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We are seeing high levels of inefficiency in some areas of our manufacturing process. Could Activity-Based Costing help?

Activity-Based Costing


Topic Expert
Bob Scarborough
Title: CEO
Company: Tensoft, Inc.
(CEO, Tensoft, Inc.) |

Certainly there is a role for Finance in Manufacturing Operations. Usually that role is a partnership related to inventory – cost reduction and management, inventory valuation, and appropriate inventory levels to maintain. The point where Finance plays the strongest role is where your feedback matches your responsibility in the partnership – which, I’m guessing, is your reason for discussing Activity-Based Costing.

I would suggest that the strongest statement is made by using standard costing. The general models on manufactured inventory valuation fall into either the actual (moving average, etc) cost model or in the standard cost model. Standard cost is commonly associated with a swift inventory value that streamlines transaction processing. The area to focus on for manufacturing efficiency – as reflected in the cost of the resultant manufactured product – is in the standard cost variances.

When manufacturing and finance partner over inventory costing (and cost reduction) using a standard cost model you can think of standard cost as a plan. You are setting goals for what inventory cost should be based on the inputs and manufacturing requirements. Variances identify reasons for moving away from the plan – such as yield hits, productivity (units absorbed for throughput), PPV variances, rework variances, and so on. Correctly identifying and categorizing the variances lets manufacturing operations and finance review why the goals were not met – and what the specific variances tell you about not meeting the goals. Approached in this view, standard costing plus variance analysis is actually requires the most active engagement in cost modeling and results management – setting a plan and measuring performance against the plan.
Activity based costing can be used in either an actual costing or a standard costing model. On its own – defining the appropriate cost buckets, defining the appropriate allocation base – it doesn’t really show inefficiency without stated goals to measure against.

Hope this helps.

Topic Expert
Barrett Peterson
Title: Senior Manager, Actg Stnds & Analysis
Company: TTX
(Senior Manager, Actg Stnds & Analysis, TTX) |

Activity based costing - done with a simplified design particularly if your company is below $100 million can work. I prefer a direct costing system focused on improving margin dollares per month, reducing waste, and improving volume run through the operation per month, with data reflecting direct prduce margin to cover major volume driven processes [manufacturing by operation, inboud logistics, outbound logistics, warehouse operations, purchasing and sourcing] which can use drive based average cost measures to obtain a "roughly right result. Improve the product cost by waste reduction and improvement of processing throughput rfates. Improve transporation costs by shiping as much as possible in truckload/container volume and as little as possible by individual pallet load or LTL as full truck/container rates are much lower per "pallet" cube. Combine customer shipments with multiple drops [routing] where possible to obtain favorable freight rates. use space wisely and minimize idle physical capacity.

Maximizing margin per month will drive profitability, but mix can complicate.

scott graves
Title: CFO
Company: Armstrong Teasdale LLC
(CFO, Armstrong Teasdale LLC) |

A good standard cost system will give you some guidance as to where your largest costs reside: typically that's in materials. So having a good strategic sourcing group to drive down purchase price, freight, inventory levels, etc. will have the biggest and quickest impact on your business. Spend most of your time here. Note that engineering should be tasked with cost reducing the products through redesign.

Overhead is typically your next largest operating expense. Meticulously review and challenge the OH structure: supplies, admin/supervisors, utilities, etc. Put together task force teams to address the largest spending with goals to reduce by 50%...they may not achieve 50% but by focusing on such a large and seemingly impossible goal, unique and out-of-the-box thinking should drive step-wise changes in processes and spending.

To drive labor and takt time efficiencies in the manufacturing area:
-reduce the amount of space the the product moves by redesigning your plant floor and production layout (movement = waste)
-reduce the amount of employee movement when performing their jobs (movement = waste)
-determine the best way to perform an action and implement, measure and reinforce that practice (standard work)
-review other related items: rework, scrap, freight, excess & obsolete inventory, etc.

I wouldn't recommend ABC as it's extremely cumbersome to implement and maintain and the resulting analysis is typically based upon allocations since many employees, machinery and facility overhead is common or shared across product groups or platforms.

Steve Player
Title: Program Director
Company: Beyond Budgeting Round Table
(Program Director, Beyond Budgeting Round Table) |

If the manufacturing inefficency is in overhead areas, then ABC can be used to identify the activities comprising those overhead areas. Activities can then be tagged with attribute flags to identify wasteful activities that should be examined to see how they can be eliminated.
If the inefficency is in materials or labor, you need to look for other approaches.
As noted above, lean manufacturing attacks the sources of waste as identified by the Toyota production system (wastes such as storage, movement, producing products in excess of customer demand, etc.). Traditional costing methods like standard costing often send the wrong signals. For examples accounting calls excess production a good thing since it creates a "favorable" usage variance. In reality the accounting function is the source of inefficency by sending incorrect signals.

Mike Poe
Title: CFO
Company: XinRay Systems Inc
(CFO, XinRay Systems Inc) |

I’ve experienced both Activity Based Costing and Lean Manufacturing, and concur with the recommendations above to put your efforts into Lean. Activity Based Costing is costly and tedious, and is not likely to drive down costs nearly as effectively as Lean. Lean focuses on identifying and eliminating waste, can dramatically reduce your production costs, and its potential for significantly reducing the time required to make any given product can transform your business and provide important competitive advantages.

If you don’t already have expertise in Lean within your organization, you may have a higher initial investment in hiring consultants or staff who can guide your Lean implementation, but the ROI is likely to be much higher, and your chances of success are also higher than with ABC. However, Lean usually results in some significant changes in how business is done as well as reductions in staff, so it takes a firm commitment from top management to drive the changes over objections from conventional thinkers, and discipline to prevent backsliding. But the results can be well worth it. I've seen 75% reductions in product costs, 50% reductions in required manufacturing and warehousing space, and ten-fold reductions in product delivery times.

Henry Dietz
Title: CFO
(CFO, ) |

I agree with Mike, Activity Based Costing may give some results, but experts with training in Lean Six Sigma Manufacturing consulting will dive to the root of the problem with both quantitative and qualitative analysis leading to cost efficient and process improvements.

Topic Expert
Bob Scarborough
Title: CEO
Company: Tensoft, Inc.
(CEO, Tensoft, Inc.) |

Interesting discussion – we have moved from costing models that could help uncover and fix manufacturing inefficiencies to consideration of manufacturing inefficiencies in total. This this is an excellent discussion I would offer a couple of cautions:
1) All systems have uses and flaws – blanket recommendation of specific solutions without deeper analysis of the specific situation or at least consideration of the industry specific variables leads to imperfect results at best.
2) Finance, except in rare occasions, does not own the operations organization. As such Finance needs to find ways to work within the organization structure and financial preview to achieve goals. The chances of Finance dictating a successful outcome to operations are not high.

Manufacturing operations is a highly inter-dependent organization. Manufacturing inefficiencies can result from a number of contributing factors:
1) Engineering driven. These can result from excessive in line change or poor configuration management or poor manufacturing engineering (products not designed for effective manufacture). If your engineering organization is running manufacturing that is often a warning indicator all its own.
2) Sales or Demand driven. Operations runs best as a steady state organization, while demand can be lumpy or reactive. If your demand models are whipping operations in multiple directions on a regular basis considerable inefficiency is created.
3) Finance driven. Yep – the finance organization can contribute by promoting under investment in plant and equipment, or inappropriate staffing levels or insufficient investment in training through a budget process that looks at short term cash instead of long term efficiency.
4) Manufacturing driven. In the end it could come down to manufacturing of course – and even in the best organizations there is always room for efficiency and cost of goods improvement.

Given the need for Finance to influence rather than dictate to the Manufacturing organization – cost and inventory cost reduction is usually the best place to find common purpose. Most experienced manufacturing executives understand inventory cost reduction is part of their responsibility. Finding ways to partner – and to establish a culture of cost reduction – will require understanding the demands placed on the operations organization and the drivers of cost.

To some of the specific thoughts here – related to models and systems:
1) Activity based costing and standard cost are, in my experience, not opposites. Standard cost can be used with activity based costing – allocation based on standard. To simplify – the two sides of the coin are standard or actual based costing. I would propose that standard is active involvement in costing (setting goals, measuring against goals) and actual costing is passive (accepting what is given and reacting going forward). All systems can work of course – and all systems can lead to inefficient results if the full set of needs and measurements is not considered.
2) Lean manufacturing has had considerable success. At the same time it is not the blanket answer to all issues. It requires decisions on cycle time to customer delivery trade-offs and optimization – which if your inefficiencies are generated by demand whipsaws will not lead to improvement. It requires a large degree of coordination and efficiency across your organization. Even then it may not yield the best results – you may find that outsourcing some or all of your production is more cost effective.

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