ACTIVITYBASED COSTING BEYOND THE SMOKE AND MIRRORS Essays, Book Reports, Term Papers

This essay ACTIVITYBASED COSTING BEYOND THE SMOKE AND MIRRORS Essays, Book Reports, Term Papers has a total of 3199 words and 20 pages.

ACTIVITYBASED 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 [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]. Order e

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