Part one of this series contained an explanation of activity-based costing and its use and effects. Part two explained the activity analysis and looked at the benefits. Part three of this article will provide a step-by-step explanation of the entire activity-based costing process for small businesses—including mold shops—and its benefits and cost.
As costs have been distributed to the cost objectives (or fully absorbed), the ABC process can lead to better pricing, focused cost reduction and continuous improvement. Accurate fully absorbed costs help answer the question how much. Just a few of these questions include: are we making the profit that we need to, where can we reduce costs, who are our best customers or clients, and where can we improve?
The ABC Process for Your Mold Shop
Step One: Conduct an ABC Analysis
Conduct an initial activity analysis of the mold shop. Instead of a complete company analysis, a separate department or unit is sometimes used as an ABC pilot project. The activity analysis must identify the activities that are involved in carrying out the purpose(s) or objectives of the mold shop. The analysis classifies the activities as to whether they are primary (revenue-enhancing) or secondary (administrative), and whether they are value-adding activities or non value-adding activities. These classifications can be used later in cost cutting and business improvement.
Mold shops without adequate in-house accounting and cost experience will need to hire an outside consultant for the ABC effort. Others may be able to train an employee as the ABC facilitator and undertake an in-house ABC pilot project. We believe; however, that it would be best to hire an ABC consultant for the initial work (see Part 1).
Step Two: Develop the Activity Centers
Divide the business activities of the mold shop into Activity Centers. Activities are either direct activities or support activities. Support activities are usually called overhead or burden. An example of overhead activities for most businesses—including mold shops, would be supervision, buildings and grounds, purchasing, and general and administrative expenses. There could be more overhead categories, depending upon the specific business involved. The level of effort required of support activities and the basis for assigning them to direct activities is determined during this step. For instance, the marketing activity might be split up into several activities, based on the level of effort required for marketing different products.
Step Three: Accumulate Costs in Pools and Distribute Them to Objectives
Assign costs to the activities, accumulate the activity costs in pools, and distribute the pool costs to the cost objectives of the mold shop. This determines the level of effort or support furnished by support activities to the cost objectives. Reasons or drivers for the supporting activities are determined, and they are distributed to the cost objectives during the cost accumulation process based on the driver involved. This process provides a good understanding of the organization.
It's important during this step to realize that accuracy is more important than precision for small businesses. In all organizations there are only 10 to 15 significant business processes that all the activities are designed to achieve. A small business can roll up its activities into about 10 or so major activities that are involved in the business processes carried out in order to achieve the firm's objectives. In order to save time and effort, don't be too concerned with getting costs to the exact penny. This will result in a more cost effective and timely ABC analysis for a small business.
Step Four: Use the ABC Information Developed to Make Strategic Decisions
The ABC information provides a very effective tool for analyzing various business scenarios. This information can be used to determine the activities (and resulting costs) required to produce a given quantity and mix of jobs, products or services. Just a few of the what if questions that can be answered include: whether or not to accept a special order; whether or not to outsource an activity; whether or not to make or buy a part; how to price any excess capacity; and, how much can be saved by improving leadtime.
The information developed with ABC can be used to make better strategic decisions. For example, using the ABC information to project the effect of a new job upon the mold shop—provided the capacity exists to perform the job. If capacity is insufficient, then a new ABC model should be prepared incorporating the new resources needed and showing the new cost structure at that capacity. You can use ABC information to evaluate com-pleted jobs and identify those at which you performed well and those at which you didn't. In the future, you might decide to concentrate upon those types of jobs that you did well.
You can also look into the reasons for not doing well on some jobs, with an eye toward improvement.
Step Five: Use the ABC Information Developed to Make Organizational Improvements
To use the results of an ABC study as the basis for an in-house business improvement program, a mold shop will need an improvement team composed of a trained ABC facilitator and one or more employees having good knowledge and experience in the area to be improved. Improvement efforts should be concentrated upon activities identified during the activity analysis as good prospects for improvement.
Concentrate upon those activities with the most cost. You can also use the activity analysis classifications of primary/secon-dary and value/non value (see Part II) to identify wasteful activities. As a goal, non-value activities should be eliminated, and secondary (or administrative) activities should be minimized.
Summary of ABC Costing
Activity based costing is a simple and logical process of defining the costs of a business in terms of the activities that produced the costs. The heart of the ABC process is an activity analysis that defines and classifies the activities involved in business operations and collects the costs in activity centers or pools.
ABC distributes the direct costs of raw material, purchased components and outside services to business cost objectives. The indirect (or overhead) activity pools that service/support the direct costs are distributed to the business cost objectives based on the drivers (reasons) for their incurrence. Purchasing department operating costs, for instance, might be distributed to the business objectives based on the number of purchase orders issued, while the cost of operating the sales department might be distributed based on the number of sales dollars.
The end result of the ABC process is the accumulation of all costs into activity pools and their distribution to business objec-tives. The activity analysis and cost accu-mulation/distribution information deve-loped by ABC yields numerous benefits and provides knowledge that a mold shop can use for costing, pricing, estimating, evaluating, budgeting, improving and so on.
This series of articles has tried to help moldmakers see that the cost of ABC is nominal, but the results are phenomenal.
According to one ABC practitioner who is heavily involved with in-house ABC training, the average cost improvement action plan defined by employees during an ABC improvement project achieves about $50,000 in savings with a six-month payback of about 6 to 1. ABC is just as much a tool for management decisions as it is a costing method. One profitable contract or job obtained by using activity-based costing information can greatly increase the bottom line, while one unprofitable contract or job avoided by using ABC information can save a business.
The Cost of ABC
According to those who have used ABC, ABC literature and other various experiences: there are 10 to 15 significant business processes per organization. There are five to 10 significant activities per department. For small businesses, which would include many mold shops, an ABC analysis only needs to deal with the most important activities. A large business is one that has several hundred employees and/or $100 million or more in annual gross revenues; anything less would be a small business.
In a basic ABC study, a small business does not need to map out in detail every task involved in carrying out every activity. Costs only need to be collected into the activity pools defined by the significant activities involved in the business processes that carry out the firm's objectives. For instance, the departments in a small mold shop could serve as the activity pools—eliminating the need for a higher level of precision in the activity analysis.
The cost of an ABC study is mainly determined by the time required for the ABC analysis, which depends upon the level of precision needed. The level of precision depends upon the size and complexity of a business and the use that will be made of the ABC study. The basic study provides very good benefits on its own and is the basis for any additional use of ABC for business analysis and improvement.
According to those who have used ABC and other various experiences, it is believed that the cost of a basic ABC study for a small to mid-sized business shouldn't exceed 1/2 percent of its annual gross revenues (0.005 times gross revenues). It is generally accepted among experienced ABC practitioners that there is about a 20 percent waste in most budgets. Therefore, there is a potential $200,000 savings to be achieved if ABC is used to develop a cost savings/improvement program. This does not include the benefits that can also be gained from putting the ABC information to use for other purposes.