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

Summary by Kellie Quinn
Master of Accountancy Program
University of South Florida, Summer 2002

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This article includes a discussion of the three methods used to assign costs to a cost object and the advantages and disadvantages of each method. The author defines a cost object as "an activity, a product, department, project, customer, or some other focus for which a decision maker would like to know the cost." The cost object chosen is dependent on the type of decision that management needs to make. Costs should only be assigned to a cost object if the benefit exceeds the cost of the assignment.

Costs are assigned to a cost object by direct tracing, cause-and-effect cost assignment or cost allocation. Direct tracing requires that, by physical observations, a cost can easily and accurately be related to a cost object. This method is less expensive than assignment or allocation and the result is usually more accurate.

One disadvantage of the direct tracing method is that some costs may be traced directly but will not be because they are indirect costs. The author gave an example of a focused factory with one area that is dedicated to a certain product. Since this area is used for a single product, salaries of supervisors who are dedicated to the area and depreciation on this portion of the building and all machinery and equipment used in the area can be traced directly to the product. If these costs are considered overhead and it is assumed that costs cannot be directly traced, then allocation or assignment of these costs will lead to greater cost and less accuracy than direct tracing. Another disadvantage is that too many resources may be used for the physical observation required to directly trace a cost to an object. If a cost cannot be easily traced to a cost object then another method should be used. Finally, physical observation may lead to the wrong conclusions resulting in inaccurate tracing. For example, the labor cost (considered direct labor) of a machine operator who works on several machines may be traced equally to each machine. Tracing costs to each machine in this manner will be incorrect if one machine requires more of his time than the others.

The author noted that the direct tracing method does not identify the cost driver or the resource. Therefore, resource and cost driver analysis cannot be performed. However, this does not limit the ability to manage costs since the relationship between the cost object and the cost can usually be observed.

Cause-and-effect cost assignment should be used when costs either cannot be directly traced or it is not cost-effective to do so. This method assigns costs to the cost object based on the long-run cause of the cost. For example, costs may be assigned to a material handling cost pool based on the number of moves for each part during the year. The total material handling cost, the total number of moves and the total number of parts are forecasted and the appropriate cost is assigned to the cost pool. Since the cause of the cost is determined by cause-and-effect assignment, the costs assigned to a cost object are usually more accurate than if the cost had been allocated. Moreover, identifying the cost driver will assist management in managing the costs.

The cause-and-effect method is not without its disadvantages. The cause-and-effect method assumes that costs have only one cause. As a result, costs that are assigned using this method will be inaccurate if the cost has two or more causes. Moreover, managers may ignore the additional causes and focus only on the cause identified for the assignment. This method may also yield inaccurate costs if the wrong cost driver is identified. Without the right cost driver, managers will find the cost harder to manage and to explain.

The cost allocation method should used if the cost can neither be traced nor assigned to cost object. The cost allocation method is similar to cause-and-effect assignment, except that the allocation base in not the cause. In most cases, the allocation base is usually some quantity that is already being tracked, such as sales or direct labor. Since the allocation is not based on a causal relationship, the cost allocation method will usually yield a cost that is less accurate than the two methods described above. In fact, the accuracy of an allocation can usually not be determined.

It is possible that the cost assigned to a cost object is correct. This will occur when there is a high positive correlation between the cost and the allocation base. Even if the costs assigned are accurate, this method provides little help to managers wishing to control costs.

Exhibit 1 provides a comparison of the three methods described above:

* The assignment by itself is not a great help in controlling the cost.

According to the author, "if accuracy of the cost is so arbitrary that the cost allocation will not be useful for decision making and if no regulation (e.g., defense contracts, GAAP, or Medicare) requires the allocation, then the costs should not be allocated" (p.34). Some experts argue that costs on future products and idle capacity costs should not be assigned to products at all. If allocation is used, a complete disclosure should be made.

The author argues that literature about ABC and ABM identify two stages of assigning costs when, in fact, there are three stages. The stage that has been excluded is the first stage, which requires that costs be assigned to the appropriate year. The correct year, according to Keyes, is "the year in which the cost produces benefit." Since most traditional systems assign costs to the wrong year, it follows that the ABC system will attempt to assign costs that are in the wrong year to products produced that year. The result will be inaccurate product costs, regardless of how well costs are traced to activities or departments in Stage 2 or how well the activities or departments are assigned to a cost object in Stage 3.

Keyes provides three alternatives for assigning costs to the appropriate year. The first alternative is that costs can be assigned to the year in which it produces benefit. This alternative produces accurate costs but makes cost assignment more complex since the portion of the costs that benefits the current period and future periods would have to be estimated. The second alternative is to assign the cost to the period in which the cost is incurred, but not assign it to the year’s activities. This alternative is simpler than the first alternative but will consistently understate the cost of the product. The last alternative, and precisely what most ABC systems do today, is to leave the cost in the period it is incurred and assign it to the products in this period. The author states that if the third alternative is chosen, a disclosure should be made.

Keys reiterates that, by ignoring the "real" first stage of the ABC costing, companies are concentrating on assigning inaccurate costs. Since this inaccuracy is unlikely to be disclosed, it limits the usefulness of ABM information to managers.

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