Measure Costs Right

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Use activity based costing to guide corporate strategy.

Measure osts

Right

Make the Right Decisians

by Robin Cooper and Robert

S.

Kaplan

Managers in companies selling m ulti ple products

are making im porta nt decisions about pricing, prod-

uct mix, and process technology based on distorted

cost information. W hat s worse, alternative informa-

tion rarely exists to alert these managers that prod-

uct costs are badly flawed. Most companies detect

the problem only after their competitiveness and

profitability have deteriorated.

Distor ted cost information is the result of sensible

accounting choices made decades ago, when most

companies m anufactured a narrow range of products.

Back then, the costs of direct labor and materials, t he

most important production factors, could be traced

easily to individual products . Disto rtions from allo-

cating factory and corporate overhead by burden

rates on direct labor we re minor. And th e expense of

collecting and processing data made it hard to justify

more sophisticated allocation of these and other in-

direct costs.

Today, product lines and ma rketing channels have

proliferated. Direct labor now rep resen ts a small frac-

tion of corporate costs, while expenses covering fac-

tory support operations, marketing, d istr ibution,

engineering, and other overhead functions have ex-

ploded. But mo st com panies still allocate these rising

overhead and support costs by their dim inishing di-

rect labor base or as with marketing and distribution

costs, not at all.

These simplistic- approaches-are-no-longer-j-iistifi:^

able - especially given the p lum me ting costs of infor-

ma tion technology. They can also be dangerous. In-

tensified global competition and radically new pro-

duction technologies have.made accurate product

cost information crucial to com petitive success.

Bad information on

product

costs

ieads to bad

com petitive strategy

We have written extensively on the shortcomings

of typical cost accounting system s. In this article we

present an alternative approach, whic h we refer to as

act iv i ty -base d cos t ing . The theory beh ind our

meth od is sim ple. Virtually all of a company s activi-

ties exist to support the production and delivery of

today s goods and services. The y sho uld therefore all

be considered product

costs.

And since nea rly all fac-

Robin ooper is associate professor of business adminis

tration at the Harvard B usiness Sch ool and a fellow of

the Institute of Chartered Accoun tants in England and

Wales. Robert

S

Kaplan is Arthur Lowes Dickinson Pro

fessor of Accounting at the Harvard Business School and

professor of industrial administration at Carnegie Mel

lon University. This is his fourth article for HBR .

HARVARD BUSINESS REVIEW Sep temb er-Oe tober 1988



tory and corporate supp ort costs are divisible or sepa-

rable, they can be split apart and traced to individual

prod ucts or produ ct families. The se costs include:

Logistics

Production

Ma rketing and Sales

Distribution

Service

Technology

Financial Ad ministration

Information Resources

General Administration

Convent ional economics and management ac-

counting treat costs as variable only if they change

Vi^ith short-term fluctuations in output. W e (and oth-

ers) have found that many important cost catego-

ries vary not w ith short-term changes in output but

vi^ith changes over a period of years in the design,

mix, and range of a company's products and cus-

tom ers. An effective sys tem to measu re prod uct

costs must ident ify and assign to products these

costs of complexity.

Many managers understand intuitively that their

accounting systems distort product costs, so they

ma ke informal adjustments to compensate. But few

can predict the magnitude and impact of the adjust-

m ents they should be making.

Consider the experience of a leading m anufacturer

of hydraul ic valves whose product l ine included

thousands of items. About 20% of the valves gener-

ated 80% of total reven ues, a typical ratio for m ulti-

produ ct orga nizations. Of even greater interest, 60%

of the products genera ted 99% of the revenues .

Nonetheless , management remained enthus ias t ic

about the 4 0 of its products th at generated only 1%

of revenue s. According to its cost system , these spe-

cialty items had the best gross margins.

An ana lysis using activity-based co sting told

a

very

different story. More than 75% of this company's

products (mostly the low-volume items) were

losing

money. The products that did make money (fewer

than one in four) generated more than 80% of sales

an d 3 0 0 of net profits.

Top executives may be understandably reluctant

to abandon existing product cost system s in favor of a

new approach that reflects a radically different phi-

losophy. W e d o not advocate such an abrupt overhaul.

The availability of cheap, powerful personal com-

puters , spread sheets, and data-base languages allows

businesses to develop new cost systems for strate-

1.

See Robert

S .

Kaplan and

H .

Thomas Johnson,

Relevance

Lost

The Rise

an d all of Management Accounting

(Boston: Harvard Business School

Press,

1987) and Robin Cooper and R obert S. Kaplan, How Cost Ae-

eounting Distorts Produet Costs, Management Accounting April

1 9 8 8 , p . 2 0 .

gic purposes off-line from official accounting sys-

tems. Companies don't have to com mit their e ntire

accoun ting system to activity-based c osting to use it.

Indeed, activity-based c osting is as mu ch a tool of

corporate strategy as it is a formal accounting sys-

tem . Decisions ab out pricing, marketing, produ ct de-

sign, and mix are among the most important ones

managers make. None of them can be made effec-

tively wi tho ut accu rate knowledge of produ ct costs.

W ha t D is to r ts Cos t Da ta

Product cost distortions occur in virtually all or-

ganizations producing and selling multiple products

or services. To understand why, consider two hypo-

thetical plants turning out a simple product, ball-

po int pen s. Th e factories are the same size and

have the same capital equipment. Every year Plant I

makes one million blue pens. Plant II also produces

blue pen s, but on ly 100,000 per

year T o

fill the plant,

keep the work force busy, and absorb fixed costs.

Plant II also produces a variety of similar products:

60,000 black pens, 12,000 red pens, 10,000 lavender

pens, and so o n . In a typical year Plant II produces up

to 1,000 produ ct variations with volum es ranging b e -

tween 500 and 100,000 units. Its aggregate annual

output equals the one million units of Plant I , and it

requires the same total standard direct labor hours,

machine hours, and direct material.

Despite the similarities in product and total out-

put, a visitor walking through the two plants would

notice dramatic differences. Plant II would have a

much larger production support staff-more people

to schedule machines, perform setups, inspect items

after setup, receive and inspect incoming materials

and parts, move inventory, assemble and sh ip orders,

expedite orders, rework defective items, design and

implement engineering change orders, negotiate

with vendors, schedule materials and parts receipts,

and update and program the m uch larger computer-

based information system . Plant II wou ld also oper-

ate with considerably higher levels of idle t ime,

overtim e, inventory, rework, and scrap.

Plant II's extensive factory support resources and

production inefficiencies generate cost-system dis-

tortions. Most companies allocate factory support

costs in a two-step process. First, they collect the

costs into categories that correspond to responsibil-

ity centers (production co ntrol, quality assurance, re-

ceiving) and assign these costs to operating depart-

me nts. Many com panies do this first step very well.

But the second step - tracing costs from the operat-

ing departments to specific products-is done sim-



MEASURING COSTS

plistically. Many companies still use direct labor

hours as an allocation base. Others, recognizing the

declining role of direct labor, use two additional allo-

cation bases. Materials-related expenses (costs to

purchase, receive, inspect, and store materials) are al-

located directly to products as a percentage markup

over direct m aterials costs. And mac hine hours, or

processing time, are used to allocate production costs

in highly automated environments.

Whether Plant II uses one or al l of these ap-

proaches, its cost system invariably-and mistaken-

ly- repor t s product ion cos ts for the high-volume

product (blue pens) that greatly exceed the costs

for the same produ ct built in P lant L One does no t

need to kno w m uch about the cost system or the pro-

duction process in Plant II to predict tha t blue pens,

wh ich represent 10 of outp ut, will have about 10

of the factory costs allocated to them. Similarly, lav-

ender pens, wh ich represen t 1 of Plant II's outpu t,

will have about 1 of the factory's costs allocated to

the m . In fact, if the stand ard o utpu t per unit of direct

labor

hours,

machine h ours, and materials quan tities

are the same for blue pens as for lavender pens, the

two types of pens will have identic l reported costs

Existing cost syst ms frequently

understate profits

on li igh volume products

and overstate profits on

specialty items.

- even though lavender pens, which are ordered,

fabricated, packaged, and shipped in much lower

volumes, consum e far mo re overhead per un it.

Think of the strategic consequences. Over time,

the market price for blue pens, as for most high-

volu me prod ucts, will be determ ined by focused and

efficient producers like Plant I. Managers of Plant II

will notice that their profit margin on blue pens is

lower th an o n their spe cialty products. Th e price for

blue pens is lower th an for lavender

pens,

but the cost

system reports that blue pens are as expensive to

ma ke as the lavender.

While disappointed w ith the low margins on blue

pens. Plant II's managers are pleased they're a full-

line producer. Custome rs are willing to pay p remi-

um s for specialty produc ts like lavender pens, which

are apparent ly no more expensive to make than

commodity-type blue pens. The logical strategic re-

sponse? De-emphasize blue pens and offer an ex-

panded line of differentiated products with unique

features and options.

In reality, of course, this strategy w ill be disas trous

Blue pens in P lant II are cheaper to mak e than laven

der pens-no matter what the cost system reports

Scaling back on blue pen s and replacing the lost out-

pu t by adding new mod els will further increase over

head. Plant II's managers will simmer with frustra-

tion as total co sts rise and profitability goals rem ain

elusive. An activity-based cost system would no

generate distorted information and misguided stra-

tegic signals of this sort.

Designing an Activity Based

Cost System

Th e first step in designing a new prod uct c ost sys

tem is to collect accurate data on direct labor and m

terials costs. Next, examine the demands made by

particular produ cts on indirect resources. Three rules

should guide this process:

1. Focus on expensive resources.

2. Emphasize resources whose consumption va

ies significantly by product and product type,- look

for diversity.

3 . Focus on resources whose d emand patterns a

uncorrelated with traditional allocation measures

like direct labor, processing time , and m aterials.

Rule 1 leads us to resource ca tegories wher e th e

new costing process has the p otentia l to ma ke big dif

ferences in product costs. A company that makes in

dustrial goods with a high ratio of factory costs to

total costs will wan t a system th at emphasizes trac

ing manufacturing overhead to products. A con

sumer goods producer will want to analyze its mar

keting, distribution, and service costs by produc

l ines ,

channe l s , cus tomers , and r eg ions . H igh

technology companies must s tudy the demands

mad e on engineering, product im prov eme nt, and pr

cess development resources by their different prod

ucts and product lines.

Rules 2 and 3 identify resources with the greates

potential for distortion under traditional systems

They point to activities for which the usual surro

gates-labor hours, material quantities, or machine

hours-do not represent adequate measures of re

source consum ption. The central question is, which

parts of the organization tend to grow as the com

pany increases the diversity of its product line, its

processing technologies, its customer base, its mar

keting chann els, its supplier base?

The process of tracing

costs,

first from re sourc es

activities and then from activities to specific prod

ucts, carmot be done with surgical precision. We ca

not est imate to four signif icant digi ts the added



A l l o c a t in g C o s t s u n d e r a n A c t iv i t y B a s e d S y s t e m

The process of designing and implementing an

activity-based cost system for support departments

usual ly begins with interviews of the department

heads. The interviews yield insights into depart-

mental operations and into the factors that trigger

departmental activities. Subsequent analysis traces

these activities to specific pro ducts.

The fol lowing example i l lustrates the act ivi ty-

based costing process for an inventory control de-

p a r t m e n t r e s p o n s i b l e f o r r a w m a t e r i a l s a n d

purc ha se d c ompone nt s . The a nnua l c os t s a s so-

c i a t e d wi t h t he de pa r t me nt (ma i n l y pe r sonne l

costs) are 500,000.

Interview D epartment Head

Q: How m any peo ple work for you?

A: Twelve.

Q: W hat do they do?

A: Six of them spend most of their time handling

Incoming shipm ents of purchased parts. They han-

dle every thing-fro m docum enta t ion to t ransfer-

ring parts to the W IP stockroom. Three others work

in raw materials. After the material clears inspec-

tion, they move it into inventory and take care of

the paperwork.

Q: Wh at determines th e time required to process an

incoming shipment? Does i t ma tter if the sh ipment

is large or small?

A: N ot for parts. They go directly to the WIP stock-

room , and unless it 's an extremely large shipme nt it

can be handled in one t r ip . Wi th raw mater ia l s ,

though, volume can play a big role in processing

time. But there are only a few large raw material

shipments. Over the course of a year, the time re-

quired to process a part or raw material really de-

pends on the number of times it 's received, not on

the size of the shipm ents in wh ich i t comes.

Q: W hat othe r factors affect you r dep artm en t 's

work load?

A: Well, there are three peo ple I haven 't discussed

yet. They disburse raw material to the shop floor.

Again, volume is not really an issue; it 's more the

number of times material has to be disbursed.

Q: D o you usual ly disburse the total amou nt of ma-

terial required for a production run all at once, or

does it go out in smaller quan tities?

A: It varies with the size of the ru n. On a big run we

can't disburse i t al l at once—there would be too

much raw material on the shop floor. On smaller

runs-and I 'd say that 's 80% of al l runs-we'd send

it there in a single trip once setup is com plete.

Design the System

After th e interview, the system designer can use

the num ber of people involved in each activity to al-

locate the dep artme nt's 500,000 cost:

Activity

Receiving

purchased parts

Receiving

raw material

Disbursing

material

People

6

3

3

Ibtal Cost

250,000

125,000

125,000

In 1 9 8 7 , this company received 25,000 ship men ts

of purchased parts and 10,000 shipments of raw

materials. The factory mad e 5,000 production run s.

Di v i d i ng t he se t o t a l s i n t o t he suppor t do l l a r s

associated with each activity yields the following

costs per unit of activity:

Activity

Allocation Measure Un it Cost

Receiving

purchased parts

Receiving

raw material

Disbursing

material

Number of ship-

ments p r year

Numb er of ship-

ments p r year

Number o f

production runs

10 per

shipment

12.50 per

shipment

25 per

run

We can now at tribute inventory control support

costs to specific products. Suppose the company

manufactures 1,000 units of Product A in a year.

Product A is a comp lex product with more th an 50

purchased parts and several different types of raw

mater ial. Du ring the year, the 1,000 u nits were as-

sembled in 10 different prod uction ru ns req uiring

200 purchased parts shipm ents and 50 different raw

mate rial shipm ents. Product A incurs 2,875 in in-

ventory control overhead ( 10x 200 12 . 50x50

-F 25 X10) to produce the 1,000 un its, or 2.88 of

inventor y control costs per unit.

Product A also consum ed 1,000 h ours of direct la-

bor out of the factory's total of 400,000 hours. A

l a bor -ba se d a l l oc a t i on sys t e m woul d a l l oc a t e

1,250 of inventory control costs to the 1,000 u nits

produced ( 500,000/400,000 x

1,000

for a per-unit

cost of

1 . 2 5 .

The

2 3 0 %

cost difference betw een th e

act ivi ty-based at t ribut ion ( 2.88) and the labor-

based allocation ( 1.25) reflects the fact that the

complex, low-volume Product A demands a mu ch

greater share of inventory control resources tha n its

share of factory direct-labor hours.



MEASURING COSTS

burden on suppo rt resources of introducing

variatio ns of a prod uct. But it is better to be basically

correct with activity-based costing, say, within 5% or

10 % of the actual demands a product mak es on or-

ganizational resources, than to be precisely wrong

(perhaps by as muc h as

200%

using ou tdated alloca-

tion techniques.

Th e inser t Allocating Costs und er an Activity-

Based Sy stem shows how a comp any might cal-

culate and assign the support costs of a common

m anuf ac t u r i ng ove r head f un c t i o n - r a w m a t e r i -

als and parts control. The principles and methods,

while i l lustrated in a conventional manufacturing

setting, are applicable to any significant collection

of corporate resources in the manufacturing or ser-

vice sector.

The

I m p a c t

of

Act iv ity Bas ed Cost ing

An activity-based system can paint a picture of

product costs radically different from data generated

by traditional systems. These differences arise be-

cause of the system 's more sop histicated approach to

attrib utin g factory overhead, corporate overhead, and

other organizational resources, first to activities and

then to the produ cts that create deman d for these in-

direct resources.

Manufacturing

Overhead

Let's look more closely

at the manufacturer of hydraulic valves mentioned

earlier. Cost information on seven representative

products is presented in the table How A ctivity-

Based Co sting Changes Product Profitability. Und er

the old cost system , the overhead charge per unit did

not differ much among the seven valves, ranging

from $5.34 to $8.88. Under the new system, which

traces overhead costs directly to factory support ac-

tivities and then to products, the range in overhead

cost per unit widened dramatically-from $4.39 to

$77.64. W ith four low- to med ium-v olum e products

(valves 2 through 5) , the overhead cost est im ate

increased by 10 0% or more . For the two highest vol-

um e prod ucts (valves 1 and 6), the ov erhead cost

declined.

The strategic consequences of these data are enor-

mo u s .

Under the labor-based cost system , valve 3-

was considered the most profitable product of the

seven, with a gross marg in of 47% . The activity-

based system, in contrast, revealed that w hen orders

for valve 3 arrived, the company would have done

better to mail its customers cash to buy the valves

elsewhere than to make th em

itself

Labor-based cost system s do n't always u nderesti-

ma te the overhead dema nds of low-volum e products.

Valve

7,

with the second lowest volum e in the group,

shows a marked decrease in overhead under an

activity-based system. Why? Valve 7 is assembled

from components already being used on the high-

volum e products (valves 1 and 6). Th e bulk of any fac

tory's overhead costs are associated with ordering

parts,

keeping track of them, inspecting them, and

set t ing up to produce components . For par ts and

components ordered or fabricated in large volumes,

the per-unit impact of these transaction costs is mod-

est. Therefore, specialized products assembled from

high-volume components will have low production

costs even if shipping volum e is not high.

Marketing Expenses

Th e redesign of cost sys tems

should not be limited to factory support costs. Many

companies hav e selling, general, and adm inistrative

(SG&A) expenses that exceed 20 % of total revenue s.

Yet they treat these costs as period expenses, not

charges to be allocated to products. Wh ile such be-

low the [gross margin] line treatm ent may be ade-

quate, even required, for financial accounting, it is

poor practice for m easuring produ ct co sts.

We studied a building supplies company that dis-

tributed its products through six channels-two in

the consumer market and four in the commercial

mark et. Across all its products, this com pany had an

average gross m argin of 34% . Ma rketing costs for the

six channels averaged 16.4% of sales, wit h general

and administrative expenses another 8.5 % . (The ta-

bles entitled OEM Ch anges from a Laggard...to a

Solid Performer present information on the four

comm ercial channels.)

With op erating profits in the c omm ercial sector at

only about 10% of revenues, the com pany was look-

iVIa n a g e n n e n t th o u g h t v a i v e 3

wa s a c a s h c o w . It m ig h t

as w ll h a v e m a i le d c h e c ks t o

its cus tom ers.

ing to improve its profitability. M ana gem ent decided

to focus on SG&A expen ses. Previously, the co mp any

had allocated SG&A costs by assigning 25 % of sales

- the company average-to each dist r ibut ion seg-

me nt. A more sophisticated an alysis, similar in phi-

losophy to the overhead analysis performed by the

hydraulic valve company, produced striking chan ges

in product costs.

The OEM business was originally a prime target

for elim inatio n. Its 27% gross ma rgin and laggard 2 %

operating margin put it at the bottom of the pack

among comm ercial channels. But the OEM channel



H o w A c t iv i t y B a s e d C o s t in g C h a n g e s P r o d u c t P r o f i t a b i l i t y

Manufacturing Overhead

P er

Unit

ross

Margin

Valve

Number

1

2

3

4

5

6

7

Annual

Volume

units)

43,562

500

53

2,079

5 67

11,196

42 3

Old

System

$5.44

6.15

7.30

8.88

7.58

5.34

5.92

New

System

$ 4.76

12.86

77.64

19.76

15.17

5.26

4.39

Percent

Difference

-

12.5%

-1-109.0

-t-964.0

-1-123.0

-f-100.0

- 1.5

- 26.0

Old

System

41 %

30

47

26

39

41

31

New

System

46%

- 24

- 2 5 8

- 32

2

41

43

*W e

are not confident th at th e table's figures are exactly cone ct. For examp le, stude nts of this case have estimated th e appropriate overhead charge on

valve 3 |listed a t $77.64 per un it| to he as low as $64 and as high as

$84.

W hatever the exact figure, the difference betw een this activity-based cost and

the original estimate ($7.30 per unit) suggests that the ciirrent labor-based system is seriously flawed.

used virtually no resources in several major selling

categories: advertising, catalog, sales prom otion, and

warranty. In the remaining selling categories, the

OEM cha nnel used prop ortionately fewer resources

per sales dollar than the other major channels. Its

marketing expenses were 9% of sales, well helow

the 15% average for the four commercial channels.

A sounder estimate of OEM operating margin was

9%, not 2% .

The OEM segment looked even hetter after the

company extended the analysis by al locat ing in-

vested capital to specific channels. The OEM busi-

ness required far less investment in working capi-

t a l - accoun t s r ece i vab l e and i nven t o r y - t han t he

other commercial channels. Thus, even though the

OEM channel had a below-average gross margin, its

bottom-line retum-on-investment turned out to be

higher than th e com mercial average.

Other Corporate Overhead

Virtually all organiza-

tional costs, not just factory overhead or marketing

expenses, can and should be traced to the activi-

t ies for which these resources are used, and then

to the divisions, channels , and product l ines that

consum e them. W eyerhaeuser Company recent ly

instituted a charge-back system to trace corporate

overhead depar tment cos t s to the ac t iv i t i es tha t

drive them.^

For exam ple, W eyerhaeuser's financial services de-

partment analyzed all the activities i t performed-

including data-base administration, general account-

ing, accounts payable and receivable, and invoic-

i ng - t o de t e r m i ne w ha t f ac t o r s c r ea t e dem ands

for them. A division dealing with a small number

2.

See H. Thom as Johnson and Dennis A. Loewe, How W eyerhaeuser

Manages Corporate Overhead Costs,

Management Accounting,

Au -

gust

1987, p.

20 .

of high-volume customers makes very different

demands on activities like accounts receivable from

a division with man y low-volume custom ers. Be-

fore ins t i tu t in g the charge-back sys tem , W eyer -

haeuser applied the cost of accounts receivable and

other functions as a uniform percentage of a divi-

sion's sa le s- a driver that bore little or no relation to

the activities that created the administrative work.

No w it allocates costs based on wh ich divisions (and

product lines) generate the c osts.

Similarly, companies engaged in major product de-

velopment and process improvements should at-

tribu te the co sts of design and engineering resource s

to the products and product lines that benefit from

them. Otherwise, product and process modification

costs will be shifted o nto produ ct lines for wh ich lit-

tle development effort is being performed.

W h e r e

D oe s

Ac t iv i ty Ba sed

C ost ing Stop?

W e believe that only two types of costs should be

excluded from a system of activity-based costing.

First , the costs of excess capacity should not be

charged to individual products. To use a simplified

example, consider a one-product pla nt wh ose practi-

cal produ ction capacity is one million u nits per year.

The plant 's total annual costs amo unt to $5 million.

At full capacity th e cost per un it is $5 . Th is is the

unit product cost the company should use regardless

of the plant 's budgeted production vo lume. The cost

of excess or idle capacity shou ld be trea ted as a sepa-

rate l ine it e m -a cost of the period, not of individ-

ual products.



MEASURING COSTS

O E M

C h a n g e s

ro m a L a g g a r d

Profits by Comm eicial Distribution Channel Old System)

Contract

Industrial

Suppliers

Goverament OEM

Tbtal

Commeicial

Annual Sales

in thousands of dolíais)

$79,434 $25,110 $422

$9,200 $114,166

Gross Margin

34

41%

2 3

2 7 3 5

Gross Profit

$27,375 $10,284 $136 $2,461 $ 40,256

SG&A Allowance*

in thousands of dollars)

$19,746 $ 6 242

$105

$2,287

$ 31,814

Operating Profit


7,629

4,042

31

174

11,876

Operating Margin

10% 16%

7

2

10%

Invested Capital Allov/ancet

in thousands of dollars) $33 ,609 $10 ,624 $179

$3,893

$ 48,305

Return on Investment

23 38

17%

*SG&A allowance

for each chan nel is

25%

of that channel's

revenues,

tinvested capital

allowance for each channel is 42% of that channel's revenues.

4

2 5

Many companies, however, spread capacity costs

over budgeted volume. Returning to our example, if

demand exists for only 500,000 units, a traditional

cost system w^ill report that each unit cost $10 to

build ($5 million /500 ,000) even tho ug h v^^orkers and

machines have become no less efficient in terms of

what they could produce. Such a procedure causes

produ ct costs to fluctuate erratically wi th changes in

assumed product ion volume and can lead to the

dea th spiral. A dow ntur n in forecast demand cre-

ates idle capacity. The cost system reports higher

costs.

So management raises prices, which guaran-

tees even less demand in the future and still higher

idle capacity costs.

The second exclusion from an activity-based cost

system is research and developm ent for entirely new

products and lines. We recommend split t ing R&D

costs into two categories: those that relate to im-

provements and modifications of existing products

and lines and those that relate to entirely new prod-

ucts. The first category can and should be traced to

the products that will benefit from the development

effort. O therw ise, the c osts will he spread to p roducts

and lines that bear no relationship to the applied

R 6 L D

program.

The second category is a different animal. Finan-

cial accounting treats RSUD as a cost of the period

in which it takes place. The management account-

ing system, in contrast, should treat these costs as

investments in the future. Companies engaged in

extensive R&D for products with short l ife cycles

should me asure costs and revenu es over the life cycle

of their produc ts. Any periodic assessmen t of product

profitability will be misleading, since it depend s on

the arbitrary amortization of investment expendi-

tures including R&X).

Strategic mpl icat ions

The examples we've discussed demonstrate how

an activity-based cost system can lead to radically

different evaluations of product costs and profitabil-

i ty than more simplist ic approaches. I t does not

imply that because some low-volume products (lav-

ender pens or valve 3) now are unprofitable, a com -

pany should immediately drop them . Man y custom -

ers value having a single sourc e of

supply,

a big reason

comp anies becom e full-line produ cers, it may b e im-

possible to cherry pick a l ine and build only prof-

i table products . If the mult iprod uct pen compan y

wa nts to sell its profitable blue and b lack pens, it ma y

have to absorb the c osts of filling the occasional order

for lavender pen s.

Once executives are armed w ith m ore reliable cost

information, th ey can ponder a range of strategic op-

tions. Dropping unprofitable products is one. So is

raising prices, perhaps drastically. M any low-vo lume

products have surpris ingly low price elast ici t ies .

Custome rs who w ant lavender pens or valve 3 m ay

be willing to pay muc h m ore than the cu rrent price

On the other hand, these custom ers may also react to

a price increase by switching aw ay from low-vo lume

products. That too is acceptable; the company would

be supplying fewer money-losing ite m s.



t o a S o l id P e r fo r m e r

Profits by Commercial Distribution Channel New System)

Gross Profit

from previous table)

Selling Expenses*

ll in thousands of dollars)

Commission

Advertising

Catalog

Co-op Advertising

Sales Promotion

Warranty

Sales A dministration

Cash Discount

Total

G & A in thousands o f dollars)

Operating Profit


Operating Margin

Invested Capital*

Return on Investment

Contract

27,375

4,682

132

504

416

39 4

64

5 696

892

12,780

6 740

7 855

1 0

33,154

2 4

Industrial

Suppliers

10,284

1,344

38

160

120

114

22

1,714

252

3 764

2,131

4,389

1 7

10,974

4 0

*Selling expenses and invested capital estimated under an activity-based sy stem.

Government

136

12

0

0

0

0

0

20

12

44

36

56

1 3

184

3 0

OEM

2,461

372

2

0

0

2

4

35 1

114

845

781

835

9%

2,748

3 0

Tbtal

Commercial

40,256

6,410

172

664

536

510

90

7,781

1,270

17,433

9 688

13,135

1 2

47,060

2 8

More accurate cost information also raises strate-

gic options for high-volume products. Plant n migh t

consider dropping its prices on hlue pens. The old

cost system, which shifted overhead charges onto

these high-volume products, created a price umhrella

that benefited focused competitors like Plant

I .

Pric-

ing its core product more com petitively m ight help

Plant n reverse a ma rket-sh are slide.

Managers in the building supplies company we

described took several profit-enhancing steps after

receiving the revised cost data by distribution chan-

nels.

They began emphasizing the newly attractive

OEM segment and any new business whe re mark et-

ing costs would be well below the company average.

Information generated by an activity-based cost

system can also encourage companies to redesign

products to use more common parts. Managers fre-

quently exhort their engineers to design or modify

products so they use fewer parts and are easier to

manufacture. But these exhortations will ring hol-

low if the compan y's cost system cann ot identify t he

benefi ts to design and manufacturing simplici ty.

Recall valve 7, a low -volu me p rodu ct m ade from

components fabricated in large volumes for other

products. No w that the com pany can quantify, using

activity-based techniques, the impressive cost bene-

fits of comp onen t standardiza tion, the entire organi-

zation will better understand the value of designing

produ cts for man ufacturability.

Likewise, activity-based costing can change how

m a n a g e r s e v a l u a t e n e w p r o c e s s t e c h n o l o g i e s .

Streamlining the manufacturing process to reduce

setup times, rationalizing plant layout to lower ma-

terial handling costs, and improving quality to re-

duce postproduction inspections can all have major

impacts on product costs -im pa cts tha t become visi-

ble on a product-by-product basis wi th activity-based

costing. A more accurate tmderstanding of the costs

of specialized products may also make computer-

integrated manufacturing (CIM) look more attrac-

tive, since CIM is most efficient in high-variety,

low-volume envirorunents.

Activity-based costing is not designed to trigger

automatic decisions. It is designed to provide more

accurate information about production and support

activities and product costs so that man agem ent can

focus its attention on the products and processes

w ith th e mo st leverage for increasing profits. It helps

managers make better decisions about product de-

sign, pricing, marketing, and mix, and encourages

continual operating improv emen ts. ^

Reprint 88503

HARVARD BUSINESS REVIEW Septem ber-O ctober 1988 3



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Measure Costs Right

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