Performance Operations: Grahame Steven Traces the Development of Activity-Based Costing and Shows How It Can Be Applied to Inform Activity-Based Management
Steven, Grahame, Financial Management (UK)
Many accounting experts in the eighties and nineties argued that absorption costing, which had been developed at the turn of the 20th century, needed to be replaced by new costing systems that were more appropriate for modern business. The main changes that had necessitated a different approach included the growth in production overheads relative to direct costs; the increase in factories' complexity (ie, they were making a far wider range of goods); the rising level of non-production overheads; and the growth of the service sector.
The key breakthrough in the development of what would become known as activity-based costing (ABC) was the realisation that many production overheads should not be charged to products on a single volume basis--eg, units made--because they weren't driven by these bases. Other factors gave a better explanation of why such costs were incurred. So a more effective way of charging overheads to products was achieved by creating cost pools for each of the main activities and then charging the cost of each pool to products using the cost driver--eg, the inspection of goods--identified for each pool. Activities were often classified under four categories to enable the identification of appropriate drivers: unit level, batch level, product level and facility level.
While it's acknowledged as a big step into modernity, ABC (like many good ideas) has its foundations in the past. The initial focus during the development of standard costing in the late 19th century was on direct costs, but even then it was recognised that overheads needed to be accounted for to determine the profitability of products. Alexander Hamilton Church was the first writer to make this point when he realised that product costs had to include prime costs (wages and materials), indirect shop costs (production) and general and selling expenses. He observed that the production and non-production overhead often "equals and sometimes surpasses in value the item of wages" in some companies. Contrary to the views of some modern writers, then, it seems I that some factories at the turn of the 20th century were already complex organisations with high levels of overheads. Church also criticised the use of time and percentages to charge overheads to products, since few i overheads related to these factors.
While he acknowledged that simple absorption methods wouldn't produce "alarmingly incorrect" costs in a factory with "machines all of a size and kind performing practically identical operations", Church noted that such an approach would not be "trustworthy" in complex factories producing diverse goods. He believed that product costing systems had to identify "the connection of expenditure of all classes with the items of output on which they are incident" to determine the resources required for each product--which sounds a bit like ABC.
1a Connoisseur Collection's P&L account Public Corporate Number of cases sold 15,000 9,000 Sales ([pounds sterling]) 1,050,000 567,000 Cost of sales ([pounds sterling]) 576,000 334,800 Gross profit ([pounds sterling]) 474,000 232,200 Operating expenses ([pounds sterling]) Delivery Visits to customers Warehouse Web site Other selling expenses Finance and admin Net profit ([pounds sterling]) Retail Total Number of cases sold 36,000 60,000 Sales ([pounds sterling]) 2,052,000 3,669,000 Cost of sales ([pounds sterling]) 1,296,000 2,206,800 Gross profit ([pounds sterling]) 756,000 1,462,200 Operating expenses ([pounds sterling]) Delivery 254,000 Visits to customers 96,000 Warehouse 192,000 Web site 80,000 Other selling expenses 120,000 Finance and admin 285,000 Net profit ([pounds sterling]) 435,200 1b Current product profitability analysis of Connisseur Collection's three markets Public Corporate Retail Sales price ([pounds sterling]) 70.00 63.00 57.00 Wine ([pounds sterling]) 38.40 37.20 36.00 Other expenses ([pounds sterling]) 17.12 17.12 17.12 Profit per case ([pounds sterling]) 14.48 8.68 3.88 2 ABC data for Connoisseur Collection's three markets Public Corporate Retail Average 1.5 9.0 12.0 cases sold per customer Sales 10,000 1,000 3,000 orders Average [pounds sterling]7 [pounds sterling]40 [pounds delivery sterling]48 cost per order Visits to 0 300 180 customers Cost per [pounds sterling]0 [pounds sterling]200 [pounds visit sterling]200 Web site 130,000 20,000 10,000 hits ABC drivers Warehouse: number of cases. Web site: number of hits. Other selling expenses: percentage of sales. Finance and admin: number of sales orders.
Church also made the following excellent point about the dangers of using simple cost-charging methods: "No one ever argues that, if $200 has been spent on 20 articles, then the cost of each can be safely considered at $10, unless indeed the product is absolutely uniform. Such a suggestion would be treated with ridicule, because obviously the only use of detailed costs is to reveal the relative amounts of wages and material that the different orders have absorbed."
It's hard to fathom why Church's advice was ignored at the time in favour of simpler methods of charging overheads. Whatever the reason, his ideas can now be seen as underpinning ABC's development.
Let's consider a fictitious firm, Connoisseur Collection, to show how ABC can be used and consider its implications for activity-based management (ABM). The company imports wine for resale in the UK. Although it sold mainly to retail outlets for many years, it has recently developed a business selling directly to the public via the web and has also significantly increased its income from corporate customers by using freelance sales reps. The firm uses a simple analysis of profitability by case of wine sold by each of the three lines: Retail, Corporate and Public. The only direct cost recognised in the current analysis is that of the wine. All other overheads are charged to the three lines on the number of cases sold--ie, total overheads divided by total cases (see tables 1a and lb, previous page). In this example, it's ([pounds sterling]254,000 + [pounds sterling]96,000 + [pounds sterling]192,000 + [pounds sterling]80,000 + [pounds sterling]120,000 + [pounds sterling]285,000)4/60,000 = [pounds sterling]17.12. The new chief executive is unhappy with this approach. He thinks that ABC should be introduced, since the firm is now selling to diverse markets.
As a result, an investigation is conducted to identify the activities that cause costs. The resulting analysis (see table 2, previous page) reveals that only warehouse costs should be charged on the current basis. Delivery costs should be charged in relation to the average cost of delivering an order. Customer visits should be charged only to the Corporate and Retail lines. Members of the public account for nearly all hits recorded by the company's web site. Percentage of sales is considered to offer a fair reflection of the use of other selling expenses by each of the product lines. And the number of sales orders is seen as the most appropriate basis of charging finance and administration costs, since most of this work is focused on customer orders.
Table 3 is an ABC analysis that calculates how much of each resource is consumed by each of the different lines. While delivery and customer visits can be readily identified with each line, the figures for the other costs require more calculation. The cost of the driver is calculated (eg, for sales orders it's [pounds sterling]285,000 / 14,000 = [pounds sterling]20.36), then total costs are apportioned to each product type. Lastly, a cost per case is calculated from the apportioned cost.
3 ABC analysis of Connoisseur Collection's three markets Public Corporate Delivery Cost per [pounds [pounds delivery sterling]7 sterling]40 Average 1.5 9.0 number of cases Cost per [pounds [pounds case sterling]4.67 sterling]4.44 Visits to customers Number of 0 300 visits Cost per [pounds [pounds visit sterling]0 sterling]200 Cost of [pounds [pounds visits sterling]0 sterling]60,000 Number of 15,000 9,000 cases sold Cost per [pounds [pounds case sterling]0 sterling]6.67 Warehouse Cost [pounds sterling]192,000 Number of 60,000 cases Cost per [pounds [pounds [pounds case sterling]3.20 sterling]3.20 sterling]3.20 Web site Cost [pounds sterling]80,000 Number of 160,000 hits Cost per [pounds hit sterling]0.50 Allocation [pounds [pounds of costs sterling]65,000 sterling]10,000 Number of 15,000 9,000 cases sold Cost per [pounds [pounds case sterling]4.33 sterling]1.11 Other selling expenses Cost [pounds sterling]120,000 Sales [pounds sterling]3,669,000 Percentage 3.27% of sales Allocation [pounds [pounds of costs sterling]34,342 sterling]18,545 Number of 15,000 9,000 cases sold Cost per [pounds [pounds case sterling]2.29 sterling]2,06 Finance and admin Cost [pounds sterling]285,000 Sales 14,000 orders Cost per [pounds order sterling]20.36 Allocation [pounds [pounds of costs sterling]203,571 sterling]20,357 Number of 15,000 9,000 cases sold Cost per [pounds [pounds case sterling]13.57 sterling]2.26 Retail Delivery Cost per delivery [pounds sterling]48 Average number of cases 12.0 Cost per case [pounds sterling]4.00 Visits to customers Number of visits 180 Cost per visit [pounds sterling]200 Cost of visits [pounds sterling]36,000 Number of cases sold 36,000 Cost per case [pounds sterling]1.00 Warehouse Cost Number of cases Cost per case [pounds sterling]3.20 Web site Cost Number of hits Cost per hit Allocation of costs [pounds sterling]5,000 Number of cases sold 36,000 Cost per case [pounds sterling]0.14 Other selling expenses Cost Sales Percentage of sales Allocation of costs [pounds sterling]67,114 Number of cases sold 36,000 Cost per case [pounds sterling]1.86 Finance and admin Cost Sales orders Cost per order Allocation of costs [pounds sterling]61,071 Number of cases sold 36,000 Cost per case [pounds sterling]1.70
The revised product profitability analysis (see table 4) reveals a different picture, since it provides a better reflection of the resources consumed by the three lines. It reveals that Retail is the most profitable line while Public is the least profitable. This finding is typical for many firms that have introduced ABC. Traditional absorption costing systems tend to overstate the costs of high-volume products and understate those of low-volume products. At Connoisseur Collection the first analysis charged an excessive proportion of finance and administration, customer visits and web site costs to Retail. But don't forget that it's impossible to calculate completely accurate product costs, since all costing systems involve apportionments of shared costs, many of which are fixed or semi-fixed.
4 Revised product profitability analysis of Connoisseur Collection's three markets Public Corporate Retail Sales price ([pounds sterling]) 70.00 63.00 57.00 Wine ([pounds sterling]) 38.40 37.20 36.00 Delivery ([pounds sterling]) 4.67 4.44 4.00 Visits to customers ([pounds sterling]) 0 6.67 1.00 Warehouse ([pounds sterling]) 3.20 3.20 3.20 Web site ([pounds sterling]) 4.33 1.11 0.14 Other selling expenses ([pounds sterling]) 2.29 2.06 1.86 Finance and admin ([pounds sterling]) 13.57 2.26 1.70 Profit per case ([pounds sterling]) 3.54 6.06 9.10
The ABC analysis reveals that the company needs to focus its efforts on Public and Corporate, which is where ABM comes in. ABM covers many types of analysis and action, but in simple terms it's concerned with using the information obtained from ABC to improve performance and profits. The analysis raises the following questions for Connoisseur Collection's managers:
* Why are there relatively more sales visits to Corporate customers than to Retail customers? Is this because the company is using a "spray-gun" approach to developing this market? Should more effort be made to identify customers with worthwhile sales potential?
* Is it possible to reduce the costs of maintaining the web site and/or to convert more hits into sales?
* Could a third party host the web site for a lower cost than [pounds sterling]0.50 per hit?
* What can be done to reduce the high cost of finance and administration ([pounds sterling]13.57) for Public?
* Is some process re-engineering required--eg, the adoption of an e-commerce system to reduce the high cost of the finance and administration driver ([pounds sterling]20.36)?
* Should Connoisseur Collection approach a haulage company that operates bonded warehouses to see whether it could provide a warehouse service at a lower cost than [pounds sterling]3.20 per case?
* Is the company undertaking any nonvalue-adding activities? If so, could these be eliminated or reduced in scale?
* How accurate is the ABC analysis? Has it identified the correct cost drivers? Are sales orders the most appropriate driver for administration costs? (NB: the exam practice question in the panel on the right considers revised ABC data for Connoisseur Collection.)
The data obtained from the ABC analysis can also be used to produce a customer profitability analysis for Corporate and Retail. Such analyses can sometimes produce surprising results, since some big customers may not be as profitable as they might seem.
Grahame Steven is a teaching fellow in the School of Accounting, Economics and Statistics at Edinburgh Napier University.
RELATED ARTICLE: Exam practice
Try the following question to test your understanding of ABC. The solution will appear in CIMA's student e-magazine, Velocity (www.cimaglobal.com/velocity).)
The ABC product profitability analysis, presented at Connoisseur Collection's recent executive management meeting, provided much food for thought (see main text and table 4). While the managers welcomed the analysis, there was some concern about the basis of some of the calculations. As a result, they asked the ABC team to review its analysis, since they were uneasy about acting upon it until they were confident that it gave an accurate reflection of product profitability.
The ABC team reviewed their analysis and made the following amendments:
* Finance and administration should be split into its constituent parts: [pounds sterling]175,000 for finance and [pounds sterling]110,000 for administration.
* Number of cases was identified as the cost driver for admin. (NB: sales orders were still considered to be the appropriate driver for finance.)
* Purchase orders were determined to be the appropriate cost driver for warehouse, since there was little overlap between the wines sold to each of the company's markets. The number of purchase orders raised for each product line was as follows: 180 for Public, 120 for Corporate and 300 for Retail.
You are required to prepare a revised ABC analysis and consider it in relation to the initial ABC analysis.
P1 further reading
H Johnson and R Kaplan, Relevance Lost, Harvard Business School Press, 1987. R Scarlett, CIMA Official Learning System--Performance Operations (2010 edition), CIMA Publishing, 2009.…
Questia, a part of Gale, Cengage Learning. www.questia.com
Publication information: Article title: Performance Operations: Grahame Steven Traces the Development of Activity-Based Costing and Shows How It Can Be Applied to Inform Activity-Based Management. Contributors: Steven, Grahame - Author. Magazine title: Financial Management (UK). Publication date: January-February 2010. Page number: 40+. © 2009 Chartered Institute of Management Accountants (CIMA). COPYRIGHT 2010 Gale Group.