Learning Objective 7 Explain how managers use activity-based costing systems in activity-based management
The emphasis of this chapter so far has been on the role of ABC systems in obtaining better, or more accurate, product costs. However, Plastim’s managers must now use this information to make decisions (Step 4 of the five-step decision process) and to implement the decision, evaluate performance, and learn (Step 5). Activity-based management (ABM) is a method of management decision making that uses activity-based costing information to improve customer satisfaction and profitability. We define ABM broadly to include decisions about pricing and product mix, cost reduction, process improvement, and product and process design.
An ABC system gives managers information about the costs of making and selling diverse products. With this information, managers can make pricing and product-mix decisions. For example, the ABC system indicates that Plastim can match its competitor’s price of $53 for the S3 lens and still make a profit because the ABC cost of S3 is $49.98 (see Exhibit 5-5).
Plastim’s managers offer Giovanni Motors a price of $52 for the S3 lens. Plastim’s managers are confident that they can use the deeper understanding of costs that the ABC system provides to improve efficiency and further reduce the cost of the S3 lens. Without information from the ABC system, Plastim managers might have erroneously concluded that they would incur an operating loss on the S3 lens at a price of $53. This incorrect conclusion would have probably caused Plastim to reduce or exit its business in simple lenses and focus instead on complex lenses, where its single indirect-cost-pool system indicated it was very profitable.
Focusing on complex lenses would have been a mistake. The ABC system indicates that the cost of making the complex lens is much higher—$132.07 versus $97 indicated by the direct manufacturing labor-hour-based costing system Plastim had been using. As Plastim’s operations staff had thought all along, Plastim has no competitive advantage in making C5 lenses. At a price of $137 per lens for C5, the profit margin is very small As Plastim reduces its prices on simple lenses, it would need to negotiate a higher price for complex lenses while also reducing costs in order to generate a higher profit margin.