Your Role in This Case, Is to Serve As a Consultant Experienced in Implementing Activity-Based

Your role in this case, is to serve as a consultant experienced in implementing activity-based costing systems as a means to providing management with the requisite information to make more informed and effective business decisions. Specifically, you will compute the cost of providing a service to a client using traditional cost allocation methods. Then you will apply the concepts of activity-based costing to determine the cost of providing a service to a client that reflects the resources consumed for the client. You will write a report to the partners of the firm highlighting the benefits of activity-based costing and discuss the impediments to implement the system in the law firm. You will also use incremental analysis to analyze information and make a recommendation regarding the outsourcing of the library research services.

The case begins at the offices of Clark, Long, Winters, and Smith. The partners at Clark, Long, Winters, and Smith, a medium size law firm in the Northeast, have hired you because the firm is experiencing a severe decline in income. The firm has four partners and currently does litigation work for clients. Partners are evaluated based on the revenues they bring into the firm. Presently, the accounting system tracks partner hours and paralegal hours to every client. It also charges a basic overhead rate that is determined at the beginning of each year. Quarterly, the firm’s accountant prepares a report comparing actual costs to budgeted costs.

Attorneys Clark and Smith have long believed the current accounting system is not providing them with the information they need to make informed decisions, including how to improve profits. Both Clark and Smith recently read an article that discussed how activity-based costing could help them in determining the profitability of each of client. All of the partners are considering outsourcing the library research department; it is a costly resource that may be cheaper on a per usage basis using an external research organization. Long and Winters have consistently generated the largest revenues in the firm and do not see the benefit of hiring you. They definitely do not want to change the way the firm is managed, but are eager to find ways to increase profits.

Clark recently attended a professional development seminar where she listened to your presentation on activity-based costing. She thought it would be good for her firm to see if the concept would help the firm identify profitable and unprofitable clients. The firm is currently considering outsourcing the library and research department. She feels you may be able to provide the analysis that would help the firm make the right decision.

You begin your consulting job by discussing your information needs with the office manager and asking for the latest financial statements. After a thorough review of the financial statements, you discover the firm prepares an annual budget, but has not computed the overhead application rate for the current year. In past years, the overhead application rate has been calculated by allocating the projected overhead expenses divided by the billable hours of the four partners. Typically, partners work 2,000 hours a year and charge 80% of their time to clients. The rest of their time is associated with professional development seminars, community presentations, and charity work.

Your first task is to develop the overhead application rate currently used to bill a client. You may feel the need to review information and the calculation of an overhead application rate. The firm currently has five very large clients and several smaller clients. Some of the clients require extensive travel while others require extensive research. You will use traditional job-order costing to determine the costs associated with five of the law firm’s biggest clients.

You then interview the partners, paralegals, and support staff. As a result of your discussions, you find that the firm currently tracks the following direct costs:

1. Professional partner compensation - You were informed that partners are paid $500 an hour and are billed to the client at $800 per hour

2. Paralegal compensation- You were informed that paralegals are paid $40 per hour and are billed to the client at $200 per hour.

The firm treats all of the following as indirect costs:

1. General office support, the office

2. Library and research support

3. Travel expenses

4. Telephone for making appointments and responding to clients

5. Photocopying

6. Rent, heat, property taxes, insurance, and accounting services

Currently, the firm’s accounting system only treats professional hours as direct. All other costs, such as the paralegal costs are treated as overhead. Determine the overhead rate per professional direct labor hour. Consider the impact of only 80% of the partners’ time is charged to clients. All of the paralegal labor is considered overhead.

You prepare a report using an EXCEL file that demonstrates how the overhead rate is determined. Your report includes the operating budget for the year, the calculation of the overhead rate, and the costs assigned to the five clients for the month of January.

Satisfied that your traditional job-order costing analysis and allocation are correct, you apply activity-based costing to determine the cost associated with the same five clients for the month of January. The law firm’s accounting department provides you with cost data. The department also provided you with additional information that you requested related to several cost drivers associated with each cost pool. You continue with the same EXCEL file to include the cost pools and cost data. You demonstrate how you determined the cost driver rate per cost pool item. You then determine the cost of each client for January using the ABC approach to cost allocations.

Next, you compare the costs assigned to each client under both methods. After comparing the cost associated with each client using traditional costing methods and activity-based costing procedures, you will write a recommendation to the partners.

The report must include sufficient explanation as to why there are differences. Identify which clients are consuming more or less of which resources. Your report should discuss the complexity of using seven cost pools and how to reduce the number of cost pools Your report will include advantages as well as disadvantages of activity-based costing. You will also discuss how to overcome resistance to change. In addition, you will conduct an incremental analysis to determine whether to retain or discontinue the library and research support department or outsource these services and make recommendations to the partners.

III. Steps to Completion –

Step 1: Milestone 1 You begin by reviewing your understanding of activity based costing. In addition to the text, a useful resource is http://www.accountingcoach.com/activity-based-costing/explanation, https://www.youtube.com/watch?v=P2wU1d_vhW4. Note the following video addresses activity=based costing in a service organization: https://www.youtube.com/watch?v=pL4dKcRLdLc

Step 2: Milestone 1 Review the budgeted income statement (Exhibit 1) for the current year. Use and EXCEL file. The budgeted income statement appears as the first sheet in the EXCEL file under the label “Exhibit 1 budgeted income statement”.

The four partners work 2,000 hours a year and estimate that they are able to charge 80% of their time to clients. Thus, some of the professional labor costs are assigned to overhead. Currently, the firm’s accounting system only treats professional hours as direct. All other costs, such as the paralegal costs are treated as overhead. Determine the overhead rate per productive professional direct labor hour. Be sure you distinguish between the cost associated with each client as compared to the amount billed to each clients for services rendered.

Calculate the overhead application rate using the traditional method, using the sheet “Budget ”

Step 3: Milestone 1 – Traditional analysis (in EXCEL)

Milestone 1 Use the sheet labeled “Budget” to first calculate the overhead rate. Then use the sheet #4 to show the total costs charged to each of the five clients for the month of January using the traditional cost allocation method. billed Use the overhead application rate you calculated in step Then determine the amount of revenue billed to each client. Remember, clients are billed for both paralegal hours and professional hours. Finally, determine the profitability by client for the month of January using the traditional cost allocation method.

Step 4: Milestone 2 ABC analysis (7 cost pools) using Same Excel file

You want to show the firm how activity-based costing will lead to a more precise allocation of costs. Further, one goal is to demonstrate to the partners, that having access to reporting with more precise allocation of costs will lead to more effective decisions to improve profitability. In this step, you will prepare an activity-based cost analysis associated with clients for the month of January. To accomplish this task, you have identified seven cost pools (Exhibit 2 ABC Cost Pools) and use the information provided by the law firm (Exhibit 3 ABC Cost Drivers) to review the cost drivers. For each cost pool.

Remember, partners are paid $500 an hour and paralegals are paid $40 per hour. The firm also tracks travel expenses that are directly associated with a client. In addition, library and research costs can be traced directly to each client. The firm’s accounting department provided you with an estimate of the activity expected for each of the three cost pools for the year.

Cost pool / Estimated total hours / Estimated productive (chargeable) hours
Library and Research Support Staff Hours / 5,000 / 3,600
General Staff Hours / 5,000 / 4,000
Paralegal Salary / 20,000 / 16,000

The indirect costs will be assigned to the following cost pools.

1. Telephone for making appointments and responding to clients

2. Photocopying

3. General office overhead

Thus, there are seven cost pools as shown in Exhibit 3 of this case.

The Library and Research Support Cost Pool expenses will be allocated based on library and research staff labor hour, the Telephone and Photocopying Cost Pool expenses will be allocated on the basis of general staff hour, and General office overhead is allocated on the basis of professional direct labor hours.

Use Exhibit 3 – ABC Cost Driver” to calculate the cost driver rates for the 7 cost pools. You should determine a cost driver rate for each of the cost pools.

When determining the cost driver rates consider whether to use the estimated total hours associated with the cost pools or only the productive (chargeable) hours.

Develop the costs associated with each client when ABC cost allocation is used. Use Exhibit 4 Traditional vs. ABC to calculate the costs associated with each client using the ABC cost allocation method. Then show the profitability by client using the ABC cost allocation method

Compare the costs and profits allocated to the five clients under the two cost allocation methods. In step 5 you will analyze the differences in sufficient detail to explain the differences in a memo to management.

Step 5. Milestone 3 – Memo #1 to Management – Explanation of profitability calculations using traditional costing as compared to ABC.

Use a WORD document, prepare a memo to management first explaining the two approaches to determining a client’s profitability. Your memo should include at least two professional sources that addresses the issues related to Activity-Based Costing. Be sure to cite your references.

Describe how the costs and profits assigned to each client under (1) traditional costing and (2) activity-based costing were determine. Then provide a detailed explanation for why there are differences. Your explanation should discussion how different activities consume different resources. Conclude with a recommendation for how to use the information generated by the ABC analysis to better manage the firm’s resources.

Your memo should include at least 2 references to professional literature with proper citations.

You anticipate resistance from two of the partners, so your report should also include the benefits of implementing the ABC system as well as how to overcome resistance to change.

NOTE – THERE IS NO WORD LIMIT OR EXPECTATION PREPARE THE MEMO TO MANAGEMENT AS EFFICIENTLY AND EFFECTIVELY AS NEEDED TO INCLUDE ALL OF THE REQUIRE ELEMENTS.

Step 6. Milestone 3 - Memo #2 Reducing Complexity in ABC and Revised EXCEL file

Continue with the same WORD document, however, you will prepare a separate memo. You now believe that seven cost pools might be too complex for the firm to maintain. Suggest ways to reduce the complexity and apply the changes to your analysis. . Support your calculations with a revised Excel file showing less than 7 cost pools. Label the sheet ABC Revised.

Your report should refer to your analysis and discuss the trade-off of using seven cost pools as compared to a smaller number of cost pools.

Step 7. Milestone 3 Memo #3 – Outsourcing/ Incremental analysis decision

Continue with the same WORD document, However, you will prepare a separate memo. The partners agree the ABC costing model provides better information and will consider implementing it. However, they feel you should now focus your attention to whether or not to continue in-house library and research services or outsource these services to an external firm. You have requested quotes from vendors who supply this service. One vendor is willing to provide the service at a flat fee of $2,250 per month. Another vendor will provide the service based on an hourly fee of $30. Determine the annual costs that would have been incurred for each of the two outsourcing alternatives. Present your report using incremental analysis.