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
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
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
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