Profitability Analysis Using Activity-Based Costing by Priscilla Wisner

Executive Summary
• • Traditional cost allocation methodologies in firms can provide misleading information about the profitability of products, product lines, customers, and markets. Activity-based costing (ABC) provides more meaningful information about the drivers of costs, the activities performed in a firm, and the relationship between costs and products, customers, markets, and segments. In addition to supplying more detailed and better cost and profitability information, an ABC analysis enables managers to evaluate processes from an activity viewpoint, leading to identification of non value-adding activities and process inefficiencies. ABC does not change overall profitability in a firm; it better aligns cost assignment to the causes of those costs. With better information, better decisions can be made in a firm to improve profitability—this is the power of ABC.

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Introduction
Cost allocation in firms can provide misleading information about the profitability of products, product lines, customers, and markets. Traditional cost allocation practices allocate all manufacturing overhead costs using a single driver such as direct labor hours, direct labor dollars, or machine hours. Sales-related costs are typically ignored. While technically accurate, in most complex organizations a single overhead cost driver is not sufficient to accurately assign the pool of overhead costs to the products that are being produced or the customers that are being served. Many firms—from manufacturing to medical and healthcare to banking and financial services to hospitality and not-for-profit organizations—have benefited from designing and implementing ABC allocation systems. Using ABC tools has helped these organizations to understand profitability more clearly, and has provided meaningful information about processes and costs associated with delivering goods and services. A welldesigned and implemented ABC system is a powerful aid to management evaluation and decision-making, thereby improving organizational performance.

Traditional Cost Allocation
Factory overhead costs in a manufacturing organization are varied and complex. These costs consist of indirect labor, indirect materials, and other indirect factory support costs. Factory support personnel include process design engineers, supervisors, maintenance workers, inspectors, purchasing agents, security personnel, and administrative workers such as accountants and human resource personnel. Indirect materials are those materials that cannot be individually associated with a product—such as drill bits, shop supplies, paper goods, and maintenance supplies. Other indirect costs include utilities for the plant, depreciation of the machinery, training costs, and technology to run the production systems. Using a traditional cost allocation methodology, factory overhead costs are allocated to products using a single driver, often direct labor hours. Sales, general, and administrative costs are typically ignored in a traditional costing methodology, since they are not part of the production process and are not considered in the cost of goods sold equation. Overhead costs have grown substantially in the past decades, as a result of factors such as globalization, technology, product customization, security concerns, and regulatory oversight. In the past, when overhead costs were a smaller proportion of factory costs and direct labor was a larger proportion, it made sense to allocate overhead costs to products using a traditional methodology. The direct labor base was a large proportion of costs, and overhead support costs were a relatively small proportion of total costs. As shown in Figure 1, direct labor costs have declined as a percentage of total costs, while overhead costs have grown.
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Figure 1. Total costs over time The increased complexity of manufacturing operations makes the traditional methodology obsolete. What is needed to improve the understanding of costs is, first, to associate costs with the activities that are causing the resources to be used, and then to associate these activities with the products that are being produced. This way, products that require a complex set of activities or a high-cost set of resources as part of the production process will be allocated the costs associated with these activities and resources.

Is Your Cost Allocation System Faulty?
There are various indicators that a cost allocation system is not providing accurate information. You need a new cost system when: • • The volume of production increases but profitability declines. This often happens when management cannot accurately determine the cost of activities and resources associated with production processes. The product mix changes from lower- to higher-margin products, but profitability declines. This situation indicates that the “high-margin” product was actually using more resources than it was being allocated in the cost system. As the firm makes more of this product, more resources are consumed and profitability decreases. Managers do not trust the numbers from the accounting system and sometimes build their own cost systems. Functional managers often have good process knowledge about the organization. For example, when the sales group ignores accounting information in pricing products and instead uses its own calculations, it is an indication that the accounting system is not supplying accurate information. The firm produces a mix of higher-volume standardized products or services and lower-volume customized products or services, yet the cost allocation system uses a single driver to assign overhead costs to products. A single driver ignores variation in overhead costs and variation in process activity, resulting in an average number. As complexity increases in a firm, averages distort information at a segment level.

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ABC: How It Works
Consider an organization with two primary products: • The first product is well established in the marketplace, sells in high volumes, and is made from a relatively small number of components. In sum, it is a relatively simple product to make and support. Each month, 2,500 direct labor hours are used to produce 100,000 units of this product.

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The second product is newer and sells in smaller volumes. It requires a complex series of steps to produce, with modifications to units requested by various customers. Each month, 2,500 direct labor hours are used to produce 25,000 units of this product.

Using a traditional cost allocation methodology, all overhead costs would be assigned using the number of direct labor hours used to produce each product; therefore, each product line would be assigned 50% of the overhead costs because each product line uses 2,500 direct labor hours. However, the second product is more complex to make, in that: • • • more supervisory oversight is needed to ensure that the product is correctly made; each item has to be inspected to make sure that the modifications have been correctly done; the shipped batches are much smaller in size.

Each of these resources—supervision, inspection, packing, and shipping—costs money, and the need for them is increased by the second product line. An ABC allocation would more accurately associate their costs with the product lines that consumed them, thereby assigning more supervision, inspection, and packand-ship costs to the second product line. The data in the following example compare a traditional costing outcome with an ABC outcome for the two products.

Table 1. Comparison of traditional and ABC costings for the same product lines

Case Study
ABC Used to Improve Processes and Evaluate Customer Profitability
Kanthal is a global producer of electrical heating material and elements that are used in industries including electronics, chemical, ceramics, medical, and appliances. Headquartered in Sweden, Kanthal sells its products throughout the world. In the mid-1980s, Kanthal implemented an ABC project to help it realize its strategy for higher growth and profitability. The specific goals of the company were to: • • • achieve profit objectives by division, product line, and market; determine order and sales support costs, so that the sales force could make better decisions about customer requests; increase sales without increasing overhead costs.
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At the time of the initial analysis, Kanthal had about 10,000 customers and produced about 15,000 items.

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The ABC analysis showed that, of Kanthal’s total Swedish customer base, 30% contributed the majority of the profits, about 40% were break even, and 30% were not profitable. The analysis also showed that two of the largest customers were among the least profitable for the firm. An activity analysis helped to focus on the root causes of the low-margin customers. These were the customers that ordered in small order sizes or in unpredictable amounts, changed their orders frequently, ordered nonstocked or customized products, required additional technical advice and support either preor post-sale, demanded large discounts, or were slow to pay invoices. In a culture that focuses on building sales, many firms say yes to one-off customer requests and demands; however, the additional sales volume then comes at costs that very often are not directly associated with the customer’s order. Kanthal management used the ABC information to change internal processes and also to change its relationships with customers. The firm reduced the variation in product offerings, and used distributors to stock smaller-volume items, enabling it to meet more orders from stock rather than building to order. On-line order entry systems were installed for the large customers. Some customers were given a small discount as an incentive to increase order sizes; for example, when one customer was given a 5% discount to increase order lines by 50%, profitability for that customer increased from 19% to 45%. In one division, average order size increased by over 60%, the percentage of orders fulfilled from stock increased from 36% to 63%, and profitability went from a small loss to a 9% positive margin. For the company as a whole, sales increased by 20% without a corresponding increase in employees, leading to a 45% increase in profitability.

Benefits of ABC
An ABC analysis provides management with a wealth of financial and operational information. The benefits of ABC include the following: • • • • • • Costs are associated with activities that create those costs. Profitability can be calculated from multiple perspectives, such as product line, customer, or market. It provides information about “hidden” losers and winners, i.e. which product lines/customers/markets have lower profit margins than was originally thought and which give better profit margins. It provides cost rates for organizational activities that are helpful for benchmarking and making process decisions. It aligns with business process reengineering work by helping managers to put a price tag on non value-added activities, such as waste or rework. Attention is focused on process costs and how they interact with profitability segments. Armed with explicit measurements of the costs of activities and processes, management can communicate that paying attention to these factors is important. In other words, what gets measured gets managed.

Making It Happen
To conduct an ABC analysis, organizational data are needed about costs incurred, work performed, and the cost objectives (for example products, customers, markets) of the analysis. An ABC analysis can be done for one department, for an entire manufacturing operation, or for the whole organization. However, it is often an advantage to start with a smaller-sized project (a single department or a plant) as the learning curve is steep. 1 Gather the cost data from the general ledger or other financial records. Segment the data into cost pools, whereby each cost pool represents a related set of costs. For example, a maintenance cost pool might consist of maintenance labor costs, supervision, tools and equipment used for maintenance, and training costs for maintenance workers. 2 Define the activities of the business (what work is performed), using the following framework: • • Facility-level activities: Those related to overall operations (for example management, human resources, security, legal). Cost-object level activities: Activities that support a product (for example design, testing, engineering), or a customer (for example order processing, shipping, technical support), or a market (for example advertising, sales support).

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Batch-level activities: Activities related to a batch, equally and at the same time (for example set-up, material handling, inspection). Unit-level activities: Activities performed for each unit of activity (for example direct labor).

Once the activities of work are determined, assign the resource costs to the activities. 3 Assign the activity costs to the cost objectives (product lines, customer, markets, etc.) according to the cost object’s use of each activity. Determining the allocation basis requires process knowledge and transactional data; often statistical analysis can be used to verify relationships between transactions performed and costs incurred.

Conclusion
An ABC analysis requires an in-depth evaluation of an organization’s processes and activities, which in turn enables an allocation of costs that better reflects resource usage. Conducting an ABC analysis provides financial and operational information to management that facilitates more effective decision-making, thereby leading to improved financial outcomes.

More Info
Books:
• • • Bleeker, Ron R., and Kenneth J. Euske (eds). Activity-based Cost Management Design Framework: Getting It Right the First Time. Austin, TX: Consortium of Advanced Management, International, 2004. Cokins, Gary. Activity-based Cost Management: An Executive’s Guide. New York: Wiley, 2001. Kaplan, Robert S., and Steven R. Anderson. Time-driven Activity-based Costing: A Simpler and More Powerful Path to Higher Profits. Boston, MA: Harvard Business School Press, 2007.

Websites:
• • The Activity Based Costing Benchmarking Association (ABCBA) is a group of ABC practitioners who share data and best practice information: www.abcbenchmarking.com The Consortium of Advanced Management, International (CAM-I), is an international consortium of business, government, and academic leaders who work collaboratively on cost, process, and performance management issues: www.cam-i.org The Institute of Management Accountants (IMA) is a global organization that “provides a dynamic forum for management accounting and finance professionals to develop and advance their careers through certification, research and practice development, education, networking, and the advocacy of the highest ethical and professional practices”: www.imanet.org The International Federation of Accountants (IFAC) is a global consortium of accountants that promulgates standards and publishes articles and papers on topics of interest in the accounting and finance disciplines: www.ifac.org The Management and Accounting Web is dedicated to education, research, and the practice of management and accounting disciplines. Contains links to dozens of management accounting and finance resources: maaw.info

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Notes
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Data for this mini-case were reported in Robert S. Kaplan, Kanthal (A), Harvard Business School Case 190-002, 1995.

See Also
Thinkers • Michael Eugene Porter
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Profitability Analysis Using Activity-Based Costing

Finance Library • Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance

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