This action might not be possible to undo. Are you sure you want to continue?
B Y S I D N E Y J . B A X E N D A L E , D B A , C M A , C F M , C P A ; P. S . R A J U , P H . D . ;
MAHESH GUPTA, PH.D.
DISCUSS THE ACTIONABLE COST OBJECT SELECTION CRITERIA THEY HAVE
DEVELOPED AS A RESULT OF SUPERVISING APPROXIMATELY
STUDIES OVER THE PAST NINE YEARS.
EXECUTIVE SUMMARY This article discusses the selection of cost objects that enable an activity-based costing (ABC)
system to provide meaningful information to those developing a coordinated operations and marketing strategy to enhance company profits. As a result of having supervised many MBA student team projects that used ABC to help create business plans for small businesses, the authors have developed some guidelines for selecting cost objects that provide information to suggest profit-enhancing actions by the business. Those guidelines are discussed and examples are provided from some of the more successful student projects conducted for small businesses.
or several years, we have team-taught an MBA module that integrates marketing, operations management, and management accounting. The module involves a practicum in which the students work in project teams to develop a business plan for a small business of their choice. The business plan focuses primarily on a coordinated operations strategy and marketing strategy for the small business. As part of the practicum, however, the project
team supplements the traditional accounting system of the small business with an activity-based costing (ABC) system. The team is encouraged to use the information from the ABC system as a basis for coordinating the operations and marketing strategies in the business plan. In the early years of this integrated module, the project teams would choose the company’s various products or services as the cost objects and develop their ABC information systems to determine the profitability of
M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY
SPRING 2006, VOL. 7, NO. 3
An “actionable” cost object is one that. Robert S. Identifying a bundle of primary and secondary products and services that creates a market niche will likely provide the small business with some pricing power.” This was especially true of products or services that were like a commodity. NO. the ABC information system often revealed that some products or services were unprofitable. we have stressed the need to be creative in specifying the cost objects selected as the focus of the ABC information system. Marketing makes a distinction between the primary product and the related secondary service. After supervising several project teams working with small businesses during the early years of the module. ABC was touted as a cost assignment method that would result in more accurate product costs.2 The overwhelming majority of the ABC literature has focused on using either a company’s various products or services sold or the cost of serving the customer as the cost objects. 3 . Kaplan and others made it clear that ABC could provide more precise cost information for any cost object. 7. The article also offers real world examples to support our arguments related to the selection of “actionable” cost objects. when used in conjunction with ABC. S E L E C T I N G AC T I O N A B L E CO ST O B J E C T S When it was first introduced in the mid-1980s. The secondary service is something bundled with the primary product that will enhance the product from the customer’s perspective. We further encouraged the project teams to think in terms of cost objects that would permit the small business to carve out a niche in an otherwise competitive market place and to seek market niches that were complemented by unique operations capabilities. unit sales would drop off considerably. As one might expect. As we will illustrate through real examples. M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 10 SPRING 2006. yields information that permits management to make decisions that enhance company profits. If the business owner were to raise the price above the market price. the project teams often chose order size or delivery time as the secondary services to be bundled with the primary products. This required an assessment of the capabilities of the small company’s operations. The project teams had to assess the extent to which the operating environment supported the product and service bundling that was likely to contribute to a profitable niche business strategy.” not “price makers. the obvious solution to enhancing the company’s profitability was to increase the prices of those products or services. The primary product is what the customer expects. but the owners of the small businesses were quick to point out that the price is determined by the market and that their businesses were “price takers. There is only limited discussion in the literature about using cost objects other than product or customer. From the project team’s viewpoint. Kaplan wrote many Harvard Business School cases in which he demonstrated the power of ABC to get more accurate product costs in situations where the various products used activities with differing intensities. The business plans that focused on the products or services were often less than satisfactory because of the highly competitive environment in which the companies operated. This article attempts to expand the definition of “cost object” in a manner that is meaningful to both operations and marketing management as they seek to make better use of activity-based cost information to enhance profits. we realized that the proper selection of the cost objects could make a positive difference in the extent to which the resultant business plan could guide the small business owners to enhanced profitability. Even though the focus of many of the ABC cases was on product cost and product profitability. TRADITIONAL COST OBJECTS Other than products.each product or service.1 In our instructions to the project teams in recent years. We encouraged the project teams to think beyond the obvious products or services of the small businesses and to look to couple a product or service with service elements related to the product or service. the cost object featured most often in the Harvard Business School cases was the customer. VOL. the project teams realized that such cost objects would only be actionable to the extent that operations could produce small batches or deliver immediately in a cost-effective manner. In selecting a cost object that focused on marketing products sold in small orders or with immediate delivery.
000 gallons for small batch sizes. a large batch of waterbased paint required 5. The first is of a small manufacturer of powdered paint that saw a market for custommade industrial paint that could be produced and delivered to the customer who needed the paint almost immediately. 2. Before settling on a cost object that bundled the product and delivery lead time.25 hours of filtering time for a large batch of solvent or high-solids-based paint.12 hours of milling time per 1. Likewise. 4.86 per gallon. For example. The clean-up after each batch of the colored paint product line was much longer because the significant differences in color necessitated significant cleaning of the production equipment after each batch. provided a well-supported business plan that focused on actionable cost objects that enhanced business profits.25 hours of filtering time vs. the project team made an assessment of the operations capabilities of the small company. VOL. For instance. It had not exploited this marketing opportunity. but the black paint to be delivered in less than one week would earn a profit of $1. NO.37 per gallon. The project team recommended that the business alter its sales commission structure to encourage the salespeople to seek sales of the most profitable cost objects. B A S E M AT E R I A L AS AND B AT C H S I Z E COST OBJECT ELEMENTS The next example examines a liquid paint manufacturer that had only limited unused capacity for its milling and filtering activities given the current level of market demand for the various products. we present three examples. The potential that the milling and filtering activities could limit market growth suggested to the project team that the cost objects selected for the ABC information system should somehow be sensitive to the dif- M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 11 SPRING 2006. But limited market research revealed that the company could sell the black paint to be delivered in less than one week at a 34% premium over the selling price of the black paint with standing or otherwise scheduled orders. Operations chose to have two production lines because the clean-up associated with black paint was minimal. Those two potentially constraining production activities were used in varying intensities depending on the base material required for making the paint. a batch of red paint might be followed by a batch of white paint. The ABC system.27 hours of milling time per 1. and changing from one customer’s custom black paint to another customer’s custom black paint could be done with minimum downtime for clean up. 3 . That situation suggested an opportunity to select a cost object that combined a market demand (timeliness of delivery) with an operations capability (short clean-up time when a current job is interrupted to meet immediate customer demand for black paint). They found that the company had two production lines—one for black paint and one for colored paint. 7.P R I M A RY P R O D UC T TIME AS AND D E L I V E RY COST OBJECT ELEMENTS To illustrate the subtle marketing and operations considerations that are important in settling on the bundle of primary product and secondary services that are likely to enhance a small company’s profitability. The project team realized that the ABC information system could determine the actual cost to produce and sell the custom product to customers needing it almost immediately. For example. the batch size (in most instances.000 gallons for large batch sizes and 10. coupled with an understanding of marketing opportunities and operations capabilities. The project team chose the following cost objects for their ABC portion of the business plan development: x Colored paint to be delivered in less than one week x Colored paint to be delivered in one to two weeks x Colored paint with standing or otherwise scheduled orders x Black paint to be delivered in less than one week x Black paint to be delivered in one to two weeks x Black paint with standing or otherwise scheduled orders The ABC analysis using those cost objects revealed that black paint delivered in less than one week was going to be 21% more costly to produce than the black paint with standing or otherwise scheduled orders. the customer order size as well) had a sizable differential impact on the time required in the milling activity. The ABC system revealed that the profit per unit for the black paint with standing or otherwise scheduled orders was $. because it assumed that the production interruptions necessary to market to that niche would cause the product to be too costly. however.
the project team settled on the following cost objects: x Automatic. The project team chose to combine batch size and base material to define the cost objects. large batch An assessment of the company’s operations revealed that there was a rather large unused storage area where paint could be stored. more than 25 grams x Semi-automatic. inventory the product on site. The combination of batch size (small. large order. Discussions with the company owners revealed that there was considerable diversity in the size of the orders the company received. or high solids) used in making the liquid paint resulted in nine different cost objects: x Water-based. small batch x Water-based. An ABC-based computer model enabled an evaluation that demon- strated that the paint company could enhance their operating profit considerably through the use of this coordinated operations and marketing strategy. medium batch x Solvent-based. The company could produce large batches. As the project team considered the ABC system design for the small company. More importantly. more than 25 grams x Semi-automatic. small batch x High solids. more than 25 grams The ABC information system revealed that the M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 12 SPRING 2006. more than 750 gallons) and base material (water. solvent. but there would be significant differences among the products in any product line. NO. the owners suggested that the larger products (those weighing more than 25 grams for each unit of product) used the various activities more intensely than the products that weighed 25 grams or less per unit of product because of the additional complexity of the larger products.ferential demands placed on the milling and filtering activities by the different base materials and batch sizes. some products were produced on an automated production line while others were produced on a semi-automated production line (some human intervention in the production process). P R O C E S S . the paint company offered something that competitors were not offering. The milling and filtering activities. medium. P R I M A R Y P R O D U C T. 3 . and large. ORDER SIZE AS AND COST OBJECT ELEMENTS In the third example. The choice of combining product characteristics (base material) and secondary service characteristics (timeliness of delivery) for the cost objects was critical in the development of such a strategy. small order. however. large order. small order. By taking on the inventory management function at no additional cost to the customer. the paint company would give them the price for a large-volume purchase but would deliver according to the customer’s production schedule in small batches. more than 25 grams x Automatic. Thus. small batch x Solvent-based. small order. medium batch x High solids. Additionally. by planning the production. 25 grams or less x Semi-automatic. 7. and deliver it as the customer needs it. This strategy necessitated the additional expense of inventory management and an added investment in finished goods inventory. 151 to 750 gallons. large order. If a customer would commit to a large annual sales quantity. large order. large batch x High solids. cost and profitability information on products or product lines was not actionable from a marketing perspective because of the intense price competition in the plastics industry. 25 grams or less x Automatic. it was obvious that any attempt to use products as the cost objects would require the aggregation of the products into product lines. The project team recommended that the company expand their market by differentiating themselves from competitors in terms of timely delivery. This unused storage capacity suggested a unique marketing strategy: an inventory management system that the company could offer its customers. medium batch x Water-based. 25 grams or less x Automatic. Also. would have sufficient unused capacity to permit an aggressive market expansion. Because there were too many products to regard each as a cost object and the company had no pricing power in the competitive market for plastic parts. a plastic parts manufacturer produces thousands of different plastic parts. large batch x Solvent-based. 25 grams or less x Semi-automatic. VOL. the paint manufacturing company could minimize the production of small batch sizes and free some capacity in the milling activity and filtering activities by minimizing equipment setups. 50 to 150 gallons. small order.
AC K N OW L E D G M E N T S The authors wish to acknowledge the efforts of our MBA students in collecting and organizing the data for the studies cited in this article. the small cost objects were more costly to process because of the setup costs and other disruptions caused by small batches. semi-automatic). DBA. Large orders were less costly on a per unit product basis because the setup costs associated with the batch could be spread over a larger quantity. P. 2 Kaplan.edu.S. Mahesh Gupta. the ABC system provided better and more accurate information that allowed the marketing strategy to focus on small orders processed on the semi-automated production line as well as providing the cost information that was necessary to implement a differential pricing strategy for small orders processed on the semi-automated production line. Because the competition was focused on large orders. ABC information systems that are designed with a focus on “actionable cost objects” consider market niche opportunities and operational capabilities in the selection of the cost objects for the ABC system. Pillsbury: Customer Driven Reengineering. a company can profitably exploit market niche opportunities that are leveraged by unique operational capabilities. the most popular cost objects have been the company’s products or its customers. the company had an opportunity to charge more for the small orders. Ky.edu. NO. The semiautomatic. The company was not charging extra for these additional costs associated with small orders. however. The ABC information system indicated the extent to which the selling price of small orders would have to increase to render the small orders as profitable as the large orders. 1990. CMA. He can be reached at (502) 852-4783 or mcgupt01@gwise. Baxendale. 1995. and Robert S. ABC information systems identify resource costs with activities and then attribute those activity costs to cost objects. Ky. AC T I O N A B L E CO ST O B J E C T S relative profitability of producing and selling each product or serving each customer. CPA.D. a market niche in which there were few competitors. Ky. CFM. 3 . Sales order size was an important cost differentiation feature from an operations management perspective. 1987. By including the nature of the production process (automatic vs. s Sidney J. Harvard Business School Case #9-190-002. Harvard Business School Case #9-187-107. raising the price to correct the situation may not be feasible. Thoughtful cost object selection increases the likelihood that the ABC system will provide information to facilitate the coordination of an operations and marketing strategy that will enhance the company’s profits. The ABC system that used order size as one element of the cost object properly recognized the cost differences between large and small orders. John Deere Component Works.louisville. In highly competitive industries. But once the company knows this. This suggested that the company was not properly pricing the small orders it accepted for production in the semi-automatic production process. is professor of marketing at the College of Business and Public Administration of the University of Louisville in Louisville. Those are appropriate when the company wants to know the M A N A G E M E N T A C C O U N T I N G Q U A R T E R LY 13 SPRING 2006.semi-automatic. VOL. 1 Robert S. and Robert S. According to the ABC system. By selecting cost objects that bundle the primary product with secondary services. Small orders were very costly on a per unit basis because the setup costs were spread over only a small number of units. Harvard Business School Case #9-195-144. Raju. large order costs objects (all gram sizes) were the most profitable on a per unit basis. 1990. Historically. He can be reached at (502) 489-5236 or baxendale@louisville. 7. Kanthal. Ph. 25 grams or less was experiencing a loss at the operating profit level. is professor of accountancy at the College of Business and Public Administration of the University of Louisville in Louisville. Kaplan. small order. He can be reached at (502) 852-4868 or psraju@louisville. is professor of operations management at the College of Business and Public Administration of the University of Louisville in Louisville. All of the products produced in the automatic process were reasonably profitable on a per unit basis. the next area of concern is figuring out what to do with the unprofitable products or services. Kaplan and Artemis March.D. Kaplan..edu.. Ph.