Cooper and Kaplan

Consider a purchasing department in which the equivalent of 10 full-time people [the resource supplied] are committed to processing purchase orders [the activity performed]. If the monthly cost of a full-time employee is $2,500,^ the monthly cost of the activity, “Process Purchase Orders,” equals $25,000. Assume that each employee, working at practical capacity, can process 125 purchase orders per month, leading to an estimated cost of $20 for processing each purchase order. ® Thus, the organization, each month, spends $25,000.

This expenditure provides a capability to process up to 1,250 purchase orders [the activity availability] during the month. During any particular month, the department may be asked to process fewer purchase orders, say only 1,O(X). At an estimated cost of $20 /purchase order, the ABC system would assign $20,000 of expenses to the parts and materials ordered by the purchasing department that month. The remaining $5,000 of monthly operating expenses represents the cost of unused capacity in the purchase order processing activity.

This example shows why companies need two different reporting systems. The periodic financial statements provide information on the cost of activities supplied each period (the $25,000 monthly expense in the purchasing department); and the activity-based cost system provides information on the quantity (1,000 purchase orders) and the estimated cost ($20,000) of activities actually used in a period. The difference ($5,000) between the cost of activities supplied ($25,000) and the cost of activities used ($20,000) equals the cost of unused capacity (or capacity shortage) during the period.

And this difference is measured for each organizational activity, defined by the ABC system. ” The two systems provide different types of information for management. The cost of resources supplied is relevant for predicting near-term spending. Spending on many organizational resources will not vary with shortterm fluctuations in activity volume and mix. That is why these costs have been classified as “fixed” in numerous accounting systems and textbooks.

But measuring and managing the operating expenses of most organizational resovirces as fixed in the short-run does not give much insight as to why the resources were acquired, what the resources are currently being used for, and the level of resources that will likely be required in the future. While the cost of supplying the resources may be fixed in the short-run,^ the quantity of these resources used each period fluctuates based on activities performed for the outputs produced. Activity-based systems measure the cost of using these resources, even though the cost of supplying them will not vary, in the short run, with usage.

The ABC resource usage cost information can be used by managers to monitor and predict the changes in demands for activities as a function of changes in output volume and mix, process changes and improvements, introduction of new technology, and changes in product and process design. As such changes are contemplated, managers can predict where either shortages or excesses of capacity will occur. The managers can then either modify their decisions so that activity demand will be brought into balance with activity supply, or they can change the level of activities to be supplied in forthcoming periods.

For example, if newly designed custom products, with many unique parts and materials, are added to the mix, managers may forecast a much higher demand for the purchasing activity, perhaps now requiring that 2,000 purchase orders a month be processed. With no change in the process or efficiency of the processing purchasing order activity, this increase in demand will exceed available suphis cost includes the costs of fringe benefits, secretarial and administrative support, equipment costs, and space charges associated with each purchaMng department employee. Note that this calculation does not use actual activity levels during the period; the denominator represents service capacity not actual usage of this capacity. ^Later in the paper, we will show how to develop a new format for the periodic income or expense statement that highlights the costs of resources used and unused. ^More accurately, the spending on (or expenses assigned to) these resources will be independent of the volume and mix of outputs produced during the period.

Activity-Based Systems: Measuring the Costs of Resource Usage ply by 750 purchase orders per month, a shortage that can be relieved by hiring six more piirchasing clerks. The ABC model, in addition, will trace purchasing costs directly to the newly designed custom products that are creating the demand for these additional purchasing resources, enabling managers to determine whether the revenues received fully compensate the organization for the cost of all the resources used to produce and deliver these products.

Of course, supplying additional purchasing clerks is only one possible action that the managers can take to the contemplated activity shortage. The engineering department can be asked to redesign the custom products so that they make more use of existing part numbers, an action that would reduce the amount of additional purchase orders required. Or the managers can search for process improvements or technology that would make the piirchase order processing activity more efficient, perhaps raising the monthly output per person from 125 to 200 purchase orders.

Thus, measuring the costs of resources supplied indicates to managers the level of current spending (or, more generally, expenses) and the capacity to perform activities that this spending has provided. Measuring the costs of resources used by individual outputs provides information for managerial actions, as will be discussed more fully subsequently in the paper. II. ISN’T THE UNUSED CAPACITY CALCULATION JUST A NEW NAME FOR THE VOLUME VARIANCE? The calculation of unused capacity each period looks, at first glance, suspiciously like the traditional cost accounting volume variance.

But the formulas: Activity Availability = Activity Usage + Unused Capacity = Cost of + Cost of Activity Unused Used Activity differ from the standai’d cost calculations of a volume variance in several significant ways. or Cost of Activity Supplied First, and most obviously, volume variances are reported only in aggregate financial terms since traditional cost systems do not identify the quantity of overhead resources supplied or used. The activity-based approach reports both the quantity (number of piirchase orders not written) and the cost of unused capacity.

Second, traditional volxune variances are often calculated with a denominator volume based on budgeted production, rather than practical capacity. In the activity-based approach, the “denominator voliime” must always be the practical capacity of the activity being supplied, not the anticipated volume. And, third, the traditional cost accounting procedure of allocating overhead with a denominator volume is viewed as useful only for inventory valuation, not to provide information relevant for management; e. g..

The preselected production volume level of the application base used to set a budgeted fixed-factory-overhead rate for applying costs to inventory is called the denominator volume. In summary, the production volume variance arises because tlie actual production volume level achieved usually does not coincide with the production level used as a denominator volume for computing a budgeted application rate for inventory costing of fixed-factory overhead. ^ (emphasis added) Note how students are instructed that the calculation involves only the application of (socalled) ^jced-factory overhead to units of production.

Clearly, the volume variance is viewed, at least in textbooks (but not always in practice), as a cost accounting exercise for financial statements that is devoid of managerial significance. These three differences between volume variances and measurements of imused capacity, while real, are not, however, the most important distinction. The cost accounting calculation that leads to a volume variance uses a measure of activity volume for the period (i. e. , the denominator voliune, also called the allocation base) that varies with the number of units produced. Direct labor hours, units of ^Charles T.

Homgren and George Foster, Cost Account- ing: A Managerial Emphasis, Seventh Edition (Prentice-Hall, 1991), pages 258 and 265. Accounting Horizons I September 1992 production, materials purchases, and machine hours are typical allocation bases used by traditional systems to assign factory expenses to products in production cost centers. ^” Implicitly, this procedure assumes that factory expenses are used by products in proportion to the overhead allocation base, i. e. , proportional to volume of units produced. In practice, of course, this assumption is not valid.

Activity-based cost systems use separate activity cost drivers (the ABC generalization of an assignment or allocation base) for each activity. The activity cost drivers are not devices to allocate costs. They represent the demand that outputs make on each activity. For example, the activity cost driver for the setup activity could be the number of setups or the number of setup hours; the activity cost driver for processing purchase orders could be the number of purchase orders; the cost driver for administering and maintaining parts in the system could be the number of active part numbers.

While some activity cost drivers are unit-related (such as machine and labor hours), as conventionally assumed, many activity cost drivers are batch-related, order-related, product-sustaining, and customer-sustaining. ^^ Because traditional cost systems use allocation bases that do not represent the demands for support resources by activities, the volume variance for a period can be zero even while substantial shortages or surpluses of capadty exist for many individual activities.

For example, if actual production includes an unexpectedly high proportion of mature, standard products, produced in large batches, the demands for many batch and product-sustaining activities will be well below the quantity of resources supplied to perform these activities and much unused capacity will exist during the period. Conversely, if the actual production volume includes a substantial and unexpectedly high number of new, cvistomized products, that are made in very small batches, the demand for batch and product-sustaining activities may exceed the quantity supplied.

Shortages, delays, and overtime may occur in the batch and product-sustaining activities even though the total quantity of units pro- duced during the period equaled the budgeted or antidpated amount. The distinction between the measiirement, by activity-based cost systems, of the cost of activities used (and unused) and the traditional cost accounting emphasis on fixed versus variable costs can be reconciled by examining closely the way managers contract for and supply resources to perform organizational activities. I I RESOURCES THAT ARE I.