Using Activity-Based Costing to ImplementSupply Chain Improvements

Terrance L. PohlenLt Col, USAF, PhD

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

•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

Transportation and logistics managers need more

accurate cost information

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

“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 Magazine12 October 1997

Activity

DIRECTMATERIALS

DirectLabor

Activity

DIRECTMATERIALS

Activity

DIRECTMATERIALS

Activity

DIRECTMATERIALS

OUTPUT $$

Traditional Cost Accounting

DirectLabor

DirectLabor

DirectLabor

Overhead

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

Are U.S. Manufacturers’ AccountingSystems a Major Tool Used in

Management Decision-Making?

Source: National Center for Manufacturing Sciences, Focus, 1993

Yes82%

No18%

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.

SupervisionSupervisionOfficeOffice

SupportSupport UtilitiesUtilities SuppliesSupplies EquipmentEquipment

ReceivingReceiving Put-AwayPut-Away Set-UpsSet-Ups

Resources

Activities

Cost

Objects

Packing &Packing &

ShippingShipping

ProductProductDivision ADivision A

ProductProductDivision BDivision B

ProductProductDivision CDivision C

ProductProductDivision DDivision D

a technique to assign more accurately direct and indirect costs to the activities, customers or products which consume an organization’s resources

Activity-Based Costing

Activity-Based Costing

IS:

An overhead allocation technique which generates the cost of activities

IS NOT:

A bookkeeping system

A consolidation system

GeneralLedger

(accountbalances)

ABCModel

Data

DecisionMakers

Activity-basedinformation

Cost datatranslatedby ABC

ABC translates traditional costing into actionable information for decision-makers

SupervisionSupervisionOfficeOffice

SupportSupport UtilitiesUtilities SuppliesSupplies EquipmentEquipment

ReceivingReceiving Put-AwayPut-Away Set-UpsSet-Ups

Resources

Activities

Cost

Objects

Packing &Packing &

ShippingShipping

ProductProduct

Division ADivision A

ProductProduct

Division BDivision B

ProductProduct

Division CDivision C

ProductProduct

Division DDivision D

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

Activity

DIRECTMATERIALS

DirectLabor

Activity

DIRECTMATERIALS

Activity

DIRECTMATERIALS

Activity

DIRECTMATERIALS

OUTPUT $$

Activity-based costing approach

OverheadDirectLabor

OverheadDirectLabor

OverheadDirectLabor

Overhead

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

Office Labor9%

Dock Labor

32%

Yard Labor5%

Utilities1%

Pickup & DeliveryDrivers

18%

License1%

Fuel7%

Maintenance5%

Depreciation

4%

Insurance2%

Terminal13%

Supervision3%

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

Office Labor9%

Dock Labor32%

Yard Labor5%

Utilities1%

Pickup & Delivery18%

License1%

Fuel7%

Maintenance5%

Depreciation4%

Insurance2%

Terminal13%

Supervision3%

Billing4% Handling

10%

Pickup6%

Deliver LTL17%

Deliver TL8%Accessorial Services

5%

Line haul8%

Scheduling3%

Load line haul6%

Load delivery6%

Unload8%

Maintain vehicles10%

Process Claims4%

Marketing5%

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

Labor

47%

Facility

36%

Supplies10%

MHE2%Supervision

4%Maintenance

1%

LTL Shipping Activity

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

Pick listsPlaced inWindow

Pallet pickssent by RFto Fork lifts

WarehouseSigns for and

Takes Pick List

Property pickedandPalletized

Pallet movedto Shrink

Wrap Area

PalletShrink-Wrapped

Pallet moved to Staging

Area

Pallet pickssent by RFto Fork lifts

WarehousemanAnnotatesWork Log

Orders RequiringCHEP PalletsRe-palletized

Receiving CartageUnload and inspectPutaway

Storage Bulk storageAerosol storage

Transp Planning Pre-shipment schedulingTruckload planningPost-shipment supportTransportation Administration

Picking Manual pickingMechanical pickingStage pallet for orderBuild pallet

Special Handling Adjust pallet heightClamp off/slip sheetSpec Hdling/Warehouse office

Shipping Load palletCheck full palletCheck mixed palletShip international orderShip small package order

Administration ReturnsReworkAdministration

Product

Customer

Brand

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

Billing4% Handling

10%

Pickup6%

Deliver LTL17%

Deliver TL8%Accessorial Services

5%

Line haul8%

Scheduling3%

Load line haul6%

Load delivery6%

Unload8%

Maintain vehicles10%

Process Claims4%

Marketing5%

Customer A32%

Customer B26%

Customer C17%

Customer D10%

Customer E8%

Others7%

Assigning Distribution Center Costs

We assign thecost of thisactivity

Manual pickingReworkUnload & inspectTruckload plngBulk storageAdministration

tothiscost object:

customerbrandproductcustomerproductbrand

usingthisactivity driver

cartons mech pickedcartons reworkedpallets unloadedpounds shippedavg pallet on handno. of cartons shipped

Cost Objects

• The final output of the organization

• Typically a customer, product, service, or distribution channel

• Provides total cost of logistics support

Customer A32%

Customer B26%

Customer C17%

Customer D10%

Customer E8%

Others7%

Cost Object: Bill of Activities

Pickup15%

Billing2%

Line Haul55%

Delivery6%

Dockhandling-Origin10%

Processing Claims1%Dockhandling-

Destination8%

Scheduling3%

Breakout ofCustomer A Costs

Product Division A31%

Product Division B40%

Product Division C

16%

Product Division D13%

ABCResults

Product Division A29%

Product Division B30%

Product Division C20%

Product Division D21%

TraditionalCosting Results

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

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

Benefits Obtained From ABC

Identify cost driver

Performance measures

Improved cost info

Better pricing

Elim redundant work

Cost control

65%

59%

47%

41%

41%

23%

LaLonde and Pohlen, Journal of Business Logistics, 1994

Office Labor9%

Dock Labor32%

Yard Labor5%

Utilities1%

Pickup & DeliveryDrivers

18%

License1%

Fuel7%

Maintenance5%

Depreciation

4%

Insurance2%

Terminal13%

Supervision3%

Load delivery

Billing4% Handling

10%

Pickup6%

Deliver LTL17%

Deliver TL8%Accessorial

Services5%

Line haul8%

Scheduling3%

Load line haul

6%

6%

Unload8%

Maintain vehicles10%

Process Claims4%

Marketing5%

Customer A32%

Customer B26%

Customer C17%

Customer D10%

Customer E8%

Others7%

ABC demonstrateshow logistics resources

and activities are consumed

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

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

Application of activity-based costing tosupply 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

Vendor(Upstream)

Customer(Downstream)

Perspective ofthe Firm

MarketplaceLanded Cost

Total Cost ofOwnership

DPP, ABC

DPP, ABC

Sup

ply

Cha

in C

ostin

g

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

MaterielsManagement

Operations

PhysicalDistribution

Customer

Tra

nsa

ctio

n c

ost

s

Info

rma

tion

co

sts

Ph

ysic

al f

low

cos

ts

Supply Chain Costs

Inve

nto

ry C

arry

ing

Co

sts

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

Using ABC to simulate cost changeswithin the supply chain

TargetSetting

ActivityAnalysis

Processredesign

Activity-basedcosting

Performancemeasurement

& benchmarking

Problemsolving

Time Quality Cost Flexibility

The Continuous Improvement Cycle, Paul Sharman, CMA Magazine, Vol 66, No. 4

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

Activity volume example

Activity

Load Whse Transfer

Load Pool Shipment

Load LTL/UPS

Storage

Process Orders

Process Returns

Pull/Put Full Pallets

Ship Priority

Ship Routine

Pick/Build Orders

Receive Whse Transfer

Cost per Activity

$150/truck

210/truck

16/shipment

125/pallet/year

18/order

75/return

4/pallet

$40/shipment

36/order

95/WT

Activity Volume

+300

+300

-2,100

4,800

+5,400

$10,800

-10

+300

Net change to the DC: +$18,900

$25/shipment

Change

INDICATOR LEVEL 0 LEVEL 1 LEVEL 2 LEVEL 3 LEVEL 4

ReceivingOptimization

Non-staged or unitizedshipments manuallyreceived with driversoften expected to unload;information processed attime of delivery with noadvanced preparationand poor document andload integrity

Pallets staged to reducehand unloading andimprove unloadingefficiency; informationprocessed at time ofdelivery with no advancedpreparation and limiteddocument and loadintegrity

Pallets staged and loadedto minimize in-transitdamage; manufacturerelectronically transmitsinformation (ASNs andEDI) prior to delivery toupdate files, increasedocument integrity andallow retailer receiptpreparation; somedelivery exceptions

Manufacturer hasestablished cost effectivefreight configurationguidelines to optimizespace and unload time fordifferent load types,supports drop and hook,uses EDI and ASNtransmissions; allowsretailer receiptpreparation (matching,label printing, etc);minimal deliveryexceptions

Joint assessment foreach order and shipmentto reduce receiving timeand space, using freightconfiguration, “tie andhigh” capability, and DCreceiving area utilization(drop and hook usedwhere applicable)supported by EDI andASN transmissions thatsupport pre-deliveryactivities; rare deliveryexceptions

CrossDock—CustomCubes

Cross docking at retailerDC not supported bymanufacturer

Cross docking supportedonly for promotionalitems for largest storesand with extended orderlead time

Cross docking done forpromotional items formost stores and withabove normal lead times;beginning to support turnitems

Manufacturer supportssystemic cross dockingfor both promotional andturn items, primarily forsingle SKU pallets;normal lead times;deliveries accompaniedby ASNs/Pallet UCC 128

Manufacturer supportscross docking of store-ready pallets; minimallead times; deliveriesaccompanied by ASNs

Pallet andCaseLabels(Barcoding)

No labels supplied orsupported

Testing UCC/EAN-128pallet labeling withretailer; UPC (SCC-14)bar codes available onmost outgoing cases

Supports UPC (SCC-14)and UCC/EAN-128 (SSC-18) on outgoing casesand pallets; included onASNs, but not used toreceive via scanning;considering complianceissues

Pallet and case labelingis integrated fully withASNs to automatereceiving via scanning;consistent compliancewith industry standards

Joint implementation ofpallet and case labelingwith retailer based on acomplete analysis of allcosts including the cost ofapplying labels;consistent compliancewith industry standards

Using ECR scorecards to determine supply chain capabilities and costs

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

The Two-Dimensional ABC Model

Activities Performance Measures

Cost Drivers

Cost Objects

Resources

Process View

Peter B. B. Turney, Common Cents

Cost Assignment View

Cost Assignment View

Focus of early ABC efforts

Objective - more accurate product costs for product mix, sourcing and product design decisions

Activities

Cost Objects

Resources

Cost Assignment View

Process View

Focus of newer ABC implementations

Objective - improving operational processes by identifying (and

eliminating)

non-value-added activities

Activities Performance Measures

Cost Drivers

Process View

Balanced scorecard approach

Financial Perspective

Goals Measures

Internal Business Perspective

Goals Measures

Innovation andLearning Perspective

Goals Measures

Customer Perspective

Goals Measures

How do we lookto shareholders?

What must we excel at?

Can we continue toimprove and create value?

How do customers see us?

Kaplan, Robert S., and David P. Norton, “The Balanced Scorecard - MeasuresThat Drive Performance,” Harvard Business Review, January-February 1992, pp. 71-79.

Vendor/Carrier Evaluation

• 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

Use ABC to assess current carriers and vendors:

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