Costing: How accurate is it?

by Steve Vanderlinden, CIRAS

Activity Based Costing (ABC) is a method of measuring the cost and performance of activities, products, and customers. In product costing applications, for example, ABC allows costs to be apportioned to products by the actual activities and resources consumed in designing, developing, producing, marketing, selling, delivering, and servicing the product. ABC is somewhat of a new approach to cost management.

This article will answer three basic questions about ABC:

  • What is activity based costing?
  • Will it work for my business?
  • Will it lower my costs and increase my profits?

An activity based approach to cost management provides a more effective basis for decision making. Profitability is more accurately measured when all of the particular work activities required by a product are included in the analysis. Focusing on performance measurements dealing with causes helps to more accurately assess operating results. Product mix can be better analyzed with insights into costs associated with product line complexity. Decision analysis is more reliable with better profiles of costs/benefits for make or buy, retain or drop, expand or contract capacity decisions and so on.

The objective of this new cost management system is to provide relevant, accurate, and timely knowledge pertaining to the past, present, and future performance of the enterprise for planning, control, and decision making. A cost management perspective provides management with the ability to evaluate its business in a more meaningful manner. Examples include formulating product strategies based on the ability to create product value, associating capital investment to value-producing activities, reconfiguring operations to optimize the use of overhead, and evaluating technologies, competitiveness, and environmental changes as to their effect on the business.

Activity accounting is a collection of financial and operational performance information about the significant activities of a firm. Conventional cost accounting focuses on the costs incurred by a firm, rather than on what causes the cost. Conventional cost systems assume that products consume resources, whereas activity accounting concepts say resources are consumed by activities which, in turn, are consumed by products. A conventional system covers a specified time period, such as one month or one year. ABC covers the life of the product or customer, which is almost always different from the conventional accounting period.

In the conventional cost system, overhead is applied at a rate-per-hour of labor or a percentage of labor dollars. With less labor involved in producing products today, some of the rates-per-hour or percentages become quite large. For example, overhead rates of $100.00 per hour or 300% or more of labor dollars are not uncommon. Generally, all overhead costs are lumped together into one rate including engineering, purchasing, material handling, shipping, marketing, and service, as well as production overheads. When all of these overheads are added together and divided by the productive labor hour, you get the very large hourly overhead rates.

In activity accounting, the approach is somewhat different. First you have to define the activities or tasks. For example, purchasing might be one task or activity, but engineering might have two or three tasks associated with it. You could have new product design, manufacturing process design and so on.

Next you must define the cost drivers. A cost driver is an activity that has a direct influence on the cost or performance of other activities resulting in the consumption of resources. The percentage of parts received that are defective would be an example of a cost driver. Information must be collected about these activities, such as dollars or the number of purchase orders processed or the number of parts in the design of a product.

Technology costs must be properly assigned. Technology costs include research and development for a product, process development, start-up, equipment, maintenance, utilities, taxes, insurance, and interest on investment. Carrying costs of inventory are also recognized. Non-value added activities are defined. An example would be a forklift moving parts to the other end of the building for one step and then moving them back for the next step. This is necessary (unless the layout can be improved) but it does not add any value to the product.

The goal of ABC is to assign the resources consumed to activities undertaken in producing the product. A product that has been produced for a long time should not be assigned current engineering design overhead. A new product, however, should receive the amount of engineering costs associated with its design. If this new product is not stored in finished goods (it is shipped as soon as it is completed) it would not carry any finished goods inventory costs.

ABC information used extensively and continuously for business improvement does transfer to the bottom line. The reduction of non-value added costs will improve your profits. Will it work in your business? Will it lower your costs and improve your profits? The answer to both of these questions is yes. It will work in most businesses. An analysis of individual businesses would be necessary.

CIRAS News, Vol. 31, No. 1, Fall 1996