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Activity-based costing: usage and pitfalls.

By Cortese-Danile, Teresa M.

Publication: Review of Business

Date: Tuesday, January 1 2002

There are many variables that need to be considered when determining the
type of costing system, such as ABC, that is best for an organization. It is the
evaluating and balancing of these many variables that continues to make
accountants valuable members of any organization.
Introduction
Activity-based costing (ABC) has become extremely popular in recent years
(2,5). In fact, it is difficult to find an academic or practitioner journal that does
not include at least one article on activity-based costing, activity-based
management, or activity-based budgeting. As a result, it is difficult for any
organization, whether it be a manufacturer, distributor, or service provider not
to jump onto the activity-based bandwagon.
However, the use of activity-based concepts is not for everybody. It is vital
that accountants and managers understand the organizational conditions in
which ABC works best, the underlying assumptions of ABC and the cost
distortions that can result from the violation of those assumptions.
This article will attempt to provide guidance in the use of activity-based
costing -- as well as highlight some of the pitfalls associated with ABC.
History of Activity-Based Costing
First, it may be advantageous to understand the historical origins of ABC. In
the early 1960's, General Electric's (GE) finance and accounting people
attempted to improve the usefulness of accounting information in controlling
ever-increasing indirect costs. The GE staff noted that indirect costs are often
the result of "upstream" decisions that are made long before the costs are
actually incurred.
For example, engineering design and change orders often resulted in
significant increases in parts ordering, machine changeovers, retooling and
parts stocking. In addition, the engineering department was never informed of
the consequences their actions had on the other parts of the organization.
GE's work in this area could be considered what we now call, "activity-based
management"
A few business consultants and manufacturing companies accomplished the
second phase in the development of ABC in the 1970s and early 1980s. Their
impetus was to improve product cost information to assist pricing and product
mix decisions (3).
Knowledge of the historical development of activity-based costing is important
in order to clearly understand what ABC analysis was originally intended to
accomplish. The first intent was to assist in managing indirect costs (Activity-
Based Management) and the second was to provide more precise individual
product costs than traditional accounting methods (Activity-Based Costing).
The Importance of ABC as a Consequence of Changing organizational Cost
Structures and Product Diversity
One of the quest ions that may arise concerning ABC is: "Why is ABC
important now when it was not important in the past?" There are two reasons
to explain this phenomenon. The first is the changing cost structure of many
contemporary organizations, and the second is the increasing diversity of
products that companies are manufacturing and selling.
The changing cost structure in manufacturing companies is a good example.
In traditional labor intensive manufacturing companies, direct labor can
constitute 40-60% of manufacturing costs, direct materials can range from 30-
40% and overhead could be as low as 8-12% of total manufacturing costs (1).
In this scenario the vast majority of product costs could be directly traced to
the product In addition, any inaccuracies created by improper assignment of
indirect overhead costs to products had only a small impact on individual
product costs. At the same time, in many cases most overhead costs were in
some way related to a volume-based activity such as direct labor hours or
direct labor dollars.
In contrast, contemporary, capital-intensive manufacturing companies have a
very different cost structure. In these companies manufacturing overhead can
be 50% or more of the total manufacturing costs. In this case improper
assignment of indirect costs could have a dramatic impact on individual
product costs and lead to disastrous pricing, product profitability, and
customer profitability management decisions (1).
The second need for ABC revolves around the diversity of products
companies manufacture and sell. In traditional organizations, companies
produce and sell either one product or products that are somewhat similar in
nature. In these cases the indirect overhead costs including selling and
administrative costs consumed by the various products is relatively equal (4).
Therefore, volume-based application of overhead costs like units produced
creates very little distortion of product costs.
The same cannot be said for many more contemporary companies. As a
result of manufacturing techniques such as flexible manufacturing, companies
are able to produce several and often significantly diverse products within the
same facility. In these cases the consumption of indirect costs, including
selling and administrative costs, can be considerably different from one
product to the next.
Basic Steps in Applying ABC
Once it is determined that the use of ABC may be applicable to an
organization, it is important that accountants understand the basics of ABC.
ABC is basically a six-step process. The first step is to determine all the direct
material and direct labor costs associated with each product or service. The
second step is to group overhead costs, including selling and administrative
costs, into four categories: output unit-level costs, batch-level costs, product-
sustaining (service sustaining) costs, and facility-sustaining costs.
Output unit-level costs are those costs generated from the use of resources
on each individual unit of a product or service. Examples of output unit-level
costs are energy used by production equipment, equipment depreciation, and
machinery repairs and maintenance.
Batch-level costs are costs related to the consumption of resources related to
a group of units of product(s) or service(s) and not related to the production of
a single unit of output Machine set-up costs and material procurement cost
such as placing orders, receiving materials, and paying suppliers are
examples of batch-level costs.
Product-sustaining (service sustaining) costs are costs that relate to the use
of resources to support products or services. Design costs and engineering
costs to change product designs are examples.
Facility-sustaining costs are those costs that support the organization as a
whole and cannot be traced to any product or service. Examples of these
types of costs are the president's salary and building security. It is
recommended that these costs not be assigned to individual products or
services because of the lack of any relationship between these costs and the
product and services provided. Instead these costs should be charged against
operating income (2).
The third step in the application of ABC is the identification of cost drivers
(activities) that may have a causal effect on the costs incurred. The classifying
of cost by level in step one can aid in the selection of cost drivers. Output unit-
level cost drivers could include units produced, machine hours and/or direct
labor hours. Number of set-ups per product and/or number of purchase orders
placed per product are activities that might be used for batch-level costs. An
example of a product-sustaining cost driver could be the number of
engineering change orders per product (2).
It is important to determine appropriate activities that have a cause-and-effect
relation with the costs incurred. However, it is important not to choose too few
activities or too many. Too few activities can lead to cost distortions and too
many activities may make the system uneconomical. The determination of the
number of cost drivers is a cost/benefit decision. The decision that needs to
be made is how many activities are necessary to achieve the product costing
precision needed and still be economically feasible (6).
The fourth step is to group the costs at each cost level that are affected by the
same activity into cost pools. Again, the most important consideration
concerning group costs is the cause-and-effect relationship between the costs
and the activity.
The fifth step in ABC application is the determination of cost rates per activity.
These rates are determined by dividing the total costs in each cost pool by the
total number of activity units identified with each cost pool.
Finally, the sixth step is the assignment of the overhead costs to the products
or services based on the activity rates determined in step five times the
amount of activities consumed by each product or service.
ABC Assumptions
Once the basic application of ABC is understood, it is crucial during
implementation that accountants keep in mind the underlying assumptions
inherent to ABC. It is vital that the underlying assumptions of ABC are
understood because if these assumptions are violated the costing distortions
created may result in the ABC product costing method being as inaccurate as
traditional single rate applications of overhead costs, if not worse.
The two assumptions underlying activity-based costing are:
* Homogeneous cost drivers (activities) drive the costs in each pool.
* The costs in each cost pool are strictly proportional to the activity.
The homogeneity assumption means that the costs assigned to each cost
pool are driven by one activity or a group of highly correlated activities. When
activities are highly correlated it means that a change in one activity level
results in a proportional change in the other activities. When activities are
highly correlated, only one of the activities needs to be used as a cost driver
since a change in the level of that activity will result in a proportional change a
the other activities. However, if costs are driven by more than one activity and
the activities are highly correlated, some of the costs will be arbitrarily
assigned to the cost object (product, product line, customer, etc.) (7).
An example of a violation of the homogeneity assumption would be if machine
setup costs were assigned using minutes of time necessary for the setups,
when in actuality setup costs are driven by minutes of time for setups and
supplies necessary for setup. In this case, setups that required short setup
times but required large amount of supplies could be under-costed, and
setups that required considerable time to setup but few supplies, would be
over-costed. The proper handling of the assignment of setup costs should
include both minutes to setup and supply dollars as the activities (7).
The decision as to which activities should be included in assigning costs can
be evaluated using regression analysis with the costs as the dependent
variable and the activity levels as the independent variables. The resulting
coefficient of determination will provide support as to whether or not all of the
activities driving the costs have been included. When there is a perfect match
of all of the activities and the costs included in the cost pool, the coefficient of
determination would equal one. A coefficient of determination considerably
lower than one may indicate that additional activities need to be included to
properly assign costs to cost objects (7).
The assumption of proportionality relates to the costs included in each cost
pool and the activity (activities) determined to be the cost driver(s). If the
assumption of proportionality is not violated, a proportional change in all the
costs will result from a change in the activity (activities) level(s).
Probably, the most common violation of the proportionality assumption occurs
when fixed and variable costs are included in the same cost pool. Since most
costs are mixed costs (i.e., costs that contain a fixed and variable portion) this
violation of the proportionality assumption could be quite prevalent (8).
A good example of a mixed cost could be utility costs. Utility costs are often
times incurred regardless of usage. In these cases, the variable costs
associated with usage could be assigned to the cost object using kilowatt-
hours and the fixed utility portion assigned using an activity such as capacity.
There are many ways to separate the fixed and variable portions of mixed
costs. However, the most efficient and accurate is the use of regression
analysis with the cost(s) as the dependent variable and the activity (activities)
level(s) as the independent variable(s). The constant term in the regression
equation would be the fixed component of the cost(s). The variable
component would be given in the regression results as a dollar amount per
each activity. If a high coefficient of determination is also included in the
results, the indication could be that a fixed cost portion exists and not that an
activity has not been included (7).
Conclusion
In conclusion, ABC is a valuable tool that accountants can use to improve
management reporting and decision-making. However, several questions
need to be addressed before accountants undertake the application of ABC.
Is ABC necessary based on the organization's operating structure and product
diversity? In many cases, where organizations use traditional, labor-intensive
production methods with a small portion of product costs related to indirect
costs, single overhead application may be sufficient
Second, if ABC appears to have value to an organization, it is important that
accountants understand the inherent underlying assumptions of ABC and how
the violation of those assumptions can result in cost distortions that can lead
to inappropriate management decisions.
Finally, it is important that accountants understand that, no matter how
complicated the costing system is, the assigning of costs to cost objects is still
an estimate. Therefore, it is necessary that accountants perform a cost/benefit
analysis to determine the costing precision required by the organization. Often
the cost of accumulating data to increase the precision of the information
provided might be more than the benefit derived from the increased precision.
There are many variables that need to be considered when determining the
type of costing system, such as ABC, that is best for an organization. It is the
evaluating and balancing of these n many variables that continues to make
accountants valuable members of any organization.
References
(1.) Hardy, J.W. and E.D. Hubbard. "ABC: Revisiting the Basics," CMA
Magazine, November 1992, 24-28.
(2.) Horngren, C.T., G. Foster and S.M. Datar. Cost Accounting: A Managerial
Emphasis, 10th ed., Prentice Hall, Upper Saddle River, NJ, 2000.
(3.) Johnson, H.T. "It's Time to Stop Over-Selling Activity-Based Concepts,"
Management Accounting, September 1992, 40-49.
(4.) Krumwiede, K.R. "ABC: Why It's Tried and How It Succeeds,"
Management Accounting, April 1998, 32-38.
(5.) Palmer, R.J. and M. Vied. "Could ABC Threaten the Survival of Your
Company," Management Accounting, November 1998, 33-36.
(6.) Raiborn, C.A., J.T. Barfield, and M.R. Kinney. Managerial Accounting, 2nd
ed., West Publishing Company, Saint Paul, MN, 1993.
(7.) Roth, H.P. and A.F. Borthick. "Are You Distorting Costs by Violating ABC
Assumptions?," Management Accounting, November, 1991, 112-115.
(8.) Woods, M. "Economic Choices with ABC," Management Accounting,
December 1992, 119-123.
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