Using Activity-Based Costing - Accounting Chores - QuickBooks 2017 All-In-One For Dummies (2016)

QuickBooks 2017 All-In-One For Dummies (2016)

Book 4

Accounting Chores

Chapter 4

Using Activity-Based Costing

IN THIS CHAPTER

check Understanding traditional overhead allocation

check Seeing how ABC works

check Introducing a simple ABC system

check Working with ABC in QuickBooks

check Activating the Class Tracking feature

check Working with classes in ABC

Activity-based costing (ABC for short) may be the best new accounting idea in the past three decades. No, I must amend that: Activity-based costing is the best new idea in accounting in the past three decades.

ABC gives businesses a better way to estimate the profits of products and services, which is more important than you may think. The problem in many businesses is that overhead expenses or operating expenses don’t cleanly tie to products or services. Without good allocation of overhead or operating expenses, businesses can’t accurately determine which products make money and which don’t.

ABC addresses this problem by using the power of the computer (QuickBooks, in this example) to directly trace overhead costs to products and services. Surprisingly, ABC accomplishes this task in a pretty straightforward, simple fashion. In this chapter, I show you what I mean.

Reviewing Traditional Overhead Allocation

To really understand the contribution that ABC makes, you need to understand how overhead allocation traditionally works. To give you an example, take a look at Table 4-1 . This is the same simple income statement that I show in several chapters throughout the book.

TABLE 4-1 A Simple Income Statement

Sales revenue

$13,000

Less: Cost of goods sold

3,000

Gross margin

$10,000

Operating expenses

Rent

1,000

Wages

4,000

Supplies

1 ,000

Total operating expenses

6,000

Operating profit

$4,000

As you may recall, this simple income statement shows the profit for an imaginary hot-dog-stand business that you operate on the opening day of baseball season in your city.

Suppose that in this imaginary business, you sell two products: a regular hot dog for $2.50 and a super-duper chili dog for $4.00. Suppose also that you sell 2,000 of both of these products. Therefore, the $13,000 of revenue shown in Table 4-1 actually represents $5,000 in sales of regular hot dogs and $8,000 in sales of chili dogs.

Further suppose that you can break down the cost of goods sold as follows:

· Buns: Each bun cost you 15 cents. This means that you spent $300 on buns for regular dogs and $300 on buns for the chili dogs.

· Dogs: Each hot dog cost you 40 cents. This means that you spent $800 on hot dogs for the regular hot dog product line and another $800 on hot dogs for the chili dog product line.

· Chili: Each serving of chili for the chili dogs cost you 40 cents. (A serving is three heaping tablespoons of chili, as you enjoy telling customers.) This means that you spent another $800 on chili for the chili dog product line.

Given this information, you can create an income statement that shows revenue, cost of goods sold, and gross margin by product line, as shown in Table 4-2 . Furthermore, note that Table 4-2 does something very traditional: It allocates operating expenses by using a simple rule. In Table 4-2 , I’ve simply split the operating expenses right down the middle, allocating $3,000 of operating expenses to the regular hot dog product line and $3,000 of operating expenses to the chili dog product line.

TABLE 4-2 Traditional Income Statement by Product Line

$2.50 Hot Dogs

$4 Chili Dogs

Total

Sales revenue

(2,000 sold in each product line)

$5,000

$8,000

$13,000

Cost of goods sold

$0.15 buns

300

300

600

$0.40 hot dogs

800

800

1,600

$0.40 of chili for each chili dog

___

800

800

Total cost of goods sold

1,100

1,900

3,000

Gross margin

3,900

6,100

10,000

Operating expenses

Rent

$500

$500

$1,000

Wages

2,000

2,000

4,000

Supplies

500

500

1,000

Total operating expenses

3,000

3,000

6,000

Net profit

900

3,100

4,000

Stop for a minute and look at the information shown in Table 4-2 . When you consider and make decisions based on this information, it becomes much easier to understand traditional overhead allocations.

If you examine the income statement shown in Table 4-2 , several pieces of data suggest that there’s money in them there chili dogs. Look at the sales revenue, for example. The income statement shows that chili dogs generate $8,000 of sales revenue, whereas regular hot dogs generate only $5,000 of sales revenue. Now look at the gross margin. The income statement shows that chili dogs generate $6,100 of gross margin, whereas regular hot dogs generate only $3,900 of gross margin. Finally, look at the net profit. Based on a simple split of overhead or operating expenses, the net profit from the regular hot dog line equals a measly $900, whereas the net profit from the chili dog product line equals a whopping $3,100.

After reviewing the information shown in Table 4-2 , what is your conclusion? It seems pretty clear that you should sell more chili dogs and fewer hot dogs. In fact, you may want to give up on selling regular hot dogs and concentrate on chili dogs. You may also decide that your chili dogs are priced too high; perhaps you could shave the cost a bit on these. You may further decide that the regular hot dogs are priced too low; perhaps the price of these should be bumped up a bit.

Indeed, you can make all sorts of decisions from the collective set of data shown in Table 4-2 . You may not realize that the overhead allocation plays an important part in all of this. Unfortunately, the overhead allocation shown in Table 4-2 and any of the conclusions I suggest in the preceding paragraphs are wrong. This error, however, doesn’t show up until you use activity-based costing, and that’s why ABC is cool.

Understanding How ABC Works

In this section, I tell you how, with ABC, you can create an equivalent income statement for product-line profitability. After that, I generalize about the ABC process and define the buzzwords that people usually use to talk about ABC.

The ABC product-line income statement

To create an ABC product-line income statement, you attempt to trace the overhead cost directly to products or services. Suppose that in the case of the imaginary hot-dog-stand business, the rent expense is necessary because you need an electrical hookup to keep the pot of chili heated. Perhaps you also need an electrical hookup to run the can opener that you use (surreptitiously) to open the cans of chili needed to refill the pot. This means, then, that the rent expense really can’t be split between regular hot dogs and chili dogs. It needs to be allocated to chili dogs.

You can treat the supplies expense in a very similar way. Suppose that the $1,000 of supplies is really just napkins. Also suppose that based on your observations, a regular hot dog customer grabs two napkins for his hot dog, whereas a chili dog customer grabs eight napkins for his chili dog (you know, to clean up the mess on the front of his shirt when the chili spills). In this case, you can use this information to better allocate the $1,000 of supplies expense. Consider that this information means that regular hot dog customers use roughly 4,000 napkins. (I calculated this by multiplying the 2,000 hot dogs you’ve sold by the 2 napkins used for each regular hot dog customer.) And chili dog customers use 16,000 napkins. (I calculated this by multiplying the 2,000 chili dogs that you’ve sold by the 8 napkins used by each chili dog customer.)

Using this napkin-use information, you can calculate which percentage of the supplies expense is used by regular hot dog customers and which percentage is used by chili dog customers. If regular hot dog customers use 4,000 of a total 20,000 napkins, 20 percent of the napkins are going to regular hot dog customers (20 percent of the $1,000 of supplies expense equals $200). Therefore, the correct allocation of supplies expense to the regular hot dog line is $200.

You can allocate a portion of the supplies expense for chili dogs by using similar math. If 16,000 of the 20,000 napkins go to chili dog customers, that’s 80 percent of the napkins (80 percent of the $1,000 of supplies expense equals $800). Therefore, logically, $800 out of $1,000 of supplies expense should be allocated, or traced, to the chili dog product line.

All this makes sense, right? All you’re trying to do is trace overhead costs, or operating expenses, to product lines.

The wages expense of $4,000 probably works in a very similar fashion. Before going further, though, I have to delve into some of the ABC buzzwords. Suppose that all the $4,000 of wages expense goes to serving customers hot dogs. Furthermore, suppose that the process of serving a regular hot dog to a customer requires two steps:

1. Grab a hot dog bun.

2. Slide a hot-off-the-grill frankfurter into the bun.

By comparison, the process of serving a chili dog requires five steps:

1. Grab a hot dog bun.

2. Slide a hot-off-the-grill frankfurter into the bun.

3. Ladle a heaping tablespoon of chili into the bun.

4. Ladle another heaping tablespoon of chili into the bun.

5. Ladle a third heaping tablespoon of chili into the bun (yes, you read that correctly).

You may see where I’m going with this. I’ve actually done something very special — something that business-school professors would dress up with a bunch of fancy words in academic business journals. In this example, I state that the wages expense actually gets used in an activity called serving or serving customers. I also note in this example that the process of serving a regular hot dog customer requires two steps, but the process of serving a chili dog customer actually requires five steps.

These steps are known as cost drivers. That sounds like something you may not understand right away, but in fact, the notion of cost drivers is simple common sense. The term cost drivers simply suggests that the number of steps an employee takes to serve a customer is a good base on which to allocate the wages expense that comprises the activity of serving.

You may have already guessed how to do this, but I’ll tell you anyway: By looking at the total number of steps required to serve regular hot dogs and the total number of steps required to serve chili dogs, you can trace the wages expense to the regular hot dog and chili dog product lines.

If you sell 2,000 regular hot dogs, and each hot dog requires 2 steps, regular hot dogs require 4,000 steps in total. If you sell 2,000 chili dogs, and each chili dog requires 5 steps, the chili dog product line requires 10,000 steps.

You can use these two values — the number of steps for the regular hot dog line and the number of steps for the chili dog line — to allocate the wages expense. To calculate the percentage of the wages expense that goes into preparing regular hot dogs, you make the following calculation:

4,000 (steps for regular hot dogs) / 14,000 (total steps) × $4,000

This calculation returns the value $1,143.

In a similar fashion, you can use the steps information to allocate wages expense to the chili dog product line. Here’s how that calculation may work:

10,000 (steps for chili dogs) / 14,000 (total steps) × $4,000

This calculation returns the value $2,857.

Now take a look at Table 4-3 , which summarizes all this ABC analysis that I’ve discussed over the past few paragraphs. The most noteworthy item — and the first item to observe about ABC analysis — is that an ABC approach to product-line profitability often produces surprising results.

TABLE 4-3 ABC Income Statement by Product Line

$2.50 Hot Dogs

$4 Chili Dogs

Total

Sales revenue

(2,000 sold in each product line)

$5,000

$8,000

$13,000

Cost of goods sold

$.15 buns

$300

$300

$600

$.40 hot dogs

800

800

1,600

$.40 of chili for each chili dog

0

800

800

Total cost of goods sold

1,100

1,900

3,000

Gross margin

3,900

6,100

10,000

Operating expenses

Rent

$0

$1,000

$1,000

Wages

1,143

2,857

4,000

Supplies

200

800

1,000

Total operating expenses

1,343

4,657

6,000

Net profit

2,557

1,443

4,000

If you think back to the impressions you had after looking at the income statement shown in Table 4-2 , you may have concluded that chili dogs are really a much better product to sell. As Table 4-3 shows when you look at the net profit number, however, regular hot dogs make twice as much profit as chili dogs — even though they sell for less money and even though they produce much less gross margin. Only a fair and accurate tracing of overhead expenses shows this fact. Wow. Pass the mustard.

All this is pretty neat, isn’t it? If you step away from your imaginary hot-dog-stand business and look at your real business, you may find yourself asking new and awkward questions, such as “That product generates all that revenue? Maybe a fair accounting of overhead would show it actually loses money… .” Remember that cheapo product or cheapo service that you never spend much money on — you know the one — and that doesn’t generate much gross margin? Well, you may be making a lot more money on it than you thought. Scary, isn’t it?

ABC in a small firm

I want to make three important observations about ABC in a small firm. Some of this stuff is obvious, and some of it is redundant, but I think it’s important enough for you hear it at least one more time:

· ABC is most useful when you have lots of overhead and a bunch of products. In any environment that doesn’t have a lot of overhead, ABC isn’t worth the work and won’t deliver insights. Likewise, ABC doesn’t make sense in any business that sells a single product or that provides a single service, which may be the case in a small firm. (Keep reading, though, because analysis of cost drivers can provide one unique insight.)

· ABC may not make sense for custom manufacturing environments. In a custom manufacturing environment — this is any business in which you make specific things for specific customers — you can often use job costing to provide good product or service profitability measures. In the case of a single-family-home builder, for example, the builder can use job costing to track revenue and expenses by job (single-family home), and that job costing may provide the detailed profitability-by-product-line information that’s the big benefit of ABC.

remember ABC is first and foremost a tool for better allocating overhead costs.

· Cost drivers “drive” costs. In the discussion of the hot-dog-stand business and the activity labeled serving a customer, the serving steps are the cost drivers. The number of steps required to serve a customer drive the costs of serving the customer. That may sound really dumb, but sometimes, one of the benefits that ABC provides is an insight into how changing the number of cost drivers changes your costs. Suppose that instead of spooning three heaping tablespoons of chili onto a chili dog, you purchase one spoon equivalent to three tablespoons; this would change the number of steps from five to three. Recall the original, five-step approach to serving the chili dog customer:

1. Grab a hot dog bun.

2. Slide a hot-off-the-grill frankfurter into the bun.

3. Ladle a heaping tablespoon of chili into the bun.

4. Ladle another heaping tablespoon of chili into the bun.

5. Ladle a third heaping tablespoon of chili into the bun.

This sounds so obvious as to be unworthy of inclusion in this book. But if you get a three-tablespoon spoon, you can simplify the serving of a chili dog into three steps:

1. Grab a bun.

2. Slide a hot dog into the bun.

3. Heap a three-tablespoon serving of chili into the bun.

Changing the number of steps required to serve a customer a chili dog changes the cost of the serving activity for a chili dog. And changing the cost of serving a chili dog changes the profitability (potentially) of serving a chili dog. I say “potentially” because you may not actually be able to reduce your wages expense by buying a three-tablespoon spoon for lathering up your chili dogs with chili, but you get the idea. Note: To really save money by reducing the number of steps, you need to be able to cut your wages expense.

The bottom line concerning ABC is this: ABC lets you better allocate overhead costs, and as a bonus, ABC often gives you unique insights into what drives your overhead costs. With this information in hand, you can make better decisions about your product and service lines, and sometimes, you can even change your business operations in a way that reduces your costs.

Implementing a Simple ABC System

I’ll admit this right up front: You can make ABC very complicated. Furthermore, if you go out and hire an outside consultant — somebody who wants to charge you thousands or even tens of thousands of dollars to set up one of these systems — you may end up with something that is very, very powerful and very, very complicated.

That being said, however, ABC systems don’t have to be that complicated, particularly if you just want better allocation of your overhead costs rather than a system to look at the cost drivers or the activities that comprise your overhead costs. ABC can be pretty straightforward. This is especially true in a small or medium-size firm. In fact, I think you can probably implement a good, first-rate ABC system by taking the following four steps:

1. Look at your overhead costs.

Verify that you have enough overhead to be worrying about. If you’re in a business with big fat margins and very low overhead, ABC may not make any sense for you. The incremental value that you achieve by allocating overhead more precisely may be simply a manifestation of an obsessive-compulsive personality disorder rather than good accounting.

2. Identify the big overhead cost.

You must do this if you decide that you want to allocate some or a bunch of your overhead via an ABC approach. Don’t spend time trying to accurately allocate some penny-ante amounts (unless they’re simple-to-allocate ones that can be done at the same time as the bigger project). Go for the biggest bang you can get for your buck. Create an ABC system that allocates, with a minimal amount of effort, a large chunk of your overhead. Don’t get too pedantic.

3. Identify the principal activities that use up the overhead costs.

In the simple example of the imaginary hot-dog-stand business, you have only a single activity: serving a customer. You’re certainly going to have more activities than that. But you don’t need to create a list of 80 activities. Identify the big activities that enable you to allocate your overhead. The fewer the activities you can use to do this, the easier your accounting will be. Find a handful of activities that let you fairly and accurately allocate overhead to product lines. That’s the big picture.

4. Trace the activities to products by using the appropriate measures.

After you’ve identified the handful of activities that let you connect overhead expenses to products, be sure to use the appropriate measure — also known as a cost driver — to tie the overhead expenses to the product lines or service lines.

In the example of the hot-dog-stand business, one overhead cost — rent — didn’t even need a cost driver. The supplies expense also didn’t need a cost driver because you were able to allocate that cost through simple observation. The wages expense required a more sophisticated textbook approach to allocation. To allocate the wages expense, you created an activity called serving the customer and then allocated that activity’s cost based on the number of steps that each product line required.

remember An ABC system is a tool that you can use to manage your overhead costs and the profitability of the products or services that you sell. Practically, you want to focus on the big overhead costs, and in the end, all you really want is an ABC system that produces useful numbers — numbers that help you think about your business more clearly and creatively.

Seeing How QuickBooks Supports ABC

Okay, you’re probably saying to yourself, “Steve, all this sounds pretty good. But you’re a little short on specifics and a little long on theory. Where’s the beef, buddy?”

Oh, that’s right. I do need to tell you how an ABC system works in QuickBooks, don’t I? No problem — the approach is actually really straightforward if you’ve already been using QuickBooks. In short, all you do to implement a simple ABC system in QuickBooks is what you’re doing right now. In other words, just keep on tracking your operating expenses by using a good, decent chart of accounts. That’s 90 percent of the battle.

You also need to take care of just one or two minor, additional items. First, you turn on the QuickBooks Class Tracking feature. Class Tracking lets you categorize income and expense transactions as falling not just into income and expense accounts, but also into particular classes.

Second, when you record an expense, you also identify the class into which the expense falls. Using classes that correspond to your activities — well, you can see that’s all it takes, right?

Turning On Class Tracking

To turn on Class Tracking in QuickBooks, follow these steps:

1. Choose Edit  ⇒  Preferences.

QuickBooks displays the Preferences dialog box.

2. Tell QuickBooks you want to work with the accounting preferences.

To tell QuickBooks that you want to change one of its accounting preferences — Class Tracking, in this case — click the Accounting icon, which appears in the list box along the left edge of the Preferences dialog box. Figure 4-1 shows the Company Preferences tab for the accounting preferences. (If the Company Preferences tab doesn’t appear on your screen, simply click the tab name.)

3. Select the Use Class Tracking for Transactions check box to turn on Class Tracking.

4. You may as well also select the Prompt to Assign Classes box so that QuickBooks reminds you to use the classes.

5. Click OK.

From this point forward, QuickBooks adds a Class drop-down list or field to the windows that you use to record revenues and expenses (such as the Create Invoices window, the Write Checks window, the Enter Bills window, and so on). All you do is tag transactions as they fit into a particular class.

image

FIGURE 4-1: The Company Preferences check boxes for setting your accounting preferences.

Using Classes for ABC

After you turn on Class Tracking, using classes is really straightforward. You set up classes for the product lines or service lines for which you want to measure profitability. You classify transactions as fitting into a particular class either as they’re recorded (if you can) or after the fact (if you need to fiddle with the activity and cost driver math).

Setting up your classes

You set up a class for each product or service for which you want to measure profitability. In the imaginary hot-dog-stand business, for example, you set up two classes: one for regular hot dogs and one for chili dogs.

To set up a class, you can just enter the class name in the class box that appears in the window that you use to record invoices, write checks, and make journal entries. (These windows are shown later in this section.) Alternatively, you can choose Lists  ⇒  Class List. When QuickBooks displays the Class List window, click the Class button shown at the bottom of the window, and choose New from the menu that QuickBooks displays. Use the New Class window that appears, as shown in Figure 4-2 , to describe the new class.

image

FIGURE 4-2: The New Class window.

Classifying revenue amounts

To classify revenue as fitting into a particular class, use the Class box that appears in the Create Invoices window and in the Enter Sales Receipt window. (These are the two windows that you use to record sales.) If an invoice records sales of a hot dog, for example, you may record the class as Regular Dog. If a sales receipt records sales of a chili dog, you may record the class as Chili Dog. Figure 4-3 shows the Create Invoices window filled out to record the day’s chili dog sales.

image

FIGURE 4-3: The Create Invoices window.

tip The Class drop-down list is near the top of the window, next to the Customer:Job drop-down list.

Classifying expense amounts

To record a check that pays some expense that fits into a particular activity, you also use the Class column — this appears on the Expenses tab, shown in Figure 4-4 — to identify the product line or service into which the expense fits. Figure 4-4 shows how the Write Checks window may appear to record $1,000 of rent expense allocated to the chili dog product line.

image

FIGURE 4-4: The Write Checks window.

tip The Class column is located along the right edge of the Expenses tab.

After-the-fact classifications

In some cases, you won’t be able to classify an expense or revenue amount at the time the initial transaction is recorded. In the hot-dog-stand example, you probably won’t be able to figure out how to split the wages expense between regular hot dogs and chili dogs until after you pay the employees. The same thing is true of the supplies expense. In both cases, you need to know how many regular hot dogs and how many chili dogs you sold before you can allocate, or trace, supplies and wages.

In these sorts of cases, you use the Make General Journal Entries window to classify previously unclassified expenses. Figure 4-5 shows you how to take $4,000 of previously unclassified wages expense and allocate the amount to the regular and chili dog product lines.

image

FIGURE 4-5: The Make General Journal Entries window.

tip The Class column is located along the right edge of the Make General Journal Entries window.

Producing ABC reports

After you allocate as much overhead as you can to the product or service lines, you can prepare a profit and loss statement by class that shows the profitability-by-product-line data. Book 4, Chapter 2 explains and discusses QuickBooks reports. Note that if you used the example data discussed in this chapter, you could produce a QuickBooks report that looks almost identical to the income statement shown in Table 4-3 , earlier in this chapter.

tip To produce a profit and loss statement by class, choose the Reports  ⇒  Company & Financial  ⇒  Profit & Loss by Class command.