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Learning to love ABC.



Why CPAs stumble on activity-based costing In a business organization, Activity-based costing (ABC) is a method of allocating costs to products and services. It is generally used as a tool for planning and control. This is a necessary tool for doing value chain analysis.  projects.

Hard as it is to believe, activity-based costing (ABC ABC
 in full American Broadcasting Co.

Major U.S. television network. It began when the expanding national radio network NBC split into the separate Red and Blue networks in 1928.
) works best with a minimum amount of detail and estimated cost figures. By training and inclination inclination, in astronomy, the angle of intersection between two planes, one of which is an orbital plane. The inclination of the plane of the moon's orbit is 5°9' with respect to the plane of the ecliptic (the plane of the earth's orbit around the sun).  accountants are detail oriented o·ri·ent  
n.
1. Orient The countries of Asia, especially of eastern Asia.

2.
a. The luster characteristic of a pearl of high quality.

b. A pearl having exceptional luster.

3.
, abhorring ab·hor  
tr.v. ab·horred, ab·hor·ring, ab·hors
To regard with horror or loathing; detest: "The problem with Establishment Republicans is they abhor the unseemliness of a political brawl" 
 lack of precision and vagueness. Unfortunately, these qualities that accountants excel in are incompatible with ABC. As a result, when CPAs undertake an ABC project, they typically become overwhelmed o·ver·whelm  
tr.v. o·ver·whelmed, o·ver·whelm·ing, o·ver·whelms
1. To surge over and submerge; engulf: waves overwhelming the rocky shoreline.

2.
a.
 with data.

It's ironic. Because ABC is designed to provide useful financial insights into a company's operations, it's a process that should be well within accountants' sphere of expertise. Yet the fact remains: CPAs and ABC don't mix.

What's behind this incompatibility The inability of a Husband and Wife to cohabit in a marital relationship.


incompatibility n. the state of a marriage in which the spouses no longer have the mutual desire to live together and/or stay married, and is thus a ground for divorce
? Those who have successfully implemented ABC say that, when gathering the underlying data for ABC, close enough is not only good enough, it's often key to its success. But, typically, when accountants try to apply ABC, they strive for a level of exactness that is both difficult to attain and time-consuming--and that eventually becomes the project's kiss of death kiss of death

gangsters’ farewell ritual before murdering victim. [Am. Cult.: Misc.]

See : Farewell
.

The goal of this article is not to make accountants scapegoats for failed ABC projects. Quite the contrary: It's to get CPAs to see that activity-based costing is not that hard to implement, and it truly can enhance their roles as business partner and consultant.

THE POWER OF ABC

To illustrate the potential of ABC, consider the following two financial reports or a department's expenses. One is taken from a general ledger General Ledger

A company's accounting records. This formal ledger contains all the financial accounts and statements of a business.

Notes:
The ledger uses two columns: one records debits, the other has offsetting credits.
 and the other from an ABC analysis ABC analysis is a business term used to define an inventory categorization technique often used in materials management.

ABC analysis provides a mechanism for identifying items which will have a significant impact on overall inventory cost [1]
:

How much financial insight is a manager likely to get from the chart of accounts report? Although it provides the same total as the ABC report, the ABC report provides information that can be applied to cost management. The ledger information, although accurate, fails to report the business-process costs that run cross-functionally--that is, across an organization's departmental boundaries. It fails to show the true total cost of fulfilling a customer order that passes through many hands. And that's understandable: After all, the general ledger is structured to collect transactions by departments--not to provide insights into work-related costs. As a result, the general ledger is effective: for bookkeeping bookkeeping, maintenance of systematic and convenient records of money transactions in order to show the condition of a business enterprise. The essential purpose of bookkeeping is to reveal the amounts and sources of the losses and profits for any given period. , but it's structurally deficient de·fi·cient
adj.
1. Lacking an essential quality or element.

2. Inadequate in amount or degree; insufficient.



deficient

a state of being in deficit.
 for assisting in decision making.
Chart of Accounts View

Salaries            $621,400
Equipment            161,200
Travel expenses       58,000
Supplies              43,900
Use and occupancy     30,000

Total               $914,500

Activity-Based Costing View

Key/scan claims                32,000
Analyze claims                121,000
Suspend claims                 32,500
Receive provider inquiries    101,500
Resolve member problems        83,400
Process batches                45,000
Determine eligibility         119,000
Make copies                   145,000
Write correspondence           77,100
Attend training               158,000

Total                        $914,500


ABC is not a replacement for traditional general ledger accounting. Rather, it's a way to translate general ledger data into a format that helps managers make decisions.

ABC corrects for the limitations of traditional costing by identifying all the work activities--and their costs--that go into manufacturing a product, delivering a service or performing a process. When the individual costs are added up, a clear picture of the total cost of a process comes into view. ABC can even distinguish the cost of servicing different customers.

The traditional cost management approach--in which cost allocation is based on labor hours, gallons, pounds or other units of output--rarely reflects the true cause-and-effect relationship between indirect and overhead costs overhead costs

see fixed costs.
 and individual products, services, channels or customers. ABC was developed as a practical solution for problems associated with traditional cost management--a technique that usually fails to allocate costs correctly because:

* Too many of the costs are lumped together in some categories.

* The average rates selected for many costs tend to be excessively broad.

* Often irrelevant factors are used to allocate indirect costs Indirect costs are costs that are not directly accountable to a particular function or product; these are fixed costs. Indirect costs include taxes, administration, personnel and security costs. See also
  • Operating cost
. For example, should product-inspection costs be spread among all products or only those products being inspected?

TURNING LOSS INTO PROFIT

Why is it important to know the true cost of a process, product or service? Because companies that use traditional indirect-cost allocations may actually lose money on certain products, orders and customers, even though their accounting systems report them as profitable. Because pricing and quotation practices usually rely on the same flawed flaw 1  
n.
1. An imperfection, often concealed, that impairs soundness: a flaw in the crystal that caused it to shatter. See Synonyms at blemish.

2.
 cost data, the errors are perpetuated.

Once ABC is set up to determine true costs, cost estimating is a natural next step. It begins with forecasts of a product's output; then, by adding the various cost driver rates for that activity, the total projected cost can be determined. For that reason, what-if analysis and predictive planning are popular ABC applications.

OFFSETTING ERRORS

How can it be that less detail and estimated figures produce an accurate costing picture?

Although the notion is counterintuitive coun·ter·in·tu·i·tive  
adj.
Contrary to what intuition or common sense would indicate: "Scientists made clear what may at first seem counterintuitive, that the capacity to be pleasant toward a fellow creature is ...
, consider this: With ABC, the assigned costs that result from an estimating error (that is, estimating percentage of labor time per work activity) don't necessarily compound. When a potential error in ABC's activity costs combines with a potential error in the activity driver rates and assignments, the total error can actually become smaller when the errors offset each other. Cost allocating is a zero-sum error game. If an indirect cost allocation is incorrect, then some cost objects will be set too high while the remainder will be set too low, and the net sum error is zero.

However, when each of the activity costs are reaggregated into their specific products or services to customers, the probability is slim to none that an individual product will receive activity costs from only the activities that were set too high.

Allied Signal and Coca-Cola, which have developed world-class ABC modeling teams, learned this lesson by putting their ABC systems through several redesigns. They found that simpler designs generally produced higher levels of accuracy.

Critics of ABC argue that the costing process is just another way to spin financial data. But as many companies have discovered, ABC puts the "management" back into management reporting, and the accounting profession can be instrumental in this move--but only if accountants ease up on their heavy appetite for precision and place greater emphasis on relevance. Using ABC data can achieve relevant cost estimates as a basis for sound management decisions.

RELATED ARTICLE: EXECUTIVE SUMMARY

* ACTIVITY-BASED COSTING (ABC) was developed as a practical solution for problems associated with traditional cost management.

* THE CPA-ABC INCOMPATIBILITY problem probably has its roots in accountants' instincts and training, which aim for precision. But with ABC close enough is not only good enough, it's often key to its effectiveness.

* ABC IS NOT A REPLACEMENT for traditional general ledger accounting. Rather, it translates general ledger data into costing information.

* IT'S IMPORTANT TO know the true cost of a process, product or service because companies that use traditional indirect-cost allocations may actually lose money on certain products, orders and customers, even though their accounting system reports them as profitable.

* ONCE ABC IS SET UP to determine true costs, cost estimating is a natural next step.

* WHEN AN ABC PROJECT fails, the most likely reason is that its managers designed the ABC system to be too large and require too much detail.

RELATED ARTICLE: The Rise of ABC

For years, activity-based costing (ABC) was considered an expensive management project that only large organizations with extensive resources could undertake. But today, with the proliferation proliferation /pro·lif·er·a·tion/ (pro-lif?er-a´shun) the reproduction or multiplication of similar forms, especially of cells.prolif´erativeprolif´erous

pro·lif·er·a·tion
n.
 of computers for data gathering and computing computing - computer  plus the recognition that most data for decision making need not be accurate to several decimal places decimal place
n.
The position of a digit to the right of a decimal point, usually identified by successive ascending ordinal numbers with the digit immediately to the right of the decimal point being first:
, any organization can implement ABC.

In the early 1980s many companies began to realize their traditional accounting systems were generating inaccurate costing information. While calculating costs using direct-labor-based (or volume-based) allocations may have provided accurate enough results in the past, these simplistic sim·plism  
n.
The tendency to oversimplify an issue or a problem by ignoring complexities or complications.



[French simplisme, from simple, simple, from Old French; see simple
 allocation methods became outdated as most organization's cost structures began to change in the '80s.

As organizations became more complicated, indirect and overhead costs grew at a faster rate than sales or services and displaced displaced

see displacement.
 the costs of the front-line worker. In addition, the diversity of products and service lines expanded; similarly, the diversity of customers and channels increased, too. As a result, no single volume-based allocation method could fairly trace indirect costs into the rich variation of products, service lines and customers. ABC resolves this.

The sharp rise of competition also contributed to the failure of the old costing methods. No longer could a company continue to carry unprofitable products and unprofitable customers by hoping the profitable ones would make up the difference. Price quotations, capital-investment decisions, product mix, technology choices, outsourcing (1) Contracting with outside consultants, software houses or service bureaus to perform systems analysis, programming and datacenter operations. Contrast with insourcing. See netsourcing, ASP, SSP and facilities management.  and make-vs.-buy decisions today all require a sharper pencil.

Many managers understood intuitively that their accounting system was distorting the assignment of costs, so they sometimes made informal adjustments. But over time, even those adjustments failed.

Two economic factors contributed to ABC's growing success. As the power of the personal computer grew and prices fell, it processed and stored more accounting data; as a result, the necessary data, in essentially the correct format, became more available to the ABC system and its users. Second, increasing competition has forced all organizations to focus not just on their top line--sales or budget funding. Now they must also understand their middle line--their costs.

GARY COKINS, CPIM, is director of industry relations at ABC Technologies, Inc., Beaverton, Oregon Beaverton is a city in Washington County, Oregon, United States, seven miles west of Portland in the Tualatin River Valley. As of May 2006, its population is estimated to be 84,270,[1] 9.1% more than the 2000 census figure of 76,129. . He has written An ABC Manager's Primer (1993) and Activity-Based Cost Management: Making It Work (1996), both published by McGraw-Hill. His email address See Internet address.  is garyc@abctech.com.3
COPYRIGHT 1999 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1999, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

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Article Details
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Title Annotation:accountants; activity-based costing
Author:Cokins, Gary
Publication:Journal of Accountancy
Geographic Code:1USA
Date:Aug 1, 1999
Words:1545
Previous Article:Buyer beware.
Next Article:Yes, ABC is for small business, too.
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