A FEW WORDS ABOUT ACTIVITY BASED COSTING

Different people have very different views of EDM/PDM. Some think of it as a bit bucket. Others see it as an illustration of a paradigm shift. The particular paradigm they see being shifted is the one that shows how we view manufacturing organizations. The traditional paradigm was primarily a departmental picture, the future paradigm looks along a product life cycle from which departmental barriers have been removed.

Under the old paradigm, with departmental cost-justification, EDM/PDM didn't look too good, since the major benefits of EDM/PDM occur outside the Engineering department. In companies that take a departmental view of EDM/PDM, the Engineering Department often can't justify the cost of EDM/PDM because it can't account for the benefits that occur outside the Engineering Department. Under the new life-cycle paradigm, EDM/PDM makes much more sense.

Another paradigm shift under way relates to engineering processes. In the old paradigm, real engineers dreamt of, and then developed, wonderful new products. They weren't interested in engineering processes. With the new paradigm, engineers are beginning to see that product quality is heavily influenced by the quality of engineering processes, and the perceived importance of engineering processes is increasing. In the new paradigm, process-related activities, such as Concurrent Engineering, are becoming acceptable.

Among the benefits expected from EDM/PDM are reductions in product costs and product development costs. Do the above paradigm shifts, away from the departmental view, and towards process and product life cycle views, have any effect on calculating these costs? They do, and over the last few years there has been a growing interest in Activity Based Costing, a technique that results from a related paradigm shift.

Activity Based Costing is a costing technique that tries to overcome some of the deficiencies of traditional product costing systems which may, under certain conditions, such as high volume and product-diversity, calculate inaccurate product costs.

The reason for these errors is often that the attributes generally chosen to characterize the costs related to a particular product are attributes of unit products (such as direct labor hours per product), whereas in reality many of the costs (such as set-up time, engineering change time) are related to batches of products, or families of products, or even all of a company's products.

Additionally, traditional product costing systems have spread overhead as a function of direct labor hours per unit product. As the cost of direct labor hours is becoming a smaller and smaller percentage of product cost, this gives an inaccurate view of real product costs, masks the need to clearly account for, and reduce overhead costs, and focuses attention on dollar costs rather than on time cycles which are becoming increasingly more important.

Traditional cost management is accomplished through variance reporting. Departmental costs are broken down into cost categories such as labor, supplies, utilities, travel etc. Budgets are set for each department and each area is responsible for controlling its costs against budgeted expenditures. Management can easily check if a cost center has its costs under control by looking at the variance figures. The management focus is on managing the figures rather than managing the factors which drive the costs of the process. With this approach to cost management, management is focusing people on efficiency, not effectiveness. By controlling the individual cost elements, they may be leading people to do the wrong things in a cost efficient way.

Traditionally, costs have been controlled at the point of occurrence rather than at their source. The cost centers that actually incur the expenditure may not be responsible for the factors which contribute to the actual costs. For example, the costs of Engineering's mistakes are often paid by Manufacturing. The most critical time for controlling a product's cost is in the upstream stage even though most of the product's costs are not incurred until much later. This discrepancy between when costs are committed to (i.e. in the development stage) and when they are actually incurred (i.e. during the manufacturing and distribution phases of the product's life cycle), is another major weakness of traditional costing systems.

Under traditional cost management approaches, product costs may be misleading, performance measures inappropriate, cost control unfocused, and accounting systems irrelevant for cost management purposes. Yet accurate product costs are at the heart of pricing decisions for new product introductions, obsolete product withdrawal, and responding to competitive products. Activity based costing tries to remedy the problems.

The Activity Based Costing paradigm is based on the principle that it is not the products that a company produces that generate costs, but rather the activities that are performed in planning, procuring and producing the products. It is the resources that are necessary to support the activities performed during the course of business that result in costs being incurred. Product costs should therefore be calculated by determining the extent to which each product makes use of the activities being performed. Products 'consume' activities and activities 'consume' costs.

Activity based costing starts by matching the resources of the business with the activities that are being performed. This is done by finding out which tasks are performed, and then identifying which personnel and other resources are required to perform each activity. Product costs are then calculated by driving the activity costs down to products based on how each product consumes the activities. Different products require the support of each activity to a different extent. For example, one product may require a lot of prototyping, or generate regular engineering change activities. Another product may require little or no prototyping, and may not require any engineering changes. Controlling the activities (i.e. the process), rather than the individual cost elements, will lead to actions which improve the effectiveness of the activities performed by the people in the life cycles of the various products.

Activity based costing more accurately represents real product costs because the costs are driven down to products based on the actual consumption of activities and resources by each product. Activity based costs better reflect the true cost behavior or profile of a product.

Traditional view of costing	$	Activity based view	$
Salaries	560,000	Develop master schedule	100,000
Technology	120,000	Schedule orders	150,000
Travel expenses	100,000	Release orders	140,000
Supplies	110,000	Check order status	120,000
Facilities	100,000	Expedite orders	260,000
		Management	220,000
Total	990,000	Total	990,000

Copyright 1998 by John Stark