Activity-based costing, commonly known as ABC, is an accounting method being called the TQM (total quality management) of the '90s by accounting gurus everywhere. A. Charlene Sullivan, associate professor of management in Purdue University's Krannert Graduate School of Management, says activity-based costing is an effective management tool that business students would be smart to learn.
"Businesses are constantly seeking ways to work more efficiently and better-manage their organizations," she says. "Outdated manufacturing systems are going by the wayside, and new ones are taking their place. Accounting systems are no different. Activity-based costing allows companies to see exactly what and where their costs are and make management decisions based on those findings.
"Business students who hope to be involved in the management decision-making process in virtually any company had better know their ABCs."
At Purdue, management students take accounting courses that place heavy emphasis on activity-based costing. ABC assigns costs to each activity in making each product, rather than lumping together all costs for all products. It's simply a better way of doing things, Sullivan says.
"It works, and it works very well," she says. "It teaches students to be better managers and increases their adaptability, which is what is required in a business world that is changing rapidly in the face of technological advances and restructuring as a result of the recent recession.
"Activity-based costing's greatest benefits lie in the area of managing systems. But ABC is only the number-generating process. What you do with it is ABM, or activity-based management. That's what students really need to learn to do."
What companies across the country are doing with the numbers generated by activity-based costing is trim waste, update manufacturing procedures and improve management practices, she says.
"The biggest complaint managers have about their old accounting system is that the numbers make no sense and aren't useful for managing the company," Sullivan says. "ABC reveals how business processes operate and allows managers to be proactive."
Sullivan says that's where strategic management enters the picture.
"Foresight is very important," she says. "If your company is thinking about introducing a new product line, activity-based costing tells you where existing costs are -- before you actually start producing the new product."
Traditional accounting methods tend to assess the cost of materials and labor for each product a company produces. But they usually lump overhead costs (everything from research and development to rent) into one category and divide it by the number of units to arrive at a unit cost, Sullivan says. When numerous product lines are involved, there's no way to tell what activities or products caused the overhead or how much it actually costs to produce a specific product.
Activity-based costing reaches the same bottom line as traditional methods, but allows companies to charge costs to products more accurately and break down overhead more precisely.
For example, assume a factory makes two products: A and B. Materials and labor to make product A cost $100. Materials and labor to make product B cost $75. Overhead is lumped together for a cost of $200. Using the traditional method, the overhead cost would be calculated at $100 for each product. Adding in the materials and labor costs of each product would give a final unit cost of $200 for product A and $175 for product B. Assume the company wants to make a modest profit, so it adds 10 percent to the cost -- for a sales price of $220 for product A and $192.50 for product B.
Activity-based costing, however, finds that 75 percent of the overhead can be attributed to activities associated with product B. That means overhead actually is $50 for product A and $150 for product B. Adding in materials and labor now shows that it costs only $150 to make product A, and it costs $225 to make product B. Obviously, the company is losing money on product B and perhaps charging too much for product A. From here, the company can change its management focus by adjusting prices, reducing costs or eliminating the product.
Although it sounds appealing, not everyone is pleased with such discoveries, Sullivan says.
"If your company makes washers and dryers, you're not going to be too thrilled to find out you're losing money making washers," she says. "That doesn't mean you have to stop making washers. You might decide to raise prices, get rid of some overhead or find a more efficient and cheaper method for making certain parts."
Those difficult decisions often scare people away from activity-based costing, Sullivan says.
"Many companies have given up and say it doesn't work," she says. "What they are really saying is that it's too hard. The results can be very painful, and sometimes management isn't willing to make decisions necessary to make the organization competitive."
In the future, managers are going to have to be trained to recognize ways to increase management efficiency and be prepared to make difficult decisions, Sullivan says. Activity-based costing is just one more tool at their disposal.
Source: A. Charlene Sullivan, (765) 494-4382; Internet, firstname.lastname@example.org
Writer: Victor B. Herr, (765) 494-2077; Internet, email@example.com
Purdue News Service: (765) 494-2096; e-mail, firstname.lastname@example.org
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