Summary by Lori Meister
Master of Accountancy Program
University of South Florida, Summer 2003
ABC Main Page | Capacity Related Main Page
The purpose of this article is to explain how activity-based cost systems are needed and much more relevant than traditional cost systems. It looks at common mistakes that traditional systems make, and it suggest ways for managers to utilize all the information that activity-based systems provide.
ABC Systems as Resource Usage Models
One of the most important components of activity-based costing is the fact that it can estimate the cost of resources used to produce outputs. There is a relationship between the costs of resources used and the cost of resources supplied:
Activity Availability = Activity Usage + Unused Capacity
or
Cost of Activity Supplied = Cost of Activity Used + Cost of Unused Activity
The authors provide an example to illustrate this equation. It describes a department of ten employees who process purchase orders. The payroll for each of these employees is $2,500 monthly, which leads to a total expense of $25,000 per month. The example focuses on the capacity of each employee. At practical capacity, each employee can process 125 purchase orders per month, or 1,250 processed in total. Now assume that only 1,000 purchase orders are needed this month. A traditional costing system would allocate the full $25,000 towards the cost. An ABC system would analyze it differently. Since it costs $2,500 to pay the employee each month and practical capacity is 125 purchase orders, $20 (2,500/125) should be allocated to the cost of each purchase order. Since only 1,000 purchase orders were processed, $20,000 worth of expenses would be charged and the remaining $5,000 would represent unused capacity. Lets look at the formula again:
$25,000 (cost supplied) = $20,000 (cost used) + $5,000 (unused capacity)
The financial statements will show the total expense of $25,000, while the ABC system will show the $20,000 actual cost of activities used.
Many companies tend to think of the $25,000 cost of resources supplied (employees) as a fixed cost. This may seem true in the short-run, but it is important to recognize that the quantity of resources used will fluctuate depending on the activities performed (purchased orders processed).
Two key terms have been used in this example. The measurement of costs of resources supplied shows current spending and the capacity that the spending allows. The costs of resources used will give the managers information needed for performance actions. Providing managers with the amount of unused capacity can lead to finding ways to eliminate this unused capacity, or using it in some other way.
Isn't the Unused Capacity Calculation just a New Name for the Volume Variance?
Some may argue that unused capacity is just a volume variance. The authors describe three ways in which they differ:
Volume variances only use aggregate amounts since they ignore the quantity supplied or used. ABC shows both the quantity used and the unused capacity that could have been used.
Volume variances only look at a set standard capacity, rather than a practical capacity. ABC ignores what the projected capacity was and only looks at the practical capacity.
Allocating overhead for traditional systems only helps with inventory valuation rather than management information.
The authors then go on to discuss what they feel is the most important distinction between the two. Volume variances use allocation bases such as direct labor hours, machine hours, etc. that vary with the number of units produced. This leads to the assumption that these factory costs are directly proportional to the volume of units produced, which is invalid.
ABC systems use drivers that are not used to allocate costs, but to show the costs demanded by outputs in each activity.
Resources that are Supplied as Used (and Needed)
Resources are purchased mainly in two different ways. Some are acquired when they are needed, while others are purchased in advance.
For those that are acquired as needed, the cost of the resources supplied will equal the cost of resources used. Many people consider these to be “variable costs.” The costs will vary proportionally to the amount needed. They do not have unused capacity because what is used is supplied.
Resources that are Supplied in Advance of Usage
The most common type of resources purchased in advance is fixed assets such as buildings and equipment. They incur expenses, such as depreciation, on a predetermined allocated basis. These expenses are independent of the amount of the resource used. Another example is employees paid on salary. The payroll expense will be incurred regardless of the production of the employee. Many people associate these costs as “fixed costs.”
Measuring Costs of Resources Used in a Period: The Role for Activity-Based Cost Systems
Cooper and Kaplan describe a basic ABC income statement to show the difference between resources supplied as needed, and those supplied in advance. Contribution margin is calculated as sales minus those expenses of resources supplied as used (materials, energy, short-term labor). The remaining expenses are then those that were acquired prior to usage (machine run-time, purchasing, engineering changes).
A problem many companies face is the fact that they use the information from ABC systems to produce monthly budgets. They discuss this problem using a Hewlett Packard: Queensferry Telecommunications Division (QTD) case.
QTD used ABC to both help product engineers design less expensive products, and to monitor production performance. These roles became a problem when production dropped due to a major contract being postponed. In order not to show large volume variances, they came up with new higher cost drivers to make up for lower production and less unused capacity. By doing this they completely ignored the original purpose of the ABC system. Unused capacity should not be viewed as a change in the cost of performing the activity (8).
Relevance for Managerial Decisions: Using ABC to Increase Profits
The biggest question companies have is, how do ABC systems help us become more profitable? ABC allows a company to look at their pricing and product mix. You need to find which products are unprofitable. Once you have found them, you can either raise the price or eliminate the product. You must be careful with eliminating the product because you need to be aware of all the resources that the product uses. ABC allows managers to have a detailed analysis in areas where needed, instead of looking at the whole picture.
Another use of ABC is in helping managers reduce resource usage. By reducing this usage, you will create unused capacity that can be managed away or used to process more (10).
If you find that one of your products in unprofitable, you can reduce the number of activities performed, and use the unused capacity to other more profitable products.
Another action would be to increase your efficiency. This lets you have the same quantity, but with fewer resources (10). Total quality management and just-in-time are two programs geared towards continuous improvement in efficiency.
Companies need to be careful when changing their product mix and improving efficiency because at the same time they are changing the demand for activities. An ABC system will help in planning and budgeting for these changes. Resource costs will only remain “fixed” if managers do not take advantage of the unused capacity created (12).
Summary and Conclusions
ABC systems emphasize two major points. First, activities performed are not demanded in proportion to total volume of units produced (12). The demand is based on the product itself and the customer mix that purchases it. Second, ABC should not be used for projecting costs in the short-run. They show the cost of resources used in activities for different outputs (12). Managers need to start using the information provided by ABC systems. They need to look for unused capacity, and utilize it to a profitable advantage.
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Related summaries:
Anderson, S. 1995. A framework for assessing cost management system changes: The case of activity based costing implementation at General Motors, 1986-1993. Journal of Management Accounting Research (7): 1-51. (Summary).
Anderson, S. W., J. W. Hesford and S. M. Young. 2002. Factors influencing the performance of activity based costing teams: A field study of ABC model development time in the automobile industry. Accounting, Organizations and Society 27(3): 195-211. (Summary).
Brausch, J. M. and T. C. Taylor. 1997. Who is accounting for the cost of capacity? Management Accounting (February): 44-46, 48-50. (Summary).
Church, A. H. 1995. Overhead: The cost of production preparedness. Journal of Cost Management (Summer): 66-71. (Reprint of Church, A. H. 1931. Overhead: The cost of production preparedness. Factory and Industrial Management (January): 38-41. (Summary).
Cooper, R. 1990. Implementing an activity-based cost system. Journal of Cost Management (Spring): 33-42. (Summary).
Cooper, R., and R. S. Kaplan. 1998. The promise - and peril - of integrated cost systems. Harvard Business Review (July-August): 109-119. (Summary 1, (Summary 2).
Debruine, M. and P. R. Sopariwala. 1994. The use of practical capacity for better management decisions. Journal of Cost Management (Spring): 25-31. (Summary).
Gantt, H. L. 1994. The relation between production and costs. Journal of Cost Management (Spring): 4-11. This is a presentation Gantt made in 1915. (Summary).
Greer, H. C. 1966. Anyone for widgets? The Journal of Accountancy (April): 41-49. (Summary).
Jones, T. C. and D. Dugdale. 2002. The ABC bandwagon and the juggernaut of modernity. Accounting, Organizations and Society 27(1-2): 121-163. (Summary).
Kaplan, R. S. 1990. The four stage model of cost systems design. Management Accounting (February): 22-26. (Summary).
Kaplan, R. S. and M. E. Porter. 2011. How to solve the cost crisis in health care: The biggest problem with health care isn't with insurance or politics. It's that we're measuring the wrong things the wrong way. Harvard Business Review (September): 46-64. (Time-driven ABC applied to health care). (Summary).
Kaplan, R. S. and S. R. Anderson. 2004. Time-driven activity-based costing. Harvard Business Review (November): 131-138. (Summary).
Kaplan, R. S. and S. R. Anderson. 2007. The innovation of time-driven activity-based costing. Cost Management (March/April): 5-15. (Summary).
Kaplan, R. S., M. E. Porter and M. L. Frigo. 2017. Managing healthcare costs and value. Strategic Finance (January): 24-33. (Summary).
Krumwiede, K. R. 1998. ABC: Why it's tried and how it succeeds. Management Accounting (April): 32-34, 36, 38. (Summary).
Mangan, T. N. 1995. Integrating an activity-based cost system. Journal of Cost Management (Winter): 5-13. (Summary).
Martin, J. R. Not dated. Activity based management models. Management And Accounting Web. ABMModels.htm
Martin, J. R. Not dated. Chapter 7: Activity Based Product Costing. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter7.htm
Martin, J. R. Not dated. Chapter 8: Just-In-Time, Theory of Constraints, and Activity Based Management Concepts and Techniques. Management Accounting: Concepts, Techniques & Controversial Issues. Management And Accounting Web. Chapter8.htm
McNair, C. J. 1994. The hidden costs of capacity. Journal of Cost Management (Spring): 12-24. (Summary).
Mecimore, C. D. and A. T. Bell. 1995. Are we ready for fourth-generation ABC? Management Accounting (January): 22-26. (Summary).