There are some universal truisms that apply to all businesses. The first of these is that, over time, a business must be able to provide products and services at a lower overall cost than its competition. The second is that the inflation-adjusted cost of production and logistics must continuously decrease. This is, hopefully, accounted for through experience or the learning curve. The importance of knowing the true cost and profit picture of each product is the third truism. Finally, understanding and managing cash flow is as important as profit.

Each of these areas involve decisions that have a profound impact on the organization. Cost-cutting is often an area of decision-making that can start a cycle of decay. This can be caused by cost cuts that erode the competitive posture of the company, a result of decisions made using traditional financial accounting data rather than control-oriented data.

Traditional accounting practices attribute indirect costs in a general fashion, spread equally across departments and products. Activity-based costing is a method of identifying all costs to a specific activity, thus placing the burden directly on the source of the cost contribution. This produces the cost control-oriented data needed for critical decision-making in the organization.

Activity-based costing (ABC) systems are not financial models of how expenses change in the short run. Instead, they are intended to provide the costs of resources used to perform activities or services in fulfillment of a business function. ABC systems model how activity usage, and thus cost, varies with demand. While traditional accounting tends to blur the relationship between so-called fixed costs and associated product activity, ABC targets a more clear delineation.

In the decision-making process, virtually all costs should be considered product costs. They should also be considered either direct or manageable in almost every instance. One can classify costs as either bedrock fixed, managed fixed, direct variable or shared.

The first group consists of costs over which there is absolutely no managed control. Few costs fall into this category.

The majority of costs fall into the managed fixed category. Here is where management can influence cost patterns over an extended period, once the structure of the cost is understood. The application of ABC assists management in identifying unused resources and capacity. Decisions can then be made to either optimize use of a resource, reduce costs or eliminate it.

ABC is not a panacea for all the ills of an operation. If the data used in constructing the system is flawed, past errors will simply be repeated. It is, however, a useful tool for many of the management decisions facing companies today. It can bring a picture of the operation to light that may not be obvious through other analysis tools. ABC is useful in analyzing specific segments of an organization such as a market line, a group of products or even a single product, a customer or an employee.

ABC is a complement to total quality management (TQM). It provides quantitative data that can track the financial impact of improvements implemented as part of a TQM initiative. Amoco Performance Products, Transparent Container Company and Fellowes Manufacturing are a few companies that have utilized the ABC/TQM model to improve performance and profitability.

Growing demands by customers for value-added services without an accompanying increase in revenue is an area of concern for all companies. Labeling requirements, special packaging, handling and shipping are all areas that can increase managed fixed costs. If these expenses are not clearly associated with the activity source, the revenue picture becomes blurred. The decision process may not be based on quality information, allowing errors in judgment to occur. The concept of firing a customer can become possible, even viable, if it is understood that the cost of having that customer exceeds the margins derived.

Activity-based costing is a management decision tool that provides financial support data structured in a fashion fundamentally different from accounting data in a general ledger. By associating cost to the activity, a clear relationship can be established between sources of activity demand and the related costs. This association can determine where costs are being incurred, what is initiating the costs and where to apply efforts to curb inflationary costs. This can be of particular value in tracking new products or customers. It can also provide tracking of logistics costs, one of the fastest-growing areas of expense to the operation.

Robert Olsen is project manager for Tompkins Associates, Raleigh, N.C. Tompkins has practices in manufacturing, warehousing, logistics, organizational excellence and quality. They can be reached at www.tompkinsinc.com or (800) 789-1257.

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