Cause and Effect in Activity Based Costing

When we talk about costing, it is assumed that we are talking about the Product Cost. We have been trained to calculate the product costs. The reason could be that costing was primarily used in manufacturing industry and for calculating the ‘Inventory Cost’ to be used on the financial results. The same information was then started for pricing the products. Good old days when the price was typically calculated as Cost plus Profit.
Typical Product cost calculation is like

• Manufacturing cost
• Material Cost
• Direct Material costs
• Material overheads ( as % of material cost)
• Direct Labour Production overheads (as % of labour cost or machine hr or labour hr or cost of output)
• Special Direct costs
• Sales Cost (as % of Sales value or volume)
• Administration Cost (as % of Manufacturing cost or Cost of Sales)
  

What is wrong with this calculation?

In a typical product costing method we take all the expenses in the financial accounting to the products. This is call as ‘Fully Allocated Costs (FAC)’. Various regulatory bodies ask specifically the FAC for various products or services. Nothing is wrong in this calculation when you get this for the first time. When the Business Head starts getting this information on a regular interval and she does not see the relation between business changes and the product costs then she starts worrying about the product cost report that is received.

If we take a simple example that in an organization there are three products (A, B, C). Based on the FAC method the products A and C are profit making but the product B is making a marginal loss. The product manager defends for her product saying today it is making losses but it has got future potential and we should continue with the product. After a year the company introduces another product D. Now the FAC is calculated for all the products A, B, C and D. Surprisingly with the new calculations product B starts looking profitable.

Why? Because the same amount of overheads that were distributed over 3 products are now distributed over 4 products. Now the product manager for product B is confused. She says I have not done anything different for my product. Now the questions arises that which is product is correct? One that shows Loss or that shows ‘Profit”. This is where business managers start disbelieving the product costs.

What is the reason?

The basic reason for this is the absence of ‘Cause-and-Effect’ relationship in typical product costing. The assumption is that ‘all-the-costs-should-go-to-product’. This is different than the real business scenario. All the costs are not caused by product only. In any business the causes of the costs are Product, Customer, Built in Capacity and Business Sustenance. We should segregate the expenses in Product Costs, Customer Costs, cost of Capacity Available to Use and Cost to Sustain Business. Once we segregate in this way the same information can be used for various business decisions.

Product Costs - The product cost typically consists of cost to product the product. We can add the cost of any improvements, advertisements, product catalogues any other collaterals etc.

Customer Costs – The cost of selling the product, delivery, recovery expenses and campaigns run for specific customer segments, fulfilling various requests by the customer are all that related to the various customers and not related to the products that they buy. Once we understand and accept this then we can understand that the same product if sold to different customers can bring different amount of profit for the organization. This gives you a more correct (read as ‘real’) profitability than the typical customer profitability calculation.

Cost Available to Use – The management takes the investment decisions and invest in various resources like plant and machinery, people, branches, ATMs etc. This installed capacity causes cost to the organization, which may not be fully utilized by the products or customers. The unused capacity is typically called as ‘Idle capacity’. This term was mainly used for machinery. In the current context we can calculate the capacity of the human resources also and they do not like to be called as ‘Idle’. This is correct in some sense. They are not ‘Idle’ but they are ‘Available to use’.

We will take an extreme example to understand this concept. Let us assume that a bank has installed an ATM in a very remote place for the use of its customers. It spends a lot of money in running the ATM, but very rarely it is used by the customers, because of its location. One fine day a customer uses the ATM to withdraw money. That is the only transaction that happened in that month. If you take all the expenses of running the ATM for that month to the specific customer then this customer will be shown unprofitable almost for whole relationship period.

Cost to sustain business – These are the costs that are caused by various functions like Secretarial, Internal Audit, Accounting finalization etc. These functions are required to run the business, manage the statutory authorities. These costs do not belong to any product or customer. They should be taken to products or customers for any business decision. They can be taken to products only in the case where the statutory authorities ask for FAC. How to then take those costs to products? Well, one can take using any basis and we can debate on the most correct basis till the end, without any conclusion. This is because any basis is not a logical basis.

Activity Based Costing uses this ‘Cause-and-Effect’ relationship while calculating the costs for the organization. Using this method we can also calculate the capacity utilization of the functions like HR, IT, Administration etc. Finally once we segregate the costs like this then it quite simpler to take various business decisions on product pricing, customer pricing, utilization of the resources and improvement in the costs.