ACTIVITY-BASED COSTING: BEYOND THE SMOKE AND MIRRO Essay

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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 [13]. 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" [16].

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" [11]. 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 [10]. Among reasons cited for low adoption were employee
resistance and major organizational changes required with the use of
ABC [11]. Some trace the source of slow adoption of ABC to technical
as well as cultural issues [5]. Others feel that ABC would be more
widespread in industry if it were marketed better by the cost
accounting profession itself [1].

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 [2]. 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 [17]. Indeed, "marketing costs make up more
than 50 percent of the total costs in many product lines," not direct
labor costs [8].

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 [3]. 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 [7]. 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
[14]. 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 [15]. 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 [9].

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 [6].

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 [4]. 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 [12].
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