Case Study
Activity Based Costing
A metal fabricator that supplies both standard and custom sub-assemblies to major manufacturers found little need for a sophisticated job tracking system, let alone cost accounting. However with increased market competition and their desire to expand their market presence it became apparent that they needed a much better way of understanding their costs. Routinely customers would ask for parts to be expedited, modified, quantities changed, raw material supplier changes, and delivery changes. With their traditional manual quote system most of these indirect costs were ignored and simply absorbed into overhead. Many of these overhead costs were related to the paperwork and office overhead and ended up in G&A cost of the company. As a consequence some orders were over bid while others were underbid. They would always seem to win the orders that had the most "invisible cost" associated with them since the competition knew enough to factor those costs into their bids. Conversely the "clean orders" were generally overbid since a general overhead markup was placed on all orders indescriminatly.
The first step in creating an accurate costing system was to identify work centers of machines and people that met the needs of rough-cut capacity planning, similar cost of operation, same billing rate, and of sufficient granularity to describe the process for estimating. Each work center was established with traditional run and setup times. The application of overheads was more challenging, though, since most costs could not be driven by labor hours and should not be cross-product volume sensitive. Overhead pools were established for each major activity with a cost driver that truly measured each overhead's contribution to a particular job. Typical overhead drivers were: purchase order activity (number of PO lines), part administration (number of part numbers), and mid-job changes (number of changes). Costs were now being driven down to the lowest possible level of value contribution.
Identification of value-added was desirable but they were not assigned traditional value-added and non-value added attributes. Rather a three-tiered assignment was used. Value added to the customer (what the customer is willing to pay for), value added to operate a business (e.g. paying bills and taxes), and non-value added (e.g. rework and scrap). In addition each value added attribute was assigned a weighting to give feedback to employees of the relative merit of the measurement.
The general ledger was completely restructured to allow for the gathering of costs into each work center and overhead pool. Certain expenses were driven down to a machine level to aid in capital decision making. The financial statements were redesigned to absorb all costs into Costs of Goods Sold except for interest, taxes, and extraordinary expenses. In addition a schedule of value added contribution was provided. More traditional statements were also routinely prepared for external purposes.
Quoting orders became a process of building a router of operations, materials, and overheads. Project tracking took place on all levels of cost activity and superior justification could be given to their customers for price changes. Finally, a historical database by part number aided the estimator by displaying how well they did each time that particular part had been run.