Activity-Based Costing Essential to Competitiveness

Article excerpt

Let's say your tooling center racks up costs of $1,000 in an accounting period; its work is divided equally ($500 each) between two products. Suppose Product A sells 200 units during the reporting period; Product B, 50 units.

When it comes time to figure product profitability, tooling costs are clear: Product A (200 units) gets tagged with its $500 in tooling, which works out to $2.50 per unit. Product B (50 units) absorbs the other $500, or $10 per unit.

But that "obvious" answer is probably not the one you'll get from your accounting system. Sad to say, most traditional systems would compute "250 total units, $1,000 in tooling charges, $4 per unit." Then when you assess product performance, these costing schemes end up assigning $800 in tooling costs to Product A (200 units times $4 per unit), and $200 to Product B (50 units, $4 per unit)!

This silliness is one of the hundreds of cases consultant-practitioner Peter Turney examines in his new book, "Common Cents: The ABC Performance Breakthrough." The "ABC," now at work in many firms, is activity-based costing.

The premise: Assign costs to "stuff" (activities) according to what is actually done.

The pressing need for ABC arises partly from accounting systems'

tendency to spread all indirect costs across products based on the direct-labor hours the product requires. That was satisfactory in a bygone era, when direct labor was a firm's biggest expense. But now, direct labor seldom amounts to more than 15 percent of total costs. Typically, undifferentiated overhead _ order entry, design, marketing, inspection, tooling _ comprises the bulk of expenses.

Consider another case: Each batch (100 units) of Product C requires four direct-labor hours and needs to be inspected once; a batch of Product D (also 100 units) uses two direct-labor hours, but must be inspected twice. Suppose the cost of one inspection is Product C clearly should get tagged with an inspection cost of $50 per batch of 100 units; Product D, with two inspections, has an inspection cost of $100 for every 100- unit batch. But don't bet on it!

Suppose you produce one batch of each product. You incur $150 in inspection costs and consume six direct-labor hours in all. Traditional systems would usually calculate inspection costs at $25 per direct-labor hour used, and would end up assigning inspection costs of $100 to Product C (four direct-labor hours times $25 per hour), $50 to Product D (two hours times $25). That is, Product C's unit cost of inspection, assigned on the basis of direct-labor hours, will be double, not half, Product D's. Reality be damned.

Turney leads us through true tales much more horrific than this. …