ACTIVITY-BASED COSTING: BEYOND THE SMOKE AND MIRRORS
The business environment in the 1990s is markedly different from that
of the past when conventional cost accounting procedures were
established. Activity-based costing (ABC), pioneered in the late
1980s, offered a new costing approach consistent with the changed
environment. However, ABC did not diffuse rapidly into the business
community. This article demonstrates why adopting ABC is important by
documenting the potential of ABC in supporting contemporary managerial
Everything happens faster in business today. Even new management tools
(some say "fads") follow a meteoric path. For example, the ink on new
articles describing activity-based costing (ABC) was hardly dry before
consulting firms had integrated it into their slick brochures and
presentations. All they needed was someone to use it. To illustrate,
Romano identified only 110 installations by August 1990, nearly two
years after the procedure was developed, with 77 percent of these in
two major firms . Perhaps this phase, in the process of
introducing the new procedure, could be called "the period of wild
over-promise." However, even by the mid-1990s, ABC has not spread
widely throughout the industry and "even in large firms, widespread
success of ABC is not obvious" .
According to Ness and Cucuzza, "thousands of companies have adopted or
explored the feasibility of adopting ABC. However, (they) estimate
that no more than ten percent of companies now use activity-based
management in a significant number of their operations" . A survey
conducted by the Institute of Management Accountants' cost management
group found that only 29 percent of companies used ABC instead of
traditional systems, but this was an increase from 25 percent in the
previous year . Among reasons cited for low adoption were employee
resistance and major organizational changes required with the use of
ABC . Some trace the source of slow adoption of ABC to technical
as well as cultural issues . Others feel that ABC would be more
widespread in industry if it were marketed better by the cost
accounting profession itself .
As the dust has settled, ABC has turned out to be less a revolutionary
technique than a useful refinement to proven systems. The costs of
products and services must be accurate, or management can be misled.
Decisions can rarely be better than the information on which they are
based. ABC allocates costs to the things people are doing in companies
and assures that these costs are paid by the products that generated
them. The "corporate socialism" in which some products pay the bills
of other products is exposed. It is the purpose of this article to
illustrate how ABC more accurately reveals the true costs of operating
in the business environment of the mid-1990s and supports managerial
decision making by providing information consistent with this
environment. Beyond the smoke and mirrors, ABC can contribute to
What is ABC?
The full cost of a manufactured product or line of products includes
direct labor, material, variable overhead, and fixed costs. Direct
labor and material are normally observed and measured by manufacturing
and maintained as "standards." The overhead costs are reported by
responsibility centers, such as departments or plants. The difficult
decision is what to do about allocating overhead costs to products or
The typical business uses a two-step system for absorption costing in
which costs are accumulated in a pool and then allocated to specific
products based on a single, plant-wide base, such as direct labor
hours utilized in producing the product . Other allocation bases
are machine hours or direct labor cost, for example. The wide use of
direct labor hours as an allocation basis is historical. When cost
accounting systems were being developed in the mid-1920s, labor was a
major cost and thus a target of management attention. However, it is
now apparent that the historical model is oversimplified. Direct labor
costs that once accounted for 80 percent of all costs, now account for
no more than eight to 12 percent of all costs in advanced
manufacturing industries . Indeed, "marketing costs make up more
than 50 percent of the total costs in many product lines," not direct
labor costs .
Activity-based costing, pioneered by Harvard's Cooper and Kaplan,
responded to changes in the business environment with a new approach
that allocated staff and overhead costs to products (or lines or
territories) based on how the products actually consumed or generated
the costs . The process is similar to that used by engineering to
develop a bid or to estimate the cost of a project. ABC identifies
systematic cause and effect linkages between products and costs,
before resorting to across-the-board allocations. In ABC, these
linkages are called cost "drivers," i.e. costs are driven up or down
by these factors. Companies are using labor hours, machine hours,
floor space used, ordersentered, warehousing, size, weight, and sales
costs as drivers. Refer to Exhibit 1. Costs are first accumulated, as
has been done traditionally, but are then allocated to the product or
territory by the appropriate drivers. For example, a product using 30
percent of warehouse space might get 30 percent of the space costs,
one using 20 percent of sales effort might receive 20 percent of that
Changes in the Business Environment
Operating managers have known for 50 years that the conventional
costing approach was inaccurate; however, it was close enough. Today,
because of the multitude of changes in the business environment, the
errors of conventional costing are systematic and can affect too many
decisions. These widespread changes have fundamentally altered the
essential assumptions of conventional cost accounting.
Direct labor is down dramatically. Not many years ago labor comprised
25 to 50 percent of a product's cost. However, since the 1960s, many
businesses in America have gone through a quiet revolution. For
example, the textile industry junked 100-year old shuttle looms for
European air-jet looms, doubling output with half the manpower. In
steel, the "Nucors" of the U.S. used continuous casting machines to
yield labor costs of $60/ton compared with traditional "Big Steel's"
$130/ton. In short, labor cost now is infrequently the dominant
driving force it was during the development period of cost accounting.
Instead, indirect costs have replaced labor as the dominant portion of
costs for some products . To use labor as the major basis for
allocating overhead in such cases, as conventional accounting does,
may be misleading.
Overhead costs are higher. Overhead costs are higher due to decisions
regarding machinery, human resources, and support systems. There has
been a move to more sophisticated machinery that must be used properly
by fewer and more skilled workers, supported by expanded auxiliary
systems. Responsive, flexible machinery is the key to the success of
many companies. Few can rely on sales of large quantities of
undifferentiated products. Flexible manufacturing systems (FMS) are
the models for the advanced application. Machines with a desired range
of capability and designed for ease of a changeover are integrated for
efficiency and controlled by computers for maximum responsiveness
. Millions in capital investment are monitored by one or two
operators but supported by programmers and technicians. Obviously,
this affects human resources because a smaller workforce is needed.
Nevertheless, many companies are seeing their training costs double in
a single year as resources are poured into the building of employee
teams. Initiatives in total quality management (TQM) involve heavy
commitments to personnel. For some companies, the cost is significant
enough to warrant care in where it is charged. For example, Univar,
the largest chemical distributor in the U.S., committed $2 million to
TQM training and implementation . Conventional cost accounting is
unable to reveal accurately such investments in personnel.
All these changes have involved investment in support services such as
engineering, sales, and information systems. Many companies, such as
Ingersol-Rand's Compressor Division, believe that sales outside the
U.S. may soon require ISO 9000 certification. Besides the direct costs
of the certification visits required, the costs of all the systems
must be in place throughout the company to support this endeavor.
Registration for ISO 9000 certification cost one international
corporation $2,000 to $3,000 per plant; the corporation registered 20
such plants .
Inventories are decreased. In the past, inventories have acted as a
buffer to disconnect manufacturing from the market. Today, competitive
effectiveness calls for just the opposite. When the market needs it,
responsiveness is provided with reduced inventory. Again, there are
cost implications in information systems, such as material
requirements planning (MRP) and the support of more skilled workers in
JIT systems. Moreover, today's smaller inventories require more setups
and more frequent orders of smaller quantifies .
Product life cycles are shorter. As the pace of technological change
has quickened, many new product innovations have entered the market.
These entrants have reduced market shares of established products so
that product-elimination decisions occur more frequently. Accurate
costinformation is critical in determining the actual costs of
frequent product changes and in knowing at what point profits no
longer justify continuation of a product or line.
New product development is faster and more frequent. The shortening
length of product life cycles means that new product development is an
ongoing process. In the past, this process was largely a function of
marketing, with its cost relegated to marketing overhead. Today,
concurrent engineering, simultaneous product development, and venture
teams mean that costs, prior to manufacturing, are incurred throughout
the organization. Ultimately, faster new product development can lead
to lower total costs, but many costs are hidden . This can lead to
incorrect measures of profitability and incorrect market entry
Product lines are more complex. Product lines were simpler in the
past. The Model T came in one color. Now, market segmentation and
market fragmentation mean different products for different (smaller)
markets; this means lower sales and profits per product. Under these
circumstances, accurate costing is essential. There may no longer be
large volume sales to cover high hidden costs. On the contrary, mass
customization is fast approaching. More than 200 companies, including
Westinghouse, Chrysler, and Honeywell, have joined the Agile
Manufacturing Enterprise Forum, an association seeking to meet the
need for customized products made as quickly and cheaply as those that
are mass produced .
Order entry is more frequent. As product variety increased, order
entry frequency did also. More specialized products for diverse
markets means more customers entering orders for different products,
more frequently. Furthermore, such customization means that it is more
difficult to produce large quantities for stock. Also, because the
cost of holding inventories is prohibitive, more frequent orders are
entered at the plant in response to JIT buying. Key costs are shifted
away from manufacturing to marketing subsystems, but they must be
captured and related to the products and lines that generate them.
Distribution is expensive. As JIT shifts costs away from storage, it
shifts them into distribution. This may mean that transportation
expenses increase or channel costs must go up to compensate dealers
for holding inventory. These costs must be allocated appropriately if
prices and profits are to be reflected accurately in management
Selling is more costly. More customers and customized products mean
more sales calls and sales expenses. In some industries, the cost of a
business-to-business sales call now exceeds $300. Such costs across
product lines can easily eclipse direct labor expense in the factory
and significantly impact profitability. Many companies are seeking to
reduce costs by employing telemarketing and direct mail. Others are
seeking more productivity from sales by using personal computers,
"virtual" offices, and key account marketing. But these approaches may
generate marketing costs as they shift them away from direct labor.
These costs must be recognized in the cost accounting system.
How Do the Changes Impact Costs?
The changes documented above have had a profound impact on the costs
of operating a business in the 1990s. Using a conventional cost
accounting approach in today's environment may provide distorted
information to management. This can result in incorrect decisions. The
use of ABC, on the other hand, provides a way to reflect the
contemporary business environment in a firm's accounting system. The
exhibits below illustrate the physical changes on the plant floor and
the market changes in the environment, trace these changes in the
accounting system, and show how the costing approach can dramatically
alter the apparent profitability of a company's strategies.
Two stereotypical products are displayed in Exhibit 2. The
"traditional" product has high labor cost and a simple manufacturing
environment. The "contemporary" product, reflecting the mid-1990s
environment for many companies, has much less labor, lower volume,
more change/turnover in manufacturing, and increased sales effort. The
exhibit summarizes these general differences.
Exhibit 3 takes the product characteristics in Exhibit 2 and shows
representative activities that these characteristics might entail. For
example, the traditional product's higher sales volumes would lead to
many units sold (23,000) and fewer setups, i.e., longer production
runs. This is consistent with the business environment of the past.
The traditional product is labor intensive, five hours versus one hour
for the contemporary product, and material intensive, $15 versus
$13.50. On theother hand, the contemporary product requires more
setups, 18 versus nine, and engineering changes, 12 versus seven. The
contemporary product's increased selling effort requires more sales
calls and more advertising.
The total costs of some departments providing the services are also
shown in Exhibit 3. These costs, reflecting the different business
conditions of the mid-1990s, are documented to develop a realistic
model of the two types of operating environments. Total costs for the
period are $4,015,000. This information will be used later in
comparing conventional cost accounting with ABC to show the potential
impact of ABC.
The information in Exhibit 3 is used to generate the costs of each
product and the total costs under both the conventional method and the
ABC method of allocating costs. Refer to Exhibits 4 and 5. In Exhibit
4, labor and material are derived from actual costs as usual. The
contemporary product has much less direct labor, $12 compared with
$60, and uses less material, $13.50 versus $15.00. Using the
conventional (non-ABC) costing method, overhead costs are allocated by
labor according to the formula shown in Exhibit 4, $68.83 to the
traditional product but only $13.77 to the contemporary product. This
yields a total traditional product cost of $143.83 per unit versus
$39.27 for the contemporary product.
The development of costs using ABC is shown in Exhibit 5. Direct
material and labor are the same as they were in Exhibit 4. Using ABC,
overhead costs were distributed across products by the drivers, as
explained in Exhibit 5. In other words, rather than simply allocating
costs based on direct labor, costs were allocated by the unique
drivers identified in Exhibit 3. For example, the receiving department
cost $61,000 and received 950 shipments, as shown in Exhibit 3.
Therefore, each receipt of materials cost $64.21. The traditional
product required 350 material receipts generating receiving costs of
$22,474. Since 23,000 units of traditional product were sold, each
unit sold generated $0.98 in receiving costs. Other overhead costs
were allocated similarly to distribute total product costs of
$4,015,000; each unit of the traditional product cost $105.18. The per
unit cost of the contemporary product was $88.65. These costs are
quite different from those of the conventional method in Exhibit 4.
The dramatic impact on apparent profitability due to this change in
cost allocation is shown in Exhibits 6 and 7 on page 30. Using
conventional cost accounting methods with labor-based allocations, the
traditional product's higher labor accumulated excessive overhead
costs, such as engineering or sales, that it did not generate. Instead
of losing more than $548,000 as shown in Exhibit 6, the traditional
product would have generated net profits in excess of $340,000 as
shown in Exhibit 7. On the other hand, the contemporary product was
undercharged for costs it incurred, generating an apparent net profit
of more than $1 million, shown in Exhibit 6. However, when costs were
charged to the products as they actually occurred using ABC, the
picture was quite different as shown in Exhibit 7. The contemporary
product's $1 million profit shrank to about $204,000. Thus, ABC
avoided a potentially erroneous decision to drop the traditional
product and seek more business for the contemporary product.
Exhibit 8 on page 30 summarizes these results. The traditional product
shows a significant decrease in costs using ABC rather than historic
costing. The contemporary product, which required more support and
service (changes, setup, sales calls, and orders), saw costs per unit
increase to reflect these expenses. In this situation, ABC exposed the
charges inherent in the 1990s business environment whereas historic
costing concealed them.
The business environment of the 1990s is vastly different from that of
the 1920s when conventional cost accounting procedures were
established. The primary difference is the decline of labor costs and
the increase in overhead generated by shorter product-life cycles,
product-line complexities, expensive new technology, and the other
realities of today's business environment. As a result, the
information necessary to make good decisions regarding products and
markets can be obscured by conventional costing procedures.
Activity-based costing, a natural progression of the technology of
information systems, can more realistically model the cost structure
facing businesses today.
Surprisingly however, ABC has spread very slowly in the industry. This
means that important strategic decisions are being based on incomplete
(inaccurate) information. The examples used in this article show how
profoundly the information used for decision making can be influenced.
The purpose of the examples is not to suggest that contemporary
products are less profitable than traditional ones. Even if that were
true, management does not have the option of producing only
traditional products. The market dictates which products are required,
and the market of the 1990s is different. Instead, the examples are
used to draw attention to how these differences in the market need to
be recognized in costing.
The pioneers of the ABC concept wrote that activity-based costing "is
designed to provide more accurate information about production and
support activities and product costs so that management can focus its
attention on the products and processes with the most leverage for
increasing profits. It helps managers make better decisions about
product design, pricing, marketing, and mix and encourages continual
operating improvements" [31:103]. The purpose of this article was to
show that there is more to ABC than smoke and mirrors. ABC can make a
genuine contribution to improving decision making.
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