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INSIDE Activity-Based COST SYSTEMS

By Beaulieu, Philip,Mikulecky, Mandi
Publication: Industrial Management
Date: Thursday, May 1 2008

HEADNOTE
EXECUTIVE SUMMARY
Decision makers in operations and marketing prefer different calculations of unit costs. The
authors explain how unit costs can confuse decision makers in each area if calculations are not
adjusted for their preferences and demonstrate adjustments within the framework of activity-based
costing systems. Current accounting practices that capitalize on flexible unit costs will serve
companies best.
IMAGE ILLUSTRATION1
Flexibility in calculating unit costs is valued in cost systems because managers performing
different functions use them for many purposes. This article focuses on process improvements in
operations and cost-plus pricing in marketing, while illustrating how allocations of cost to units of
product can be adjusted to suit managers making both types of decisions. Activity-based costing
(ABC) systems allow for flexible calculations of unit costs in operations and marketing, but such
costs are often misunderstood. We recommend less allocation of cost down to the unit level in
operations and show why marketing personnel prefer greater allocation to individual units.
Direct costs such as materials and labor can be conveniently traced to units of product because it
is easy to observe how much of the resource has been used to produce each unit. Indirect costs,
usually called overhead or common costs, are shared by many products and are difficult to trace to
individual units of any single product. Even the most complex costing systems are hard-pressed to
assign such costs as building leases and IT to individual units in a multiproduct manufacturing
facility. When they do allocate these costs, it is often done arbitrarily; for instance, a costing
system might divide total leasing costs by the percentage of total square footage required by each
product, even though these products share common areas such as shipping and receiving.
Variable costs vary with production at a constant rate; materials are the best example. Fixed costs
like building leases and IT remain constant in total as production changes over wide ranges of
activity. They can be allocated arbitrarily to units of product but these allocations should not be
interpreted as marginal costs of producing additional units, which they clearly are not.
Indirect costs are usually also fixed, as is the case for building leases and IT, but these terms are
not synonyms. Some costs are indirect and variable (e.g., indirect labor such as forklift drivers),
and some are direct and fixed (e.g., engineering and design costs that support only one product).
However, costs that are both indirect and fixed are the most difficult for any costing system to
assign to units of product.
Fixed or mixed?
ABC is a complex costing system that deals with indirect and fixed costs by constructing a
hierarchy of four activity levels based on these cost definitions. The example of a firm called
Hierarchy Manufacturing Co. presented in Figure 1 illustrates this system. The first category
consists of the unit-level activities of materials and labor; these are set up as separate cost pools
(sometimes called buckets), each having its own cost driver: pounds and labor hours respectively.
The hallmark of unit-level costs is that they are variable and direct; material and labor costs will
increase in proportion to increases in output and can be easily traced to units. In Figure 1, two
products are listed with X being the high-volume product (40,000 units annually versus 10,000
units of Y). The unit-level costs are allocated to these units at the rates of $5 per pound of material
and $12 per labor hour.
IMAGE TABLE2
Figure 1. Cost drivers and cost driver rates at Hierarchy Manufacturing Co.
The second level of activities in the ABC system, known as the batch level, includes costs of
activities performed on batches of units produced rather than on each unit individually. Batchlevel
cost pools in Figure 1 are set-up and inspection; it is not difficult to trace costs at this level to
products, so they are direct. Strictly speaking, batch costs are not variable with respect to units of
production, but if batch sizes do not vary greatly, treating the cost driver rates of $4,500 per batch
and $1,000 per shipment as variable will not cause much error in costing.
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Figure 2. Cost-plus pricing markup calculations at Hierarchy Manufacturing Co.
Product-sustaining activities are the third level of the hierarchy; the costs associated with these
activities serve a specific product and are concurrently direct and fixed. Figure 1 provides two
engineering activities, design and change orders, as examples of product-sustaining cost pools.
The cost driver rates are $50 per engineering hour and $1,000 per change order, but unlike the
rates for unhand batch-level activities, these rates are simply average costs calculated over wide
ranges of activity. They are not marginal costs of each additional engineering hour or change order.
Finally, facility-level activities support the entire production process, as opposed to a specific
product line or unit of product, and are both common and fixed. In Hierarchy Manufacturing,
occupancy is the only cost pool at this level with square footage as the cost driver. At first glance, it
might appear that occupancy costs are not common because 60,000 sq.ft. of the facility are
devoted to Product X and 100,000 sq. ft. are required for Product Y. The resulting cost allocations
at $20 per square foot, $1,200,000 and $2,000,000, respectively, seem to be traceable to each
product. However, these are not avoidable costs of X and Y; if production of X ceased, the plant
could not immediately be shrunk down to two-thirds of its former size. Furthermore, as stated
previously, there probably are common areas such as shipping and receiving that must either be
excluded from the total area used for allocation (total area would be greater than the 160,000 sq.
ft.) or arbitrarily divided between products (the amounts of 60,000 and 100,000 sq. ft. already
include allocated common space).
In summary, the ABC hierarchy of activities consists of two levels for which costs can be
considered both direct and variable with respect to units of production (unit- and batchlevel), a
level for which costs are direct but not variable (product-sustaining), and a level for which costs are
both indirect and fixed (facility). A great deal of data analysis and many interviews with production
and management personnel are required to generate the cost pools and cost driver rates; their
apparent simplicity masks a complex implementation not shown in the figure. ABC consultants
claim that this complexity enables full tracing of costs to units of production, but the result includes
arbitrary allocations of costs.
The calculation of unit costs is demonstrated in an ABC costing report for Hierarchy Manufacturing
that uses the cost driver rates in Figure 1. For each activity, total allocated costs are simply divided
by annual volumes; 40,000 units for Product X and 10,000 units for Product Y. Unit- and batch-
level costs are $123 and $16.50 per unit of X and $83 and $65 per unit of Y. If the ABC report
included only direct and variable costs (quasi-variable with respect to the batch level), Unit Cost
Option 1 would be presented, with unit costs of $139.50 for X and $148 for Y.
An interesting dilemma arises at the product-sustaining level in this example because the
engineering costs related to design and change orders can be fixed over wide ranges of activity.
CAD software, for example, is an infrastructure item that does not truly vary at a consistent
incremental rate of $50 per engineering hour; it varies in lump sum amounts as upgrades are
purchased. Operationally, allocation of these costs per unit of X and Y does not provide insight into
how to manage them; the insight comes from understanding that substantial variations in
engineering time and change orders will push software, salaries, and other product-sustaining
costs past critical threshold levels. Productsustaining costs (and similarly, facility costs) would be
reported in aggregate amounts for ranges of activity.
Although this reporting option makes sense operationally, it is rarely seen in practice since
marketing personnel prefer full cost allocations, especially for cost-plus pricing decisions. As a
result, some companies are using Unit Cost Option 2, which includes the first three levels of the
ABC cost hierarchy, excluding only the facility cost level. In our example, these unit costs are
$178.50 for Product X and $252 for Product Y. However, Option 2 is still not a full unit cost, and by
far the option employed most often is Option 3, which contains all four cost pool levels, including
$3.2 million of facility occupancy costs. The end result of this ABC cost tracing is a much greater
unit cost for Product Y ($452) compared to Product X ($208.50). The nuisance for operational
decisions though is that $200 of Y's unit cost and just $30 of Xs cost consist of common fixed
occupancy costs. These are substantial portions of the total unit cost of each product but
occupancy costs do not change at these rates as volumes change.
IMAGE TABLE4
Figure 3. Financial executives' opinions about cost assumptions at Hierarchy Manufacturing Co.
The scale for the response ranged from 1 (strongly disagree) to 7 (strongly agree) with 4 being
neutral.
Operationally, much can be learned about facility costs through the process of grouping them into
activity centers, after which it is simple and inexpensive to calculate full unit costs. This provides
the temptation to go ahead and calculate these costs, and marketing and corporate staff prefer
these numbers anyway. However, the major drawback to using ABC costing to make operational
decisions when facility costs are traced down to the individual unit level is that these facility
(indirect) costs are allocated to units using volume-based cost drivers, such as square feet in the
Hierarchy Manufacturing example.
These cost drivers are the same as the ones used in simpler traditional costing systems and the
result is the same: arbitrary allocations of cost to units of product. It is not as if cost drivers have
been found that can be said to cause facility costs directly. In fact, the person most responsible for
popularizing ABC, Robert Kaplan of Harvard University, recommends excluding facility level costs
from unit costs for this reason.
In contrast, the appeal of full unit costs for marketing personnel is illustraced in Figure 2, which
displays cost-plus markup calculations. The calculations, taken as the unit cost plus a markup
percentage times the unit cost, have been arranged so that the same price results from all three
costing options: $250.20 for Product X and $542.40 for Product Y. The advantage of Option 3 is
that marketing managers can apply a consistent and familiar markup percentage of 20 percent to
their cost-plus calculations and think that they will be covering full costs. Options é and 2 pose a
difficulty because with smaller cost bases, the markup percentages become much larger and
irregular (up to 266 percent for Y under Option 1).
Larger markup percentages enable full cost recovery but marketers tend to look at the smaller unit
costs and worry that prices will not cover all costs. Thus, the form of ABC unit cost allocations that
serves operational process improvements best by avoiding unitized fixed and common costs
(Options 1 and 2) complicates pricing decisions and forces marketers out of their comfort zones. It
is difficult to satisfy both operational and marketing managers with the same set of unit costs.
Key performance/profit indicators
Although flexibility in calculating unit costs has been a core concept in management accounting for
decades, it has only been recently that firms in North America have experimented with these
adjustable calculations to provide various decision makers in the same firm with different unit costs.
Many consultants offer solutions that combine ABC and throughput costing, an innovation under
the theory of constraints in which the only unit costs are materials. Such hybrid costing solutions
can be confusing because they derive from different theories of product costs. Under full ABC unit
costing, all costs are deemed to be variable and direct, whereas in throughput costing almost all
costs are treated as fixed and indirect.
While consultants recognize the need to provide different unit cost numbers for different purposes,
as shown by Hierarchy Manufacturing, it is difficult to explain their hybrid cost solutions to the
operations and marketing personnel who must use them.
The challenge of understanding hybrid costing is illustrated by the fact that even finance
executives are undecided as to whether the assumptions supporting ABC and throughput costing
methods, the polar opposite approaches to calculating unit costs, are valid. We surveyed
controllers and vice presidents of finance in 44 firms and found that they have mixed or
uncommitted opinions on this topic. Results are presented in Figure 3.
The executives were asked to what degree they agreed with four statements that are underlying
assumptions of either ABC or throughput costing. The first two are assumptions of ABC: Virtually
all costs can be traced and all costs are variable. The second pair of assumptions questions the
ability to trace costs of support activities accurately, a motivation for throughput costing.
The scale for each question was 1 to 7, with 1 being "strongly disagree," 7 being "strongly agree,"
and 4 being "neutral." The average response was around 4 or 5 (neutral or weakly agree) for all
statements. For each of them, there were answers on both extremes of the scale; combined with
the neutral average responses, this indicates a lack of consensus among finance executives
regarding the direct versus indirect and variable versus fixed nature of costs. If this group has
mixed opinions, it is unlikely that operations and marketing personnel will be shown a clear
perspective on the validity of alternative unit cost calculations.
However, prospects for intelligible flexible unit cost calculations such as those used in the ABC
costing system are satisfactory based on experience in Europe. An innovation dating back to the
1950s in German-speaking countries called Grenzplankostenrechnung (GPK, "flexible margin
costing") does not allocate fixed costs to units of product and is well-suited to support process
improvements. In some longer-term decision situations though, fixed costs are sometimes
allocated in GPK systems, resulting in various forms of margin calculations ranging from product
lines to companywide levels. One such long-term decision is list pricing, where cost-plus pricing
calculations are used and where marketing departments would be more comfortable with unit
costs that include fixed cost allocations than with the strict GPK version that includes only direct
and variable costs.
ABC unit costs have been staged by levels in the cost hierarchy in a similar fashion to GPK,
although there may be more resistance to this approach in North America due to a longer history
of unquestioned full cost allocation. Nevertheless, increased use of flexible unit costing here is
possible; accounting numbers used for internal decision making purposes are allowed to differ
from those presented to investors and creditors in external reports.
Incentive compensation awarded on the basis of profitability may deter many firms from
undertaking flexible unit cost calculations because of perceived inequities. It might not seem fair to
marketing personnel that their bonuses are determined in part on the basis of larger, fully allocated
unit costs, whereas bonuses in operations might be based on smaller variable costs. However,
another management technique that is gaining acceptance as a framework for computing incentive
compensation, the balanced scorecard, could be used to reduce concerns over fairness.
A tenet of the balanced scorecard, often called scorecarding for short, is that different
combinations of key performance indicators can be selected for different business units and
functional areas. Thus, a marketing unit might base profitability measures on full unit costs, but an
operational unit could combine variable unit costs with measures of total fixed costs at the plant
level in bonus calculations. Fixed and indirect costs would be addressed in both compensation
schemes, but not in the form of unit costs in operations.
There is no shortage of consultants available to advise firms how to implement flexible unit costing
systems. A recent Internet search using the terms "theory of constraints," "activity-based costing,"
and "consulting" resulted in 2,790 hits. Many of these hits are for American consulting firms that
offer multiple methods of computing unit costs. Resources are available to firms willing to invest in
cost information that is relevant to all of their business units.
IMAGE ILLUSTRATION5SIDEBAR
Activity-based costing (ABC) systems allow for flexible calculations of unit costs in operations and
marketing, but such costs are often misunderstood.
SIDEBAR
Facility-level activities support the entire production process.
SIDEBAR
It is difficult to satisfy both operational and marketing managers with the same set of unit costs.
SIDEBAR
Incentive compensation awarded on the basis of profitability may deter many firms from
undertaking flexible unit cost calculations because of perceived inequities.
IMAGE PHOTOGRAPH6
Philip Beaulieu
AUTHOR_AFFILIATION
Philip Beaulieu joined the Maskayne School of Business at the University of Calgary in 1991 and
teaches managerial accounting at the undergraduate, master's, and doctoral levels. His research
fields include managerial accounting, commercial lending, auditing, and cognitive psychology.
Beaulieu studies cost behavior and the processes used to establish the credibility of accounting
information.
IMAGE PHOTOGRAPH7
Mandi Mikulecky
AUTHOR_AFFILIATION
Mandi Mikulecky is an alumna of the University of Calgary in Alberta, Canada, with a bachelor's of
commerce in accounting from the Haskayne School of Business and a bachelor's of art in Spanish.
She is currently pursuing her Chartered Accountant designation and has experience in cost and
financial accounting in both the for-profit and not-for-profit sectors.
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