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ACTIVITY-BASED COSTING: BEYOND THE SMOKE AND MIRRORS

Summary

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

decision making.

Introduction

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 [13]. 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" [16].

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" [11]. 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 [10]. Among reasons cited for low adoption were employee

resistance and major organizational changes required with the use of

ABC [11]. Some trace the source of slow adoption of ABC to technical

as well as cultural issues [5]. Others feel that ABC would be more

widespread in industry if it were marketed better by the cost

accounting profession itself [1].

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

success.

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

territories.

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 [2]. 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 [17]. Indeed, "marketing costs make up more

than 50 percent of the total costs in many product lines," not direct

labor costs [8].

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 [3]. 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

cost.

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 [7]. 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

[14]. 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 [15]. 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 [9].

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 [6].

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 [4]. This can lead to

incorrect measures of profitability and incorrect market entry

decisions.

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 [12].

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

decision making.

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.

Managerial Implications

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.

Conclusion

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.

References

1. Brausch, J.M. "Selling ABC: New Cost Systems Can Flounder if They

Are Not Marketed." Management Accounting, February 1992, pp. 42-46.

2. Collins, F. and M.L. Werner. "Improving Performance with Cost

Drivers." Journal of Accountancy, June 1990, pp. 131-134.

3. Cooper, R. and R.S. Kaplan. "Measure Costs Right: Make the Right

Decisions." Harvard Business Review, September/October 1988, pp.

96-103.

4. Crawford, C.M. "The Hidden Costs of Accelerated Product

Development." Journal of Product Innovation Management, September

1992, pp. 188-199.

5. Geishecker, M.L. "New Technologies Support ABC." Management

Accounting, March 1996, pp. 42-48.

6. Heizer, J. and B. Render. Production and Operations Management.

Prentice Hall, 1996, p. 581.

7. Kelly, K. "A Bean-Counter's Best Friend." Business Week, October

25, 1991, pp. 42-43.

8. Lewis, R.J. "Activity-Based Costing for Marketing." Management

Accounting, November 1991, pp. 33-38.

9. Lofgren, G.Q. "Quality System Registration: A Guide to Q90/ISO 9000

Series Registration." Quality Progress, May 1991, p. 37.

10. "More Companies Turn to ABC."Journal of Accountancy, July 1994, p.

14.

11. Ness, J.A. and T.G. Cucuzza. "Tapping the Full Potential of ABC."

Harvard Business Review, July/August 1995, pp. 130-131.

12. Port, O. "Custom-Made, Direct from the Plant." Business Week,

November 18, 1994, p. 158.

13. Romano, P.L. "Trends in Management Accounting." Management

Accounting, August 1990, pp. 53-56.

14. Roth, A.V., C. Gaimon, and L. Krazewski. "Optimal Acquisition of

FMS Technology Subject to Technological Process." Decision Sciences,

Vol. 22, No. 2, Spring 1991, pp. 308-334.

15. Schonberger, R.J. and E.M. Knod Jr. Operations Management:

Continuous Improvement. Richard D. Irwin, 1994, p. 44.

16. Selto, F.H. and D.W. Jasinski. "ABC and High Technology: A Story

with a Moral." Management Accounting, March 1996, pp. 37-40.

17. Smith, R.B. "Competitiveness in the '90s." Management Accounting,

September 1989, pp. 24-29.

Word Count: 3358

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