A Practical Activity-Based Costing Application in
Logistics Business
Jouni Lyly-Yrjänäinen, Harri I. Kulmala, Jari Paranko
Tampere University of Technology, PL 541, 33101 Tampere, Finland
E-mail: jouni.lyly-yrjanainen@tut.fi
ABSTRACT
The aim of the paper is to present a new method for simplifying activitybased costing. The need to simplify relates to the implementation and
updating of the accounting system. The simplifying is done by dividing
activities into three levels and by using a product category portfolio. The
case company for the method operates in the area of logistics business and
the activity-based costing project has been undergoing development and
implementation for one year.
In action science researchers become active participants in the process under
study: they become agents of change. In that sense an action research
method has been used. An activity-based costing method was used to
improve the quality of cost information.
The main result of the project was the classification of products into ten
classes based on products’ activity structure instead of defining the amount
of activities separately for each of the products. The simplification of the
system is significant. Even if the complexity of the system grows while
constructing a more detailed costing model, the classification presented in
the paper creates a practical way to make the implementation and updating
of an activity-based costing system easier.
1
1.1
INTRODUCTION
Background
The basis of this paper lies in the networking environment and its new
challenges for cost management. (Kulmala, 1999; Kulmala et al. 2000a,
2000b; Lahikainen et al. 2000) The case company operates in a logistics
business providing engineering services and system assemblies to industrial
customers. The company uses a four-category portfolio to manage product
flow. According to our research, small and medium-sized companies do not
know their product costs or customer costs. While networking requires close
relations between partners, the actual costs should be known in order to be
able to decide who to commit oneself to. At the same time, the pressure to
reduce costs is becoming stronger.
1.2
Objectives of the Study
The aim of the paper is to create a practical activity-based costing (ABC)
method for logistics business. The authors present a solid basis for the
method, which is easy to implement and update. An ABC model is
simplified by dividing activities into three levels and by using a product
category portfolio.
1.3
Research Approach
The study is carried out using an action research approach. There are also
elements of the constructive research approach in the construction of the
accounting application. (Kasanen et al., 1991) An applied activity-based
costing method is constructed on the existing theory and on the experience
from the case company business.
2
PRINCIPLES OF LOGISTICS COSTING
Developing an appropriate logistics-oriented costing system requires the
ability to focus on the output of the distribution system, in essence the
provision of customer service, and to identify the unique costs associated
with that output. One of the basic principles of logistics costing is that the
system should mirror the flow of materials. The second principle is that the
system should be capable of enabling separate cost and revenue analyses to
be made by customer type and by market segment or ditribution channel. To
operationalize these principles requires an output orientation to costing. In
other words the desired outputs of the logistics system should first be
defined and then one should seek to identify the costs associated with
providing those outputs. (Christopher, 1998)
Van der Veeken & Rutten (1998) have developed the C-PED (Costing,
Profiling, Evaluating, Differentiating) method. It enables an organization to
tailor the logistics service offered to different customer requirements. This
model is analogous to the target marketing concept described by Kotler
(1997). The application of the model results in a number of customer
profiles that groups customers according to their ordering behavior (van der
Veeken & Rutten, 1998).
A useful concept here is the idea of “mission”. In the context of logistics, a
mission is a set of customer service goals to be achieved by the system
within a specific product or market context. The mission can be defined in
terms of the type of market served, which products are offered, and within
which constraints of service or cost. A mission by its very nature goes
beyond traditional company boundaries. The successful achievement of
defined mission goals involves inputs from a large number of functional
areas and activity centers within the firm. (Christopher, 1998, pp. 74-75) In
cost accounting the method is known as “mission costing” (Christopher,
1971). The pioneering work of Barrett developed a framework for the
application of mission costing (Barrett, 1982). This approach requires firstly
that the activity centers associated with a particular distribution mission
should be identified, and secondly that the incremental costs for each activity
center incurred as a result of undertaking that mission should be isolated.
(Christopher, 1998, p.76)
The mission approach offers an analytical framework for analyzing the
distribution process (Barrett, 1982). There are four stages in the
implementation of an effective mission costing process: (Christopher, 1998)
1) Define the customer service segment
2) Identify the factors that produce variations in the cost of service
3) Identify the specific resources used to support customer segments
4) Attribute activity costs by customer type or segment.
The main interest of mission costing is in identifying the real costs of serving
different types of customers or different channels of distribution.
There are certain parallels between activity-based costing and the idea of
mission costing. Mission costing seeks to identify the unique costs that are
generated as a result of specific customer service strategies aimed at targeted
market segments. The aim is to establish a better matching of the service
needs of the various markets that the company addresses with the inevitably
limited resources of the company. (Christopher, 1998)
3
3.1
INSTALLATION OF ABC IS CHALLENGING WORK
Problems with Implementing ABC
There has been a number of problems with adopting ABC (Sohal, 1998, pp.
139-144; Kleinsorge, 1991, pp. 5-6; Ness, 1995, p. 13). Many companies
seriously underestimate how big a job gathering the information needed to
set up an ABC system is.
An ABC system should be as accurate as it reasonably can be, but the costs
of implementing the system must justify the desired improvements in
managing the business. (Kleinsorge, 1991, pp. 5-6) One reason is that ABC
is much more detailed and complex than traditional cost accounting. Another
reason is time-consuming data collecting. Especially in the beginning,
figuring out precisely what kind of information is required to set up an ABC
system and where to find it takes a while. Most companies go overboard at
first and end up with a mountain of excruciatingly detailed information,
which overwhelms both their people and their computer systems. When
Chrysler installed ABC at its first factory, it gathered three times the
information it could use practically. Because of that overkill, collecting the
information took twice the resources that it would now, given Chrysler’s
knowledge and experience. (Ness, 1995, p. 13)
In activity-based costing the cost assigning is made in at least three different
phases: Cost factors are assigned to the resources, the resources are assigned
to the activities by the resource drivers, and the activities are assigned to the
cost-objects by the activity drivers. This process is described in Figure 1.
Cost factor
Resource
Cost assignment
Activity
Resource driver
Cost-object
Activity driver
Figure 1. Assigning the costs to the cost-objects.
According to our experience the most difficult phase is the activity
assignment to the cost-objects. This is the case especially in product costing.
The number of products is high even in middle-sized companies. The
number of resources, activities, and drivers ranges from a couple of tens to
hundreds. It is the large amount of products that is the main reason for the
complexity and clumsiness of the accounting systems.
3.2
Interviews Are Keys to Understanding
The time usage of a single activity can be detected by either the direct or
indirect method. In applying the direct method, the interviewee is asked to
estimate the unit time of an activity or the unit time is measured. The indirect
method, on the other hand, is based on calculating the unit time of the
activity when the resource time available is known. The interviewee should
list the activities he/she typically performs and estimate the relative time
usage between the activites. The result is annual time usage listed by
activities. The unit time of an activity may then be calculated by dividing the
annual time used for the activity by the number of single activities performed
annually. Both of the methods are presented in Figure 2.
Resource time available (h)
1600
Indirect method
Activity
Activity A
Activity B
Activity C
Relative
time usage
for
the
activites
Annual time
usage for
the activity
(h)
Number
of
single activites
performed
annually
Unit time
of
an
activity(h)
50 %
30 %
20 %
800
480
320
1600
100
10
8
8
48
40
100 %
Direct method
Figure 2. Indirect and direct methods for calculating the unit time of an
activity.
In order to check the correctness of the unit times of the activites, it is
recommended to use both of the methods. The direct method can be verified
by adding up the unit times of the activities performed in a year. If the result
is close to the resource time available, the unit times of the activites are
reliable. The results from the indirect method can be verified, for example,
by simply timing some of the activities, which is basically the same as the
direct method. Therefore, these two methods are complementary and support
each other.
A by-product of the indirect method is a list of activities performed by a
resource. Without this information it is impossible to study how the resource
time is divided between the activites. An essential part of the interviews is to
look into the reasons that make an activity more time consuming than
another. The interviews produce valuable internal information on the
company and on the business it is in. If the responsibility of constructing the
cost model is on persons not deeply involved in the business, the direct
method is very useful.
3.3
Activities in Three Levels
In order to assign an activity to cost-objects by activity drivers, it is
necessary to define two variables: an activity driver and its amount. A
certain activity is assigned to all the cost-objects by the same driver.
Different cost-objects demand different amounts of the activity. A
conventional way of defining the activity amounts would be to handle all the
cost-objects separately. However, activities can be divided into difficulty
levels and weighted by weight factors (see e.g. Kaplan – Atkinson, 1998,
p.110). This requires knowledge of the activities’ difficulty level
distribution. The leveling aims to standardize the amount components of
activity drivers. There is no need to define separate driver amounts for all
the cost-objects; the amounts could be chosen from the standardized levels.
The suitable number of difficulty levels within an activity depends on the
variation of the activity time usage. If the theoretical time frame between
minimum and maximum activity time is wide, the activity time variation and
cumulative behavior should be noticed. All the levels should have
approximately equal probability to occur and the levels should sufficiently
differ from each other.
The levels can be formed by finding out the amounts of each activity
demanded by each cost-object. The amounts should be statistically analyzed
to define the reasonable levels. The levels can also be formed by direct
questions answered by resources. The interviewee should be the best person
to estimate drivers by the following scale: small, normal, and large demand.
Taking a look at the invoicing activity, a “quick” invoice may take one
minute to complete, a “normal” one five minutes, and a “slow” one even half
an hour. Using this method the expertise of a person performing certain
activities is utilized to minimize calculations or work measurement. The
drawback of this method lies in inaccuracy. All the activities could be
leveled by specific analysis and interviews. The possible inaccuracy could
be noticed and somehow even eliminated by for example sensitivity analysis.
Table 3 presents the accounting method used in this paper. The activities are
at three levels: quick, normal, and slow. The weight index of time use gives
the time usage ratio between “normal” and “quick” and between “slow” and
“quick” activity levels. The percentage of level occurrence identifies the
relative share of the level occurrence within the activity. Driver quantity is
counted by the relative shares of levels and the total driver quantity. The
share of time used for a level is that level’s share of time used for the
activity. The share of total time used by resource X tells the share of the
resource’s total working time used for the level. The annual cost of a level is
calculated by the level’s relative share of the resource’s annual cost and time
usage. The unit cost of a level is calculated by dividing the annual cost of the
level by the level´s driver quantity.
Table 3. The information needed when calculating the unit cost of the
difficulty levels for an activity.
Total driver quantity
X
Time used for the activity by resource X
Y%
Total annual cost of resource X
Z
Activity Level
Weight
index of
time use
Percentage
of
level
occurrence
Driver
quantity
Share
of
time
used
for the level
Share
of
total
time
used
by
resource X
Annual cost
of level
Unit cost
of level
Quick
Normal
Slow
A
B
C
AA %
BB %
CC %
100 %
X11
X2
X3
X
A12
B1
C1
100 %
A23
B2
C2
Y%
A34
B3
C3
Z * Y%
A45
B4
C4
3.4
Product Portfolio Approach in Purchasing and Logistics
Four-category portfolios derive from the Pareto analysis, the rule of 80/20.
The products are categorized for example by the annual sales volumes. With
the help of categorizing the management can use limited resources in the
most effective way by assigning operations to the products that require most
of the work. Products in different categories are controlled, operated, and
managed in separate ways.
Difficulty of
managing the
purchase situation
Olsen & Ellram (1997) have developed a categorizing tool that is based on
the strategic importance of a purchase and the difficulty of managing the
purchase situation (Figure 3).
Bottleneck
Non-critical
Strategic
Leverage
Strategic importance of the purchase
Figure 3. Product categorizing by strategic importance and
difficulty of purchase.
1
X1 = AA% * X
2
A1 = X1 x 100% / (A x X1 + B x X2 + C x X3)
3
A2 = A1 x Y%
4
A3 = A2 x Z
5
A4= A3 / X1
Products are divided into four categories in order to create purchasing and
logistics operations that support the managing of each category. Problems
with different products are generic within a category but different between
categories. The product portfolio approach creates a solid basis for
management accounting. If all the activities or operations are separate
between the categories, why not locate also the cost information in the
categories?
4
4.1
CASE DESCRIPTION
Component Supply Business – Product Costs Unknown
The case-company is a Finnish sales company forming part of an
international consolidated company specializing in technical wholesaling.
The company employed about one hundred people and the net sales were 40
MEUR in 1999. During the past few years the company has been actively
oriented toward a system supplier providing engineering services in addition
to the components. The objective is to both deliver large assemblies and
make the logistics services as easy as possible for the customer. This is the
company´s answer to the outsourcing development in the machine
construction business.
As is typical of this industry, material costs are high, in this case
approximately 70 % of the total costs. The activity costs assigned to the
products build up mainly from the indirect labor related to purchase, sales,
and logistics. Comparable with direct labor are only storage activities and
assembly of parts. However, these costs are not tracked at the product level
and their slice of the total cost is small. According to the basic ideas of the
ABC, product profitability cannot be known unless a company has
knowledge of its own activities. Because the time used by white-collar
workers to perform different activities is not followed – “My work can’t be
measured” – the cost structures of the products are unknown.
4.2
Company Activities and Their Division into Different Levels
The ABC project was started in October 1999. The activites performed in
the case company were identified by using questionnaires and interviews,
and a process model was created. Similarily, the resource time of different
activities was established. When the resource costs had been calculated, they
were assigned to activities based on the time used by the resources. At this
point the annual costs of the activities were determined.
Interviewees were also asked which of the single activites performed by
them could be divided into three levels according to the time usage required.
For example, the people in the purchase department were able to divide the
purchase activity into “quick”, “normal”, and “slow” levels. Other activities
divided into three levels were order entry, delivery control, and storage
activities.
In order to calculate the unit costs of the activities, it was necessary to find
out how many times each activity was performed in a year. For instance, the
number of positions (4800) was used as an activity driver for the purchase
activity. The share of the different levels of the activity estimated by the
purchaser was used to calculate how many times each level occurred
annually. With the weighted indices also estimated by the purchaser and the
annual occurrence calculated above, it was possible to calculate first the
distribution of the time spent for a single activity and then the distribution of
the total time of a single resource to the different levels. The weighted
indices, their shares, driver quantities, and the distribution of the resource
time used for purchasing activity as well as the distribution of the total time
of the purchaser to the different levels is shown in Table 2. The table also
shows the calculated unit costs of the different levels of the purchasing
activity. The levels´ unit costs for the rest of the activities were calculated
similarly and are illustrated in Table 3.
Table 2. Example of purchasing -activity time and cost distribution.
Total driver quantity
4800
Time used for the activity by resource X
60 %
Total annual cost of resource X (EUR)
51000
Activity Level
Weight
index of
time use
Percentage
of
level
occurrence
Driver
quantity
Share
of
time
used
for the level
Share
of
total
time
used
by
resource X
Annual cost
of
level
(EUR)
Unit cost
of level
(EUR)
Quick
Normal
Slow
1
10
15
50 %
30 %
20 %
2400
1440
960
4800
7.7 % 6
46.2 %
46.2 %
100.0 %
4.6 % 7
27.7 %
27.7 %
60 %
23468
14127
14127
30600
0.97 9
9.75
14.63
Table 3. Unit costs of the levels of activities (EUR).
Storage activities
Quick
6.00
Normal
10.18
Slow
20.51
Delivery control
Quick
Normal
Slow
7.61
22.77
90.95
Order entry
Quick
Normal
Slow
1.45
4.34
7.32
The unit costs of the levels show significant differences. Thus it is not
insignificant how the activities are assigned to the cost-objects. Leveling the
6
2400 * 100% / (1 + 2400 + 10 * 1440 + 15 * 960)
7
7.7 * 0.6
8
4.6 % * 51000 EUR
9
2346 EUR / 2400
activities to at least three different levels is necessary if the objective is to
analyze product profitabilities.
5
INNOVATIVE APPLICATION
5.1
Managing the Categories in the Case Company
Prior to the beginning of the ABC project, the case company had decided to
improve its logistics by implementing a four-category portfolio. The
categorization application implemented differs from the categorization
applications presented in the literature. The literature applications have been
reshaped to take into account better the special characteristics of the
company. The most significant difference is that the categorization is
completely based on separate groups. In the applications found in the
literature both the horizontal and the vertical axis, which form the basis for
the categorization, are continuous. The main features of the categorization
applied in the case company are illustrated in Figure 4 below.
Volume Items
-Items purchased and sold continuously
-Several customers
-Good availability
Order-Based Items
-Items purchased only for a customer
order
-Usually one customer
-Delivery time equals the delivery time
of the supplier
-The customer must accept the delivery
time
Prognosis-Based Items
-Items with constant stockturn
-Items sold to certain customers
-One or several customers
-Better availability with regular deliveries
-Conceivably safety stock contracts
Strategic Items
-Storing by customer contract
-One customer or customer group
-Low availability without storing
Figure 4. The four-category portfolio implemented in the case company.
After calculating the unit costs of the activities, it was time to assign the
activity costs to cost-objects in order to study product profitabilities.
Because of the large number of products and activity structure combinations,
it was decided to choose a few pilot products from each of the four
categories and track down their activity-based cost structures. At this point a
new idea was born: If it was possible to find activity structures common to
many products, the cost structures could create a basis for classification of
the products.
5.2
Creating the First Pilot
The activity-based costs of a product are not related to the price of the
product, but only to the demand for activities by that individual product. The
costs calculated for a single pilot product are therefore the same as the costs
of every product having similar activity structure. According to the
parameters of the categorization, the products within a category have similar
activity demands. Volume products, for example, demand mostly “quick” or
“normal” purchase activities. Delivery control and order entry activities are
normally also “quick” for these products. Prognosis-based products on the
other hand demand “normal” or “slow” purchase activities, and order entry
requires more time as well.
Conventional activity-based models normally assign the activity costs to
each cost-object individually. Therefore, the amount component of each of
the activities has to be determined individually for every single product. This
would be very time consuming in an environment where the number of sales
products is large. Implementing activity leveling eliminates the need to
measure the amount component of the activities for each and every product.
All that needs to be evaluated is which level (quick, normal, or slow) of the
activities best describes the activity demand of the product. This makes the
determination of the amount component much faster. However, each product
must be gone through activity by activity, which is still pretty time
consuming. The problem can be solved when classes are formed from the
different activity and level combinations. The activities demanded by a
product are no longer evaluated individually, but the product is placed in a
class which best describes its activity structure.
5.3
Classification Model
The activities chosen to form the basis for the classification had to be
dividable into different levels. Classification parameters were purchase,
delivery control, order entry, and storage activities. These four activites,
with three levels each, form 81 possible activity and level combinations10.
The number of classes decreased significantly when the process and product
expertize of the employees was used. The activity and level combinations
that do not exist in the case company were excluded. Based on the
discussions with employees of the case company, ten significant activity and
level combinations were found. These ten classes make it possible to classify
all products with adequate accuracy to support strategic product and
customer decisions. For this purpose ABC is considered to be at its best
(Cooper & Kaplan, 1998). The activity and level combinations are
illustrated in Figure 5.
10
3 4=81
Prognosis-Based Items
Volume Items
Class 1
Class 2
Class 3
Class 4
P
Q
N
Q
N
DC.
Q
Q
S
OE
Q
Q
N
N
SA
Q
N
Q
S
Class 5
Class 6
Order-Based Items
Class 7
Class 8
P
Q
S
DC.
-
OE
Q
S
P
N
S
DC.
-
OE
S
Q
SA
S
S
Strategic Items
SA
Q
Q
Class 9
Class 10
P
N
S
DC.
-
OE
Q
Q
SA
S
Q
Figure 5. Classification of items by chosen variables (purchase P, delivery
control DC, order entry OE, storage activities SA) and measured values
(quick Q, normal N, slow S) in the case company
Calculating the costs of all the 81 combinations would not cause that much
extra work, but the great number of classes would make the model much
more difficult to use. The aim of the model is, that with the help of Figure 5,
each one of the company´s products can be placed in one of the classes fast.
Once a product has found its way to the right class, activity-based costs can
easily be assigned.
Calculating activity-based costs for new products using the model is smooth
and fast. This is an important distinction compared with conventional ABC
systems, which are quite troublesome when calculating product costs. When
the model was developed, it was important that the model could also be used
by employees regardless of expertize in accounting. By applying the model
it should be easy for sales people and company management to calculate
activity-based product costs.
5.4
Problems in Applying the Model
Dividing the activities into three levels proved to be difficult because the
interviewees found it hard to name elements that would explain the time
differences between the activity levels. Therefore, even some costly and
important activities remained undivided. On the other hand, annual costs of
some activites were low enough not to require leveling.
Characteristic of the company is that engineering services are an important
part of the business operations, and vital to the customers as well.
Engineering services are more or less related to project sales; the company
designs a subsystem for a product of their customer. The company then sells
components to the customer for several years. Engineering services and sales
are thereby strongly bound to each other and within this project it was not
possible to separate them. Because the resources were unable to identify
elements that would have explained the differences between the activity
levels, dividing these activities into levels was out of the question. The most
important thing in developing the model further is to level all the most
significant activities.
For a single product, the time demanded by activities related to inbound
logistics is similar to the time demanded to perform the activities related to
outbound logistics. In other words, if a product is identified as “slow” when
received and stored, it is most likely to be “slow” when picked and shipped
as well. Therefore, in this model it is possible to treat storage activities as
one single classification criterion.
As explained earlier, the ten classes were created by dividing the activities
into levels and using the expertise of the employees and the categorization
model. The most expensive activity is, however, excluded from the
classification model. One of the classification criteria should definitely be
sales and engineering activity, because of its high annual costs. If the fifth
classification criterion were included in the classification model, the number
of possible classes would rise from 81 to 243. If the ratio of possible
combinations and eventual classes in the model were the same, the improved
classification model would have about 30 classes.
6
CONCLUSIONS
The aim of the paper was to present a new method for simplifying activitybased costing. The reason for simplifying lies in making the implementation
and updating of the accounting system easier. To assign activities to
products becomes a challenging task if the number of products is high. This
is the phase in activity-based costing which was developed in this paper. The
simplifying was done by dividing activities into three levels and by using a
product category portfolio.
Conventional activity-based models normally assign the activity costs to
each cost-object individually. Therefore the amount component of each of
the activities has to be determined individually for every single product.
Implementing activity leveling eliminates the need to measure the amount
component of the activities for each and every product. All that needs to be
evaluated is which level (quick, normal, or slow) of the activities best
describes the activity demand of the product. Leveling of activities operates
at the individual activity level.
Going through each product activity by activity is still pretty time
consuming. This problem was solved in the classification model. The
classification model is based on three key elements: leveling of activities, the
four-category portfolio, and the expertise of the employees. The aim of the
model is that each of the company´s products can be placed in one of the
classes fast. The activities demanded by a product are no longer evaluated
individually, rather the product is placed in a class which best describes its
activity structure. The classification model operates at the activity structure
level.
Activity-based costing, activity leveling, and product portfolio management
create a natural triangle:
− The idea behind activity-based costing is that cost-objects consume
activities. Activity drivers measure the consumed activities.
− The basis for activity leveling lies in standardization of the quantity
of activity driver needed.
− Product portfolio management emphasizes different treatment
(activities) of products in different categories.
The common point of interest in the triangle is activities.
The value of the paper lies in its practicality. Earlier studies have been based
mainly on customer segmentation. They have stated that activity-based
costing is well suited for carrying out costing demanded by different
customer segments. This paper is more detailed. The idea of connecting
activity-based costing, activity leveling, and product portfolio management
is new.
The classification has the following requirements:
1. All the products do not demand the same amount of a single
activity.
2. There are products that demand almost the same amount of a
certain activity. The amount of activity within a certain level should
have sufficiently small distribution.
3. There are groups of products that do not just demand the same
amount of a single activity, rather the whole activity structure is
similar.
4. There are experts available who can eliminate combinations of
activity structures that do not exist.
Fulfillment of the first requirement is somehow natural. The second
requirement was also achieved; the leveling was carried out by dividing
activities into “quick”, “normal”, and “slow” levels. Four activities with
three levels each formed 81 possible activity and level combinations
(requirement 3). The experts from the case company eliminated classes that
do not exist. Ten classes made possible the classification of all products with
adequate accuracy.
During the development of the classification model the role of the product
portfolio was mainly to give direction to ideas. It also made the experts’ job
of excluding combinations easier. At the operational level of the model the
product portfolio has an important role: after a product’s category is known,
the maximum number of classes to choose from is four.
Based on one case company it is impossible to say anything about the
generalization of the results. However, according to this study it is obvious
that companies in logistics business could gain significant benefit in
implementing and updating their accounting system by analogous
classifications.
In further development of the system the number of classes will grow
because of the amount of details to be included in the model. The need for
accurate product costing also awaits solutions.
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