Management And Accounting Web

Palmer, R. J. and M. Vied. 1998. Could ABC threaten the survival of your company? Management Accounting (November): 33-36.

Summary by Deborah Bichsel
Master of Accountancy Program
University of South Florida, Summer 2003

ABC Main Page | ABM Main Page | Cost Management Main Page

Although activity-based costing (ABC) is a popular theory, it is not always easy to convert from theory to practice. Companies choosing to implement ABC face a wide variety of issues associated with the conversion. This article describes in detail one company’s struggle to convert to an activity-based costing system, without creating upheaval within the company itself. While this article is about a specific company, “Inkslinger, Inc.,” it is a reflection of the problems many other companies face when considering an ABC system.

In order to understand the issues Inkslinger faced, it is important to understand the basic structure of the company. Inkslinger has five business teams that produce different types of pens. It has four manufacturing plants - one in Kentucky and three in California. The leaders of the five business teams use standard costing to purchase their products from the different plants and can perform “standard shopping” between them. Each plant uses a plant-wide overhead rate to allocate overhead. When the Kentucky plant began production of a newly developed product, its total overhead greatly increased. Correspondingly, the standard cost of the other products produced in the plant increased The leaders of the business teams began to purchase their products from the California plants that had a lower standard cost.

Senior management was concerned that the shift of purchases from the Kentucky plant to the California plants would cause a “cost accounting death spiral.” Lower production demands at the Kentucky facility would cause the overhead cost per unit to increase and, consequentially, increase the standard cost even more. Because of this dilemma, Inkslinger conducted a Product Line Costing (PLC) analysis in the Kentucky plant. PLC was Inkslinger’s term for an ABC system and allocated overhead based on different cost drivers rather than using a plant-wide rate. Analysis confirmed management’s suspicions that the new product was causing the older products to be overcosted under the traditional costing system. This discovery created the real dilemma for senior management: What should they do about it?

Management would have to address several issues before it would be able to successfully covert to an ABC system. First, it worried that the team managers would not believe the results of the analysis were accurate. Second, it worried that they may agree to adopt the system in order to boost their bonuses. Of the five team managers, only the manager of the team with the new product did not stand to benefit from the conversion. The standard cost of that product would increase, lowering income and any bonuses based on that income. The standard cost of the other products would have the converse effect, increasing income and manager bonuses. Managers were also worried about Inkslinger losing its competitive edge because new products would not have the opportunity to take off because high costs would reduce the management’s ability to justify production based on future market share.

Inkslinger team managers were generally supportive of the change. They were already aware of the existence of costing problems. They also wanted to ensure that Inkslinger served to benefit from the change, not just their individual business team.

Inkslinger also had to deal with the issue of which plants needed ABC. If the California plants did not also use ABC, or used different costing techniques, there would not be a fair comparison of standard costs between the plants. The change in any or all of the plants’ standard costing systems would create the need for adjustments to the decision-making process and standard shopping behavior within the company. Operating managers would also have to change the way of thinking they had used for a long time. Inkslinger would need to solve these issues before it could adopt an ABC system.

Another problem was the justification of using such a complex system to determine the cost of products when simpler costing models were available. Many people believed that ABC was too complicated.

Senior management’s decision was to implement ABC on a long-term basis, rather than making a quick switch. Inkslinger would continue to use the traditional costing system during the implementation process. This would allow the company to continue with its strategy of product innovation and give the company time to adjust its team leader compensation packages. Senior management also believed that it was important to have a complete understanding of the impact of the transition to ABC on production before the system was implemented. Management decided to use PLC immediately for monthly financial analysis. It would also create an ABC implementation plan in order to make the transition smoothly.

Any company considering a conversion to an ABC system needs to keep in mind the pitfalls that come along with it. Although it can greatly benefit a company if implemented correctly, the negative effects of hasty conversion can be very damaging. Many of the obstacles that a company encounters can be addressed by educating employees on the theory of ABC. Management accountants must also be fully prepared to answer questions and respond to concerns that may arise from employees.

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