The Importance of Activity Based Costing in Managing a Turnaround

by Douglas W. Zeisel

Jun 1, 1997

(TMA Global)

Much attention has been given to the latest management techniques related to turnaround situations. These include Total Quality Management, Business Process Re-engineering, and more recently—Open Book Management. While the driving force behind these very effective strategies is profit maximization, and the general facilitator is information technology, the most important tool is Activity Based Costing.

Activity Based Costing is a modern, powerful tool for Management Accounting. While the goal of Financial Accounting is to provide an accurate picture of the firm’s financial condition to its stakeholders, the goal of Management Accounting is to provide the managers of the firm with accurate information about the costs of the activities and processes that drive the firm’s production. This information is used to shape managers’ decisions on a daily, tactical, and strategic level. Until the early 1990s, Management Accountants relied on traditional cost accounting methods to provide information about product and service costs for these decisions. Traditional cost accounting, however, exacerbates a troubled situation.

Why Traditional Cost Accounting Exacerbates a Turnaround Situation

Traditional cost accounting assigns costs to products and services based on three cost concepts—“direct” materials (those actually used in making the product), “direct” labor (the labor required to convert the direct materials to a finished good), and “overhead” that includes all costs not directly traceable to the process. Overhead includes such items as rent, electricity, and janitorial services, which are lumped together and typically distributed to individual products as a percentage of the direct costs based on a budget. This system appears to work when a company is producing profits because the results hide the system’s shortcomings.

In today’s business environment where labor inputs have been dramatically reduced, traditional cost accounting does not adequately reflect the true cost of a product or service. The result is that many incorrect decisions are made that lead to continued decline in profits and liquidity. Unfortunately, just when a faltering organization needs accurate information the most, its outdated cost accounting system is feeding managers inaccurate data upon which decisions are made. Many of these decisions prove to be incorrect because of the faulty data provided by the cost accounting system. Thus, managers find themselves compounding their problems because of faulty information provided by their simplistic cost systems.

For example, an industrial coatings contractor followed industry practice and based the prices bid for a particular job on the estimated cost of paint, thinner, and direct labor hours on the project. The “overhead” costs of electricity, storage, benefits, rent, and the like were lumped together and distributed to the job price based on the estimated direct labor hours at a predetermined rate. On the surface, this process appears to capture the relevant costs and help formulate decisions about pricing for each job.

However, when the company faced profitability problems, the flaws became evident. First, the “predetermined” overhead burden rate is inaccurate because it is based on assumptions that are too broad.

Second, the company performs two very different services. The first is “shop” work where structural steel is sent to the company’s facility to be sand blasted and coated. The other service is “field” work where the company sends painters to a facility (such as a manufacturing plant) to perform maintenance painting. The company’s overhead burden rate includes rent on the 25,000-square-foot shop, the shop manager’s salary, and electricity that powers the shop’s lighting system and rotary blasting equipment. Clearly these items have no bearing whatsoever on the cost of a painter performing maintenance work at a customer’s site. Traditional managerial accounting failed miserably to provide accurate information in this situation and caused sales persons to quote too high for much of the field work and too low for shop work. The result was that the shop was regularly losing money and the company was not getting its share of field work.

The flaws of traditional management accounting are even more insidious when applied to a manufacturing operation. Over the past 50 years, the amount of direct labor involved in manufacturing operations has declined significantly. In an automated production facility, direct labor is probably the lowest component of direct cost.

Consider a manufacturing operation with two departments showing the following data ($ in thousands) using the traditional, company-wide overhead allocation method:

This means that all indirect costs would be applied to products at 200% of the direct labor cost. Initially, there is little problem since the direct labor costs of each department are not significantly different. However, when the company added a computer controlled assemble line in Department A, its direct labor cost was reduced by $130,000, while the department’s overhead increased by $100,000. The result:

The problems with this approach become obvious when we look at the “costs” of two products produced independently in each department before and after the installation of the equipment:

The most obvious flaw in this method is revealed when you realize that there is no rational basis for the cost of part “B” to increase—it is produced independently of part “A” and the purchase of the equipment has no effect on the operations in Dept. B. Second, common sense tell us that the real savings in Dept. A is the labor savings ($130,000) less the cost of the equipment ($100,000), or $30,000 compared to the “company-wide” costing scheme that indicates a cost savings of $26,988. While this hypothetical example may oversimplify the situation encountered in an actual manufacturing environment, it clearly illustrates the shortcomings of traditional management accounting.

Further, the complexity of an actual manufacturing environment demands a rational approach to costing that can deal with the inherent complexity where traditional cost accounting fails. In a turnaround situation, cost reduction is often a key strategy. Unfortunately, many times the focus of cost reduction is on reducing the direct cost of labor and materials. But, according to Grieco & Pilachowshi in their book, Activity Based Costing: The Key to World Class Performance, “it has been shown that reducing the direct costs can actually generate more costs than savings.” The opportunities for significant cost reduction lie in stamping out waste hidden in the overhead burden. A large portion of the components of overhead are waste camouflaged as overhead and do not usually attract attention. Companies that need to focus on profit improvement must find ways to eliminate this waste. Activity Based Costing helps achieve this objective by revealing “hidden” waste buried in overhead.

The challenge is to create an organization in which costs are directly traceable to the activities that generate those costs. To meet this challenge, we need to redefine the cost system. This requires increased use of direct costing and more sensible allocations. Grieco & Pilachowshi state: “Functions like Sales, Engineering, Quality, and Purchasing, which traditionally do not account for their activities, will now have to identify the costs of their activities and how the costs of these activities contribute to product cost. More important, they will have to show that these costs add value to the product or service. This does not mean that individuals in these functions will need to start filling out time cards, but attempts must be made to identify tasks performed in the day-to-day operations of their jobs, and then most importantly, start associating costs to these tasks and then assign costs directly to the lowest practice management reporting level.” This is the essence of Activity Based Costing.

The objective of Activity Based Costing is to create a system that effectively captures, allocates, and distributes costs by area of responsibility. This allows us to build an environment where people are encouraged to take up the challenge of responsibility accounting—improving the profitability of the firm. This is achieved through goal-setting of expected improvements in cost reductions that are realistic and obtainable. Thus Activity Based Costing goes hand-in-hand with all of the modern management paradigms.

Nowhere is Activity Based Costing more important than in Business Process Re-engineering. Here the cost of every basic processes of each business function should be determined before any changes are instituted. These baseline costs are essential factors to be used in determining any savings from process changes. Frequently, companies claim outrageous savings from Business Process Re-engineering without taking into account the costs of planning and implementing the changes. While these are one time costs, they should be accounted for in a net present value analysis and distributed to the processes that were changed.

Total Quality Management (TQM) is another area where Actual Based Costing is essential. While the stated aim of TQM is to reduce rejection rate and improve productivity, the yardstick of improvement is cost savings. These savings can only be measured accurately by proper application of Activity Based Costing before and after change implementation. TQM can easily be applied to service businesses, but only if Activity Based Costing is utilized to measure results.

The latest management “fad” is “Open Book Management” where the leaders of an organization “open the books” (share income and balance sheet information with employees). The aim of Open Book Management is to make employees aware of the company’s financial condition and their stake in the company. Opening the books will do little to make employees aware of their stake in the business if they are not also made aware of the costs of their activities and how those costs impact the company’s product (or service) costs. If incentives are to be offered to employees for process improvement, then those incentives must be tied to measurable cost savings that can only be determined through proper application of Activity Based Costing.

Activity Based Costing is the most important tool in the manager’s bag of tricks for managing a Turnaround, regardless of the general management technique he employs. Use of Activity Based Costing guarantees that results of changes can be measured and puts science back into management.

 

Douglas W. Zeisel CTP
Principal
Catalyst Corporate Finance, LLC
dzeisel@catalystcorpfinance.com

With more than 25 years’ business experience, Zeisel received his CTP in 1997 and serves as a financial advisor and “restructuring CFO” to a variety of industries ranging from manufacturing to high tech. A 16-year TMA member, he has served for 15 years on the Chesapeake Chapter’s Board of Directors. There, he has been treasurer, secretary, membership chair, and pro bono chair.


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