Effective Activity-Based-Costing and Optimal Cost Management

How do firms choose their overhead cost assignment? How do firms choose optimal cost management based on critical production activities that create and capture values? What is the nature and function of expense assignment? What are sources of expense indicators or cost drivers? What are some policy implications of the Activity Based Costing in formulating effective cost assignment and cost management strategies?

These managerial accounting questions relate to effective cost assignment and optimal cost management strategies of a business enterprise-the appropriate mix of costs management strategies that maximizes the return on investment and shareholders’ wealth while minimizing the cost of operations, simultaneously.

The correlation between optimal cost management and effective activity-based costing is critical to sound business strategic options designed to maximize the wealth producing capacity of the enterprise. In these series on effective cost assignment and optimal cost management, we will focus on the pertinent strategic cost questions and proffer some operational guidance.

The overriding purpose of this review is to highlight some basic cost theory, strategic costs relationships, and industry best practices in effective cost assignment designed to optimize cost management. For firm-specific cost management strategies, please consult a competent professional.

Activity-based costing (ABC) is an effective management technique for assigning and controlling the overhead costs. Overhead expense analysis and assignment can be made more accurate by using ABC techniques for a wide range of products, for product expenses and profitability analysis and for appropriate distribution and control of the overheads.

Please note that the optimal cost management and effective activity based costing for each firm differs markedly based on overall industry dynamic, market structure-degree of competition, height of entry/exit barriers, market contestability, stage of industry life cycle, and its market competitive position. Indeed, as with most market performance indicators firm-specific cost management position is insightful only in reference to the industry expected value (average) and generally accepted industry benchmarks and best practices.

Phases of Cost Assignment:

In the first phase, major activities for manufacturing or sale of finished products are properly identified and classified according to the expenditure hierarchy. Expenditure hierarchy facilitates classification of activities based on the ease with which they are traceable to a product or product lines. Such activities may include material procurements, production runs, material handling, order processing, inventory management, warehousing, and transportation.

In the second stage, activity expenditures are assigned to each product or product lines and cost indicators or cost drivers, and overheads are listed in accordance with the major activities required to create and capture values. A brief review of the extant academic literature suggests that the nature of production activity or transaction decides appropriate expense indicators or expense drivers.

Activity-based costing system uses an appropriate cost driver that differs with the nature of production activities that create expenses. Additionally, there are several levels of activities: Unit level, batch level, product level and facility level. Moreover, facility level activities are carried out at the plant level and a bit difficult to trace while unit-level activities are product-specific and most easily traceable to products.

In practice, proper identification and careful analysis of cost incurred for each cost pool are required and critical for appropriate cost driver rate determination. Finally, firms trace and allocate the cost of activities or operations to the final products-goods and services. As you know, cost tracing is the process of directly matching an expense with a product being produced, where expense allocation uses estimates to apply costs to products or product lines. While many costs can be allocated to products directly, some costs relate to multiple products or change on a per-unit basis and should be allocated proportionately.

Some Operational Guidance:

Effective cost assignments require management accounting staff to identify the objects to which the relevant costs will be assigned, accumulate the relevant costs in different cost pools, and identify the most appropriate basis/method for allocating relevant costs. Please note that not all expenditures are relevant and expense controls are subject to vertical differentiation-level organizational authority.

Additionally, not all expenses should be unitized. For example, fixed costs do not change with an increase or decrease in the quantity of goods or services produced or sold. Indeed, fixed costs are expenses that must be paid by firms, independent of any business activity within a specific scale of production. Therefore, it may be misleading to unitize fixed costs of production, ceteris paribus.

To formulate optimal cost assignment strategies, management should understand and anticipate some challenges derivative of expense allocation and activity based costing. Some of these challenges include: traceability, materiality, method, accuracy, and timeliness. As I have already explained, some expenses are not easy to trace. Appropriate expenditure identification, analysis, tracing and assignment should be conducted using multiple methods and defensible assumptions.

In practice, expenses allocation are data driven and managerial analytics aided by computer technology. However, sound analysis of expense drivers and assignments, should be guided by full grasp of well-established cost theory and generally accepted accounting principles. For example, when examining cost tracing and assignment, firms should determine how closely to allocate individual expenses. With modern computer systems and cost analytics, it is often possible to trace every expense driver even when there are multiple products -goods and services.

Further, not all expenditures are material. And because there are costs and benefits associated with search, analysis and assignment of expense data, firms must decide to what extent to account for expense drivers. This is the accounting concept of materiality. Firms must always weigh the costs and benefits of all managerial decisions. Business managers must decide whether the benefits justify the costs and what amount of cost analytics is optimal as it pertains to firm profitability.

Finally, firms should create and maintain multiple costing systems. And use appropriate techniques such as traditional costing, job-order costing, process costing, or variable costing to facilitate internal managerial decision making and external financial reporting requirements. Please note that variable costing is not permissible for external reporting but may be useful in assisting managers to make resource allocation and other business decisions, efficiently and effectively. Often, successful businesses maintain managerial accounting costing systems to facilitate internal planning and financial accounting costing systems designed to support the external financial reporting function.

In sum, cost accounting systems and activity based costing facilitate accurate estimation of expenses of products-goods and services which is critical for profitable business operations. Business managers should know, understand, and anticipate which products are profitable and which products are not profitable. Therefore, cost analytics must be relevant, accurate, timely, and consistent with the calculus of economic advantage. To create and sustain competitive advantage in the global marketplace, firms need effective identification of cost drivers, cost assignment and optimal expenditure management strategies-the appropriate mix of expenditures management strategies that maximizes the return on investment and shareholders’ wealth while minimizing the cost of operations, simultaneously.

COST MANAGEMENT: Squeezing the (NON)VALUE Out of Overhead – An Activity Analysis Approach

In the Pleistocene era of manufacturing cost accounting (actually, only about one hundred years ago – it just seems longer), product costs were classified as: Labor, Materials and, Overhead – in that order. The order was not haphazard; it connoted the relative importance in dollar size of each. Labor was then the highest cost component, materials was next and overhead was a poor third. Well, now at the dawn of the twenty-first century and actually around the middle of the twentieth century, the order is reversed. Overhead is the most expensive component of the cost equation. In fact, as labor declines to third in the cost hierarchy and materials costs begin to stabilize in some of the mature manufacturing companies, the management of overhead spending can be the strategic management element in the profitability success equation. Knowing that overhead is the major component of manufacturing spending and putting aside the arcane methods for its accounting and allocation, how then can the senior management of manufacturing companies discern value in overhead in relation to its cost? Let’s take a look at some of the options and combine them into an overall program to find the value and reduce the costs.

What really is manufacturing overhead?

In plain managerial terms, manufacturing overhead is that agglomeration of expenses that don’t “add value” to the products made by the enterprise. Non-value-added activities, now the bogeyman of the era of Lean Manufacturing, are those activities that customers wouldn’t pay for if they knew the extent to which they existed. The most cited example of non-value-added activity is a quality inspection function. The customers would be saying to themselves, why would I want to pay for this when you the manufacturer should have been able to get it right the first time? The strategic implication being, of course, that if we were able to reduce or eliminate non-value added activities; the customer would not have to pay for them through lower prices. The potential for lower prices is largely a near term marketing issue but, in the long run, the costs incurred for products have a structural impact on a company’s and an industry’s prices and profitability. Recognizing that all non-value-added activities can’t be eliminated, some are placed in the category of “non-value-added, but necessary.” These are typically those that are driven by regulations (e.g., GMP, OSHA, FDA, SEC etc.). Other non-value-added activities, despite not being regulation driven, are tenacious in their seemingly innate ability to survive because people believe that if they weren’t incurred, dire consequences would follow.

From a micro-economic perspective, manufacturing overhead is a large component of the break-even point of the enterprise and therefore part of squeezing out value lies in minimizing it. It is the fixed period cost base that the enterprise must cover with incremental gross margin. Accounting gives us numerous expense classification and departmental views of overhead in the detail needed to analyze and reduce/contain this strategically important manufacturing cost component.

Manufacturing overhead has a time and variability dimension

Critical to the comprehension of value and the potential for manufacturing overhead reduction/containment is an understanding as to the behavior of individual natural expense classifications. Virtually all period costs are driven by one or another variable some of which are static and others dynamic. For example, the variable that drives depreciation is the dollar amount of fixed assets which in turn is driven by long-term investment decisions – a value decision that has already been made and absent a sea change in perceived value the cost associated with the decision is fixed. On the other hand, indirect labor in a large shipping department might vary (not in direct proportion necessarily) with shipment cubic footage. Of these two examples, one is driven by a static decision and the other by operating circumstances. The difference in time with which a change may be effected in these two expense classifications is dramatic. So, it is wise to view natural expenses for value and optimization in the following groupings:

Fixed in the long-term. Those related to a long-term decision – depreciation, real estate taxes, property insurance for which there are cost reduction opportunities in the next long-term decision cycle.

Fixed and controllable in the short-term. Those that have no discernible connection to a numerical variable – travel expense, outside services – for which value and magnitude judgments may be made on a monthly/quarterly basis.

Variable with activities. Expenses that may be connected to the occurrence of measurable production volume or non-production activities – indirect labor, manufacturing supplies, utilities – which may be controlled by management of the underlying cost driving activities.

Purely Variable. Expenses that vary in direct proportion to the production or sales curve. There are not many of these. Utilities and consumable tools in a machine intensive shop come immediately to mind.

The departmental dimension

There is a departmental dimension to analysis and control of manufacturing overhead as well. Overhead in manufacturing and manufacturing support departments is more easily related to activities on the shop floor and is susceptible to industrial engineering analysis. For example, the “indirect labor” and other expenses of a metal shearing department may be related to lineal feet of incoming sheet metal or the number of strokes of the presses. In contrast, expenses in administrative departments are principally related to management imperatives (that may not be relevant any longer) and may be analyzed and controlled through value/discretionary analysis and zero-based budgeting.

A new dimension – value

The watchwords of the lean era are “value-added” and “non-value added” so it seems that a discussion of value in manufacturing overhead would be a contradiction in terms. If value added is found only in those activities that actually alter the product to suit the customer’s needs, then how can a shipping department confer value upon the product and the enterprise? Perhaps we need to take a closer look at these notions of non-value added and value added to answer this question.

Much is said about how much time and effort is expended on control and reduction of the manufacturing activities that add value and how little is spent on the non-value added side of the shop. The popular estimates are that ten percent of shop activity is in value added activity and ninety percent is found in non-value added activity on the shop floor. The natural consequence of this revelation is to suggest that the “waste” inherent in such shop floor activities as inspection and material movement ought to receive the lion’s share of attention in reduction of non-value added work. Little is said in the same context about such “indirect” labor in manufacturing departments and administrative labor in the offices of a plant. So, in understanding value or its lack, we need to re-categorize activities and expenses according to a value dimension that overlays the time/variability and departmental dimensions. A value dimension goes beyond the simple assumption that all overhead is non-value added and will suggest that some “overheads” really aren’t that at all. The value dimension adds the following overlay categories:

Elimination potential: Those overhead activities and related expenses that represent inherent waste and should be eliminated. Improvement here is not an option; nothing is more useless than improving the way you do something you shouldn’t have been doing in the first place.

Exploitation/enhancement potential: This category covers those activities that might be considered “non-value added but necessary” and present an opportunity to improve the way they are done and to exploit them to squeeze value out of them. The numerous regulatory body proscriptions – ISO, FDA, GMP, Sarbanes-Oxley – that can’t be eliminated come under this heading.

Reduction potential: Expenses and activities that can be reduced correlate well with the time/variability groupings called fixed and controllable in the short-term and variable with activities.

Consolidation/redeployment potential: Here we will find the many administrative functions that have grown up in the organization in ways that either seemed to make sense once upon a time or were patched on to the organization when the need arose.

Part one – categorize the costs

The first thing to do in discerning value or non-value is to slot both natural expenses and departmental costs into one of the above value categories. Let’s take some examples.

In the “exploit/enhance” category, we might find the departmental expenses associated with an ISO effort – there are two basic ways to exploit this overhead grouping: minimization of the costs by controlling activities and by using the program as an adjunct to a quality at the source initiative.

In the “eliminate” category, we would note such really non-value added activities/expenses such as inspection, material handling, kiting and the like that we want to eliminate as rapidly as possible.

Moving to the “reduce” category is where we slot the activity intensive overhead items. These are the expense classifications that while variable with an activity, must be consciously managed when the activity level changes.

Finally, those overhead costs that don’t have much real variability but can be controlled go in the “consolidate/redeploy” category. Typically, these are administrative departmental costs which may need to be reconsidered from an organization standpoint to make sure that the managerial value desired is being received in relation to their cost.

Part two – perform the activity analysis

For those costs slotted in “reduce and eliminate categories,” the search for actual activities and cost “drivers” is the first task at hand. For these activities, we will want to discover that which the underlying cause of them is. The best way to do this is by drawing a value stream map of the entire manufacturing process. Value stream mapping is a subject unto itself but for our purposes, we can simply say that such a map is a diagrammatic and narrative picture of the human, material and information movements that comprise each operation in the sequence of the operations plotted against time. Such a map enables us to see the non-value added steps in the process and identify their root causes. Through further investigation, we can also quantify the drivers and activities that comprise the root causes and plot such quantities over time and identify their trend line. For example, after the value stream mapping and quantification of activities has been performed for a shipping department the significant overhead cost is indirect labor and perhaps the plant could get along with less people if shipments from this department decline. The shipping department would have been identified on a value stream map as non-value added yet reducible in short run with the potential to re-engineer the process and eliminate the entire shipping operation in the long run. There are usually numerous cost drivers and related activities like maintenance supplies expense would be driven by the quantity of small parts utilized which in turn is related to machine hours. The driver and activity can be plotted over time as in the indirect labor example above and a similar overage or underage computed.

Costs that come under the “eliminate as soon as possible” category are those which are susceptible to engineering analysis. Materials kitting or inspection on the shop floor, which may have drivers and activities, ought to be subjected first to industrial engineering analysis to determine how they may be eliminated and only be viewed as a reduction opportunity if elimination must be delayed.

Part three – redeploy

The growth of local administrative functions over the previous quarter century has added between fifteen and twenty percent to total overhead expenses. Such functions as accounting, materials and production planning, purchasing, human resources, once thought to add managerial value as part of a plant management team are now often being more efficiently and effectively deployed in corporate “centers of excellence.” Such centers of excellence provide the professional critical mass so that the highly trained and educated people who staff these functions can associate with their peers and can still interact with operations management at the plants for which they have responsibility through modern communications. Professional critical mass is the value component of center of excellence deployment and the value is enhanced by the economies of scale realized from having professional manufacturing staff work spread across more than one plant. It is of questionable value to have numerous purchasing professionals overworking local procurement issues by being physically and organizationally located on a plant site. Similarly, much of on-site plant accounting (accounts payable, cost accounting, general ledger), once believed to be the financial counsel to the plant manager, may hardly be relevant in an era of MBA plant managers.

Consolidation of administrative functions does not represent doing more with less. Rather, it represents doing the same with less and doing it better through superior deployment of resources.

Part four – exploit and enhance

Finally, we come to “exploit/enhance.” Here are located the overhead costs that can be classified as “non-value added but required.” These costs primarily represent an opportunity to cast them in the light of value. Most obvious, for those companies that have ISO programs in place, is the chance to utilize the ISO documentation for quality enhancement. More subtle but equally as valuable are the Sarbanes-Oxley business control requirements as they translate to accurate inventory records or accurate bills of material for cost of sales reporting. These “SOX” control requirements, while part of a mandate, can enhance the way manufacturing is managed and can contribute to lower costs (of physical inventory, accounting errors, etc,) in the future. Rather than bemoaning the cost of such apparent non-value added costs, they should be embraced and exploited for their business value.

No one would argue that these costs should be not be subject to cost controls while value is being sought. A quality department subject to FDA regulations could maintain a traditional program to contain the cost of the regulations and simultaneously pursue a program of lean practices to make compliance efficient and less costly over time.

Overhead and value are not necessarily contradictory terms. A program that categorizes overhead according to behavior and value keeps a focus on this all important cost component and permits management to ascertain that it is getting value for its money!

Unproductive Vs Productive Activities

I hope all of you are putting together a solid marketing plan. I know it seems to be the same song and dance year after year, but what are you going to do differently this year?

I want you to take some time and examine your current situation and ask a tough question. That question is “Why?” Why am I in this situation? What behaviors, habits, and events have worked together to land me into my current situation – be it good or bad?

Straight answers work best here, even if it’s not what you want to hear or admit. I’ll give you a little peak into a few of these “self chats” I’ve had with myself. I put everything on paper or into files on my PC, so I can always go back and find my habits. Here’s one from a few years back:

Negative habits:

– Too many activities going at once

– Find it difficult to say ‘no’ to new ventures

– Organization of files

– Too much time spent online

– Checking and responding to non-critical emails

– Work too many hours

Those were the negatives I found in myself. I’m sure this is by no means a conclusive list. haha – But I had to come to terms with the fact that those seemingly small issues were working together to limit my income and productivity. Here were the positives I came up with:

– Take action quickly

– Not afraid of cold calls or prospecting

– Creative with marketing and sales approach

– Proficient with online marketing

– Straight forward with prospects

Now I had to find a way to enhance my positives and minimize my negatives. Of course when doing this exercise I expanded on each item so that all the facts were on the table staring me in the face. Once you’ve identified your positives and negatives, you will be better equipped to structure your marketing plan for 10.

It is of vital importance that your plan for 10 addresses your negative attributes/habits or else you’ll simply repeat 09 as the same mistakes are made over and over again. Been there done that…

For those of you who want something 100% different from anything else on the market for Loan Officer’s and Realtors, I suggest you stop by: Loan Officer/Realtor 2.0 – Dominating the Search Engines

Productive Activities to Engage in If You’re Bored at Home

How productive are you on a day-to-day basis?

Whether you’re an established entrepreneur or just breaking out of the corporate office, how productive you are now can make a huge impact on the results you see later. If you feel swamped with projects, aren’t making any progress or find yourself lacking time for other things (hobbies, friends or family), you probably aren’t being productive with your time.

Productivity is all about getting results.

But managing your time isn’t always easy, especially at home where you’re the most prone to distractions. Something unexpected is bound to happen or an emergency will occur, and it will knock your schedule off track. Other times, you just won’t feel motivated to get anything done at all.

While you can’t control every situation, you still can get more done around the house and spend more time with the people you love.

Let’s look at a few ways to do just that.

  • Be smart about watching TV.By combining your TV habits with other activities, you can actually make major headway on your business and lifestyle goals. The next time you sit down to watch your favorite show, consider using that time to burn some extra calories (exercise in front of the TV), plan out the rest of the week (what meal are you going to make for dinner?) or answer email. What you watch on TV can also inspire new ideas and educate your mind. But be careful what you watch! I’m personally addicted to watching anything from WWII battles to the advancement in space, technology and health on the Discovery Channel. On the other hand, I avoid reality TV as much as possible; it isn’t realistic, and it’s often a waste of time.
  • Listen to something inspirational while you clean.Mindless chores (like sweeping, doing the dishes or preparing meals) have to be done, but that doesn’t mean you can’t make the most of your time while doing them. I love listening to inspirational CDs or books on tape while completing chores around the house. That way, my mind is still constantly developing new ideas.
  • Spend quality time with family.It’s not healthy to work all of the time. Taking occasional breaks will reduce stress from work, so why not spend that time you do have with your family? Playing catch with your son, watching a movie with your spouse or calling your brother to see how he’s doing will help foster stronger relationships and create tighter family bonds.
  • Add exercise to your morning routine.Exercising regularly won’t just make you healthy, but exercise is a major source of energy as well. By consistently spending 10-30 minutes exercising three days per week, coffee will become less of a necessity and you’ll have more energy to devote to work, friends, family and personal hobbies. You don’t even have to have a gym membership. Instead of driving to the gym, I’ll often pop in an Insanity fitness CD.
  • Brainstorm new ideas.Is a project due soon for a client? Consider brainstorming ideas and mapping out possible solutions to any problems you may have. If the project requires multiple steps, make a to-do list. You can also use to-do lists for shopping or tasks around the house, as well as for planning upcoming events and special occasions.
  • Keep things organized.It’s hard to stay productive if you’re working in a messy or disorganized environment. Take some time to organize your closet, office or kitchen, putting anything away that seems out of place. You can also take this time to clean out your purse or wallet, and get rid of any junk you might have thrown in on the go.
  • Get motivated.If you’re stuck while working on a project for a client or just want to take a break from work, consider picking up an inspirational book to give your mind the boost it needs to keep going. Success stories, case studies, blog posts and podcasts can all be good sources of motivation whenever you feel stressed or discouraged and start to procrastinate.
  • Update your finances.If you find yourself lacking something to do, have a look at some outstanding bills that need to be paid, reassess your budget, balance your checkbook or organize your recent transactions so that you don’t fall behind in your finances.

Not all day-to-day routines will go to plan, but with a little bit of time and patience, you can achieve a productive lifestyle, reduce stress and feel more in control over your life in the long run.