A number of organizations have adopted activity based costing to link operating behavior to product and customer segment cost. Overhead costs cannot be easily traced to products. Using a plant-wide predetermined overhead rate is simple, but using such a rate may inaccurately assign costs to products. Activity-based costing is an alternative that attempts to accurately assign overhead costs to products for financial reporting and other purposes. When cost systems were developed in the 1800s, the emphasis was on simplicity because cost and activity data had to be collected by hand and all calculations were done with paper and pencil. Most companies produced a limited variety of similar products, so there was little difference in the overhead costs consumed by each product. In the interest of simplicity, companies often established a single overhead pool for an entire factory that used direct labor as the allocation base. Direct labor was the obvious choice because, the information about direct labor was already being recorded, direct labor was a large component of product costs, and managers believed direct labor and overhead costs were highly correlated.
However, conditions changes necessitating a change in the evaluation of costs. Most companies now sell a large variety of products that consume differing amounts of overhead. As a percentage of total costs, direct labor has been shrinking and overhead has been increasing. Many of these growing overhead costs may not be correlated with direct labor. Technology advancements have reduced the cost and complexity of gathering diverse sources of data. These changes suggest that a plant-wide overhead allocation system may not be optimal for many companies in today’s business environment. Many companies use departmental overhead rates, instead of a plant-wide overhead rate. The nature of the work performed in a department will determine the department’s allocation base. For example, the overhead costs in a machining department may be allocated using machine hours. On the other hand, the overhead costs in an assembly department may be allocated using direct labor hours.
Departmental overhead rates, however, will not correctly assign overhead costs in situations where a company has a range of products and complex overhead costs. This is because the departmental approach relies exclusively on volume-related allocation bases. Some overhead costs may be caused by factors that are not related to the volume of production. A more sophisticated approach, such as activity-based costing, is required to account for these other factors.
Activity based costing (ABC) uses numerous allocation bases in an attempt to assign overhead costs more accurately to products than the plant-wide or departmental approaches discussed thus far. The basic idea of ABC is as follows: A customer order triggers a number of activities --> Performing the activities consumes resources --> The consumption of resources incurs costs. An activity in activity-based costing is an event that causes the consumption of overhead resources. An activity cost pool can be thought of as a “cost bucket” in which costs related to a particular activity are accumulated. An activity measure expresses how much of the activity is carried out and is used as the allocation base for applying overhead costs to products and services. Activity measures may or may not be related to volume. An activity rate is a predetermined overhead rate in an activity-based costing system. Each activity cost pool has its own activity rate that is used to apply overhead costs to cost objects.
In most companies, hundreds or even thousands of different activities cause overhead costs. The challenge is to select a reasonably small number of activities that explain the bulk of the variation in overhead costs. Activities are usually chosen by interviewing a broad range of managers to find out what activities they think consume most of the organization’s resources. Related activities are frequently combined to reduce the amount of detail and record-keeping costs. For example, several activities may be involved in handling and moving raw materials, but these may be combined into a single activity entitled material handling. An activity dictionary defines each of the activities that will be included in the activity-based costing system and how the activities will be measured.
A common framework for combining activities in manufacturing companies is as follows:
- Unit-level activities are performed each time a unit is produced. For example, providing power to run processing equipment is a unit-level activity.
- Batch-level activities are performed each time a batch is handled or processed, regardless of how many units are in the batch. For example, setting up equipment and shipping customer orders are batch-level activities.
- Product-level activities relate to specific products and must be carried out, regardless of how many batches are run or units produced and sold. For example, designing or advertising a product are product-level activities.
- Facility-level activities are carried out regardless of which products are produced, how many batches are run, or how many units are made. For example, heating a factory and cleaning executive offices are facility level activities.
Using activity based costing, the manufacturing overhead costs are allocated to products using a two-stage process. In the first stage, overhead costs are assigned to the following six activity cost pools:
- Labor related pool
- Machine related pool
- Setup pool
- Production order pool
- Parts administration pool
- General factory pool
In the second stage, the costs in the activity cost pools are allocated to products, using activity rates and activity measures. For example, if the total cost in the production order cost pool was $450,000 and the company expected to process 1,200 orders, the activity rate would be $375 per order. Each order would be charged $375 for production order costs. Notice, the example shown on the slide includes two unit-level activities, two batch-level activities, one product-level activity, and one facility-level activity.
UPS has adopted ABC to manage their complex operational environment (Source: http://govinfo.library.unt.edu/usps/offices/domestic-finance/usps/pdf/Holsen.pdf):
The complexity has increased the need for providing information about the package and has increased downstream activities.
To address this issue, UPS system is based on traditional ABC in that it takes detailed functional cost and maps it to products based on the activities that the products drive.
UPS’s ABC System leverages their database of work measurement and package movement detail to improve our understanding of activity cost drivers. Work measurement studies have been performed on work activity at UPS as far back as 1921. These studies provide important insights into the content of activities and the rate at which products drive these activities.
UPS maintains detailed package flow control systems. The information regarding how products move through UPS system provides important cost insights. Additionally, ready access to this data allows for frequent re-calibration of their models.
UPS has a highly efficient network of shared assets that constantly adjusts to meet demand. Resources are shared across product lines making it difficult to identify unique cost differences. Analysis of UPS package flow models provides a framework to begin to answer such questions as:
- What activities were needed to get the package to the final destination?
- What information system resources were required?
- What share of the activities and resources did the package consume?
- What did these activities and resources cost?
The ABC system supports several applications:
1) Performance Measurement: Provides a view of cost and profitability of a division by product across the network.
2) Planning & Forecasting: Helps in integrating financial business plans with profit objectives.
3) Cost Reduction Efforts: Database of cost information helps with internal cost comparisons and analysis.
4) Pricing Tool: Ensures appropriate pricing.
5) Incentive Administration System: Monitoring system aids in tracking performance by customer and account representative.
6) Customer Performance Measurement: Data mining techniques enables with segmenting customers.
UPS costing methodologies allow for the creation of P&L views across multiple dimensions:
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Activity and Customer analysis help in determining the most efficient way to minimize cost for both UPS and the customer. It helps in:
- Focusing operational improvement efforts on high impact areas.
- Changing shipping behavior to minimize cost impact on UPS’s network.
- Modifying distribution network to reduce total transportation cost.
- Integrating logistic solutions to help optimize benefits across the entire value change.
UPS uses data mining techniques to analyze over 50 million records so that profits can be associated to all packages and customers. Customer level profitability gives insights into trends affecting their customer portfolio. Data mining techniques such as Classification and Regression Trees (CART), Chi-square Automatic Interaction Detector (CHAID), Self Organizing Maps, etc. are used to identify meaningful customer groupings. Monitoring customer accounts has enhanced their ability to understand effects of various strategic initiatives.
UPS has extended their Activity Based Costing techniques to measure invested capital. Invested capital is assigned to products based on unique usage of each asset type. Results reflect widely varying degrees of capital intensity across ground and air operations. UPS includes capital requirements into pricing and growth strategies to ensure positive economic profit.