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International Journal of Physical Distribution & Logistics Management

Supply chain costing: an activity-based perspective


Binshan Lin, James Collins, Robert K. Su,
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International Journal of Physical Distribution & Logistics Management, Vol. 31 Issue: 10,pp. 702-713, doi:
10.1108/EUM0000000006286
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IJPDLM
31,10 Supply chain costing:
an activity-based perspective
Binshan Lin
702 Department of Management & Marketing,
College of Business Administration,
Louisiana State University in Shreveport, Shreveport, Louisiana, USA
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Received March 2001


Revised September 2001
James Collins
Cole, Evans and Peterson, Shreveport, Louisiana, USA, and
Robert K. Su
Department of Accounting, College of Commerce,
National Cheng Chi University, Taiwan
Keywords Activity-based costing, Supply chain, Supply-chain management, Implementation
Abstract The purpose of this research paper is to help managers improve their understanding
of logistics costs and the accounting for those costs in order to optimize use of the total cost
approach to managing logistics processes. This paper will discuss the history and evolution of
logistics management and activity-based costing (ABC), the driving cost factors affecting the key
logistics activities, and the use of ABC systems to help improve the allocation of logistics costs to
specific cost objects. This paper also includes several important managerial implications and
implementation techniques for an ABC system.

Introduction
As the business world changes, business functions must do the same. To
stay competitive in the emerging global market, businesses must change the
way they view their traditional business functions. Businesses must look
beyond what the function currently accomplishes and envision what the
function can accomplish. Logistics has recently become a focus of such
attention. Traditionally, logistics was viewed as an expensive, necessary
cost of business rather than as a possible source of competitive advantage.
Only recently have experts begun to see the awesome potential in logistics
management, more commonly known as part of a broader supply chain
management.
Supply chain management as its own discipline did not exist a few
decades ago. In the late 1970s, deregulation of the public transportation
industry brought about a closer analysis of traffic management in many
corporations and allowed more decision-making capabilities in selecting
modes of transportation. Then in the 1980s, the functions of warehousing
and inventory management became of more concern among corporate
officers due to increasingly high interest rates and a flux of corporate
International Journal of Physical
Distribution & Logistics
buyouts. Another factor affecting the recent evolution of supply chain
Management, Vol. 31 No. 10, 2001,
pp. 702-713. # MCB University
management was the highly successful use of just-in-time manufacturing in
Press, 0960-0035 many Japanese firms. The rapid succession of these events prompted
companies to focus increasingly on coordinating the inbound and outbound Supply
flow of goods and services in a more cost-effective manner, which, in chain
essence, embodies the general idea of logistics management (Prince, 1999). costing
Logistics management can be formally defined as that part of the supply
chain process that plans, implements, and controls the effective, efficient
flow and storage of goods, services, and related information from the point
of origin to the point of consumption in order to meet customer 703
requirements (Chopra and Meindl, 2001). Supply chain management has
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now evolved beyond a mere cost-reducing business function into a core


competency and source of competitive advantage for many firms because of
its impact on customer service the output of the entire logistics function.
In a highly competitive marketplace where products, prices, and quality are
easily imitated, superior customer service can be the key element that ranks
one firm above another (Lambert et al., 1998; Ferguson, 2000). Thus, the
logistics function obviously plays a vital role in the success or failure of a
company.
The purpose of this paper is to help increase management's
understanding of logistics activities and the related costs of those activities
and their influence on corporate decision making. This paper will focus
specifically on the use of activity-based costing (ABC) in allocating the cost
of activities to specific cost objects and the issues involved in implementing
ABC within an organization.

ABC
Customer service, the outcome of the logistics function, ``involves getting the
right product to the right customer at the right place, in the right condition and
at the right time, at the lowest total cost possible'' (Lambert et al., 1998). To
know the lowest total cost at a given level of customer service, a keen
understanding of the logistics activities and underlying costs of those activities
is paramount. ABC is the method by which this critical cost data can be
gathered for analysis and utilization either in a single firm or among the firms
in the supply chain.
Although ABC has been around since before the Second World War, it has
only emerged into the limelight of corporate decision-making strategies
(Harrison and Sullivan, 1995). ABC can be defined as a system of:
. . . calculat[ing] the costs of individual activities and assign[ing] [those] costs to cost objects
such as products and services on the basis of the activities undertaken to produce each
product or service (Horngren et al., 2000).

In essence, ABC uncovers the true cost of business.


To illustrate how the true costs of business are revealed, suppose 20
percent of a particular firm's total sales volume is derived from an
international retailer with whom the firm does business. The firm also does
business with a regional retailer that represents around 3 percent of total
IJPDLM sales volume. Owing to the larger sales volume of the international retailer,
31,10 it may appear that the big international customer is more valuable than the
smaller regional one. However, when the costs of doing business with each
company are compared to the actual revenues earned from each company,
the smaller retailer actually provides a higher total profitability of an
account (Gooley, 1995).
704 The reason the smaller firm provides more profit is because the
individual activities that are required in doing business with this customer
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are less costly than those required for the big retailer. ABC helps reveal the
true cost of doing business with a particular customer, supplier, or
distributor by comparing the revenues earned to the cost incurred on each
particular party. Consequently, the company can then point to the cost of its
internal activities in determining how to continue to do business with its
customers on a more profitable basis.
One of the major influences on the increased awareness and use of ABC is
the change in the nature of costs. As corporate strategies change and
manufacturing operations become more diverse, overhead costs increase at an
alarming rate. Research indicates that overhead costs represent around
37 percent and 66 percent of total costs in manufacturing and service firms,
respectively (Develin, 1999).
Traditional cost accounting systems have become extremely inadequate
since they continue to allocate these escalating overhead costs on a volume-
driven basis such as labor hours or machine hours which no longer depict
the true consumption of resources in modern manufacturing and design.
Some proponents of ABC contend that overhead should not be allocated
at all but become directly traceable, variable costs of the individual product
or process (Morton, 1997a, b; Harrison and Sullivan, 1995). In any case,
modern manufacturing and logistics operations now consume resources in a
very different manner from their predecessors of just a few decades ago in
which operations were more focused, less automated, and more labor
intensive.
ABC does not replace traditional accounting systems and records; ABC
merely attempts to define further the data aggregated in traditional accounts
into a more advantageous decision-making form for managers. ABC traces the
consumption of resources back to the consuming activity and then traces those
activities to particular cost objects such as specific products, territories,
customers, or departments of the corporation (Brac, 2000).

Integrating supply chain and ABC


In order for supply chain management to achieve its objectives, the costs of
the supply chain must be known. However, before the costs can be
determined through ABC, a thorough understanding of the logistics
activities and their relationship to activity-based costs must be developed.
Figure 1 illustrates ABC within the supply chain and in relation to other
Supply
chain
costing

705
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Figure 1.
Activity-based costing
within the supply chain

costing techniques. The total cost of ownership and direct product


profitability techniques illuminate the cost effects of purchasing through a
particular supplier and the profit contribution of specific products,
respectively. This paper specifically focuses on ABC as the preferred
costing technique since it logically allocates all costs to activities, which can
then be meaningfully allocated to cost objects.
The major logistics processes that facilitate the flow of a product or
service from the point of origin to the point of consumption include
customer service, demand forecasting, inventory management, material
handling, packaging, service support, site selection, procurement, reverse
logistics, transportation, and warehousing (Lambert et al., 1998; Ferguson,
2000). Each of these general processes is a part of supply chain
management. However, in order to thoroughly evaluate the total cost of
logistics activities, all related activities or sub-activities must be taken into
account. Once a basic understanding of these logistics processes is attained,
the relationship between the processes and the major logistics costs
becomes more evident.
The major logistics costs can be categorized as follows (Lambert et al., 1998):
. inventory carrying costs;
. procurement costs;
. order processing costs;
. transportation costs; and
. warehousing costs.
IJPDLM These costs are influenced by the logistics processes. For example, the
31,10 activities of inventory management, packaging, and reverse logistics affect the
inventory carrying costs, while storage and warehouse site selection activities
drive warehousing costs (Ferguson, 2000). Each of these general cost categories
is comprised of variable and fixed overhead costs that will be traced to specific
logistics activities during the ABC process.
706
Implementation issues of ABC
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The implementation of ABC for supply chain management can be broken down
into seven distinct steps (Gooley, 1995; Henricks, 1999; Thomas, 1994):
(1) selecting the team;
(2) analyzing the supply chain functions;
(3) breaking processes down into activities;
(4) identifying the resources consumed in performing the activities;
(5) determining the costs of the activities;
(6) tracing the costs to the cost objects; and
(7) analyzing the final cost information from a total cost perspective.

Selecting the team


One of the most important steps in implementing ABC is that of selecting the
right team players. In order for the ABC project, and thus the entire supply
chain costing endeavor, to be a success, the involvement, integration and
commitment from all the partners in the supply chain is necessary
(McCormack, 1999). The effects of ABC costing are far reaching and, in some
way direct or indirect affect each area of the company.
Thus, those who understand and perform the activities that consume the
resources in the different branches of the business and who have the
expertise needed to analyze the cost information of each activity should
be represented on the ABC team. A manager or employee of each division
of the firm, from the top manager of finance to the head logistics officer,
should be present on the team throughout the life of the project (Gooley,
1995). Once the team is in place, analysis of the logistics functions can
begin.

Analyzing the supply chain function


This step involves scrutinizing the logistics function and identifying and
classifying the major processes within the logistics function. As mentioned
earlier, many processes are affected by or interface with the logistics
functions, such as customer service, site selection, and demand forecasting
(Lambert et al., 1998). In this step, we are primarily concerned with
identifying the large, encompassing processes of the logistics function such
as inventory management, material handling, warehousing, order Supply
processing, and transportation. A firm may have more or fewer processes chain
depending on the nature of the business and the level of outsourcing costing
implemented.
After the processes have been identified, they should be put into a flowchart
in order to better illustrate the chain of processes within the logistics function
(Conley, 1999). Once the major processes within the logistics function have been 707
identified and put in the flowchart, the processes can then be further
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differentiated by activities.

Breaking processes down into activities


This step of the implementation procedure distinguishes specific, resource-
consuming business activities within each logistics process. For example,
the logistics process of order processing in a distribution center may be
broken down into the following activities: preparing paperwork; picking
and building an order; pulling down ready-made pallets; counting and
checking the order; loading the truck; and dispatching the truck (Gooley,
1995).
Breaking down each logistics process into as many as possible well-
defined activities allows for better analysis of the cost of the process. If the
category is too general, an underlying activity that consumes the majority
of the resources may not be uncovered. For example, in the above
illustration of order processing, if the activity of counting and checking the
order is consuming a disproportionate share of the labor resource, it would
not be discovered if the order processing procedure is not broken down into
individual activities.
In most circumstances, each major process should be broken down into
activities for further analysis until the cost of the activity is irrelevant (Gooley,
1995). For example, the receiving activity can further be defined into receiving
by types of items or shipments. However, if the further sub-divided activities
provide no significant additional cost information or consume no substantially
increased amounts of resources as opposed to the cost of ordinary receiving
activities, the process does not need to be broken down any further.

Identifying the resources consumed in performing the activities


The goal of the ABC system is to uncover the costs of the relevant activities
that have now been identified in the previous step. However, in order to
discover the activities' true costs, we must first pinpoint the resources that each
activity consumes. Depending on the activity and how it is performed in the
individual business, different types of resources are consumed. An activity that
may use manual labor resources in one corporation may be completely
automated in another and thus use capital equipment resources instead.
However, most resources in any company can be divided into the following
IJPDLM major categories: labor, materials, equipment, facilities, property, and capital
31,10 (Kaplan and Cooper, 1998; Brimson, 1991).
Using an illustration of the truck driving activity in the delivery process,
obvious resources used include: labor the truck driver's compensation;
equipment the truck, assuming it is company owned; and capital the money
used to pay the price of gasoline and oil. All of these resources, and possibly
708 others depending on how the activity is performed, can be identified with the
truck driving activity.
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No matter how great or small the resource consumed, theoretically it should


be included in the cost of the activity. Some companies allocate all business
costs, from the president's annual salary to the cost of a screw, to a particular
business function or activity (Morton, 1997a, b). This intricate allocation is the
only way to capture the true cost of business.

Determining the cost of the activities


Once the resources for each logistics activity are identified, the cost of the
activities can now be determined. The traditional general ledger system
aggregates the costs of these resources in a few large accounts for financial
reporting purposes. But, to be useful in the ABC process, these accounts must
be broken down into meaningful cost data to show the relationship between the
activity and the consumption of the resources (Brimson, 1991; Kaplan and
Cooper, 1998; Develin, 1999).
The cost data from the ledger must be allocated to specific activities. For
example, to allocate the cost of labor to an activity, each employee's time
and pay rate must be determined and traced to that activity. Some costs will
trace directly from the ledger to the activity, while others will require
extensive interviews with employees and on-site observations to determine
how much of a resource is consumed in the activity. For example, one
employee may spend 100 percent of his/her time on a specific activity, which
makes cost tracing from the ledgers easy; however, a fellow employee may
only spend a fraction of his/her time on a particular activity creating a more
difficult task of tracing the cost of labor to the activity. Due to the indirect
nature of the costs this can be a difficult step in the implementation process
(Conley, 1999; Gooley, 1995). Figure 2 helps illustrate the general flow of
resource information in the ABC system.
In order to identify the cause and effect relationship between consumption
of resources and performance of activities, ABC employs the concept of
cost-drivers. A cost driver is simply a factor that causes or influences costs. For
example, the layout or square footage of a plant or distribution center is a
driver of the cost of material movement (Brimson, 1991).
In ABC each cost has at least one cost driver. Some costs may have
numerous drivers, but only the most relevant driver(s) should be used. The
most relevant driver(s) can often be determined by questioning those
employees who are most familiar with the activity to indicate which factor
Supply
chain
costing

709
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Figure 2.
Flow of resources within
ABC

causes an increase or decrease in the time and effort they spend on the activity.
The cost driver should have a direct relationship with the amount of effort
required to perform the task. For example, in an order-picking situation, the
number of cases per order would be a better cost driver than the number of
orders if each case on an order has to be handled, because an order with more
cases requires more effort and time and thus more resources and costs to
perform (Gooley, 1995; Conley, 1999). Another way of finding the true cause-
effect relationship of a cost driver is to run correlation analysis on a spread
sheet software program. A driver whose level of activity is more highly
correlated with the amount of resources consumed is a more relevant cost
driver.

Tracing the costs to the cost objects


A cost driver is usually expressed on a cost per unit basis. In the previous
illustration of order picking, the cost driver would be expressed as a dollar
amount per case handled, derived by dividing the total cost of resources
used on the activity such as the labor hours spent or equipment utilized in
picking the order by the number of cases handled. ABC then multiplies the
usage amount of a cost driver in performing an activity by the unit cost of
the driver to determine the total cost of that activity for an individual cost
object. Thus, each order-picking activity would be assigned a different cost
proportionate to the number of cases handled (Horngren et al., 2000).
Once we have determined the cost of performing each activity for a cost
object, we can better understand the profit potential of the cost object. The
cost object is selected depending upon the corporate decision-making needs.
Managers may be interested in identifying the cost differential between
customers, market segments, products, territories, or distribution channels.
IJPDLM The ability to trace costs to specific cost objects has unmeasurable benefits
31,10 in corporate decision-making roles. From product costing and production
setup and design to negotiation of transportation contracts and hiring of
personnel, cost data is the core element in the decision-making process
(Olsen, 1998). Tracing resources directly to activities and specific cost
objects that utilize the activities is what managers base their work upon and
710 is the ultimate outcome of the ABC system.
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Analyzing the final cost information from a total cost perspective


The final step in the implementation process involves analyzing the
feedback from the ABC system. Although the ABC system provides critical
cost data for specific logistics activities, management must not focus on
individual activities alone. A total cost approach to supply chain
management should be used. That is, the goal of the organization should be
to reduce the total cost of the logistics activities instead of individual
activity costs (Lambert et al., 1998).
Focusing on only one area of the logistics function may cause
inefficiencies in other areas. For example, the cost savings realized by
implementing a new warehousing technique may be more than offset by a
corresponding increase in transportation costs or inventory holding costs.
Management must view every feasible solution to reducing total logistics
costs and consider the important tradeoffs that must be made between the
costs of the separate activities.

Managerial implications
The discourse on ABC would not be complete without the inclusion of
several managerial implications concerning the drawbacks of ABC. Several
significant factors concerning the drawbacks of ABC are the lack of perfect
cost data, loss of customer focus, and the potentially negative effect of
internal politics.

Lack of perfect cost data


No cost accounting system is perfect, including ABC, because of
the near impossibility of tracking and attaching every resource cost to
a particular activity. Hundreds and possibly even thousands of
activities take place in corporations every day. Some activities may not
be identifiable or measurable without a significant amount of effort
and cost. Consequently, the cost of such activities may not be calculated
for pragmatic reasons. However, the ABC system, through the analysis
of the major resource-consuming activities, does help bring true costs
to light (Harrison and Sullivan, 1995). Managers should keep in mind
this lack of perfect cost data when making important business
decisions.
Loss of customer focus Supply
Another drawback is the tendency of managers to forget the customer service chain
element of logistics and strictly focus on costs alone. As previously mentioned, costing
the entire output of the logistics function is customer service. The cost
information provided by the ABC system should be used to focus better on
customers as well as improve profit potential. However, management can
711
become too preoccupied with the cost side of the picture such that they neglect
the customer service side, resulting in a lack of important tradeoffs between the
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cost of the logistics function and the customer service level it attains (Harrison
and Sullivan, 1995; Develin, 1999).

Effect of internal politics


Another negative factor that unfortunately exists is that of internal politics. ABC
provides answers to questions concerning a company's performance. However, the
answers derived are not always received well and not acted on for fear of losing a
prominent job position or customer or qualms about adjusting to the dramatic
changes that may be necessary (Morton, 1997a, b). It is vital that from the outset of
the project the team players, with the support of the top officials, establish a plan of
action to be taken once the more accurate cost data is provided by the ABC system
(Develin, 1999).

Implementation techniques
Obviously, other drawbacks exist that apply to any major change in
information systems such as cost and time. However, these factors can often
be offset by the advantages obtained from the new system and helpful
implementation techniques. Several techniques to help counter the
disadvantages of the ABC system (Computerworld, 1999; Henricks, 1999;
Conley, 1999; Thomas, 1994) are listed below.
. Keep it simple. There is no end to the number of activities and cost
drivers within an organization. Do not get bogged down with petty
details that cannot be explained or do not provide any added benefit. Use
only the relevant cost information.
. Establish a balanced team. As mentioned in step one of the
implementation process, all facets of the corporation must
be represented, from line operator to CEO. For ABC to be
successful, it must consider the cost activities of every area of the
organization.
. Set a reasonable time frame. A reasonable, aggressive time frame is six
months to a year, depending on the scope of the project. If the time frame
is exceeded, the project will lose its momentum and support from many
of those involved.
IJPDLM . Induce management to change. Make sure that top management is
31,10 supportive of the project. ABC will require a fresh perspective and
outlook for all parties involved. If any lack of support is indicated, be
sure to reinstate the invaluable benefits ABC can provide and cite cases
of successful ABC projects.
. Start where it matters. ABC will not affect all areas of a company in the
712
same manner. Start with an area that will display obvious benefits. This
will be a proving ground that ABC works and an additional way to get
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support from upper-level management.

Conclusion
ABC is a complex system of cost allocation that assists in making important
strategic business decisions. Every aspect of decision making in supply chain
management from relocating distribution centers to outsourcing the
transportation function to third-party logistics service providers requires cost
data.
This vital cost information will only increase in significance in the near
future, especially in the field of supply chain management, as the global
economy continues to become more competitive and focus on streamlining
logistics operations. The logistics function can be more than just an expensive,
necessary, unavoidable cost of business. With the strategic use of ABC, the
support of management, and a vision of success, logistics can become a source
of competitive advantage.
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