Activity Based Costing In today's competitive economy, the cost structure is much more complex than that of the past, and there is a lot less room for error than that allowed in the more laid back economy of the past. Today's costing concerns arise from the growing disparity between direct and indirect product costs. American manufacturers have been pursuing a steady stream of manufacturing methods and technologies. The goal was simple and uniform: to reduce or eliminate direct costs. But as manufacturing has evolved, so has the structure of a product's cost. Direct costs, such as labor, are no longer the dominant cost of a product.

The cost of indirect activities such as automation, marketing, sales, engineering, and order processing have dramatically increased. Overhead has grown to become the most expensive element of product cost structure. This might not be so bad if conventional product costing systems could handle the shift in cost structure. Unfortunately, they don t.

Most conventional systems allocate overhead based on some burdened rate (direct labor hours is a good example). This was acceptable when overhead was small and direct costs were high. But in today s automated factory, this can lead to disaster. Conventional systems report inaccurate product costs– often grossly inaccurate. Management, in turn, makes strategic decisions based on these inaccurate product costs. Traditional cost systems assume all overhead activities are consumed equally by all products relative to volume produced.

Further, all costs are allocated to products because the system assumes that current output drives current overhead costs. Overhead costs are allocated to products on the basis of the product's demand for some volume variable direct cost, usually labor hours, machine hours, or materials cost. But none of these bases individually represents the actual overhead incurred to make the product. Conventional thinking holds that the inaccuracy is not relevant because in total all costs are accounted for, and on average the relative distortion in margin reporting can not be significant.

Activity based costing, by contrast, identifies what activities are performed by the overhead organization and calculates the cost incurred to perform each activity. Costs are traced to products on the basis of the individual product's demand for these activities throughout the process of converting raw materials, energy and human enterprise into the finished article. The allocation bases used in ABC, then, are the quantification's of activities performed. These might include hours of labor or number of times handled. As already mentioned, conventional costing often leads to gross inaccuracies.

This is because direct costs– especially direct labor– have been minimized by automation. At the same time, indirect costs have increased dramatically. And it s the indirect costs that get averaged across product lines by conventional methods. To see how bad the errors can be, look at the following chart. Conventional costing says that product B has a much lower overhead cost per unit ($4. 80 vs.

$7. 20 for Product A). But this can t be so. Product B consumes five times as much engineering change activity as Product A. Product B should cost more to produce. What has happened here is that the conventional system has averaged overhead costs across both products.

The total cost of engineering changes is divided by the total direct labor hours. The result, $2. 40 per direct labor hour, is then applied to each product. This overhead averaging causes Product A to carry an unfair– and inaccurate– portion of the overhead costs. Now guess what happens when these cost figures are used in pricing. Product A will probably be overpriced for the market, and Product B will be sold for less than its true production cost.

Conventional costing says that product B has a much lower overhead cost per unit ($4. 80 vs. $7. 20 for Product A). But this can t be so. Product B consumes five times as much engineering change activity as Product A.

Product B should cost more to produce. What has happened here is that the conventional system has averaged overhead costs across both products. The total cost of engineering changes is divided by the total direct labor hours. The result, $2. 40 per direct labor hour, is then applied to each product.

This overhead averaging causes Product A to carry an unfair– and inaccurate– portion of the overhead costs. Now, using the ABC concept, the costs are apportioned according to a driver, the number of engineering change orders. (ECO's) The next graph shows the reallocation of overhead costs by the ABC method. Product B is now carrying its fair share of ECO processing costs. As would be expected, Product B actually costs five times more than Product A in terms of indirect activity consumption. As you have seen, activity based costing can offer much clearer insight into the operations of a business than the conventional method.

of the past. When ABC is used as a management system, it is a powerful tool for rethinking and improving products, services, processes and a company's market strategies.