Activity Based Costing in the
International Express Business
Cost allocation in VitA Lite
Graduate Thesis for Study “Technische Bedrijfswetenschappen” at University of Groningen
Date: October 22, 2002 Version: Final
Author: Jasper de Jonge
Management Summary
A characteristic of the international express business is that more than 80% of the costs are fixed. The complexity in cost structure and unexpected losses prompted TNT to implement an Activity Based Costing (ABC) model in 1992. TNT management recognised that decisions based on intuition would lead to oversimplified conclusions. Traditional volume based cost allocation methods oversimplify and therefore distort the allocation of costs.
Changes in the business and improvements in TNT’s information system over the past 10 years make it necessary to review the cost allocation methods established in 1992.
The subject of this thesis is cost allocation in VitA Lite. VitA Lite is the name of the international cost allocation model of TNT Express. The objective of this thesis is to improve the relationship between the cost allocation model and the dynamics of the TNT business process, in order to provide accurate cost information.
The research starts with a study on ABC literature to get a better
understanding of the ABC theory. The cohesiveness of different ABC concepts will be presented in the conceptual model.
Reviewing all cost allocation methods in order to improve the cost allocation model would be very time-consuming. The focus of this thesis therefore is on the biggest opportunities for improving VitA Lite methods and accuracy. These opportunities can be found in cost allocation methods where the output, the calculated cost differ the most from the actual cost. The more material a cost pool, the bigger the opportunity for improvement of the cost allocation model.
Two evaluation cycles have been carried out to find the opportunities for improvement. Criteria have been found those indicate a relationship with accuracy of cost information per cost pool. The cost allocation methods have been evaluated on these criteria. Based on the score on these criteria and the materiality, the biggest opportunities for improvement of the cost allocation model have been selected. The Warehouse- and Field Sales cost allocation methods have been selected.
The Field Sales cost allocation method consists of a cost driver and
exceptions. No weighting was applied. An opportunity for improvement was expected but a thorough research concluded that the current cost
allocation method appears to be the most appropriate. The original rational for the cost driver is supported by the current KPI’s in the field sales process. The other opportunity for improvement is the cost allocation method for warehouse costs. The weightings have been reviewed. The result of the review was that it could be concluded that freight is currently under-cost. Based on the available volume information the new cost allocation method
resulted in a rate increase for outbound freight of almost 100%. To ensure the reliability of the new cost allocation method for warehouse costs, it is
recommended to do some more time and motion studies in several depots. The research carried out indicates that continual review and maintenance of cost allocation models is beneficial due to changes in TNT’s business process. Accurate cost information is key to understand profitability. In paragraph 6.2, a model will be presented that enables TNT to review and maintain their cost allocation model. The “cost allocation model” review and maintenance process is explained step by step.
Contents
MANAGEMENT SUMMARY ______________________________________________________ 3 CONTENTS _____________________________________________________________________ 5 PREFACE _______________________________________________________________________ 5 1 INTRODUCTION TO COMPANY AND PROBLEM _______________________________ 8 1.1 TNT POST GROUP_____________________________________________________________ 8 1.1.1 History _________________________________________________________________ 8 1.1.2 PTT Post ________________________________________________________________ 9 1.1.3 TNT ____________________________________________________________________ 9 1.2 TNT EXPRESS_______________________________________________________________ 11 1.2.1 Market________________________________________________________________ 11 1.2.2 Strategy ______________________________________________________________ 11 1.2.3 Organisation __________________________________________________________ 12 1.3 BUSINESS PROCESS___________________________________________________________ 12 1.3.1 Preface_______________________________________________________________ 12 1.3.2 Network ______________________________________________________________ 12 1.3.3 Transfer pricing ________________________________________________________ 14 1.3.4 Cost allocation in VitA-Lite _____________________________________________ 14
1.4 RESEARCH PLAN_____________________________________________________________ 16
1.4.1 Research objective____________________________________________________ 16 1.4.2 Conceptual Model (CM) ______________________________________________ 16 1.4.3 Central Question of Research __________________________________________ 18 1.4.4 Research Questions ___________________________________________________ 18 1.4.5 Restrictions ____________________________________________________________ 18 1.4.6 Supervision____________________________________________________________ 19
2 THEORETICAL FRAMEWORK ______________________________________________ 19 2.1 INTRODUCTION______________________________________________________________ 19 2.2 MOTIVE FOR ACTIVITY BASED COSTING___________________________________________ 19 2.3 THE ABC METHODOLOGY______________________________________________________ 20 2.4 ACCURACY OF ABC SYSTEMS___________________________________________________ 23 2.5 SELECTION OF COST DRIVERS ___________________________________________________ 25 2.6 THE OPTIMAL COST SYSTEM ____________________________________________________ 25 2.7 2-DIMENSIONAL ACTIVITY-BASED COSTING _______________________________________ 27
2.7.1 The Cost Assignment View _____________________________________________ 27 2.7.2 The process View ______________________________________________________ 28
2.8 RESOURCE USAGE____________________________________________________________ 28 3 THE CURRENT COST ALLOCATION MODEL AND THE OPPORTUNITIES FOR IMPROVEMENT________________________________________________________________ 29 3.1 PREFACE___________________________________________________________________ 29 3.2 VITA LITE__________________________________________________________________ 29 3.2.1 History ________________________________________________________________ 29 3.2.2 Objective _____________________________________________________________ 30 3.2.3 Principles _____________________________________________________________ 30 3.2.4 Database_____________________________________________________________ 30 3.3 APPLICATIONS_______________________________________________________________ 30 3.3.1 NCS __________________________________________________________________ 31 3.3.2 INCA __________________________________________ Error! Bookmark not defined. 3.3.3 AEMS __________________________________________ Error! Bookmark not defined. 3.3.4 Performance indicators derived from applications Error! Bookmark not defined.
3.4 PERFORMANCE INDICATORS FROM LITERATURE _____________________________________ 32
3.4.1 Preface________________________________________ Error! Bookmark not defined. 3.4.2 Product Diversity _______________________________ Error! Bookmark not defined. 3.4.3 Volume Diversity________________________________ Error! Bookmark not defined. 3.4.4 The relative cost of the activities aggregated ____ Error! Bookmark not defined.
3.5 OPPORTUNITIES FOR IMPROVEMENT______________________________________________ 33 3.6 VOLUME BASED COST DRIVERS__________________________________________________ 36
3.6.1 Consignment driven cost pools _______________________ Error! Bookmark not defined. 3.6.2 Statistical weight driven cost pools ____________________ Error! Bookmark not defined. 3.6.3 Invoiced revenue driven cost pools ____________________ Error! Bookmark not defined.
3.7 CONCLUSION________________________________________________________________ 37 4 EVALUATION OF 4 COST ALLOCATION METHODS __________________________ 38 4.1 PREFACE___________________________________________________________________ 39 4.2 EVALUATION METHOD_________________________________________________________ 39 4.3 SHORT TERM PROFITABILITY____________________________________________________ 41
4.3.1 Improvements suggested by McKinsey (S1) ______ Error! Bookmark not defined.
4.3.2 Possible scale benefits taken into account accurately (S2) __ Error! Bookmark not defined.
4.4 LONG TERM PROFITABILITY_____________________________________________________ 41
4.4.1 Related to the 7 right first time key processes (L1) ________ Error! Bookmark not defined. 4.4.2 Development of the relative size of the cost pools during the last 5 years (L2)_______ Error!
Bookmark not defined.
4.5 EVALUATION AND CONCLUSION _________________________________________________ 42 5 REVIEW OF TWO COST ALLOCATION METHODS ___________________________ 45 5.1 PREFACE___________________________________________________________________ 45 5.2 THE CURRENT COST ALLOCATION METHODS________________________________________ 45
5.2.1 Warehouse ____________________________________ Error! Bookmark not defined. 5.2.2 Field Sales______________________________________ Error! Bookmark not defined.
5.3 DATA COLLECTION FOR REVIEW COST ALLOCATION METHODS__________________________ 45
5.3.1 Preface_______________________________________________________________ 49 5.3.2 Warehouse ___________________________________________________________ 49 5.3.3 Field Sales_____________________________________________________________ 50
5.4 DEVELOPMENT OF AN ALTERNATIVE COST ALLOCATION METHOD _______________________ 52
5.4.1 Field Sales_____________________________________________________________ 56 5.4.2 Warehouse ____________________________________ Error! Bookmark not defined.
5.5 IMPACT ANALYSIS____________________________________________________________ 56 5.6 CONCLUSION________________________________________________________________ 57 6 CONCLUSIONS AND RECOMMENDATIONS__________________________________ 61 6.1 CONCLUSIONS_______________________________________________________________ 62 6.2 RECOMMENDATIONS__________________________________________________________ 62 BIBLIOGRAPHY________________________________________________________________ 67
Preface
This is the result of a research in order to complete the study “Technische Bedrijfswetenschappen” (Industrial Engineering & Management Science) at the University of Groningen.
This thesis is carried out in TNT Express at the divisional head office at the Business Economics department. The subject of this thesis is cost allocation in VitA Lite. VitA Lite is a model that is used in TNT for the allocation of costs to the international express products.
Many people contributed to my research and I would like to express my gratitude to the following people:
Mr. Jansen, the first supervisor from University, I would like to thank him for the good working relationship. He was always available for an ad-hoc question and I enjoyed the co-operation.
Mr. Wijngaard, the second supervisor from University, I would pass on my thanks to him for arranging the supervision of this research and his valuable input.
David MacMillan, he was my first supervisor from TNT. In the research period he has spent many hours on my thesis. His feedback has been very valuable for my research. He has put a lot of efforts into my introduction to the TNT organisation and my English writing style. I have learned a lot from him. Perry Heijne, as a manager of Business Economics and he was responsible for my hiring me for this internship. He was also my second supervisor at TNT. I would like to pass on my thanks for the opportunities he gave me, his input and the job he offered me.
My colleagues from the Business Economics department supported me during this internship. They provided feedback and came up with valuable
suggestions. In the time I was there as an intern they always treated me as a team member. I enjoyed all social events with the Business Economics team. TNT Germany, I would like to thank the following people in Germany who me helped doing the detailed review: Marc Fonseca, Anjum Dar, Herbert
Brueggen and the people at his depot that contributed to the research. Finally I would like to pass on my thanks to my family, my girlfriend and all friends that contributed to this research, for their support and help during this project.
1
Introduction to company and problem
1.1 TNT Post Group
TNT Post Group (TPG) is the holding company of Royal PTT Post and TNT. TPG is the world’s first publicly traded company with roots in the postal business. TPG has been listed on the Amsterdam, London, New York and Frankfurt stock exchanges since 29 June 1998. The logo represents the concept of one company with two brands, see exhibit 1.1. Red is the colour of PTT Post, while the distinctive orange represents TNT. Blue was added to unite the two colours and represents the corporate head office.
Exhibit 1.1: Holding company TPG of Royal PTT Post and TNT 1.1.1 History
PTT Post came into existence in 1779 when postal services were converted to a national enterprise, following the French example. Through the ages the state owned PTT collected lots of communication-related activities.
In June 1994 the Dutch government sold 30% off its shares in PTT Nederland N.V. The joint mail and telecom company was listed on the Amsterdam stock exchange as Koninklijke PTT Nederland (KPN).
At the end of 1996 TNT was friendly taken over by KPN. To ensure the integration of the two companies a number of measures were taken. The core business was defined and some of TNT’s operations were sold off because they did not fit.
In 1997 KPN began the process of integrating TNT and PTT post. In June of the same year the Board of Management announced that it had passed a resolution authorising the demerger of all mail, express and logistics
operations. This resulted in the formation of the new holding company, TPG, containing the brands TNT and PTT-Post.
1.1.2 PTT Post
PTT Post (Mail division) has been the national postal company in the Netherlands for over 200 since it establishment in 1799. An ultramodern infrastructure for sorting and distributing postal items and about 57,000 postal delivery- and sorting employees ensure that 23 million items are delivered daily to more than 7 million addresses in the Netherlands.
PTT Post is also a market leader in international business mail. Besides delivering postal items, PTT Post provides a diverse range of Direct Mail services, all based on the use of postal items as an advertising medium. Print & Mail is a growing subsidiary that prints information that customers supply electronically and delivers it as physical mail.
On the occasion of it 200-year anniversary on 15 January 1999 PTT Post is granted the title “Royal PTT Post”. The crown in the logo is reflecting this royalty, see figure 1. In January 2002 TPG received permission from the Dutch queen to change the name PTT Post into TPG Post without loosing its royalty. The new name is “Royal TPG Post”.
1.1.3 TNT
The roots of the divisions under this name are in Australia. In 1946, Ken Thomas started his own company – Thomas Nation-wide Transport (TNT) – with a fleet consisting of a single truck. In less than half a century, his company grew into a global enterprise, even operating its own fleet of aircraft. Much of the growth came from take-overs and interests acquired in other companies. Nowadays two divisions carry the TNT brand; these divisions are TNT Express and TNT Logistics.
TNT Express is the largest division of TPG and provides global express, mail and
logistics services. TNT Express offers on-demand time-definite and day-certain door to door express delivery services for documents, parcels and freight. The international operations are focused on the key areas of world trade in
Europe, Asia, North- and South America. TNT also has strong domestic networks in Australia and Europe.
TNT Logistics is the fastest growing division of TPG through a combination of
organic growth and selected acquisitions geared to the creation of a global footprint in terms in geography and sectors.
The core business is to manage infrastructure, processes and technologies for customers to ensure that the right goods, in the right quantities and condition, are available at the right place and time. TNT logistics has a strong presence in the following industry sectors:
• Automotive
• Tyres
• Hi-Tech Electronics/Telecom
• Consumer and Media
TPG
Countries with company owned operations 58
Employees at year end 129,675
Postal items delivered in the Netherlands 7,022,000,000
Number of delivery addresses 7,278,000
Post Offices in the Netherlands (including 500 Bruna outlets) More than 2500
Total kilograms of international mail carried 89,141,000
Express
Vehicles 19,126
Aircraft 61
Depot/hubs 840
Countries served by Express More than 200
Total tonnes carried 3,298,000
Total consignments carried 217,266,000
Logistics
Warehouses 392
Square meters in Logistics warehouses 4,500,000
1.2 TNT Express
1.2.1 Market
TNT Express (TNT) provides on-demand, time-definite and day-certain delivery of documents, parcels and freight. TNT provides regional, national and global express delivery services. At the regional and national markets TNT meets lots of competitors. But four big companies own the main part of the global market, these companies are:
• DHL (Dalsey, Hillbloom and Lynn)
• FedEx (Federal Express)
• UPS (United Parcel Service)
• TNT (Thomas Nation-wide Transport)
The core market of UPS and FedEx is the USA, while Europe is the core market of DHL and TNT. At the European market these four companies had the following market shares: DHL 25%, TNT 21%, UPS 13% and FedEx 5%. (Internal competitor analysis, 1999)
1.2.2 Strategy
TNT’s strategy is to be the best and most successful express delivery provider. The vision behind this objective is “to be the fastest and most reliable provider of express delivery services”. An overview of the TNT vision, strategy,
stakeholders and quality principles is included in appendix 1. The core of the TNT strategy is:
• Maintaining a strong customer focus by creating tailored express solutions for large and mid-size customers and offering excellent customer service by applying state of the art information technology.
• Expanding capacity, coverage and technology capabilities through the addition of road and air fleet, hubs, depots and other infrastructure and through the development of technology.
• Reducing costs and improving services by integrating its international and domestic distribution networks and offering seamless services through its air and road networks for line haul and delivery operations.
• Further strengthening of the TNT brand to increase recognition and appreciation in the global marketplace.
The domestic Express products are tailored to meet customer needs for fast and reliable on-demand door-to-door delivery services in national markets. The core global Express product range is equally customer focussed and available throughout the world. It includes the following door-to-door services, all of which are offered for documents, parcels and freight:
• Sameday: on-demand, round-the-clock immediate delivery
• 9:00 Express: next-day delivery by 9 a.m. specific major cities world-wide
• 12:00 Express: next-day delivery by noon to major cities world-wide
• Road Express: fastest-by-road daily express delivery throughout Europe
1.2.3 Organisation
The organisation of TNT Express division consists of nine Business Units (BU’s). Four central organised departments support the BU’s, see exhibit 1.2. These supporting staff departments are organised by function. The group-managing director, Alan Jones, is also a member of the board of TPG responsible for TNT Express.
The international BU includes all South- and North American countries and all the other countries not included by the other BU’s.
Looking at the organic structure of TNT it becomes clear that the emphasis of the global activities of TNT is in Europe.
Exhibit 1.2: Organic structure TNT Express
1.3 Business Process
1.3.1 Preface
A high level definition of the business process of TNT Express (TNT) is the transportation of material (document, parcels and freight) from A to B. In paragraph 1.3.2 this network will be described. In paragraph 1.3.3 transfer pricing is described.
1.3.2 Network
For the world-wide transportation from A to B TNT designed a network of own- and third party activities. In Europe TNT owns the entire network but it is not economic for TNT to build a world-wide network because the volumes are not
DHO Express David Burton IS & e-Commerce Shawn Moubarak Express Finance Michael Murray Express Security Ken Matthews Group Managing Director TNTExpress Alan Jones TNT UK & Ireland Tom Bell TNT Italy Giuseppe Smeriglio TNT International James McCormac TNT Australia Roger Corcoran TNT Benelux Jan Schipper TNT France Marie-Christine Lombard TNT Asia, Middle East & Africa
Ken McCall TNT Air/Road Network Christian Drenthen TNT Germany Innight Donald Pilz
big enough to own a world-wide service. In this section is explained how TNT is enabled to offer it customers a world-wide service. Like most networks TNT’s
network consists of hub’s and spokes. This structure enables TNT to offer its
customer a flexible service with a fixed structure.
In for example the Netherlands the network consists of one hub and 5 spokes to 5 depots. The depot is the starting- and end hub of the shipment through the network. The 5 Dutch depots fully cover the Netherlands.
When a customers requests TNT to ship a consignment the material will be picked-up by a van or a truck that is responsible for the area where the customer is based. This area belongs to a region. A region belongs to a depot. See figure 1.3 on the next page for a simplified image of region.
Exhibit 1.3: Region
The material will be transported to the depot. In the depot all collected material is sorted. When the destination of the material is in the region of the depot then the material stays for one night at the depot and will be delivered the next day in most cases.
When the destination is outside the region the material will be shipped to the national hub. At the national hub the material is again sorted on destination. When the destination is domestic (in the Netherlands) the material will be shipped to the one of the national depots. The depots then take care of the delivery during the next working day.
When the destination is international the material will be shipped to the European hub. TNT has two European networks: a road network and an air network. Time sensitive shipments will be shipped to the central hub of the European air network and the other material will be shipped to central hub of the European road network.
In both European hubs the material is again sorted on destination. After the sorting process the material is sent to the national hubs. In the national hubs the material is again sorted on destination region/depot. The Netherlands has just one national hub. Bigger countries like France and Germany have more than five national hubs that have been connected with the European hubs. When the destination of the material is outside of Europe truck or plane will ship it from the European hubs to an airport. Which airport is dependent of the destination and the service level of the shipment.
From the airport a third commercial party will ship it to the destination country. At some main airports in the world TNT owns own sorting centres, called
non-Depot Area
network hubs. There are two main reasons why TNT owns hubs while the air connections are serviced by third parties:
• Third parties charge too much money for the sorting process and it is more economic to own the non-network hub.
• The ownership of the non-network hub enables TNT to maintain a higher service quality.
Finally the shipment will arrive in the destination country outside Europe. This country could be a TNT country or an associate. In a TNT country TNT own the national network itself. In an associate country a franchised associate
company delivers the shipments at the destination address. Exhibit 1.4 shows a simplified picture of the network.
Exhibit 1.4: Simplified illustration of a network segment 1.3.3 Transfer pricing
All the business units and countries within a business unit are profit centres. Most regional depots are cost centres but in some countries even the depots are profit centres.
An origin sending country is normally the point where customers are invoiced and revenue is recognised. When the shipment is international only a part of the cost is incurred in the origin country itself. The international network and the destination country incur remaining costs. The destination country has to deliver the consignment to the receiving customer.
To maintain a desired service level it is important that the partner country that delivers the material is compensated in a way closely related to the activity level regarding to the partner activities. Otherwise the delivery of material for partners would be loss making and therefore de-motivating. The starting point of transfer pricing is the allocation of costs to units of efforts.
1.3.4 Cost allocation in VitA-Lite
TNT has an activity based costing system, called VitA-Lite, that allocates costs to services based on resources used. ABC systems estimate the cost of the
European Hub
activities/resources deployed to the specific service or product. The ABC system was initiated in the early nineties.
In those days TNT was investing in the network for the long term. The volume through the network was low at that stage and had to increase. A
characteristic of the express business is that the greater part of the costs is fixed. The ABC system was initiated to provide product- and traffic lane, cost- and profitability information. This information was desired in order to gain a better understanding of contribution and cost structure.
The cost allocation method depends on the dynamics of an activity or process. Each method should fit the specifics of the activity to allocate the cost realistically. Realistic cost information is needed to determine whether a service is profitable or not. TNT would like to build an enterprise-wide ABC solution. The next paragraph presents the research plan. The research plan shows the applied approach for this research.
1.4 Research Plan
1.4.1 Research objective
To improve the relationship between the cost allocation model and the dynamics of business process in order to ensure:
-Accurate costing
-Decision making support
1.4.2 Conceptual Model (CM)
The conceptual model shows on which aspects are focussed on to come to conclusions.
The first part of the research focuses on finding the opportunities for
improvement. These can be found in cost allocation methods that produce calculate cost that differ significantly from the actual cost. The resources that are actually consumed by a product are the actual cost. The accuracy of cost information is dependent on the difference between the two costs. The materiality of a cost pool together with the accuracy result in an impact on decision making. Based on this impact the cost allocation method will be selected. For a detailed review of a cost allocation method an activity analysis is required. The results of this analysis are used to develop a cost allocation method. The model illustrates that a cost allocation method requires cost driver(s), weightings and exceptions.
Activity Analysis
Weightings
Cost Driver(s)
Exceptions
Cost Allocation
Calculated Cost
Actual Cost
Impact on Decision
Accuracy of Cost
Materiality
1.4.3 Central Question of Research
How can the relationship between the dynamics of business processes and the cost allocation methods be improved?
1.4.4 Research Questions
Research questions are exploitations of the central question of research. The solutions of the research questions must provide information to answer the central question of research. The conceptual model is an overview of the research process and the research questions are derived from the
conceptual model.
The research questions are:
1. What are the key performance indicators (KPI’s), the requirements and conditions for cost allocation in literature?
2. What level of accuracy in cost allocation is desired in the TNT international express business?
3. How are costs currently allocated?
4. Which cost allocation methods need to be reviewed based on accuracy in cost allocation and impact on long- and short-term profitability?
5. What is the most accurate cost allocation method for the 2 selected cost pools?
6. What will the impact be on the unit rates when applying the alternative cost allocation method(s)?
7. What are the financial and practical feasibility of proposed cost allocation methods for TNT?
1.4.5 Restrictions
There are several restrictions concerning the results and research process:
• The research is confidential, during and after the research period.
• During the internship the student is a member of the business economics (BE) team, time available:
-50 % of the student’s formal capacity is dedicated to BE activities
-50 % of the student’s formal capacity is dedicated to the research
1.4.6 Supervision
• Supervisors from the university: 1. Mr. Dr. E.P. Jansen 2. Mr. Prof. J. Wijngaard
• Supervisors from TNT: 1. David MacMillan 2. Perry Heijne
2 Theoretical
Framework
2.1 Introduction
The popularity of the ABC concept has begun with the existence of the articles of Cooper and Kaplan. In general they are regarded as the founders of the cost pricing method based on activities deployed to produce products or services. The two scientists published their first article about this subject in 1987 in the Harvard Business Review. The world viewed the article as
revolutionary. Subsequently many articles have been published about this subject in the Journal of Cost Management and in the Harvard Business Review.
2.2 Motive for Activity Based Costing
One of the most famous examples of the line production is the production of the T-Ford. The design of the factory and the production process were based on Taylor’s scientific management principles. This line production situation is ideal for large volume production and less variability. A very well known quote of Henry Ford was: “You can choose any colour you want, as long as it is black.” Images of this production situation are shown in Charlie Chaplin’s movie “Modern Times”.
In these days industrial production was supply driven. The demand was matched to the price by changing the price. As a consequence of the growing competition since the industrial revolution the market has changed from a supply-driven in a demand-driven market. This means that the supply is matched with the demand. This different approach increased the product diversification, based on customer wants, in order to comply with customer’s wishes.
The increased variety of the product range increased the complexity in the production situation. Differences existed between the number of activities, the routing and the batch size of products in the factories. Up till about 15 years ago most cost calculation methods assumed a situation similar to the Ford example. In that case all the direct costs are directly allocated to products and all the indirect costs or overhead are allocated to products based on volume assuming that the utilisation of the indirect resources was similar for every product. Cost systems that assign overhead in proportion to production volume can be called unit-based systems. (Cooper, 1)
These systems do not take into account that the different products could have different routings, -number of activities and -batch sizes. Due to mechanisation and automation the proportion of the indirect costs have increased over the past decades. As a result of this the direct cost for example labour have decreased.
The increased variety of products and the increased share of indirect costs in combination with the unit-based costing system result in incorrect cost
calculations. Products produced in large batches, with a low number of activities are over-priced. Products produced in small batches, with many activities are under-priced. The inaccurate cost information resulted in wrong decisions. Products that seemed profitable were loss-making and vice versa. There was a need for a system that allocated costs to products based on the actual utilisation of the resources to prevent companies from destroying value by producing loss-making products.
2.3 The ABC methodology
In paragraph 2.2 the shortcomings of the unit-based costing system are demonstrated. Another approach in cost allocation is the activity-based costing system. The main principle of ABC is that activities in a facility’s
production process make costs instead of products (Cooper & Kaplan, 1991). An ABC system roughly consists of two parts:
The first step in an ABC system allocates costs of the resources to activities.
When designing the system, the designer has to make choices about the level of detail of activities in the ABC system. The higher the levels of detail of activities in the ABC system the more accurate the cost information. The more detail also makes the system more complex and expensive to run. The
choices surrounding the level of detail will be discussed in more detail later in this chapter.
When costs of different resources are grouped as activity-centre, the cost behaviour must be similar otherwise the cost would be allocated
inaccurately. The cost behaviour of an activity-centre is the relation between the change of costs of the activities and the change of the cost-driver
volume.
A cost driver is a factor that determines the workload and effort required of an activity and the resources needed. An activity may have multiple cost drivers associated with it. (Turney, 1992)
ABC systems represent the production process of a company as a hierarchy of four mutually exclusive and exhaustive categories of activities:
1. Unit-level activities, which are performed each time a unit is produced; 2. Batch-level activities, which are performed each time a batch of goods is
3. Product-level activities, which are performed as needed to support the production of each different type of product; and
4. Facility-level activities, which simply sustain a facility’s general manufacturing process. (Cooper, 1)
In exhibit 2.1 the hierarchy of activities is shown. Under expenses some factory related examples are shown for each type of activity.
Exhibit 2.1: Profit Priorities from Activity-Based Costing, Robin Cooper and Robert S. Kaplan, Harvard Business Review, May-June 1991, p. 130-135.
According to Turney (1992) two additional categories of activities exist in addition to the four categories of activities mentioned in exhibit 2.1. He also defines ‘Process-level activities’ and ‘Customer-level activities’.
• Process-level activities support individual processes in an organisation. The costs of these activities are direct for a group of products using the
involved process, but indirect from an individual product point of view.
• Customer-level activities are performed specific to a certain customer. The costs of those activities can be allocated to the customers. Examples of customer-level activities are customer specific order processing or logistic support.
The customer-level activities can however be regarded as batch sustaining activities. A customer generates the demand for a batch of products. For instance the sales efforts directly related to the customer can be allocated to the products that the customer has consumed (the batch).
In the second step of the ABC system, costs of the activity centres are
allocated to products. The Unit-level activities can be direct related to
products. The batch-, product-, process- and customer level activities can be indirectly related to products. The costs of facility-level activities, however, are treated as period costs or allocated to products in some arbitrary manner. (Cooper, 1)
The starting point of the cost allocation from the activity centres to products is the volume of activity consumed by the products. The total volume of the cost driver consumed by the product s is required to calculate a rate for a
FACILITY SUSTAINING ACTIVITIES PRODUCT SUSTAINING ACTIVITIES BATCH SUSTAINING ACTIVITIES UNIT-LEVEL ACTIVITIES PLANT MANAGEMENT BUILDING AND GROUNDS HEATING AND LIGHTING
PROCESS ENGINEERING PRODUCT SPECIFICATIONS ENGINEERING CHANGE NOTICES SETUPS MATERIAL MOVEMENTS PURCHASE ORDERS INSPECTION DIRECT LABOUR MATERIALS MACHINE COSTS ENERGY
ACTIVITIES
EXPENSES
unit of the cost driver. The price per unit of the cost driver is determined by the costs of an activity centre under normal circumstances divided by the
volume of the cost driver under normal circumstances.
Costs of the activity centre under normal circumstances
Unit price cost driver = --- Volume of the cost driver under normal
circumstances
The number of cost driver units consumed per product, the weighting, multiplied by the cost driver unit price results in an activity unit price per product.
For the direct related activities the allocation of the costs to the product units is a quite simple. For the indirect activities an extra calculation is needed. This calculation is need to transform the unit price of a batch-, product-,
customer- or process- sustaining activity into a unit price per product for these activities. To calculate this the number of units per batch, product, customer or process must be known.
Unit price of a batch
Unit price/product for a batch sustaining activity = ---
Number of units in the batch
2.4 Accuracy of ABC systems
The accuracy of an ABC-system is mainly determined by the number of cost pools and cost drivers used. The accuracy of reported costs out of the ABC system increases in general as the number of cost pools and cost driver increases. The need for a more accurate cost system increases as the complexity of the product mix increases.
Three factors determine whether a single driver cost allocation system causes distortion e.g. more cost pools and cost drivers are needed:
1. Product diversity: Products are said to be diverse when they consume activities in different proportions.
2. The relative costs of the activities aggregated: This is a measure of how much each activity costs as percentage of the total cost of the
production process.
3. Volume diversity: This occurs when products are manufactured in batches of different sizes.
The disadvantage of a more accurate ABC system is the greater complexity of the system and the higher register costs. A more complex ABC-system will be accepted less quickly. (Cooper, winter 1989)
2.5 Selection of cost drivers
When the desired accuracy is determined by the factors: product diversity, relative cost of the activities aggregated and volume diversity, the
appropriate cost drivers can be selected. Three factors should be taken into account when selecting a cost driver:
1. The ease of obtaining the data required by that cost driver (cost of measure measurement);
2. The correlation of the consumption of the activity implied by the cost driver and the actual consumption (degree of correlation); and 3. The behaviour induced by that driver (behavioural effects). (Cooper,
Summer 1988)
2.6 The optimal cost system
An important consideration before implementing an ABC system is the net result of the implementation of an ABC system.
The benefits of an ABC system are most prevalent when the objective is to continually create value. The more accurate the ABC system the less chance of errors that end up in destroying value. Errors can occur in product pricing, operating decisions, buy- and sell decisions, investments, strategic fit, etc. Cooper refers to this as “Cost of errors”.
Exhibit 2.2: Optimal Cost System (Cooper, Fall 1988)
Figure 2.Optimal Cost System, The Rise of Activity-Based Costing-Part
Two: When Do I Need an Activity-Based Cost System?, Robin Cooper
For the cost of an ABC system uses Cooper the term “Cost of measurement”. This term includes all the cost of an ABC system. (Cooper, fall 1988) The more accurate the ABC-system the more expensive the ABC-system will be. To improve the accuracy of the ABC-system, extra driver information is needed in most cases. Collecting additional driver information increases the cost of the ABC-system.
The sum of the cost of errors and the cost of measurement results in the total cost of the ABC-system. The desired accuracy level is the level where the cost of the system are outweighed to a point where the ROI generated by the additional accuracy is greater than the weighted average cost of capital (WACC) i.e. value adding.
O p t i m a l C o s t S y s t e m 0 5 0 1 0 0 1 5 0 2 0 0 2 5 0 1 4 7 10 13 16 19 22 25 A c c u r a c y Co st T o t a l C o s t C o s t o f e r r o r s C o s t o f m e a s u r e m e n t
When a company for example decides to decrease its product- and volume diversity the cost of errors will also decrease. As a result of this the minimum of the total cost curve will shift to the left indicating that the desired accuracy has also decreased.
2.7 2-Dimensional Activity-Based Costing
ABC allocates cost to products in a more accurate way than the traditional cost allocation systems. Besides this improvement the ABC system also increases the ability to get a better understanding of the factors that determine the performance of activities.
Turner’s second generation ABC has two main views. The first is the cost assignment view. This is the vertical part of the model shown in figure 2. It reflects the need for organisations to assign costs to activities and cost objects. The second, the process view, reflects another need for information that can be distracted from an ABC system. This is information about events that influence the performance of activities and activity performance. That is, what causes work and how well is it done.
Exhibit 2.3: The ABC model (Turney, 1992) 2.7.1 The Cost Assignment View
The cost assignment view focuses on the allocation of costs to activities and cost objects (products, customers) in order to improve the decision making process. This decision making process includes price setting, product mix, expand issues, product development and prioritising improvements. The cost assignment view delivers financial information.
The information is focused on the consumption of resources, the activities and the cost objects. In Turney’s ABC model the customer is also regarded as a cost object. The need for customer service and customer support activities depends on the business. A large part of the costs consists of those customer related in most businesses. Early ABC systems resided exclusively within the
Cost Assignment View
Cost Drivers
Cost Objects
Resources
Performance
Activities
Process Viewwalls of the plant. Their focus was exclusively on manufacturing activities. (Turney, 1992)
2.7.2 The process View
The process view focuses on the determination of the factors that influence the performance level of the activities and the relationship with other activities.
A process is series of activities that are linked to perform a specific goal. Each activity is a customer of another activity and, in turn, has it own customers. In short, activities are all part of a customer chain, all working together to provide value to the outside customer. (Turney, 1992)
On a more detailed level the process view provides information about cost drivers and performance measurements of every activity or process within the customer chain. This information is primarily non-financial and is essential for analysing and improving the performance level of both activities and process.
Cost drivers are the factors that determine the number of activities that must be performed. Cost drivers therefore indicate why an activity must be
performed and how many resources must be consumed to perform these activities. Analysing the relationship between cost drivers, activities and processes increases the understanding of the improvement areas.
Performance measures describe the work done and the results achieved in an activity. They tell how well and activity is performed. They communicate how the activity is meeting the needs of its internal or external customers. They include measurements of the efficiency of the activity, the time required to complete the activity, and the quality of the work done. (Turney, 1992) The operational information allows management to obtain answers to question such as:
• What events trigger the performance of the activity?
• What factors negatively affect the performance of the activity?
• How efficiently, how fast, and with what quality is the work carried out?
2.8 Resource Usage
An alternative for the process view is the resource usage model presented by Cooper and Kaplan. As mentioned before the unit rate for a cost driver is calculated based on normal circumstances. When in a period, the demand for activities decreases, the demand for resources should also decrease maintaining the same unit-rate.
In practice this relationship will not always be satisfied. The conventional fixed versus variable cost classification can explain why the resource usage will not decrease proportional. A share of the resource costs is fixed and can not be decreased within a short period of time.
This explanation does not really challenge to perform actions on managing the level of the unit rates. Cooper and Kaplan propose the following
Activity Availability = Activity Usage + Unused Capacity
The ABC resource usage cost information can be used by managers to monitor and predict the changes in demands for activities as a function of changes in output volume and mix, process changes and improvements, introduction of new technology, and changes in product and process design. As such changes are contemplated, managers can predict where either modify their decisions so that activity demand will be brought into balance with activity supply, or they can change the level of activities to be supplied in forthcoming periods. (Cooper and Kaplan, 7)
3
The current cost allocation model and the
opportunities for improvement
3.1 Preface
The cost information derived from an allocation model is used primarily as input into the decision making process. The accuracy of output depends on:
• The ability of a cost allocation model to capture the complexity of the business.
• The required accuracy of the cost information by the users, to minimise the risk associated with errors.
This chapter has the following objectives:
• Investigate the current cost allocation model.
• Ascertain the level of accuracy required by the cost information users.
• Find opportunities for improvement of the current cost allocation model. These opportunities are found by focusing on cost allocation methods that apply volume-based drivers.
3.2 VitA Lite
3.2.1 History
3.2.2 Objective
The objective of VitA Lite is to provide cost- and profitability information by product and traffic lane, in order to gain a better understanding of
contribution and cost structure. It generates base data for the commercial system, AEMS and the transfer pricing systems INCA and NCS. The commercial system and transfer pricing systems will be described towards the end of this chapter. 3.2.3 Principles 3.2.4 Database
Confidential
Confidential
Confidential
3.3 Applications
3.4 Performance indicators from literature
3.5 Opportunities for improvement
3.6 Volume based cost drivers
3.7 Conclusion
4
Evaluation of 4 cost allocation methods
4.1 Preface
In the previous chapter the cost allocation methods have been evaluated from a theoretical point of view. This evaluation identified 4 cost allocation methods that may provide a “quick win” if they were to be improved. The overall objective of this research is to improve the relationship between the dynamics of the business processes and the cost allocation model in order to ensure the quality (accuracy) of cost information. Time constraints required that the research evaluate 4 cost allocation methods, eliminate 2 of the 4 cost allocation methods after the first round of evaluation and focus the remaining research time on 2 cost allocation methods.
The objective is to evaluate the 4 cost allocation methods to be able to select 2 of them for a detailed review. The evaluation deals with the following cost pools:
• Warehouse (sorting)
• Field Sales (regional sales)
• Rest of World overhead charge (TPG/TNT head office cost, etc)
• Regional/National Management (country- and business unit management)
The remainder of the chapter flows as follows:
• Paragraph 4.2: Evaluation method
• Paragraph 4.3: Short term profitability evaluation criteria
• Paragraph 4.4: Long term profitability evaluation criteria
• Paragraph 4.5: Evaluation and conclusion
4.2 Evaluation method
Accuracy of the cost allocation methods is required for a good understanding of the profitability and therefore for good decisions and management. Accuracy however is very hard to measure especially from a high level. The more accurate the method, the volume- and the cost information the better is the output, the cost information.
Exhibit 4.2: Simplified image of an allocation method
For this evaluation it is assumed that the quality of the input data, the volumes and the costs, remains the same. Ceteris Paribus, an improvement to the cost allocation method will increase the quality of the cost information.
The cost allocation method intends to reflect the cost behaviour of the underlying activity related to the cost pool. The cost allocation method consists of a cost driver, weighting(s) and exceptions. The cost driver concept is explained in chapter 2. Weightings are applied to reflect the relative
consumption differences per product for an activity. Exceptions in a cost allocation method are applied to reflect non-standard cost behaviour, of the underlying activity related to the cost pool, for non-standard products. The quality of the three components determines the quality of the cost allocation method. Changes to underlying operational process will impact the accuracy of a cost allocation method that may lead to a change to the method depending on the size of the impact.
The cost pools will be evaluated based on criteria that are closely related to short- and long-term accuracy. For this evaluation it is assumed that accuracy on the long term influences the long-term profitability. Accuracy on the short term influences the short-term profitability. The rationale for selecting these categories is that lack of accuracy causes incorrect information. Incorrect information leads to incorrect decisions that lead to a decrease of the profitability.
For the evaluation of the cost allocation methods, criteria or indicators must be found that measure the performance of the cost allocation method. To maintain structure in the evaluation criteria have been categorised into short-term- and long-term accuracy. Criteria related to short-term accuracy
identify the current shortcomings of the cost allocation methods. Criteria related long-term accuracy identify potential shortcomings of the cost allocation methods in the future.
An investigation of the documentation of the cost allocation model and theory has taken place to identify these criteria. A quantitative list is created with criteria that may have a relationship with the accuracy of the cost allocation methods. This list was reviewed to ensure that the criteria do not intend to measure the same shortcomings of the cost allocation methods. There is a great chance that you measure the same impact more than once. This can result in the fact that such an impact can dominate the evaluation. To prevent from this error the final criteria have been double-checked by and
Allocation
method
Volume Cost Costed Volumediscussed with the supervisor of this research at TNT, David MacMillan and the head of corporate strategy at TPG, Peter van Laarhoven.
In the two following paragraphs the two categories are explained and their criteria are identified.
The objective of using those criteria is to detect the lack of accuracy in the 4 methods that were left over after theoretical review of the cost allocation model. The criteria are made quantifiable and the cost allocation methods can score on each criterion.
For the quantification of the criteria it is decided that the maximum score on each criterion is 2. The rationale for equal maximum scores is that the
weighting of each criterion is very difficult to define. Therefore it is assumed that all criteria have the same weighting in terms of impact on accuracy. The following logic is applied for the scoring:
• If two options exist, a cost allocation method can score 0 or 2.
• If three options exist, a cost allocation method can score 0, 1 or 2. Two criteria exist per category and therefore the maximum score to be achieved is 8.
The two cost allocation methods that get the highest overall score will be selected for a detailed review.
4.3 Short term profitability
4.4 Long term profitability
4.5 Evaluation and conclusion
The scores on the criteria are summarised in the table below. The multiplier is applied to calculate the final scores on impact on short- and long-term profitability. After the scoring the 4 cost pools are plotted in a graphic. The horizontal axis represents the impact on short-term profitability. The vertical axis represents the impact on long-term profitability.
Cost Pool
ST Profitability LT Profitability Score S1 Score S2 Score L1 Score L2Multipl. Short T Long T Warehouse 2 0 2 1 4.21 8.42 12.63 Field Sales 2 1 2 1 2.44 7.32 7.32 Reg/Nat Management 0 2 1 1 1.82 3.64 3.64 ROWHead Office Charge 0 2 0 2 2.73 5.46 5.46
Exhibit 4.6 Evaluation scores
Graph 4.1: Evaluation results graphically
The result of this evaluation is that the Warehouse- and Field Sales activity have the highest score on both criteria. It can be concluded that the impact on short- and long-term profitability is the highest. It is assumed that the biggest opportunities for improvement can be found in these cost allocation methods. Therefore are these cost allocation methods selected for a detailed review. 0 2 4 6 8 10 12 14 0 2 4 6 8 10 Impact on ST profitability Im pact on LT pr ofitability Warehouse Field Sales
ROW Head Office Charge Regional/National Management
5
Review of two cost allocation methods
5.1 Preface
In the previous chapter 2 cost allocation methods were selected for a review. These were the cost allocation methods for warehouse and field sales. A more in-depth evaluation of these two cost pools will be considered in this chapter. The objective of this chapter is to investigate the opportunities for improvement of the accuracy of the two cost allocation methods.
In section 5.2 both current cost allocation methods are discussed. The way they were developed is presented. Section 5.3 explains how the data is collected required to develop an alternative method. In section 5.4 an alternative cost allocation method is developed for the warehouse activity. This alternative method is tested in section 5.5 by presenting an impact
analysis. This chapter ends with a conclusion and further recommendations in section 5.6.
5.2 The current cost allocation methods
5.3 Data collection for review cost allocation methods
5.3.1 Preface 5.3.2 WarehouseConfidential
Confidential
Exhibit 5.2: Data collection warehouse
Data Collection Warehouse
Activity: Deliverable: Required for: Research Method Duration
A
Investigate other costs: relative size, relationship with activities, relationship with products
A way how to deal with the allocation of other costs than direct Labour
Accurate allocation of the other costs
Interview with F&A in a depot and an observation of the sorting process in the
warehouse for increase of understanding
1/2 day
B
Investigate the cost behaviour of non standard products
Overview of the cost baviour of non standard products
Accurate allocation of cost of non standard products
Interview with a depot supervisor and an observation for increase of understanding
1/2 day
C
Check and update the activity list used for the previous time and motion study
An updated activity list Time and motion study and the
validity check of the previous time and motion study
Interview with supervisor in a depot and
optional an observation
1/4 day
D
Time and motion study Total handling times for the
different kind of products
The improvement of the cost allocation method
Observation of both import- and export
shift in the depot
1 day
5.3.3 Field Sales
The presented approach above is presented in a spreadsheet below, exhibit
5.4.
Exhibit 5.5: Warehouse data collection activity list
Data Collection
Sales Field
Activity: Deliverable: Required for: Research Method Duration
A
Find out which types of customers existClassification of different types of customers
Development of cost allocation method
B
Find out how many sales efforts/time these types of customers require
Relationship between sales efforts/time and the type of customer
Allocation of sales efforts to customers
C
Find out what kind of consumption patterns belongs to the different types of customers
Relationship between consumption patterns and customers
Allocation of sales efforts to products
D
Find out which KPI's are applied in the Sales Field process
A good understanding of the criteria/indicators that determine whether a salesman has done a good job or not.
To deal with the behavioural aspect of sales cost allocation method
1/2 day
Interview with two
sales persons
5.4 Development of an alternative cost allocation method
5.4.1 Field Sales
5.5 Impact analysis
5.6 Conclusion
6
Conclusions and recommendations
6.1 Conclusions
6.2 Recommendations
In order to advise TNT on the maintenance of the cost allocation model, a method will be provided in this paragraph. The method is represented below in exhibit 6.1. Exhibit 6.1 shows a model containing 7 activities. The 7 activities and their sequence will be explained.
Exhibit 6.1. Maintenance Model
Adapt alternative method Continue current method
1. Evaluation of cost allocation model i.e. cost pools
2. Selection of a number of cost pools
3. Understanding of current cost allocation methods of selected cost pools
4. Activity analysis of selected activities (cost allocation methods)
5. Summarisation and collation of collected data
6. Development of alternative model or decision to continue current cost allocation method
In Closing
After the explanation of the maintenance model it is clear that a good preparation of each activity in the model will save a lot of work and
resources. When the cost allocation methods are selected for a review it is very important to already think over a few steps ahead. When you collect data that is not applicable for the development of an alternative cost allocation method, most of the resources are wasted.
Bibliography
Books and articles
1. COOPER, R., COST CLASSIFICATION IN UNIT-BASED AND ACTIVITY-BASED
MANUFACTURING COST SYSTEMS. READINGS AND ISSUES IN COST MANAGEMENT, JAMES
M. REEVE, SOUTH WESTERN COLLEGE PUBLISHING
2. COOPER, R. AND R.S. KAPLAN, PROFIT PRIORITIES FROM ACTIVITY-BASED COSTING. HARVARD BUSINESS REVIEW, MAY-JUNE 1991, P. 130 - 135
3. COOPER, R., THE RISE OF ACTIVITY-BASED COSTING – PART ONE: WHAT IS AN ACTIVITY -BASED COST SYSTEM? JOURNAL OF COST MANAGEMENT, SUMMER 1988, P. 45 – 54 4. COOPER, R., THE RISE OF ACTIVITY-BASED COSTING – PART TWO: WHEN DO I NEED AN
ACTIVITY-BASED COST SYSTEM? JOURNAL OF COST MANAGEMENT, FALL 1988, P. 41 – 48
5. COOPER, R., THE RISE OF ACTIVITY-BASED COSTING – PART THREE: HOW MANY COST
DRIVERS DO YOU NEED, AND HOW DO YOU SELECT THEM? JOURNAL OF COST
MANAGEMENT, WINTER 1989, P. 34 – 46
6. COOPER, R., THE RISE OF ACTIVITY-BASED COSTING – PART FOUR: WHAT DO ACTIVITY -BASED COST SYSTEMS LOOK LIKE? JOURNAL OF COST MANAGEMENT, SPRING 1989, P. 38 – 49
7. COOPER, R. AND KAPLAN, R.S., ACTIVITY-BASED SYSTEMS: MEASURING THE COSTS OF
RESOURCE USAGE, READINGS AND ISSUES IN COST MANAGEMENT, JAMES M. REEVE, SOUTH WESTERN COLLEGE PUBLISHING
8. COOPER, R. AND KAPLAN, R.S., THE DESIGN OF COST MANAGEMENT SYSTEMS. TEXT, CASES, AND READINGS. ENGLE WOOD CLIFFS, U.S.A.: PRENTICE HALL, INC.
9. TURNEY, P.B.B., COMMON CENTS: THE ABC PERFORMANCE BREAKTHROUGH: HOW TO SUCCEED WITH ACTIVITY-BASED COSTING, HILLSBORO; PORTLAND: COST TECHNOLOGY, 1992
Internet sites, annual reports and internal documentation
❈ http://www.tnt.com, February 2002
❈ http://www.tpg.com, February 2002
❈ TPG Annual report 2000
❈ Internal competitor analysis, 1999 ❈ TNT Express intranet
❈ Recast cost allocation method overview files ❈ Manuals for NCS, INCA and AEMS
❈ McKinsey report: “Developing structural improvements to business profitability”
