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Nov 01, 2000 10:30 PM  By

Activity-based costing is a potent tool to calculate your direct and indirect costs accurately. In the first of a two-part series, logistics expert Terrance L. Pohlen defines and explains the technique

If you knew that one of the personalized services you offer cost your operation several thousand dollars of processing time last month, would you continue to provide it? And would you have invested in that new picking process if you had known the exact cost of the supervision it requires? Activity-based costing (ABC) enables you to answer those questions quickly and make the appropriate decisions. By allowing you to calculate the precise costs of specific operational functions and assign them to the correct areas, ABC serves as a powerful information management and cost-reduction method.

Despite ABC’s reported benefits, many companies have not implemented it because they fear a considerable up-front investment or lack of concrete results. However, a rapid prototyping approach for implementing ABC can provide tremendous insight with minimal time and effort. Part Two of this series, scheduled to run in the January 2001 issue, will discuss activity-based management (ABM), which uses ABC information to assist managers in reducing costs, analyzing customer profitability, and developing effective performance measures.

Operations and fulfillment managers urgently need accurate cost information. They need to understand what is driving costs; which customers or products consume the most time, money, and effort; and why costs may have changed when sales volume or some other leading indicator has not. These managers need to clearly understand and demonstrate how their performance affects corporate profitability, especially when competing for additional resources or capital investment. They also must continually review the order fulfillment process for opportunities to reduce costs and increase productivity.

Traditional cost accounting falls woefully short of providing the information managers require for improving their operations. The visibility of operations and fulfillment costs is lost because they are often rolled up as part of sales, general, and administrative (SG&A). Conventional cost accounting further distorts the information by allocating these costs to customers or products using an arbitrary yardstick such as total sales or cases shipped. Such measures assume that “a case is a case” or that “a customer is a customer” and fail to recognize any of the unique services provided to specific product lines or customer accounts. There is usually no attempt to determine the cost of performing specific activities such as order processing, and the difference between processing a small, routine order and a large, specialized one is certainly not captured. The resulting information precludes managers from accurately determining the costs and profitability of supporting different products, customers, or distribution channels. It may also lead them to make bad decisions based on faulty cost allocations suggesting that customers are profitable when they are really not.

Managers handling direct-to-customer fulfillment cannot directly determine what drives their costs or explain why costs have risen or fallen based on financial performance, nor can they engage in discussions with their supply chain partners on how to jointly lower costs and improve profitability. Companies such as Sears Logistics Services, Schneider, and others have turned to ABC as a means to overcome these problems.

ABC is a technique to assign the direct and indirect costs of a firm to the activities it performs and the costs to the customer or products consuming those activities. It differs from traditional cost accounting by using multiple drivers to assign costs, developing the costs of performing specific activities, and determining the costs of supporting specific customers or products. Thus, ABC translates traditional costing into actionable information for operations and fulfillment decision makers.

By the way it assigns costs, ABC provides considerable management insight. First, activity costs are determined by assigning the amount, or cost, of each resource used by that activity. Next, activity costs are assigned to products or customers on a per-activity basis. This two-stage approach enables managers to view costs at three different levels: resource, activity, and cost object (customer or product). Each level portrays costs in a different manner, demonstrating how costs are actually being consumed and indicating opportunities to reduce them.

Need for speed Rapid prototyping can greatly reduce the time and expense associated with ABC implementation. Typical implementation efforts require a team of three to seven individuals working for three to four months with a total fee topping $300,000, including software, just to obtain an initial breakout of costs. Prototyping, by contrast, reduces time and expense by keeping the project focused and using standardized templates to collect information quickly. A rapid-prototype ABC model for a 100- to 200-person division can be developed in two to four weeks, and can be adapted or revised based on the resulting management feedback. The quick results help sustain management interest and use.

The primary disadvantage stems from the limited scope of rapid prototyping – it may not answer all of the key questions later posed by management. ABC development should begin with a clear understanding of what questions senior management needs answered; however, the method generally provokes a whole new set of questions once management has access to detailed costs by activity or by customer. Rapid prototyping overcomes this constraint by quickly producing a model and rapidly revising it if management requires additional detail.

Let’s take a closer look at the information ABC can provide. ABC begins by identifying the resources required by an organization to perform its mission. Resource costs are obtained by pulling together the budget and general ledger account information for the company. The result should provide a complete picture of all the resources that the business consumes, including assignable indirect costs such as personnel and payroll. In many instances, information within the general ledger or budget will require reclassification or breakdown to reflect how resources are actually managed. An organization typically does not manage “labor” but instead manages individuals with specific skills. The labor account would be subdivided into traffic management, purchasing, order processing, order picking, and so on. The reclassification makes assigning costs to activities much easier; for example, order-picking labor would be assigned only to order-picking activities. This also makes the model more intelligible to decision makers, because they manage specific resources and not general ledger accounts.

Cost of resources The resource view of costs provides the linkage from ABC to the financial system. Resource costs can be traced back to the general ledger or budgets. In many cases, ABC may include costs not included in traditional cost accounting. For example, inventory carrying cost may appear in ABC to demonstrate the cost trade-offs associated with holding inventory. Traditional financial reports would not reflect this cost because the firm does not actually incur this expense. However, most managers consider inventory carrying costs in their decisions and attempt to minimize them. ABC simply makes this cost visible so that managers can more effectively demonstrate cost trade-offs such as “trading information for inventory.”

This capability to include information such as inventory carrying costs raises an important point. ABC is meant to make cost information relevant and useful. It should not be viewed as rigid, inflexible, or just another financial management system.

When the first stage is completed, what appears is a full view of the resources consumed by the organization. In many cases, managers have never seen the total resources required to perform their activities. The resource view provides another useful benefit by no longer placing resources in large cost buckets such as overhead. Instead, costs such as personnel are directly traceable, enabling managers to determine how their activities and performance drive the need, or lack thereof, for these resources.

The next step of ABC assigns resource costs to the activities performed by the organization. The cost assigned depends directly on how much of each resource an activity consumes. For example, ABC would assign the cost associated with shrinkwrap to an activity labeled “shrinkwrapping.” In many cases, labor represents the largest single resource and its assignment generates the most interest. Most firms rely on interviews to assign labor costs. A rapid prototyping approach would begin with interviews of functional experts to determine the activities performed by each labor resource. Next, a template would be developed for the remainder of the workforce in each functional area. For instance, warehouse workers would receive a template that included only warehousing activities. They would complete the template simply by using percentages to assign the amount of time spent on each activity. The process occurs very quickly and does not disrupt the workforce. This approach provides the additional benefit of accelerating implementation by rapidly compiling the information needed to assign labor resources to each of the activities.

Activity costs provide a level of information typically not available within most companies. The activity view provides the total cost of all the resources required to perform each activity. When coupled with non-financial data about the number of times an activity has been performed, ABC can further provide the cost per activity output – for example, the cost to dispatch a truck or the cost to process a telephone order. The activity cost can be broken down to show all of the resources, direct and indirect, required to perform the activity. Managers can use this information to better understand how activities actually consume resources, decide whether sufficient capacity exists to absorb additional workload for an activity, or determine how much of a resource would be freed up or released for other purposes if an activity were eliminated.

How much is too much? The number of activities to include in an ABC model represents one of the most critical decisions affecting the success of the implementation effort. Too many activities make the model complex, time-consuming, and difficult to maintain. Too few activities, and the model will not provide any significant insight into the factors driving costs or answer key management questions. Most successful rapid prototyping models use 20 to 40 activities as a starting point. With 40 activities, each activity would on average represent only 2.5% of total cost – a level probably too detailed for management consumption, but generally providing ample detail to answer most questions.

Here are some rules of thumb to apply when deciding whether to add or delete an activity from your ABC model:

Diversity. Does the activity capture differences in how it is performed? An activity labeled “pick orders” would not distinguish between case, tier, or pallet picks. It also may not capture differences based on the number of lines in an order. Capturing these differences would enable the model to more accurately assign costs as well as offer greater insight into what drives order-picking costs. The “pick orders” activity should be disaggregated into more discrete activities to capture the key differences. On the other hand, if the activity is homogenous – orders are orders – and no major differences exist in how the activity is performed, the activity should not be split further.

Cost. Will the cost of the activity warrant tracking? Tracking too many small activities adds tremendous complexity to the model without providing much additional value. Too many activities will overwhelm users with unnecessary detail, divert their attention from the activities having the greatest impact, and make it much more difficult to update the model on a frequent basis since each resource must be traced to an activity.

Measurement. Can the organization track the activity and determine the resources it consumes? If not, the activity adds little value to the model. It should be considered for elimination unless it represents a major cost or will significantly distort the costing of the organization’s activities.

Management focus. Will excluding the activity prevent the model from answering a key management question? Early in the implementation process, management should identify the major questions they needed to be answered. These questions will shape the design and scope of the ABC model and determine which activities to include.

ABC assigns activity costs on a per-activity or output basis. The per-activity cost is determined by dividing the activity cost by the number of times it is performed. Consumption of the activity’s output determines how much to assign to a specific customer or product. For example, if the total cost of the activity “process customer returns” is $386,000 and the activity is performed 2,700 times, then the cost per customer return would be $143.12. The proportion of the customer returns activity assigned to each cost object, in this example a product division, would be based on the volume of customer returns processed for that division at $143.12 each. The assignment of activity costs to the cost objects provides the final view of costs within ABC.

The cost object view shows where the organization’s outputs are finally consumed, at what cost, and in what quantity. Customers (internal or external) or products are the most frequently used cost objects in ABC.

Some firms use product divisions when internal customers consume the outputs of their activities, and the cost of their services is assigned to these internal customers. The information contained in this view of ABC provides the “bill of activities” required for supporting a specific customer (cost object) and the amount of each activity consumed. Operations managers can quickly determine which customers consume a disproportionate amount of their output for the revenue and profit generated.

Firms have used this information to develop customer profitability reports, generate product contribution statements, or accurately assign the cost of pooled support organizations, such as operations and fulfillment activities, to the profit and loss statements of the business units.

This view quickly answers whether a customer is generating a profit or loss and, more important, why. Some firms have gone beyond internal cost reduction efforts to share this information with their customers, a move that can reduce costs and increase performance across the supply chain, possibly yielding a competitive advantage in price and performance.

The three views of cost that ABC provides can assist logistics and operations managers in several ways. They can determine how changes in service requirements will affect logistics costs. ABC also provides managers the capability to analyze how changes in the performance of operations and fulfillment activities will affect the need for indirect resources such as personnel, payroll, and administration.

Management can focus on high-cost activities or those having the most immediate impact on customer profitability. Viewing costs from three dimensions enables executives at all levels to make effective cost trade-offs and lower overall expenses. An especially important capability is that they can finally understand how the performance of the activities they manage directly translates into corporate profitability as well as how these activities affect customer and product profitability.

The second part of this series will demonstrate techniques for using ABC information to drive performance improvements and reduce costs. The discussion will cover techniques such as activity-based management (ABM), activity-based budgeting, and the development of cost-based performance measures. ABC only supplies more accurate cost information; management must act on the results to achieve the potential savings and performance gains.