Activity-Based Costing (ABC) and Traditional Cost Strategy have differences in how they assign costs. ABC identifies overhead activities and allocates costs based on actual consumption, while traditional costing distributes overhead expenses equally. This means ABC allows organizations to accurately determine the cost of individual products and services, enabling them to identify and eliminate unprofitable ones and reduce the prices of overpriced ones.
ABC is primarily used for comprehending the cost and profitability of products and customers. It has typically been utilized to facilitate strategic determinations like pricing, outsourcing, and recognizing and evaluating efforts to enhance processes. On the other hand, traditional costing restricts flexibility in this regard. Historically, accountants categorized costs into variable costs and fixed costs based on the correlation between cost and changes in output (business volume). They defined variable costs solely as short-term costs that vary with production expenses.
In terms of costs, while short-term costs remain the same regardless of yields, they do change over time due to factors such as product design, product mix, company’s product range, and customer scope. To address this, ABC introduced categorizations for costs, distinguishing between short-term and long-term variable costs. The short-term variable costs align with the traditional definition of variable costs as they are quantity-based and vary proportionally with product output. On the other hand, long-term costs are determined by activity levels and fluctuate with changes in activity volume.
The ABC system distinguishes fixed costs as those that do not vary with activity levels in a specific time period. Research indicates that fixed costs are a relatively small portion of total manufacturing costs. Consequently, ABC emphasizes the importance of long-term variable costs. Within ABC, nearly all costs are classified as “common costs” and typically treat indirect and short-term fixed costs as variable, enabling allocation to products or product lines. Traditional cost accountants have traditionally allocated a general percentage of expenses to indirect costs without a precise basis.
As the percentages of indirect or overhead costs increased, this technique became less accurate because not all products were affected proportionately by the indirect costs. For instance, while two products may have the same amount of direct labor and materials, one of them may require costly and frequent maintenance on a machine. Since the direct labor and materials are the same for both products, the additional cost for using the machine would not be accounted for.
Traditional costing systems are often not sufficient in determining the accurate costs of production and related services, resulting in managers being unable to make informed decisions due to inadequate data. Instead of relying on broad arbitrary percentages, ABC aims to determine cause-and-effect relationships in order to assign costs objectively. By identifying the costs of all activities, ABC allocates the cost of each activity to a product based on how much the product utilizes that specific activity.
The use of ABC (Activity-Based Costing) is common in identifying areas with high overhead costs per unit. This prompts efforts to either reduce these costs or charge higher prices for expensive products. Initially, ABC was mainly utilized in the manufacturing sector due to technological advancements and increased productivity. As a result, there has been a decrease in direct costs like labor and materials, while indirect costs have risen. For instance, automation has reduced labor expenses but increased depreciation, which falls under indirect cost category.
Financial institutions, like manufacturing industries, face the challenge of dealing with a variety of products and customers, which can lead to subsidies between different products and customers. As personnel expenses are a significant part of non-interest expenses in financial institutions, it is essential to allocate these costs accurately to specific products and customers. Although activity-based costing was initially designed for the manufacturing sector, it could be an even more advantageous tool for achieving this in financial institutions.
Benefits of Activity-Based Costing: ABC offers various advantages for small and large companies alike. One of these benefits is enhancing the effectiveness of budgeting and forecasting through the identification of cost/performance relationships within different service levels. While manufacturing and service companies have faced increasing costs and declining unit revenue, compelling them to significantly reduce costs to maintain profitable results, more and more companies are turning to the ABC system to gain a deeper understanding of costs and ultimately boost profits. Additionally, ABC provides valuable insights into the least visible manufacturing overhead or administrative/selling expense elements that exhibit significant growth. This enables companies to enhance profitability by monitoring the life-cycle costs and performance of individual products/units and promoting continuous improvement and total quality control at a process level.
In today’s dynamic and fast-changing business landscape, ABC enables companies to enhance their pricing decisions and achieve precise reporting and forecasting of costs, profits, and other necessities linked to fluctuations in production volumes, organizational setup, and resource costs. Furthermore, through the utilization of ABC, companies can pinpoint value-added and non-value-added products and channels for refining their product mix or aiding managers in evaluating their products against competitors.
Having substitutes available in the market, it is crucial for companies to understand the value of these benefits in order to distinguish their product from competitors. This can also aid in developing effective marketing and branding strategies. Additionally, the transparency offered by ABC is valuable for identifying reasons behind poor financial performance and enables senior management to make informed decisions that will impact shareholder value.
By implementing ABC, companies can gain valuable insights into product value for customers and improve bargaining power with clients and suppliers. The Boeing Commercial Airplane Group Wichita Division successfully implemented ABC and utilized the generated insights to support their cost management strategy. Being the largest manufacturer of commercial airplanes worldwide, BCAG contributes 60% of Boeing’s total revenues. With a vision to become a leading aerospace manufacturer, BCAG Wichita focuses on developing an efficient design and production system alongside an effective cost management strategy. Post-ABC implementation, BCAG Wichita observed significant cost reductions in two key areas – Light Structures and Structural Bond – while also experiencing improvements in capacity and quality.
The initial phase of the Light Structures Area focuses on the capacity of assets. This involves transporting and processing fuselage parts (specifically outside panels and brackets) through a series of chemical treatment baths before assembly. On a daily basis, an average of 30 hoods are produced through the tank line, which results in a utilization rate of 55% for the existing assets. The implementation team from ABC estimates that if the asset utilization level is increased to a conservative 80%, the Division could bring back 135,000 parts into the facility. This would eliminate the need to rely on external contractors and avoid paying a premium of 50 cents per part.
The ABCM implementation team determined that the increase in capacity would not necessitate hiring more staff and would lead to significant cost reductions for BCAG Wichita. Additional examination was conducted to calculate the monthly savings generated by reversing the practice of outsourcing parts to vendors and underutilizing the facility’s resources. By evaluating the average monthly output for each product line, the ABCM implementation team could identify the product line that would contribute the highest amount to the savings.
The team found that by utilizing under-used asset capacity, the facility could save approximately $1,579,500 over 12 months. The next phase of the manufacturing process, known as Structural Bond Area (Phase II), involves the chemical treatment of parts. In this stage, Wichita used ABC to manage its cost of quality, which includes prevention, appraisal, and failure costs. The ABC team analyzed the cost of quality by conducting a cause and effect analysis to identify the main factor contributing to failure costs.
The analysis found that rework accounted for the majority of failure costs, amounting to $1.3 million per quarter. The implementation team then divided rework into various activities, including laminate, wheat starch, anodize, laser scribe, trim and cut, assemble, chemically mill, load, paint, and hand work. Hand working parts was the main driver of rework expenses, making up over $350,000 per quarter out of the initial $1.3 million total rework costs.
The ABC implementation team determined which shops had the highest handwork costs and found that Shop 3162 was responsible for over 50% of the handwork rework. This in-depth investigation revealed that Shop 3162 had defects in the parts they were reworking, which were caused by two potential sources. The first source was a part that entered Phase I without damage but left damaged, and the second source was a part that entered Phase I already damaged but still moved on to Phase II. These two problems resulted in a large amount of rework accumulating in Shop 3162, and eventually some of it had to be outsourced to vendors outside the company.
The implementation team of ABCM closely collaborated with quality assurance personnel and shop leads to establish a set of standardized quality criteria. Consequently, a standard metric was created to evaluate whether parts required rework. BCAG Wichita witnessed a 20% decrease in rework-required parts, with shop 3162 alone saving approximately $900,000 annually in rework expenditures. Additionally, the company observed a noteworthy reduction in overtime hours resulting from the decline in rework activities. Successful ABC Implementation: Kemps LLC.
Kemps, a leading U.S. dairy company based in Minneapolis, exemplifies how time-driven ABC empowered managers to utilize the information collected for cultivating customer relationships and collaboratively seeking cost-reduction opportunities. In the 1990s, Kemps witnessed significant consolidation within its customer base, with small independent retailers either being absorbed or forced out of business by retail giants like Wal-Mart and Target. The purchasing strength of these major distributors and retailers greatly impacted suppliers’ profit margins.
Wholesale and retail customers have been placing increasing demands on packaging, distribution, warehousing, and “just-in-time” replenishment services. These customers expect more specialization and are becoming more strict about inventory management. To control expenses, large retailers are reducing their receiving capacity and making suppliers responsible for managing inventory. Some retailers are even charging dairy suppliers for handling and storing products in their freezers. Additionally, Target has implemented consignment sales, where Kemps will only earn revenues after consumers have paid for the product at Target’s checkout counters.
Jim Green, CEO of Kemps, recognized that Kemps needed to rethink and reshape its strategy because of the consolidation of buyers, the increase in administrative costs, and the growing demand for specialized services from customers. Previously, the company concentrated on building lasting relationships with customers. However, Kemps could no longer sustain being a company that meets every customer’s needs. Instead, Kemps was shifting towards a lower-total-cost strategy that required a thorough understanding of costs associated with products, brands, and above all else, customers.
Kemps previously utilized a manufacturing standard costing system that involved data regarding material costs and plant operating expenses within each department. Overhead costs were applied as a percentage of direct manufacturing costs. However, this system was not effective for tracing cost drivers during production and distribution for Kemps. For instance, to meet customer demands for specialized distribution, Kemps managed a complex transportation system offering various delivery options.
Kemps’ trucks provided delivery services to supermarkets, distribution centers, convenience stores, small retail stores, and homes. They also shipped ice cream to distribution centers nationwide. However, Kemps’ costing system did not account for the costs associated with handling and distributing products to customers’ locations. Regardless of the various delivery options, the existing cost system calculated trucking costs at a fixed rate of $0.7 per mile for full-truckload shipments, without considering adjustments for LTL deliveries or the number of stops on a route. While the average shipment cost for a case of products was $0.30, studies revealed that the actual cost was 20% lower when preparing full pallets of standard cartons and up to 35% higher when picking and loading a partial case for LTL delivery. To cater to customer and consumer demands for a diverse range of products, Kemps’ plants introduced special dairy recipes that required customized, small-scale, and unpredictable production runs.
The standard costs did not take into account the impact of run size because the system did not include information about setups or teardowns as machines switched between flavors, products, and packaging. As a result, changeovers were expensive, as product was lost at the beginning of each production run until the process stabilized, and lost at the end of each run when the machine had to be stopped and cleaned for the next product. In the filling line, additional changeover costs occurred when personnel had to set up a special run for a customer’s unique labels and containers.
The current cost system implemented a 4% allowance on sales to account for administrative costs. However, this fixed markup did not account for the varying administrative requirements across different customer segments. For instance, small convenience stores lacked electronic ordering capabilities and relied on manual order entry by administrative staff after speaking with a store manager. Additionally, these stores experienced frequent turnover among managers, resulting in multiple calls from Kemps order entry personnel to finalize an order’s terms on a daily basis.
The store managers lacked experience and proper training, which led to poor ordering and merchandising decisions. As a result, stale inventory was often returned to Kemps for refund credits. On the other hand, Kemps’ high-volume accounts had experienced managers and utilized electronic ordering and processing, minimizing the need for human intervention.
In order to address the deficiencies of the current manufacturing standard cost system, Kemps implemented a time-driven ABC system. This system aims to accurately measure resource consumption and track the cost drivers and actual costs incurred during the production and distribution cycles.
As a component of the Kemps lower-total-cost strategy, senior management aimed to allocate operating expenses for each month to the products and orders handled for customers. To achieve this, the time-driven ABC model distributed each department’s monthly costs across the activities it carried out during that month, based on the proportion of total time spent on each activity in the respective department. For instance, the costs related to the production line would be allocated to individual stock-keeping units (SKU) produced, taking into account the percentage of time that each SKU required on the production line in that specific month (including both changeover and run time).
For warehousing operations, 32% of the processing times in the cooler department is attributed to the activity of “picking and loading partial cases”. Consequently, 32% of the monthly costs of that department are assigned to all the partial cases handled during that month. This cost is then distributed proportionately among each partial case handled, allowing it to be included in the overall cost of serving each customer who ordered a partial case during that month. In terms of distribution activities, on-board computers are provided to truck drivers for logging daily drive and serve times.
To estimate distribution expenses, the team decided to include daily drive and serve times in an activity equation. Managers found that in some cases, the actual delivery and serve expenses did not align with customer pricing. It was discovered that certain customers were not being fully billed for the cost of delivery services they needed. After successfully implementing a time-driven ABC costing system, Kemps realized it was experiencing a financial loss with one of its customers, a chain of specialty high-end shops. This was due to the small just-in-time deliveries and the high variety of products ordered, in addition to the low volume.
Kemp’s VP of sales visited the customer and presented three choices: (1) accept a price increase and a minimum order requirement, (2) replace their private-label ice cream with Kemp’s standard branded product, which was already being efficiently manufactured in large quantities, or (3) find a different supplier for ice cream. The customer then asked why Kemps was making this change, to which the VP explained that after 25 years, Kemps finally comprehended its actual manufacturing expenses and the effect of specialized production on its profits.
The customer agreed to accept a price increase of 13%, remove two low-volume products, and accept full truckload orders instead of partial ones. This resulted in the elimination of internal storage charges for Kemps and led to immediate benefits of $150,000 per year, making the customer profitable. Kemps also discovered that some smaller convenience store customers were over-ordering and returning expired products. To avoid the cost of these returns, Kemps offered a 2% discount to retailers who managed their own inventory without the return option. This reduced out-of-code returns by 95% and saved $120,000 per year. Overall, implementing activity-based costing allowed managers to realize that not all revenue is valuable and not all customers are profitable. Time-driven ABC gave Kemps a powerful tool to engage customers and foster loyalty by working transparently together to discover cost reduction opportunities.
There are challenges and shortcomings associated with Activity-Based Costing (ABC). Despite its numerous benefits such as cost control, budgeting, forecasting, and fostering business relationships, ABC also has limitations. The main obstacle in implementing ABC is the transition of the financial department from its traditional accounting role to that of a business partner. Another significant barrier to widespread adoption of ABC is the existing company culture. Regardless of the industry, companies planning to implement ABC must create the ABC model and identify activity cost pools and relevant cost drivers.
The development of the ABC model requires management with a deep understanding of the company’s characteristics and operations. Additionally, not all product costs can be easily allocated to various activity cost pools. If managers or the ABC implementation team fails to correctly identify the appropriate activity or cost driver, the estimated costs will be biased. The ABC system necessitates a meticulous identification of cost drivers, extensive data collection, and the maintenance of a more complex model. Consequently, it is not surprising that the cost of maintaining the ABC system is quite substantial.
ABC implementation can be done by companies of any size. However, it is more beneficial for companies with significant overhead and diverse product portfolios, service lines, channels, and customers. ABC is not limited to the manufacturing industry; it can also allocate selling and administrative expenses, benefitting industries like Financial Services, Public Sector, Communications, and others. These industries are using ABC to improve decision-making and increase competitiveness and profitability. Implementing ABC is a long-term project that requires multiple steps, time, and cost. Before deciding to implement ABC, companies need to assess their resources and staffing levels. ABC may not be effective for companies seeking a short-term solution. Different implementation approaches are available, and consulting companies offer services to assist with ABC implementation.
There are a couple of factors to think about when considering the current state and financial performance of the company. It is important to also consider the main activities carried out by the company and the operating costs associated with each activity. Furthermore, it is essential to identify the cost drivers that impact these operating costs and the cost and capital charges for cost objects.
To simplify and control the process, companies may choose to group different functions together into one allocation pool. By using the same cost driver for all invoices, companies can reduce the number of cost drivers and prevent themselves from being overwhelmed by numerous activities, cost drivers, and allocations that might obscure the purpose of activity-based costing (ABC).
