By Paul Pillat

Most companies that produce multiple goods or services use traditional methods to calculate their costs.  When goods are manufactured this involves calculating the cost of raw materials, direct labor and then applying some formula to approximate direct and indirect overhead costs.

Many companies can benefit by throwing out their micrometers and old school methodologies and realizing that close is good enough.  It is normal to assume that there will be unassigned costs, assets and liabilities in the production cycle.  Over calculating costs can many times lead to the wrong costing conclusion and drive incorrect business conclusions.

The purpose of using an activity based costing (“ABC”) is to provide strategic and operational guidance to decision making and not for pricing of your products and services.  ABC is a process  whereby companies identify those cost drivers which relate to their products and/or services.

An activity based costing approach involves eleven steps:

  1. Identify the product concept and markets.
  2. Identify products within markets
  3. Assign direct costs and specifically caused indirect costs
  4. Identify other critical success factors
  5. Identify measures of effectiveness as possible sources of cost drivers
  6. Understand your company’s cost of capital and the cost gap
  7. Identify all processes in your company
  8. Document processes within your company
  9. Categorize activities within your company as value-adding, non-value-adding and necessary, but non-value added activities
  10. Reformulate your internal income statement from one based on generally accepted accounting principles to one that is “activity based.”
  11. Determine what steps are needed to reduce and if possible, eliminate waste.

For purposes of this article, I intend to look at steps 1-5 and then will follow-up with the remaining steps next month.

In identifying product concepts and markets one has to understand why customers or consumers choose their product or service.  It involves using a comprehensive approach to understanding consumer requirements with respect to demand, satisfaction and pricing.  For example, Apple, Inc. in its 10-K Report says that “The company is committed to bringing the best user experience to its customers through its innovative hardware, software, peripherals and services.”  Apple, also identifies the markets they serve as “Consumer, Small and mid-sized businesses, Education, Enterprise and Government.”

Once you determine your markets, the next step is to determine products and/or services within those markets.  Each product and/or service should be viewed as a specific cost driver.  Companies should then develop criteria to either add a product or service or drop a product or service.  Once again, using Apple as an example, one could segregate their products and services to include Mac computer products, iPhones, iPads, iPods, iTunes, Mac App Store and iCloud.  Related costs should be allocated as direct costs to markets and products within markets in order to achieve a rational analysis of profitability.

Direct costs are those costs directly associated with a specific product or service.  Indirect costs not specifically a part of a product or service should only be allocated if “caused” by the product or service.

Critical success factors are anything, the presence or absence of which, that could result in the success or failure of a company.   To examine company valuation and critical success factors, we need to understand the vision, mission and strategy of a company. They involve not only operational critical factors but also risk mitigation.

Measures of effectiveness involve the understanding of the key performance indicators associated with each critical success factor.  Once identified, these need to be closely monitored by management as they serve as the basis for management action within an organization.

Activity base costing blends the disciplines of economics and accounting and can be implemented by any profit or non-profit organization.  As mentioned previously, I will discuss steps 6-11 next month.

Paul Pillat, Managing Director of Investment Banking for Cornerstone Business Services serving the middle-market M&A in the Midwest.  Reach him at 888-829-9061 or [email protected].

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