Get a handle on manufacturing costs with 'activity-based costing.'

Processors needing accurate manufacturing-cost information now have an alternative to traditional cost accounting. Activity-Based Cost Management (ABCM) can help reveal formerly hidden cost pitfalls in any type of processing business--and show where the money really goes.

Unlike less-specific costing methods, ABCM measures the costs from each and every activity associated with the manufacturing process. That list includes not only the processing itself but also related activities such as design, assembly, finishing, order processing, and distribution.

Conventional costing, by contrast, allocates overhead costs using direct labor content as the primary yardstick--though it also takes other departmental expenses into account. This "burden-rate" approach tends to blend costs within departments into a catch-all "overhead" category. "The whole idea with ABCM to is to explode overhead. By breaking up the overhead, ABCM gets at what it really costs to make a plastic component and get it to the customer," explains Elizabeth Knight Barnard, who recommends ABCM techniques to processors as part of her job as process improvement manager for GE Plastics in Pittsfield, Mass.

As Knight points out, lumping costs together into an aggregate overhead can too easily mask losses on a particular product within a department or category that's performing well overall. Also, this cost agglomeration can neglect the part-specific nature of some activities normally considered generic--such as materials handling, for instance. "Overhead is a lovely place for people to put costs they don't want you to know about," she says.

If it sounds like ABCM is it just a new way for the bean counters to crunch numbers, think again. Knight says the method is a tool best used by decision makers who distribute a business's overhead resources--not necessarily by those who keep the books. With the knowledge gained from ABCM, those distribution decisions are based on what each activity--and ultimately, the whole part or assembly--truly costs.

NOT YET WIDESPREAD

Though it holds out the promise of better business decisions, ABCM has not yet been widely adopted in plastics-processing operations. Knight blames this lack of acceptance on a perception problem. "It has been slow to catch on with processors because most think it's something for accountants," says Knight. Yet some forward-thinking molders out there do have ongoing ABCM projects, she says.

Windsor Plastics is one of them. This Evansville, Ind., molder of high-value parts for automotive, business-machine, and appliance markets has worked with a quarterly ABCM system for about two years. "We use it to recognize the issues that result in an expensive part," says executive v.p. Robert Carpenter. The company is now refining its system by adding more and more specificity. "The next level is more detail," Carpenter says.

Windsor's experience points up the eye-opening nature of ABCM--even for a company that already had a sophisticated costing system. "We've always had a good handle on all the total dollars and cents; the key was to relate them to the appropriate activities." Under its old burden-rate structure, Windsor looked at how direct labor drove costs for entire departments and for common production tasks. But Carpenter explains that this costing structure didn't capture the many instances of product differentiation, which affects costs within departments. "The question is whether direct labor is the best driver of cost," says Carpenter. "We now know that it's not."

Before ABCM, for example, Windsor's "batch" costs--set-up or materials handling--were pooled together regardless of differences in volume between jobs. A single cost category might have included both short runs of 50 pieces and long ones that took two days. "These sorts of costs were blended over subsequent costs," says Carpenter. Now, with ABCM information in hand, Carpenter has better quantified the balance between volume and these batch costs. Optimal volumes often add a small amount of profit--roughly 2-5%. When volume considerations work against you, however, the downside can be greater. "Negative margins of 100% are possible," he notes.

Thus when it comes to cost accounting, the stakes can be high. Molders have even been known to incur long-term losses on parts they were making in high volumes, mistakenly believing the jobs to be profitable. As Carpenter puts it: "Over the years, the molder can end up subsidizing the part."

Still, Carpenter cautions that any surprising revelations turned up by ABCM should not trigger harsh pricing adjustments against current customers. "We don't use ABCM punitively; our past lack of knowledge wasn't the customer's fault," he says. Rather, the improved costing information should be used down the road to "look at new jobs cautiously" and plan appropriate strategies for the future, he says. Windsor's use of ABCM has helped it bring in more parts that fit its operation and make more competitive quotes.

HOW TO GET STARTED

To give ABCM a try, Knight advises processors to perform case studies of only one or a few parts at a time. "You may find that you already have a good handle on costs," she says. Then again, you may not.

Be forewarned: ABCM may mean an extensive reconfiguration of existing manufacturing-cost information into unfamiliar categories. Activities and their costs--known as "activity cost pools"--must be identified along with the causal factors that underlie cost. According to Knight, these cost pools belong to different "levels," such as batch-level costs like set-up and material handling. Unit-level costs include the direct labor and machine hours, for example. Product-level costs might include engineering and administration costs. And facility-level costs would encompass plant maintenance and heating, as just two examples.

Also, ABCM may require collection of some new numbers. Windsor, however, managed to fill in any gaps through relatively simple employee interviews to find out how many hours a given activity takes. Such activities included filling hoppers and setting up machines. "We were after real nuts-and-bolts descriptions," says Carpenter.

MACHINE-HOUR RATES

Does ABCM change the way you figure machine-hour rates? No--and yes. Machine-hour rates remain one cost factor among many, and they still figure in ABCM calculations at the unit level. Yet, the traditional emphasis on hourly rates as the key cost factor does diminish somewhat under the new costing scheme. "ABCM lessens machine-hour rates' impact as the only driver," says Carpenter. ABCM looks at causality--where the cost comes from. "And machine-hours don't cause every cost."

Also, Knight points out that the "whole philosophy behind ABCM is that all costs are variable." While it's true that a given machine in any plant will continue to carry the same hourly rate, ABCM takes a more complex look at the cost of running a press. For example, Knight poses the scenario of a hard-to-run tool that must go on a single machine. ABCM demands the consideration of any costs associated with that lack of flexibility.

One source of more information on ABCM and detailed examples of how to break up your cost information is GE Plastics.