ABC Analysis Essay, Research Paper
ACTIVITY-BASED COSTING: BEYOND THE SMOKE AND MIRRORS
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 . 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 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 . 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 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 . 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 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 . 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. 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