STRATEGIC COST MANAGEMENT:

An Activity-Based Costing Approach

Richard Chivaka, Carol Cairney. Accountancy SA. Johannesburg: Jul 2007.

Abstract (Summary)

The rationale behind activity-based costing (ABC) is that the provision of

products and service requires the performance of activities. The performance
of activities in turn consumes (uses) resources. It is the consumption (use) of
resources that generates costs, most of which are overheads (indirect costs).
However, where a company produces several products or services, assigning
these costs to the different products and services is often not easy, because
such costs arise from the consumption of common resources. It is necessary
that ABC be applied in the context of a cost management as opposed to a
cost cutting philosophy. In addition, the real benefits of an ABC system can
only be realised if the costing system is informed by, and thus integrated
into, an organisation's strategy.

Copyright South African Institute of Chartered Accountants Jul 2007

This article discusses activitybased costing (ABC) as a strategic costing

technique with the objective of demonstrating what makes it a superior
costing technique in comparison to the traditional costing techniques.

The article then discusses what really makes ABC a strategic costing
technique. In doing this, the article highlights the significance of the
philosophy underpinning the use of ABC as a strategic costing technique.

Introduction

Part 1 of this series discussed strategic cost management in the context of the
philosophy that informs the manner in which costing techniques are used in
order to realise benefits from any cost management initiatives. The purpose
of part 1 was to establish the context within which strategic costing
techniques such as activity-based costing are used. In this article, ABC is
discussed with the objective of demonstrating why and how it is superior to
 traditional costing techniques, how it can be used as a strategic costing
technique and how it is integrated within an organisation's strategy.

In a recent study conducted across Australian manufacturing firms, which

asked users to indicate their satisfaction with a wide range of management
accounting techniques, ABC and activity-based management (ABM) were
ranked amongst the bottom 10% of the wide range of techniques listed
(Chenhall and Langfield-Smith, 1998). Given the dissatisfaction with the
technique that exists, it is not surprising that numerous attempts have been
made to explain the failure of the technique to deliver its promised benefits -
primarily of improved decision making and cost management.

It is interesting to note that criticism is seldom levelled at the underlying

logic of the technique itself, but rather, explanations revolve around a variety
of organisational and other contextual factors. It is with this in mind that this
part 11 of the series is written to discuss organisational and contextual
factors, which form the philosophy that informs the use of ABC. Before we
discuss these organisational and contextual factors, we will briefly discuss
the characteristics and logic of the ABC technique in order to highlight some
of the crucial factors that practitioners should take into account in order to
realise fully the benefits of this technique.

Activity-based costing system: Characteristics and logic

The rationale behind ABC is that the provision of products and service
requires the performance of activities. The performance of activities in turn
consumes (uses) resources. It is the consumption (use) of resources that
generates costs, most of which are overheads (indirect costs). However,
where a company produces several products or services, assigning these
costs to the different products and services is often not easy, because such
costs arise from the consumption of common resources.

The cost caused by the use of the common resources cannot easily be traced
to a particular product or service, thus making the costing of products and
services difficult. Yet, many companies require accurate product and service
costs to establish (1) what should be charged to customers (in cases of cost
plus pricing), (2) how profitable products and services are, and (3) how best
to provide such products and services in a cost-effective way.

Therefore, in order to have a more accurate picture of the costs of products

and services, it is necessary first to understand and identify the activities that
the products and services require. Once activities required by the product
and service have been identified, the costs incurred (resources consumed) in
the performance of those activities can then be established.
 ABC therefore recognises that there is no direct relationship between the
overhead costs incurred and the products and services provided to
customers. The relationship between overhead costs incurred and the various
products and services provided by companies is established via the activities
that those products and services consume. As such, ABC establishes a causal
relationship between overhead costs incurred and the products and services
provided to consumers via the activities that the products and services
require. The process of assigning overhead costs to products and services is
done in the following manner:

(i) Overhead costs are first assigned to activities that have consumed the
resources that gave rise to these costs.

(ii) The costs assigned to activities are then assigned to the various products
and services that have consumed those activities.

The result of this process of assigning costs to products/services is a more

accurate picture of the common resources consumed by the
products/services, and thus a better picture of the overhead costs associated
with these products/services.

Benefits of ABC

In order to support strategic cost management effectively, companies should

allocate overhead costs correctly by identifying the relevant activities
associated with the different products and services. Using ABC, the costs
associated with the unit-level, batch-level and service-sustaining activities
can be identified and assigned as such. This process allows company
management to understand fully what is driving costs (the identification of
root causes of costs as discussed in part 1 of the series) in the different
products and services it provides.

It is important to point out the fact that, for most products and services, the
assumption made by the traditional costing methods that only one cost driver
explains why overhead costs are increasing in the cost structure is not valid.
ABC is superior to the traditional costing methods because it captures every
form of diversity that causes overhead costs in products and services, as
shown in figure 1 opposite.

Figure 1 (on next page) demonstrates that there is no one cost driver that
explains why companies incur overhead costs. Thus the overhead costs, as
shown in the company's accounting records (as recorded in the general
ledger), arise from, or are caused by, a number of cost drivers, such as the
complexity of the process that generates a product or service, volume of
output and degree of product/ service customisation. The more complex the
 process, the higher the number of activities that need to be performed, and
thus the more the costs incurred in the provision of such a product or service.

Where products, services and processes are highly customised, companies

perform numerous activities, which in turn consume resources, resulting in
higher overhead costs. Also, the customisation of products and services
precludes companies from realising economies of scale due to very few
identical products and services that can be produced. Thus, from a cost
behaviour point of view, the fixed cost per unit for such products and
services is usually higher than if standard products and services (which can
be mass produced) were produced.

Figure 1: Cost consequences of production/ service diversity

In addition, ABC facilitates the identification of the root causes of costs

(primary causes of costs) as a way of achieving effective cost management.
The point here is that a company needs to understand the difference between
primary causes of overhead cost (product customisation and process
complexity) and secondary causes of overheads (technology and support
infrastructure).

We can summarise the relationship between primary causes of overheads

and secondary causes of overheads as shown in figure 2 below. Overhead
costs that manifest in high technology and support infrastructure costs are
usually only symptoms of decisions about a company's business model.
Decisions about a company's business model (how the company chooses to
compete against others) do have an impact on the level of process
complexity, volume of different products produced and degree of product
and service customisation. Product and service diversity forms the primary
cause of overheads, which in turn impacts on nature and extent of the
technology and support infrastructure required.

If a company fails to make the distinction between primary and secondary

causes of overheads, its cost analysis will result in wrong cost management
decisions. For example, if the primary cause of overhead is process
complexity, a company may be forced to use technology to manage such
complexity (secondary cause). In that situation, trying to achieve cost
management by cutting back on labour might not work because such an
action is simply 'barking up the wrong tree'. What the company needs is to
simplify its processes, which will then lead to less expensive technology
needed, and thus less overhead costs being incurred.
Figure 2: The relationship between primary ft secondary causes of overheads

Alternatively, failure to identify that process complexity is the root cause of

overheads results in management focusing its attention on labour (a
secondary cause of overheads) as a way of reducing costs. However, the
benefits from such cost cutting measures are short-lived as the main cause of
overhead costs is left unchanged.

In addition to the above, companies should assign overheads on the basis of

the various products' consumption of activities, rather than simply on
volume. Failure to take into account the different demands that products
place on activities, which in turn results in different overhead costs that
should be assigned to these products, results in a larger proportion of
overheads being assigned to high-volume products and a lower proportion
being assigned to low-volume products.
However, such an approach fails to take into account the fact that it is not
necessarily the volume of a particular product, but its consumption of
activities (which is a function of complexity or customisation) that causes
costs.

Such an approach results in cross-subsidisation among product and service

lines by default due to failure to identify root causes of costs. This in turn
negatively impacts on the company's ability to identify sources of rising
costs. Consequently, companies are unable, amongst other things, to identify
process improvement opportunities.

An objection that is frequently raised is that many overhead costs are fixed
in nature and will not decline in line with reduced usage of the resource to
which that fixed cost is attached. A typical example is that of the rental cost
of the premises from which a factory or warehouse operates. The rental cost
is incurred regardless of the activities carried out, or distribution of space
within the factory/warehouse premises. However, charging rental costs to
products based on the space and time consumed by that product, would have
the following effects, provided proper accountability structures are in place:
Departments and staff responsible for sales would de-emphasise the products
that consume above average space in the factory/warehouse as the increase
in cost charged to the product impacts unfavourably on the profitability of
that product

The converse would also occur, with products (or services) that are less
resource intensive receiving increased emphasis, provided that sales staff are
incentivised on the basis of profit, and not volume or revenue. This change
in behaviour leads to more profitable use of the warehouse space by
changing the mix of activities from unprofitable products and services to
more profitable ones. By influencing the organisational attention away from
less profitable to more profitable products and services, a company
invariably increases its return on the assets (warehouse space in this
example).

It is necessary to point out at this juncture that, despite the seemingly

impeccable credentials of the ABC technique enshrined in its basic logic and
characteristics, the benefits that the technique can potentially confer on
companies remain largely elusive. We argue that the explanation for this
paradox lies, amongst other factors, in what actually makes ABC a strategic
costing technique. Here, our thesis is that, it is the ability of organisations to
(i) adopt an appropriate cost management philosophy, and (ii) integrate ABC
in their strategies, which collectively transform a costing technique into a
strategic costing technique.
Cost management philosophy and ABC

As discussed in part 1 of this series, a strategic cost; management philosophy

takes a process view rather than a silo mentality to the arrangement of work
and understanding of costs, adopts a multi-functional team approach; rather
than an individual approach, views cost management as a managerial rather
than a finance function; takes a long-term rather than a short-term, quick-fix
cost cutting approach, and broadens the scope of cost management to
include both suppliers and customers.

A process view of the organisation facilitates process mapping and activity

mapping, which are prerequisites for the implementation of ABC. In order to
conduct process mapping and activity mapping successfully, a
multifunctional approach is required due to the fact that processes often cut
across functional boundaries. Thus, a process view supported by a multi-
functional team approach facilitates an understanding of how the actions of
one functional area or business unit within an enterprise impact on resources
consumed by another. An end-to-end cost visibility is therefore made
possible, which in turn enhances the elimination of duplication (non-value
added activities). Using the silo approach, a lot of costs are regarded as
facility sustaining for each function within an organisation, and thus
unalterable (fixed).

As such, the cause and effect relationship between many of these costs and
the activities that actually drive them is not evident, due to the activity
driving costs of one functional area falling within the ambit of another
functional area of the organisation (see the third part of this series for more
discussion of this issue). The point that we want to make is that a costcutting
philosophy that adopts a silo approach cannot support the effective
implementation of ABC. As a technique that relies of process and activity
visibility, ABC requires a cost management philosophy in order for its
potential benefits to be realised.

Integration of ABC into organisation strategy

In part 1 of the series, it was argued that:

".......strategic cost management requires that a cost managemen t system

should be designed and developed in such a way that its structure and life-
cycle evolve to support a company's changing competitive strategy with
respect to product/service, market, human resources and technologies,
" (Chivaka, June 2007; pp 38).
The above point means that successful implementation of ABC should be
based on a careful analysis of the organisation itself. This requires answering
the following two questions (Estrin et al,, 2004;p73):

1. Is it likely that ABC will generate cost information that is significantly

different from, and better than, cost information produced by the
conventional accounting?

2. If ABC generates cost information that is regarded as better than the

current information, will the better information change management
decisions that are dependent on this information?

The first question is concerned about the extent to which cost information
generated by ABC is more accurate than that produced by the traditional
costing system. The second question centres on the usefulness of ABC
information in supporting strategy, given constraints imposed by the
organisation's strategic options.

This means that ABC information should be used to support organisation

strategy by creating cost visibility, reducing costs and improving processes
and, at the same time, strengthening the strategic position of the company.
However, in order to achieve this, the information produced by an ABC
system should be in sync with the decision-making processes necessitated by
organisational strategy. As such, managers must regard ABC cost
information as more beneficial for the company in order to use it in decision-
making. In addition, the environment within which managers operate must
facilitate the use of this information. This means that the organisational
culture, the nature of competition facing the company, the legal as well as
the social environment must all be conducive to the use of ABC cost
information. Factors that influence management's ability to use the ABC
generated cost information freely in supporting organisational strategy
include the following (Estrin et al, 2004; p 73):

* Management's freedom to set prices.

* The ratio of period costs to total costs.

* Strategic considerations.

* The climate and culture of cost management within the organisation.

* The frequency of analysis that is desirable or necessary.

Strategic considerations are constraints imposed by an organisation's explicit

or implicit strategies on management decisions. It is important to take into
account the extent to which such strategic constraints override insights
generated by ABC cost information when it comes to management
decisionmaking. Therefore, the suitability and benefits of ABC cost
information should be evaluated on the basis of the organisation's strategic
focus and information needs. Management should thus answer some of the
following questions (Estrin et al., 2004; p 76):

* Is a 'market niche' strategy being employed? Is the strategy dependent on

product profitability/costs?

* Are capital expenditures for new products, manufacturing changes, or

capacity expansions frequently justified explicitly on the basis of 'strategic
reasons' rather than economic returns?

* Are capital expenditures frequently initiated implicitly and driven by

strategic considerations, with financial benefits of the project being used
merely to obtain project approval?

* What type of analysis and justification is necessary for approval of REtD

expenditures? Is the true rationale more strategic in nature?

* Does the organisation establish customer process based on costs or

market? If the company sells to related entities using prices based on costs,
would changes in the transfer pricing result in changes in volume or in the
receiving location's decisions?

* Are changes in product design or manufacturing process driven mainly by

costs, or are other sources such as market or product requirements critical?

* Are product discontinuation analyses performed regularly in an attempt to

reduce (indirectly) costs, or for reasons such as fostering specific market
perceptions?

The insights generated from answering these questions do inform

management of the usefulness of applying ABC to support organisation
strategy. For example, where most decisions are based on strategic
considerations rather than costs, investing huge sums of money in a costing
system such as ABC will not necessarily make for better decisions. The
implication of this point is that management and finance professionals
should ensure that organisation strategy informs the nature of costing
techniques used. It is only when that link is established that the costing
technique used assumes the strategic dimension that makes it a strategic
costing technique.
Conclusion

It is necessary that ABC be applied in the context of a cost management

as opposed to a cost cutting philosophy. In addition, the real benefits of
an ABC system can only be realised if the costing system is informed by,
and thus integrated into, an organisation's strategy. On its own, ABC is
simply a costing system that has potential to give more accurate cost
information compared to the traditional costing systems. Its true potency
as a strategic costing technique is subject to the extent to which it is fully
integrated into an organisation strategy.

In other words, it is very dangerous for managers and finance

professionals to think that ABC on its own is the antithesis to traditional
cost cutting systems, and thus a panacea to costing, decisionmaking as
well as process improvement problems. On the contrary, trying to
implement ABC in an organisation that is informed by a cost cutting
culture, with no strategic cost management philosophy, can only result in
the dismal failure of the costing system to generate the anticipated
benefits. In conclusion, there is nothing inherently strategic' about ABC;
rather it is (i) the philosophy that underpins its implementation, (ii) the
use to which ABC information is put and (iii) the extent to which it is
integrated into an organisation's strategy; that make ABC a strategic
costing technique. Consequently, both finance professionals and general
management need to bear this in mind before spending huge sums of
money and effort trying to implement ABC and yet at the same time
remaining in the cost-cutting mode that divorces a costing system from
organisation strategy and other contextual factors. Without synchronising
the organisation's strategy information needs and ABC, and the creation
of a cost management philosophy that supports the implementation of
ABC, attempts to realise benefits conferred by ABC will only be
disappointing at best.
Reference

[Reference]

Chenhall, R.H. and Langfield-Smith, K., (1998). "Adoption and benefits of

management accounting practices: An Australian study," Management Accounting
Rexarch, Vol. 9, pp. 1-19
Chivaka, R., (2007). Strategic Cost Management: Context and Philosophy,
Accountancy SA, June 2007, pp 38.
Cokins, G., (1996). Activity-Based Cost Management Making it work, McGraw-Hill,
1996.
Estrin, T.L., Kantor., J., and Albers., (2004). "Is ABC Suitable for Your Company? An
impartial analysis of overall operations can tell you yes or no": in Readings in
Management Accounting, fourth edition, Pearson Prentice Hall pp. 73 - 78.

[Author Affiliation]
Dr Richard Chivoka PhD, MSc, BCom, is an Associate Professor, Department of
Accounting at the University of Cape Town and Carol Cairney CA(SA) is a lecturer,
Department of Accounting at the University of Cope Town.

[Photograph
]

[Author Affiliation]
Dr Richard Chivaka is an Associate Professor in the Dept of Accounting at UCT. He
is Director of the Honours & Masters degree programme in Strategic Cost
Management. His research interests include strategic cost management, costing
systems design (ABC Et ABM), supply chain management and value chain analysis.