Activity Based Costing Overview

Dave Packard Chairmen of Hewlett-Packard said				hundreds of cost drivers. There is howÂever,
"Tell me how a person is measured and I'll tell you				a diminishing return. Data collection costs usually
how they will perform."				increase faster than the benefit gained by the
Business Metrics are tailored performance				improved precision of the allocation. Some
measures that promote the strategic goals and				companies in Europe have as many as 50 -
objectives of the organizaÂtion.				150cost drivers. In the United States
The spectrum of business measurements spans a				approximately 6-25is more common. Europe has
wide variety of management methods. Traditional				been using ABC longer than the U.S.; this may
financial measures, such as Work in Process (WIP)				account for the wide difference in the number of
and piece rates, are rapidly being replaced by time				cost drivers.
based measures, like Raw and In-Process (RIP)				"Firms facing intense competition and having both
and rate based planning.				high product diversity and low measurement cost
As competition and the internal search for				are best suited to taking advantage of the
improved performance becomes more critical, the				increased accuracy of an activity-based costing
development of time-based measures has				system." Robin Cooper, Harvard Business School
become a cornerstone of the World Class				By prioritizing the Overhead costs you can focus
Manufacturing paradigm.				on those with the biggest potential for causing the
There are several recent business measurement				product cost to be inaccurate. As with all projects
innovations that this series of articles will cover.				of this nature a multiÂfunctional team is
We begin this series with "What is Activity Based				required to effectively cover the wide variety of
Costing (ABC)".				business activities related to product costs.
Traditional cost accounting systems measure the				Cost drivers should be developed for those
cost of a product by spreading all of the				activities that contribute to product cost on both
overhead costs over the direct labor costs based				a volume and volume inÂdependent basis. For
on production volumes.				example a set-up would be volume independent if
For example:				the order quantity was changed. Warehouse
Product A takes 3 hours/unit of DL				activity, on the other hand, is directly related to
Product B takes 7 hours/unit of DL				the volume of product being handled.
DL = Direct Labor				Chapter 4 of MEASURING UP by Hall, Johnson,
If quantity one of each is produced:				and Turney provides a good basic understanding
Product A receives 30% of overhead Product B				of ABC. This book is available from Amazon:
receives 70% of overhead				Measuring UP
Therefore if Total overhead cost was $100 and				For more information on the current evolution of
the labor rate was $10/hour, then the costs				ABC see the Robert Kaplan article from the
would be:				Harvard Business Review:
Product A (3* 10) + (.3* 100) =30+ 30= $ 60/unit				Automating ABC
Product B (7* 10) + (.7* 100) =70+ 70= $140				The EasyABCPlus (TM) program is divided into
unit				three major areas. The first is overhead; here
ARRIVING AT THE CORRECT PRODUCT COST				your company General Ledger can be entered.
Under Activity Based Costing the concept of cost				This can be done either by typing in the
drivers is developed to clearly define which costs				Overhead Accounts, or by reading a file from
are associated with each product. An example of				your accounting package, or a spreadsheet. The
a cost driver might be the number of parts in a				second area is activities; this module is the core
product, or the number of set-ups needed to				of the system. It defines the Cost Drivers and
produce the product, or the number of change				the allocation methods from the Overhead
orders after release to production.				module to the third area, Cost Objects. In the
To clarify the above example:				Cost Object area the actual products to be
Product A requires 45 component parts Product				costed are linked to the activities used to produce
B requires 5 component parts				them.
Each part is purchased from a separate vendor.				Let's review each module in a little more detail.
The cost to generate a Purchase order is $70. If				Within the overhead module you can see the
we assume that we issue purchase orders and				structure of the accounts, with actual and budget
receive and pay for material once per month the				amounts for each. There is also a block map
costs of the products would be:				showing where you are in the system. As you
Product A (45 parts x $70) = $3150				move from module to module the three boxes
Product B ( 5 parts x $70) = $ 350				are highlighted to show where you are in the
Total Purchasing cost= $3500				program. There are also three icons or graphic
Under the traditional cost allocation procedures the				symbols that represent different views of the
$3500 purchasing overhead would be divided as				data. The icons are available in all three modules.
follows:				They are: Decomposition, Allocation and Tabular.
Product A: $3500 x .3 = $1050				Each presents the information in that module using
Product B: $3500 x .7 = $2450				the same data, but with a different perspective.
As you can see the purchasing cost of the				Data entry in the modules is primarily via menus
products are significantly different using the				selected using a mouse. A mouse is a small device
traditional cost accounting method.				attached to your PC that moves the cursor on
Developing a Simple ABC system.				the screen. Clicking a mouse button activates the
To begin we must start with a few new				function that the cursor is covering.
definitions. OverÂhead Activities are divided				An example of data for the Overhead Module
into Cost Pools. An example of a cost pool would				would be:
be the Sales Department. Cost pools contain cost				Sales Department with a cost center Product
elements. An example of an overhead cost				Support.
element would be order processing.				The Activity Module contains the cost drivers and
Once the overhead cost pools are established,				other resources used by the product. A typical
Activity Cost Pools are developed. An example				structure might include a Support Activities group.
would be product support which is volume				This could have within it activities such as Testing,
dependent. Activity Cost Pools, known as Cost				Engineering Support, and Phone Support.
drivers, contain cost elements also. An example				The Product Support cost center is linked to the
of an Activity Cost element would be product				Testing, Engineering and Phone Support Activities.
test.				This means that a structure similar to a bill of
Finally, there are Product Cost Objects. An				material is created. The allocation methods are by
example of a product cost object is a product				percentage or cost driver. The allocation method
line. Product Cost Objects also contain cost				is comparable to the quantity per in a bill of
elements. An example of a Product Cost element				material.
would be a specific product within the product line.				The Cost Object module is where the products
Hewlett-Packard's Roseville Division manufactured				are defined. After entering Product A and Product
printed circuit boards. They implemented ABC as				B, we select which Activities and how much of
part of a Total Quality Control (TQC) project that				each activity is used by each product. The
focused on Design for Manufacturability. The new				Activities such as Testing might be the number of
costing data allowed design engineers to make				Test hours, Engineering Support is the number of
more effective cost tradeoffs which reduced the				Engineering Change Orders, and Phone Support is
total cost to manufacture new products. Roseville				measÂured by the number of phone calls.
developed 12 cost pools that impacted product				We are now ready to run the model. The model
cost. In Purchasing, the cost drivers are the				can be run for any number of periods. It can also
number of active parts and the complexity of the				be run by module to observe the effect of
part. In the ProducÂt Planning and Production				changes at each level. To see the results click on
Engineering areas, the cost driver is the number				the icon in front of the product. This brings up a
of assemblies in the product. In printed circuit				screen that shows the actual cost and budget of
board loading areas the cost driver is the number				each of the activities used.
of insertions, an insertion being a component that				The Attribute Costing report summarizes the
is soldered to a printed circuit board. The Support				costs of all value added and non-value added
cost pool is sub-divided into several smaller				activities. This is especially useful in Lean process
groups, such as Test Engineering and IT. The cost				improvement programs.
driver for Support is % of Usage.				On-line help is available for each area in the
In the traditional accounting system only one				system.
measure is used to allocate overhead costs,				This completes the Activity Based Costing
Direct Labor Hours. Using ABC we can create				overview.

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Activity Based Costing Overview

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