In every business, there is a cost associated with every action taken during the day. Each cost must be covered by the company's net sales or it won't be worth the time to come through the door in the morning—the company won't be showing a profit. Activity-based costing (ABC) is a system to identify activities and assign costs to those activities—regardless of the nature or size of a business.
ABC was created by large manufacturing companies and industry associations, and many people still believe that ABC is applicable only to large manufacturers, but this is not the case. By using ABC concepts, a mold shop's management team can gain a competitive advantage through having a greater understanding of its product or service, and by understanding its processing costs through identifying all the activities performed in carrying out their missions and objectives.
ABC makes a rational assignment of overhead/support costs to their related business activities, and ultimately distributes all costs among the objectives of the business—usually 10 basic activities/cost pools. By using ABC, decisions concerning the profitability of a mold shop's products and services can be assured.
Traditional Methods Versus ABC
Traditional cost systems (such as standard costing or job order costing) determine the value of inventory and cost of sales, but they can lead to inaccurate measurements of the total processing of products or services. Traditional systems also can lead management to make inaccurate business decisions. A management team needs the best information possible, and with ABC, accurate cost information is provided in real time.
ABC provides a flow-down procedure (or model) that provides accurate information on direct/throughput costs (cost of purchases from outside the business for raw material, components and services that directly benefit business objectives) and indirect costs (cost of overhead/services/support that are incurred inside the business).
Cost objectives consist of the activities that the business must conduct in order to fulfill its purpose. For instance, although every business is a different, it is possible to distill a small machine shop down into the following cost objectives:
- General and administrative support
- Support for raw materials purchased
- Support for purchased components
- Support for purchased outside services
- Machine setup
- Machine operations
- Product assembly
- Product inspection/shipping
Both direct and indirect costs are incurred in order to accomplish the objectives of the business. Indirect costs include:
- Salaries and wages
- Fringe benefits
- Specific assignment costs—depreciation, rentals, leases, supplies (both office and shop), utilities, insurance, taxes, etc.
- Service centers (the supporting activities like engineering, maintenance and the tool room)
- Operational support activities—general overhead, material burden, material management, quality control, etc.
- Administrative support activities
- Cost of operating activities
All costs accumulate into final cost objectives with the accumulated cost being matched against the net revenue. The 10-step procedure for small business ABC should be completed after a mold shop has established a need to better its cost system (see ABC Is Needed When sidebar). ABC could be conducted by a cost management consultant or an employee who has received ABC training (see Factors to Consider When Deciding on an ABC Consultant or Doing It Yourself sidebar and Selecting an ABC Consultant sidebar). The steps for ABC include:
- Identify the definition of the activities within the firm.
- Organize the cost centers or cost pools.
- Define the elements of cost within the cost centers.
- Obtain relationships between cost and activities/pools.
- Identify what drives the cost to accumulate from activities to products or services.
- Show the cost flowing throughout the process.
- Obtain the proper tools for computing the cost of the flow.
- Formulate the cost accumulation model.
- Collect the data to drive the cost accumulation model.
- Use the cost accumulation model to follow the cost structure and come up with appropriate costing rates.
Working through the 10 steps is an ongoing process. By the time the last step is completed, the decisions made in the earlier steps will most likely have to be changed to achieve the most accurate results. ABC is somewhat time-consuming because information must be gathered through financial reports and employee interviews, and management must understand the entire process and its cost. Provided there is a traditional cost system already in place, implementing an ABC system usually takes approximately 250 man-hours. Without a cost system in place, the total implementation can run up to 500 man-hours for a cost management consultant or an employee with small business ABC knowledge (see Steps for Using In-house for ABC sidebar).
Uses and Effects
The ABC model is being used in manufacturing, wholesale and retail firms—domestic and global, and it can be used for mold shops. It ensures that everyone knows what the activity cost centers are, and what drives their cost. The steps in the flow-down system can be modified to add other steps or to fit a mold shop. Although the 10 steps of obtaining the financial model remain constant, additional time is necessary if new steps are added.
Like a recipe card for baking a cake, ABC provides a recipe card for a business, giving moldmakers the knowledge to make those important decisions on whether or not the business they seek will be profitable. It shows what employees are actually doing and which activities add value. Limiting activities that do not add value will decrease costs and increase profits.
The ABC system has been used to increase efficiency and reduce the cost of a customer service department, to identify internal fraud, and to gain a complete understanding of a process and its price schedule. ABC cost distribution/accumulation information also can be used for projections and other what if analysis.
ABC information is especially important when analyzing multi-year price contract situations that include mandated cost reductions. This involves taking the cost information developed during the ABC effort and factoring in the scheduled cost reductions in order to project the expected costs over the term of the contract. By comparing the revised cost with the corresponding revenue, it is possible to determine whether the contract is worthwhile. Focusing on the total net revenue over the term of the contract rather than in any one particular year is key.
ABC's emphasis upon activities is applicable to all businesses and organizations, including moldmakers, because all businesses conduct activities in carrying out their objectives, and activities consume costs. By defining the activities and assigning costs in a logical manner, ABC provides a new costing methodology that is superior to traditional costing methodologies. Acting on the information provided opens the door to a host of benefits besides costing/pricing.