In today's recessionary economy, your costs are your biggest enemy. But conventional accounting methods may be distorting your expenditure estimates drastically. Now, a hot new tool, Activity Based Costing (ABC), offers a way to calculate the real costs of your products. And to transform your costing exercise into enterprise-wide process management initiatives aimed at reducing costs in every activity.

By Nanda Majumdar

Have you adopted the new alphabet of cost management? After decades of bowing to the demands of orthodox accounting practices to calculate the cost of their products, ceos are beginning to use a new script. Starting with ABC. Standing, respectively, for Activity. Based. And Costing (ABC). An exciting tool that has been reborn, after its origin in the 1970s, with perfect timing--after all, squirming as it is in the twin pincers of competition and recession, corporate India's compulsion for cost cutting has never been greater--ABC could well rewrite both your age-old accounting practices and your costs.

Captured from the cross-currents of classic cost-flows, and remoulded into a powerful tool by Harvard University dons Robert S. Kaplan and Robin Cooper in 1988, ABC as we know it today is designed to wipe off the inadequacies in conventional cost-accounting practices, and furnish more accurate cost information for strategic and management decision-making. Its simple, two-step premise: activities cause costs to the company; and the precise cost of all activities that go into a product must be factored in to compute its actual total cost to the company. The outcome: ABC promises not only to deliver a new costing model to you, but also to greatly impact your management decisions with the findings of that model.

Just how will ABC transform your cost structures? The real change that it engineers lies in the treatment of what your cost accountant refers to as overheads--the combined total expenses run up by all the factors other than direct material and direct labour. Traditionally, companies distribute their overheads between different products in the same ratio as the respective costs of direct labour in those products. Thus, if a unit of product A consumes twice as many labour hours as a unit of product B, the total overhead cost per unit is also distributed between products A and B in the same ratio. However, this hides an important part of the story. For, the manufacture of the two products normally uses the overheads in a proportion that bears no relationship with labour costs.

For instance, product A may need far fewer shutdowns in the assembly line, but far greater computer time and transportation requirements than product B. To account accurately for such costs, ABC operates in two stages. First, it allocates the total overhead costs to different activities such as machine set-ups required, purchase orders issued, the number of inspections needed, and so on. Tracing each of these back to a unique cost-driver, ABC actually tries to locate as many different cost-drivers as possible so as to distribute the total costs accurately between them. The next step: finding out what proportion of each of these drivers is needed for each product. Thus, if 80 per cent of Activity 1 is directed towards product A, and 20 per cent towards product B, the costs associated with Activity 1 are also divided between products A and B in the same proportion. The results of this model can be dramatic: while the total cost for all products remains unchanged, as it must, the respective costs of different products are often found to be as much as 50 per cent higher, or lower, than those computed on the basis of orthodox models.
If there's one critical reason for corporates favouring ABC today, it is the proliferation of products. For, the resultant upstream and downstream complexities--in terms of sourcing raw material and components, using a variety of processes, planning manufacturing schedules, juggling different product lines, and addressing several different customer segments--are playing havoc with traditional, predictable costing structures. Comments P.S. Srinivasan, 44, director, A.F. Ferguson & Co.: "While orthodox cost accounting works well under unchanging conditions, it increasingly leads to distortions under complex operations." By contrast, ABC offers a more accurate picture of costs.

The pay-off? Consider the case of a Mumbai-based electrical parts manufacturer, whose products were of two genres: a standardised, no-frills, low-margin line, accounting for 60 per cent of the output and sold through the company's dealer network; and a value-added, customised, high mark-up line, marketed through direct institutional selling. The company's dilemma: compelled to squeeze costs by scaling back resource allocation, which of the two genres should it cut back on? The company had originally allocated 60 per cent of all overheads and marketing costs to the standardised products, and 40 per cent to the customised ones--in the same ratio as their respective outputs. Once it started applying ABC, however, the focus shifted to activities--among which were not just manufacturing and labour, but also support actions like quality checks, transportation, phone calls to customers, and cold calls.

Following the ABC system, the company analysed the costs of these activities and distributed them between the two product categories, depending on the extent to which they used these activities. The results? The costs of the customised line were found to be dramatically higher--and those of the standardised line proportionately lower--than the company had imagined. So, while it had thought it was making large profits on the high-value product, and modest ones on the other, the ABC exercise revealed that the former was actually making a loss. And the latter, huge profits. So, the company chose to divert resources from the value-added line--where it focused on compressing costs--to the standardised one. Says G.P. Jakhotiya, 36, professor, Jamnalal Bajaj Institute of Management Studies (JBIMS): "It was obvious how inaccurate the original assumptions were."

Despite its benefits, however, there's one fundamental barrier to the use of ABC. And that relates to the proportion of overhead costs to total costs. While these are high in businesses with complex product portfolios, frequent switch-overs, and extensive customer-oriented servicing, they are really far less relevant to large businesses rolling out the same product end-to-end on a gigantic scale, with little room for flexibility. Says Sid Khanna, 44, managing partner, Andersen Consulting, dismissively: "ABC does not really fit in with Indian businesses." But if your company does have a low direct-to-total cost ratio, you could use ABC--and abm (m for management)--profitably.

Indeed, the real value of ABC lies not just in the accuracy of the costing structures that it offers, but also in its ability to spawn an entire cost-management system. And the benefits flow when the data is acted upon--when ABC becomes abm. Says A.N. Raman, 39, director of the Chennai-based consultants, Cost Technology Asia (CTA), which taps the expertise of the Portland (US)-based ABC guru Peter Turney: "It can be a powerful management weapon." For instance, a precise breakdown of costs can become your basis for a pricing decision for that product, or for attacking the costs of each of those activities, or for identifying activities that are contributing to costs, but not adding value.

Observes K.V.S.S. Narayan Rao, 41, associate professor (strategy), National Institute of Industrial Engineering (NIIE): "The big plus of ABC is that it is capable of providing managers with fairly accurate cost information for making a wide array of decisions. It is flexible enough, for instance, to analyse costs by cost objects other than products." So, you can slice your cost information by customer, by regional office, by division, by functions, or by process, and take decisions accordingly.

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