Activity Based Costing

Best Practices

Paper #606

The Supply Chain Management Research Group

Marketing Department
Max M. Fisher College of Business
The Ohio State University
1775 College Road
Columbus, Ohio 43210

Ph. (614) 292-5233

Fax (614) 688-3955

Prof. Bernard J. La Londe James L. Ginter

Ph. (614) 292-2507 Ph. (614) 292-2267
lalonde.3@osu.edu ginter.1@osu.edu
A Summary of
Activity-Based Costing
Best Practices

Prepared by:

The Ohio State University’s

Supply Chain Management Research Group

1
 A SUMMARY OF
ACTIVITY-BASED COSTING
BEST PRACTICES

Background

Activity-based costing (ABC) is a technique to more accurately assign the indirect and
direct resources of an organization to the activities performed based on consumption. ABC uses
a two stage cost assignment approach. In the first stage, resource costs are assigned to activities
based on the amount of resources consumed in performing the activity. An activity cost would
equal the sum of all the resources consumed in performing the activity. In the second stage,
activity costs are traced to the products, services, or customers based on how frequently the
activity is performed in support of these cost objects.

Two Stage Assignment Process

Office
Supervision Utilities Supplies Equipment
Support

Resources

Packing &
Receiving Put-Away Set-Ups Shipping

Activities

Prod A Prod B Prod C Prod D Cost

Objects

ABC has received significant interest in the past five years with the earliest reported
applications occurring nearly fifteen years ago to cost product manufacturing. The concept of
ABC is not new and has paralleled the development of traditional cost management. Heckert
used the terms resources, activities, and activity drivers to discuss how to more accurately assign
logistics costs in his 1940 text Distribution Costing. However, it took three events to occur
before ABC would gain importance and acceptance: diversity in the resources consumed by
different products or services produced by an organization, the development of low cost
computing capability, and the increase of indirect costs in comparison to direct costs with ratios
now exceeding 1000 percent in some firms.
Implementation of activity-based costing within service industries, such as logistics, have
trailed manufacturing applications. Most ABC applications have focused initially on the
manufacturing environment due to the need to accurately determine product costs. However,
many service industries, including logistics, have also begun to implement ABC with most cases
being reported only within the last five years. Drucker suggests that ABC may have its greatest

2
impact within the service industries since they have practically had no cost information at all. He
further suggests that ABC is a tool executives will truly need to manage in the future.1
Despite ABC’s recent emergence, many logistics “best practices” have emerged. ABC
applications generally fit into three major categories: diagnostic, reengineering, or integrated
cost management systems. The categories differ in focus, detail, and sophistication. The grocery
industry’s adoption of efficient consumer response (ECR) has also resulted in a three tiered
categorization of ABC sophistication: general analysis, category analysis, and menu pricing.
The ECR categories reflect the level of cost aggregation and the ability to use ABC to support
product or service pricing. The ECR scorecards also have specific categories to reflect the extent
of ABC implementation within a vendor, distributor, broker, or retail firm. Best practices have
finally moved beyond the extent of ABC implementation to specific ABC applications to support
logistics decision-making. These best practices include customer profitability analysis, total cost
of ownership, supply chain costing, price-led costing, capacity analysis, activity-based budgeting,
and use of activity-based non-financial performance measures.

Best Practices: Categories of ABC Implementation

Implementation Categories

Activity-based costing applications tend to fall into one of three major categories:
diagnostic, reengineering, or financial management systems. These categories differ in the level
of cost aggregation and update frequency.

Diagnostic models. The diagnostic model represents the most frequently encountered and
simplest of the three models. Diagnostic applications focus on providing snapshot cost
information at widely spaced intervals, typically three to six months apart. These models provide
critically needed information such as activity costs, output costs, resource consumption, activity
consumption, and the activities consumed by product, customer, service, or distribution channel.
These models produce another “set of books” for the firm—a set of books especially designed to
support management decision-making. A diagnostic model enables managers to diagnose
potential problems within their key processes. High cost activities or processes can be targeted
for cost reduction through reengineering or process improvement.
Diagnostic models have become the most widespread form of activity-based costing due
to their lower cost and to having no impact on the existing financial management system. They
have a lower cost since most firms rely on internal resources and off-the-shelf software for
development. Initial implementation typically requires three to four individuals working on a
full-time basis for three to four months. Updates require significantly less time since the
personnel are only updating the model with resource or activity changes. Diagnostics models do
not replace the traditional financial system. Instead, they draw cost information from the
financial system’s general ledger accounts. As a result, diagnostic models can be quickly
implemented, cause minimal disruption, and do not require any changes to the existing cost
accounting system.

1
Drucker, Peter F., “The Information Executives Truly Need,” Harvard Business Review, January-February 1995,
pp. 54-62.

3
 ABC translates traditional costing
into actionable information for decision-makers
Cost data
translated
by ABC
Activity-based
General information
Ledger
ABC
Data
(account Model
balances)
Decision
Makers

Implementation of diagnostic ABC models follow two approaches: a “top down” or a

“bottom up.” The “bottom up” approach is the process used in reengineering models. The “top
down” approach begins with a single activity to describe the organization. Decomposition of the
activity leads to the identification of indentured sets of activities representing the key processes
of the firm and the activities which comprise the processes. The decomposition process
continues until the level of disaggregation eliminates the major effects of product or customer
diversity. These ABC models typically have between 20 to 50 activities. The “top-down”
approach has the major advantage of speed. An organization can quickly produce accurate
activity-based costs using this approach. The major drawback stems from the lack of detail. A
“top-down” approach cannot be used to identify non-value-added activities or support process
reengineering.
Firms reporting the use of diagnostic models include Schneider, Amoco Chemical, Sears
Logistics, Molson Breweries, and AT&T.

The Traditional Organization

A1 A2 A3

A11 A12 A13

A21 A22 A23

A31 A32 A33

The Activity Model

4
 Reengineering. A reengineering or “bottom up” approach begins with an activity analysis
at the lowest level within the firm. The activity analysis attempts to identify the performance of
any non-value-added activities. Aggregation of activities occurs to reduce complexity of the
model by combining low cost or highly correlated activities. The “bottom up” approach has the
major strength of providing greater insight into the activities performed within the organization
and its ability to support reengineering efforts. The approach suffers from lengthy
implementation times, complexity, and significant update costs due to the number of activities.
ABC can directly support reengineering efforts by examining how proposed changes will
not only affect process costs but also cycle time, quality, and flexibility. A significant amount of
non-financial information is captured in determining activity volumes and consumption. The
model frequently tracks the amount of time required to perform specific activities or the number
of times a non-value-added activity is performed. Reengineering can use this information to
simulate how changes will impact these key performance measures.

Determine
Supply Chain
Alternatives

Establish Formulate Supply Measure Assess

Supply Chain Supply Chain Chain and Evaluate Supply Chain
Objectives Strategy Costing Performance Structure

Evaluate
Supply Chain
Alternatives

Time
Quality
Cost
Flexibility

Using Supply Chain Costing to Simulate Change. Adapted from Lambert Douglas M. and James R. Stock, “Steps in
the Design Process,” Strategic Logistics Management, 3rd ed., Richard R. Irwin, Inc., 1993, page 88.

Most initial ABC applications and consulting-led efforts followed a “bottom up”
approach; however, recent applications have favored a “top down” approach. The shift has
responded to long implementation times required for a “bottom up” approach. After six months
of effort, many firms had only completed their activity analysis and still could not cost a single
activity. To provide a quick success and sustain management interest, “top down” approaches
have become more popular. They require much less effort and can quickly provide cost
information. Management can also use “top down” models to determine which activities offer
the greatest opportunity for cost savings. They target these activities for more detailed activity
analyses rather than trying to simultaneously analyze all activities. Managers can also digest 20
to 50 activity costs but can become quickly overwhelmed by the amount of detail produced by
“bottom up” models which may have 100 to 250 or more activity costs.

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 Integrated Cost Management System. Reeve2 suggests that integrated activity-based
management systems are the most mature forms of activity based management [costing]. They
differ from diagnostic or reengineering models because they are: updated frequently, fully
relational, flexible to changes, have automated feeds from other systems, and have on-line
reporting and query capabilities. He further suggests many less than successful ABC
implementations have occurred because the diagnostic and reengineering models promise the
capabilities of an integrated cost management system but cannot deliver the same results.
A very limited number of firms possess integrated cost management systems. Research
performed by The Ohio State University has detected only two such applications within logistics.
Both required significant financial and resource investments from the firms. The development
occurred as part of the firms’ strategic plan to have the kind of information needed to support
future decisionmaking. ABC and an integrated cost management system represented the best
vehicles to obtain the information required.
SAP’s R3 CO-PA module and ABC Technology’s Oros product provide only a fraction
of the characteristics of an integrated cost management system. A well developed cost
management system will feed directly from the firm’s financial system to draw resource costs,
interface with automated processes to obtain activity volume information, and EDI to obtain
activity as well as customer/product/channel information. A relational database format enables
firms with an integrated cost management system to breakout costs on a real-time basis by
activity, customer, SKU or distribution channel. The information can be used to support
customer or product profitability analyses.
Firms reported to be using integrated cost management systems include Hewlett-Packard,
John Deere, and AT&T.

ECR Categories of ABC Sophistication

ABC implementation within the grocery industry appears to evolve through three stages.
These include general analysis, category analysis, and menu of service pricing.

General analysis. The general analysis stage resembles the diagnostic version of ABC.
“Distributors analyze their operations in broad areas like transportation or warehousing to
determine the nature and extent of costs, and which measures can reduce them.”3 These models
have an internal focus and cost the major activities performed within the organization. The
costing does not trace costs to the products or customers consuming the costs. Journal and trade
articles suggest the following firms fit in this category: Roundy’s, Food Lion, Tops, Coca-Cola,
Pepsi-Cola, Dial Corp, Bozzotos, Kroger, and Shaws. Giant Foods is also reported as using ABC
to reengineer its processes.

2
Reeve, James M., “Projects, Models, and Systems—Where is ABM Headed?” Journal of Cost Management, Vol
10, No 2 (Summer 1996), pp. 5-16.
3
O’Leary, Chris, “Accosting Costs: Activity-Based Costing and Distribution Efficiency,” Supermarket News, Vol
46, No 8 (February 1996).

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 Category Analysis. The category analysis stage enables firms to use ABC to examine
profitability by product categories and individual SKUs. Activity-based information enables the
firm to determine not only whether a product is unprofitable but what activities are contributing
to the product’s distribution costs. Firms identified as possessing a category analysis capability
include Nabisco, Proctor and Gamble, Supervalu, Fleming Cos., H.E. Butt Grocery, and
Wegmans Food Markets.

Menu of Service Pricing. Menu of service pricing represents the most sophisticated use
of ABC to date in the supermarket industry. “Once costs are unbundled, wholesalers can offer
retailers basic service rates, with separate value-added features available to customers as if on a
restaurant's a la carte menu.” 4 Firms possessing this level of sophistication include Fleming,
Supervalu, and Spartan Stores.
Menu of service pricing may offer the potential to discriminate in pricing. The Robinson-
Patman Act allows price differences if cost differences occur in providing a product or service.
All customers could buy the product for the same price but would have to purchase different
services based on volume or other services required. ABC would be used to determine the cost
of activities offered in the “menu of services.”
Grocery manufacturers may begin backing away from a menu of service pricing
approach. Many manufacturers have a national price for their products which permits cross-
subsidization across customers. Menu of service pricing eliminates the cross-subsidization, and
many manufacturers appear to believe this will affect sales to certain classes of trade or major
customers. Most importantly, they do not have a clear understanding of how a menu of service
pricing strategy will affect profitability. ABC has become synonymous with menu of service
pricing, and grocery manufacturers may become less willing to share their experience with ABC
as they do not want to be required to offer menu of service pricing to their customers.

ECR Scorecards

The Joint Industry Project on Efficient Consumer Response developed ECR scorecards to
enable industry participants to track their progress in implementing ECR, assess the capability
and progress of their trading partners, support development of an ECR plan, measure a
company’s individual capabilities, translate business strategies into an actionable business plan,
and establish a goal-setting tool for trading partners to highlight common ECR objectives.5
The ECR scorecard is “an assessment and management tool that supports a review of
your company’s readiness to execute ECR over time with a particular trading partner, and their
readiness to execute ECR with you.”6 The scorecards address each of the major ECR areas:
category management, efficient introductions, efficient replenishment, efficient assortment, and
efficient promotions.

4
Ibid.
5
Joint Industry Project on Efficient Consumer Response, The ECR Scorecard—Measuring Progress (Draft), 24 July
1996, p. 3.
6
Ibid, p. 5.

7
 Table 1
ECR Scorecard
Category Management: Activity Based Costing7

INDICATOR LEVEL 0 LEVEL 1 LEVEL 2 LEVEL 3 LEVEL 4

Manufacturer Method Traditional cost More sophisticated ABC is being piloted ABC is in place for ABC is used
for Understanding Cost accounting systems are costing methods are and tested in parts of most of the throughout the
used to support used; ABC has not the organization organization and organization to support
management decisions been implemented or provides accurate management decisions
piloted activity costs for based on accurate mfg
manufacturer activities activity costs and an
only understanding of
retailer activity costs
Extensiveness of Does not understand Product & service The costs of some Most product and Product and service
Activity Cost activity costs costs are somewhat critical activities are service activities are costs are entirely ABC-
Understanding understood through understood using defined and their costs based and allow for a
meaningful allocations ABC; costs are still not understood using ABC joint common
(non-ABC) of costs entirely ABC-based at the case level. understanding of all
but are beginning to supply chain costs at
incorporate some the SKU level on a
activity costs. transaction basis
Tools Used to Deliver No cost analysis tools Traditional accounting Activity-based reports ABC data are available Activity costs are
and Analyze Cost are used reports are used for are created on an ad- on a regular basis and available in a data
Information management reporting hoc basis to support support both warehouse and are
activity analysis management reporting dynamically generated
through the use of PC- and decision-support to support changing
based applications. tools. decision needs
covering the entire
supply chain
Collaboration with Does not support the Supports retailer with Provides cost analysis Assists in identifying Support retailer’s
Retailer to Understand retailer with cost cost information but is on impact of retailer cost reduction planning and
Activity Costs information not ABC-based decisions not captured opportunities and in implementation of
by retailer accounting ABC pilot projects ABC systems,
systems; beginning to with retailer. including accounting
provide ABC-based system changes and
data. cost reengineering

The ECR scorecards include activity-based costing as one of the key components of
category management. ABC was added due to its capability to accurately cost activities and to
isolate costs and benefits by product categories. The ABC component of category management
“measures the level to which costs and activities are understood and acted upon. Also assesses
the effectiveness of the accounting system to support business decisions, reengineering efforts
and reward and recognition systems.
The ECR scorecard provides a means for individual firms to compare themselves and
their supply chain partners against industry best practices in ABC. The scorecards reflect four
attributes or levels of sophistication for several ABC indicators. The Level 4 attributes in the
Category Management: Activity-Based Costing scorecard represent ABC best practices for the
four indicators in the ABC component of category management.8

7
Ibid, p. 75.
8
Ibid, p. 75.

8
 Best Practices: Logistics Applications

Customer Profitability Analysis

Customer profitability analysis provides the capability to determine how individual

customers or customer groupings contribute to profitability. All sales do not contribute to
profitability in equal proportions. Some customers consume more logistics resources than others.
Firms have tailored their logistics services to satisfy specific customer requirements.9
“Fragmentation” of the supply chain suggests wide differences may occur in the amount of
logistics resources, or costs, required to support individual customers. Resources potentially
impacted by differences in customer consumption include volume discounts, commissions, sales
support, inventory and distribution support, inventory holding requirements, freight, credit and
collection, accounts receivable, order entry and customer support, field service.10

Contribution Analysis by Customer

Revenues
Sales 1,389,300
Other income 145 Customer A
Reimbursables 32,286
Total Revenue 1,357,168 P&L
Expenses Customer B
COGS 818,100
Transportation 1,441 P&L
Other Mat’l Related Exp 1,218
Operations Expense 273,409 Customer C
Total Cost of Sales 1,094,168
P&L
Net Profit before Taxes $263,000
Customer D
P&L

Customer driven costs have become increasingly important not only to their effect on
profitability but also due to their magnitude. Traditional cost accounting approaches have
assumed that these costs are relatively small in magnitude and do not vary with volume and
remain relatively fixed. As a result, arbitrarily allocating these costs using sales or another
volume-based driver would not seriously distort costs. However, in many instances, customer
driven activities represent a significant cost to the firm. In many instances, the type of customer
affects the consumption of logistics resources more than the type of product, and distribution
costs may exceed manufacturing costs, especially in the packaged goods industry.11
Customer profitability analysis has the objective to assign the revenues, expenses, assets,
and liabilities of an organization to the customers causing them. The assignment of these costs
follows the same premise as product-driven costs using ABC: “. . . activities consume the

9
Fuller, Joseph B., James O’Conor, and Richard Rawlinson, “Tailored Logistics: The Next Advantage,” Harvard
Business Review, May-June 1993, pp. 87-98.
10
Howell, Robert A.
11
Sterling, Jay U., and Douglas M. Lambert, “Segment Profitability Reports: You Can’t Manage Your Business
Without Them,” Unpublished working paper, June 1992.

9
resources of the organization, and cost objects (e.g., components, products, customers, or
markets) consume those activities by creating the need for their performance.”12 The activities
and their levels of attachment for customer driven activities will differ from those used by
product driven activities. Customer driven activities usually occur at the order, customer,
channel, market, and enterprise level.13

Public Business
Shipping Billing Promotions
Warehouses licenses

Number of Number of Number of Dollars ($)

shipments invoices cubic feet by market

Orders
Customers
Channel
Markets
Enterprise

Adapted from O’Guin, Michael C., and Steven A. Rebischke, “Customer-Driven Costs Using Activity-
Based Costing,” Handbook of Cost Management, 1994.

Logistics applications of ABC have found that customers tend to drive more of the
activities performed than product. Customer determine the labeling, packaging, palletization,
information requirements, service levels, and mode of shipment. One firm used the following
example to demonstrate how products, customers, and brands drive the activities performed in
their organization:
Receiving Cartage
Unload and inspect
Product Putaway
Storage Bulk storage
Aerosol storage
Transp Planning Pre-shipment scheduling
Truckload planning
Post-shipment support
Transportation Adminstration
Picking Manual picking
Mechanical picking
Customer Stage pallet for order
Build pallet
Special Handling Adjust pallet height
Clamp off/slip sheet
Spec Hdling/Warehouse office
Shipping Load pallet
Check full pallet
Check mixed pallet
Ship international order
Ship small package order
Administration Returns
Brand Rework
Administration

12
O’Guin, Michael C. and Steven A. Rebischke, “Customer-Driven Costs Using Activity-Based Costing,” Handbook
of Cost Management, Edited by Barry J. Brinker, New York, NY: Warren, Gorham, and Lamont, 1994, p. B5-11.
13
Ibid, p. B5-12.

10
 Several features of customer profitability analysis distinguish it from other types of
contribution analysis.14 The analysis cuts across costs across the entire value chain. It focuses on
multiple transactions with a customer than on a single transaction. The analysis concentrates on
all the products purchased by the customer rather than a single product purchased by multiple
customers. Customer profitability analysis recognizes customer specific costs which are not
specific to other cost objects. It can be aggregated at different levels from a specific customer to
a customer group or class of trade.
The assignment of activity costs by customer does confront some major challenges.15
The traditional cost accounting system serves as the starting point for many ABC analyses. The
general ledger accounts frequently do not breakout costs by customer or permit ready access to
the information—frequently several financial and non-financial reports must be combined to
trace costs to specific customers. The cost information may not be reliable due to problems with
decentralized purchasing, multiple names and customer buying locations, or the use of multiple
distribution channels by the customer. Customer costs may be incurred in the current period but
the benefit may be incurred in future periods.
Some of the most recent examples of best practices in customer profitability analysis have
occured in the food service and banking industries. Super Bakery, Inc., the company formed by
former Pittsburgh Steelers’ running back Franco Harris in 1983, captures costs by customer order
enabling management to calculate the cost of processing each order and servicing each
customer’s account.16 This allows Super Bakery to price orders accurately, recoup the costs of
servicing its customers, and achieve targeted profits. (Note: I could embellish Super Bakery with
more specifics) Customer profitability analysis has also become more popular in the banking
industry.17 The lifetime value of customers is being evaluated based on sales of products and
services, the number of accounts held, and tenure. Banks have realized that the key to their
marketing efforts is securing a volume of future revenues from customers with a potential long-
term tenure and a high propensity to purchase other products and services.

Total Cost of Ownership

Total Cost of Ownership (TCO) provides a methodology for costing the upstream portion
of the supply chain. “Total cost of ownership is a structured approach for determining the total
costs associated with the acquisition and subsequent use of a given item or service from a given
supplier.”18 The approach recognizes that the item’s purchase price represents only a portion of
the total cost of acquiring an item. Vendor performance also affects the costs of ordering,
expediting, receiving, and inspecting. Many firms obscure these costs by burying them in

14
Foster, George, Mahendra Gupta, and Leif Sjoblom, “Customer Profitability Analysis: Challenges and New
Directions,” Journal of Cost Management, Vol 10, No 1 (Spring 1996), p. 10.
15
Ibid., p. 10.
16
Davis, Tim R.V., and Bruce L. Darling, “ABC in a Virtual Corporation, Management Accounting, October, 1996,
pp. 18-26.
17
Meltzer, Michael, “Are your customers profitable?”, Bank Marketing International, October, 1996, p.14.
18
Carr, Lawrence P. and Christopher D. Ittner, “Measuring the Cost of Ownership,” Journal of Cost Management,
Vol. 6, No. 3 (Fall 1992), p. 42.

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overhead or general expenses.19 TCO attempts to identify the total acquisition price by including
the costs of purchasing, holding, poor quality, and delivery failure.
Companies have already begun to use TCO as a means for measuring and evaluating their
suppliers. Assigning costs to activities affected by the buyer decision provides another tool in the
supplier decision. Buyers can evaluate alternate vendors based on the costs associated with the
number of product returns, undershipments, nonconformance, or late shipments. Companies
incorporating these factors into their ownership analysis can better determine which suppliers
offer the best overall value to them.
TCO provides the capability to assess how inter-firm relationships affect costs within the
purchasing firm. It links supplier performance to specific activities performed throughout the
purchasing firm and translates the activities into costs. When coupled with activity-based
costing, TCO can provide an even more accurate depiction of the activities and resources
consumed in dealing with specific vendors.20 Companies employing TCO can use the
information to negotiate with or select upstream channel members based on total acquisition
costs and other performance criteria. Although TCO does provide more accurate information on
how the performance of one firm in the supply chain affects the costs of another, it does not
provide the total supply chain cost.
The costs captured in a TCO analysis only include the costs of one member of the supply
chain. TCO does not capture the upstream firm’s costs. By not capturing these costs, TCO may
miss opportunities for making inter-firm cost trade-offs. One of the firms may more efficiently
perform some activities than the other such as transportation, packaging, warehousing, or
inventory management. TCO also does not demonstrate how the buyer’s behavior may affect the
suppliers’ costs. The lack of an integrated costing approach may preclude the supply chain from
achieving a cost competitive position.
Firms reported as using TCO include: General Electric, Hewlett-Packard, Intel,
Motorola, Northern Telecom, Siemens, and AT&T.

Supply Chain Costing21

Supply chain costing provides a mechanism for developing cost-based performance

measures for the activities comprising the key processes within the supply chain. The
capabilities provided by supply chain include the ability to: determine the overall effectiveness
of the supply chain, identify opportunities for further improvement or reengineering, measure
performance of individual activities or processes, evaluate alternative supply chain structures or
select supply chain partners, evaluate effects of technology improvements. Supply chain costing
employs many of the techniques embedded in DPP, ABC, TCO, and ECR; however, it differs by
costing activities across the entire supply chain. The approach overcomes the obstacles regarding
the availability of cost information by making use of standard or engineered times and existing
rate information. Supply chain costing also differs by including transaction, information,

19
Ellram, Lisa M., Total Cost Modeling in Purchasing, Tempe, AZ: Center for Advanced Purchasing Studies, 1994.
20
Kurt Salmon Associates, Inc., Efficient Consumer Response: Enhancing Customer Value in the Grocery Industry,
January 1993.
21
LaLonde, Bernard J., and Terrance L. Pohlen, “Issues in Supply Chain Costing,” The International Journal of
Logistics Management, Vol 7, No 1, 1996, pp. 5-8.

12
physical flow, and inventory carrying costs. The costing makes use of standard or engineered
times to determine resource requirements.
Supply chain costing does not replace traditional cost accounting or general ledger
accounts. Instead, it translates existing ledger accounts into a diagnostic tool that managers can
use to evaluate performance and resource consumption. Supply chain costing essentially creates
another set of “books” that can be used to trace the effect of management decision making to
corporate profitability or to supply chain costs and performance.
The methodology employs six steps: analyzing supply chain processes, breaking
processes down into activities, identifying the resources required to perform an activity, costing
the activities, tracing activity costs to supply chain outputs, and analysis and simulation.
The major drawbacks to supply chain costing stem from the compatibility and
confidentiality of cost information and the lack of a viable means to allocate benefits and burdens
between firms. Supply chain costing will require participating firms to assign costs in a
consistent manner across firms and to specific activities. The ECR scorecards represent a first
step in this direction by providing general direction for the grocery industry. The sharing of cost
information may also prove a major obstacle as firms may be concerned about the release of
confidential information to their competitors. The ECR scorecards may again prove to be an
alternative since the scoring of specific indicators can be translated into specific capabilities
which drive costs throughout the supply chain.
Supply chain costing can play an integral role in allocating benefits and burdens within
the channel. It lays the foundation for an allocation mechanism by accurately tracing costs to the
specific resources contributed and the gains each partner will receive. Firms can then use this
information to identify discrepancies and negotiate mechanisms to overcome perceived
inequities.22 The information can also be used to determine how best to share any resulting
savings across the supply chain. Savings could be evenly split between partners or distributed
based on the proportion of resources contributed by each supply chain partner. A transaction
cost or fee-for-service approach could be established to charge other channel members based on
the actual costs of performing services. The fee charged would be based on the resource costs
required to perform the activity and a fair rate of return. Allocation mechanism which fairly
distribute the savings according to contribution will increase the commitment to change within
the supply chain and towards the building of a sustainable competitive advantage.
Drucker suggests that supply chain costing and management will need to move from
“fiction” to reality for a firm to maintain a competitive advantage.23 Firms will need to know not
only their costs but the costs of what is going on within their supply chain. Companies such as
Wal-Mart Stores have exploited their ability to manage costs across the supply chain, rather than
just their internal costs, to gain a significant cost advantage. The ability to successfully employ
supply chain costing will enable firms to adopt a price-led costing strategy.

Price-Led Costing

22
Dyer, Jeffrey H., “How Chrysler Created an American Keiretsu,” Harvard Business Review, Vol 74, No 4 (July-
August 1996), pp. 42-56.
23
Drucker, pp. 56-57.

13
 Drucker contends the shift from cost-led pricing to price-led costing strategies will drive
the importance of economic [supply] chain costing.24 Price-led costing uses the price the
customer is willing to pay to determine the allowable costs, beginning with the design stage.
Companies can only practice price-led costing if they know and manage all of the costs within
the supply chain. He cites Chrysler’s success with recent models and GM’s Saturn as examples
of price-led costing. Other examples of price-led costing include Baxter and Owens & Minor
which must operate in a cost containment environment and an industry reporting margins under
two percent.25

24
Drucker, p. 58.
25
Scott, Lisa, “Materials Management: Squeezed Distributors Try New Methods,” Modern Healthcare, 27 May
1996, p. 38.

14
Capacity Analysis

The ability to measure and cost resource usage represents an essential capability within
activity-based costing. Cooper and Kaplan state “The measurement of unused capacity provides
the critical link between the costs of resources used, as measured by an ABC model, and the
costs of resources supplied or available, as reported by the organization’s periodic financial
statements.26 Expenditures on resources will not vary in the short run, and as a result, they are
frequently considered “fixed” in traditional cost systems. However, this approach does not
provide key information regarding how much of the resource was used, for what purposes, and
what excess capacity may exist for potential redeployment elsewhere in the firm. ABC models
should determine the capacity of each resource and assign resource costs to activities based on
actual consumption.
Recognition of capacity provides greater management insight and more accurate costs.
Managers can determine how much capacity or resources are available to support other functions.
They can also determine how changes in activity volumes or performance will affect resource
consumption. Reengineered activities will “free up” resource capacity which must be redeployed
to other productive requirements or reduced to lower total costs. The identification of capacity
usage and excess capacity will produce more accurate costs. Excess capacity is not assigned to
the activities. As a result, activity costs will appear consistent from period even if activity
volumes increase or decrease. Any excess capacity would be identified and assigned to wasted
or excess costs.
Four definitions of capacity appear in the literature: theoretical, practical, normal, and
master budget.27
Master budget capacity is the most frequently encountered approach. It essentially
ignores any consideration of underutilized capacity. All costs are “fully loaded” as if all the
resources were fully consumed during the reporting period. The overhead rate will include
different amounts of underutilized capacity during each financial reporting period. As a result,
activity costs can artificially increase or decrease from period to period.
Theoretical capacity reflects “perfect” use of capacity. Theoretical capacity assumes each
resource will perform perfectly and will produce at its theoretical limit.
Normal capacity reflects capacity utilization over a span of time. This approach assumes
the normal capacity reflects how resources are really consumed based on historical usage. The
major drawback of this approach stems from using historical averages. It does not recognize
process improvements, the existence of excess capacity over time, and assumes management had
sufficient visibility over capacity utilization.
Practical capacity reflects the maximum level at which the plant, department or
organization can operate efficiently. It allows for unavoidable interruptions such as repair or
waiting times.
Practical capacity represents the most reasonable approach for determining capacity
within an ABC model. The use of practical capacity ensures resource utilization is not
overstated, and excess capacity is visible within the ABC model. Incorporating practical capacity

26
Cooper, Robin and Robert S. Kaplan, “Activity-Based Systems: Measuring the Cost of Resource Usage,”
Accounting Horizons, Vol. 6, No. 3 (September 1992), pp. 1-13.
27
DeBruine, Marinus and Parvez R. Sopariwala, “The Use of Practical Capacity for Better Management Decisions,”
Journal of Cost Management, Vol. 8, No. 1, Spring 1994, p. 26.

15
also ensures consistent product costs which do not artificially vary from period to period. The
incorporation of excess capacity reporting also enables the ABC model to reflect what resources
were “freed up” or “released” when reengineering or business process improvement efforts
eliminated or reduced an activity in a process.

Activity-Based Budgeting

Activity-based budgeting uses activity drivers developed during activity-based costing to

budget for future periods. Project sales volumes can be multiplied by the costs of affected
activities to determine activity costs and resource requirements. Process changes, increased
productivity, capacity utilization, and resource availability can be factored into the ABC model to
refine the budget to reflect anticipated changes within the organization. Activity-based budgeting
appears to be gaining greater acceptance. It differs from traditional budgeting by concentrating
budget information on the activities and processes which add value to the customer rather than by
trying to manage costs by organization.28
The traditional approach to budgeting has focused on the validation of data and
explanation of significant trends and variations. The interpretation of the data and non-financial
information becomes the responsibility of operational managers with the financial analysts acting
as little more than messengers. Financial analysts can integrate non-financial measures with
financial measurements to provide a predictive or leading indicator of financial consequences.
Activity/process-based performance measurement systems enable this integration.29
An activity-based budgeting approach requires a significantly different logic since it
requires negotiation between functional managers and process owners. Activity-based costing
provides the framework for activity-based budgeting by identifying the activities performed,
resource requirements, and cost per activity. The budget negotiation process uses this
information to determine what activities will be required, what driver and resources will be
supplied, and what levels of funding will occur. Activity-based budgeting can change the focus
from prior-period or rearward facing to a forward view by using the information to drive strategy
on an on-going basis and to align the day-to-day activities or behavior with strategy
implementation.

Activity-Based Management

Activity-Based Management (ABM) goes beyond budgeting to make proactive strategic

and operating decisions based on activity information and assessing the value-adding content of
work in business processes.30 Managers have been particularily successful implementing ABM
in retailing.
ABM has allowed retailers to evaluate the costs of receipt, the cost of merchandising and
warehousing, and the cost of providing shelf space, labor, and store overhead for a product or
line of products.31 This information has allowed managers to: (1) establish performance criteria

28
McClenahen, John S., “Generally Accepted Practice?” Industry Week, 6 November 1995, p. 13.
29
Sharman, Paul, “Activity/Process Budgets: A Tool for Change Management,” CMA Magazine, Vol 70, No 2
(March 1996), pp 21.
30
Cokins, Gary, Activity-Based Cost Management: Making It Work, Irwin Professional Punlishing, 1996.
31
Yost, Terry, “Activity-Based Management Redefines Store Operations,” Business Monitor, October 16, 1996.

16
for suppliers that address the costs of providing merchandise, (2) recommend that suppliers use
alternative methods of sourcing or delivering products, (3) reduce or eliminate forward buying,
which increases inventory and risk, (4) assign costs to merchandise that reflect the “true
transaction cost” of providing the product to the customer, (5) recommend that suppliers
unbundle pricing to make retail operations more efficient, and (6) gain more competitive pricing
from suppliers.

Non-Financial Performance Measures

Activity-based costing produces a significant amount of non-financial information as a

by-product of its costing process. The resource and activity drivers within the ABC model reflect
the amount of time or other resources consumed in performing a specific activity. The model
also will indicate the amount of unutilized capacity or resources which can be redeployed to
support other activities within the organization. The nonfinancial information takes a horizontal
or process view of activity performance while ABC takes a vertical cost assignment approach:
Cost Assignment View

Resources

Process View

Performance
Cost Drivers Activities
Measures

Cost Objects

Peter B. B. Turney, Common Cents

Activity-based management couples the non-financial information with the cost

information obtained through activity-based costing. Cost-based performance measures can be
established for specific areas where traditional financial performance measures may not apply or
are not applicable.
Traditional financial measures alone do not provide sufficient information to manage the
business. Financial variances are not actionable at the operating level, and causality is difficult to
determine. Costs and measures are summarized at too high a level and preclude accountability at
lower levels within the organization. Traditional measures typically rely on direct measures and
allocations. As a result, they cannot provide insight into how changes in volume drive total cost
due to the presence of non-volume related indirect costs. The inability of traditional financial
measures to trace the effect of management action or decision-making directly to total costs
frequently leads to suboptimization of specific functions. Managers are graded on minimizing
their costs and not on total process costs.
Nonfinancial performance measures must overcome several problems to increase their
management utility. They typically are not related to cost or financial reports. As a result,

17
management by nonfinancial performance measures cannot be translated directly to profitability
or the “bottom line.” The lack of a linkage enables lower echelon managers to “game” the
system. They will increase output or vary the measurement unit to inflate the performance
measure. Nonfinancial performance measures frequently conflict with financial performance
measures in the short run. Financial performance measures may not recognize the linkages
between nonfinancial performance measures and costs, quality, or cycle time.
Activity-based costing can overcome many of the problems associated with non-financial
performance measures by establishing a linkage between the performance measure and the
activity cost. The process view of activity-based costing can translate performance measures into
changes into activity costs and identify the drivers of these costs and performance.

Process View

Activities Performance
Cost Drivers Activities
Measures

Horizontal or Process View of Activity-Based Costing

The linkage enables performance to be translated into cost information and subsequently to how
performance affects process costs or profitability. Improved performance can also be translated
into a revised activity cost which requires less corporate resources. The vertical or cost view of
activity-based costing allows the activity-costs to be translated into changes in required resources
or into customer/product/service costs.

Cost Assignment View

Resources

Activities
Activities

Cost Objects

18
 Vertical or Cost Assignment View of Activity-Based Costing

Summary

Applications of activity-based costing (ABC) have significantly increased in logistics due

to its ability to provide greater insight into the costs of performing specific logistics services and
their impact on supply chain performance and costs. The applications of activity-based costing
differ in their focus and in complexity. The relatively recent application within logistics has
caused most ABC models to be diagnostic or reengineering focused. However, the emphasis of
major initiatives such as efficient consumer response will require firms to integrate ABC with
their financial management systems to apply activity-based cost information to a wider array of
management problems and decisions such as vendor and carrier selection, performance
measurement, supply chain structure, and pricing.

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