Activity Based Costing Overview
Dave Packard Chairmen of Hewlett-Packard said "Tell me how a person is measured and I'll tell you how they will perform."
Business Metrics are tailored performance measures that promote the strategic goals and objectives of the organization.
The spectrum of business measurements spans a wide variety of Management Accounting methods. Traditional financial measures, such as Work in Process (WIP) and piece rates, are rapidly being replaced by time based measures, like Raw and In-Process (RIP) and rate based planning.
As competition and the internal search for improved performance becomes more critical, the development of time-based measures has become a cornerstone of the World Class Manufacturing paradigm.
There are several recent business measurement innovations that this series of articles will cover. We begin this series with "What is Activity Based Costing (ABC)".
Traditional cost accounting systems measure the cost of a product by spreading all of the overhead costs over the direct labor costs based on production volumes.
For example:
Product A takes 3 hours/unit of DL
Product B takes 7 hours/unit of DL
DL = Direct Labor
If quantity one of each is produced:
Product A receives 30% of overhead Product B receives 70% of overhead
Therefore if Total overhead cost was $100 and the labor rate was $10/hour, then the costs would be:
Product A (3* 10) + (.3* 100) =30+ 30= $ 60/unit
Product B (7* 10) + (.7* 100) =70+ 70= $140/unit
ARRIVING AT THE CORRECT PRODUCT COST
Under Activity Based Costing the concept of cost drivers is developed to clearly define which costs are associated with each product. An example of a cost driver might be the number of parts in a product, or the number of set-ups needed to produce the product, or the number of change orders after release to production.
To clarify the above example:
Product A requires 45 component parts Product B requires 5 component parts
Each part is purchased from a separate vendor. The cost to generate a Purchase order is $70. If we assume that we issue purchase orders and receive and pay for material once per month the costs of the products would be:
Product A (45 parts x $70) = $3150
Product B ( 5 parts x $70) = $ 350
Total Purchasing cost= $3500
Under the traditional cost allocation procedures the $3500 purchasing overhead would be divided as follows:
Product A: $3500 x .3 = $1050
Product B: $3500 x .7 = $2450
As you can see the purchasing cost of the products are significantly different using the traditional cost accounting method.
Developing a Simple ABC system
To begin we must start with a few new definitions. Overhead Activities are divided into Cost Pools. An example of a cost pool would be the Sales Department. Cost pools contain cost elements. An example of an overhead cost element would be order processing.
Once the overhead cost pools are established, Activity Cost Pools are developed. An example would be product support which is volume dependent. Activity Cost Pools, known as Cost drivers, contain cost elements also. An example of an Activity Cost element would be product test.
Finally, there are Product Cost Objects. An example of a product cost object is a product line. Product Cost Objects also contain cost elements. An example of a Product Cost element would be a specific product within the product line.
Hewlett-Packard's Roseville Division manufactured printed circuit boards. They implemented ABC as part of a Total Quality Control (TQC) project that focused on Design for Manufacturability. The new costing data allowed design engineers to make more effective cost tradeoffs which reduced the total cost to manufacture new products. Roseville developed 12 cost pools that impacted product cost. In Purchasing, the cost drivers are the number of active parts and the complexity of the part. In the Product Planning and Production Engineering areas, the cost driver is the number of assemblies in the product. In printed circuit board loading areas the cost driver is the number of insertions, an insertion being a component that is soldered to a printed circuit board. The Support cost pool is sub-divided into several smaller groups, such as Test Engineering and IT. The cost driver for Support is % of Usage.
In the traditional accounting system only one measure is used to allocate overhead costs, Direct Labor Hours. Using ABC we can create hundreds of cost drivers. There is however, a diminishing return. Data collection costs usually increase faster than the benefit gained by the improved precision of the allocation. Some companies in Europe have as many as 50 - 150cost drivers. In the United States approximately 6-25is more common. Europe has been using ABC longer than the U.S.; this may account for the wide difference in the number of cost drivers.
"Firms facing intense competition and having both high product diversity and low measurement cost are best suited to taking advantage of the increased accuracy of an activity-based Costing system." Robin Cooper, Harvard Business School
By prioritizing the Overhead costs you can focus on those with the biggest potential for causing the product cost to be inaccurate. As with all projects of this nature a multifunctional team is required to effectively cover the wide variety of business activities related to product costs.
Cost drivers should be developed for those activities that contribute to product cost on both a volume and volume independent basis. For example a set-up would be volume independent if the order quantity was changed. Warehouse activity, on the other hand, is directly related to the volume of product being handled.
Chapter 4 of MEASURING UP by Hall, Johnson, and Turney provides a good basic understanding of ABC. This book is available from Amazon: Measuring UP
For more information on the current evolution of ABC see the Robert Kaplan article from the Harvard Business Review: [http://hbswk.hbs.edu/item/4587.html]
Automating ABC
The EasyABCPlus ™ program is divided into three major areas. The first is overhead; here your company General Ledger can be entered. This can be done either by typing in the Overhead Accounts, or by reading a file from your accounting package, or a spreadsheet. The second area is activities; this module is the core of the system. It defines the Cost Drivers and the allocation methods from the Overhead module to the third area, Cost Objects. In the Cost Object area the actual products to be costed are linked to the activities used to produce them.
Let's review each module in a little more detail. Within the overhead module you can see the structure of the accounts, with actual and budget amounts for each. There is also a block map showing where you are in the system. As you move from module to module the three boxes are highlighted to show where you are in the program. There are also three icons or graphic symbols that represent different views of the data. The icons are available in all three modules. They are: Decomposition, Allocation and Tabular. Each presents the information in that module using the same data, but with a different perspective.
Data entry in the modules is primarily via menus selected using a mouse. A mouse is a small device attached to your PC that moves the cursor on the screen. Clicking a mouse button activates the function that the cursor is covering.
An example of data for the Overhead Module would be:
Sales Department with a cost center Product Support.
The Activity Module contains the cost drivers and other resources used by the product. A typical structure might include a Support Activities group. This could have within it activities such as Testing, Engineering Support, and Phone Support.
The Product Support cost center is linked to the Testing, Engineering and Phone Support Activities. This means that a structure similar to a bill of material is created. The allocation methods are by percentage or cost driver. The allocation method is comparable to the quantity per in a bill of material.
The Cost Object module is where the products are defined. After entering Product A and Product B, we select which Activities and how much of each activity is used by each product. The Activities such as Testing might be the number of Test hours, Engineering Support is the number of Engineering Change Orders, and Phone Support is measured by the number of phone calls.
We are now ready to run the model. The model can be run for any number of periods. It can also be run by module to observe the effect of changes at each level. To see the results click on the icon in front of the product. This brings up a screen that shows the actual cost and budget of each of the activities used.
The Attribute Costing report summarizes the costs of all value added and non-value added activities. This is especially useful in Lean process improvement programs.
On-line help is available for each area in the system.
This completes the Activity Based Costing overview.
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