Lean ERP and Activity Based Costing

Posted by Gerry Poe

lean erp activity based costingQuestions to Ask Before You Implement Activity Based Costing
Managers from companies of all sizes have read about activity-based costing (ABC) or even attended conferences about ABC.  Many are now trying to reap the benefits that ABC offers.  But the rush to understand and implement ABC has caused some issues to be poorly understood.  To summarize these issues, this article identifies some questions people often ask about ABC.  Companies that answer these questions before implementing ABC are more likely to have successful ABC systems.

Many accountants, engineers, and marketers have embraced activity-based costing (ABC) because it seems to correct traditional cost accounting.  ABC is based on the idea that activities consume resources and products consume activities, and it addresses the problems of managing people who work in these activities.  An important result of managing activities and reducing non-value-added activities should be lower costs.

Traditional costing focuses on outputs or products and on full-absorption costing.  ABC by contrast, focuses on inputs or activities and on relevant costs.  ABC is consistent with the operational philosophies of total quality management (TQM) and just in time (JIT).  All three focus on processes and activities; all three also encourage the elimination of waste.  In layman's terms, ABC, TQM, and JIT focus on the work of the organization rather than on outputs.

Here are some questions that people often ask about ABC.  These questions summarize issues that have been poorly understood until now.  By answering these questions, companies that implement ABC are more likely to succeed.

1.  Is top management outwardly committed to ABC? ABC is not only the concern of your accountant.  Once an ABC system is initiated, management must be prepared to support that implementation by providing additional short-term resources.  When management shows this level of commitment, the organization will begin to believe that it "must be important, or they wouldn't be spending money on it."

2.  Is the firm ready for change? Be prepared to initiate some tests prior to implementing ABC.  Stable organizations may resist change at any level.  Use pilot projects to test your readiness.  Employees must believe that changes to ABC will improve matters.  Instill and promote education.  Educating your work force about ABC before the change is also important.  In any implementation of ABC, operational data must be collected.  Reassignments may also be a part of the changes that naturally occur within your organization.

3.  Do performance measurement and reward systems take ABC into account? As far as employees know, the company is changing the rules of the game when it introduces ABC.  Until the reward system demonstrates that rewards are tied to the new performance evaluation rules, employees will experience confusion and dissonance.  The ultimate goal is for employees to gain confidence that using ABC will cause the company to make better decisions based on more equitable and meaningful allocations cost.

4.  Do performance measures help you manage the "forest" or the individual? One of the weaknesses of traditional management practice is the demand for efficiency in each department, which too often leads to increased work-in-process and ending inventories -- and, thus, to higher inventory costs.  Optimizing each activity does not necessarily lead to a more productive company as a whole; often the contrary is true.  Companies must therefore establish overall performance measures that monitor and encourage both managers and employees to take the "forest" view rather than the "tree" view.

5.  Does the cost system emphasize managing activities rather than managing costs? Probably the most exciting difference between traditional costing and ABC is the direct influence ABC can have on non financial operations management.  The notion that managing activities efficiently will reduce total costs is fundamental to ABC.

6.  Have you "kept it simple"? An ABC system should be as accurate as it reasonably can be, but the costs of implementing the system must justify the desired improvements in managing the business.  For this reason, companies should do a cost-benefit analysis that considers the costs of:

  • Data collection;
  • Data maintenance;
  • Time required to keep the ABC system up-to-date;
  • Staffing; and
  • Computer and software requirements.

7.  Are you prepared to reassign or terminate personnel as excess resources are identified? Employees need to have the correct skills; they must not spend their time performing non-value-added activities.  Managers and employees must use ABC to identify value-added functions and eliminate functions that do not directly relate to the company's success.  The good news is that ABC implementations take time  -- as do retraining, re deployment, and thoughtful terminations.

8.  Do you understand ABC is a management system -- not a costing system? ABC is not in accordance with generally accepted accounting principles (GAAP), and for a good reason: All costs need not to be absorbed or included in product costs under ABC, because ABC costs are not intended for use in inventory valuation.  Instead, the purpose of ABC costs is to provide information for managing the business.

Summary: Reviewing these questions should make it clearer the primary issues involved in ABC implementation are management issues, not costing issues.  An ABC system does not replace the company's cost accounting department, because ABC is a management system, not a costing system.

ABC supports a shift in how businesses operate to a much more humanistic approach.  ABC should bring rewards to those organizations that commit the time and resources required to view the workplace from the standpoint of activities.

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Tags: ERP, Lean Operations, Lean Manufacturing, Activity Based Costing, Medical Devices

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