The first article in this series discussed what activity-based costing (ABC) is and how to use it effectively in a mold shop. This article will delve deeper into the ABC process.
Using ABC, all the activities involved in operating a mold shop are identified. Overhead/support costs are then rationally assigned to their related activities, and are distributed among the business' final cost objectives. ABC computes the real cost of doing business, which can lead to better cost calculations and improved business results. Small businesses, including mold makers, can benefit from using an ABC process.
Low Cost and Budgeting
Implementing ABC in a small business is not expensive. Any spreadsheet software can be used to build the financial model—MS Excel (any version), Lotus 1-2-3 (any version) or MS Works Spreadsheet. Dedicated ABC software is available, but it can be difficult to install and maintain, the capability varies from software to software, and it can be quite expensive. The cost ranges from about $4,000 into the hundreds of thousands of dollars (as part of an Enterprise Resource Planning package). Although the major disadvantage for mold makers would probably be cost, another disadvantage is that too much time would likely be devoted to the software and not enough time to the intellectual effort required for a good ABC study.
Introducing new software sometimes requires a business to change the way that accounting is handled, and with some software, moldmakers must even change the way they do business. ABC, however, does not require moldmakers to change their chart of accounts—the accounting categories used to collect and classify income and expenses of the organization. Nor does it require a moldmaker to re-engineer the organization; the shop and its procedures do not have to be redesigned or changed to increase efficiency and reduce costs. ABC uses the information provided in the existing chart of accounts combined with employee interviews to define the true process systems and workflow from the personnel who are actually producing the business product and services.
By using ABC, reliable costing schedules, budgeting/forecasting, what if scenarios and capabilities studies can be derived with a minimum of effort. ABC also provides valuable information for decision makers in the human resource, operations, market-ing, and financial areas.
When businesses set prices, they often neglect to consider the different levels of sales or service required by customers. Some customers require more effort to sell and service than others because of their specific requirements or their geographic location. ABC lets management know how much it costs to support sales activities, which in turn enables prices to be set accordingly—charging more for customers with extra effort or demands. The knowledge gained from ABC can provide the price optimization information that smaller businesses need.
Mold shops that have separate marketing and sales functions can generally save 90 percent of their marketing and related costs when selling to an existing customer compared to selling to a new customer. In most businesses, 20 percent of existing customers provide 80 percent of the profits. ABC enables a mold shop to calculate not only its real profit, but the profitability of individual customers as well. ABC identifies the more profitable customers so that the shop can nurture their relationships with them. Insight gained from ABC can often provide vital customer relationship man-agement information that smaller businesses need.
As an example, the cost information determined from the ABC process can allow a shop to quantify, or assign a cost to, the extra effort/support required/demanded by a particular customer. Management can then compare costs and revenue from the customer and decide whether to increase prices to them or, failing that, to drop the customer. ABC can also identify customers that do not require extra effort/support and target them for additional sales opportunities or perhaps extend them price reductions to encourage more orders.
Activity Analysis and Business Improvement
Activity analysis is the heart of ABC and provides management with a better understanding of the business and the activities and processes it conducts to achieve its objectives.
Realistic Cost Cutting
ABC can also lead to more realistic cost cutting as well as organizational improvements. Many managers cut costs across the board in order not to make anyone feel unfairly singled out.
For example, a couple of years ago a local transit agency made across-the-board cost cuts by laying off employees and instituting a hiring freeze. One of the four claims adjusters was laid off, but the number of claims didn't decrease. The work of the three remaining adjusters increased, claims backed up, unpaid overtime became necessary and morale plummeted. At the same time, other activities with excess capacity had no problem completing their activities, even with fewer employees. This illustrates what happens—decreased efficiency and lowered morale—when some costs are cut unnecessarily while others are cut more than is necessary. The result is contrary to the reason for cost cutting in the first place. Even though an employee has been laid off, the work has to continue if the organization has the same objectives as it did previously. A conscientious activity analysis indicates activities/areas with a high concentration of costs that are the best candidates for cost cutting, and it will also determine whether an activity adds value to the organization.
Management should first conduct an activity analysis of any area that is under consideration for cost cutting. For ex-ample, an activity analysis of the core and cavity roughing operation in a shop might indicate that a significant portion of employee time is devoted to square grinding and re-grinding of the cavity blocks prior to heat treating. This might indicate problems with the overall approach to mold fabrication that result in the need to perform this work at various steps through the machining operation, and improving the general approach would drastically cut costs. The knowledge gained from the ABC activity analysis can help enable rational cost cutting that really makes a difference instead of blindly cutting costs not knowing how it will affect the organization's objectives.
As activities are identified, they are also classified as primary or secondary, and value adding or non-value adding. Non-value adding activities should be eliminated wherever possible, and second-ary (or administrative) activities should be minimized.
Primary activities are those that contribute directly to the central mission of the department or organization. Secondary activities are those that don't contribute directly to the central mission (see Primary and Secondary Activities sidebar). A typical activity analysis reveals that 80 percent of activities are primary and 20 percent are secondary. The goal in ABC is to get the secondary percentage to 10 percent. A high ratio of secondary activities indicates excessive bureaucracy and too much time spent on administration.
Value adding activities are those that are required to meet customer or external requirements. Most organizations devote about 65 percent of resources to value added activities and 35 percent to non-value added activities. The goal in ABC is get the non-value added percentage as close to zero as possible. Value added activities frequently have a product that leaves the work area.
When important purchase decisions are needed, a cost/benefit analysis is called for. In a cost/benefit analysis, the choice between two or more choices is made by totaling the costs, totaling the benefits, and comparing the two. The goal is to choose the course of action that will result in the least cost or the greatest benefit to the business.
ABC costing can help with the cost analysis by providing management with the real costs of conducting business at a realistic level of operations. This is the level of operations, or output, that the organization is set up to achieve normally with its existing resources (manpower and facilities). An activity analysis is usually performed based on a year's worth of activity reflected in operating and financial information. The information analyzed should not reflect an extraordinarily bad year, an extraordinarily good year that required extra efforts in order to achieve that level of operations, or a period covering significantly more or less than a year. Cost and operating information that doesn't reflect a realistic level of operations will distort the relationships between costs and activities developed by ABC, leading to a misunderstanding of the operating capabilities of the shop. The actual operating and financial information should be changed before ABC is com-menced, so that it reflects what the cost and operations will be at a realistic level of operations.
Performance measurement is an emerging area of business management that is concerned with developing relevant ways to monitor and measure business performance, with the goal of improving it. In a mold shop, an example of performance measurement is the direct labor hours for the month. A disproportionate amount of indirect labor to direct labor should show which departments or operations are in need of attention. Monthly budgets or estimates of direct labor hours for each department should be established and reviewed against actual hours expended. Finally the direct labor hours should be checked against the billable labor hours for the month to make certain that work is being performed in an expedient, cost efficient manner. Performance measures must be simple, relevant and measure attributes that can be improved. This means they must be easy to collect, easy to understand, capable of being controlled, and focused on output. Charts comparing actual quantities compared to estimates for a particular period of time make the best types of performance measures. ABC is concerned with business activities and their triggers or drivers, and it offers great assistance in identifying performance measures and in quantifying their im-portance to the organization.
Many businesses now use outsourcing because it frees up management to concentrate on the core business areas while someone else takes care of the non-core areas. A mold shop may, for example, choose to outsource its payroll activity to Paychex or ADP. Some businesses even outsource part of production to other companies. It is important for management to conduct an activity analysis of any business segments before outsourcing them. This will provide an understanding of the business segment and its true costs, which will allow a better evaluation of outsourcing proposals. Moreover, by identifying activities and processes that can be improved and where costs can be cut, ABC can often eliminate the need to reduce costs by outsourcing in the first place.
Reflecting Important Changes
A mold shop that has undergone changes that have not yet been reflected in the shop's cost structure is a prime candidate for ABC. Recent oil price increases, for example, might affect the cost structure of a mold shop—especially if the company has significant firm-price commitments with customers. Change is the nature of the world, especially in business and econo-mics. Depending upon the size of the mold shop, the industry and the frequency and importance of change, a complete activity analysis should be conducted anywhere from every six months to every couple of years. A shop can (and should) conduct an activity analysis in the event of major changes in its environment, i.e., factors that are important to business operations or the production process—such as increased labor costs, material costs or financing costs. Each activity analysis should be incorporated in the cost structure, pricing and planning of the business to ensure sure they reflect important changes in the industry, technology, and the economy.
Real costing, customer analysis, cost improvement and other benefits of ABC depend upon an activity analysis based on the operating capacity of a mold shop. ABC analysis should not include any activity that is significantly less than or greater than the shop's normal operating capacity. The activity analysis leads to a greater understanding of the business and yields useful information that can be used to improve various categories of business activities.