Activity-based costing is useful in arriving at more realistic product cost information for financial reporting. However, it can also be used to help control costs in all areas of a business. The authors explain the basic premise, give an example of how it works, and show how it can be used to help managers develop successful strategies in running the business.

Cost information is good within the bounds of an accounting system, but for running the business it's of little value." Anonymous plant general manager.

Product costs are routinely calculated for inventory valuation, a critical element of externally published financial statements. While required for GAAP financial reporting, such information is of limited use to managers who run the business. Running the business means making important decisions such as product mix, product pricing, and product emphasis. Activity-based costing (ABC) provides managers with useful product cost information for making these decisions.

ABC is a product-costing method radically different from traditional volume-based approaches. ABC is essentially forward-looking, while traditional product costing is historically oriented. Traditional product-cost information is useful in answering the question, "How well was the firm managed in the past?" In contrast, ABC concepts are useful to managers in answering the question, "What strategies shall we pursue in the future?"

ABC concepts can be useful in planning and controlling costs in all areas of the firm, including those related to product design, marketing, and distribution, ABC also provides insights into the strategic linkages that exist between different cost areas in the firm. Figure 1 shows that total product cost is the sum of all costs incurred in manufacturing and selling a product. Managing costs across the firm means managing the costs incurred before the product is manufactured (upstream costs), while the product is manufactured (manufacturing costs), and after the product is manufactured (downstream costs). Product costs calculated for financial statement purposes are often irrelevant for internal management decision making because they are based upon incorrect assumptions about what is driving, or determining, product cost. A common and often incorrect assumption is that production volume is the major cost driver.

Manufacturing Costs

Consider first the cost of manufacturing a product. Total manufacturing cost is the sum of the cost of materials, labor, and applied overhead. If manufacturing overhead were a negligible portion of total product cost, misapplication of manufacturing overhead would not be a concern. However, in a business environment characterized by high technology manufacturing, overhead cost is a large percentage of total manufacturing cost. A 1985 survey of American manufacturers found overhead costs average 35% of production costs. While overhead as a percentage of total manufacturing costs has steadily increased, the percentage of direct labor content has decreased.

In many instances, total manufacturing overhead cost may be driven by the number of activities associated with a product, rather than the number of units of product produced. To illustrate, suppose a firm manufactures two similar products. One of the products is composed of ten distinct components, the other is composed of two hundred distinct components. Each component must be accounted for when it arrives and must be inspected before assembling the product. The product composed of two hundred distinct components will require more receiving and inspection activity and cost than the product composed of only ten distinct components.

Measuring product cost in an environment characterized by high overhead cost and non-volume related cost drivers means the accountant will not be able to use a traditional product cost system applying overhead based on production volume to accurately capture product cost. In breaking with this tradition, the accountant working in a modern manufacturing environment must think about product costing in an entirely new way.

A hypothetical company that manufactures circuit boards, Circuit Board Manufacturer, is useful in illustrating how ABC can serve as a management tool within each of the three cost areas (upstream, manufacturing, and downstream).

Circuit Board Manufacturer

Circuit Board Manufacturer (CBM) manufactures printed circuit boards used in personal computers. Production is organized as a simple batch process. Boards are manufactured to meet specific customer orders or to build inventory. Two different types of printed circuit boards are manufactured, referred to as Model I and Model II. Model I is a very simple board while Model II is a more complex board which is more difficult to make. CBM manufactures and sells about 20,000 Model I boards and 4,000 Model II boards each year.

The production process for Model I and Model II boards involves attaching various electrical components to a raw circuit board. A single printed circuit board assembly line produces the two different types of board. Most of the electrical components are axial-lead components, such as resistors and diodes. Some of the electrical components can be automatically inserted by machines, while the rest must be attached manually. CBM purchases raw boards and electrical components from about 75 different electronics manufacturers.

FIGURE2

CIRCUITBOARDPRODUCTIONINFORMATION

TotalNumberofNumberofNumberof

BoardProductionRunsOrdersUnits/Order

I20,000445,000

II4,0001010400

ProductionvolumeforBoardIisfivetimesasgreatasproductionvolumefor

BoardII.However,BoardIIhasmorethantwiceasmanyrunsandseparate

orders(andthereforedeliveries)asBoardI.

The production process is highly automated; there is no separate direct labor cost category. The sequence of production steps is the same for both boards:

1. Automatic insertion of components into raw circuit boards, using sophisticated automatic equipment.

2. Hand insertion of components that require special preparation.

3. Soldering of components to boards.

4. Hand attachment of components that cannot withstand soldering.

5. Final testing.

Basic production data are provided in Figure 2. The steady demand level for Model I boards and the sporadic demand for Model II boards explains why there are four runs of five thousand boards each for the Model I board and ten runs of four hundred boards each for the Model II board. Since the setup time per run is five hours, 20 hours of setup time are required for the Model I boards each year as compared to 50 hours required for the Model II boards. Compared with Model II, Model I is a simple board with few components, part numbers, and slots. The Model I board also requires fewer engineering change orders than the Model II board. Engineering change orders occur when purchasers of the board demand changes in the design of the board. Since the boards are used in personal computers, an engineering change order is initiated when the computer manufacturer redesigns the product.

The direct materials needed for manufacturing Model I boards arrive in just a few separate shipments each year. On the other hand, due to its irregular production, many small shipments of the direct materials required for Model II boards arrive frequently at CBM.

Calculating Manufacturing Cost Using Traditional Costing

Gale Newell, the CBM controller, is very concerned about accurate product costing. As chief accounting officer, his primary concern is with external financial reporting, although he is also responsible for preparing internal cost accounting reports. Newell has assembled the budgeted cost information shown in Figure 3. The cost of raw materials for the Model I and Model II boards is $60.00 and $25.00, respectively. Since direct labor content is negligible, it is included in overhead and not accounted for separately. Total manufacturing overhead is budgeted to be $2,089,750 annually. Overhead costs consist of engineering cost, receiving and inspection cost, quality assurance cost, setup cost, and other indirect manufacturing cost. Engineering cost refers to the cost of engineering change orders. Receiving and inspection cost is the cost of receiving and inspecting the incoming direct materials needed for the manufacture of Models I and II. Quality assurance cost refers to the cost of testing the completed Model I and Model II boards before they are shipped to customers. Setup cost is the cost of preparing the production line for a run of a particular model of the board. Other indirect manufacturing cost refers to other indirect costs of manufacturing the boards such as machining, insurance, depreciation, and miscellaneous manufacturing salaries.

FIGURE3

TRADITIONALVOLUME-BASEDCOSTINFORMATION

TraditionalCostSystem

ModelI

Directmaterials$60.00

Manufacturingoverhead1MH*$74.6374.63

$134.63

ModelII

Directmaterials$25.00

Manufacturingoverhead2MH*$74.63149.26

$174.26

ManufacturingOverheadAppliedontheBasisofMachineHours

Engineeringcost$800,000

Receivingandinspectioncost250,000

Qualityassurancecost450,000

Setupcost(5hoursperrun)($25.00perhour)

(14runs)1,750

Otherindirectmanufacturingcost588,000

Totalmanufacturingoverhead$2,089,750

$2,089,750/28,000machinehours=$74.63/MH

Newell decided the most appropriate basis for overhead application was machine hours. He estimated the total number of machine hours for the coming year would be 28,000. Thus, the manufacturing overhead application rate computes to $74.63 per machine hour. Using this rate, Newell derived the estimated costs of $134.63 for the Model I and $174.26 for the Model II shown in Figure 3. Calculating Manufacturing Cost Using Activity-Based Costing

Newell suspected these product costs used for external financial reporting purposes were not useful for internal management decision making. He came to this conclusion when he discovered the Model I product manager had developed an informal "back of the envelope" product costing system for the boards. The manager told Newell the traditional volume-based product costing system did not capture the economic reality associated with manufacturing the two boards. She didn't believe the Model II board only cost $39.63 more to manufacture than the Model I board. The Model II board was much more difficult to manufacture and had to cost much more than $174.26.

Newell thought the Model I product manager might be correct. He began to think about other ways of calculating the cost of manufacturing the boards. Newell had heard of activity-based costing, and used ABe concepts to derive a cost for each of the two circuit board models.

After extensive interviews and careful analysis of each department's records, Newell compiled the information presented in Figure 4. Eighty percent of the engineering change orders were associated with the Model II boards, because the customers for Model II boards frequently redesigned their computers. About 60% of receiving and inspection costs were associated with Model II, due to the complexity and number of components in Model II boards. Receiving and inspection costs are affected by the frequent small deliveries of components used in Model II boards. Further, about 65% of total quality assurance costs were associated with Model II, again due to the complexity of the board and the relatively large number of parts to be inserted into it.

With respect to "Other Indirect Manufacturing Costs," Newell decided to allocate them on a machine-hour basis since machine hours did drive these costs. Thus, the product costs shown in Figure 5 are applied to the boards both on an activity basis and on a machine-hour basis. The key issue in developing the information presented in Figure 5 is to first determine what is driving specific costs, and then allocate these costs to specific products in a manner consistent with true cost driver behavior.

Figure 6 presents the revised product costs using ABC information. The cost of the Model I board is $101.91, and the cost of the Model II board is $337.94. The traditional volume-based cost system had overcosted the Model I board ($134.63 versus $101.91) and undercosted the Model II board ($174.26 versus $337.94). Traditional volume-based product costing systems typically undercost low volume products and overcost high volume products because high volume products tend to absorb more than the proper amount of manufacturing overhead, while low volume products absorb too little manufacturing overhead.

Strategic Implications

ABC's usefulness extends beyond the manufacturing area. Specifically, ABC concepts can be the basis for a cost management system to help managers develop successful strategies. In applying ABC concepts in strategy development, the fundamental issue is that activities rather than production volume may drive costs. ABC concepts can help managers at all levels of the firm make decisions about product design, materials sourcing, product pricing, product emphasis, and marketing and distribution strategy.

FIGURE4

BREAKDOWNOFACTIVITIESGENERATEDBYEACHPRODUCT

ActivitiesModelIModelII

Engineeringcosts

(Totalcost,$800,00)20%80%

Receivingandinspection

(Totalcost,$250,000)40%60%

Qualityassurance

(Totalcost,$450,000)35%65%

Setupcost

(Totalcost,$1,750)29%71%

Machinehoursperboard1hour2hours

Product Design. Products difficult to make are more costly to make because they require more overhead support activities. Top management should encourage designers to design boards which can be easily manufactured. For example, reducing the number of components needed for each board will lead to savings in receiving and inspection costs and quality assurance costs. Similarly, fewer components per board might mean lower quality assurance costs because there are fewer components to test.

Designers should also design boards so that as many components as possible can be inserted automatically. This means the designers must not put parts too close together or to the edge of the board. Designing the board so the maximum number of parts can be inserted automatically means manufacturing the boards as simply as possible. The circuit board designers at CBM should focus not just on controlling the costs of raw materials used in the boards. Rather, the designers should attempt to minimize all costs associated with manufacturing the board. Materials Sourcing. One way to minimize the costs of inspections is to shift the responsibility for direct materials inspection to the supplier. Instead of performing incoming inspection tasks, CBM might require a supplier to inspect the raw circuit boards and components before the supplier ships the items to CBM. CBM management could stipulate they will deal only with suppliers who will inspect their products prior to shipment to CBM and guarantee inspection quality will equal or surpass CBM inspection quality. Why would a supplier agree to such an arrangement? CBM might have to assure the supplier of a long-term contract. CBM should also consider reducing the number of suppliers of direct materials. It is easier and less costly for CBM to deal with fewer suppliers because there are fewer delivery trucks backing up to the dock, fewer salespeople to deal with, and less paperwork. To reduce the number of direct-materials suppliers, CBM may have to pay more for certain items. However, this additional cost must be weighed against the benefits of being able to do business with fewer suppliers. Again, the emphasis is on minimizing the sum of all product costs. Product Pricing and Product Emphasis. Consider the following scenario: CBM management has been trying to raise the price charged for Model I boards, but with little success. CBM currently charges customers $160 for each Model I board, and wants to increase this price to $180 per board. Based on the cost information provided by the traditional volume-based cost system, the $180 price is not unreasonable. However, customers complained loudly and threatened to purchase a similar board from a competitor who offered the board for $163. How could the competitor sell the board at such a low price? The ABC information suggests CBM was overcosting and overpricing the Model I board. A competitor, with more accurate product cost information, might realize a profit could be made even if the Model I type board were sold for $163. CBM management successfully increased the price for the Model II board without losing any customers. CBM management was amazed that these customers did not complain about the price increases, nor did they switch suppliers. Instead, they accepted one CBM price increase after another. CBM currently sold the Model II for $290.00. No competition appeared for the Model II customers. CBM management thought they were providing customers with superb value, and in fact they were: CBM was selling Model II boards at a price below cost.

The activity-based cost information provides insight into product pricing and product emphasis strategies. CBM may be able to lower prices on Model I boards and gain market share. Further, CBM must either raise the price of the Model II board or stop selling them altogether. Currently, CBM loses money with each sale of a Model II board. Product emphasis strategies cannot be developed until the Model I price is lowered and the Model II price raised. Once these prices are adjusted, it can then be determined what prices the market will bear and which model provides the greatest profit margin.

FIGURE5

BREAKDOWNOFMANUFACTURINGOVERHEADCOSTS

DirectMaterials

ModelI$60.00

ModelII25.00

EngineeringCosts

ModelI($800,000*20%)/20,000$8.00

ModelII($800,000*80%)/4,000160.00

ReceivingandInspectionCosts

ModelI($250,000*40%)/20,000$5.00

ModelII($250,000*60%)/4,00037.50

QualityAssuranceCosts:

ModelI($450,000*35%)/20,000$7.88

ModelII($450,000*65%)/4,00073.13

SetupCosts

ModelI

(5hours/run)($25.00/hour)(4runs)/20,000boards$.025/board

ModelII

(5hours/run)($25.00/hour)(10runs)/4,000boards$.313/board

BudgetedManufacturingOverhead

Totalmachinehoursperyear

ModelI20,000boards*1hour/board20,000hours

ModelII4,000boards*2hours/board8,000hours

Totalmachinehours28,000

BudgetedIndirectManufacturingCost$588,000

$588,000/28,000machinehours=$21.00

ModelI1hour/run*$21.00/hour$21.00

ModelII2hours/run*$21.00/hour$42.00

Marketing and Distribution. Marketing and distribution costs are often substantial for firms serving U.S. markets. In fact, marketing and distribution costs may be equal to or greater than 50% of total product cost. Although these costs are substantial, little effort is expended to understand and control them. Rather, managers have historically attempted only to understand and control manufacturing costs. An ABC system can lead to more efficient management of the cost of marketing and distribution activities. To illustrate, consider again the 20,000 units of Model I and the 4,000 units of Model II CBM sells each year. Model I units are distributed in four orders of 5,000 units and Model II units are distributed over ten orders of 400 units each. If sales volume is the most important driver of distribution costs, the 20,000 units of Model I should generate more distribution costs than the 5,000 units of Model II. We suspect this is not the case. Rather, it is the distribution activity that drives distribution cost. That is, the number of orders is a more important cost driver than the sales volume.

Therefore, in setting a price for a particular customer, management must consider not only the number of units the customer will purchase, but also the number of deliveries the customer requires. ABC considerations are especially important if CBM sells to a customer who is switching over to a just-in-time (JIT) inventory system. Under such a JIT system, the customer might require suppliers to make frequent deliveries of a very small number of boards. In fact, supplying a JIT firm may mean the supplier is required to make daily deliveries. When CBM management applies ABC concepts, they may find the total cost of selling to a customer with a JIT inventory system exceeds the revenues from selling the product to that customer. This new awareness of the real benefit or cost to the company of producing Model II boards may lead management to consider renegotiating prices with customers or "firing" customers not willing or able to cooperate to reach a mutually beneficial agreement about how the product is distributed.

FIGURE6

REVISEDPRODUCTCOSTSUSINGABCINFORMATION

ModelI

Directmaterials$60.00

Engineering8.00

Receivingandinspection5.00

Qualityassurance7.88

Setup.03

Budgetedindirectmanufacturingcosts21.00

TotalCost$101.91

ModelII

Directmaterials$25.00

Engineering160.00

Receivingandinspection37.50

Qualityassurance73.13

Setup.31

Budgetedindirectmanufacturingcosts42.00

TotalCost$337.94

ABC: Forward-Looking Product-Costing Method

ABC represents an evolution of the way we think about product costing in at least two ways. First, ABC provides insights which are useful in understanding and controlling costs incurred across all cost areas in a firm, not just costs incurred in the manufacturing area. That is, ABC allows managers to take a more holistic approach to cost management. Second, ABC provides cost information which is useful in "running the business." This means managers now have at their disposal a new and useful tool to use against foreign and domestic competitors in an increasingly complex and high-tech world.

Jack M. Ruhl, PhD, is an assistant professor of accounting at Western Michigan University. Dr. Ruhl is a frequent contributor to professional journals and authored "Providing Advisory Services to Funeral Directors" in the March 1993 issue of The CPA Journal. Trina A. Bailey is a doctoral student in accounting at Louisiana State University.