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ABC's of activity-based costing.

A story has been going around for some time now. The CEO and the president of a midwestem company were flying in a hot air balloon. The basket attached to the balloon was uncomfortable but they were still enjoying the ride. After the two officers were in the air for a while, some trouble developed in the balloon's heating system. They tried to fix it, but could not. However, they were lucky. Their balloon landed safely in a cornfield. But they had no idea where they were.

Just then they saw a well dressed gentleman passing on a bicycle. They asked him, "Sir, can you tell us where we are?" The gentleman on the bicycle said, "Sure, you are in a cornfield standing in a basket." The president was a little annoyed, but he asked, "Sir, are you an accountant?" The face of the gentleman on the bicycle lit up and he said, "Yes. How did you know?" The president answered, "Because your information is precise but totally irrelevant."

This story indicates a problem with our traditional costing systems, and the reason why Goldratt and Fox, authors of The Goal, may accounting the number one enemy of production. Most accounting systems generate product cost data that are precise, objective, verifiable and good for external reporting. But they do not always provide relevant data for management decisions. Johnson and Kaplan discussed this phenomenon in The Relevance Lost: The Rise and Fall of Management Accounting. They represent how many engineering managers felt about accounting numbers for a long time. Now activity-based costing (ABC) has been suggested as an alternative method for providing relevant information for various kinds of decisions.

ABC started as a method of product costing but is now being proposed as a powerful tool for cost management, total quality management (TQM) and business process reengineering.

Product costing

Companies use product cost information for making internal decisions as well as for external reporting. Internally, management may use cost information for deciding prices, product mix, production scheduling and whether to make or buy certain parts. Since these are internal decisions, managers are generally free to use cost information in any form or way they like.

For external reporting -- reporting inventory value on the balance sheet and cost of goods sold on the income statement for example -- businesses must follow generally accepted accounting principles (GAAP). According to GAAP, products should be valued at full cost, which includes the costs of material and labor directly traceable to a product (called direct costs), and a fair share of indirect manufacturing overhead costs. Manufacturing overhead costs, such as the cost of warehouse employees, janitors, support staff, or the manager of a plant making several products, cannot be traced directly to each product. Therefore, the share of overhead assigned to each product is calculated on the basis of some measure such as direct labor hours or machine hours spent on the product. This process is called cost allocation.

For example, assume that the cost of indirect labor engaged in material handling on the factory floor and warehouse is expected to be $10,000 for a month when direct labor hours (DLH) are expected to be 20,000. This translates into an overhead rate of $0.50 per DLH ($10,000/20,000 DLH). If a job or product completed during the month required 200 direct labor hours, an indirect labor cost of $100 (200 DLH X $0.50) would be allocated to that job or product.

Cost allocation is usually a two stage process. First, general overhead costs of a plant (the plant manager's salary) and the costs of service departments (data processing, legal or personnel departments), are allocated to production departments. Second, the total costs of production departments are allocated to products manufactured in those departments. Some smaller firms with simpler operations combine all untraceable or overhead costs into one cost pool, and allocate the costs to products on a basis common to all products such as material cost, direct labor hours or machine hours. In other firms, stage one costs are allocated according to the ability to bear those costs (total revenues of different divisions), or according to cost driving measures (personnel department costs allocated according to the number of employees in a department, and data processing department costs according to the number of reports requested or total CPU time required). However, in stage two, these companies also use a single volume-related measure such as DLH, direct labor cost or machine hours. DLH is the most popular measure.

Ideally, to obtain accurate product costs, the allocation base should be a cost driver, an attribute of production driving a particular overhead cost. However, it is not always possible to find a perfect cost driver for all costs -- it is difficult to allocate a plant manager's salary to various products because the salary is not determined by any attribute of production.

In other cases, measuring a cost driver may not be cost-effective -- measuring in direct labor minutes spent on handling each shipment may cost more than the likely benefits derived.

Two points may be noted here regarding external reporting. First, it requires only aggregate figures, i.e., total cost of goods sold, and total value of inventory for all products included. Second, the method of allocating indirect costs for external reporting should be objective and verifiable so that auditors can certify external reports. As our costing systems primarily focused on external reporting, simple allocation bases such as direct labor hours served the purpose quite well.

Historically, labor cost has been a major component of total product cost compared to overhead of only about 5 percent to 15 percent. Therefore, detailed records of labor cost were maintained and monitored. Basing allocation on direct labor hours was easier and cheaper than using a more accurate allocation base. Moreover, in labor-based operations most of the overhead costs did vary with labor. If labor hours were not an accurate cost driver, the end result was not materially different, because overhead was a small portion of total cost and external reporting needed only aggregate figures. Direct labor also represented product complexity because a complex product needed more labor time. So, cost allocation based on DLH worked well for a long time. But now it is distorting product costs.

Problems with traditional costing systems

Conditions under which labor provided a valid base have drastically changed for many industries in recent years. Overhead costs, which include depreciation and maintenance, have become the major part of total product cost because of increased automation. In some high-tech companies, direct labor cost is so limited that it is now included in overhead. And, overhead may not be correlated with labor. Product complexity has increased, resulting in less labor and more work on sophisticated machines.

In addition, traditionally selected bases, such as direct labor hours or machine hours, are volume-related bases. The assumption underlying traditional costing systems is that overhead costs vary with the volume of output. But that assumption is not always correct. Many other factors, such as the number of parts in a product or the number of machine setups, also drive costs. Costs are incurred in ordering, receiving, inspecting and handling each part separately. If a product is made in small batches, it may require more total setups, incurring a higher setup cost as well as additional costs on material handling, inspection and moving.

If a costing system collects all overhead costs in one pool and allocates the pool according to one volume-related allocation base, what is the result? Overhead costs allocated to complex low volume products are too low. Such products drive total costs up because of their complexity -- they need more parts, more setups and longer inspections. But their unit cost obtained from the system is low because their complexity does not translate into more labor or machine hours. Therefore, the costs of complex, low-volume products are under-stated, and the costs of simple, high-volume products are over-stated.

If inaccurate information is the basis of management decisions, a firm may not survive long under the current intense global competition. The cost of making errors is enormous. At the same time, the cost of information systems has come down. So, the cost of keeping records of bases more accurate than DLH has decreased. Thus, many firms need to use a new costing system for management decisions and cost management.

Activity-based costing

ABC starts by rejecting the assumption that products consume resources and drive costs. It recognizes that activities link products and costs. Products consume activities and activities consume resources, which drive costs up.

For cost allocation under ABC, one needs to identify different activities needed by a product and find the costs incurred by those activities. Costs are then allocated to products according to the amount and the cost of activities consumed by products, not by some measure related to product volume.

Consider the ABC system used for product costing at Hewlett-Packard Roseville Networks division (Berlant et al). The division manufactures different kinds of PC boards. Its manufacturing overhead costs are first divided into three large cost pools: procurement overhead, production overhead and support overhead. Support overhead, consisting of the cost of production and process engineering, data processing and engineering management is allocated to the other two overheads, which are then allocated to products.

Procurement overhead costs are incurred on such activities as parts procurement, incoming inspection, storing and cycle, counting of parts, documentation. production planning and product logistics. All these costs are driven by the number of parts in a product. Hence, procurement costs are collected in one cost pool, the cost per part is calculated, and total costs are allocated according to the number of parts in each product.

Production manufacturing overhead costs are incurred on several activities, such as start station, axial insertion, dip insertion, manual insertion, wave solder, backload, testing and defect analysis. Each of these activities is driven by a separate cost driver. For example, the cost of start stations is driven by the number of raw PC boards started, the costs of axial and dip, and manual insertions are determined by the number of each type of insertions needed in a PC board. The cost of testing increases with the standard test time per board. Therefore, the costs in this pool are collected for each activity and allocated according to their respective cost drivers.

Thus, multiple cost pools are established in an ABC system. The cost in these pools should vary in direct proportion to the activities identified as their cost drivers. Costs are then allocated to products according to cost driver activities consumed by various products.

Potential benefits of ABC

Cost allocation according to ABC provides information regarding activities and more accurate product costs. This information can be used for making decisions regarding product profitability, customer profitability, cost management and project accounting. These four potential benefits are listed below.

* Product Profitability -- The case of Schrader Bellows discussed by Cooper provides an example of how more accurate product costs can help in determining product profitability and deciding product mix. After a new ABC-type system was implemented, costs of several products changed dramatically. The unit cost of a low-volume product (annual volume 53 units) calculated at $7.30 under the old system was $77.40. This meant actual gross margin on this product was 258 percent instead of 47 percent calculated earlier. Another product (annual production 2,079 units) showed an increase of 123 percent in unit cost and a change in gross margin from 26 percent to -32 percent. Overall, the reported costs of high volume products decreased under the new system.

Since the ABC system was more detailed and based on cost drivers, it provided more accurate costs. Therefore, these figures demonstrated that a labor-based costing system may be highly flawed. Some managers believe they can anticipate cost distortions in traditional labor-based costing systems and adjust their decisions accordingly. Schrader Bellows and other cases have shown that such cost distortions are usually more than what managers can anticipate.

* Customer Profitability -- Similar to product profitability analysis, one can analyze profitability of major customers and marketing channels. Different customers buy different product mixes. Their order sizes differ and they need different levels of customer support. All of these costs are typically paid in the period during which they are incurred. However, if the cost of activities such as processing an order, providing on-site service, or telephone support is known, the profitability can be calculated for each customer or customers grouped according to marketing channels.

* Cost Management -- Many companies try to reduce costs by arbitrary methods. Usually, direct material and direct labor costs cannot be reduced easily and accounting systems do not provide any guidance as to where other costs can be reduced because all other conversion and support costs are combined as overhead. As a result, the most convenient places to cut costs include R&D, employee training, advertising and support staff. But cutting these costs indiscriminately may hurt company profitability in the long run. ABC systems can provide information regarding an activity's performance and costs. This information can be used for effective cost management through activity analysis, which involves the following steps:

* Focus on activities that use the largest value of resources;

* Analyze their effectiveness in terms of whether they are adding value for internal or external customers--whoever uses the activities' output;

* Consider whether the activities can be eliminated; and

* If the activities cannot be eliminated, consider ways of making them more efficient, such as changing product design (e.g., using fewer parts), changing manufacturing process (e.g., by automation) or redesigning the factory layout. ABC systems can provide information for this type of analysis and evaluation. For example, detailed information can be provided regarding the cost of handling parts, which includes the cost of contacting suppliers, ordering parts, followup, receiving, inspecting, warehousing, maintaining inventory and issuing parts to the factory floor.

Thus, when ABC information is used for cost management, the focus shifts from cost to activities, and activities are managed to control costs.

* Project Accounting -- ABC concepts are quite applicable to project accounting because activities are the basic work units of a project. Project managers organize work breakdown structure (WBS), breaking the work down into tasks, subtasks, work packages and ultimately activities. WBS is then used for planning, control and costing at different levels.

Costing for WBS elements is usually accomplished by departments since required workers and machines may be coming from several departments. After estimating all direct costs, overhead is allocated at specified rates according to engineering time or machine hours needed, or as a percentage of labor cost or total cost. As engineering projects become more complex, labor-based allocations give distorted information. For example, such allocations do not account for differences in the number of parts or new suppliers required for a project.

Alternatively, cost information can be developed at activity levels as activities form the core of a project. Managers can use activity-based information to estimate project costs for competitive bidding. They can calculate more accurately the profitability of current projects, and they can make more effective resource allocation decisions. Projects can be planned better because the success of PERT/cost models and CPM time costing methods depends on accurate estimates of cost. Finally, project costs can be managed more effectively by focusing on activities and their cost drivers.

Besides the applications discussed above, ABC information can be used for improving product design and production processes, and formulating company strategy. The use of ABC information for making business decisions has been called activity-based management (ABM). Brimson listed several companies that have used ABC for various purposes such as the following:

* General Dynamics, Fort Worth division: For analyzing the effects of a factory modernization and productivity improvement program.

* General Motors: For make or buy decisions.

* Hewlett-Packard, Roseville Network division: focus on processes.

* Martin Marietta Energy Systems: For analyzing causes of OH (cost drivers) such as environmental, health/safety and security activities.

* Siemens: To focus on key business activities.

More recently, companies have used ABC in purchasing and procurement, operations, marketing and selling, distribution, and general and administrative expenses. The number of such examples is growing every day.

An increase in the number of companies adopting ABC systems does not imply that other companies should follow, nor is an ABC system a solution to all the problems. ABC information can enable managers to find solutions. The cost of changing the system, however, may not be trivial. Therefore, the need for an ABC system should be evaluated on a case-by-case basis.

Need for ABC

Managers need to determine for their companies, departments, or programs whether their present cost systems are obsolete and whether they really need new cost systems. These questions may be answered by the following considerations.

Two sets of costs are related to the accuracy of cost information provided: the cost of measurement and the cost of decision errors. There is a trade-off between these costs. If a costing system becomes a little less accurate for management decisions, the cost of decision errors increases but the cost of measurement decreases, and vice-versa.

For a given accuracy level, the cost of decision errors may change with the market conditions, such as demand volatility, change in market prices or the extent of profit margins. On the other hand, the cost of measurement increases with an increase in the diversity and complexity of products and production processes. But it decreases with developments in information technology.

Theoretically, the optimal cost point corresponds to the bottom of the total cost curve. Compared to conditions 5 years or 10 years ago, the cost of decision errors has gone up because of global competition, high customer demands, and low profit margins. However, the cost of measurement has been reduced because of developments in data processing technology. So the total cost curve has moved to the right, meaning that the optimal level of accuracy is now higher than before.

However, there is a problem. It is difficult to put any numbers on these factors. Another problem is that the cost of changing a costing system can be easily measured, but it is extremely difficult to measure the cost of errors not made because of a better costing system. How would you measure the cost of those errors an excellent manager would have made because of reliance on an inaccurate costing system? It is almost impossible to have an exact measure of these benefits. That is why it is hard to sell the idea of a new costing system.

There are a number of changes in a firm's environment that should prompt one to think about the firm's costing system (Cooper). The system may become obsolete if the firm has experienced automation or other changes in manufacturing processes, product market strategy, use of support functions, overall strategy or behavioral goals.

Other symptoms may also appear if decisions are based on inaccurate outdated costing systems. Some of these symptoms indicate that a functional manager's knowledge of operations conflicts with accounting reports. So, a manager may want to drop product lines reported as profitable. Products perceived as hard to make show large accounting profits. Various departments mistrust accounting numbers so they either collect costs on their own or ask their accounting department to obtain relevant costs as special projects. Externally, cost based prices may cause outcomes that are not easy to explain. For example, competitors' prices may seem unrealistically low, competitors may not be entering a high-margin product niche dominated by your firm, customers may be easily accepting price increases, or the firm may be winning its high-priced bids but losing the low priced bids. These symptoms may not result solely from a faulty costing system, but they certainly call for attention.

What next?

The ABC system has enormous potential benefits, but it is not appropriate if a new system is likely to cost more than the benefits. The nature and scope, hence the cost, of the new system will be determined by the intended use of the new information. An ABC system may be a broad company-wide integrated system replacing the existing system. Or it may be added to the existing system and kept limited to marketing, production or any other process where more accurate and relevant information is needed for management. In the latter case, the existing system may still be used for external reporting purposes. The intended purpose of a new costing system is your decision and surely one of a series of decisions needed for designing and implementing a new costing system.

For further reading

Berlant, D., R. Browning, and George Foster, "How Hewlett-Packard Gets Numbers It Can Trust," Harvard Business Review, Jan.-Feb. 1990.

Brimson, J., Activity Accounting, New York, John Wiley, 1991.

Cooper, R., "Measure Costs Right; Make the Right Decisions," Harvard Business Review, Sept.-Oct. 1988.

Cooper, R., "You Need a New Cost System When," Harvard Business Review, Jan;-Feb. 1989.

Cooper, R., R. Kaplan, L. Maisel, E. Morissey, and R. Oehm, Implementing Activity Based Cost Management: Moving from Analysis to Action, Montvale, NJ, Institute of Management Accountants, 1992.

Goldratt, Eli and Jeff Cox, The Goal, Croton-on-Hudson, NY, North River Press, 1992.

Howell, R. and S. Soucy, "Customer Profitability as Critical as Product Profitability." Management Accounting, Oct. 1990.

Johnson, H. Thomas and Robert Kaplan, Relevance Lost: The Rise and Fall of Management Accounting Boston, MA, Harvard Business School Press, 1987.

Kerzner, H., Project Management, New York, Van Nostrand Reinhold, 1992.

Turney, P. B. B., Common Cents: The ABC Performance Breakthrough. Hillsboro, OR, Cost Technology, 1991.


Traditional Costing Products consume resources.
Activity-based Costing Products consume activities and
 activities consume resources.



Consider the following two costs related to a costing system:

* The cost of errors (varying with competitive conditions e.g., product market volatility and profit margins), and

* The cost of measurement (varying with product diversity,

Vidya N. Awasthi, Ph.D., is currently an assistant professor of accounting at Santa Clara University, Santa Clara, Calif.
COPYRIGHT 1994 Institute of Industrial Engineers, Inc. (IIE)
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1994 Gale, Cengage Learning. All rights reserved.

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Author:Awasthi, Vidya N.
Publication:Industrial Management
Date:Jul 1, 1994
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