April 2000


By David Bukovinsky, Hans Sprohge, and John Talbott

In activity-based costing, costs flow from the general ledger to activities and then to cost objects (products, customers, and services). Early on, a formidable task for most companies that switch to ABC is collecting information for specifying and assigning costs to activities. This phase involves identifying three things:

* What the company actually does (as opposed to its functional identification),
* Appropriate assignment bases (resource drivers) to determine the cost of the activities, and
* Activity drivers to assign the activity costs to cost objects.

The following case study illustrates the advantages of ABC in the sales and administrative areas.

Case Study

Robotics (a hypothetical company) is the U.S. distributor for industrial robots manufactured in Japan by a major Japanese company. The product line consists of robots designed for applications in the areas of welding, material handling, dispensing, and cutting. The product is segmented into standard and nonstandard products. The primary standard product is shipped without alteration to American customers and constitutes about one-sixth of total annual sales. The chief customized product is altered in the United States to fit customer specifications and represents about one-third of total annual sales. A variety of service endeavors, designated as "Others" in the income statement, generate approximately $1 million of revenue monthly. Robotics was relatively satisfied with the accuracy of the gross profit by product line as initially shown in Exhibit 2.

As with most distributors, Robotics' cost of sales is composed of direct charges for the product and labor and material related to modification and installation. However, management didn't like how selling and administrative costs were allocated. Allocations to product lines were based on booking dollars, with significant time lag between booking and revenue recognition. The standard robots usually required little or no additional administrative or selling effort. The nonstandard, customized robots, however, required substantial additional administrative effort before customers were satisfied. Management couldn't understand why the customized line continually showed a profit while the standard line showed a loss. Management decided to engage in an activity-based costing study to more accurately determine the selling and administrative effort by product line.

Robotics' Experience

The first step included gathering information from each department. Questionnaires asked employees two questions:

* What did they feel was the function of the department?
* Given the authority, how would they allocate costs?

The first step was to define activities. The questionnaire results showed that activities could be approximated by some of the existing cost centers in Robotics' general ledger system. Exhibit 3 shows a graphical presentation of this approach.

First, Robotics used a modified step method to allocate some activities to other activities and allocate other activities directly to cost objects (product lines). Exhibit 1 shows this assignment of costs to activities and the intermediate assignments between activity based on the questionnaire results. For example, 20% of the corporate administrative cost was driven to the advanced engineering activity.

Once selling and administrative costs were captured by activity, the next step was to drive activity costs to the various product lines using activity drivers. The questionnaire results indicated that the number of bookings and customers had a strong effect on activity costs, regardless of the dollar value of the bookings.

The last column in Exhibit 1 shows how the drivers are employed, and the revised section of Exhibit 2 shows the resulting income statement. Using activity-based costing, the monthly operating income of the standard robotic product line increased by almost $150,000, validating management's concerns about the old allocation method. Although management realized that the existing income statement provided erroneous data, the magnitude of the problem was greater than they anticipated.

This kind of information facilitates strategic decision-making about product line emphasis. It also shows that activity-based costing is as helpful in the administrative and marketing areas as in the manufacturing area. *

David Bukovinsky, CPA, Hans Sprohge, CPA, and John Talbott, CMA, are professors at Wright State University, Dayton, Ohio.

James L. Craig, Jr., CPA
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