Implementing Activity-Based Costing

By Ted R. Compton

The author has developed a primer on activity-based costing (ABC). He first presents the whys and wherefores of ABC. He then provides a comprehensive case analysis to illustrate the merits of ABC systems modeling and how computer technology can and should be used in making ABC work.

Businesses operate in an uncertain and competitive world; accurate cost information is a primary weapon for survival and success, whatever the industry. If a company can't maximize information gathering and utilization capacity, it will be left in the wake of those who can. Companies, successful in disseminating relevant information, i.e., providing information empowerment to all levels of their operations, can be on their way to becoming world class organizations. Many organizations have found the pursuit of this mission can best be achieved by installing activity-based costing (ABC) systems.

Many companies are doomed to failure before they begin installing ABC systems, in part due to a number of misconceptions about ABC systems and what they are actually designed to accomplish. Another major reason for failure is a faulty planning, design, and implementation strategy. The purpose here is to provide a road map that will increase the likelihood of success.

Some Misconceptions

Some proponents of ABC suggest that the cost of a product can be computed by calculating the activity-based cost for each component and subassembly. Care must be taken with this approach to product costing, sometimes called roll-up costing. If the activity-based cost of a part is developed from cost roll-ups, each product using that part will bear an equal share of the overhead costs associated with the part. But one of the products may be responsible for a greater share of the overhead costs associated with the part because the product in question has a less stable production schedule and is the cause of most of the expediting costs associated with the part. This is further illustrated in the accompanying Case Study.

Another misconception is that ABC systems cannot calculate product costs accurately because of the difficulty in tracing activity costs to products if activities are not performed on the products. While cost allocation procedures are by nature arbitrary, well designed ABC systems use cause-and-effect criteria for defining how costs are to be allocated. For example, most purchasing activities are oriented toward the acquisition of components. Because components may be common to many products, it is difficult to come up with activity drivers that precisely trace the cost of purchasing activities to specific products. In such cases, activity analysis will yield an activity to trace costs to products more accurately than conventional cost systems.

Still another misconception about ABC is that it replaces the existing cost
system. One essential function of conventional costs systems is to value inventory used to generate financial reports in accordance with FASB, IRS, and SEC requirements. Although there is no prohibition against a company utilizing ABC analysis to value inventory, most companies use ABC systems for internal reports designed to help manage costs and improve performance. ABC systems are intended to complement--not replace--conventional cost accounting systems.

Probably the greatest misconception about ABC is that it does not work well for service organizations. ABC is equally valuable as a management tool in service organizations as it is in manufacturing firms. The same methodology and cost- flow concepts can be utilized in developing activity-based modeling for either type of organization. All that differs are the particulars, e.g., patient visits instead of machine hours or activity costs instead of manufacturing conversion costs.

Selling ABC to Management

To be successful, an organization must be committed to ABC. The effective use of ABC information technology must start with the endorsement and support of top management and user groups.

The process begins by stimulating the interest of management in ABC. One way to do this is to look at the successes of other companies using ABC. Management can learn of the benefits through printed materials, seminars, and videotapes. Outside consultants can be useful in helping to sell ABC.

Deficiencies of the current system can be used to help demonstrate the merits of ABC. An effective method for winning support is to use a small pilot project to demonstrate ABC's merits. The pilot project chosen should be "a winner," an organizational unit where it is known waste exists or faulty decisions are being made because of inaccurate cost information.

Obtaining commitment from management is a necessity when selling potential users on the merits of ABC. One way to strengthen commitment and acceptance is to form a steering committee. Because cost-information systems span functional and divisional boundaries, the steering committee should consist of top managers from each of the user groups.

An Implementation Strategy

As with most systems projects, objectives must be set and the scope defined. The establishment of a project goal is the first step. It may be to determine the cost of a product, product line, or bundle of services. Questions that may lead to the selection of a test product include the following. Are manufacturing costs too high when compared to competitors? Are customers only buying selected products from the product line--in other words cherry picking? This kind of benchmarking provides valuable information for cost management.

If this is the company's first experience with ABC technology, a pilot project should be completed in 4-6 weeks. Historical costs should be used to construct the model. Once the model is operational, it can be converted to forecast costs. Modeling techniques, discussed later, should be used to establish boundaries and identify the crucial components of the ABC project.

An initial feasibility analysis should be part of the early stage. While it may be concluded that a new system is needed, is it feasible at this time? If not feasible, the implementation strategy may have to be rethought. When exploring the feasibility question, the following should be considered:

Operational Feasibility. Does the company have the organizational climate and necessary manpower to carry out an ABC project?

Economic Feasibility. Is the cost of installing a new ABC system too much at this time? Can the company afford to give selected personnel "time-off" to work on the proposed system?

Technical feasibility. Before beginning the ABC project, the technical know how of the organization must be assessed. Can the organization "pull it off?" Does the organization have the necessary computer expertise? What type of technical assistance is available from the outside?

Schedule Feasibility. Given other priorities and ongoing projects, can adequate time be devoted to the project by the right people? Nothing destroys confidence in the project management team more than delays.

Organizing the ABC Undertaking

Establishing an ABC project structure is more than assigning responsibilities. It's an opportunity to strengthen commitment and acceptance. Typically, three factors should be considered. First is the formulation of a project management team. Part-time members may be desirable for small projects, but for large projects full-time members are the answer. Second, cross-functionality is a major consideration. Clearly, choices depend on availability of qualified staff as well as the project's size and complexity. A typical ABC project management team for a manufacturing concern with cross functionality, would be as shown in Exhibit 1.

Third, a project leader must be appointed, one who possesses leadership abilities with a knowledge of ABC technology. It is important to pick an individual who has complete knowledge of the company's products and activities--in most cases, an insider. It's icing on the cake if that individual has
previous experience in implementing ABC projects.

A steering committee, typically from upper management and generally composed of major users of the information systems, can assist in providing overall guidance for the ABC project. Additionally, the steering committee helps establish priorities and monitors the progress of the project while also helping to win acceptance. It is important to remember that users of ABC systems are more likely to accept change if their cooperation is solicited and they are asked about the present cost system, its problems, and needed changes.

Planning the Project

When it's time to put the project together, the project manager, with other members of the team, should begin to discuss and summarize the tasks necessary to complete the project. It is helpful to formalize these plans with the aid of a Gantt chart (Exhibit 2) or other project management tool such as a CPM or PERT network. Planning forces the project team to think about the tasks at hand, the inter-relationships, time constraints, and manpower requirements. Only after considering and documenting these types of issues can project completion dates be determined.

ABC Project Training

Training is crucial for effective implementation, execution, use, and acceptance of an ABC system. Training is an ongoing process occurring throughout the life of the project. Three groups should be addressed in designing a training program.

Management. It's important that management is exposed to and buys into the ABC undertaking.

Implementers. The implementation team must be knowledgeable about technical design needs, software modeling capabilities, and project organization.

Users. Users should understand the benefits of the ABC information system and how this information can be used in decision-making.

Gathering Information

A vital component of any well-conceived information system is the information requirements of its users. Each phase of information gathering should include a member of the project team and the user. The requirements of the system and the information needed should be explored. Questions each user should attempt to answer include--What key decisions must I make, and how often do they arise? What other cost information would be useful in carrying out my responsibilities?

Knowing where to look for information is one thing, successfully gathering it is another. Techniques for gathering facts include documentation and note taking of reviews of records, observations, interviews, questionnaires, and interfaces with the existing information systems.

Interviewing is perhaps the oldest device for obtaining information; the major advantage is a great deal of information can be gathered when straightforward questions are employed. The disadvantages are there are many questions people will not answer directly, and extensive interviewing can be quite expensive. When an ABC project is undertaken, the analyst will frequently start interviewing at the top of management hierarchy and work down.

A fast and inexpensive method for obtaining information is accomplished by "looking around." To be effective at observing requires experience and
the ability to draw relevant and correct conclusions.

The company's information systems or database provide a vast reservoir of information. The wealth of information can be overwhelming if the reviewer does not know what to look for or where to look. Because of the complexity of most computerized information systems, knowing what data exists and how to extract it presents a major challenge for the project team. It is, therefore, important to include an MIS representative on the ABC project team.

For most ABC projects, the most common location for financial information pertaining to company resources is the general ledger. Most general ledgers are of little assistance regarding current costs. They are, however, a good starting point. General ledgers are not designed to provide information about activities. They must be converted to a data set that can be utilized by the ABC project management team. Departmental and cost-center reports might provide more relevant information. The real challenge is trying to extract relevant information at a reasonable cost.

An important step in the information gathering phase is the activity inventory, which among other things, becomes the basis for focusing upon nonvalue-added activities. This phase of the analysis should help determine if activities are primary or secondary. Primary activities are normally related to the organization's mission, while secondary activities provide support for primary activities. Organizations don't want too many secondary activities. A ratio of 80% primary activities to 20% secondary is excellent in most organizations. According to James Brimson in Activity Accounting, if the ratio approaches 50/50, the organizational unit is a prime candidate for ABC.

The activity inventory will reveal a hierarchy of activities. Basically, there are four levels of activities:

Unit Activities. These are performed on units of products. Machining a metal part is an example of a unit activity.

Batch Activities. These are performed on batches of products rather than individual product units. Setting up a machine to produce products is an example of batch-related activities.

Product Activities. These benefit all units of a product. An example is development costs or promotion costs. These costs tend to be life-cycle costs. These kinds of costs should be spread over the estimated life of the product.

Facility and Organizational Activities. Facilities activities are incurred only to support the ongoing facility operations. These are activities common to many products or services and can only be assigned on an arbitrary basis. Examples include depreciation costs or the salary of the plant or divisional manager.

Creating an ABC Systems Model

Probably the most important step in the design of an ABC information system is creating the model. Each model has a set of resources, resource drivers, activity centers, activities, activity drivers, cost elements, and cost objects. Modeling helps define the scope of the project. A boundary can be placed around the project, i.e., a department or product line, which will limit the complexity and help reduce a very complex, detailed, and abstract process to a manageable level of detail.

Flowcharting is recommended to gain a better perspective and understanding of the complexities of cost allocation. The flowchart in Exhibit 3 related to the manufacturing department in the Case Study provides an overview of an ABC cost assignment model.

The key elements of ABC are as
follows:

Resources. Economic elements used to perform activities, such as, management costs, facilities support, etc.

Activity. Processes or procedures used to do work. Examples would include setting up machines or processing invoices.

Activity Center. A cluster of related activities.

Resource Drivers. Factors used to allocate resources or pools of costs to activities. The drivers are usually estimates of management costs or square footage for allocating facility costs.

Activity Cost Pool. Total cost assigned to an activity.

Activity Driver. A factor used to assign cost from an activity center to other activity cost pools or cost objects.

Cost Element. The amount paid for a resource and assigned to an activity.

Cost Object. The ultimate goal for performing an activity, and in ABC it represents the final costs assigned to a product or service.

Where does model building begin? The organizational chart is a good starting point. The process of converting the organization chart to an ABC flowchart by breaking down tasks into divisions, resource centers, and activity centers is called functional decomposition.

It should be kept simple. Macro activities (centers) should be established. To accomplish this, all activities related to accomplishing a particular attribute should be grouped. These clusters of activities become macro activities. For example, training and consulting might be two major activities in an EDP department. By clustering all the related detailed activities into one of these two macro activities, the level of detail should be substantially reduced. Insignificant activities should be ignored. A good rule of thumb is not to have more than 20 to 25 activity centers for an ABC project.

When trying to build a model for an ABC project, an important consideration is analyzing and identifying cost drivers. There are two types of drivers. Resource drivers are the links between the resources and the activities. This phase is commonly referred to as first-stage allocation. In a nutshell, the costs from the general ledger should be assigned to activity centers. For example, the costs (resources) assigned to the production department may be distributed to the activities inspection, material handling, and assembly on a basis of 30%, 40%, and 30% respectively. Resource drivers determine how activity centers consume resources. It is quite common to classify many of the units as facility or organizational support costs and to use square feet, effort spent by department managers, or other estimates as resource drivers.

Activity drivers are methods of assigning activity costs to cost objects. Activity drivers are selected based on use of activities when producing a product or providing a service. This is commonly referred as second-stage allocation. A cardinal rule to follow in selecting resource and activity drivers is to pick drivers that will show a cause-and-effect relationship. Some tips for selecting resource and activity drivers follow:

• All costs should be assigned to resource and activity centers.
• Costs should be traced to resource and activity centers where possible.
• Resource and activity centers should be chosen that show a cause-and-effect relationship.
• Common sense should be used to determine how to allocate.
• Drivers should be chosen that match the type of activity.
• The expertise of the various operating groups should be used as needed.
• An attempt should be made to build a consensus among operating personnel, cost accounting, industrial engineering, etc.
• The number of drivers should be kept to a minimum.
• Drivers should be chosen that focus on improving performance.
• Drivers should be chosen that have a modest cost of measurement.
• Drivers should be chosen that don't require extensive measurements.

Allocation is the process of distributing resources to accounts, activities, or cost objects. The allocation path specifies how the costs will be distributed by percentages or by quantities based upon use of resources (a driver). With a large ABC project, this complexity can be overwhelming. It is important to use modeling techniques and computer technology. This can be seen in the complexity that would be encountered with allocation paths for 20 or 25 activity centers and several products. Here are some examples of possible allocation paths: