Using ActivityBased Costing to Implement

1
Using Activity-Based Costing to Implement Supply
Chain Improvements
Terrance L. Pohlen Lt Col, USAF, PhD
2
Overview

• Why transportation and logistics managers require
  more accurate cost information
• How activity-based costing can provide greater
  management insight
• Using ABC to support transportation and logistics
  decision-makers
• Applying ABC to supply chain management

3
Transportation and logistics managers need more
accurate cost information

• Critical link exists between corporate
  profitability and logistics costs and
  performance
• Many logistics costs and effects of logistics
  decisions buried in overhead costs
• Logistics particularly requires accurate costing
• Diversity in resource consumption
• Products and resource consumption not
  correlated with unit based allocation measures
• Identifying and costing activities may reveal
  opportunities to improve operating efficiencies

4
Problems typically encountered in transportation
and logistics accounting systems

• Visibility frequently lost--included as part of
  SGA
• Allocated using cases shipped, miles, or
  sales
• Costs not available by product, customer, or
  supply channel
• Affect of logistics decisions/improvements
  not readily apparent
• Output measures frequently not captured

5
The imaginary profits--and losses--that arise
from flawed cost systems can lead to very
expensive blunders. We may be giving away the
best business (high volume, but supposedly low
margin products) to foreign companies.
Competitors dont want your cats and dogs--they
want the volume business. Once the high volume
products are abandoned, those that remain must
carry a greater share of overhead, and thus they
too become less profitable.
Fortune Magazine 12 October 1997
6
Traditional Cost Accounting
Overhead
Direct Labor
Direct Labor
Direct Labor
Direct Labor
OUTPUT
Activity
Activity
Activity
Activity
DIRECT MATERIALS
DIRECT MATERIALS
DIRECT MATERIALS
DIRECT MATERIALS
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Problems with Traditional Costing of
Transportation Logistics

• Unit based allocation suggests costs will vary
  with volume--cannot accurately determine how
  changes in customer service effect total costs
• No reward for reducing indirect cost
  categories--benefits diffused across all products
• Costs reduced by eliminating direct labor
• Overhead costs appear fixed and not affected by
  management action
• Rewards based on cost center performance and not
  on total product/customer/channel profitability

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Are U.S. Manufacturers AccountingSystems a
Major Tool Used in Management Decision-Making?
No
18
Yes
82
Source National Center for Manufacturing
Sciences, Focus, 1993
9
Warning Signals

• Division managers want to drop seemingly
  profitable lines
• Product or customer profitability is hard to
  explain
• Departments develop internal costing systems
• The accounting department performs many special
  projects
• Competitors prices appear unrealistically low
• You have a high-margin niche all to yourself
• Customers dont mind price increases

Adapted from Cooper, Robin, You Need a New Cost
System When..., Harvard Business Review,
January-February 1989, pp 77-79.
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Activity-Based Costing

• a technique to assign more accurately direct
  and indirect costs to the activities, customers
  or products which consume an organizations
  resources

Resources
Activities
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Activity-Based Costing

• IS
• An overhead allocation technique which generates
  the cost of activities

• IS NOT
• A bookkeeping system
• A consolidation system

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ABC translates traditional costing into
actionable information for decision-makers
Cost data translated by ABC
Activity-based information
General Ledger (account balances)
ABC Model
Data
Decision Makers
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How Does ABC Assign Costs?

• ABC uses a two-stage process to assign costs
• Resource costs are assigned to activities based
  on use
• Activity costs are assigned to the products or
  customers consuming the activity

Resources
Activities
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Activity-based costing approach
Overhead
Overhead
Overhead
Overhead
Direct Labor
Direct Labor
Direct Labor
Direct Labor
OUTPUT
Activity
Activity
Activity
Activity
DIRECT MATERIALS
DIRECT MATERIALS
DIRECT MATERIALS
DIRECT MATERIALS
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Resources

• Resources are usually derived from the general
  ledger accounts
• Represent the resources the organization has to
  perform its mission
• Many ABC models use budget information to
  determine resources

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Assigning Resource Costs

• Resource drivers used to assign costs to
  activities
• Interviews frequently used for making the cost
  assignments
• Activity costs are sum of all resources needed to
  perform the activity

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Activity Cost

• An activitys cost is the sum of the resources
  used in performing the activity
• Consumption used to trace resource costs to the
  activities

MHE
2
Supervision
Maintenance
4
1
Supplies
10
Labor
47
Facility
36
LTL Shipping Activity
18
Identification and Number of Activities

• Activities identified by implementation team
• Level of detail determined by
• Cost
• Diversity
• Management Focus
• Most DCs using 20-40 activities for costing

19
Receiving Cartage Unload and
inspect Putaway Storage Bulk
storage Aerosol storage Transp
Planning Pre-shipment scheduling Truckload
planning Post-shipment support Transportatio
n Administration Picking Manual
picking Mechanical picking Stage pallet for
order Build pallet Special Handling Adjust
pallet height Clamp off/slip sheet Spec
Hdling/Warehouse office Shipping Load
pallet Check full pallet Check mixed
pallet Ship international order Ship small
package order Administration Returns Rework
Administration
Product
Customer
Brand
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Assigning Activity Costs

• Activity costs assigned using cost drivers
• Costs assigned on a per activity basis (per case,
  shipment, bill of lading)
• Desired behavior should be considered when
  selecting a cost driver

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Assigning Distribution Center Costs
We assign the cost of this activity Manual
picking Rework Unload inspect Truckload
plng Bulk storage Administration
to this cost object customer brand product custo
mer product brand
using this activity driver cartons mech
picked cartons reworked pallets unloaded pounds
shipped avg pallet on hand no. of cartons shipped
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Cost Objects

• The final output of the organization
• Typically a customer, product, service, or
  distribution channel
• Provides total cost of logistics support

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Cost Object Bill of Activities
Breakout of Customer A Costs
24
Product Division D
13
Product Division A
31
Product Division C
16
Product Division B
40
Product Division D
Product Division A
21
29
Product Division C
20
Product Division B
30
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Comparison of ABC and Traditional Costing

• Focus shifts from correlating unit level cost
  drivers (direct labor hours) to correlating cost
  drivers at the unit, batch, and process levels
• Overhead assigned to activities based on
  consumption--costs assigned to products based on
  the consumption of the activities performed
• Fixed costs viewed as long-term variable costs
  affected by short-term management decisions
• Isolation of costs enables managers to trace cost
  reduction efforts to specific products,
  customers, or supply channels--benefits no longer
  diffused
• Managers can trace the effect of decisions on
  product or customer profitability--ABC captures
  the effects of diversity
• ABC provides significant amounts of non-financial
  information--useful for integrating cost
  management with performance management

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How ABC Can AssistLogistics Decision-makers

• Can more accurately determine how changes in
  service requirements will affect logistics costs
• Provides ability to trace indirect resources to
  logistics activities and outputs
• Focus on high cost activities or processes
• Translate logistics performance into corporate
  profitability
• Greater visibility over logistics costs--better
  trade-offs within the firm
• Simulate changes and impact on logistics costs

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Benefits Obtained From ABC
65
Identify cost driver
59
Improved cost info
47
Better pricing
41
Performance measures
Elim redundant work
41
Cost control
23
LaLonde and Pohlen, Journal of Business
Logistics, 1994
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Supervision
Office Labor
Terminal
3
ABC demonstrates how logistics resources and
activities are consumed
9
13
Insurance
2
Depreciation
4
Maintenance
5
Dock Labor
Fuel
32
7
License
1
Pickup Delivery Drivers
Yard Labor
Utilities
5
1
18
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Problems frequently encountered during ABC
implementation

• Management and employee buy-in
• A new system and stand alone initiative
• Accuracy versus precision
• Delay in immediate pay-off
• Multiple views on cost allocations and costs
• Putting controller in charge
• Too much detail--costing vs reengineering
• Cost and effort required during implementation

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Where ABC best practices are being implemented
General Analysis
Nabisco, Roundys, Food Lion, Tops, Coca-Cola,
Pepsi-Cola, Dial Corp, Bozzotos, Kroger, Shaws
Category Analysis
Procter Gamble, Super Valu, Fleming, H.E. Butt
Menu Pricing
Spartan, Fleming, Super Valu
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Application of activity-based costing to supply
chain management

• ABC can evaluate alternative supply chains
• Activity analysis can achieve a sustainable
• competitive advantage by lowering costs or
• differentiating services
• Supply chain analysis enables firms to exploit
• linkages and perform trade-offs across the
• entire supply chain
• ABC/ABM provides means for assessing
• individual firm as well as supply chain
• performance

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Vendor (Upstream)
Total Cost of Ownership
Perspective of the Firm
Supply Chain Costing
DPP, ABC
Customer (Downstream)
DPP, ABC
Marketplace Landed Cost
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Why supply chain costing?

• Determine overall effectiveness of the supply
  chain
• Identify opportunities for improvement
• Measure performance
• Evaluate alternative supply chain structures
• Select supply chain partners
• Support make versus buy decisions
• Negotiate prices
• Evaluate effects of technology improvements
• Reengineer the supply chain

Supplier
Materiels Management
Inventory Carrying Costs
Information costs
Physical flow costs
Transaction costs
Operations
Physical Distribution
Customer
Supply Chain Costs
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Why use supply chain costing? customer and
channel profitability

• Type of customer and distribution channel
  generally have greater affect on costs than
  product type
• ABC can determine how customers/ channels
  drive indirect costs
• Customer/channel costing provides technique
  for assessing profitability
• Joint action between supply chain members
  can reduce costs

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Using ABC to simulate cost changes within the
supply chain
Process redesign
Performance measurement benchmarking
Problem solving
Target Setting
Activity Analysis
Activity- based costing
Time
Quality
Cost
Flexibility
The Continuous Improvement Cycle, Paul Sharman,
CMA Magazine, Vol 66, No. 4
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Distribution Center ApplicationActivity Volume
Change

• Determine how anticipated shifts in activity
  volumes will affect distribution center costs.
• Use cost per activity and activity volume to
  assess effect
• Example
• Customers order more frequently but in smaller
  quantities

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Activity volume example
Activity
Cost per Activity
Activity Volume
Change
Load Whse Transfer
150/truck
Load Pool Shipment
210/truck
-2,100
-10
Load LTL/UPS
16/shipment
4,800
300
Storage
125/pallet/year
Process Orders
18/order
300
5,400
Process Returns
75/return
Pull/Put Full Pallets
4/pallet
Ship Priority
40/shipment
Ship Routine
25/shipment
Pick/Build Orders
36/order
300
10,800
Receive Whse Transfer
95/WT
Net change to the DC 18,900
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Using ECR scorecards to determine supply chain
capabilities and costs
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Activity-Based Management

• Use non-financial data provided by ABC to drive
  continuous improvement and reengineering
• Link performance measurement system to changes in
  process costs or profitability
• ABC can trace effect of management decisions to
  changes in total process cost or profitability

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The Two-Dimensional ABC Model
Cost Assignment View
Resources
Process View
Activities
Performance Measures
Cost Drivers
Cost Objects
Peter B. B. Turney, Common Cents
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Cost Assignment View
Cost Assignment View

• Focus of early ABC efforts
• Objective - more accurate product costs for
  product mix, sourcing and product design
  decisions

Resources
Activities
Cost Objects
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Process View

• Focus of newer ABC implementations
• Objective - improving operational processes
  by identifying (and eliminating)
• non-value-added activities

Process View
Activities
Performance Measures
Cost Drivers
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Balanced scorecard approach
How do we look to shareholders?
Financial Perspective
Goals
Measures
How do customers see us?
What must we excel at?
Internal Business Perspective
Customer Perspective
Goals
Measures
Goals
Measures
Innovation and Learning Perspective
Goals
Measures
Can we continue to improve and create value?
Kaplan, Robert S., and David P. Norton, The
Balanced Scorecard - Measures That Drive
Performance, Harvard Business Review,
January-February 1992, pp. 71-79.
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Vendor/Carrier Evaluation
Use ABC to assess current carriers and vendors

• Vendor selection affects the costs of ordering,
  expediting, receiving, inspection, production,
  and distribution
• ABC provides a means of more accurately tracing
  how vendor decisions affect total costs
• Purchasing managers can use total cost of
  ownership in vendor selection and evaluation
• Activity analysis opens potential for exploiting
  vendor-buyer linkages to reduce costs and
  differentiate service

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Key References

• Turney, Peter B. B., Common Cents The ABC
  Performance Breakthrough, Portland, OR Cost
  Technology, 1993.
• Player, Steve and David Keys, Activity-Based
  Management Arthur Andersens Lessons from the
  ABM Battlefield, New York Mastermedia Ltd.,
  1995
• Journal of Cost Management published by Warren,
  Gorham Lamont
• Brinker, Barry, editor, Emerging Practices in
  Cost Management 1996 Edition, Warren, Gorham
  Lamont, 31 St. James Avenue, Boston, MA 02116,
  [phone]
• Cokins, Gary, Activity-Based Cost Management
  Making It Work, Chicago, IL Irwing Professional
  Publishing, 1996