Preface of Activity-Based Costing (ABC)

“ABC may be used in common parlance to indicate a degree of simplicity, but as an acronym for Activity – Based Costing, it introduces some of the most revolutionary and fundamental changes in management accounting theory and practice.

What originally appeared to be simply a new method of tracing costs to products has led to the development of an entirely new philosophy referred to as Activity Based Costing and Management (ABC & M). In this text a holistic approach is proposed to fundamental issues such as the management of cost, time, quality, funds and constraints through the use of ABC & M.  ABC & M is therefore not just a new way of computing business figures but requires the fundamental understanding of all management issues. It is about understanding and not about calculations.

ABC & M not only exposes the shortcomings of traditional accounting systems but proposes to:

• More accurately determine product costs and the costs of a multitude of other cost objects such as customers, processes, market segments or distribution channels.
• Engender a better understanding and greater transparency of operational processes activities and cost structures, mainly owing to the particular methodology involved.
• Focus on the outputs of the organization rather than on the mere measurement of the consumption of the resources.
• Expose the shortcomings of functionally structured organizational reporting and replace it with process-orientated, boundary-free structures which have the objective of delivering what the customer wants.
• Incorporate the wealth of non-financial information which is usually an earlier, and often a more accurate, indicator of organizational performance.
• Produce timely, relevant and readily understandable management accounts to support decision making.
• Link strategic direction and planning to operational reporting and develop a strategic support methodology by interpreting, measuring, and reporting on critical success factors.
• Foster an improved cost management philosophy, inter alia through the elimination of all forms of wastage in the organization and the identification of value-adding and non-value adding activities in the organization.
• Move the emphasis from mere cost measurement and rather focus on the understanding and interpretation of cost structures. This enables organizations to better predict and control future costs.

The approach of ABC & M is not merely a theoretical one but a practical one which has been tried, tested and shaped by numerous installations. This is particularly apt when ABC is applied to value chain principles and the use of residual income theory. It is believed that this approach may have far reaching effects on accounting systems in the future as it provides answers to many perplexing problems.” (ABC & M; E Glad & H Becker; 1994)

Shortcomings of Traditional Cost Accounting

The major weakness of the traditional method of allocating indirect overhead cost, is the allocation on the basis of just one factor e.g. direct labour hours, machine hours etc. The traditional method implies there is only one driver of the indirect overhead and the driver is machine hours, or direct labor hours, or some other indicator of volume produced.

In reality there are many drivers of the indirect overhead: machine setups, unique inspections, special handling, special storage, and so on. The more diversity in products and/or in customer demands, the bigger the problem of allocating all the costs of these various activities via only one activity such as the direct labour hours.
Under the traditional method, the costs of performing all of the diverse activities will be contained in one cost pool and will be divided by one driver e.g. the number of direct labour hours. This results in one average rate that is applied to all products regardless of the number of activities and the complexity of those activities. Since the cost of many of the diverse activities do not correlate at all with the number of direct labour hours, the resulting allocations are misleading.
Activity-based costing is intended to overcome the weakness of the traditional method by having various pools of costs and then allocating each pool’s costs on the basis of its root cause e.g.

The following statements were made by Johnson and Kaplan in their book, “Relevance lost: The rise and fall of management accounting”:

• Management accounting information is produced too late, too aggregated, and too distorted to be relevant for managers’ planning and control decisions.
• Management accounting systems:

– do not provide detailed information on process efficiencies,

– focus too narrowly on inputs, such as direct labour, that are relatively insignificant, in today’s production environment, and

– fail to provide accurate product costs.”

“To be effective and appropriate, modern cost accounting systems and information should:

– resemble the physical business processes and not necessarily the functional proceedings;

– be detailed enough to ascertain reasonably true cost;

– provide information for life-cycle decision making;

– incorporate time as an important cost driver;

– provide a multi-dimensional focus on a multiplicity of cost objects such as, customers, products, services, functions, processes and activities;

– incorporate physical measures such as quality, productivity and capacity, and follow the physical flow of the product or other cost object;

– have not only and input focus on cost but also an output focus (what has been achieved with what costs);

– measure and induce the elimination of wastage;

– identify non-value-adding processes and expenditure;

– focus less on cost tracking and reporting and more on cost planning and control;

– entail value-added management accounting and focus on future value creation;

– use modern technology;

– reflect all special attributes attached to individual products; and support every key business decision, including sourcing, pricing, investment justification, efficiency and productivity measures, product elimination and new product introduction.” (ABC & M; E Glad & H Becker; 1994)

Introductory Presentations

The following PowerPoint presentations are available should you want to meet with us and present it to you: “Appendix I; How does the ABC & M Model work?”, “Appendix III; Cost allocation and Activity-Based Costing (ABC) systems”, and also, “Activity-Based Costing and Management Workshop Training – Overview “.

 

WHAT IS COST ENGINEERING (CE)?

Preface of Cost Engineering (CE)

Cost Engineering is part and parcel of Project Management. Although there are different definitions of “cost engineering”, probably one of the most fitting abbreviated definitions is: “Cost engineering, the engineering practise devoted to the management of project cost, involving such activities as estimating, cost control, cost forecasting, investment (cost) appraisal e.g. capital expenditure and risk analysis. Cost Engineers budget, plan and monitor investment (cost) projects. “They seek the optimum balance between cost, quality and time requirements.” (AACE – American Association of Cost Engineering).

In this context, cost refers to the monetary value or financial pricing of a specific project activity (Project ABC). This cost includes all anticipated expenditures / cost that are expected to be part of the entire project, as well as the monetary value of the total sum of resources to be expended (activity cost of all resources consumed) during the process.

The relationship between Cost Engineering and Project Controls is very closely linked / correlated. Project controls can simply not be effective without Cost Engineering and visa-versa. Project Controls discipline encompasses cost estimation, cost engineering/control etc.

Cost Engineering (CE) combined with ABC also applies project finance modelling (NPV, PAYBACK, ROI, IRR etc.) to prepare project appraisal reports.

A financial / cost model can be constructed as a tool to conduct negotiations and e.g. prepare a capital expenditure (cost) project appraisal report. It is usually a comprehensive list of input assumptions and to provide outputs that reflect the anticipated real life interaction between data and calculated values for a particular capital expenditure project.

Properly designed, such a financial / cost model is also capable of sensitivity analysis, i.e. calculating new outputs based on a range of data variations.

From both a CE and ABC point of view combined, activity investment analysis, inter alia, determines the cost of the use of the assets e.g. depreciation, wear and tear (tax application) or investments associated with activities. This necessitates analyzing assets according to the activity structure. Information about assets invested in each activity facilitates the evaluation of capital productivity and may eventually be useful in investment decision making e.g. RONA (Return On Net Assets), ROI (Return On Investment) and NPV etc. calculations and comparisons /benchmarking. This almost has the effect of being able to see the balance sheet from an activity perspective, which also facilitates evaluation of the use of the cost of capital. (ABC & M; E Glad & H Becker; 1994).

Cost of capital in many businesses represents one of the most significant cost elements. Because of the fact that a major part of the cost of capital, namely return on shareholders’ funds does not necessarily represent a cash outflow, the cost of capital is seldom traced to cost objects (CO). The application of using the necessary tools and techniques available in CE and ABC make it possible to analyse and trace cost of capital to cost objects (CO).

 

The following PowerPoint presentations are available should you want to meet with us and present it to you: “Appendix IV; What is Cost Engineering for Capital Projects?”