Using Activity-Based Costing to Implement Supply Chain Improvements

1. Using Activity-Based Costing to Implement Supply Chain Improvements Terrance L. Pohlen Lt Col, USAF, PhD

2. Overview • Why transportation and logistics managers require more accurate cost information • How activity-based costing can provide greater management insight • Using ABC to support transportation and logistics decision-makers • Applying ABC to supply chain management

3. Transportation and logistics managers need more accurate cost information • Critical link exists between corporate profitability and logistics costs and performance • Many logistics costs and effects of logistics decisions buried in overhead costs • Logistics particularly requires accurate costing • Diversity in resource consumption • Products and resource consumption not correlated with unit based allocation measures • Identifying and costing activities may reveal opportunities to improve operating efficiencies

4. Problems typically encountered in transportation and logistics accounting systems • Visibility frequently lost--included as part of SG&A • Allocated using cases shipped, miles, or sales • Costs not available by product, customer, or supply channel • Affect of logistics decisions/improvements not readily apparent • Output measures frequently not captured

5. “The imaginary profits--and losses--that arise from flawed cost systems can lead to very expensive blunders. We may be giving away the best business (high volume, but supposedly low margin products) to foreign companies. Competitors don’t want your cats and dogs--they want the volume business. Once the high volume products are abandoned, those that remain must carry a greater share of overhead, and thus they too become less profitable.” Fortune Magazine 12 October 1997

6. Traditional Cost Accounting Overhead Direct Labor Direct Labor Direct Labor Direct Labor OUTPUT $$ Activity Activity Activity Activity DIRECT MATERIALS DIRECT MATERIALS DIRECT MATERIALS DIRECT MATERIALS

7. Problems with Traditional Costing of Transportation & Logistics • Unit based allocation suggests costs will vary with volume--cannot accurately determine how changes in customer service effect total costs • No reward for reducing indirect cost categories--benefits diffused across all products • Costs “reduced” by eliminating direct labor • Overhead costs appear “fixed” and not affected by management action • Rewards based on cost center performance and not on total product/customer/channel profitability

8. Are U.S. Manufacturers’ AccountingSystems a Major Tool Used in Management Decision-Making? No 18% Yes 82% Source: National Center for Manufacturing Sciences, Focus, 1993

9. Warning Signals: • Division managers want to drop seemingly profitable lines • Product or customer profitability is hard to explain • Departments develop internal costing systems • The accounting department performs many special projects • Competitors’ prices appear unrealistically low • You have a high-margin niche all to yourself • Customers don’t mind price increases Adapted from Cooper, Robin, “You Need a New Cost System When...,” Harvard Business Review, January-February 1989, pp 77-79.

10. Office Supervision Utilities Supplies Equipment Support Packing & Receiving Put-Away Set-Ups Shipping Product Product Product Product Cost Division A Division B Division C Division D Objects Activity-Based Costing a technique to assign more accurately direct and indirect costs to the activities, customers or products which consume an organization’s resources Resources Activities

11. IS: An overhead allocation technique which generates the cost of activities IS NOT: A bookkeeping system A consolidation system Activity-Based Costing

12. ABC translates traditional costing into actionable information for decision-makers Cost data translated by ABC Activity-based information General Ledger (account balances) ABC Model Data Decision Makers

13. Office Supervision Utilities Supplies Equipment Support Packing & Receiving Put-Away Set-Ups Shipping Product Product Product Product Cost Division A Division B Division C Division D Objects How Does ABC Assign Costs? ABC uses a two-stage process to assign costs • Resource costs are assigned to activities based on use • Activity costs are assigned to the products or customers consuming the activity Resources Activities

14. Activity-based costing approach Overhead Overhead Overhead Overhead Direct Labor Direct Labor Direct Labor Direct Labor OUTPUT $$ Activity Activity Activity Activity DIRECT MATERIALS DIRECT MATERIALS DIRECT MATERIALS DIRECT MATERIALS

15. Supervision Office Labor Terminal 3% 9% 13% Insurance Dock Labor 2% 32% Depreciation 4% Maintenance 5% Fuel 7% License 1% Pickup & Delivery Drivers Yard Labor Utilities 5% 1% 18% Resources • Resources are usually derived from the general ledger accounts • Represent the resources the organization has to perform its mission • Many ABC models use budget information to determine resources

16. Supervision Office Labor Terminal 3% 9% 13% Insurance 2% Depreciation 4% Maintenance Dock Labor 5% 32% Fuel 7% License 1% Pickup & Delivery Yard Labor Utilities 18% 5% 1% Assigning Resource Costs • Resource drivers used to assign costs to activities • Interviews frequently used for making the cost assignments • Activity costs are sum of all resources needed to perform the activity

17. Activity Cost • An activity’s cost is the sum of the resources used in performing the activity • Consumption used to trace resource costs to the activities MHE 2% Supervision Maintenance 4% 1% Supplies 10% Labor 47% Facility 36% LTL Shipping Activity

18. Pallet picks sent by RF to Fork lifts Pick lists Placed in Window Pallet picks sent by RF to Fork lifts Warehouse Signs for and Takes Pick List Warehouseman Annotates Work Log Orders Requiring CHEP Pallets Re-palletized Property picked and Palletized Pallet moved to Shrink Wrap Area Pallet moved to Staging Area Pallet Shrink-Wrapped Identification and Number of Activities • Activities identified by implementation team • Level of detail determined by: • Cost • Diversity • Management Focus • Most DCs using 20-40 activities for costing

19. Receiving Cartage Unload and inspect Putaway Storage Bulk storage Aerosol storage Transp Planning Pre-shipment scheduling Truckload planning Post-shipment support Transportation Administration Picking Manual picking Mechanical picking Stage pallet for order Build pallet Special Handling Adjust pallet height Clamp off/slip sheet Spec Hdling/Warehouse office Shipping Load pallet Check full pallet Check mixed pallet Ship international order Ship small package order Administration Returns Rework Administration Product Customer Brand

20. Assigning Activity Costs • Activity costs assigned using cost drivers • Costs assigned on a per activity basis (per case, shipment, bill of lading) • Desired behavior should be considered when selecting a cost driver

21. Assigning Distribution Center Costs We assign the cost of this activity Manual picking Rework Unload & inspect Truckload plng Bulk storage Administration to this cost object: customer brand product customer product brand using this activity driver cartons mech picked cartons reworked pallets unloaded pounds shipped avg pallet on hand no. of cartons shipped

22. Cost Objects • The final output of the organization • Typically a customer, product, service, or distribution channel • Provides total cost of logistics support

23. Line Haul 55% Delivery 6% Billing 2% Dockhandling-Origin 10% Pickup Processing Claims 15% Dockhandling- 1% Scheduling Destination 3% 8% Cost Object: Bill of Activities Breakout of Customer A Costs

24. ABC Results Traditional Costing Results Product Division D 13% Product Division A 31% Product Division C 16% Product Division B 40% Product Division D Product Division A 21% 29% Product Division C 20% Product Division B 30%

25. Comparison of ABC and Traditional Costing • Focus shifts from correlating unit level cost drivers (direct labor hours) to correlating cost drivers at the unit, batch, and process levels • Overhead assigned to activities based on consumption--costs assigned to products based on the consumption of the activities performed • “Fixed costs” viewed as long-term variable costs affected by short-term management decisions • Isolation of costs enables managers to trace cost reduction efforts to specific products, customers, or supply channels--benefits no longer diffused • Managers can trace the effect of decisions on product or customer profitability--ABC captures the effects of diversity • ABC provides significant amounts of non-financial information--useful for integrating cost management with performance management

26. How ABC Can AssistLogistics Decision-makers • Can more accurately determine how changes in service requirements will affect logistics costs • Provides ability to trace indirect resources to logistics activities and outputs • Focus on high cost activities or processes • Translate logistics performance into corporate profitability • Greater visibility over logistics costs--better trade-offs within the firm • Simulate changes and impact on logistics costs

27. Benefits Obtained From ABC 65% Identify cost driver 59% Improved cost info 47% Better pricing 41% Performance measures Elim redundant work 41% Cost control 23% LaLonde and Pohlen, Journal of Business Logistics, 1994

28. Supervision Marketing Billing 5% Process Claims Handling 4% 4% 10% Maintain vehicles Pickup 10% 6% Unload 8% Load delivery Deliver LTL 6% Others Load line haul 7% 17% Customer E 8% 6% Scheduling Deliver TL Customer D Line haul 3% Accessorial Services 8% 8% 10% 5% Customer A 32% Customer C 17% Customer B 26% Office Labor Terminal 3% ABC demonstrates how logistics resources and activities are consumed 9% 13% Insurance 2% Depreciation 4% Maintenance 5% Dock Labor Fuel 32% 7% License 1% Pickup & Delivery Drivers Yard Labor Utilities 5% 1% 18%

29. Problems frequently encountered during ABC implementation • Management and employee buy-in • A new “system” and stand alone initiative • Accuracy versus precision • Delay in immediate pay-off • Multiple views on cost allocations and costs • Putting controller in charge • Too much detail--costing vs reengineering • Cost and effort required during implementation

30. Where ABC best practices are being implemented General Analysis: Nabisco, Roundy’s, Food Lion, Tops, Coca-Cola, Pepsi-Cola, Dial Corp, Bozzotos, Kroger, Shaw’s Category Analysis: Procter & Gamble, Super Valu, Fleming, H.E. Butt Menu Pricing: Spartan, Fleming, Super Valu

31. Application of activity-based costing to supply chain management • ABC can evaluate alternative supply chains • Activity analysis can achieve a sustainable • competitive advantage by lowering costs or • differentiating services • Supply chain analysis enables firms to exploit • linkages and perform trade-offs across the • entire supply chain • ABC/ABM provides means for assessing • individual firm as well as supply chain • performance

32. Vendor (Upstream) Total Cost of Ownership Perspective of the Firm Supply Chain Costing DPP, ABC Customer (Downstream) DPP, ABC Marketplace Landed Cost

33. Why supply chain costing? • Determine overall effectiveness of the supply chain • Identify opportunities for improvement • Measure performance • Evaluate alternative supply chain structures • Select supply chain partners • Support “make versus buy” decisions • Negotiate prices • Evaluate effects of technology improvements • Reengineer the supply chain Supplier Materiels Management Inventory Carrying Costs Information costs Physical flow costs Transaction costs Operations Physical Distribution Customer Supply Chain Costs

34. Why use supply chain costing?: customer and channel profitability • Type of customer and distribution channel generally have greater affect on costs than product type • ABC can determine how customers/ channels drive indirect costs • Customer/channel costing provides technique for assessing profitability • Joint action between supply chain members can reduce costs

35. Using ABC to simulate cost changes within the supply chain Process redesign Performance measurement & benchmarking Problem solving Target Setting Activity Analysis Activity- based costing Time Quality Cost Flexibility The Continuous Improvement Cycle, Paul Sharman, CMA Magazine, Vol 66, No. 4

36. Distribution Center Application:Activity Volume Change • Determine how anticipated shifts in activity volumes will affect distribution center costs. • Use cost per activity and activity volume to assess effect • Example: Customers order more frequently but in smaller quantities

37. Activity volume example Activity Cost per Activity Activity Volume Change Load Whse Transfer $150/truck Load Pool Shipment 210/truck -2,100 -10 Load LTL/UPS 16/shipment +300 4,800 Storage 125/pallet/year Process Orders 18/order +300 +5,400 Process Returns 75/return Pull/Put Full Pallets 4/pallet Ship Priority $40/shipment Ship Routine $25/shipment Pick/Build Orders 36/order +300 $10,800 Receive Whse Transfer 95/WT Net change to the DC: +$18,900

38. Using ECR scorecards to determine supply chain capabilities and costs

39. Activity-Based Management • Use non-financial data provided by ABC to drive continuous improvement and reengineering • Link performance measurement system to changes in process costs or profitability • ABC can trace effect of management decisions to changes in total process cost or profitability

40. The Two-Dimensional ABC Model Cost Assignment View Resources Process View Cost Drivers Activities Performance Measures Cost Objects Peter B. B. Turney, Common Cents

41. Cost Assignment View Cost Assignment View Focus of early ABC efforts Objective - more accurate product costs for product mix, sourcing and product design decisions Resources Activities Cost Objects

42. Process View Focus of newer ABC implementations Objective - improving operational processes by identifying (and eliminating) non-value-added activities Process View Cost Drivers Activities Performance Measures

43. Balanced scorecard approach How do we look to shareholders? Financial Perspective Goals Measures How do customers see us? What must we excel at? Internal Business Perspective Customer Perspective Goals Measures Goals Measures Innovation and Learning Perspective Goals Measures Can we continue to improve and create value? Kaplan, Robert S., and David P. Norton, “The Balanced Scorecard - Measures That Drive Performance,” Harvard Business Review, January-February 1992, pp. 71-79.

44. Vendor/Carrier Evaluation Use ABC to assess current carriers and vendors: • Vendor selection affects the costs of ordering, expediting, receiving, inspection, production, and distribution • ABC provides a means of more accurately tracing how vendor decisions affect total costs • Purchasing managers can use “total cost of ownership” in vendor selection and evaluation • Activity analysis opens potential for exploiting vendor-buyer linkages to reduce costs and differentiate service

45. Key References • Turney, Peter B. B., Common Cents: The ABC Performance Breakthrough, Portland, OR: Cost Technology, 1993. • Player, Steve and David Keys, Activity-Based Management: Arthur Andersen’s Lessons from the ABM Battlefield, New York: Mastermedia Ltd., 1995 • Journal of Cost Management published by Warren, Gorham & Lamont • Brinker, Barry, editor, Emerging Practices in Cost Management: 1996 Edition, Warren, Gorham & Lamont, 31 St. James Avenue, Boston, MA 02116, (800) 950-1213 • Cokins, Gary, Activity-Based Cost Management: Making It Work, Chicago, IL: Irwing Professional Publishing, 1996