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Improving performance with cost drivers.

IMPROVING PERFORMANCE WITH COST DRIVERS

Due to changes in manufacturing, the traditional overhead allocation method can lead to inaccurate products costs. Frank Collins, CPA, professor of accounting, and Michael L. Werner, CPA, lecturer in accounting at the University of Miami, Coral Gables, Florida, illustrate how the new cost-driver approach can improve cost management. Traditionally, most companies allocated costs to production using application bases such as direct labor. However, as businesses become more capital intensive and production methods change, this procedure can lead to inaccurate determinations of product costs. The new cost-driver approach can remedy this situation.

USING COST DRIVERS

The cost-driver approach allocates a cost to production, based on the actions or factors that cause it. For example, the cleanup costs of a printing press might be allocated based on the number of colors used. As illustrated in the sidebar on TRADITIONAL vs. COST-DRIVER APPROACHES this results in more accurate costing.

The exhibit on Basic work phases and cost drivers shows typical cost drivers for the various stages of work (planning, getting ready to work, working, finishing and inspecting work). Examining the second stage--getting ready to work--we find activities that contribute costs to this stage include ordering raw materials and setting up machines. After accumulating applicable costs in pools, cost drivers are used to allocate these cost pools to production. Potential cost drivers for this second stage include the number of production runs or machine set-ups. If it is determined the number of production runs is the most appropriate cost driver, this pool is allocated to production in proportion to the number of production runs necessary to make the product.

TRADITIONAL APPROACH

How does this approach differ from the traditional one? Traditionally, costs are pooled and allocated to production as a function of direct labor hours or machine hours. These bases are used because it is assumed that, over the long run, factory costs are likely to be highly correlated with one of these measures. But because of changes in manufacturing this is often no longer true.

A rate per hour is determined and used to allocate each cost pool to the product. See the sidebar below for a comparison of the traditional and cost-driver approaches to allocating cleanup costs in a printing company.

BETTER COSTING AND CONTROL

The chief benefit of the cost-driver approach is that it provides better product costing for individual products. Accurate product costs are invaluable when setting sales prices, evaluating product lines for discontinuance or developing marketing and production strategies.

The manager who wants to control costs now looks to controlling their causes--the cost drivers. Using the traditional method, a manager wishing to reduce overhead cost allocations to his or her department seeks to reduce direct labor hours (or whatever the allocation basis happens to be), a practice not likely to get at the root causes of the costs. Using the cost-driver approach, accountants and managers look for the events and activities that cause costs.

OTHER BENEFITS

Beyond better product costing and control, the tangible benefits of identifying cost drivers include:

Eliminating and reducing cost. After identifying cost drivers, the natural next step--to see if some of these costs can be eliminated or reduced--is greatly facilitated.

Highlighting cost of complexity. Maintaining an elaborate product line is costly, particularly when it results in short and numerous production runs. Usually these costs are not separated and thus are hidden. In the search for cost drivers, they will be disclosed and associated with individual products. Though marketing strategy may continue to call for having an elaborate product line, the costs will be more apparent.

Reexamining long-term costs. American management and accounting practice often are criticized for focusing on the short run. The cost-driver approach, with its focus on cost causes and behavior, leads one to examine not only short-term variable production costs but also long-term costs that were considered committed or fixed. Indeed, many costs often considered fixed often do vary, however gradually, over the long term and are therefore subject to better control.

Developing management awareness. Managers can be encouraged to develop awareness of the causes of costs. Their bonuses, promotions and performance evaluations can be based on the application of cost-driver performance.

TIPS FOR GETTING STARTED

When adopting a cost-driver system, consider the following tips.

Enlist top management support. Without support by top management it is futile to implement a cost-driver system. There are too many changes and new policies and too large a perceived change to proceed without top-level support.

Start simply. To simplify initial cost-driver determinations, start with existing pools. Select manageable and self-contained pools. They should not have extensive cross allocations from other cost pools. Rather, they should stand alone.

Use a team approach. Create teams to investigate operations and determine cost drivers for each pool. Using a team approach makes it more likely operating and accounting personnel will accept the new approach. Any major systems change requires widespread personnel commitment to make it work.

PILOT STUDY

Implementation should occur in phases and start with a pilot study to identify cost drivers for selected operations. More important, it will provide training in isolating and using cost drivers, as well as a basis for evaluating implementation of a much wider cost-driver system. Later phases will build on the pilot study and should result in improved cost management in other areas of the company.

TRADITIONAL vs. COST-DRIVER APPROACHES

The following illustrates the allocation of cleanup costs in a printing company under both the traditional and cost-driver approaches. These cleanup costs include labor, supervision, cleaning supplies, etc., of a large printing press designed for relatively long, high volume production runs. The press has seven printing units, each used to print a particular color. (A job requiring four colors uses four printing units, while a job requiring two colors uses only two.)

Traditional approach. Traditionally, the accumulation and allocation of these costs were based on machine hours. Assume the estimated total annual operating cost of the press is $4,550,000; this includes cleanup costs of $325,000. Estimated annual production run time of the press is 6,500 machine hours. We compute a cost application rate of $700 per machine hour ($4,550,000/6,500=$700). Therefore, a seven-color printing job that runs for 10 hours is assigned a cost of $7,000 (10 x $700). Cleanup costs constitute $50 of the $700 application rate--$325,000/6,500=$50.

This allocation method does not consider differences between jobs that actually affect cost. Thus, the cost assigned to cleanup for both a one-color and a seven-color job, each of which takes 10 printing hours, would be $500. Although it is suitable for external financial reporting purposes, the traditional approach falls short of providing accurate costs for individual products.

Cost-driver approach. The cost-driver approach examines the printing operation to find what causes cleanup costs. In searching for the causes of the $325,000 budgeted cleanup cost, we note that only printing units actually used in the printing process require cleanup. It becomes apparent the use of additional colors causes additional cleanup costs and, therefore, the cause of cleanup costs--the cost driver--is the number of colors used. From this information, we develop an application rate for cleanup costs based on the number of colors to be used. Estimating 1,250 colors will be used annually, the rate is $260 per color ($325,000/1,250=$260). Based on the cost-driver approach, the cleanup cost allocated to the seven-color order would be $1,820 (7 x $260) or $1,320 more than the cost assigned using the traditional method. In the traditional approach, a product requiring multiple colors and having the same printing run time will have the same overhead cost per job as one requiring only two colors. This results in cost from the more complex product being shifted to the simpler product and obscuring the true profitability of both. [Exhibit 1 Omitted]
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Article Details
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Author:Werner, Michael L.
Publication:Journal of Accountancy
Date:Jun 1, 1990
Words:1316
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