Yes, ABC Is for Small Business, Too

A challenge to conventional wisdom.
BY DOUGLAS T. HICKS

EXECUTIVE SUMMARY
  • CONTRARY TO CONVENTIONAL wisdom, activity-based costing (ABC) is not only for large companies. It works just as well for small organizations
  • WHILE IT'S TRUE that ABC is still being used mostly by large organizations, that's largely because the large-company myth became deeply imbedded in conventional business thinking. That's beginning to change: Smaller businesses are adding ABC to their management tools and recognize it as a powerful aid.
  • A SMALL MANUFACTURER realized that a direct-labor-based, plantwide manufacturing rate didn't accurately reflect the cost of individual products. Neither did the total cost-based G&A percentage reflect the amount of administrative effort required to support a part, a customer or both. As a result, management assembled a multidisciplinary team to apply the basic concept of ABC to create a cost model that would accurately cost out each of the company's parts.
  • ONCE THE ABC TEAM DETERMINED appropriate methods for costing these manufacturing and several nonmanufacturing activities (such as raw material procurement and order processing), it created a cost model and a spreadsheet template that used the rates generated by the model to cost individual products. All this was done without the need for the company to change its day-to-day accounting system.
  • SINCE ADOPTING ABC four years ago, the company's sales have tripled, while its profits have increased fivefold.
  • WHERE ONCE MANAGERS had their own way of measuring the cost impact of management actions, they now measure those costs in a formal, uniform way. When managers contemplate changes, they have a mental model that directs them toward changes that truly benefit the organization. As the company's CFO likes to say, "Costs around here were once opinions, now they're facts."
DOUGLAS T. HICKS, CPA, CMC, is a team leader—decision costing services practice—at Olive, LLP, Farmington Hills, Michigan. He is the author of Activity-Based Costing: Making it Work for Small and Mid-Sized Companies, published in 1998 by John Wiley & Sons. His e-mail address is dohicks@aol.com .

n the decade since activity-based costing (ABC) was introduced, small and midsize companies were advised to steer clear of it. They were warned, mostly by those who labored long and hard—and often unsuccessfully—to implement ABC for Fortune 1000 enterprises, that its installation takes massive resources.

It's time to debunk the notion that size matters.

My experience, and the experience of a growing number of other ABC experts, indicates that ABC doesn't require a massive effort to implement and that it is effective for any size business. Why has ABC been seen as inappropriate for smaller organizations? The negative assessment was originated by managers of large companies who toiled unsuccessfully to implement the program. (For more on why ABC projects fail, see " Learning to Love ABC," by Gary Cokins, page 37.) The reality is they failed to fully understand ABC. Despite the bad press, smaller organizations are beginning to see that ABC can work as effectively for them as it does for large companies.

The concept of activity-based costing is actually very simple. We can summarize it like this: An organization has to perform certain activities to provide the products and services it sells, and those activities cost money. The cost of each of those activities is measured and assigned only to those products and services requiring the activity, using appropriate assignment bases (called drivers). In that way it's possible to get an accurate picture of the real cost of producing each product or providing each service. In fact, the data can be formatted to provide the cost of serving each customer, too. Nonactivity costs—such as direct materials or direct outside services—don't need to be included because they already are attributable to specific products or services.  

A WALK THROUGH

To demonstrate how easy it is to apply ABC, let's walk through one of my ABC engagements. I've changed the company name and some identifying details to protect the confidentiality of the client.

Small Company is a $10-million manufacturer of components for the automobile industry: It makes the products by hot forging and machining. To understand how the ABC process was applied, it's necessary to understand the company's product-related operating activities. Here they are in summary:

  • Small Company buys steel bars from outside vendors.
  • Upon delivery, Small Company workers test the steel and move it to storage.
  • When the bars are needed for an order, workers move them to the preforging area, where they're sandblasted and cut to desired lengths. Most of the bars are large and heavy, and they are moved in bins that hold from 20 to 50 pieces.
  • After sizing the bars, workers move them to a forging operation, where they're shaped and then moved again to an in-process storage facility. In some cases, the steel needs to be forged as many as three times.
  • For each forging procedure, workers move the bars from in-process storage to the forging area and then back to in-process storage.
  • After the final forging, workers move the steel parts from in-process storage to the machining area, where they are finished and sent to a finished-goods storage facility.
  • Finally, the parts go to the shipping area to be sorted, packed and loaded into trucks for delivery to customers.

Before adopting ABC, the company assigned manufacturing costs to products using a plantwide costing rate based on direct labor. It included setup costs in manufacturing overhead. Nonmanufacturing costs were assigned to products via a general and administrative (G&A) rate that was calculated as a percentage of total cost. Both rates were based on the company's actual results for the preceding year. This was done despite the fact that it was obvious to management that the direct-labor-based, plantwide manufacturing rate didn't accurately reflect the cost of individual products. Neither did the total cost-based G&A percentage reflect the amount of administrative effort required to generate a part, support a customer or both.  

COST CONSCIOUSNESS

Management assembled a multidisciplinary team to apply the basic concept of ABC to create a cost model that would accurately reflect the effort that went into creating each of the company's parts. The company retained my firm to facilitate the effort. Together we identified the major costing issues and organized a model for assigning costs for individual parts. Our ABC team determined that changes must be made in the company's cost model if it was to generate accurate product costs. As you'll see, all the changes are obvious and intuitive. There was no need to buy special software. A simple spreadsheet application handled all the details. Here are the changes we made:

  • Setup costs: Because equipment is set up to produce a specific quantity of a specific part, the setup cost should be assigned only to the parts it produces. So, for example, a $2,500 setup that is used to produce 2,500 parts results in a per-part setup cost of $1; similarly, a $2,500 setup to produce 10,000 parts results in a per-part setup cost of 25 cents. However, if the setups were included in overhead—as was done previously—each part would have been assigned a flat per-part rate of 40 cents for setup, and that would have been 60 cents per part too little for the first one and 15 cents too much for the second.
  • Forging costs: The same forging press can be used to manufacture products of significantly different weights. More than one operator is needed for very heavy products. However, when two operators run a machine, press-operating costs don't double: Although the labor cost doubles, the cost of operating the press is the same as if one operator is working. To accurately determine the cost of operating a press, the labor cost and the press cost must be separated. If only one operator is required, the product cost includes one labor hour for each press hour; when two operators are required, it includes two labor hours for each press hour. Each part must be induction heated prior to forging. The cost of heating a part, however, is not a function of time—the base used to assign other forging costs. It's a function of the mass of the part being heated. It costs twice as much to heat a 20-pound part as a 10-pound part. As a result, the ABC team determined three separate rates:
  • Press operating costs based on press hours.
  • Production labor costs based on labor hours.
  • Induction heating costs based on a part's weight.
  • Machining costs: The machine centers don't require full-time operators. Once machines are set up, workers load and unload parts for multiple centers. On average, one machine-worker hour is required for every two-and-one-half machine hours. Under such conditions, machine shop workers' pay is not considered a direct labor cost. Instead, since the workers are indirect material handlers, their pay is part of machining activity costs. As a result, the ABC team determined that the cost of machine shop workers shouldn't be treated as a direct cost, but as one of the indirect costs assigned to products on the basis of machine hours.
  • Material movement costs: Material movement is a significant activity at the company. More than 15% of hourly labor costs are for workers moving parts within the facility. Under the old costing methods, all such material-movement costs were buried in the direct-labor-based, plantwide costing rate. These costs, however, aren't related to the amount of manufacturing activity that takes place; they are a function of the size of the part moved and the number of different manufacturing activities required by the part.

For example, one large part moves through its manufacturing operations in bins containing 30 parts. During the manufacturing process, a worker must move the part 15 times. As a result, each part requires one-half of a complete move (1/30 of a move x 15 moves). A smaller part moves through its manufacturing operations in bins containing 120 parts also must be moved 15 times. Each of these parts requires only one-eighth of a complete move (1/120 of a move x 15 moves). As a result, the ABC team determined that it wouldn't treat material movement as manufacturing overhead, but as a direct activity assigned to products as a cost-per-move basis.

A summary of the costs assigned to each manufacturing activity and the ways they are assigned to individual products is shown in the exhibit, above.

Once the ABC team determined the appropriate methods for costing these manufacturing and production-related nonmanufacturing activities (such as raw-material procurement and order processing), it created a cost model and a spreadsheet template that used the rates generated by the model to cost individual products.

All this was done without the company changing its day-to-day accounting system. When ABC is instituted in large companies, however, it is typically incorporated into the general ledger. While such a move provides more data, it's also more complex and thus more costly. Small Company was able to achieve many of the same goals using a simple spreadsheet model.

THE PAYOFF

Since adopting ABC four years ago, the company's sales have tripled, while its profits have increased fivefold. Much of this improvement came from a more profitable mix of contracts generated by a costing/quoting process that more closely reflects the actual cost structure of the company. This has enabled the company to improve the management of its contracts.

Better costing and quoting are not, however, the only features of ABC that improved the company's profitability. ABC highlighted many areas for cost control that were hidden under the traditional costing system. Particularly useful was isolating and measuring the cost of material movement. Since this information was developed, the company has used the data to justify many operational changes, which, in turn, have produced further efficiencies.

On an important but less tangible level, management's knowledge of and attitude toward cost information have undergone a substantial change. Where once managers had their own way of measuring the cost impact of management actions, they now measure those costs in a formal, uniform way. When managers contemplate changes, they have a mental model that directs them toward changes that truly benefit the organization. As the company's CFO likes to say, "Costs around here were once opinions, now they're facts."

Any small or midsize organization can develop an ABC system. It doesn't require a great commitment of time or financial resources. Nor does it require the implementation of special software integrated into the general ledger—although for larger organizations that may be a benefit. It requires only that management view its operations through "the lens of ABC" and create a model that will enable it to measure costs in accordance with that view.

Assigning Costs Using an ABC Model
         
Directly attributable costs Forging press hour cost Machine hour cost Induction heating cost Material movement
         
  Depreciation Depreciation Depreciation Depreciation
  Utilities Utilities Utilities Equipment leases
  Manufacturing supplies Manufacturing supplies Manufacturing supplies Utilities
  Outside repairs Outside repairs Outside repairs Manufacturing supplies
    Straight-time wages   Outside repairs
    Fringe benefits   Straight-time wages
    Payroll taxes   Fringe benefits
    Overtime premium   Payroll taxes
    Shift premium   Overtime premium
Distribution Maintenance Maintenance Maintenance Maintenance
  Building and grounds Building and grounds Building and grounds Building and grounds
  Manufacturing engineering Manufacturing engineering Commodity overhead Human resources
  Commodity overhead Commodity overhead   Supervision
    Supervision    
Total Total costs Total costs Total costs Total costs
Rate $ per press hour $ per machine hour $ per heated hour $ per move

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