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Greenwood, T. G. and J. M. Reeve. 1994. Process cost management. Journal of Cost Management (Winter): 4-19.

Summary by Carolina Saavedra
Master of Accountancy Program
University of South Florida, Summer 2002

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Process Cost Management

Process Cost management is an approach that is used to determine the costs of existing processes by which goods and services are designed, procured, delivered, and supported. It can be done for benchmarking, activity cost analysis, or product costing. It is also used to simulate resource consumption levels for future process and product configurations based on cost driver relationships derived from product attributes and process parameters. Managers perform these simulations to be able to deploy and align resources with anticipated activity demands as well as respond to new business opportunities.


In the past, ABC has provided accurate product costs and a better understanding of long term relationships between activity drivers and resource levels, but there has never been a tool that links changes in products or processes to potential changes in resource levels. Information usually flows from resource to product, but emphasis now is being placed on the ability to reverse the flow of information. It’s a shift from the consumption model (product costing) to the spending model (resource decisions).

New simulation capabilities

Here are 5 problems in existing approaches that a new cost system design must overcome to provide a true simulation capability.

1. The pooling of activity costs by cost drivers obscures the costs of individual resources.

2. The assumptions that the relationship between changes in cost drivers and the consumption of resources within activities is linear.

3. Failure to acknowledge the effects of changes in process parameters that are independent of product identities.

4. The inability to consider compound effects between the consumption of a resource at a particular activity and multiple cost drivers and

5. The inability to explicitly cost alternative process segments as opposed to making simple inferences about the nature of a functionally decomposed group of activities.

PCM focuses on the process hierarchy for product costing and resource spending simulations. Product costing is when at the activity level, resources from the organizational structure are used for the production of goods/services. Resource spending simulation on the other hand goes from cost objects back through activities and then back to resource levels. This facilitates process costing, product costing, and resource management.

Spending simulation example:

Spending simulation works backwards. It goes from cost objects back to the activities that comprise business processes and then back to the specific organizational resources that are affected. Analysts want to know what impact the changes in products and processes have on resources (spending) so they must focus on the relationships between cost drivers and resource consumption.

This example shows the effect a change in the setup activity has on its resources of labor and tooling. The setup activity is influenced by both product cost drivers and process cost drivers.

Product cost drivers affect activities by changes of product attributes or characteristics (such as product design, volume, mix, or batch size). In this example the product batch size is reduced so therefore the products will need to be set up more often and the amount of set up activity required will increase.

Process cost drivers affect the efficiency or effectiveness of a process and are process parameters. They affect the process cost independently of any product mix. A simple improvement in the setup activity would affect the resources required to perform the setups, but in this example the efficiency of the setup activities does not change.

Product attributes and process parameters both drive activity consumption which in turn consumes resources. Resources are expense categories that supply the performance of the activities. When an activity is activated through the simulation you must know which resources are affected and how. For example, capital resources may be fixed over some range of activity volume while people resources may vary over the same range. Activities compromise multiple resource categories and each has their own cost profile.

Effects of reducing batch size. In this example, the setup activity consumes only two resources, labor and tooling. If the only change is a reduction in the product batch size then the number of setups will increase. Management needs to know if the change will call for additional resources for that setup activity. Since resources are purchased in lumps, the resource categories must be expressed in terms of their actual cost behaviors which will usually be step functions. Both labor and tooling are step functions which mean that there is both a fixed and variable component for each step function level and an increase in an activity may or may not need an increase in capacity. For example, each additional employee requires an additional outlay of cost whereas since tooling has additional unused capacity, an increase in setup activity will not necessarily require new tooling.

Increasing capacity of constrained activities usually corresponds to increases in output. A process improvement occurs when the output satisfies a customer demand by using only the available capacity of a particular resource. A productivity improvement has occurred if there was an increase in output without an increase in resource spending. In this example the setup related cost drivers don’t change except for the decrease in average batch size. Managers usually model resource demands from more complex simulations that have several cost driver changes such as an increase in setup efficiency along with a simultaneous reduction in average batch size. PCM accommodates complex situations by predicting future resource levels and capacity usage.

Advantages of using resource spending profile

Instead of broad generalizations about the impact on spending of alternative product and process designs, PCM generates simulations that incorporate non proportional spending functions like the ones found in the real world.

Volume based costing techniques results in distortions on typical make-versus-buy decisions. For example, marginal cost of excess labor or machine capacity is assessed at the full overhead burden rate and therefore favors outsourcing when in reality, the marginal cost of activities that consume committed but unused resources is zero.

PCM requires more specification than a typical ABM implementation. In PCM the system must support both macro and micro levels of detail. The main objective is to attain sufficient level of cost resolution to accurately portray product, activity, and process costs within reasonable time and cost. To allow firms to study particular process segments in detail, the data structures that support the process cost system are fully relational and modular. The decision support system should be flexible and allow users to switch to more resolute process cost models when they have more focused decision needs.

An extended example with multiple activities. Multiple activities are tied together in networks that form the processes that design, procure, produce, and distribute goods and services. This next example is based on a company that takes orders for wall plaques, designs, engraves, and then assembles them.

Step 1: Model the activity network.

There are three types of products each with different engraving operations and with different resource demands. The first type uses regular engraving, the second uses laser engraving, and the third type of product uses photo engraving. We then allocate the resources to the activities. Here are the resources and their codes; equipment 01, tools and supplies 02, labor 05, utilities 07, outside services 08, scrap and material rework 12. These resources are first assigned to organizational units through the budget process and then they are assigned to the activities. Resource categories are not pooled together; instead they maintain their integrity inside the activities. The activity network used in this example is the production process segment. It was developed from the bill of activities to analyze interactions between activities and to show successor relationships, process input/output boundary interdependencies, and information flow channels. PCM allows managers to identify “event-dependent cost drivers” and “boundary conditions” that must be controlled to manage the processes better. After the process hierarchy and activity costs are defined, the reporting capabilities are extensive. You can construct a costed bill of activities along process lines, or you can highlight the functional departmental costs to support a specific process.

Step 2: Identify relevant product and process cost drivers.

Managers notice a growing trend towards laser engraving and wondered how it would affect resource use. (Which resources will be overburdened or have excess capacity, and will new equipment be needed or new people hired, trained, or redeployed?). To anticipate the requirements PCM helps managers simulate the impact of alternative demand/mix forecasts. The product cost drivers for these three products are the activity times (average completion times for engraving, order processing assembly, and inspection activities) and these products are diverse in terms of demand, batch size, complexity, and technology. Process improvements can change these times either individually or across all products. The process cost drivers are process parameters that are not product specific and provide essential information about the practical capacity of the process (like production hours per shift, set up times, and activities that are common to all the products like shearing operations in our example).

Step 3 Simulate resource consumption levels for each process scenario. After identifying the product and process cost drivers, you can find out what resources are required to support the activity network. In this example, direct labor resource is determined for the planned cost driver levels. Since direct labor is a resource that is common to all four activities (engraving, shearing, assembly, and quality control) the total requirement for direct labor hours can be simulated by calculating the projected consumption for each activity and summing the results across the four.

Step 4 Determine resource spending requirements After determining the total resource commitment, the “resource spending profile” for the direct labor resource can be entered to yield the results of the simulation. You must reconcile the new resource requirements against the spending profiles for each resource category.

A complete spending simulation model will also include cost driver effects on all the other resources including capital.

Process improvement and process cost management

Accounting has not lost its purpose at all. In order to achieve aggressive target cost reductions and continuously improve business processes, cost management ownership should be driven down to lower levels in organizations and linked to the processes that deliver the outputs. The purpose of process cost management is to support management’s decisions and provide modeling tools to help evaluate alternative products and process designs. PCM can be viewed as a what-if analysis tool to model new opportunities. PCM is also being used by kaizen production teams to understand and control process costs because it allows them to quickly assess the cost advantages of several suggestions. It also ties financial goals to quality and process improvement objectives. Management uses it as a tool to make strategic decisions about resources. Finally PCM can also help make investment decisions by estimating the cost savings from different process and showing which projects should be given priority.

In conclusion, ABC Management has gone from concerns about product costing to the broader issue of improving competitiveness. PCM helps improve competitiveness by providing methods for evaluating the impact of product and process cost drivers on resource spending. It’s concerned with the relationship between processes of an organization, resources, and cost drivers and lets managers find the spending impact of what-if scenarios.


Related summaries:

Berliner, C., and J. A. Brimson, eds. 1988. Cost Management for Today's Advanced Manufacturing: The CAM-I Conceptual Design. Boston: Harvard Business School Press. (Short Summary or Concepts), (Longer Summary).

Beynon, R. 1992. Change management as a platform for activity-based management. Journal of Cost Management (Summer): 24-30. (Summary).

Coburn, S., H. Grove and C. Fukami. 1995. Benchmarking with ABCM. Management Accounting (January): 56-60. (Summary).

Cokins, G. 1999. Using ABC to become ABM. Journal of Cost Management (January/February): 29-35. (Summary).

Cokins, G. 2002. Integrating target costing and ABC. Journal of Cost Management (July/August): 13-22. (Summary).

Cooper, R. and R. S. Kaplan. 1992. Activity-based systems: Measuring the costs of resource usage. Accounting Horizons (September): 1-13. (Summary).

Edersheim, E. H., and B. Vanderbosch. 1991. How to make accounting count: Causal-based accounting. Journal of Cost Management (Winter): 5-17. (Summary).

Keys, D. E. 1994. Tracing costs in the three stages of activity-based management. Journal of Cost Management (Winter): 30-37. (Summary).

Keys, D. E. and R. J. Lefevre. 1995. Departmental activity-based management. Management Accounting (January): 27-30. (Summary).

Martin, J. R. Not dated. Activity based management models. Management And Accounting Web.

Miller, J. G. and T. E. Vollmann. 1985. The hidden factory. Harvard Business Review (September-October): 142-150. (Summary).

Reeve, J. M. 1996. Projects, models, and systems -Where is ABM headed? Journal of Cost Management (Summer): 5-16. (Summary).