a) When is the method used and what information does it provide
managers?
Solution:
The fundamental advantage of using an ABC system is to more
precisely determine how overhead is used. Once you have an ABC
system, you can obtain better information about the following
issues:
- Activity costs. ABC is designed to track the cost of
activities, so you can use it to see if activity costs are in line
with industry standards. If not, ABC is an excellent feedback tool
for measuring the ongoing cost of specific services as management
focuses on cost reduction.
- Customer profitability. Though most of the costs
incurred for individual customers are simply product costs, there
is also an overhead component, such as unusually high customer
service levels, product return handling, and cooperative marketing
agreements. An ABC system can sort through these additional
overhead costs and help you determine which customers are actually
earning you a reasonable profit. This analysis may result in some
unprofitable customers being turned away, or more emphasis being
placed on those customers who are earning the company its largest
profits.
- Distribution cost. The typical company uses a variety
of distribution channels to sell its products, such as retail,
Internet, distributors, and mail order catalogs. Most of the
structural cost of maintaining a distribution channel is overhead,
so if you can make a reasonable determination of which distribution
channels are using overhead, you can make decisions to alter how
distribution channels are used, or even to drop unprofitable
channels.
- Make or buy. ABC provides a comprehensive view of
every cost associated with the in-house manufacture of a product,
so that you can see precisely which costs will be eliminated if an
item is outsourced, versus which costs will remain.
- Margins. With proper overhead allocation from an ABC
system, you can determine the margins of various products, product
lines, and entire subsidiaries. This can be quite useful for
determining where to position company resources to earn the largest
margins.
- Minimum price. Product pricing is really based on the
price that the market will bear, but the marketing manager should
know what the cost of the product is, in order to avoid selling a
product that will lose a company money on every sale. ABC is very
good for determining which overhead costs should be included in
this minimum cost, depending upon the circumstances under which
products are being sold.
- Production facility cost. It is usually quite easy to
segregate overhead costs at the plant-wide level, so you can
compare the costs of production between different facilities.
Clearly, there are many valuable uses for the information
provided by an ABC system. However, this information will only be
available if you design the system to provide the specific set of
data needed for each decision. If you install a generic ABC system
and then use it for the above decisions, you may find that it does
not provide the information that you need. Ultimately, the design
of the system is determined by a cost-benefit analysis of which
decisions you want it to assist with, and whether the cost of the
system is worth the benefit of the resulting information.
b) Explain the benefits of using this method versus traditional
costing methods.
Activity-based costing is more accurate because it takes
important factors into account before assigning a cost to a
product. However, for this same reason, it is a bit more
complicated and time-consuming. It’s also more thorough and
considers nonmanufacturing expenses as well, such as administrative
and managerial costs.
Traditional costing is a much easier way of determining the cost
of a product, since it relies solely on assigning average overhead
rates. This also means it won’t always be as accurate, because it
doesn’t factor in nonmanufacturing expenses or determine which
overhead costs actually affect specific products.
A simple example of these costing methods can be demonstrated
with the costs of living in an apartment with roommates. Two
roommates in an apartment will typically split the costs of rent,
utilities and groceries, and they have a couple of options for
doing so. They could simply total the cost of all of the bills and
divide it exactly in two. This would be similar to traditional
costing.
The roommates also have the option of determining who uses
specific utilities and paying only for what each one uses. They can
then create an itemized bill for each roommate. For example, if one
roommate doesn’t use the internet and the other doesn’t use cable,
they won’t have to pay those parts of the bill. This method is
similar to activity-based costing.
c) Explain some disadvantages of using this method.
Many companies initiate ABC projects with the best of
intentions, only to see a very high proportion of the projects
either fail or eventually lapse into disuse. There are several
reasons for these issues, which are:
- Cost pool volume. The advantage of an ABC system is
the high quality of information that it produces, but this comes at
the cost of using a large number of cost pools – and the more cost
pools there are, the greater the cost of managing the system. To
reduce this cost, run an ongoing analysis of the cost to maintain
each cost pool, in comparison to the utility of the resulting
information. Doing so should keep the number of cost pools down to
manageable proportions.
- Installation time. ABC systems are notoriously
difficult to install, with multi-year installations being the norm
when a company attempts to install it across all product lines and
facilities. For such comprehensive installations, it is difficult
to maintain a high level of management and budgetary support as the
months roll by without installation being completed. Success rates
are much higher for smaller, more targeted ABC installations.
- Multi-department data sources. An ABC system may
require data input from multiple departments, and each of those
departments may have greater priorities than the ABC system. Thus,
the larger the number of departments involved in the system, the
greater the risk that data inputs will fail over time. This problem
can be avoided by designing the system to only need information
from the most supportive managers.
- Project basis. Many ABC projects are authorized on a
project basis, so that information is only collected once; the
information is useful for a company’s current operational
situation, and it gradually declines in usefulness as the
operational structure changes over time. Management may not
authorize funding for additional ABC projects later on, so ABC
tends to be “done” once and then discarded. To mitigate this issue,
build as much of the ABC data collection structure into the
existing accounting system, so that the cost of these projects is
reduced; at a lower cost, it is more likely that additional ABC
projects will be authorized in the future.
- Reporting of unused time. When a company asks its
employees to report on the time spent on various activities, they
have a strong tendency to make sure that the reported amounts equal
100% of their time. However, there is a large amount of slack time
in anyone’s work day that may involve breaks, administrative
meetings, playing games on the Internet, and so forth. Employees
usually mask these activities by apportioning more time to other
activities. These inflated numbers represent misallocations of
costs in the ABC system, sometimes by quite substantial
amounts.
- Separate data set. An ABC system rarely can be
constructed to pull all of the information it needs directly from
the general ledger. Instead, it requires a separate database that
pulls in information from several sources, only one of which is
existing general ledger accounts. It can be quite difficult to
maintain this extra database, since it calls for significant extra
staff time for which there may not be an adequate budget. The best
work-around is to design the system to require the minimum amount
of additional information other than that which is already
available in the general ledger.
- Targeted usage. The benefits of ABC are most apparent
when cost accounting information is difficult to discern, due to
the presence of multiple product lines, machines being used for the
production of many products, numerous machine setups, and so forth
– in other words, in complex production environments. If a company
does not operate in such an environment, then it may spend a great
deal of money on an ABC installation, only to find that the
resulting information is not overly valuable.
The broad range of issues noted here should make it clear that
ABC tends to follow a bumpy path in many organizations, with a
tendency for its usefulness to decline over time. Of the problem
mitigation suggestions noted here, the key point is to construct a
highly targeted ABC system that produces the most critical
information at a reasonable cost. If that system takes root in your
company, then consider a gradual expansion, during which you only
expand further if there is a clear and demonstrable benefit in
doing so. The worst thing you can do is to install a large and
comprehensive ABC system, since it is expensive, meets with the
most resistance, and is the most likely to fail over the long
term.