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Activity-based costing: a methodology for costing and profitability.

In today's economic and highly competitive marketplace, the ability to identify costs of product and operation activities has become crucial. Without accurate costing information, companies lack the ability to make informed decisions.

While identifying, analyzing and managing costs is no simple task, many companies have discovered a method to do just that. These companies are employing activity-based costing (ABC).

A historical costing perspective

The current challenge in cost management is the ongoing change in the makeup of direct and indirect costs. Over the last 10 to 20 years, the nature of manufacturing and, consequently, costs have evolved. For example, the term "lights out factory" means something totally different today than it did only 15 years ago. While it would have meant a plant that was closed for vacation or retooling in the past, today it refers to an automated factory that requires little lighting because there are few (or no) people.

Traditional costing methods grouped automation, information systems and other technologies into allocation pools, such as overhead. Since labor was the most significant and most measured element of the overall product cost, this cost was allocated to products based on labor. While still measured as closely today as in the past, labor is now the least significant cost in many cases.

The emergence of automated processes and information systems in manufacturing has changed the face of costing considerations. New costs, such as energy and systems maintenance, have emerged as significant elements in product costing. In these instances, closely measuring labor, while allocating other costs like energy based upon percentages of labor, can lead to a highly distorted and inaccurate picture of product costs. Decisions made against costs based on these practices can reduce profit.

ABC - a better costing tool

ABC can help meet the challenge of the changing cost mix. Several steps will help someone implement and use ABC.

First, identify the significant cost elements in the organization. This is a crucial task and requires a reasonably accurate assessment of the majorpools of cost. However, costs need not be by product or organization, by rather, they must be definitive elements or categories. Examples are material handling costs, energy or maintenance.

The next step is to identify drivers of the most significant costs or those that merit direct control and product cost identity. These drivers are the activities in activity-based costing. Again, this will be no insignificant task. However, when completed it will provide the basis of an effective ABC system. Examples of cost drivers would be machine or kilowatt hours for the energy cost pool; material moves or stationary truck hours for the material handling cost pool; and machine operation hours or production throughput for the maintenance cost pool.

The rate for each activitgy by cost pool can then be calculated by determining the use of the planned driver (or actual volume of each driver). At this point, the opportunity exists to determine two costs for each product. Expected (i.e. standard) cost is calculated by determining the expected usage of each driver/activity in the production of each product. Actual cost can be determined, but this requires a procedure for collecting actual usage of activities by product.

When compared to conventional cost analysis, an activity-based system can change the way companies do business by providing a significantly improved view of costs. ABC's more sophisticated approach can stimulate in-depth cost analysis and wider profit margins. Activity-based costing cana lead to the elimination of unprofitable activities, products, services or price changes. ABC analysis can also support improvements in product design by elpig to prioritize product development resources.

ABC requires a totally different analysis of costing and business processes. From a management perspective, it enables improved use of resources and profit-based decisions based upon accurate information. This results in greater revenue for the company at optimal costs.

An integrated software solution

Many successful companies are employing ABC to make product and service decisions on accurate cost portrayals. However, ABC requires information sharing across a range of business functions, including financial, managerial, and cost accounting, manufacturing and logistics, sales and distribution, and human resources planning. Software that can integrate these business functions provides on-line information in real-time, so managers can analyze current situations and perform "what-if" analyses.

For instance, using an integrated software system, a large multi-national corporation was able to reengineer its entire costing system. Competing in an international market, the corporation's maturing plants produce multiple products using shared facilities. With distorted cost information, the corporation's profitability and competitiveness was in jeopardy. Recognizing the need for a better costing system and system integration, the corporation installed an integrated, mainframe applications system.

Normal planning and forecasting is driven by the activity network. Activities are continually monitored anjd resources are allocated to these activities and then to products and services. Strategic information is generated foe effective production, resource and financial planning.

An integrated software system redcues effort in implementing ABC by making a fundamental shift from interfacing and reconciliation, to evaluation, management and analysis. It enables the cost and performance analysis and continuous process improvements that ABV concepts were developed to provide.
COPYRIGHT 1993 Institute of Industrial Engineers, Inc. (IIE)
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1993 Gale, Cengage Learning. All rights reserved.

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Author:Wizdo, Al
Publication:Industrial Management
Date:Sep 1, 1993
Words:848
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