Activity-Based Costing Analysis For Pharmaguard
Analysis
The level of each activity in the three market segments and the total cost incurred for each activity in 2015 is shown below:
|
Activity-based cost data |
Activity level |
|||
|
Pharmacare 2015
Activity |
General supermarket chains |
Pharmacy chains |
Total cost of activity in 2015 |
|
|
Orders processed (number) |
140 |
360 |
1 500 |
$80 000 |
|
Line-items ordered (number) |
1 960 |
4 320 |
15 000 |
63 840 |
|
Store deliveries made (number) |
120 |
360 |
1 000 |
71 000 |
|
Cartons shipped to stores (number) |
36 000 |
24 000 |
16 000 |
76 000 |
|
Shelf-stocking (hours) |
360 |
180 |
100 |
10 240 |
|
$301 080 |
1. Compute the 2015 gross-margin percentage for each of Pharmaguard’s three market segments.
2. Compute the cost driver rates for each of the five activity areas.
3. Use the activity-based costing information to allocate the $301080 of “other operating costs” to each of the market segments. Compute the operating profit for each market segment.
4. Comment on the results. What new insights are available with the ABC information?
5. The senior management at Phramaguard plans to implement ABC in its retail operations, manufacturing operations and its medical centre operations. The staff in these divisions are not in favour of implementing ABC and the Activity-based management (ABM). They are resisting these changes. Some employees are questioning, “why does the company need to change at all”?
6. As a consultant, give your professional advice on the benefits and limitations of adopting ABC for all its all operations at Pharmaguard.
Pharmaguard has approached Delots Management Consultants regarding implementing Activity-based Costing ( ABC ) in its retail operations. The company has three main market segments:
- General supermarket chains
- Pharmacy chains
- Pharmacist owned single stores
Delots Management Consultant’s scope will be to study the current segment wise profitability and analyze the gross margin and profit numbers using the traditional method being followed by Pharmaguard. The analysis starts with analyzing the drivers of the operating costs i.e., Orders processed, Line-items ordered ( number ), Store deliveries made ( number ), Cartons shipped to stores ( number ), Shelf-stocking ( hours ), goes on to find the profitability after allocating the operating costs using Activity Based costing method ( ABC ). The results are compared and the reasons for the difference are delved into. Post the analysis, a recommendation for the use of traditional and ABC method is done so that the better method is used by Pharmaguard in future. The typical pitfalls in using either of the methods are also enumerated in the analysis below. Finally, the recommendation is made as to which method should the company adopt in future so as to iron out inefficiencies and provide better business to its market segments
The company currently makes a revenue of $ 8.8 mn. 42 % of the revenue or $ 3.71 mn comes from General supermarket chains. 36 % of the revenue or $ 3.15 mn comes from Pharmacy chains. 22 % of the revenue or $ 1.98 mn comes from Pharmacist-owned single stores. The mix of the cost of goods sold is 43 : 36 : 21 for General supermarket chains, Pharmacy chains, Pharmacist owned single stores respectively. As a result, the gross margin of $ 438 k is divided into $ 108 k for General supermarket chains, $ 150 k for Pharmacy chains and $ 180 k for Pharmacist-owned single stores. Thus the gross margin % are 2.9 % for General supermarket chains, 4.8 % for Pharmacy chains, 9.1 % for Pharmacist-owned single stores. After the operating costs of $ 301 K, the operating profit is 1.5 % or $ 136 k.
Orders processed
7 % of the mix of the orders processed ( 140 ) comes from General supermarket chains, 18 % the mix of the orders processed ( 360 ) comes from Pharmacy chains, 75 % the mix of the orders processed ( 1500 ) comes from Pharmacist owned single stores. In all, 2 k orders are processed with total cost of $ 80 k. The cost per activity driver is $ 40.
9 % of the mix of the Line-items ordered ( 1960 ) comes from General supermarket chains, 20 % the mix of the Line-items ordered ( 4320 ) comes from Pharmacy chains, 70 % the mix of the Line-items ordered ( 15000 ) comes from Pharmacist owned single stores. In all, 21.28 k orders are processed with total cost of $ 64 k. The cost per activity driver is $ 3.
8 % of the mix of the stores deliveries made ( 120 ) comes from General supermarket chains, 24 % the mix of the stores deliveries made ( 360 ) comes from Pharmacy chains, 68 % the mix of the stores deliveries made ( 1000 ) comes from Pharmacist owned single stores. In all, 1.48 k orders are processed with total cost of $ 71 k. The cost per activity driver is $ 48.
47 % of the mix of the cartons shipped to stores made ( 36 k ) comes from General supermarket chains, 32 % the mix of the cartons shipped to stores made ( 24 k ) comes from Pharmacy chains, 21 % the mix of the cartons shipped to stores made ( 76 k ) comes from Pharmacist owned single stores. In all, 76 k orders are processed with total cost of $ 76 k. The cost per activity driver is $ 1.
56 % of the mix of the Line-items ordered ( 360 ) comes from General supermarket chains, 28 % the mix of the Line-items ordered ( 180 ) comes from Pharmacy chains, 16 % the mix of the Line-items ordered ( 100 ) comes from Pharmacist owned single stores. In all, 640 orders are processed with total cost of $ 10.24 k. The cost per activity driver is $ 16.
Thus the total operating cost spend of $ 301 k is divided as 27 % or $ 80 k for orders processed, 21 % or $ 64 k for line item ordered, 24 % or $ 71 k for stores deliveries made, 25 % or $ 76 k for cartons shipped to stores, 3 % or $ 10.24 k for shelf stocking.
Line-items ordered (number)
Based on the ABC method of allocating overheads on the above mentioned cost drivers, $ 301 k of cost is allocated as $ 59 k for General Super market chains, $ 71.5 k for Pharmacy Chains, $ 170.573 k for Pharmacist owned single stores. This represents a mix of 20: 24: 56 for General Super market chains, Pharmacy Chains and Pharmacist owned single stores respectively
Accordingly, the amounts allocated to the segments for the various operating cost heads are given below
7 % of the mix of the orders processed ( $ 5600 ) comes from General supermarket chains, 18 % the mix of the orders processed ( $ 14.4 k ) comes from Pharmacy chains, 75 % the mix of the orders processed ( $ 60 k ) comes from Pharmacist owned single stores.
9 % of the mix of the Line-items ordered ( $ 5.88 k ) comes from General supermarket chains, 20 % the mix of the Line-items ordered ( $ 12.96 k ) comes from Pharmacy chains, 70 % the mix of the Line-items ordered ( $ 45 k ) comes from Pharmacist owned single stores
8 % of the mix of the stores deliveries made ( $ 5.8 k ) comes from General supermarket chains, 24 % the mix of the stores deliveries made ( $ 17.3 k ) comes from Pharmacy chains, 68 % the mix of the stores deliveries made ( $ 48 k ) comes from Pharmacist owned single stores.
47 % of the mix of the cartons shipped to stores made ( $ 36 k ) comes from General supermarket chains, 32 % the mix of the cartons shipped to stores made ( $ 24 k ) comes from Pharmacy chains, 21 % the mix of the cartons shipped to stores made ( $ 76 k ) comes from Pharmacist owned single stores.
56 % of the mix of the Line-items ordered ( $ 5.76 k ) comes from General supermarket chains, 28 % the mix of the Line-items ordered ( $ 2.88 k ) comes from Pharmacy chains, 16 % the mix of the Line-items ordered ( $ 1.6 k ) comes from Pharmacist owned single stores.
Based on the above allocations, the profitability analysis i.e. operating profit is $ 49 k for General Super market chains, $ 78.5 k for Pharmacy Chains, $ 9.4 k for Pharmacist owned single stores. This represents a mix of 36 % for General Super market chains, 57 % for Pharmacy Chains, 7 % for Pharmacist owned single stores. The operating profit % is 1.3 % for General Super market chains, 2.5 % for Pharmacy Chains, 0.5 % for Pharmacist owned single stores.
Store deliveries made (number)
Based on the gross margin % , the following are the market segment ranks in terms of profitability
|
Segment |
Rank |
|
Pharmacist-owned single stores |
1 |
|
Pharmaguard Ltd |
2 |
|
Pharmacy chains |
3 |
|
General supermarket chains |
4 |
However, after the adoption of ABC costing system for allocation of other operating costs, the ranking of market segments completely changes. The new ranking is as under
|
Segment |
Operating Profit % |
Rank |
|
Pharmacy chains |
2.5 % |
1 |
|
Pharmaguard Ltd |
1.5 % |
2 |
|
General supermarket chains |
1.3 % |
3 |
|
Pharmacist-owned single stores |
0.5 % |
4 |
The market segment which was ranked 1 in the gross margin analysis has now become rank 4 after allocation of operating costs
As mentioned, the senior management is in favor of the change in the costing system to ABC system while the retail ground level staff is resisting. The reason for this is evident in the results given in the answer to d above wherein the retail pharmacist owned single stores were ranked higher in terms of gross margin profitability. Hence they were benefitting. There was no basis of allocation of operating costs earlier. Hence it was reduced from the overall gross margin to arrive at operating profitability. The true profit picture emerged only after the allocation of operating costs through ABC method. The Pharmacist owned single stores are most dismally performing.
There are some benefits of adopting ABC by Pharmaguard which can be understood by comparing it with the traditional method of costing. The pricing of products for Pharmaguard may be incorrect if ABC system is not used.
a ) The case in point is selling prices in pharmacist owned stores seemed to be correct earlier. But now they generate the lowest profitability after ABC is used. Pricing in Pharmacist owned single stores have to increase to generate the same level of profitability as before. Pricing in general super market chains may have been set too high than the market can absorb. Hence the gross margin was dismal. But after the allocation of operating cost as per ABC system, the pricing seem to be alright. Thus there is a situation where non use of ABC system leads to incorrect setting of selling price. For certain underpriced market segments, pricing may be lower and hence profits may be squandered. For high prices set, the market may not be in a position to absorb and hence market share will be squandered. Competition will take advantage
b ) The efficiencies of the team performance may not come to the fore if ABC is not used. Since the foundation is itself erroneous in the absence of ABC, the appraisal of market segment performance will be flawed. The bad performers may hide behind the incorrect costing.
c )Since different market segments will have capital and revenue budget to be earmarked, the flawed profitability analysis using non ABC methods will result in good money chasing bad market segments and the segments will not actually perform. This will affect adequacy of budgets for the good segments.
d ) The segments which have been allocated inadequate budgets will not be in a position to perform due to lack of funds. Thus they will not produce the quantum of goods or service up to their potential. Customers will not be optimally served and the market share of the segment will go down thereby affecting the entire company profitability as well.
However, the foundation of ABC is identifying the correct drivers. If that is not done, then the entire exercise will throw wrong results and decision making will be affected. However, in cases where entities have low overhead costs, the allocation methodology would not make any great change to the overall absorption and hence the costs will be similar. In cases, where the management feels that traditional costing methods to allocate operating costs are more representative and is representing a direct driver of overhead costs, use of traditional method or Activity Based costing ( ABC ) would give same results
Inference and Conclusion
Thus it is clear that the ABC method of allocating costs is a superior method compared to traditional method. Delots Management Consultants feels that the company should adopt ABC and implement the same. This will help to iron out budget flaws, the tracking of performance, the pricing to the market and maintaining or increasing market share of its respective segments.
References
AccountingCoach.com. (2016). Activity Based Costing | Explanation | AccountingCoach.
BusinessDictionary.com. (2016). What is activity based costing (ABC)? definition and meaning. .
Classes.bus.oregonstate.edu. (2016). CHAPTER 11: ACTIVITY-BASED COSTING.
The Economist. (2009). Activity-based costing.