Modernize your costing

How to collect the data that will help you improve efficiency and increase profit

Proper costing of products and services helps in understanding what makes or loses money. A cost system provides product cost and operating data, to support decisions on pricing, investments, performance, divestitures, and overall strategy. It also assists in controlling costs and in forecasting the effects of decisions, such as make or buy, which are critical in managing the business.

Unfortunately, costing used in most businesses falls short. Standard approaches tend to oversimplify, to management's detriment. For example, using bad information in quoting can lead to attracting too much of the wrong kind of sales. In operations, it might mislead managers into buying suboptimal equipment, mis-motivating employees, and even cutting or overpricing profitable products.

The key is having the right data, as modern costing systems are designed to provide. The information can guide what to measure and manage in improving profits. With proper costs, profitability can be analyzed by product, order type, service, customer, customer annual sales volume, market segment, distribution channel, or along any other meaningful dimension.

Improve management information

The better, activity-based costing ("ABC") approaches model operations, ABC emphasizes cause-and-effect relationships in performing cost assignments. This means abandoning arbitrary allocations in favor of the most realistic bases possible. By identifying causes, ABC is a tool for eliminating inefficiency. While requiring more effort than standard approaches, the lion's share of the benefits of ABC can be achieved without undue burden.

ABC organizes costing around direct activities, which are those creating the products or services, and the support activities behind them. For example, direct activities and their costing rates in a motor service facility might include:

* Order processing: $30 per order.

* Disassembly: $50 per labor hour.

* Winding setup: $25 per set-up.

* Winding run: $1 per 100 turns.

* Bum-off, bake: $2 per minute, divided over oven space utilized.

* Assembly: $200 per line hour.

* Service parts overhead: 25% of part cost.

These rates are useful for quoting and pricing. An estimating form could list activities with appropriate cost rates. The sequence would include:

* Material costs, factored up by estimated scrap and carrying costs.

* Operations costs, including cost per hour or characteristic, such as cost per setup.

* Selling, general, and administrative costs, such as sales commissions and order processing.

Double checks on the rates simultaneously provide controls over spending. ABC data provide ideal focal points for controlling costs, because they are objective, meaningful, intuitive, and readily determined from observing operations. Budgeted costs can be tested periodically, relative to actual. A flexible budget compares actual costs incurred with costs absorbed, consisting of actual cost drivers at their budgeted rates. For 200 orders processed at a $30 budgeted rate per order, a $6,000 computed cost can be compared to actual order-related costs. This direct linkage with financial results assures product costing systems are valid and up to date. Likewise, month-end financial results can be predicted more reliably.

Reporting can be elaborated to capture additional details. For example, setup statistics may function as a key indicator of efficiency. In this manner, controllable costs might be highlighted, such as scrap, shrinkage, quality substitution, and volume discounts affecting raw materials; and for labor and overhead, downtime, overtime, set-up, handling, rework, underutilized skills, production problems, lack of training, carrying costs, machine utilization, and order complexity, among others.

ABC provides the best available information for decisions involving cost savings. Regarding a particular decision, an expense will either vary or remain constant. Distinguishing variable from fixed costs becomes critical. Variable costs are those that are affected by the decision in the short-term, such as materials, direct labor, benefits, outside processing, equipment operating costs, and certain indirect costs.

For example, in make-or-buy, the vendor's quote should be compared with only the variable costs of production in-house. Similarly, products to be divested are those for which variable costs exceed sales. Small or complex orders may be underpriced, causing losses.

Manufacturers may also not charge for customization or other special services. Other companies choke on excess inventory kept in the interest of serving customers just-in-time. When built into pricing, customers find their own service level, which enables the company to maximize profits.

In purchasing or replacing equipment, on the other hand, savings in variable costs are compared to the required up-front investment, to determine whether the payback period is reasonable. The investment includes capital expenditures, tooling purchases, line setup, and learning curve costs.

Similarly, to invest in a new product, a return on investment is necessary. Projected sales less variable costs are the anticipated benefits, against which are weighed the initial costs. For new products, initial costs include research and development, new operations, and marketing and administrative activities relating to their introduction.

Model operations

ABC assigns costs using activity drivers, intended to reflect causal relationships between activities and the costs that they consume. For example, the number of purchase orders may be activity drivers for certain purchasing costs. Activity drivers are quantitative factors that best represent the causes of costs. They are used for both support cost allocations and in rate determination.

Implementation steps are summarized in the accompanying sidebar. Once direct activities are established, ABC defines support activities that are consumed by more than one direct activity. For example, an occupancy activity would include maintenance of buildings and grounds, depreciation, certain utilities, rent, real estate taxes, and property insurance. It should also include security and cleaning payroll, with associated payroll fringe, occupancy, related supplies, and other costs. The basis for assigning the cost to other activities is square footage. An activity that occupies one-half of the footage of the facility would be charged one-half of total occupancy cost.

Once support activities have been assigned, direct activities can be analyzed. A starting point would be the company's processes. Within a manufacturing operation, activities might include material handling, setup, and run, each having a separate activity driver. If it appears that a portion of an activity has one driver and another part of the same activity another, they may warrant separate treatment.

Depending on their significance, activities can be delineated further or combined with others. Ultimately, the level of detail depends on the goals of the users. For a particular activity, the appropriate level of detail reflects its significance in context. As a rule of thumb, if an activity makes up less than 1% or 2% of the total for the reporting unit, it should be combined with other similar activities.

The question arises as to how to derive hours if time is not tracked. One way is to accumulate times for completed orders from cost estimates used in quoting. Another is simply to budget a level of hours based upon anticipated utilization.

For labor, productive or order-chargeable hours can be estimated by taking the number of days in a year less weekends, holidays, and compensated absences. This gives the average number of annual workdays per employee. Then, multiply this by the number of productive hours per day, which is total time less paid breaks, end of shift clean-up, and administrative allowance for such things as training. In the end, an annual base of 1,500 to 1,750 hours per employee is reasonable. In the long term, actual time can be effectively measured by integrating routings and payroll reporting with time tracking systems, through optical character recognition and automated data accuracy checking.

Finally, some costs are non-routine and so difficult to model out. Special services include one-offs, such as order pick-up, added engineering, or special packaging. As they may occur infrequently, extra care must be taken to reflect these services in costing records properly.

Contrast with standard approaches

Relative to ABC, standard approaches are often inadequate. They may start with allocating overhead costs to divisions based upon sales. The next step of relating costs to products or services requires bases or common denominators. Traditional cost systems rely on a single base for this function. For process costing, used in line and continuous operations, the base is units produced; for job costing, used in project, job, and batch manufacturing, it is actual material charges and direct labor time for all other costs.

The limitations are significant. Process costing depends on output being homogeneous, as otherwise its averaging per unit is inappropriate. Although job costing is more detailed, it assumes that overhead costs are generated by labor.

These deficiencies become extremely clear when the actual effort in relation to sales dollars involved in producing a small, complex order is observed to be many times that of a large, routine one, and yet is applied the same processing costs per pound or production hour. While large and small orders differ in revenue, they can yet generate similar costs in quoting, credit approval, purchasing, scheduling, order processing, job tracking, billing, accounts receivable, and collection.

Similarly, standard approaches may inaccurately charge overhead costs equally to automated and manual operations on a per-unit or a per-hour basis. Or, in job costing, machine overhead cost may be assigned as a percentage of labor. Under that method, a machine that runs by itself, once it has been set up, does not have a cost. The amount of overhead per hour of operation will also vary substantially depending on the operator's pay rate, whether supervisor, assistant, or substitute from another department. Another concern is cost accounting not reflecting out-of-pocket costs outside of production, such as operations for picking and shipping parts.

The information provided by modem costing systems can guide what to measure and manage in improving profits

Five steps to activity-based costing

1. Define direct activities: Direct activities are the basis for costing products and services at the center of cost system reports. The data are used in cost estimating, quoting, pricing, budgeting, forecasts, and decision models, such as make-or-buy, repair-or-replace, cutting a product or service, and launching new ones. Sample motor service facility direct activities include order processing, disassembly, winding setup, winding run, burn-off, bake, assembly, and service parts overhead.

2. Code expense items to the activities, while creating support activities for individual items that relate to more than a single direct activity. Sample support activities include equipment-related, payroll fringe, occupancy, utilities, and indirect labor, such as supervision, maintenance, and quality control. Keep in mind that as accounting records become more detailed toward direct activities, fewer support activities will be necessary.

3. Assign each support activity cost to the activities that it supports, using the most appropriate activity driver. Allocation bases could include machine hours, headcount, time allocations, footage, metered consumption, or other appropriate factors, unless they are directly charged.

4. Once all support activity costs are assigned, and only direct activity costs remain, determine costing rates per the most appropriate driver. The basis could be such designations as unit activities (for example, inspection), transaction activities (accounting), lot-based activities (setup), machine-driven activities (run), order activities (scheduling), and customer, service or product-line level activities (dedicated staff or specific costs).

5. Assure rates are accurate by periodically comparing actual activity costs to budget, determined by multiplying budget rates by actual driver quantities: The proof of a cost system is in its feedback mechanism. If absorbed costs are below actual, additional drivers must be identified, or rates increased. Conversely, if absorbed costs are greater than actual, certain drivers may no longer be relevant, or rates may need to come down.-WW

By William H. Wiersema, CPA, EA Contributing Editor