December, 1998 Feature Article Activity-Based Costing: A Decision-Making Tool Robert Olsen Tompkins Associates (www.tompkinsinc.com) There are some universal truisms that apply to all businesses. The first of these is that, over time, a business must be able to provide products and services at a lower overall cost than the competition. The second is that the inflation-adjusted cost of production and logistics must continuously decrease. This is, hopefully, accounted for through experience, or the learning curve. Knowing the true cost and profit picture of each product is the third. Finally, understanding and managing cash flow is as important as profit. Each of these areas involve decision-making practices that have a profound impact on the organization. Cost cutting is often an area of decision-making that can start a cycle of decay if the correct decisions are not made. Cost cuts that erode the competitive posture of the company are the cause. This can result when decisions are made using traditional financial accounting data rather than control-oriented data. Traditional accounting practices attribute indirect costs in a general fashion, spread equally across departments and products. Activity-based costing is a method of identifying all costs to a specific activity, thus placing the burden directly on the source of the cost contribution. This produces the cost control-oriented data needed for critical decision-making in the organization. Activity-based costing systems (ABCs) are not financial models of how expenses change in the short run. Instead, they are intended to provide the costs of resources used to perform activities or services in fulfillment of a business function. ABC systems model how activity usage, and thus cost, varies with demand. While traditional accounting tends to blur the relationship between so-called fixed costs and associated product activity, ABC targets a more clear delineation. In the decision-making process, virtually all costs should be considered product costs. They should also be considered either direct or manageable in almost every instance. One way of classifying costs is as either bedrock fixed, managed fixed, direct variable or shared. The first group consists of costs over which there is absolutely no managed control. Few costs fall into this category. The majority of costs fall into the managed fixed category. Here is where management can find the ability to influence cost patterns over an extended period, once the structure of the cost is understood. The application of ABC assists management in identifying unused resources and capacity. Decisions can then be made to either optimize use of a resource, reduce costs or eliminate it. ABC is not a panacea for all the ills of an operation. If the data used in constructing the system is flawed, past errors will simply be repeated. It is also not the tool for all decisions. It is, however, a useful tool for many of the management decisions facing companies today. It can bring a picture of the operation to light that may not be obvious through other analysis tools. Specifically, ABC is useful in analyzing specific segments of an organization. This might include a market line, a group of products (even a single product), a customer, or an employee. ABC is a complement to total quality management (TQM). It provides quantitative data that can track the financial impact of improvements implemented as part of the TQM initiative. Some have even suggested that ABC is the most important concept introduced since TQM. Amoco Performance Products, Transparent Container Co. and Fellowes Manufacturing Co. are a few companies that have utilized the ABC/TQM modeling concept to improve performance and profitability. Wholesale distributors can gain significant advantage in the decision-making process through implementation of ABC concepts. The expansion of line offerings has brought about difficult decisions for the distributor. Using traditional financial data, overhead burden is distributed equally across the product line. Introduction of new products or vendors might also introduce variance to the overhead. For instance, the need to support a special storage area for control or environmental reasons, or the need of new handling equipment will increase overall operational costs. These costs will be spread over the product line, reducing margin on existing products and reducing the cost impact of the new items. ABC models the costs back to the activity. The burden created by the new product is correctly reflected. This allows the existing merits while leaving the new line to justify itself. Growing demands by customers for value-added services without an accompanying increase in revenue is another area of concern for distributors. Labeling requirements, special packaging, handling and shipping are all areas that can increase managed fixed costs. If these expenses are not clearly associated with the activity source, the revenue picture becomes blurred. The decision process may not be based on quality information, allowing errors in judgment to occur. The concept of firing a customer can become possible, even viable, if it is understood that cost of having the customer exceeds the margins derived. Other decisions that can be assisted by ABC include facility and resource expansion. Often the basis for relocation or opening of a new distribution center is based on cost associations. Reduction in freight or other logistics costs can offset the expense of the new facility, staff or equipment. When the numbers used are enterprise-based, the return might not develop as expected. The ABC model can identify the specific cost elements being targeted, providing a much clearer picture from which management can act. Decision support for human resources can be augmented by ABC. Where activity, and therefore cost, can be associated to an individual, new levels of financial performance can be determined. This might be appropriate in cases of branch management or sales. Adding or deleting resource slots can be determined based on costs of activities as well. The added data provided through ABC can present a number of options, including outsourcing, productivity improvements through automation, and a determination of employee/revenue ratios. In summary, activity-based costing is a management decision-making tool. It provides financial support data structured in a fashion fundamentally different from accounting data provided in the general ledger. By associating cost to the activity, a clear relationship can be established between sources of activity demand and the related costs. This association can benefit the distributor in determining where costs are being incurred, what is initiating the costs and where to apply efforts to curb inflationary costs. This can be of particular value in tracking new products or customers. It can also provide tracking of logistics costs, one of the fastest growing areas of expense to the distribution operation. Robert Olsen is project manager with Tompkins Associates (Raleigh, N.C.; www.tompkinsinc.com), a firm with practices in warehousing, logistics, organizational excellence, quality, maintenance and manufacturing. The Manufacturing Report © Copyright 1997, 1998 by Lionheart Publishing, Inc. All rights reserved. E-mail Editorial Dept: tmr-editorial@lionhrtpub.com Lionheart Publishing, Inc. 2555 Cumberland Parkway, Suite 299, Atlanta, GA 30339 USA Phone: 770-431-0867 | Fax: 770-432-6969 E-mail: lpi@lionhrtpub.com Web Design by Premier Web Designs E-mail: lionwebmaster@preweb.com