CHAPTER 7 Activity-Based Costing

The purpose of this introduction to Activity-Based Costing (ABC) is to summarize its basic principles and describe the benefits of the integration provided with SIMPROCESS. A list of ABC references is provided in the back of the chapter for further reading.

The goal of ABC is to mimic the causal relationships among Resources, Activities, and Entities in assigning overhead costs. "The fundamental belief behind this costing approach is that cost is caused and causes of cost can be managed. The closer you can come to relating the costs to their causes, the more helpful your accounting information will be in guiding the management decisions of your business." states the Ernst & Young Guide to Total Cost Management (Ernst & Young, 1992).

Enterprises use Resources to conduct activities. Resources perform activities to add value to products and services. The key to understanding cost dynamics in any enterprise is modeling the relationship between activities and their causes; and the relationship between activities and costs. If cost dynamics are not modeled (which is usually the case with traditional management accounting information systems), the performance information provided is incomplete or misleading.

ABC and SIMPROCESS

Activity Based Costing is a technique for accumulating cost for a given cost object (i.e., product, service, customer) that represents the total and true economic Resources required or consumed by the object.

Activity Based Costing occurs in two phases. First, cost data is organized into Activity cost pools. In other words, the costs of significant activities are determined. This first phase is sometimes referred to as Activity based Process costing. Then, the amounts in the cost pools are assigned to products, services, or other cost objects. The second phase is referred to as Activity based object costing.

The architecture of SIMPROCESS provides an integrating framework for ABC. ABC embodies the concept that a business is a series of inter-related Processes, and that these Processes consist of activities that convert inputs to outputs. The modeling approach in SIMPROCESS manifests this concept and builds on it by organizing and analyzing cost information on an Activity basis.

One of the major challenges in successful implementation of ABC is finding the appropriate level of detail for the business Process analysis. The organization of business Processes is critical to reorganizing the cost data into Activity pools. The hierarchical modeling approach of SIMPROCESS facilitates this organization and accommodates varying levels of detail for ABC analysis. Another significant value of the ABC analysis in SIMPROCESS comes from the dynamic analysis of costs based on the event-driven simulation. Because SIMPROCESS tracks Resource interdependencies and captures the random nature of Processes, the cost statistics provided by SIMPROCESS are far more accurate than results obtained from static analysis.

Benefits of ABC with SIMPROCESS

Focus on Cost Drivers

One of the most important benefits of ABC is the focus it provides for estimating the key causes of costs. Executives can use these estimates to prioritize and monitor improvement efforts. For example, understanding the cost of poor quality can justify the investment in a quality program. Likewise, understanding the cost of complex or diverse products and services can help streamline the product and service offerings.

Strategic Pricing

Life cycles of product and services are becoming shorter and shorter. The up-front costs of developing, testing, and marketing are not recouped until revenue is generated. Understanding the cost trade-off between life cycle stages is critical to strategically pricing the products, i.e., understanding when the total investment in product development can be recouped is valuable information for strategic pricing. ABC with SIMPROCESS allows simulation of the Process changes during the life cycle of a product/service for strategic or time-based pricing.

Evaluation of Capital Investments

Reengineering business Processes requires a trade-off between the benefits and costs of making Process improvement changes. Without the trade-off, executives and managers are faced with making large investment decisions based on gut feel.

How to Use ABC in SIMPROCESS

To get Process cost information from a SIMPROCESS model, first define the costs of the model's Resources and the cost periods to be analyzed. SIMPROCESS will distribute these costs to activities and to Entities as the simulation proceeds and provide extensive reporting of the results based on user-specified cost reporting periods.

In order to provide a comprehensive cost analysis, SIMPROCESS differentiates between fixed costs and several types of variable costs that can be assigned to a Resource. SIMPROCESS allows multiple cost periods to be analyzed simultaneously and allows model level definition of costing periods. These features help to bridge the gap between an accountant's view and a manager's view of a business Process, provide an effective communication vehicle for the participants in a Process reengineering project, and make SIMPROCESS a complete business Process analysis tool.

SIMPROCESS' costing facility is very simple to use. Prior to running a simulation, define the cost periods for cost calculation purposes or accept the default cost periods, which are based on calendar quarters. Also, define costs for at least some of the Resources in the model, presumably those that represent the most significant costs in the business Process (hourly payroll, salaries, capital equipment depreciation, etc.). The following describes how to complete these two steps.

Setting Up Cost Periods

Pick the cost periods that are most suitable for the system under study. SIMPROCESS selects Quarterly cost periods as the default but also allows Weekly, Monthly, Half Yearly, and Yearly cost periods. The following example demonstrates how to set cost periods for the default run length.

The list in the upper left of this dialog shows the currently defined cost periods. The default periods are Quarter1, Quarter2, Quarter3, and Quarter4. At the bottom of the dialog, is the Period Frequency selection list with the default Quarterly selected. Click the down arrow button to see all of the Period Frequencies that SIMPROCESS offers: Weekly, Monthly, Quarterly, Half Yearly, and Yearly. Notice that if a new Period Frequency is selected, SIMPROCESS will create a new set of periods in the period list and assign each a default name (Month1, Month2,..., or Week1, Week2,...). Notice also that SIMPROCESS will automatically create and name enough cost periods to span the currently specified run length. (The simulation Start Time and End Time are set from the Run Settings tab.)

This dialog also sets the name of the Currency used on the cost reports. This is a simple label used in the reports. SIMPROCESS provides no currency conversion facilities and assumes that all cost amounts are in the same currency (e.g., Dollars or Euros).

When a particular cost period is selected and the View... button is clicked, SIMPROCESS will display the Cost Period detail dialog which shows the start and end dates and times for the cost period and the name of the period. The name of each cost period can be changed to be more descriptive in the context of the cost report. For example, the cost periods could be called Spring, Summer, Fall, and Winter rather than Quarter1, Quarter2, etc. Click the OK button to alter the cost period name or the Cancel button to discard any changes.

Setting Up Resource Costs

Costs can be specified for each Resource in the model. All Resources do not have to have costs specified. SIMPROCESS will generate cost reports only for those Resources that have costs assigned. Both fixed and variable costs can be assigned to non-consumable Resources, and two of the three variable costs can be assigned to consumable Resources. These costs are specified as part of defining each Resource.

Select the Define/Resource option from the menu bar. Then pick a previously defined Resource from the list for editing or add a new one using the Edit or Add buttons. This will display the Resource Properties dialog as shown below:

The check box at the bottom left-hand corner of the dialog, Collect Cost Statistics, is turned on by default whenever cost information is entered. Leave this selected. Otherwise, cost statistics will not be gathered.

Variable Costs

· Usage Cost per Entity - This cost is applied to each Entity that is processed by the Resource. It is used to represent "flat fee" charging schemes. The same cost is assigned regardless of the amount of the Resource's units that is used or the duration of the Activity. Example: Often administrative charges or service call charges are based on this kind of charging scheme.

· Cost Per Unit - This cost is applied to each Entity that is Processed based only on the amount of the Resource's capacity that is used to Process the Entity. The cost is not calculated based on the time that the Activity takes to complete. Example: Fuel may be defined as a consumable Resource and cost per unit may be $1.50 per gallon. Every time a gallon of fuel is consumed, it will cost $1.50.

· Cost per Time Unit - This cost is calculated based on the amount of Resource capacity used and the time used. Example: Machine rental charges or hourly salary paid to employees are a common example of this type of cost.

Fixed Cost

Fixed Cost is defined in the box below the Variable Costs box. Enter the fixed cost amount in the Per Unit value box, and select the time basis for the cost from the selection list below. Machine depreciation or fixed salaries are common examples of this type of cost. To specify the fully burdened cost of a set of salaried employees represented by this Resource, and the cost per employee is $50,000 per year, enter 50000 in the Per Unit box, and select Yearly from the list below. Click the down arrow to the right of the list to see the available items. The list contains the same time intervals that are available for the Cost Period Frequency. These do not have to be the same in both places. SIMPROCESS will perform all the necessary conversions automatically.

For example, annual salaries can be specified and the simulation run with weekly cost periods. SIMPROCESS will convert the annual salary costs to weekly costs when generating the cost data. After a simulation is completed, reports of the costs are available. The total cost and the cost by period can be seen by choosing Display Standard Report from the Reports menu. These costs are divided into three categories: Resource by Activity, Resource by Entity, and Activity by Entity.

Cost Calculations

When a simulation is run, SIMPROCESS pauses at the end of each cost period to calculate the period costs. SIMPROCESS tracks all the activities that used the Resource and all of the types of Entities processed. For each Resource that has costs specified and that is set to calculate costs, SIMPROCESS will distribute the Resource's fixed and variable costs for the period to all of the activities that made use of the Resource during the period. This distribution is based on the amount of the available capacity used by the Activity during the period. For example, suppose that a Resource is used evenly by two activities and was busy 50% of the time for the cost period. Further, suppose that during the period each Activity processed five Entities, two of type A and three of type B. SIMPROCESS will calculate the costs for this period as follows:

2. For each of the two Resources, calculate the portion of fixed cost represented by idle time. Then calculate both the fully absorbed and capacity-based fixed costs. (In this case, the fully absorbed costs should be twice the capacity costs, since the Resource was 50% idle during the period.)

These steps are completed for all Resources in the model that are set to calculate costs. Each Activity accumulates its period costs from all of the Resources that it actually made use of during the period. Next, SIMPROCESS will calculate the Entity costs based on these Activity costs. After all Resource costs are distributed to the activities, the Activity costs are then distributed to each type of Entity Processed by the Activity, based on the total number of Entities Processed. These calculations proceed as follows:

The pool of Activity cost is broken out to each Entity type based on the Entity usage of that Activity. The Activity cost is displayed in the cost report for the total number of each Entity type, not for each Entity instance. To calculate the Entity instance cost, divide the cost for that Entity type (the cost number displayed in the report) by the total number of Entities of that type processed (available in the Standard Report).