By Mark A. Haerr, CMA, CIRM

Like flavors of the month in an ice cream store, management philosophies are promoted with claims that, upon ingestion, a fat profit line will result. And to make sure you don't forget the flavor of the month, an instant-recall acronym is usually coined. Though the acronym may be easily remembered, the concept behind the letters may not be so easily understood.

Take for instance activity-based costing (ABC) and its derivative, activity-based management (ABM). They're as easy to remember as the alphabet. But as a recently overheard conversation between two managers reveals, the principles associated with these conventional methods of accounting and management are not as straightforward as their labels lead us to believe.

Joe: Why change accounting methods now? Traditional accounting has done the job since Pacioli wrote the book on debits and credits 500 years ago!

Frank: Our methods of production have changed tremendously over the past few decades. Accordingly, our methods of accounting must change to determine accurate product costs.

Traditional cost accounting allocates overhead costs to products by correlating overhead to the labor associated with a product. If Product A has 50 percent more labor input than Product B, then A gets 50 percent more overhead.

Joe: Seems reasonable to me. The more workers on a production line, the more equipment, floor space and support used.

Frank: In Henry Ford's plant of yesteryear, that correlation was valid. Today, however, developments in technology have allowed businesses to automate the production process and to significantly reduce labor input for certain products. Yet, there is a price to pay for reducing labor through automation — increased overhead. Overhead increases as more expensive equipment and more costly support technicians are required to keep the production line running.

Joe: So today's manufacturing environment has reversed the labor-overhead correlation? Can't labor still be used as a proxy: the less labor, the more overhead?

Frank: The problem is that the correlation is not consistent or strong. In some cases, sophisticated manufacturing systems — not people — are fabricating or assembling products. Thus, direct labor can be insignificant, while overhead costs remain a very significant portion of a company's total costs. Chances of developing accurate product costs are slim when using such a small basis (labor input) to allocate a large pool of costs (overhead).

Joe: How does ABC deal with this dilemma?

Frank: ABC determines the fair-share of overhead for each product by determining the activities that must be performed to produce the product. When activities are performed, costs are incurred. The more activities performed for a product, the more costs it incurs. Thus, overhead can be allocated to products by using activities instead of labor as a proxy.

Joe: So this activity-based stuff is just another way to count the beans?

Frank: ABC is another product costing methodology, but this cost accounting methodology can — and should — be used for more than just providing numbers on paper. ABC's real power comes when managers transform this accounting approach from a way of tracking business performance to a way of doing business (a la activity-based management)!

Joe: How do you get from counting beans to managing a business?

Frank: Implementing ABC requires businesses to scrutinize the activities that form the processes throughout an organization. This analysis results in identification of product characteristics that cause activities to be performed. With these cause-and-effect relationships, managers will be able to focus on the causes — rather than the symptoms — of high costs.

Joe: Isn't there more to managing a business than just managing costs?

Frank: Of course. ABC/ABM can help managers make decisions regarding product mix strategies and resource requirements. Accurate product costs will shed light on which products are truly more profitable than others. Also, results of the activity analysis can provide insights into resource requirements that many other management techniques don't.

Joe: So we don't need all these other "flavors of the month?"

Frank: ABC/ABM can complement and support other initiatives such as quality and continuous improvement efforts. For example, managers will be able to determine the cost of quality for one product versus another. Also, activities that don't add value can be identified and eliminated.

Joe: Aahh, I get it now! ABC/ABM provides a foundation for BPR, TQM, CICs, etc. So when does ABC lead to XYZ?

Frank: Give me time, I'm still learning my ABCs!

Copyright © 2020 by APICS — The Educational Society for Resource Management. All rights reserved.

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