Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13.
Summary by Lori Meister
Master
of Accountancy Program
University of South Florida, Summer 2003
ABC Main Page | Capacity Related Main Page
The
purpose of this article is to explain how activity-based cost systems are needed
and much more relevant than traditional cost systems. It looks at common mistakes that traditional systems make, and it suggest
ways for managers to utilize all the information that activity-based systems
provide.
One
of the most important components of activity-based costing is the fact that it
can estimate the cost of resources used to produce outputs (1). There is a relationship between the costs of resources used and the cost
of resources supplied. It is shown
with this formula:
Activity Availability = Activity Usage + Unused Capacity
or
Cost of Activity Supplied = Cost of Activity Used + Cost of Unused
Activity
The
article gives an example to illustrate this equation.
It describes a department of ten employees who process purchase orders.
The payroll for each of these employees is $2,500 monthly, which leads to
a total expense of $25,000 per month. The
example then looks at the capacity of each employee.
At practical capacity, each employee can process 125 purchase orders per
month, or 1,250 processed in total. Now
assume that only 1,000 purchase orders are needed this month.
A traditional costing system would allocate the full $25,000 towards the
cost. An ABC system would analyze it
differently. Since it costs $2,500
to pay the employee each month and practical capacity is 125 purchase orders,
$20 (2,500/125) should be allocated to the cost of each purchase order.
Since only 1,000 purchase orders were processed, $20,000 worth of
expenses would be charged and the remaining $5,000 spent would be unused
capacity. Lets look at the formula
again:
$25,000 (cost supplied) = $20,000 (cost used) + $5,000 (unused capacity)
The
financial statements will show the total expense of $25,000, while the ABC
system will show the $20,000 actual cost of activities used.
Many
companies tend to think of the $25,000 cost of resources supplied (employees) as
a fixed cost. This may seem true in
the short-run, but it is important to remember that the quantity of these
resources used will fluctuate depending on the activities performed (purchased
orders processed).
Two
key terms have been used in this example. The
measurement of costs of resources supplied shows current spending and the
capacity that the spending allows (3). The
costs of resources used will give the managers information needed for
performance actions. They are able
to find the amount of unused capacity, which can lead to finding ways to
eliminate this unused capacity, or using it somewhere else.
II.
ISN’T THE UNUSED CAPACITY CALCULATION JUST A NEW NAME FOR THE VOLUME
VARIANCE?
Some
may argue that unused capacity is just a volume variance. The authors give three ways in which they differ:
· Volume variances only use aggregate amounts since they ignore the
quantity supplied or used. ABC will
show both the quantity used and the unused capacity that could have been used.
· Volume variances only look at a set standard capacity, rather than a
practical capacity. ABC ignores what
the projected capacity was and only looks at the practical capacity.
· Allocating overhead for traditional systems only helps with inventory
valuation rather than management information (3).
The
authors then go on to discuss what they feel is the most important distinction
between the two. Volume variances
use allocation bases such as direct labor hours, machine hours, etc. that vary
with the number of units produces. This
leads to the assumption that these factory expenses are directly proportional to
the volume of units produced, which is invalid.
ABC
systems use drivers that are not used to allocate costs, but to show the costs
demanded by outputs in each activity.
III. RESOURCES THAT ARE SUPPLIED AS USED (AND NEEDED)
Resources
are purchased mainly in two different ways. Some are acquired when they are needed, while others are purchased in
advance.
For
those that are acquired as needed, the cost of the resources supplied will equal
the cost of resources used. Many
people consider these to be “variable costs.” The costs will vary proportionally to the amount needed. They do not have unused capacity because what is used is supplied.
The
most common type of resources purchased in advance is fixed assets such as
buildings and equipment. They incur
expenses, such as depreciation, on a predetermined allocated basis.
These expenses are independent of the amount of the resource used.
Another example is employees paid on salary. The payroll expense will be incurred regardless of the production of the
employee. Many people associate
these costs as “fixed costs.”
V.
MEASURING COSTS OF RESOURCES USED IN A PERIOD:
THE ROLE FOR ACTIVITY-BASED COST SYSTEMS
The
article describes a basic ABC income statement to show the difference between
resources supplied as needed, and those supplied in advance. Contribution margin is calculated as sales minus those expenses of
resources supplied as used (materials, energy, short-term labor). The remaining expenses are then those that were acquired prior to usage
(machine run-time, purchasing, engineering changes).
A
problem many companies face is the fact that they use the information from ABC
systems to produce monthly budgets. They
discuss this problem using a Hewlett Packard: Queensferry Telecommunications
Division case.
QTD
used ABC to both help product engineers design less expensive products, and to
monitor production performance. These
roles became a problem when production dropped due to a major contract being
postponed. In order not to show
large volume variances, they came up with new higher cost drivers to make up for
lower production and less unused capacity. By
doing this they completely ignored the original purpose of the ABC system. Unused capacity should not be viewed as a change in the cost of
performing the activity (8).
VI.
RELEVANCE FOR MANAGERIAL DECISIONS: USING ABC TO
INCREASE PROFITS
The
biggest question companies have is, how do ABC systems help us become more
profitable? ABC allows a company to
look at their pricing and product mix. You
need to find which products are unprofitable. Once you have found them, you can either raise the price or eliminate the
product. You must be careful with
eliminating the product because you need to be aware of all the resources that
the product uses. ABC allows
managers to have a detailed analysis in areas where needed, instead of looking at
the whole picture.
Another
use of ABC is in helping managers reduce resource usage. By reducing this usage, you will create unused capacity that can be
managed away or used to process more (10).
If
you find that one of your products in unprofitable, you can reduce the number of
activities performed, and use the unused capacity to other more profitable
products.
Another
action would be to increase your efficiency. This lets you have the same quantity, but with fewer resources (10). Total quality management and just-in-time are two programs geared towards
continuous improvement in efficiency.
Companies
need to be careful when changing their product mix and improving efficiency
because at the same time they are changing the demand for activities. An ABC system will help in planning and budgeting for these changes. Resource costs will only remain “fixed” if managers do not take
advantage of the unused capacity created (12).
ABC
systems emphasize two major points. First,
activities performed are not demanded in proportion to total volume of units
produced (12). The demand is based
on the product itself and the customer mix that purchases it.
Second, ABC should not be used for projecting costs in the short-run. They show the cost of resources used in activities for different
outputs (12). Managers need to start
using the information provided by ABC systems. They need to look for unused capacity, and utilize it to a profitable
advantage.
___________________________________________
Related articles:
Church, A. H. 1995. Overhead: The cost of production preparedness. Journal of Cost Management (Summer): 66-71. (Reprint of Church, A. H. 1931. Overhead: The cost of production preparedness. Factory and Industrial Management (January): 38-41. (Summary).
Gantt, H. L. 1994. The relation between production and costs. Journal of Cost Management (Spring): 4-11. This is a presentation Gantt made in 1915. (Summary).
Greer, H. C. 1966. Anyone for widgets? The Journal of Accountancy (April): 41-49. (Summary).
