INSTRUCTIONS: Make a thoughful argument on the topic.

Kaplan and Gooper's approach to ABC

Kaplan and Cooper, in their exposition of ABC, explicitly condemn the practice of allocating nonvolume related costs to the product unit level. Consequently, their conception of ABC is as a more sophisticated marginal costing system--employing contribution analysis at several different levels.

In their approach to ABC, the firm is envisaged as a hierarchy of costs with each level representing a different type of cost variability. The lowest three levels in the hierarchy are concerned with product related costs. Unit level costs are short term variable costs such as direct material, direct labour and so on. These costs vary in direct proportion to the number of units produced.

Many product related costs are not, however, driven by the number of units produced per se, but by the number of batches/production runs undertaken. An obvious example of such 'batch level costs' is machine set-ups.

The third category of product sustaining costs relates to activities which are necessary to maintain the product in the firm's product range. For each product, a firm must maintain a bill of materials, a routing sheet, tooling and so on. Such 'product sustaining' activities will increase as more products (or product variants) are added to the product range. Such costs, however, will be independent of the number of units produced in a particular period.

In addition to the various product related costs, there are some expenses which do not relate to individual products, but to particular customers, e.g. order processing and distribution costs. Finally, there are certain general overheads which do not relate to any particular product or customer, such as the chief executive's salary.

With Kaplan's approach to cost analysis there is no need (or justification) for any allocation downwards from a higher level, of non-volume related costs to the product unit level. Rather, contribution should be rolled upward when considering a particular decision. A unit-level operating margin for individual products can be calculated by subtracting unit-level costs from sales revenue. From this unit-level margin can be subtracted batch-related and product-sustaining expenses to arrive at a product-level margin. Such a margin can be calculated for each product in the range and from this can be deducted any customer related expenses to determine the profitability of a particular sales order.

This approach can give managers better insights into the nature of their costs and thus facilitate better informed decisions when bidding for jobs or deciding which orders to accept. The method can also be applied in determining the profitability of a product over a period of time--not by calculating a full unit cost to compare with the selling price, but by identifying the demands the product puts on service and support activities. The estimated cost of these activities is then added to the short-run variable costs of producing the units sold and this total cost is then compared with the total revenue earned by the product. Thus, for example, it may be revealed that low volume products are unprofitable because of the disproportionate demands placed on batch level activities--a machine set-up is necessary whether one unit or one thousand units are being manufactured!

An important implication of Kaplan's analysis is that the non-volume related costs included in any decision analysis are not short-term incremental costs, but proxies for long-run incremental cost-based typically on existing average activity costs. Thus, for example, the total cost of machine setups is divided by the number of set-ups performed to arrive at average cost per set-up. This is then used as an estimate of the long-term incremental cost that will arise by performing machine set-ups. Kaplan and Cooper argue the superiority of this approach on two grounds.

First, they contend that it is probably not feasible to identify all the actual incremental costs of each decision in a complex, multi-product environment. Second, they argue that, during a particular period, numerous decisions are made independently of each other but the collective impact can be to drive up 'fixed' costs over time, even though these longer-term cost increases are not incremental (and hence relevant) to. any one particular decision.

The argument is that, if only actual incremental costs are considered when looking at a particular decision, a positive contribution is likely to lead decision-makers to embark upon actions (e.g. accepting marginal business) which place demands on service and support functions. Over time this consumption of service/support activities will start to drive up costs. The current actual cost of support activities can be viewed as acting as a proxy for these long-run incremental costs. The ABC approach is essentially a long-term one aimed at curbing the excesses which can result from traditional marginal costing--which ignores potential long term increases in cost.

Thus, although Kaplan and Cooper assert that ABC is not a decision-making tool (but an attention directing one), it is difficult to escape the conclusion that it is! It is nearer to the truth to say that ABC is a tool for planning/decision-making, but one which uses proxies for long-term incremental cost rather than strictly decision-relevant incremental costs.