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ABC: too much activity, not enough costing?

Brian Rutherford

ACTIVITY-based costing (ABC) hit the world of financial management with a very large bang in the late 1980s. Within a few years, 20 per cent of the UK's largest companies were using, or at least piloting, ABC systems. By the turn of the millennium, howev er, the proportion of adopters was no higher, while a third of those adopting the technique earlier actually abandoned it. Only one-third of those companies considering the use of ABC in 1994 actually adopted the system by 2000.

Why are practising financial managers proving so reluctant to embrace this revolution in one of their key disciplines, when it is so widely praised in the literature and so vigorously marketed by consultants? Are we looking at an example of the tradition al conservatism of our profession? Certainly that is the view consultants would urge on our fellow-managers.

A defender of the profession might first point out that ABC is far from guaranteed to work. Indeed, its claim to provide ``accurate'' costings are greatly exaggerated because in many situations there will be costs (essentially those relating to non-separ able resources) that ABC does not handle much better than traditional costing. The panel illustrates the ABC's deficiencies.

Nonetheless, the accusation against traditional (volume-based) costing on the back of which ABC was launched is valid. Where overheads are high and plants produce a range of items with significantly different volumes and complexity, volume-based systems over-cost high volume lines and send the wrong signals about pricing, product choices and resource allocation. But the uselessness of absorption costing for taking decisions in these areas has been understood for years and taught to generations of studen ts. Are we to believe that once they qualify and hit the streets -- or rather the multi-product plants -- accountants forget all they have learned and respond like automatons to the data emerging from traditional absorption costing systems? It seems more likely that strategic management accountants know that the output of absorption costing systems must be treated with caution -- and look for additional evidence when important decisions have to be taken.

There are well-documented tendencies for the bare numbers to drive decisions -- especially where they are made by groups which include non-accountants, who may not appreciate just how complex are the measurement issues involved. Thus, Johnson and Kaplan' s high profile reinforcement of the need to identify relevant costs correctly was to be welcomed. But was the ``invention'' of a whole new and apparently revolutionary system equally welcome or even necessary?

The installation of ABC systems is inevitably a very complex and expensive business. To the direct costs of creating the new system must be added the risk involved in dismantling legacy systems and managing the transfer. Given that traditional systems wo rk well in some situations and ABC does not always give the right answer, managers are right to be cautious.

What should worry our profession is that all the hype surrounding ABC may itself damage good financial management. Companies that feel they must make an ``all or nothing'' decision, to move to ABC or stay where they are, may miss opportunities to refine their current systems. If they do make the move to ABC, they may spend a great deal of money for little more benefit than they could obtain from such refinements.

Accountants themselves may lose confidence in the fundamentals of their discipline, feeling pressured to adopt the latest fad rather than calmly asking what steps should be taken, based on first principles. Other managers, who rely on the accountants to secure effective financial management, may lose confidence in their ability to deliver it. Companies that have installed the latest systems, at great cost, are, perhaps, more likely to rely uncritically on the numbers emerging from them, rather than enco uraging their accountants to scrutinise the output in the light of the principles they have been taught.

Further, students will seize on ``hot topics'' such as ABC and give insufficient attention to the fundamentals of the discipline, resulting in over reliance on the gurus and reinforce the merit of the tendencies outlined above. If these dangers are to be avoided, it is important that we see ABC as a refinement of the approaches to costing the profession well understands rather than a revolution displacing all that has come before.

When ABC does not work

Penco manufactures writing implements. It has 11 products, a `basic' pen and 10 different luxury models, which use more expensive materials but take up the same labour time. Each period it manufactures and sells 50,000 of the basic model and 5,000 of eac h of the luxury models. Direct costs are 50 pence per basic pen and 1.50 per luxury pen. Basic pens sell for 75 pence and luxury pens for 1.90. Set-up costs are 1,000 per run. Other costs are ignored for the purpose of this illustration.

Traditional volume-based costing treats set-up costs as an overhead. Overheads are allocated by a volume-based measure such as units produced or labour hours. In this example, both methods will yield the same rate, 11,000/100,000 = 11p the profit unit. T hus basic pens show a profit of 14p per unit (0.75-0.50-0.11) and luxury pens show a profit of 29p per unit (1.90-1.50-0.11). Total profit is 21,500.

Activity-based costing assigns costs to activities and traces activity costs on the basis of what drives them. In this case set-up costs are driven by the number of times the activity is required. The basic pen requires one set-up per 50,000 pens, so set -up costs per unit are 2p; luxury pens require one set-up per 5,000 pens and cost per unit is thus 20p. Basic pens show a profit of 23p each (0.75-0.500.02) while for luxury pens the profit is 20p each (1.90-1.50-0.20). Total profit remains as before but is now regarded as comprising of Basic (50,000 @ 23p = 11,500) and Luxury (50,000 @ 20p = 10,000).

The revised profit figures reflect the relatively high requirements for set-up activity by luxury pens. They may encourage managers to seek opportunities to expand production of basic pens rather than multiplying the number of types of luxury pen manufac tured, thereby increasing profits. (The traditional, volume-based, measure made it look better to take on more luxury pen lines.) If production of basic pens can be expanded to

60,000 while two lines of luxury pens are dropped, the set-up cost per basic pen falls to 1.667p (1,000/60,000), the profit per unit rises to 23.333p (0.75-0.50-0.01667) and total profits will rise to 22,000.

However, a much more profitable strategy would be to double the output of each line of the apparently less profitable luxury pens, abandoning basic pens altogether. Changing the length of the run affects the number of set-ups required per unit of output, and thus, the product's profitability. (Even more profit can be earned if the first production run in the second period is devoted to the same line as the last production run in the first period, thereby reducing set-up costs still further.)

How to manage costs strategically

XWhatever cost allocation methods are used, ensure that the cost assignment basis corresponds as closely as possible to cause and effect.

XRegularly review cost levels, involving senior management and those who can influence the level of each category of cost under review. Look for costs omitted from the formal costing system and those within the system. Ask, for all categories of costs id entified by the system, whether they are really caused by the activity under review.

XWhenever major decisions about pricing, production levels and resource allocation have to be taken, ask whether a special relevant costing exercise should be undertaken.

XRegularly review all cost allocation schemes -- including ABC-based schemes.

XHave the courage to manage costs rather than expect the system to do it for you.

(Source: Accounting & Business, the journal of the ACCA, London.)