Management's Stake in Improved Decision Making with Activity-Based Costing

By Barnes, Frank C. | SAM Advanced Management Journal, Summer 1992 | Go to article overview

Management's Stake in Improved Decision Making with Activity-Based Costing


Barnes, Frank C., SAM Advanced Management Journal


Managers have to make decisions: how to allocate limited resources; how to price products; when to drop a product line; how to organize the product and process. Information is the basis for these decisions; generally, the better the information the better the decision. Today, computer specialists emphasize the "systems" nature of information and decisions and discuss decision support systems. The way data is developed, summarized, and presented determines how a situation is seen and, in turn, what action will be taken. Accounting reports have been the major source of performance information and only source of profitability information. However, accounting has not fully focused on the task of supporting managers in their full range of decisions. Because accounting has to serve external groups, such as investors, bankers, and regulators, accuracy and validity in the task of representing company activities have been compromised for uniformity and simplicity in external reporting. There are significant compromises in a key part of the system, the costing out of products, which misrepresent the true behavior of the business. Specifically, overhead has been allocated in such a simplistic manner, usually on labor hours consumed, that initiatives taken in our plants to regain competitiveness have not been captured and supported in the accounting reports. Managers could be mislead, develop inappropriate strategies, and make bad decisions. For example, a small, special order requiring more design, scheduling and attention, i.e., increased overhead, would actually receive a small overhead charge because of the short runtime and low direct labor. The small order would inaccurately appear to be better than larger orders; the plant would be pushed in the wrong direction. However, a recent development, activity-based costing (ABC), provides an opportunity for management to bring these overhead allocations into line with the way the plant actually operates. The activities which cause the costs are identified so that the products which cause the activities can pay for them. ABC is not a radical or dramatic change but a subtle, fine tuning. It has the potential to significantly improve the usefulness of accounting as a decision support system for a manager's strategic moves in rebuilding competitiveness. The History of Product Costing

Seemingly minor accounting choices about costing methods can, in fact, have major external importance. The full cost of a product includes direct labor, material, variable overhead and fixed costs. Direct labor and materials are observed and measured by the industrial engineering staff and maintained as "standards." The overhead costs are captured and reported by responsibility centers, departments or plants, etc. The difficult decision is what to do about tying overhead costs to products. Accountants have long debated the value of two relevant approaches: "full absorption costing," in which all costs are allocated to the products, and "variable costing," in which only variable costs (material, labor) are allocated. Those advocating variable costing state that overhead costs are sunk or fixed and will not change with most management decisions. Therefore, overhead costs should be expensed monthly as a general cost of doing business. On the other hand, advocates of full costing believe that the cost of the product must show the full cost of getting the product out. More costs are capitalized (held out of current expenses) and put into inventory with the product rather than being expensed when they occurred. These costs will not impact the P&L statement until the individual products are sold. Thus, we see that this decision about the costing approach affects inventory costs and the timing of profit, which explains the strong external interest in a company's approach. Reporting to the financial community and for tax purposes has created strong pressure--generally accepted accounting principles (GAAP)--for accounting systems to emphasize economy-wide uniformity over relevance or usefulness in a particular industry or business. …

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Management's Stake in Improved Decision Making with Activity-Based Costing
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