March 2002

Selling Activity-Based Costing

By John C. Lere

Activity-based costing (ABC) won’t improve a company’s financial reporting. It probably won’t save money on taxes, either. It will, however, facilitate decision making in operations. To sell a company and staff on ABC, the focus must be on convincing operating managers of the benefits to them from the “new” information ABC will provide.

ABC as Cost Behavior

For cost data to facilitate decision making, the costs must be linked to levers that managers can adjust. Cost data needs to reflect how alternatives affect the level of various costs. ABC is frequently presented as product costing or cost allocation. If ABC is to facilitate decision making, it should also be presented in terms of cost behavior.

Cost behavior traditionally classifies costs as either variable—that is, varying in direct proportion with some measure of volume such as units produced, direct labor hours worked, machine hours worked, or dollar sales—or “fixed”—that is, everything else.

In the ABC literature, costs are classified as varying at the unit, batch, or product level. Costs that don’t vary at any of these levels are facility-level costs. The activity that causes a cost to change, or the measure with which it varies, is called its cost driver.

Unit-level costs vary with unit volume and are very similar to traditional variable costs. An important insight from the ABC literature is that there are two other categories of costs that vary, though not with unit volume. Batch-level costs do not vary by number of units, but rather by how these units are grouped. For example, once a machine is set up for a production run, no additional costs are incurred until the machine needs to be reset. Product-level costs are incurred to benefit all units of a type. For example, once a product’s design is complete, no additional costs are incurred, regardless of the volume of units or number of batches. Additional product design costs will only be incurred if the design is changed.

The recognition that costs also vary at the batch and product levels allows ABC to facilitate decision making. Traditionally, costs that vary at the batch and product levels would be considered fixed; therefore, estimates would not change when managers change the level of a cost driver. Ignoring changes at the batch and product levels, of course, means cost estimates provided to an operating manager may understate the cost of certain alternatives.

For example, consider the case of a sales representative for Custom Parts International who is determining whether to focus significant sales promotion resources on XYZ Products or DEF Graphics. Both customers have similar purchase histories. The difference is that XYZ Products demands weekly deliveries whereas DEF Graphics requires quarterly deliveries. Custom Parts does not have enough space to store large quantities of the part supplied to the customers. As a result, a batch of the part is produced each time a delivery is to be made. Each batch requires a machine setup. Because setup costs are batch-level costs, traditional cost behavior estimates that the cost to service these customers is the same. ABC does, however, recognize the batch-level setup costs. Custom Parts’ accountants estimate that the cost to set up a machine is $400. Therefore, the annual cost of servicing DEF Graphics entails setup costs of $1,600, whereas the annual cost of servicing XYZ Products entails setup costs of $20,800. Knowing this discrepancy may cause the sales representative to focus more sales effort on DEF Graphics than on XYZ Products.

Operational Examples

Production managers. Among the operating decisions faced by production managers are plant layout decisions and production scheduling decisions.
One consideration in plant layout decisions is the flow of units through the plant. Moving units around the plant (e.g., by loading pallets onto a lift truck) results in batch-level activities and costs. The cost of moving a group has less to do with the number of units in the group than with the distance it is moved. ABC will provide cost estimates reflecting the differences in the cost of moving units around different plant layouts while estimates based on traditional cost behavior will not.

In production scheduling, the cost to set up machines can be significant. For example, setting up a printing press requires preparing a printing plate, attaching it to the press, and running proofs to assure the plate is properly positioned and inked. ABC, unlike traditional cost behavior, provides estimates so that appropriate trade-offs between competing production schedules can be made.

Product designers. Although many product design decisions involve trade-offs among unit-level costs (e.g., attaching a case to the unit using screws or tabs), others affect batch- and product-level activities and their associated costs.

For example, the choice between using a part common to other products or using a unique part involves product-level activities. Adding a new part to existing operations requires product-level activities such as adjusting stock space to accommodate the new part, modifying computer systems for a new SKU for the new part, and modifying stock pickers’ routines.

The choice to use a unique part will also require additional ordering and receiving activities, which are usually batch-level activities. If a common part is used, quantities to be used in the new product can be ordered and received at the same time as quantities for existing products.

Supply managers. Batch- and product-level costs similar to those discussed under product design decisions are also important to supply managers as they select among alternative suppliers and delivery schedules. For example, purchasing a part from a new supplier, as opposed to an existing supplier, may require new stocking space, a new SKU, and new picking patterns for stock pickers. As discussed above, these activities all give rise to product-level costs. Adding a new supplier will also require changes in the accounting system to recognize the new supplier and arrange credit terms.

Selecting a new supplier will also increase the volume of ordering and receiving activities and their related batch-level costs not considered by traditional methods. The costs of receiving activities will also often be important in the choice among delivery schedules.

Sales representatives. Sales representatives must often decide which of several customers to focus sales efforts on, which price adjustments to work toward with a customer, and even which customers to cease serving. Activities undertaken to service a customer are often at the batch or product level. As a result, a customer who appears profitable based on traditional cost behavior estimates may actually add nothing to, or even reduce, the company’s bottom line.

A major portion of batch-level activities undertaken to service a customer relate to the number of delivery batches into which the customer divides an order. If each batch must be produced in a unique production run, manufacturing activities (such as machine setup) will be required to produce each batch. If, instead, the item is kept in stock, supply management activities (e.g., stock picking from the warehouse) must be performed for each batch.

If servicing a customer requires unique product modifications, designing and initiating those modifications requires product-level activities. Developing product tests to meet unique customer specifications is another product-level activity that may differ significantly from customer to customer.

Not only does ABC explicitly recognize that costs are associated with these activities, it also provides guidance as to how prices should be affected. For example, ABC can provide an estimate of the cost of making multiple deliveries when prices are negotiated with a customer who requires this.

Marketing managers. Marketing managers must evaluate the performance of sales representatives for the purposes of compensation, bonuses, or perhaps termination.

Because sales representatives often negotiate all terms of a sale, price and volume are not the only measures marketing managers may find relevant in evaluating sales performance. Many of the same costs that facilitate customer performance evaluation are also important to consider in evaluating sales representative performance.

For example, the sales representative may negotiate the number of locations to which an order is delivered or the amount of training provided to a customer’s employees. As discussed above, traditional costing methods will yield performance evaluation measures that suggest that the cost to service a customer at one location is the same as servicing multiple locations. The cost of customer training is independent of both the number of units sold and the number of batches. Traditional cost behavior estimates will not be affected by different amounts of customer training agreed to by a sales representative. Because ABC recognizes that costs change at the product level, it accommodates cost-based performance measures that do reflect that there is a difference between a sales representative that has agreed to provide 200 hours of training and one that has agreed to 2,000 hours of training.

Winning over Decision Makers

Implementing an accounting transformation like ABC only makes sense if it improves the ability of the organization to function. The impetus for change must come from within the organization.

Within an organization, operating managers stand to benefit the most from ABC. If the costs of major activities involved in a manager’s operations are at the batch or product level, then the cost estimates provided to these managers will often be significantly different, and more accurate, when developed under ABC.

To sell ABC to top management, it must first be sold to the operating managers, who will benefit the most. To sell it to them, one must understand the levers they can adjust and how those levers change costs.

John C. Lere, PhD, is a professor of accounting at St. Cloud State University, St. Cloud, Minn.


Robert H. Colson, PhD, CPA
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