ITS ROLE IN COST MANAGEMENT ACTIVITY BASED COST INFORMATION:

NII-Electronic Library Service The JournaL of Management Acceu]tlng,Japan

Vol. 1,No. 1 Autumn 1992

ACTIVITY BASED COST INFORMATION:

ITS ROLE IN COST MANAGEMENT

Takeo Yoshikawa: John Innes,tand FalconerMitchelli

ABSTRACT

Aetivitybased ^{costing systems emerged} inthe West duringthe mid 1980s

in order to improve product^{costing. However as activity analysis was applied}

to organizations itbecame apparent that the technique had ^a considerably wider potentialthan indicatedby thissingle initialobjective.

This _paper explores a number of other areas within the fieldof cost man- agement towhich ABC has contributed, These comprise the analysis of cost

behavior, customer profitability^{analysis, a,ctivity cost} profiling,budgeting

and cost control and performancemesurement.

While there isdanger in ^viewing ABC ^{as a} panacea ^{which will solve all}

costing problems ^{at a stroke,} itis^{an approach which offers} interesting^and

valuable insightsintohow ^{costs ca[n} be effectively managed.

KEYWORDS

ActibityBasedCosting, CostBehaviors, CostManagement, ^Budgeting,

Performa[nce Measurement

LIntroduction

The effectiveness of'cost management will,toa largeextent, be dependent on the quality

of information^available te those who have^'theresponsibility fbrit.Relevantinfbrmation

should alert those involvedto areas where their attention is^{merited and should} _guide

effectively their subsequent decisions^{and action.} Given itsdirect^relevance to the area, cost accounting has traditionally generated^{a major part of the} infbrmationflowfor^cost

managemant. However, much of ^what we might term conventional cost accounting was

developedinthe late19thand early 20thcenturies within the context of a lesscomplex ^and SubmittedMarch ^1992.

Accepted August 1992.

"Professor of Information Accounting, Department of Accounting and Information, Faculty of Business

Administration, Ybkohama National University.

tProfessor _of Accountancy,Department of Accounting, ihculty of Accountancy and BuisinessFinance, Universityof Dundee

iSenier Lecturer inAccounting, Department of Accounting,Facultyof Accountingand BusinessMethod, Universityof Edinburgh

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Activity Based Cost Information

diverseindustrialsituation (Johnson^{and Kaplan} [17])^and, particularlyinthe West, has beenheavilyinfluencedby theneed to_produce acceptable ^unit costs forinventory valuation

(Kaplan[20]).^{Inrecent years the} limitationsof conventional cost accounting information foreffective cost management inthe contemporary businesssituation havebeen increasingly

recognised (e.g.Shank & Govindarajan [26];^Cooper [6],[7]l^{Cooper & Kaplan} [9]).^This

paper^explores how activity based costing (ABC)^{can helpovercome some of the} indentified limitationsand contribute positively^{to cost managemant} ina modern business context.

2.Initial Development ofABC

The firstreported cases of ABC occurred inlamgeUSA manufacturing concerns producing

extensive product ^ranges (Cooper[7],[8],[10],[ll];^{Innes& Mit¢hell}[13]).^{These firms}

developedABC _primarily as abasis^{forimproving the accuracy of their}product linecestings.

A ^{new costing approach was} deemed ^necessary bythem forthe fo11owingreasons:

(1)^{Theirproduction overheads had grown} significantly as a cost element both in^absolute

^{and relative} terms.

(2)^{The compsiten of theirproduction overheads had gradually changed te reflect costs}

^{which were} drivenby the complexity and diVersityof their operations (e.g,^qual-

ity,scheduling, logistics,fiexibility)rather than merely by the volume of production ^output.

(3)Direct^labourcosts, particulamly^within the electronics sector, had fallenin^size but

^{was still used as a} basisfor^overhead absorption.

These three factorsresulted inmany overhead costs being unitised ina manner which

did not reflect the underlying pattern ^{of resource} consumption. This,combined with the

growing ^relative significance of these costs, meant that fu11product ^{costs were viewed} by

managemerrt with increasingdubiety,

ABC, based ^{on the} premise^{that activities} (e.g.quality^control, maintenace, procure-

ment, handling)^{consume resources and} _products ^consume activities, provided ^a framewerk for^unitising these overheads in^{a more rigorous manner.} First^{a review} is^undertaken to

identifythe major activities undertaken which gave^{rise to overhead cost.} These are clas- sified by the nature of the work contribution which ismade rather than by the fbrmal

organisational or functionalbeundaries.Thus procurement ^{activity can usually} be fbund

within the production, ^stores, adminstrationand financedepartmants as itisan activity which cuts across them all. Second,^costs are indentifiedand pooledfbreach activity. Third,

a cost driverisascertained fbr^{each cost} _pool, Thislatter^stage involved^{selecting a variable}

which reflected the volume of reseurce censumption bythe^activity, For^example, the num-

ber^of _purchase ^orders _processed ^{often represents a resonable cost} driverforprocurement

activity. Dividingthe activity cost poolsby theirrespective cost driversprovids^{a series of}

cost driver rates which could be applied to individualproducts.^The products^{then attract}

a ^{share of} the cost based on the volume ef cost driverattributable toeach of them, In _published cases on ABC, itsapplication inthis way resulted insubstantial revisions of unit costs. In particular,the cost of small volume, customised products, ^which placed

heaMy demands on support activities, rese considerably while the cost of highvolume, long production^run productsfell.Consequentlythe pattern^of preduct Iineprofitiability^was

revised and attention therefore directedon the existing sales mix policies(e,^{g,･Cooper gi}

Kaplan [IO]).

NII-Electronic Library Service The Journalof Management Accounting, Autum 1992

These early cases therefore provided confirmation that ABC ^could, in^{certain circum-}

stances, produce ^very different_product costs from those generated in ^more traditional

ways. Johnson & Kaplan [181^have promoted ^the ABC _{generated product} ^{costs as} _provid- inga measure of the firm'sIongterm vamiable cost. They ^argued thatthisinformation would

provide^{a more} appropriate basisfor^strategic leveldecisions^on the product^{range than} the

conventional variable cost and contribution basedanalysis which treatsall costs not varying with production ^{volume as} fixed.However the^value of unit cost infbrmationhas _proved

to be ^{one of} the areas where ABC has ^attracted most criticism. The ABC approach does

,not^avoid all of the arbitrariness of allocation and apportionment which underlie actual unit product ^costs. Moreover the explanatory power ^of the single cost drivers^attributed

to each activity will illevitablybe limited(Innes^{& Mitchell} [14]).^{Italso remains a system}

designedtoproduce historic'cost information,whereas decision^oriented information^should

rely on thefuture^{revenue and cost} implications^of the decision(Paper^{& Walley} [24]).^The

existence ofjoint processes ^at the level^of the cost pool,^non-zero fixed^{cost and} non-linear cost functions^negate the applicability of ABC _product ^costs inproductdesignand product

mix decisions(Noreen[22]),^{Finallyitisbased on resource} consumption while the financial

aspects of decision^{making should also rely on spellding and cash} flow (Ceoper^{& Kaplan}

[11]),

While the initial_product cost orientation of ABC isnot immune to criticism, its^applica-

tionfbrthispurpose hasledtothe discoverythatitisan approach which offers considerably more to users than simply a revised computation of theirproduct ^costs. Indeedithasbeen

suggested that itisinthe broaderareas of cost management informationthat ABC ^can

make itsmost signficant contribution (Innes^{& Mitchell}[15]).^{This paper explores the}

ways inwhich the ABC appreach has developedinto^a broad based^{novel approach} tothe provision^of informationdesignedto support cost management.

2.1 CostBehaviour

^{Ifcosts are to} be managed effectively they must firstbe understood, This necessitates an appreciatio] of how and why they change, i,^{e,, a} knowlege ^of theirbehavior.ABC has helpedconsiderably inthisareas because (a)^{itdose not accept the} conventional cost ac- counting assumption that a large_portion ^{of overhead$} are simply fixed,and (b)^itrecognises

that volume is^{not a} comprehensive explanator of cost behaviour. Moreover it_provides,

through the use of cost driverdata,^an indication of the key factorwhich influenceseach activity cost pool, Indeed,^when presentingABC based product ^{costs some} firmshave fbund it^usefu1 to organise the cost driversinto a hierarchy of the levelsat which the cost components vary. Cooper & Kaplan [11]^{have formalised thisapproach. Exhibit1 shows}

how _product ^{costs can} be layeredin^respect of thedifferentlevelsat which theirbehaviour

isdetermined.

A ^{similam approach can} be taken inthe analysis of customer related costs (see^Section2

below).Thistype of infbrmationindicatesthe }evel^{at which managerial action} isrequired

in^{erder to}influence^{cost, and} the requiste ^tlever' (cost^{driver)which can be applied inorder}

toeffect policies.Attentionisfbcused^{on a whole range of} factorswhich are critical to cost

incurrence^within the firm.Through disseminationof itsresults the system can motivate and guide ^{cest reduction effbr'ts, and} promote ^{managerial cost} consciousness particula[rlyin theoverhead area. In^addition abasis isprovided formodelling product ^costs ina way whi ¢h

will produce ^{more realistic} predictions ^{and support more effective `what} if'analysis. An ABC basedindicationof average unit costs isprovided,^{but this type of analysis emphasises}

that only a proportion^{of thiscost is}primarilydriven^by units of output and that as one

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The Japanese Association of Management Accounting

The JapaneseAssociation of ManagementAccounting

ActivityBased Cost Inforrnation

Exhibit 1

Layeringof^ProductCosts

Level TlypicalCosts Typical Costs Drivers

Unit Materials,_power ^{and other} direct^costs

Units^{of output,} labour

and ma £ hinehours Batch Set-up,^material logistricsNumber ^{of set-ups,} set-

up hours process [[lechnicalsupervision,

specialist rnaintenance

Number of employees,

number of breakdowns

Product/Product GroupManagement, _part

administration

Number of customers, number of parts

Facility Occupancy costs, senior management

Area mesures

moves up the hierarchythe tenuousness of the linkageof costs to output increases.At the

levelof the facilitycosts the apportionments have a fairlyhighdegreeof arbitrariness and

theirinherent value can therefbre be questioned but, at least inthe ABC approach, they

are sepaJrately indentifiedas requiring facilityleveldecisionsto change them.

2.2 CustomerAnalysis

ABC hasbeen extended from a concentration on production ^cost to includemost of the

costs associated with meeting customer demand (Bellis-JonesIl]).^{Thus the ABC method-}

ology has also fbcusedo] the individualcustomer as the cost object. The result allffws an insightfu1analysis of how profit^isdistributedamong customers. In one case, Kanthal

(Cooper^{& Kaplan} [10]),^{the analysis showed how a} relatively small number of customers

were apparently earning an extremely high _proportion ^of the firm's_profits. Marketing,

pricing^{and cost control} policies^{were reviewed} in^{respect of} differenttypes of customer in

the light^of thisfinding.In^another (Develin^{& Partners}[12]),^the identificationof thespe- cific costs generated by the trading relationship with a major customer ledto a successfu1

renegotiation of the trading relationship, turning a lossintoa profit.

Inorder to achieve results such as these,non-production costs must also be classified by

activities in a way which refiects how each activity has consumed resource. Then the cost

pools ^are attributed to the^{customer on} thebasis^of appropriate cost drivers(e.^g,number

of sales calls, customer location,^{number of sales returns, etc.} ).^{As with the product cost}

approach, it^{can assist} the appreciation of cost patterns ifthe various rates are put ^{into a}

meaningfu1 framework ^which _gives ^some indication^of the level^{at which} they are incurred,

Exhibit2 outlines a framework ^suggested by O'Guin ^{and Rebischke} [23].

The ^{view of cest} incurrence_provided by thistype ef analysis, beingbased on the^sales

transaction with the customer, ispamticularly^valuable tomanagerial marketplace strategy.

NII-Electronic Library Service ^{The Jourllal of} Managenient Accounting,Autum 1992

Exhibit 2

LayeringofNon-ProductionCosts

Level ^{Typical Costs [[Ypical Costs Drivers} Order Documentation ^Number of orders,

number of shipments

Customer

Channel

Creditcontrol, expediting, administration, discounts

Stafli,wareheusing, transport

Number of customers, number of non-payments

by due date

Promotion space, number

of staff, managerial

time

Market Promotion, ^market researchManagerial time, number of customer surveys

Enterprise[I]bpmanagement, general

company promotlon

Management time

Information^{isavailable on the mest valuable customers and on those whose servicing ac-}

tuallycosts the organisation money. Some indicationsof possible^{source of} these variations can also be _gleaned from the oeder, channel and mamket levelcosts. The insightsgained from thisinformation^can help^{management intargeting}distributionchannels, market seg- ments and customers in^{a manner informed by the} potential^{imPact of their decisionson}

costs and profit.

3.Profiling ActivityCosts

ABC _gives ^a differentperspective ^{on cost} incurrence.This ^comes from the infbrmation

which isgenerated^{on each activity cost pool.} Often forthe firsttime management are

presented ^{with cost} information on keyactivities, e, g,

^{- the} full^{cost of all} the^{resources used in meeting a customer's order}

- the full^{cost of all} the resources used in_purchasing ^supplies

- _the totalspend on quality,maintenance, engineering services and material

seheduling.

This^activity based^cost infbrmation_provides ^a _profile^{ofthe cost} _purpose (activity) ^rather

than simply the type of resource acquired (stationery,^{wages, etc.) Ittellsmanagement}

what they aJre getting for'their^money interms ofthe operational work contribution tothe

business(see^Exhibit3).

Activitiesare usually selected at a manageable levelof aggregation and represent signifl

icant business processes^{which are relatively} homogeneous in respect of the selected cost

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The Japanese Association of Management Accounting The JapaneseAssociation of Management Accounting

Activity Based Cost Information

Exhibit 3

Conventionat vs ActivityCostAnalysis(IPur=hasing^Cosij

[[Eraditional XOOOs

Salaries ⁴⁰⁰

Equipment depreciation llO Stationery&Posts 24

[[)ravel 39

[[lelephone/Fax 32

Occupancy^{costs 164}

769

Activity Based XOOOs

Vetting new suppliers 170 processing ^orders 202 Receivingerders 85 Expediting_problems 218 Making _payments 94

769

driver,However, from the data _gathered at the stage of iderrtifyingactivities, itisalso normally possible to identifythe composition of each activity insome detai1.Thus, for

example, vetting new suppliers could comprise: meeting management; inspecting_premises;

repeat visits; contacting other customers; travelling;report writing; presentation; ^correcting

reports and answering questions.

As itis_purpose ^oriented thistype of analysis facilitates^{a managerial assessment of costs}

in terms of the value of the activities which they support, to the firm.The inventory of activities can be analysed inrespect of thosewhich are value added and thosewhich are not (Berliner^{& Brimson} I3]).^{Value added} activities can be definedas thosewhich are essential to the provision ^of product ^{and service} to the customer at a competitive price.

Activitieswhich do not fa11within thisremit are, prima facie,candidates forreduction er elimination. Consequentlythe identificationof the cost of non-value added activities such

as those relating to the holdingof stock, the correction of errors, the expediting of events and the unnecessary movement of raw materials draw attentioii toa[reas where cost savings can potentiallybe made without an adverse effect on the^service tothe^customer. Another

similar type ^{of analysis} has been ^suggested by Bellis-Jones& Hand [2].^{They advocate}

the analysis of costs into^{core, support and} diversionaryactivities, Thus the a£ tivityof salesmen could include the core work of making sales to customers, the support work of

travellingto customer Iocationsand the diversionarywork of acting as debt collectors on overdue invoices.Where support and diversionarycosts a[re high,efforts can be made to

reduce them and so freeresources which can be used to increase core activity or toeffect cost reductions.

4. Budgeting and Cost Control

Budgeting involvesthe accountant inexpressing future plansinfinacialterms. Cost es-

timatescomprise an importantcomponent of thiswork, Fbr those costs which are deemed

variable and are primamily drivenby volume, the establishment of planned production ^out- put ^means that setting the budget will be a relatively straightfbrward event, However

the remaining costs, coventionally characterised as fixed(but^{usually exhibiting consistent}

growth)^are lesseasy to translate intobudget terms. Here the ABC approach can make a

positivecontribution simply by working back from the planned ^{output mix} to an identifi-

NII-Electronic Library Service The Journal of Management Accounting, Autum1992

cation of the cost driver volume which itimplies foreach activity cost pool. Changes in

the level^of this^volume _give^a basisforestimating the resource requirements of the activity stemming from increases^and decreasesinthe real demand forthe^{output which} itprovides.

Thus ^a 10% increaseinthe number of purchase ^orders to be _{processed gives}^an indication

t,hatsome increaseinthe budgeted ^{cost of} procurement ^{activity may} be ^merited. Of ^course

account must also be^{taken of} _proposed ^{changes inthe technology and} organisation of the

activity, inthe impact of inflationon the price ^{of the relevant} resources and in the scope

forcost cuttillg of waste and unnecessanry resource use,

The refinement of havinginformationon activities, costs and cost driversalso permits ^an

extension of the variance analysis that would normally be _possible. This would be based

on pre-determined^cost driverrates and actual activity costs. Exhibit4 illustratesthe type

of information whieh could be _produced.

Exhibit 4

Data:(i)

(ii)

PurchasingActivityVdriances

Inthe XYZ Coporationtwo products, A ^and B, ^are manufactured.

A ^{major ameas of overhead cost relates} to the purchase ^{of material}

and parts.A purchase^order is^{raised when} 100^{units of} A ^or 200

units of B are produeed. The number of purchase ^orders isthe

cost driverfbrpurchasing^activity.

For March 1992_purchasing activity and cost isas fo11ows.

Budget:

Actual:

Expected:

ProductionVblume No. of Purchase Orders PurchasingCost

ProductionVblume

No. of Purchase Orders PurchasingCost

ProductionVblume No. ^of Purchase Orders PurchasingCost

Product A

4,OOO units

40 orders

100 orders @ S50

3,OOe units

40 orders

90 orders @ £ 60 3,OOO^units

30 ^orders

80 ^orders @ £ 50

f5,OOO

S5,400

£ 4,OOO

product B

12,OOe units

60 orders

10,OOe units

50 erders

10,OOO units

50 ^orders

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The JapaneseAssociation ofManagementAccounting

^{Activity Based Cest} Information

(1) Spending1^Efficiency

Actual ActualCost ExpectedCost

Cost DriverVolume DriverVolume

at at StandardRate StandardRate

90 orders 90 orders 80 orders

× × ×

^£ 60 £ 50 _£ 50

-_£ 5,400 -_£ 4,500 ._£ 4,OOO

NtpedgV !tM ^yV

£ 9ooU £ 500U

or graphically:

£ Purchasing Cost ^£ 5,40e ^£ 5,OOO

^£ 4,500

^£ 4,OOO

i] ^Effi

80

(2)^{Volume Variance}

Purchaseorder 12eorders

processmg^capaclty

BudgetedoTders 1ooorders

Actualorders 9eorders

Expectedorders 80erders

The first^{set of variances} istraditionalinterms of expected an

90

Spending Variance

iencyYariance

Ne. ofPurchaseOrders

i

:.,

g,

g

l

i,

3e[i/

(10U)

Efficiencyof capacity usage

(10^U)

^{segmenting the} differencebetween the

d ^{actual cost of} procurement ^activity forthe periodintothat portiondue to