The business environment in the 1990s is vastly different from the past, where traditional cost accounting procedures were established. In the late 1980s, activity-based costing (ABC) was introduced as a new costing approach that aligned with the changing environment. However, the adoption of ABC was not immediate in the business community. This article aims to emphasize the importance of implementing ABC by showcasing its potential in assisting modern managerial practices. Today, everything happens at a much faster pace in the business world, including the rapid rise and fall of new management tools which are sometimes deemed as passing trends.
Consulting firms quickly incorporated activity-based costing (ABC) into their marketing materials after it was introduced, despite a lack of widespread implementation. By August 1990, only 110 installations of ABC were identified, mostly in two major firms. This phase could be considered a time of exaggerated promises. However, even by the mid-1990s, ABC had not gained significant traction in the industry. The success of ABC was not apparent even in large firms. According to Ness and Cucuzza, many companies have adopted or considered adopting ABC.
According to estimates, only about ten percent of companies are currently using activity-based management extensively [11]. A survey by the Institute of Management Accountants’ cost management group found that 29 percent of companies choose ABC over traditional systems, which is an increase from the previous year’s 25 percent [10]. The low adoption rate can be explained by factors like employee resistance and the significant organizational changes required for implementing ABC [11]. Both technical and cultural issues have been identified as reasons for the slow adoption of ABC [5].
Some argue that better marketing by the cost could lead to wider adoption of ABC in the industry. Over time, it has become clear that ABC is not a groundbreaking technique but rather a valuable improvement on existing systems. Accuracy in product and service costs is essential because incorrect costs can result in misleading management decisions. The quality of information upon which decisions are made determines their effectiveness. ABC assigns costs to specific activities within companies and ensures that these costs are attributed to the products responsible for them. This reveals the problematic practice of certain products subsidizing others, also known as “corporate socialism”. The main goal of this article is to demonstrate how ABC provides a more precise representation of operating costs in the mid-1990s business environment, thereby supporting decision-making by offering information aligned with this context.
ABC can contribute to the full cost of a manufactured product or line of products, including direct labor, material, variable overhead, and fixed costs. Direct labor and material are commonly measured as “standards” in manufacturing. Overhead costs are reported by responsibility centers, like departments or plants. The challenge lies in determining how to allocate overhead costs to products. A typical business uses a two-step system for absorption costing, wherein costs are accumulated in a pool and then allocated to specific products based on a single, plant-wide base, such as direct labor hours or machine hours. Alternatively, direct labor cost can also be used as an allocation base [2].
The historical practice of using direct labor hours to allocate costs is widely adopted. During the development of cost accounting systems in the mid-1920s, labor was a major expense and received significant management attention. However, it is evident that this traditional method is too simplistic. In advanced manufacturing industries, direct labor costs used to constitute 80 percent of total costs but now only account for eight to 12 percent [17].
More than 50 percent of total costs in many product lines are attributed to marketing expenses. In order to adapt to changes in the business environment, Harvard’s Cooper and Kaplan developed a new method known as Activity-based costing. This approach assigns staff and overhead costs to specific products, lines, or territories based on the actual consumption or generation of costs. It is similar to the process used in engineering for bidding or estimating project costs. ABC identifies cause and effect relationships between products and costs instead of using general allocations. These cause and effect relationships, known as cost “drivers,” determine how various factors influence costs.
Companies utilize various factors such as labor hours, machine hours, floor space used, orders entered, warehousing, size, weight, and sales costs as drivers for allocation. Please refer to Exhibit 1. Initially, costs are accumulated in the traditional manner but are subsequently distributed to the product or territory based on the relevant drivers. For instance, a product occupying 30 percent of warehouse space would incur 30 percent of the associated costs, while one requiring 20 percent of sales effort would bear 20 percent of those expenses. The conventional costing approach has long been recognized as flawed by operational managers, although its approximate accuracy was deemed acceptable. However, in today’s rapidly evolving business environment, these flaws have become systematic, impacting numerous decisions. These extensive changes have fundamentally overturned the fundamental assumptions of conventional cost accounting.
Direct labor costs have decreased over time. In the past, labor accounted for a significant portion of a product’s total cost, ranging from 25 to 50 percent. However, there has been a quiet revolution in numerous American businesses since the 1960s. For instance, the textile industry has replaced traditional shuttle looms with efficient European air-jet looms, resulting in double the output with half the workforce. Likewise, companies like “Nucor” in the U.S. have adopted similar strategies in the steel industry to enhance productivity and decrease reliance on labor.
Continuous casting machines are utilized to reduce labor costs to $60/ton, as compared to the traditional labor costs of $130/ton by “Big Steel.” This shift in cost dynamics indicates that labor costs no longer hold the same significance as they did during the establishment of cost accounting. Instead, indirect costs have taken over as the main component of expenses for certain products [7]. Thus, using labor as the primary basis for allocating overhead, as done in conventional accounting practices, results in higher overhead costs.
Higher overhead costs are the result of decisions made in relation to machinery, human resources, and support systems. Companies have been transitioning to advanced machinery that requires fewer, highly skilled workers and is backed by expanded auxiliary systems. The success of many companies depends on the presence of responsive and flexible machinery, as relying solely on selling large quantities of undifferentiated products is no longer feasible for most.
Flexible manufacturing systems (FMS) are advanced models that integrate machines with a desired range of capability and ease of changeover for efficient operation. These systems are controlled by computers to achieve maximum responsiveness [14]. Although only one or two operators monitor millions in capital investment, programmers and technicians provide support. As a result, there is a reduced need for a larger workforce, impacting human resources. However, companies are experiencing a doubling of training costs in a single year due to the allocation of resources towards the development of employee teams.
Implementing total quality management (TQM) initiatives requires substantial investment in personnel. This cost can be significant for certain companies, like Univar, the biggest chemical distributor in the U.S., which allocated $2 million for TQM training and implementation [15]. Traditional cost accounting methods are unable to accurately capture these personnel investments. Furthermore, various changes also necessitated investments in support services including engineering, sales, and information systems.
Ingersol-Rand’s Compressor Division and other companies anticipate the need for ISO 9000 certification for international sales. This certification requires implementing and maintaining systems throughout the company. The cost of certification visits and the overall cost of establishing these systems can be significant. One international corporation spent $2,000 to $3,000 per plant to register for ISO 9000 certification, resulting in a decrease in inventories.
In the past, inventories were used to separate manufacturing from the market. However, in today’s competitive landscape, the opposite is required. To meet market demand efficiently, inventories are now kept low for increased responsiveness. This change has cost implications, including investing in information systems like material requirements planning (MRP) and employing more skilled workers for just-in-time (JIT) systems. Additionally, smaller inventories in the current scenario necessitate more setups and frequent orders of smaller quantities [6].
Due to the fast pace of technological change, product life cycles have become shorter. This has resulted in the introduction of many new product innovations in the market. Consequently, established products have experienced a decrease in their market shares, and decisions to eliminate products are made more often. Accurate cost information is crucial for determining the actual costs associated with frequent product changes. It also aids in determining when the profits generated by a product or line are no longer enough to justify its continuation.
The speed and frequency of new product development has increased. The shorter lifespan of products requires a continuous process of developing new ones. In the past, marketing was primarily responsible for this process and the associated costs were considered part of marketing expenses. However, now with the implementation of concurrent engineering, simultaneous product development, and venture teams, costs are incurred throughout the organization before the manufacturing stage.
Faster development of new products ultimately leads to reduced expenses, but it is important to consider the numerous hidden costs associated with this approach [4]. These hidden costs can impact profitability evaluations and market entry strategies. In the past, product lines were simpler, like the Model T which was only available in one color. However, today’s market demands a variety of products tailored to smaller segments. As a result, sales and profits per product decrease.
Accurate costing is of utmost importance in this situation because large volume sales may no longer be enough to cover significant hidden expenses. However, the concept of mass customization is quickly gaining ground. Currently, over 200 companies including Westinghouse, Chrysler, and Honeywell are members of the Agile Manufacturing Enterprise Forum. This association’s goal is to meet the rising demand for customized products that can be manufactured just as swiftly and affordably as more frequently ordered items.
With the expansion of product range, there has been a rise in order entry frequency. The introduction of specialized products for diverse markets has led to an increase in customers placing orders more frequently for different products. This customization also presents challenges in producing large quantities of goods for inventory purposes. To address this, frequent orders are placed directly at the production facility in response to just-in-time (JIT) purchasing, as holding inventories is costly. It is crucial to track and attribute these costs to the specific products and lines that generate them while shifting key costs from manufacturing to marketing subsystems. However, distribution costs remain high.
As Just-In-Time (JIT) shifts costs from storage to distribution, it can lead to increased transportation expenses or higher channel costs for compensating dealers for inventory holding. Proper allocation of these costs is essential for accurate reflection of prices and profits in management. Selling becomes more expensive due to increased sales calls and sales expenses resulting from a larger customer base and customized products. In certain industries, the cost of a business-to-business sales call now surpasses $300. These costs, when incurred across multiple product lines, can easily outweigh direct labor expenses in the factory and have a significant impact on profitability.
Many companies are adopting telemarketing and direct mail to cut costs, while others are utilizing personal computers, “virtual” offices, and key account marketing to increase sales productivity. However, these approaches may result in increased marketing costs due to reduced reliance on direct labor. It is important to acknowledge these costs in the cost accounting system. These changes have significantly affected the operational costs of businesses in the 1990s. In today’s environment, relying solely on conventional cost accounting methods may mislead management with distorted information.
The use of ABC can account for the contemporary business environment in a firm’s accounting system, allowing for more accurate decision-making. The exhibits below demonstrate the physical and market changes and how they are reflected in the accounting system. Additionally, the exhibits show how the costing approach can significantly impact the perceived profitability of a company’s strategies. Exhibit 2 presents two stereotypical products.
The traditional product is characterized by high labor cost and a simple manufacturing environment. On the other hand, the contemporary product represents the mid-1990s environment for many companies, with lower labor requirements, lower volume, higher manufacturing turnover, and increased sales effort. Exhibit 3 provides an overview of these general differences. It takes the product characteristics outlined in Exhibit 2 and presents representative activities that these characteristics might involve. For instance, the traditional product’s higher sales volumes would result in a larger number of units sold (23,000) and fewer setups.
The longer production runs, as well as the labor and material-intensive nature of the traditional product (requiring five hours and costing $15), align with past business environments. On the other hand, the contemporary product requires more setups (18) and engineering changes (12), but only takes one hour to produce and costs $13.50. Additionally, the increased selling effort required for the contemporary product necessitates more sales. The costs of certain departments providing services can be seen in Exhibit 3.
These costs, amounting to $4,015,000, reflect the varying business conditions in the mid-1990s. They are provided to create a realistic model of two types of operating environments. This data will later be used to compare conventional cost accounting with ABC and demonstrate its potential. Exhibit 3 is utilized to calculate the costs of individual products and the overall costs using both the conventional method and the ABC method for allocating costs. Please see Exhibits 4 and 5 for further reference.
Exhibit 4 displays the usual derivation of labor and material from actual costs. However, the contemporary product demonstrates a significant decrease in direct labor, with a difference of $48 ($60 – $12), and a reduction in material usage, with a difference of $1.50 ($15.00 – $13.50).
Under the conventional costing method, the allocation of overhead costs is determined based on labor. As shown in Exhibit 4, $68.83 goes towards the traditional product, while only $13.77 is allocated to the contemporary product. Therefore, the total cost of the traditional product amounts to $143.
The cost per unit for the contemporary product is $39.27, while it is $83 per unit for the traditional product. Exhibit 5 demonstrates the cost breakdown using Activity-Based Costing (ABC), with direct material and labor remaining the same as in Exhibit 4. ABC distributes overhead costs across products based on specific drivers mentioned in Exhibit 5, instead of solely relying on direct labor for cost allocation. These unique drivers are highlighted in Exhibit 3.
As shown in Exhibit 3, the receiving department cost $61,000 and received 950 shipments, resulting in each receipt of materials costing $64.21. On the other hand, receiving costs for the traditional product were $22,474 from 350 material receipts. However, since 23,000 units of the traditional product were sold, each unit generated $0 in revenue.
Receiving costs accounted for $98, while other overhead costs were distributed in a similar manner to reach a total product cost of $4,015,000. The traditional product was priced at $105 per unit, whereas the contemporary product cost $88.65 per unit.
The costs of the conventional method shown in Exhibit 4 are quite different from these costs. The change in cost allocation has a dramatic impact on apparent profitability, which is shown in Exhibits 6 and 7 on page 30. By using labor-based allocations with conventional cost accounting methods, the traditional product incurred excessive overhead costs, such as engineering or sales, that it did not generate. Instead of incurring a loss of over $548,000 as depicted in Exhibit 6, the traditional product would have earned net profits exceeding $340,000 as illustrated in Exhibit 7.
In contrast, the contemporary product appeared to have made a net profit of over $1 million in Exhibit 6 but was actually undercharged for its costs. However, Exhibit 7 reveals that when actual costs were assigned to the products using ABC, the profit for the contemporary product decreased to approximately $204,000. As a result, ABC prevented a potentially incorrect decision to discontinue the traditional product and focus on expanding the contemporary product’s business. These findings are summarized in Exhibit 8 on page 30, where it is evident that ABC significantly reduced costs for the traditional product compared to historic costing.
The costs per unit for the contemporary product, which requires more support and service (such as changes, setup, sales calls, and orders), have increased to reflect these expenses. This exposes the charges inherent in the 1990s business environment, which 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 due to shorter product-life cycles, product-line complexities, expensive new technology, and other realities of today’s business environment. Consequently, conventional costing procedures can obscure the information needed to make informed decisions about products and markets. Activity-based costing, a natural progression of information systems technology, can provide a more realistic model of the cost structure. Surprisingly, however, ABC has been slow to spread in the industry.
This means that important strategic decisions are being based on incomplete (inaccurate) information. The examples used in this article demonstrate the profound influence that information used for decision making can have. The purpose of these examples is not to suggest that contemporary products are less profitable than traditional ones; even if they were, management has no option to produce solely traditional products. The market dictates which products are needed, and the market of the 1990s differs. Rather, these examples emphasize the importance of considering these market differences. The pioneers of the ABC concept stated that activity-based costing aims to provide more precise information on production and support activities and product costs so that management can prioritize products and processes with the greatest potential for increasing profits.
According to [31:103], ABC helps managers in making better decisions regarding product design, pricing, marketing, and mix, while also fostering continual operating improvements. The main objective of this article was to demonstrate that ABC goes beyond mere deception and can genuinely enhance decision making.
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