Activity-Based Costing - Part 2
Differences between Activity-Based Costing and Traditional Cost Strategy Activity-based costing (ABC) is a costing model that identifies overhead activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption, while traditional costing equally distributes all overhead expenses. Thus, an organization employing ABC, can precisely estimate the cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced.
ABC is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has mainly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives. Due to its nature, traditional costing gives less freedom in that respect. In the past, accountants divided all costs into variable costs and fixed costs based on the relationship between the cost and output (business volume) changes, where only the short-term costs that vary with the cost of production were viewed as variable costs.
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However, although short-term costs do not necessarily change with the yields, they will change in a period of time with the product design, product mix, company’s product range and customer scope. Therefore, ABC provided further visibility and divided costs into short-term and long-term variable costs. The short-term variable costs are consistent with the original definition of the variable costs, such costs are quantity-based, and change in proportion with product output. Long-term costs, however, are based on activity levels, and change with the activity volume.
In the ABC system, the fixed costs only refer to those costs that do not change with the amount of any activity in a given period of time. Some studies have shown that the fixed costs are only a small proportion of the entire manufacturing costs. Therefore, ABC would pay more attention to long-term costs that can be variable. In ABC, almost all of the costs include the so-called ‘common costs’ and usually consider indirect and short-term fixed costs as variable, which allows for allocation to the products or product lines. Traditionally, cost accountants have been arbitrarily adding a broad percentage of expenses into the indirect costs.
However as the percentages of indirect or overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not driven proportionately by all of the products. For example, two products may use the same amount of direct labor and materials, however, one of the products may have to be produced on a machine that requires more costly and frequent maintenance; since the amount of direct labor and materials are the same, the additional cost for the use of the machine would not be recognized.
The traditional costing systems are often unable to accurately determine the actual costs of production and related services. Consequently, managers are not able to make informed decisions because of this deficient data. Instead of using broad arbitrary percentages, ABC seeks to identify cause-and-effect relationships to objectively assign costs. Once costs of all activities have been identified, the cost of each activity is attributed by product to an extent in which this product uses a specified activity.
In this way, ABC often identifies areas of high overhead costs per unit and thus directs attention to finding ways to reduce these costs or to charge more for costly products. At first, ABC was focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.
Like manufacturing industries, financial institutions also have diverse products and customers which can cause cross-product cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity based costing, while originally developed for use in manufacturing sector, arguably may be even more useful tool for doing this.
Benefits of Activity-Based Costing Overall, ABC has many advantages that small and large companies can benefit from. One of these advantages includes improvement of effectiveness of budgeting and forecasting by increasing ability to identify cost/performance relationship of different service levels. While the increased costs and decreased per unit revenue have pressured management of manufacturing and service companies to reduce costs significantly in order to deliver rofitable operating results, more and more companies are beginning to consider the ABC system to better understand various costs and ultimately improve profits. Furthermore, ABC is able to provide insight into the fastest-growing and least visible manufacturing overhead or administrative/selling expense elements. It allows companies to improve profitability by monitoring life-cycle costs and performance of individual products/units and encourages continuous improvement and total quality control at a process level.
In today’s fast-paced and rapidly changing business environment, ABC is able to help companies make more accurate pricing decisions and facilitate accurate reporting and prediction of costs, profits and other requirements associated with changes in production volumes, organizational structure and cost of resources . Additionally, by using ABC, companies are able to identify value-added and non-value-added products and channels which could help in creating a better marketing mix of products or assist manages in benchmarking their products to the competition.
Since many companies on the market have substitutes, these benefits are very valuable in assessing how the company can differentiate its product from the competitor’s brand and possibly even provide some insight into a marketing/branding strategy. Moreover, the transparency that ABC provides can be used to not only identify root causes of poor financial performance but also allow senior management to make more educated/forward-looking decisions and understand implications on the bottom line shareholder value .
Having such close visibility can provide valuable insight in the worth of the product to the customer and enhance bargaining power with clients and suppliers. Implementing ABC could also potentially add to the overall value of the company if it is sold or acquired. . Successful ABC Implementation: Boeing Commercial Airplane Group Wichita Division “Employing Activity Based Costing and Management Practices within the Aerospace Industry: Sustaining the Drive for Lean” The Boeing Commercial Airplane Group Wichita Division successfully implemented the ABC system and used the insights generated by the ABC system o support their cost management strategy. BCAG is the world’s largest manufacturer of commercial airplanes. It comprises approximately 60% of Boeing’s total revenues. As part of its strategic vision to gain and retain world-class aerospace manufacturing status, BCAG Wichita is focused on developing an efficient design and production system supported by an effective cost management strategy. Upon ABC implementation, the BCAG Wichita found that two areas of their division, Light Structures and Structural Bond, achieved significant cost reductions as well as capacity and quality improvement through activity-based costing.
Light Structures Area (Phase I): Asset Capacity The first stage in a manufacturing process involves transporting and processing fuselage parts (outside panels and brackets) through a serious of pre-assembly chemical treatment baths. Daily production rates averaged 30 hoods through the tank line, a 55% utilization rate of existing assets. The ABC implementation team estimated that if the asset utilization level was set at a conservative 80%, the Division could bring 135,000 parts back into the facility instead of offloading to external contractors and paying a premium of 50 cents per part.
The ABCM implementation team did not feel that the increase in capacity would require additional staffing and would result in substantial savings for BCAG Wichita. Further analysis was done to estimate the monthly savings incurred by reversing the cycle of offloading parts to vendors and under-utilizing the facility’s assets. Breaking down the facility’s average monthly output by product line, the ABCM implementation team could estimate which product line would contribute the most to the savings.
The team concluded that just the use of under- utilized asset capacity, would save the facility approximately $1,579,500 over 12 months. Structural Bond Area (Phase II): Cost of Quality The next stage in a manufacturing process continues the chemical treatment of parts. In this phase of manufacturing, Wichita used ABC to control its cost of quality, defined as the total cost of prevention, appraisal, and failures. The ABC team analyzed the cost of quality by completing the cause and effect analysis to identify the largest contributor to the failure costs.
The analysis revealed that rework was the largest contributor to failure costs, totaling $1. 3 million per quarter. The implementation team then segmented the different activities that make up rework. These included activities such as laminate, wheat starch, anodize, laser scribe, trim and cut, assemble, chemically mill, load, paint, and hand work. Hand working parts was the largest contributor to rework costs, comprising more than $350,000 per quarter of the original $1. 3 million per quarter total rework costs.
Next, the ABC implementation team identified which shops incurred the highest handwork costs and found that Shop 3162 was performing more than 50% of the handwork rework activity. This detailed information gathering made it clear that the parts being reworked in Shop 3162 had defects “inherited” from two potential sources: one is a part that enters Phase I undamaged but exits damaged and the second is a part that enters Phase I damaged and gets passed to Phase II despite its condition. These two problems caused the accumulation of such volumes of rework in shop 3162 and eventually some had to be offloaded to outside vendors.
The ABCM implementation team worked closely with quality assurance personnel and shop leads to identify a set of standardized quality criteria. As a result, a standard metric was developed to determine if parts needed to be reworked. BCAG Wichita realized a 20% reduction in the parts that needed to be reworked; shop 3162 alone experienced a savings in rework costs of approximately $900,000 per year. Moreover, the company realized a significant reduction in overtime hours due to the reduction of the rework activities. Successful ABC Implementation: Kemps LLC
Kemps, a leading U. S. dairy company headquartered in Minneapolis, is another great example of how time-driven ABC empowered managers to use the information collected through ABC for fostering relationships with its customers and jointly searching for cost-reduction opportunities. During the 1990s, Kemps saw a major consolidation in its customer base, as small independent retailers became absorbed or put out of business by giants such as Wal-Mart and Target. The buying power of these large distributors and retailers put suppliers’ margins under heavy pressure.
The demands of wholesale and retail customers were rapidly escalating with unyielding expectations for more specialized packaging, distribution, warehousing and “just-in-time” replenishment services. Many large retailers were reducing receiving capacity to control upfront expenses and shifting the responsibility onto suppliers to manage inventory more scrupulously. Many retailers began charging its dairy suppliers for handling and storing products in their retail freezers while Target instituted consignment sales so that Kemps would earn revenues only after consumers paid for the product at Target’s checkout counters.
Jim Green, Kemps CEO, recognized that Kemps needed to rethink and reshape its strategy in light of the consolidation among buyers, escalation of administrative costs and specialized services demanded by customers. Historically, the company had focused on developing a long-term relationship with its customers. However, Kemps could no longer afford to be a company providing “all things to all customers”. Kemps was shifting to a lower-total-cost strategy which required a deep and accurate understanding of its costs by product, brand, and, most importantly customer.
Prior to time-driven ABC implementation, Kemps used a manufacturing standard costing system that incorporated data about the materials cost and plant operating expenses at the department level. The overhead was applied as a percentage of direct manufacturing costs. This system was not ideal for Kemps in tracing cost drivers incurred during production and distribution. For example, to address customer demands for more specialized distribution, Kemps managed a complex transportation system with multiple delivery options.
Its trucks delivered full loads to supermarkets and their distribution centers; made direct deliveries of less-than-truckload (LTL) quantities to convenience stores, small retail stores, and homes; and shipped double-stacked frozen loads of ice cream to distribution centers across the U. S. Kemps’ costing system did not recognize the plant’s cost to handle and distribute products to customers’ locations. Despite all the variation in delivery options, the existing cost system estimated trucking costs at a standard $0. 7/mile rate, based on a full-truckload shipment, with no adjustments made for LTL deliveries or the number of stops on a route. The average shipment cost for a case of products was $0. 30, but studies revealed the actual cost to be 20% lower when preparing full pallets of standard cartons and up to 35% higher when picking and loading a partial case of product for LTL delivery. Responding to customer and consumer demand for a wide product variety, Kemps’ plants introduced special recipes of dairy products which required customized, small, and unpredictable production runs.
The standard costs did not reflect the effects of run size, since the system did not incorporate information about the setups or teardowns as machines shifted between flavors, products, and packaging. Not surprisingly, the changeovers were costly, since some product was lost at the start 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 to prepare for the next product. On the filling line, additional changeover costs were incurred when personnel had to set up a special run for an individual customer’s special labels and containers.
The existing cost system applied an allowance of 4% of sales to cover administrative costs. This average percentage markup did not reflect the diversity in administrative demands among various customer segments. For example, small convenience stores did not have electronic ordering capabilities – all orders were manually entered by administrative staff after a phone conversation with a store manager. Moreover, these stores had high turnover among store managers, so Kemps order entry personnel often had to make two to three calls per day to finalize the terms of a single order.
The store managers’ poor ordering and merchandising decisions, due to lack of experience and proper training, often resulted in stale inventory, which was returned to Kemps for refund credits. In contrast, Kemps’ high-volume accounts had experienced managers and used electronic ordering and processing, with little human intervention required. In light of many shortfalls of the current manufacturing standard cost system, Kemps implemented a time-driven ABC system to better measure resource consumption and trace underlying cost drivers and actual costs incurred during the production and distribution cycles.
As part of the Kemps lower-total-cost strategy, senior management wanted to assign each month’s operating expenses to the products and orders processed for customers. The time-driven ABC model assigned each department’s monthly costs to all the activities it performed that month based on each activity’s percentage of total time taken in the department. For example, production line costs would be driven down to each stock-keeping unit (SKU) produced, based on the percentage of time that the SKU took on the production line that month (including both changeover and run time).
For warehousing operations, if the activity of “picking and loading partial cases” represented 32% of the processing times in the cooler department, then 32% of that department’s monthly costs were assigned to all the partial cases handled that month. This cost would then be distributed proportionately to each partial case handled that month, enabling this cost to be incorporated in the total cost of serving each customer ordering a partial case that month. For distribution activities, the truck drivers were equipped with on-board computers to log daily drive and serve times.
To estimate distribution expenses, the team decided to incorporate daily drive and serve times into an activity equation. Managers discovered that in many instances the actual delivery and serve expenses did not match to customer pricing. It turned out that many customers were not being charged the full cost of delivery services they required. Following successful implementation of time-driven ABC costing system, Kemps learned it was losing money with one of its customers, a chain of specialty high-end shops, because of the low volume and high variety of products ordered, in addition to small just-in-time deliveries the chain requested.
Kemp’s vice president of sales called on the customer, explained the situation, and offered three options: (1) accept a price increase and a minimum order size; (2) eliminate its private-label ice cream, replacing it with Kemp’s standard branded product that was already being efficiently produced in high volumes; (3) or find another ice cream supplier. When the customer inquired why Kemps was making the change, the VP responded that after 25 years, Kemps only now understood its true manufacturing costs and the impact of specialty production on its margins.
The customer accepted a price increase of 13%, agreed to the elimination of two low-volume products, and agreed to accept full rather than partial truckload orders, thereby eliminating internal storage charges for Kemps. The changes produced immediate benefits of $150,000 per year, transforming this unprofitable customer into a profitable one. Kemps also became aware that some of its smaller convenience store customers had been over-ordering and returning product when the date code expired. To avoid the high cost of these rebates and returns, Kemps offered these retailers a 2% discount if they would manage their own inventories ithout the return option. In this way, Kemps eliminated 95% of out-of-code returns, generating a net saving of $120,000 per year. Overall, the implementation of activity-based costing enabled managers to see that not all revenue is good revenue and not all customers are profitable customers. The time-driven ABC offered Kemps a powerful tool to engage the customers and foster customer loyalty through transparent ways of working and collaboration in uncovering cost reduction opportunities.
Challenges & Shortcomings of Activity-Based Costing. As we discussed above, Activity-Based Costing System has many benefits including cost control, budgeting, forecasting and fostering business relationships. . However, ABC also has some limitations. The highest hurdle in achieving ABC implementation lies in moving the financial department from its classic accounting role of scorekeeper or policeman to the role of business partner. Additionally, a single largest barrier to widespread implementation of ABC is existing culture. Companies expecting to install ABC, regardless of their industry, will need to develop the ABC model, determine activity cost pools and relevant cost drivers.
The development of ABC model calls for management that has superb insight into the company’s characteristics and operations. Meanwhile, not all products’ cost can easily be allocated into different activity cost pools. If, due to carelessness or lack of data, managers or ABC implementation team fails to identify the correct activity or cost driver, the estimated costs will be biased. ABC system requires careful identification of cost drivers, extensive data collection and maintenance of a more complex model. Not surprisingly, the cost of maintaining ABC system is quite considerable.
Implementation of Activity-Based Costing ABC can be implemented by various companies regardless of their size. However, it makes more sense to implement ABC for companies that have a significant amount of overhead and diverse product portfolio, service lines, channels and customers. Since ABC could be used not only for manufacturing overhead but towards allocation of selling and administrative expenses, manufacturing industry is not the only one benefitting from this process. Financial Services, Public Sector, Communications and other industries are lso using ABC to make better decisions and increase their competitiveness and profitability . Since ABC implementation is a multi-step long-term project, it cannot be established overnight and could get quite time consuming and costly. Before making a decision to implement ABC, companies would have to evaluate their resource capabilities and staffing levels. For companies that are looking for a short-term solution, ABC might not be proven effective. There are several implementation approaches that could be considered and a wide range of consulting companies that offer services for companies which choose to implement ABC.
Couple of things to consider, however, would be the current state and financial performance, main activities performed by the company, operating costs of each activity, cost drivers, operating cost and capital charges for cost objects . In order to reduce amount of cost drivers and keep the process under control, companies, for example, may consider grouping various functions into one allocation pool and using the same cost driver for all invoices. This would prevent companies from getting buried under a ton of various activities, cost drivers and allocations that could obscure the purpose of ABC .