Activity Based Costing for Defense Contractors

Article excerpt

Activity based costing (ABC) is a system by which overhead costs are allocated directly to products using activity drivers to measure the cost allocable to a particular product. Traditional cost accounting allocates overhead on volume-related bases such as direct labor dollars, direct labor hours, machine hours, or material dollars.

The philosophy behind ABC is that activities consume costs and the knowledge gained by understanding the cost of activities is a tool that can help a business become more competitive.

ABC is not for all businesses, but there are warning signs that an existing cost system is faulty. The AICPA's Industry Committee identified 11 symptoms of a faulty cost system in the July 1991 issue of The CPA Letter. These symptoms related to confusion about prices in the marketplace versus product cost, use of volume-related bases to allocate overhead, and high inventory values. In any of these cases, ABC is more relevant to the daily operations of a business than is a traditional income statement, a departmental income statement, or a schedule of rates prepared by a federal government contractor for the Department of Defense.

Given the assumption that ABC is a more accurate measure of the real cost of a product than are traditional cost accounting methods, does it follow that ABC should be the preferred accounting method?

THE TIME IS NOW!

Technological advances both in manufacturing and information processing over the past few years have made the implementation of ABC systems possible and afordable. Computer integrated manufacturing, just-in-time (JIT) inventory techniques, and total quality management programs have enabled companies to bring their product or service to market quicker and at lower cost. "Not only has accounting done nothing to help high tech stay globally competitive in the new decade; it had often hinders competitiveness. When it comes time to justify the investments required for factory automation, total quality, or JIT, the numbers generated by cost accounting procedures minimize the apparent gains from the new production process and inflate the apparent costs."(1)

Because of advances in information technology, namely more powerful, inexpensive computers and inexpensive modelling software, the time for ABC is here. A survey conducted in November 1990 by the Cost Management Group of the National Association of Accountants (now called the Institute of Management Accountants), found that 11% of U.S. companies were using ABC while 19% were considering ABC implementation. "A significant majority of the companies that have implemented ABC say their experience has increased the quality of cost management information."(2)

It should follow that the company with better cost management is in a position to maximize efficieny and competitiveness.

A MATTER OF SURVIVAL

Given the tighter defense budget, the recession, and the move away from second sourcing, it is a matter of survival for companies to gain a competitive edge. Yet a defense contractor faces ABC implementation obstacles that a commercial enterprise does not. Defense contractors that are required to follow Cost Accounting Standards (CAS) must consider three standards if they wish to adopt ABC.

* CAS 401 requires consistency in estimating, accumulating, and reporting costs;

* CAS 402 requires that costs incurred for the same purpose be allocated consistently; and

* CAS 418 governs the consistency, accumulation, and allocability of direct and indirect costs.

A change to ABC affects these standard and is a change in accounting practice that under Federal Acquisition Regulations (FAR) 52.230-4 requires disclosure to the government and submission of a cost impact proposal. If the costs under ABC result in lower costs to the government, then the government will initiate a downward price adjustment. If the costs under ABC result in higher costs to the government, no increase will be allowed for CAS contracts unless the contracting officer determines that it is in the interest of the government to pay for the increased costs (FAR 52. …