Is Your Order Book Telling You To Consider Activity-Based Costing?

Activity-Based Costing (ABC) is often mentioned in conversations between shop owners, but it seems to be an idea that most shops never get around to fully investigating. There are many benefits to performing even a short-term ABC project, but costs and personnel time need to be considered. These days, everyone is too busy to take on an extra project, especially another accounting study. However, your order book might be sufficient evidence that you need to get to work on an ABC project. Here’s a brief explanation of how and why.

Loss of Significant Business. In the precision machining industry, this situation can arise whenever a shop has lost a significant amount of repeat business. This leaves a much larger amount of overhead costs to be carried by the few remaining jobs. If your business has changed structurally because of a significant loss of parts volume or a specific line of parts, your costing system should change to reflect these changes. In the event that it did not change, an ABC project will identify the new allocation for overhead costs, and demonstrate to management the urgency of replacing the lost sales and taking immediate action to
reduce overhead.

Winning Complex Bids, Losing Simpler Jobs. While our industry has watched entire classes of easier-to-produce parts flow to the low-cost producers overseas, we still need to examine the balance of jobs that we are awarded to see if there are inequities or clues that our costs are out of line. Normal costing systems tend to over-cost the simpler, less complicated items, while under-costing the more sophisticated, more complex items. This is because normal costing systems tend to average costs more broadly. If you receive more than your fair share of “the tough jobs,” then an ABC study might indicate what your customers recognize in your quotes: high costs for simple jobs and relative bargains on more difficult-to-produce parts.

High-Volume Losses, Low-Volume Profits. If high-volume parts show losses or small profits, though more complicated, and small-volume products show significant profits, then this is a clue to reassess how overhead and indirect costs are allocated. It has been barely more than 100 years since Wilfredo Pareto made the observation that 20 percent of the population owned 80 percent of the wealth, but this Pareto Principle should not apply to recovery of one’s costs. An ABC study can identify the resources used by both high-volume and low-volume process streams and help to more fairly assign costs to the appropriate products.

You Always Get The Order With All Of The “Extras.” If a review of your order book shows that you “rule” when additional non-machining processing steps are required, such as heat treating, plating or other part finishing, then ABC can help determine if it is because costs are not assigned properly at the batch or customer level for the additional resources that these extra steps require. This is an area where ABC can make a difference, when indirect costs are significant (i.e. managing additional outside processes) or when there are a large number of processes or inputs. This is especially true if the cost of the “extra processing” is large in relation to the cost of the primary production process.

Some Departments Full, Others Barely Run. Again, your customer seems to have found a bargain in the departments that you run full, while they avoid patronizing your “too expensive boutique operations.” Listen to your customers’ “vote by quote” and examine the differences between how costs are allocated between busy and idle departments.

ABC is not a miracle cure for an ailing business. If your problem is the lack of business activity or a small percentage of your productive capability is actually producing, then ABC will only confirm this bad news. ABC is, however, the proper tool to help you decipher the data from the marketplace about your cost assignments. Because of the expense of collecting and analyzing ABC data, it is not necessarily a replacement for your normal costing system. However, when you have activities that are more likely the result of customer requirements than your inherent processes, ABC will help you account for the share of costs at that customer level.

Like the physician telling you to drop a few pounds, stop smoking or exercise daily, it is what we do with the message from ABC that will make the difference in our shops. Happy costing!

— Precision Machined Products Association