ABSORPTION COSTING FOR DECISION-MAKING
Mike Lucas, of the University of Buckingham, describes how absorbing
certain fixed overhead costs into unit product costs can complement Kaplan
and Cooper's approach to ABC, to improve the quality of planning and
decision making
Received wisdom has it that absorption costs should not be used for
decisionmaking, i.e. non-volume related costs should not be allocated to the
product unit level. If such costs are allocated down to the product unit level,
the resultant unit cost will be a function of production volume. Take, for
example, the cost of performing a machine set-up. This will be independent
of the number of units to be produced. Consequently, if the size of a
production run is halved, the per unit cost of a machine set-up is doubled!
Such a cost is therefore only valid for one particular volume of output,
whereas most planning or decision-making deliberations involve potential
changes in volume.
The supposed raison d'etre of ABC is to improve the quality of planning and
decision-making; an ABC unit cost is therefore of little value.
This principle is recognised by Kaplan and Cooper in their advocacy of ABC
for planning and decision-making purposes.[1] It is also acknowledged by
Drury in his fourth edition,[2] in which he describes Kaplan and Cooper's
approach to ABC. The principle is still largely disregarded by a number of
textbook writers, who continue to present ABC as primarily a product
costing system--a more sophisticated absorption costing system, using a
number of absorption bases (cost drivers), rather than just one volume
related basis such as labour hours.
Kaplan and Gooper's approach to ABC
Kaplan and Cooper, in their exposition of ABC, explicitly condemn the
practice of allocating nonvolume related costs to the product unit level.
Consequently, their conception of ABC is as a more sophisticated marginal
costing system--employing contribution analysis at several different levels.
In their approach to ABC, the firm is envisaged as a hierarchy of costs with
each level representing a different type of cost variability--as shown in
Figure 1. The lowest three levels in the hierarchy are concerned with product
related costs. Unit level costs are short term variable costs such as direct
material, direct labour and so on. These costs vary in direct proportion to the
number of units produced.
Many product related costs are not, however, driven by the number of units
produced per se, but by the number of batches/production runs undertaken.
An obvious example of such 'batch level costs' is machine set-ups.
The third category of product sustaining costs relates to activities which are
necessary to maintain the product in the firm's product range. For each
product, a firm must maintain a bill of materials, a routing sheet, tooling and
so on. Such 'product sustaining' activities will increase as more products (or
product variants) are added to the product range. Such costs, however, will
be independent of the number of units produced in a particular period.
In addition to the various product related costs, there are some expenses
which do not relate to individual products, but to particular customers, e.g.
order processing and distribution costs. Finally, there are certain general
overheads which do not relate to any particular product or customer, such as
the chief executive's salary.
With Kaplan's approach to cost analysis there is no need (or justification) for
any allocation downwards from a higher level, of non-volume related costs
(in Figure 1) to the product unit level. Rather, contribution should be rolled
upward when considering a particular decision. A unit-level operating
margin for individual products can be calculated by subtracting unit-level
costs from sales revenue. From this unit-level margin can be subtracted
batch-related and product-sustaining expenses to arrive at a product-level
margin. Such a margin can be calculated for each product in the range and
from this can be deducted any customer related expenses to determine the
profitability of a particular sales order.
This approach can give managers better insights into the nature of their
costs and thus facilitate better informed decisions when bidding for jobs or
deciding which orders to accept. The method can also be applied in
determining the profitability of a product over a period of time--not by
calculating a full unit cost to compare with the selling price, but by
identifying the demands the product puts on service and support activities.
The estimated cost of these activities is then added to the short-run variable
costs of producing the units sold and this total cost is then compared with
the total revenue earned by the product. Thus, for example, it may be
revealed that low volume products are unprofitable because of the
disproportionate demands placed on batch level activities--a machine
set-up is necessary whether one unit or one thousand units are being
manufactured!
An important implication of Kaplan's analysis is that the non-volume related
costs included in any decision analysis are not short-term incremental costs,
but proxies for long-run incremental cost-based typically on existing
average activity costs. Thus, for example, the total cost of machine setups is
divided by the number of set-ups performed to arrive at average cost per
set-up. This is then used as an estimate of the long-term incremental cost
that will arise by performing machine set-ups. Kaplan and Cooper argue the
superiority of this approach on two grounds.
First, they contend that it is probably not feasible to identify all the actual
incremental costs of each decision in a complex, multi-product environment.
Second, they argue that, during a particular period, numerous decisions are
made independently of each other but the collective impact can be to drive
up 'fixed' costs over time, even though these longer-term cost increases are
not incremental (and hence relevant) to. any one particular decision.
The argument is that, if only actual incremental costs are considered when
looking at a particular decision, a positive contribution is likely to lead
decision-makers to embark upon actions (e.g. accepting marginal business)
which place demands on service and support functions. Over time this
consumption of service/support activities will start to drive up costs. The
current actual cost of support activities can be viewed as acting as a proxy
for these long-run incremental costs. The ABC approach is essentially a
long-term one aimed at curbing the excesses which can result from
traditional marginal costing--which ignores potential long term increases in
cost.
Thus, although Kaplan and Cooper assert that ABC is not a decision-making
tool (but an attention directing one), it is difficult to escape the conclusion
that it is! It is nearer to the truth to say that ABC is a tool for
planning/decision-making, but one which uses proxies for long-term
incremental cost rather than strictly decision-relevant incremental costs.
The role of cost allocation
The Zimmerman approach
The Kaplan and Cooper approach is based on the received wisdom that
non-volume related costs should not be allocated to the product unit level.
There is, however, a school of thought in favour of such allocations,
suggesting that cost allocations have an important role to play in motivating
and controlling managers.
Zimmerman,[3] for example, suggested that there are certain
service/support costs which are fixed with respect to short-run changes in
production volume, but which are related, in the longer term, to the level of
primary inputs (e.g. labour). Such costs would typically be classified under
the general overhead category in Figure 1. An example would be a works
canteen.
Every additional worker employed places additional demands on the
canteen. Although actual cost of the canteen may be fixed in the short-term,
opportunity costs arise in the form of delays and/or degradation of service to
other users. As time goes by, management will tend to adjust the actual
level of service provided, in order to reduce delays/degradation of service,
and hence costs rise.
Zimmerman argues that these opportunity costs and consequent long-term
incremental actual costs should be taken into account by individual
managers when deploying labour resources. Such costs are hard to
observe/measure, but allocating current average cost can serve to proxy
them.
Thus, for example, a production manager deciding on the optimal mix of
factor inputs will be induced to take into account the additional costs of using
labour--in terms of the demands it places on the works canteen--if labour
hours are made to carry the burden of recovering this overhead cost.
The resultant factor input mix, it is argued, will be closer to the optimal one
than would be the case if such costs were ignored.
This principle can be illustrated by Figure 2, which shows how the selection
of input factors (in this example, capital and labour), to produce a given
output, depends on the relative prices of those factors.
The isoquant shows all the possible combinations which could be used to
produce a particular output. All points assume technical efficiency (i.e. no
waste); the optimal combination (i.e. that producing the lowest unit product
cost) will depend on the slope of the isocost line which represents the
relative prices of input factors. Isocost line 1 represents relative prices if the
demands placed by labour on service departments such as the canteen are
ignored and only the actual cost of labour itself is taken into account. The
'true' cost of using labour resource is understated and in consequence more
labour hours are used than would otherwise be the case. The manager is, in
effect, basing his decision on false price information.
If the true cost of using labour is proxied by means of charging labour hours
with service department overhead, the relative price of labour increases, as
shown by isocost line 2, and less of it should be used. The resultant input mix
(point 2) is closer to the real optimum, because the hidden costs of using
labour are recognised. By charging labour hours with fixed overhead burden,
overhead is factored into the unit product cost. If a unit requires one labour
hour, a corresponding amount of overhead will be included in the unit cost.
According to the logic of Zimmerman's argument, this is justified since, in
the longer term, actual costs of the service resource will tend to rise in
relation to the number of labour hours worked and the allocated fixed cost is
a proxy for these additional costs, i.e. one labour hour gives rise to x
canteen cost.
The question naturally arises as to which costs should be classified as
long-run volume-related costs and thus allocated to the product unit
level-after all, virtually all costs change if volume is increased enough! What
about, for example, rent? Zimmerman's argument appears to relate to those
areas where there is additional consumption of resources as a result of an
increase in a primary input such as labour. As a consequence of this
consumption of resources, delays/degradation of service to other users
occurs. These opportunity costs give rise to additional actual costs in the
longer term as management adjusts the level of service provision. This is
unlikely to apply to rent, unless a huge increase in labour force was being
contemplated-necessitating a new factory!
Therefore an assumption about the likely volume level over the planning
horizon is required in deciding whether to allocate or not to allocate. If, over
the anticipated volume range, significant delays/ degradation of service--as
a result of increasing primary inputs--are considered a realistic possibility,
then there is a good case for cost allocation. Where, over the anticipated
volume range, it is considered unlikely that delays/degradation of service to
other users will result--as a consequence of increasing primary
inputs--there is not a good case for cost allocation.
Applying this criterion, it may be appropriate to allocate works canteen,
payroll and personnel costs, for example; it will probably not be appropriate
to allocate rent and so on.
The Japanese approach
A slightly different rationale for cost allocation is that apparently adopted by
a number of Japanese manufacturing firms? These firms load labour hours
with overhead burden--not because they believe this will result in an optimal
mix of inputs, but to encourage the substitution of capital for labour as part
of their advanced manufacturing technology (AMT) strategy. All production
overhead--including non-volume related costs (i.e. batch level,
product-sustaining level costs etc) are allocated using labour hours.
Consequently, the resultant 'unit costs' are of little use for either longterm or
short-term decisions--since they are neither the short-term nor long-term
incremental costs of
producing a unit! Japanese managers do not believe that the resultant
product costs are a reasonable proxy for long run incremental costs; rather,
they believe that the behavioral benefits accruing from cost allocation
outweigh the disadvantages, namely inaccurate product costs and possible
erroneous decisions! Japanese companies tend to use estimated product
costs produced outside the management accounting system and based on
managers' past experience or intuition.[5] It appears that the primary
purpose of management accounting in Japan is to influence behaviour rather
than to provide accurate product costs. It is not clear that the West is ready
to sacrifice its penchant for accurate product cost information, which has
been the cornerstone of western management accounting since its
beginning.
Conclusion
Kaplan and Cooper argue that if higher-level, nonvolume related costs such
as batch level costs etc are allocated to the product unit level the resultant
unit cost will be largely meaningless. Clearly, their approach to ABC cannot
be reconciled to that of the Japanese companies. There is, however, no
necessary contradiction between the Kaplan/Cooper approach and that of
Zimmerman. Zimmerman merely introduces a category of long-run volume
related costs which are effectively ignored in Kaplan and Cooper's analysis.
The only necessary difference is that, with Zimmerman, the unit level cost
would include a proxy for the 'hidden' costs of using labour that arise in the
longer term. There would appear to be a good case, therefore, for including
Zimmerman type allocations in a Kaplan and Cooper style ABC system.
DIAGRAM: Figure 1: The firm's cost structure (adapted from Kaplan and
Cooper[l])
GRAPH: Figure 2: The selection of the optimal mix of input factors Point 1
shows the least cost combination of inputs when no account is taken of the
demands placed on a service function by the employment of labour. At this
point, L1 of labour will be used in conjunction with C1 of capital. If labour is
charged with the burden of service cost recovery, the least cost combination
shifts to point 2. At this point, less labour will be employed--L2, and more
capital--C2
1. KAPLAN, R.: 'Contribution margin analysis: no longer relevant
Strategic cost management: the new paradigm', from a paper
presented at annual meeting of The American Accounting Association.
Journal of Management Accounting Research, 2, Fall 1990.
2. DRURY, C.: Management and Cost Accounting (4th ed). Thompson
Business Press, 1996.
3. ZIMMERMAN, J.L.: "The costs and benefits of cost allocations', The
Accounting Review, LIV, 3, July 1979.
4. MAKIDO, T.: 'Recent trends in Japan's cost management practices' in
Japanese Management Accounting, edited by MONDEN, Y. and
SAKURAI, M. Productivity Press, Cambridge, Mass, 1989.
5. YOSHIKAWA, T.: 'Characteristics and practical applications of
Japanese cost accounting systems' in Japanese Management
Accounting edited by MONDEN, Y. and SAKURAI, M. Productivity
Press, Cambridge, Mass, 1989.
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