What Better Cost Information Can Do For Your Business

WHAT BETTER COST INFORMATION
CAN DO FOR YOUR BUSINESS

Do you know the cost of your activities?
What do a meat packing plant, a soap manufacturer, and a customs broker have in common? Just as any other organization, these Latin American companies have to carry out, in a coordinated fashion, a series of activities to meet their customer needs, providing them with products or services according to their requirements. Activities produce income and, at the same time, drive costs. Therefore, managers should control not only the way activities are carried out, inside and outside the company, but also the cost they create.
In meeting this common control objective these companies started Activity-Based Management (ABM) and Activity-Based Costing (ABC) projects.
At the beginning, the meat packer, the soap manufacturer, and the customs broker were following the traditional approach (financial accounting) in controlling costs and analyzing the performance of their different accountability centers.
On the other hand, successful management teams in competitive environments did know their product and/or service costs, in addition to being constantly looking for ways to reduce costs, without affecting value added to customers. They sought continuous improvements in both internal and external business activities, namely, by reducing activity costs, eliminating unnecessary activities, or creating new activities that added more value to customers.

How does the Activity-Based Costing System Work?
Traditionally, managers analyze financial accounting or conventional management results, and often make decisions on cost reduction after examining cost and expense line items in the company's profit and loss statement. The idea is to reduce the most representative line items, generically grouped, without considering the impact this may have on activities that are critical in attaining company goals. This approach focuses on controlling inputs, without paying any attention to the activities consuming these resources. On the contrary, ABC provides managers with information about activities, letting them know how much it costs to perform each activity and the most likely causes of activity costs.
To illustrate the above let us examine one of the three Latin American companies mentioned at the beginning. The meat packer implemented Activity-Based Costing (ABC) as a cost control tool to support its low cost strategy and got the following information:
Meat Sales Choices:

By
Roberto Mendoza,
INCAE
Instituto Centroamericano De Administración De Empresas, Costa Rica

Meat Sales Choices: Regular Packed or Vacuum Packed (Millions) Regular Packed
Revenues from boned meat	$311.3
Packing activity costs	1.5
Net income	$309.8
Vacuum Packed
Revenues from packed meat	$330.0
Packing activity costs	14.7
Packing material	9.3
Total	24.0
Net income	$306.0
Difference	$3.8

As shown by these figures, it was better to sell the meat in regular packs rather than vacuum packed. A packing activity analysis made management realize they were vacuum packing products in approximately 60 different sizes, as a response to every sales department request. This policy meant having packing materials for the different sizes, setting up machines frequently, and creating a lot of waste. Management decided to eliminate 40 sizes, in order to reduce setup activity, waste, and packing material inventory.

By further analyzing this activity with the purpose of knowing who were the customers purchasing the vacuum-packed product, two kinds of customers were found: some appreciated vacuum packing, while others did not. Management then decided to use very low cost regular packing for those customers who did not think vacuum packing was important and top-quality printed plastic material for customers who did appreciate it.

These two decisions enabled the company to continue to sell the same product volume and made the packing business more profitable. The resulting process improvements also led to a $32-million savings.

How to Manage with the Activity-Based Approach (ABM)?
The first step towards activity-based management is designing an activity-based costing system. An activity-based costing system provides information on the cost of products, services, activities, and resources consumed by activities.

In the chart below, an Activity-Based Costing Model, lower arrows show that cost objects, whether we call them products, services, customers, distribution channels, or product lines, are made up of activities and that activities are the ones consuming resources. Upper arrows show the cost tracing flow: resource cost is traced to activities and activity cost is traced to cost objects. Traditional cost accounting systems allocate resources directly to cost objects, thus ignoring activity costs

The above means that activities associated with the different products or services should be identified; that is to say, the question "What needs to be done to make these products or render these services?" must be answered. Then, the cost of these activities is determined, according to the resources they consume. This procedure also applies to activities not directly involved in making the products or rendering the services, but required to support both the production process and the organization, as a whole.

For example, the soap manufacturer started an ABC/ABM project as a pilot test in the procurement department. Data obtained from activity-based costing showed the cost of major activities in this process was broken down as follows:

Negociating with suppliers	40.3%
Following up on purchase	16.8%
Coordinating	14.9%
Carrying out paperwork	9.6%
Making claims	8.0%
Supervising	5.8%
Running administrative tasks	4.6%
Total	100%

According to these data, negotiating with suppliers was the most costly procurement activity. The ABC/ABM implementation team, together with the purchasing manager, analyzed the cost drivers for this activity, and found out that one of the major influencing factors was that the sales department was most active during the second half of each month, when they realized they were not reaching their sales goals. In such a situation, they were forced to take many urgent orders, related to packing materials, to meet last-minute customer requirements. This made it difficult to have a stable production throughout the month and to know about packing material needs well in advance.

At the same company, another activity analysis revealed that electric engines with different brands were being used for similar purposes. Since engines were distributed by different businesses, this meant having to deal with many vendors. Management made the decision of harmonizing engine brands to reduce both inventory of parts and number of vendors.

Another example of ABC/ABM application is provided by a customs broker who was experiencing a sharp decline in profits, as a result of changes in customs clearance procedures to import merchandise. Management came to the conclusion they had to increase profits either by improving efficiency (reducing costs) or by increasing income. They decided to develop a pilot Activity-Based Costing project in the customs clearance certificate department. Results showed the highest cost activities were the following:

Activities	Cost
Providing administrative support	17%
Giving customer service	15%
Sorting by tariff schedule	13%
Running procedural paperwork	12%
Filling out customs clearance permits	11%
Total	68%

From this information and other activity analysis, the team redesigned the process, eliminating some activities and merging others. While no people were laid off, the department's production capacity increased 35%, customer service time was shortened 90% and the cost of filling out the customs clearance certificate form went down 20%. Additionally, the ABC system allowed them to determine the cost of the different services they were providing and to review their pricing policy.

This example shows that activity-based costing provides valuable information to make better decisions, but management still has to analyze activities. This requires identifying activities that have room for improvement, from the point of view of creating higher value added to customers or reducing their cost. It is also possible to identify activities that must be eliminated or to add critical activities not being performed and that could increase value added or sustain long-term profits.

The results of these three pilot projects provided valuable information to companies, not only to know their product costs but also to understand their activities and their cost. The latter allowed them to make decisions on pricing policy, procurement process policies, decreasing the number of stock-keeping units without harming sales, changing the process, and increasing productivity. It is worth mentioning that, in all three cases, managers in charge of each area found activity-based costing very useful because it enabled them to gain an in-depth knowledge of areas for which they were accountable.

Conclusions
In competitive environments, managers require better information, not only about their products and services cost, but also about the cost of the different activities needed to create these products or services. Traditional accounting systems do not provide this information. The activity-based management approach allows everyone in the organization to understand where costs are being incurred, why they are being incurred, and how these activities contribute to a higher value added to customers. Additionally, ABC seeks to identify activities that can be eliminated or improved. It can also be added that, if all company employees follow the activity-based approach, communications improve and changes are easier to make.

Professor Roberto Mendoza
INCAE
Instituto Centroamericano De Administración De Empresas

Email: MendozaR@mail.incae.ac.cr

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