traditional costing and Activity Based Costing. These methods are discussed and compared in order to gain insight in their strengths and weaknesses. The next chapter uses this analysis to recommend the most appropriate model.
3.1 Basic cost terms
In this thesis the term cost is considered to be a sacrifice of resources. The main cost concepts are direct, indirect variable and fixed cost. Direct costs are costs that can be traced to a given cost object (product, department, etc.) in an economically feasible way (Kaplan 1996).
Indirect costs are costs that cannot be traced to a given cost object in an economically feasible way. These costs are also known as “overhead” or “burden.” Overhead in case of the bank is for instance the cost of the building. Overhead is usually assigned to a product group through an allocation key. This determines which part of the total overhead based on a formula can be traced to the product group.
The next to cost types are characterized through their relation to volume fluctuations. Variable
Costs are costs that change directly in proportion to changes in the related cost driver. Thus as
the volume changes these cost change with them. For instance the Full Time Employee (FTE)
time spent on an activity can be viewed as variable when they are paid per product. The more
products produced the higher the variable salary cost. However salary cost is not paid per
product within the bank. One could view them as being variably applicable thus adding them to the variable cost. Fixed Costs are costs that remain unchanged for a given time period regardless of changes in the related cost driver. The cost of the building is again an excellent example for it does not change when volumes produced change.
3.2 Cost allocation
There are three ways to allocate cost within an organization such as the bank which is divided into a service or support departments and operations departments. The first allocation method is the single step method (Horngren et al., 1997). This method deals with indirect cost of the support departments by allocating them to operations departments which use the services provided. This method takes all cost into account by allocating all of them to the operations department, leaving no cost behind.
The second method is the step-down or sequential method in which no reverse allocations are the main characteristic. In essence all cost is allocated to the next step and once costs are allocated from one department to another, they do not receive any additional allocations from other departments. In addition the department allocated not only to other departments but to products and services.
The reciprocal method takes the step down concept one step further. Departments are seen as supporting others but as well receiving support from others and that should be shown in the method. Therefore it allocates costs from one department to another based on its use plus each department receive allocation from one another. Thus taking the step-down method one step further, by implementing simultaneous allocation formulas for each department.
3.3 Three cost allocation methods
Three ways to assign support department cost and other overhead to products and services are described in literature (Kaplan 1996).
•
use of a single overhead rate
•
use of separate rate per department
•
use of several activity based overhead rates for each department
The first method allocates all indirect cost in one single company wide allocation rate. The difference of the support departments is not recognized and the whole company is seen as one department with one allocation key. A bit less ignorance to the fact that different support departments support operations in different ways is the traditional two step method; it separates service and operations departments. The first stage includes cost flowing through separate rates to the production departments. Within the allocation of cost between the operation departments and the products the second stage is defined.
The final way is called Activity Based Costing, which includes a two stage allocation process
as well. The first stage resembles the former allocation method. The second stage shows the
quality of the system by categorizing indirect cost into cost pools which reflect homogeneous
cost behaviour (Kaplan and Cooper, 1999). Therefore it can trace different categories of cost
to the products cost build up. In the following paragraphs these methods are described in detail.
3.3.1 Direct Costing
The first allocation method is known as the direct, marginal or variable costing method. This method focuses on the variable cost allocation. Hereby only the variable cost and variable overhead are included in the product cost calculation, for instance direct labour, direct materials or variable overhead. Fixed costs or overhead are treated as period costs. These costs are not regarded as product cost and thus not included in the calculation of a unit cost.
The overhead is charged to expenses in the current period and taken off the revenues of each period. Thus overhead costs are not taken into account in calculating product unit cost.
The method can be used for controlling costs, pricing products, special order situations, analysing markets and products for internal use where only variable cost matter. Horngren et al. (1999, p166) states that by allocating indirect cost of the service departments directly to the operating departments it does not recognize the interdependencies between the service departments. Therefore the direct method is oblivious for the reciprocal cost processes. The flaw in the system appears when cost are produced in one period but sold in another. The overhead is charged in the production period regardless whether the products are sold during the period. Therefore costs incurred and booked do not necessarily match each other. For this reason direct costing is applied only for internal use and not for external reporting.
3.3.2 The traditional method
Within the traditional method, costs are assigned according to a two step assignment method (Drury 1996):
The first stage consists of:
•
Allocating the service cost centers to the operating cost centers. The indirect cost generated by the support departments are allocated to other service or operation departments. Calculating separate cost drivers for each support and operations cost center.
The second stage:
•
Costs are allocated from operating departments to products. The three methods for this stage include direct, step down and the reciprocal method from paragraph 3.2
The first step is to allocate overhead cost to product and services or departments that generate
these. This is done, as shown in the figure, through an allocation key. The second step is to
trace direct cost to the products and services. According to Drury (1996) traditional cost
calculation methods are measured by using volume related values for allocating overhead to
products. Thereby dividing overhead through the number of products produced. In case of
proportionally variable overhead cost behavior this assumption is justified. For overhead is
allocated over the products according to their volume cost driver.
Figure 7 Traditional method cost allocation
The advantages are that cost match more accurately as within the direct costing method. For the cost within the two step methods do not become expenses until the inventory is sold.
Therefore it can be used for external reporting. The main disadvantage of the system relates to the assumption that overhead costs have a linear relation to the direct cost.
Disadvantages are product cost distortions and cross subsidies. Cross subsidies means that to much overhead cost flow to certain products and products get assigned too little overhead.
Therefore these two types subsidies each other. The first problem refers to the way product volume is taken into account; overhead costs are allocated to the cost objects through the drivers of the direct cost. Allocations bases for indirect cost are usually direct labor hours or machine hours. Thereby assuming that overhead and volume have a linear cost relationship and are connected. Thus when a higher volume of products is generated equal amounts of indirect cost are allocated to the cost object through this assumption. This is done usually by adding a percentage to the direct cost incurred which are driven by the volume of products produced. The second problem that arises and distorts product cost is the diversity of the products. Complex products which need many support activities tend to be under valued, while simple products over valued with less support. Product size leads to distortion because if volumes are low than a these products tend to get a low allocation of support costs which does not reflect reality.
Cooper (1998) reports several situations that can cause distortions such as volume diversity, complexity diversity, material diversity and set up diversity. Turley (1996, p21) criticizes the model within their perspective of a changed cost calculation environment. Change over the years on demands set for cost calculation systems have been evaluating without the system catching on. There is more competition and production methods have increasingly become more complex. While the traditional method is based upon simple calculation techniques and not able to grasp current reality. The main points of criticism issuing inaccurate cost drivers for allocating indirect cost. The volume based calculation of indirect cost distorts sound
Traditional method
Indirect cost
Departments Allocation Rate
Direct cost
Traceable Rate
Cost object
Service Cost object
Product Cost objects
Service / Product N
management decision taking. In addition is the way of allocating to simplistic whereby too much averages are taken into account and make the system too simplistic to be actually used in modern day production environments and provokes.
3.3.4 Activity Based Costing method
ABC is not new and has paralleled the development of traditional cost management. Heckert used the terms resources, activities, and activity drivers to discuss how to more accurately assign logistics costs in his 1940 text Distribution Costing. However, it took three events to occur before ABC would gain importance and acceptance: diversity in the resources consumed by different products or services produced by an organization, the development of low cost computing capability, and the increase of indirect costs in comparison to direct costs with ratios now exceeding 1000 percent in some firms
17.
In their article ‘Measure cost right, make the right decisions’ Kaplan and Cooper introduce Activity Based Costing as a ready to use method. Traditional costing methods split cost basically into two categories, variable and fixed (overhead) as seen in the previous paragraphs. A unit cost price is calculated by its use of this variable cost, which is assigned directly to it. However the indirect costs are split on a more arbitrary way usually based on a volume driven allocation. Since there is no causal link between indirect cost consumption and the volume of products that use them, costs prices are distorted. Cooper and Kaplan state that indirect costs are to some extend variable to fluctuations in product and customer‘s design, mix and range. Therefore they can be linked to the products and services that consume them.
In fact, Activity Based Costing takes the traditional method one step further by attempting to absorb fixed production overheads on a more relevant and appropriate basis looking at each cost individually and seeing what drives or causes the cost to increase.
Figure 3.1 conceptual model of an Activity Based Costing system
17 www.fiser.osu.edu
Activity-Based Costing
Resources
Resources Drivers
Activities
Activity Cost Drivers
Cost object
Service Cost object
Product Cost objects
Service
Recourses are consumed by activities in figure 3.1, which in their turn are consumed by products and services known as cost objects. The rate of this consumption is dictated by the cost drivers which link the resources to activities to products and services as shown in the figure below. Thereby putting effort in making all cost variables, recognizing that all cost vary, for instance production volumes or square metres for housing cost. There two stages within the Activity Based Costing technique based upon non- and production based cost drivers to allocate these cost.
The advantage of this method is that it uses the traditional two step method and takes it one step further. Through enabling the use of far more sophisticated allocation methods by using non production volume based cost drivers. A negative point is that it needs a lot more data to be constructed.
3.4 Strengths and weaknesses
The three methods compared show the following graphic:
Cost allocation
methods Variable costing Traditional Activity Based Costing
Main Characteristics
Only variable cost are included in the product cost, overhead is left out
All cost are traced or allocated to cost
object Overhead is driven through activities
to cost objects
positive
Useful for controlling costs, pricing products, special order situations, analysing markets and products for Internal use.
Widely used and conform external regulations.
Level of accuracy of unit costs calculated increases by using non production volume based cost drivers.
negative Matching error of indirect cost. Linear overhead allocation, which does not necessarily reflect reality.
Cross subsidies and price distortions.
Complex, Lots of data collection which takes time
Basis of indirect cost assignment
A production volume related activity measure, e.g., direct labour hours, machine hours, etc.
A production volume related activity measure. These may be different for each department.
Both production volume related and non-production volume related activity measures, e.g., number of purchase orders, number of set-ups, etc.
When applicable
Produces only one, or a few similar products that consume all indirect resources in the same proportions.
Each department produces only one, or a few similar products that consume all of a department's indirect resources in the same proportions.
Each department produces many products that consume resources within each department in different proportions.
Figure 3.2 the methods compared
