Learning to Love ABC

ard as it is to believe, activity-based costing (ABC) works best with a minimum amount of detail and estimated cost figures. By training and inclination accountants are detail oriented, abhorring lack of precision and vagueness. Unfortunately, these qualities that accountants excel in are incompatible with ABC. As a result, when CPAs undertake an ABC project, they typically become overwhelmed with data.

It's ironic. Because ABC is designed to provide useful financial insights into a company's operations, it's a process that should be well within accountants' sphere of expertise. Yet the fact remains: CPAs and ABC don't mix. What's behind this incompatibility? Those who have successfully implemented ABC say that, when gathering the underlying data for ABC, close enough is not only good enough, it's often key to its success. But, typically, when accountants try to apply ABC, they strive for a level of exactness that is both difficult to attain and time-consuming—and that eventually becomes the project's kiss of death.

The goal of this article is not to make accountants scapegoats for failed ABC projects. Quite the contrary: It's to get CPAs to see that activity-based costing is not that hard to implement, and it truly can enhance their roles as business partner and consultant.  

THE POWER OF ABC

To illustrate the potential of ABC, consider the following two financial reports of a department's expenses. One is taken from a general ledger and the other from an ABC analysis:  

How much financial insight is a manager likely to get from the chart of accounts report? Although it provides the same total as the ABC report, the ABC report provides information that can be applied to cost management. The ledger information, although accurate, fails to report the business-process costs that run cross-functionally—that is, across an organization's departmental boundaries. It fails to show the true total cost of fulfilling a customer order that passes through many hands. And that's understandable: After all, the general ledger is structured to collect transactions by departments—not to provide insights into work-related costs. As a result, the general ledger is effective for bookkeeping, but it's structurally deficient for assisting in decision making.

ABC is not a replacement for traditional general ledger accounting. Rather, it's a way to translate general ledger data into a format that helps managers make decisions.

ABC corrects for the limitations of traditional costing by identifying all the work activities—and their costs—that go into manufacturing a product, delivering a service or performing a process. When the individual costs are added up, a clear picture of the total cost of a process comes into view. ABC can even distinguish the cost of servicing different customers. The traditional cost management approach—in which cost allocation is based on labor hours, gallons, pounds or other units of output—rarely reflects the true cause-and-effect relationship between indirect and overhead costs and individual products, services, channels or customers. ABC was developed as a practical solution for problems associated with traditional cost management—a technique that usually fails to allocate costs correctly because:

• Too many of the costs are lumped together in some categories.
• The average rates selected for many costs tend to be excessively broad.
• Often irrelevant factors are used to allocate indirect costs. For example, should product-inspection costs be spread among all products or only those products being inspected?  

TURNING LOSS INTO PROFIT

Why is it important to know the true cost of a process, product or service? Because companies that use traditional indirect-cost allocations may actually lose money on certain products, orders and customers, even though their accounting systems report them as profitable. Because pricing and quotation practices usually rely on the same flawed cost data, the errors are perpetuated.

Once ABC is set up to determine true costs, cost estimating is a natural next step. It begins with forecasts of a product's output; then, by adding the various cost driver rates for that activity, the total projected cost can be determined. For that reason, what-if analysis and predictive planning are popular ABC applications.  

OFFSETTING ERRORS

How can it be that less detail and estimated figures produce an accurate costing picture?

Although the notion is counterintuitive, consider this: With ABC, the assigned costs that result from an estimating error (that is, estimating percentage of labor time per work activity) don't necessarily compound. When a potential error in ABC's activity costs combines with a potential error in the activity driver rates and assignments, the total error can actually become smaller when the errors offset each other. Cost allocating is a zero-sum error game. If an indirect cost allocation is incorrect, then some cost objects will be set too high while the remainder will be set too low, and the net sum error is zero.

However, when each of the activity costs are reaggregated into their specific products or services to customers, the probability is slim to none that an individual product will receive activity costs from only the activities that were set too high.

Allied Signal and Coca-Cola, which have developed world-class ABC modeling teams, learned this lesson by putting their ABC systems through several redesigns. They found that simpler designs generally produced higher levels of accuracy.

Critics of ABC argue that the costing process is just another way to spin financial data. But as many companies have discovered, ABC puts the "management" back into management reporting, and the accounting profession can be instrumental in this move—but only if accountants ease up on their heavy appetite for precision and place greater emphasis on relevance. Using ABC data can achieve relevant cost estimates as a basis for sound management decisions.

The Rise of ABC For years, activity-based costing (ABC) was considered an expensive management project that only large organizations with extensive resources could undertake. But today, with the proliferation of computers for data gathering and computing plus the recognition that most data for decision making need not be accurate to several decimal places, any organization can implement ABC. In the early 1980s many companies began to realize their traditional accounting systems were generating inaccurate costing information. While calculating costs using direct-labor-based (or volume-based) allocations may have provided accurate enough results in the past, these simplistic allocation methods became outdated as most organization's cost structures began to change in the '80s. As organizations became more complicated, indirect and overhead costs grew at a faster rate than sales or services and displaced the costs of the front-line worker. In addition, the diversity of products and service lines expanded; similarly, the diversity of customers and channels increased, too. As a result, no single volume-based allocation method could fairly trace indirect costs into the rich variation of products, service lines and customers. ABC resolves this. The sharp rise of competition also contributed to the failure of the old costing methods. No longer could a company continue to carry unprofitable products and unprofitable customers by hoping the profitable ones would make up the difference. Price quotations, capital-investment decisions, product mix, technology choices, outsourcing and make-vs.-buy decisions today all require a sharper pencil. Many managers understood intuitively that their accounting system was distorting the assignment of costs, so they sometimes made informal adjustments. But over time, even those adjustments failed. Two economic factors contributed to ABC's growing success. As the power of the personal computer grew and prices fell, it processed and stored more accounting data; as a result, the necessary data, in essentially the correct format, became more available to the ABC system and its users. Second, increasing competition has forced all organizations to focus not just on their top line—sales or budget funding. Now they must also understand their middle line—their costs.