To maximize profitability, companies must know the true cost of making and delivering their products and services. Traditional cost accounting, devised in a simpler era, does not satisfy that need. Then, direct costs (chiefly materials and labor) were a large percentage of total costs, so the inability to determine indirect cost allocations was not an important factor in determining what a company earned on each of its products. Today, these indirect and overhead costs represent a far greater percentage of the total; moreover, the “product” a company sells is much more likely to be a bundled with related services, muddying the cost structure still more. Consequently, how a company allocates these indirect and overhead costs is crucial to managing profitability.
In this environment, traditional costing methods will not accurately reflect the true economic costs – when, for example, multiple products use the same amount of direct labor and materials but one product takes considerably longer to make on an expensive machine tool. The task of costing becomes increasingly more difficult as product lives grow shorter, the rate of price change accelerates and products increasingly share capital-intensive resources. Companies that use traditional cost accounting or assign costs using the wrong methodology risk setting prices and structuring sales incentives incorrectly and consequently having their profits fall short of their potential.
Accurate costing systems have become more important as a competitive tool.
Activity-Based Costing (ABC) is a methodology for accurately determining the true cost of products and services. It is a way to assign costs based on each product’s or service’s actual consumption of a company’s resources. Engineering, testing, machine setups, and so on are activities that have associated costs because they cause the company to consume resources. Put simply, the ABC methodology involves calculating the cost of the resources used in each activity and assigning that cost to the products that use the activities. By exposing the true economic cost of business practices, ABC enables managers to make more informed decisions that can improve profitability.
ABC has been around for decades, but initially many companies were disappointed with it because the costing methods and the software used to support them was not easy to implement and was laborious to maintain. But over the past decade practitioners have refined ABC and created similar driver-based costing methodologies to enable more pragmatic approaches to costing. These advances, along with improvements to the applications available to support them, make advanced costing methodologies substantially easier to implement and use.
That’s a boon, since accurate costing systems have become more important as a competitive tool. Those companies that have the ability to do rapid and accurate cost determinations to can accelerate timely decision-making. Many organizations have learned the hard way that achieving faster decision cycles is valuable. Given their value in improving profitability, we view it as important for executives, especially those in Finance, to be familiar with the current capabilities of advanced costing methodologies such as ABC.
ABC and other such methodologies also are used as the foundation of customer profitability management efforts. Companies find that improving their cost analysis gives them better insight into the real returns they are getting from individual customers – insight that often exposes mistaken assumptions. For example, a seemingly profitable high-volume account can turn out to be far less so, or even unprofitable, when all of the costs of servicing it are considered. Better understanding of customer profitability enables a company to improve the structure of its sales terms and to align compensation packages to focus on sales that truly are more profitable.