As our physical assets become more complex and expensive, traditional means of allocating overhead costs when determining product profit margin become less and less helpful. Most companies collect costs in buckets that describe the type of expense, such as salary, supplies, depreciation, and maintenance.
This article is part of our monthly Asset Manager column. Read more from David Berger.
The trend to smarter assets and greater automation means that the direct labor component is shrinking as a percentage of total product cost, to as low as 5 percent or less for some asset-intensive manufacturers. Marketing, therefore, requires a more accurate means of apportioning the growing overhead component when determining product profit margin.
Activity-based costing (ABC) is an approach to management accounting that provides greater insight into how a company spends its precious dollars. With ABC, allocations are made based on the quantity and cost of resources consumed for a given product/service charged to a certain activity. ABC builds costs according to the tasks or activities that are performed to get the job done. (Examples of activities are ordering parts, expediting orders, and scheduling maintenance work.) Managers can then determine which activities cost more and why.
Marketing management sees ABC as a means of rolling up more accurate product costs, in order to determine the true profitability of a given product. In the past, most companies were happy with product cost as simply the total of direct labor, direct materials, and overhead. Overhead was typically expressed as a percent of direct labor. However, in today’s world of increased automation, determining product costs under ABC has made some startling revelations for some companies.
For example, a product could be soaking up a greater share of the overhead than was previously realized because either a lot of research was required to design and develop the product; the many bulky raw materials may occupy considerable space in the warehouse; or the equipment required to build the product may be very costly to set up, run, and maintain. These factors could turn what was once thought of as a profitable product line into a clear money loser.
The good news is that by drilling down to the activity level, management can identify which activities are causing what costs to be incurred. High-cost activities can then be targeted for re-engineering.
Managing business processes with ABC
Using ABC, processes are mapped end-to-end in order to capture each of the activities in sequential order. Activities are classified as value-added or non-value-added through a methodology known as value analysis. Examples of non-value-added activities are rework, inspections, and waiting for parts. By streamlining or re-engineering processes, non-value-added activities are eliminated and value-added activities are made more efficient.
ABC is by itself a better costing system. Coupled with a continuous improvement and change management program, ABC can be used more effectively to manage business processes. Thus, process and supporting system re-engineering integrates ABC into an overall management approach.
Listed below are six critical success factors for ensuring the smooth implementation of an activity-based management program:
1. Extensive education of all stakeholders. Misconceptions must be addressed by properly educating marketing, operations, accounting, and all other support groups as to what is ABC. Some of the more common misconceptions include: that cost accounting is more concerned with serving the needs of corporate accounting than operations; that cost accounting is inaccurate and inadequate; that the new numbers will be used against people; that ABC will affect the basis for remuneration; that re-engineering will remove jobs; and that things are fine the way they are now. Employees must see how the benefits of ABC will far outweigh the large time commitment required and high cost of implementation.
2. Broad-based involvement. The implementation team must represent all the key stakeholders, in order to ensure broad-based ownership of the results. Accounting, IT, or any shared service should not be seen as the driver of the project. Relevant lines of business benefiting from improvements must take a lead role, with support from shared services.
3. Proper identification of activities and drivers. The ABC team must work with the stakeholders to define all suitable activities (the events) and drivers (whatever causes resources to be consumed, such as number of work orders). One of the big issues is always granularity. For example, activity codes should not be confused with the more detailed symptom, cause, action, and failure codes employed by CMMS packages for reliability analysis.
4. Thorough testing of the model. Start with one plant or a single department and spread to the rest of the company once initial bugs have been worked out and benefits become clear. In a multi-plant environment, local management should be intimately involved to avoid the feeling that ABC has been imposed from the head office.
5. Adequate integration of key information systems. One of the key benefits of properly integrating ABC, accounting, manufacturing, shop-floor data collection systems, and maintenance systems is to provide a single, consistent repository of data. This approach removes the need to reconcile the numbers from multiple sources, thereby improving the accuracy and timeliness of reporting.
6. Focused analysis of data. An effective improvement program will require prioritization of the opportunities uncovered by ABC. Management must focus on eliminating the high cost of poor quality and the more costly non-value-added activities.
Benefits of cost management through ABC
Although each company has a unique strategy, culture, organizational structure, and so on, most companies would gain something by cost management through ABC. The key benefits are discussed below.
Management support. Having all functional areas using the same fully-integrated cost accounting system is fundamental to ABC. Although many ABC systems are stand-alone applications, it is preferable to have an enterprise-wide, fully-integrated solution. This avoids the inaccuracy and time delays associated with batch links between systems, or the inadequacies of after-the-fact reports.
For example, suppose a purchase requisition for spare parts is input into the CMMS. The requisition is then passed manually or on a batch basis to the purchasing module running on, say, an ERP system. After a purchase order is cut, the goods are received and acknowledged on the ERP system. Finally, an invoice is received and reconciled by Accounts Payable on the accounting system.
Depending on the way in which the systems are patched together, if at all, the maintenance department may never know what the actual cost of the order was. Similarly, maintenance workers may be forced to record labor hours twice, for payroll purposes and for logging hours against work orders, because of poor integration of the CMMS and payroll systems.
An ABC system provides a flexible tool for pinpointing the source and magnitude of costs. Three-dimensional reporting of costs is available (i.e., by project, cost center, or activity), including drill-down and roll-up capability on any dimension. Traditional systems report costs by project and cost center only.
The benefit of the additional dimension is that you can determine the cost of performing a given activity for one project or cost center, and compare it to the cost of performing the same activity for another. Further drill-down and analysis may point to significant productivity improvement potential, such as using spare parts from a different manufacturer. For maintenance operations, this kind of analysis coupled with reliability-centered maintenance can be an especially powerful combination.
Marketing support. More accurate distribution of indirect/overhead costs to products and services leads to better understanding of unit costs and profitability. This, in turn, allows marketing management to determine which products/services to drop, expand, or change. As well, marketing analysts will be able to more accurately determine which customers, geographic regions, and distribution channels are profitable. Finally, more realistic unit costs take the guesswork out of make or buy decisions.
Improvement opportunities. Through value analysis, process mapping, re-engineering workshops, and other improvement techniques, opportunities are identified for minimizing or eliminating activities that provide little or no value. This will lead to new processes being created and/or new information systems being implemented.