Implementing Activity Based Costing for Job Shops

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Implementing Activity Based Costingfor Job Shops

• Presented by
• Dave Lechleitner
• Business Productivity Analyst
• Exact SoftwareJobBOSS Division

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Your presenter today is Dave Lechleitner Business
Productivity Analyst
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Why are we doing this session?

• Knowing your winners from your losers is
  critical.
• Its not getting any easier out thereyou have to
  remain competitive.
• Flat shop rates dont provide a true cost
  picture.
• ABC provides a simple approach to analyze true
  cost and is now being applied even to small job
  shops.

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Key Questions

• Why do traditional flat shop rates fall short?
• What are the characteristics of shops
  implementing Activity Based Costing (ABC)?
• How does ABC work and how can a shop correctly
  and accurately allocate activity costs to jobs?
• What key tools should you look for in an ERP
  system to review costs and especially application
  of overhead?
• How should a shop implement ABC?

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Why Do Flat Shop Rates Fall Short in Determining
True Job Cost?
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Flat Shop Rate vs. ABC

• Flat shop rate costing methods were generally
  developed when a shop owner first started the
  business and may have increased or decreased
  based on gut feel or what the market may
  bear.
• Normally includes some provision for profit
  built in. Hides the real picture of what is
  going on.
• Generally has no basis on reality of the true
  cost structure of the shop.
• Inherent problem in a flat shop rate is that it
  has an averaging effect. Difficult jobs are
  under-quoted/costed and easy jobs are
  over-quoted/costed.

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Flat Shop Rate vs. ABC
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Flat Shop Rate vs. ABC
Two employees VERY different cost structure
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Flat Shop Rate vs. ABC

• Opponents of ABC often fall prey to the following
  arguments or behavior--
• We dont charge THAT cost to the customer because
  the customer wont pay it (i.e. engineering,
  quality control, customer service, etc.)
• We cant win the job quoting our actual cycle
  times so lets fudge the cycle times to get the
  price the customer will pay.
• We have to sharpen our pencils and lower our cost
  estimates (i.e. ignore the real costs and put
  down anything to get to the price the customer
  will pay.)

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Characteristics of Shops Implementing Activity
Based Costing
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Shop Characteristics

• Activity Based Costing is 30 understanding and
  using techniques correctly, and 70 the ability
  to convince others to accept beneficial change.
  No matter how brilliant the measurement, if
  people reject it, nothing has been achieved and
  the analyst has failed.
• -- Ralf Sorenson (Head of SAS Airlines)

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Shop Characteristics

• Has your time come to evaluate a new method of
  measuring and collecting data as it relates to
  job costing? It has if. . .
• Your shop is implementing new, technologically
  advanced processes into your operations without
  making adjustments to your costing processes.
• You only currently use one basis for charging
  manufacturing costs to productsdirect labor
  hours, direct labor dollars, machine hours.

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Shop Characteristics

1. You have only one plant wide overhead rate, a
   couple of rates, or worseno overhead rate at
   all.
2. You automatically change costing rates as volume
   levels change.
3. You find yourself competitive in one product line
   but not another or at one volume level but not
   another.

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Shop Characteristics

1. Your shop manufacturing operations do not always
   require the same number of operatorspartially
   attended operations or team operationsor one
   employee operating a work cell.
2. It has some customers, markets, or product lines
   that require different levels of selling,
   scheduling, service, or other support activity
   but only have one company wide GA rate.

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What is ABC and How Can Shops Accurately Allocate
Costs
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What is ABC?

• Very simple concept and key management tool.
• Jobs and contracts require a company to perform
  activities.
• Activities cause a company to incur cost.
• Cost should be associated with jobs and contracts
  that made the activity necessary.

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What is ABC?
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What is ABC?

• So, how does ABC work?
• Identification of cost pools or activities
  which a product/service must pass.
• Estimation of total cost of each activity must be
  estimated for time period.
• Estimation of number of hours spent on each
  activity for same time period.
• Determination and assigning of cost driver
  (i.e. quantity, of labor hours, of machine
  hours, of parts).

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How Does a Shop Allocate Costs?

• Project a normal level of production activity.
• Review over a longer period of time, such as a
  12-month period.
• Costs based upon shorter periods, such as weekly
  or monthly periods, may fluctuate too much.

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How Does a Shop Allocate Costs?

• Assign costs that are directly attributable to a
  job and not subject to ABC cause/effect analysis
• Direct labor (use actual employee rates)
• Raw material
• Purchased components
• Outsourced manufacturing services
• Perishable tooling consumed on a job

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How Does a Shop Allocate Costs?

• Determine the costs associated with Operational
  Support ActivitiesManufacturing Overhead
• Buildings and grounds
• Human resourcesadministrative staff required to
  support employees performing direct activities
• Maintenance
• Plant supervision and production control

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How Does a Shop Allocate Costs?

• Determine the costs associated with Customer
  Support Activities and Other General/Administrativ
  e Overhead
• Different markets or customers may require
  different effort to get new business or maintain
  existing
• Customer service activities customers who are
  jerks often cost more to maintain than
  sweethearts
• Accounting
• Sales and marketing

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Example of Indirect Shop Expenses over previous
12 months
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Allocation Calculation

• Determine a best method for allocating the costs
  by type of activityremember to use the driver of
  the cost as the basis.
• Percentage of direct labor dollars
• Dollar rate per direct labor hour
• Dollar rate per machine hour

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Allocation Calculation

• Using the same 1,000,000 of expenses for the
  last 12 months.
• Break expenses out by burden type
• Labor burden
• Machine (Manufacturing) burden
• GA (General Administrative) burden

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Allocation Calculation

• Same 1,000,000 of expenses allocated by burden
  type.
• Labor Burden (300,000) Machine Burden
  (500,000) General Administrative Burden
  (200,000) 1,000,000.

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Allocation Calculation

• Costs divided by shop hours of operation.

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Tools Available in ERP Systems to Analyze Costs
and Application of Overhead
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ERP System ToolsAccording to NTMA

• Key Principles of an ERP System
• Assign a unique job (work order) number for each
  part number on an order you receive.
• Identify customer, part, and delivery information
  on the order.
• Post cost of material at the time it is purchased
  and received or drawn from stock.
• Post all outsourced processing expenses to the
  order.
• Post hours and rates for direct labor hours and
  machine hours to the order when they occur.
• Assign manufacturing, selling, and general and
  administrative overhead to order on proportionate
  basiskey to ABC.

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ERP System Tools
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ERP System Tools

• ERP systems should give you the option to use
  Actual Employee Rates to drive true ABC
• Application of labor overhead by percentage
  yields better results if you have wide variances
  in employee wages and fringe benefits

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ERP System Tools

• Once true cost is established, ability to define
  global markup or profit goals is practical

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ERP System Tools

• Should allow ability to define markup or profit
  goals specific by quoted quantity and specific
  part

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ERP System Tools

• Ability to review estimated, actual, and variance
  against direct labor and overhead/burden costs at
  end of job.

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ERP System Tools

• Review profitability against order, produced, and
  shipped quantity

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ERP System Tools

• Catch your losers before they get out of
  controlbefore its too late!

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ERP System Tools

• Regularly monitor your allocation of your costs
  against the activities that drive them.

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How Should a Shop Implement ABC?
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Implementing ABC

• Determine your present expertise level in ABC and
  commitment to it
• Determine cost in both time (effort) and money
• Determine a timeline for completionbeginning of
  a new fiscal year is perfect time
• Select a project lead
• Establish a pilot project
• Determine action plan after pilot

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Implementing ABC

• Is it worth it?
• For most mid-sized manufacturers an ABC analysis
  can be conducted for as low as 0.08 of total
  sales for small this may creep as high as 0.3.
• Most companies realize an ROI in as little as 1
  4 months with benefits that continue to grow over
  time.

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Implementing ABC

• High-powered decision making tool for managers
  and owners
• Remembernot a system but a concept to embrace
  and encourage
• Doesnt have to be complexso take small steps

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Implementing ABC

• Resources
• Costing, Pricing, and Financial Management
• -- Published by the National Tooling Machining
  Association
• (www.ntma.org)
• The ABCs of Activity Based Costing
• -- MMS Online, Mark Albert (Article 119803)
• Activity Based Costing for Mold ShopsParts I
  III
• -- Moldmaking Technology (October December
  2004)
• Costing Traps for Manufacturers
• -- Manufacturing Engineering (December 1998)

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Key Questions

• Why do traditional flat shop rates fall short?
• What are the characteristics of shops
  implementing Activity Based Costing (ABC)?
• How does a ABC work and how can a shop correctly
  and accurately allocate costs to jobs?
• What key tools should you look for in an ERP
  system to review costs and especially application
  of overhead?
• How should a shop implement ABC?

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