Time to learn the ABC's of logistics

Manufacturers are turning to activity-based costing to get a more accurate picture of their logistics costs than traditional accounting can provide.

By Thomas A Foster -- Logistics Management, 2/1/1999

After almost a decade of slow growth, activity-based costing (ABC) is finally gaining acceptance as a tool for determining the true costs of logistics activities. Results of a survey conducted by Ohio State University show that the driving force behind ABC's growth is management's new interest in such concepts as supply chain management, process re-engineering, and "cost-to-serve" customer profitability--all of which require better cost information than traditional accounting systems can offer.

"Legacy cost systems typically do not provide much insight into the costs of logistics activities or how process improvements can lower product costs or boost profitability," says Dr. Bernard J. LaLonde, professor emeritus at Ohio State University's Supply Chain Management Research Group and co-author of the 1998 Survey of Activity-Based Costing Applications Within Business Logistics with Lt. Col. Terrance L. Pohlen of the U.S. Air Force. Pohlen is deputy comptroller for the Defense Supply Center in Columbus, Ohio.

Traditional cost accounting includes logistics as part of sales, general, and administrative (SG&A) expenses, according to LaLonde and Pohlen. Usually, these SG&A costs are allocated arbitrarily as direct labor hours consumed, cost per cases shipped, or as a simple percentage of sales.

That method, though, doesn't always meet logistics managers' information needs, the researchers say. "Logistics managers have lacked the cost information needed to demonstrate how the tailoring of services provided to different products, customers, or supply chains drives logistics costs," says Pohlen.

ABC does provide that information by using multiple drivers to assign costs based on consumption of resources. Instead of lumping logistics costs into SG&A and then allocating those costs to products, Pohlen explains, ABC breaks the general ledger apart into homogeneous resource categories and assigns those costs to the specific activities performed, such as purchasing, receiving, and warehousing.

Because ABC can assign the activity costs to the consuming customer, product, or supply chain, ABC information can provide considerable insight into how different customers or products affect the consumption of logistics activities and drive total costs. It also can serve as a useful tool in analyzing how proposed changes in logistics processes may affect the services or activities provided to the customer and how these changes will alter resource consumption.

Survey Results

Only 18 percent of the respondents to the Ohio State survey have implemented ABC, but this is a significant increase over the 4 percent that reported doing so in a 1993 survey. An additional 18 percent are in the process of implementing ABC, and 27 percent of the responding companies are considering implementation. Only 25 percent of the respondents report that they have not considered ABC.

The cost and manpower required to implement ABC clearly is the most common reason for not considering ABC or deciding against implementation. The majority of the respondents report implementation costs exceeding $100,000, with 34 percent reporting an implementation cost between $100,000 and $500,000.

In addition to daunting implementation costs, the respondents report other reasons for not shifting to ABC. Twenty-nine percent indicate that ABC is either inappropriate or inapplicable to their business processes. The remaining 19 percent consider ABC to be too complicated for their use.

Almost half of the respondents to the Ohio State survey indicate that they have used ABC for less than two years, with 87 percent indicating less than five years' experience. "The growing interest in ABC is especially strong in industries with high distribution costs such as food retailing and wholesaling and personal-care products," says LaLonde.

Why ABC?

Nearly one-fourth of respondents say the need to measure customer profitability is their primary motivation for implementing ABC. Improved cost information, which plays a major role in enabling the company to implement activity-based budgeting, evaluate outsourcing decisions, or perform benchmarking studies, ranks second. (See Figure 1.)

"ABC usually is triggered by a major event or strategic decision," says LaLonde. "If a major customer that was receiving block palletloads of product suddenly wants rainbow pallets of mixed products, shrink-wrapped, labeled, and cross-docked, there is a significant cost and profit impact. ABC can tell you what that impact is."

ABC implementations generally follow one of two major approaches: costing or re-engineering. "A costing approach concentrates on rapidly developing cost information for a limited number of activities such as order picking, receiving, shipping, storage, and so on," Pohlen explains. "Looking at between 20 and 40 of these activities, the company examines each according to variables such as specific customers, products, or distribution channels. Very quickly, the company sees the differences in costs and resources needed to serve each customer, handle each product, or use each channel."

The costing approach has the principal advantage of quickly providing cost information on the major activities performed by the organization, says Pohlen. It generally requires a more detailed analysis of high-cost or non-value-added activities, however, to bring about any cost reductions.

A re-engineering approach begins with extensive flowcharting of the hundreds of logistics activities that the organization performs, which usually requires up to six months to complete. The ABC effort then attempts to assign costs to each of the detailed activities identified during flowcharting.

Compared with a costing approach, a re-engineering approach requires significantly more time, effort, and cost to implement because it requires a much larger number of cost drivers for the assignment of resource costs to a very large number of activities. It also must determine how each activity is actually "consumed" to allow assignment of the activity costs. Yet re-engineering approaches provide considerably more insight into the elements driving process costs. The chief drawback is how long it takes to obtain cost information or achieve cost reductions.

Some companies recently have combined these approaches to achieve their respective advantages, notes Pohlen. "Implementation initially follows a costing or rapid prototype approach to determine the costs of a limited number of macro-level activities in a short period of time." The implementation team targets only the high-cost activities or those with the greatest potential for cost reduction. Detailed flowcharts are prepared only for these activities.

Pohlen provides this example: "An ABC analysis of the purchasing function would first look at the high-cost activities such as capital-goods acquisition. Every step in the process from defining the requirement, to identifying vendors, to evaluating alternatives is examined and costed out. After this flowcharting process identifies the costs, the attention is turned to where to change the process to take out costs." The survey results show that cost reduction can take many forms, he adds. These include re-engineering, outsourcing, and elimination of non-value-added activities. (See Figure 2.)

Most companies launch their ABC initiatives within manufacturing and operations because of the explosive growth of overhead rates and the need to determine product costs accurately. LaLonde believes that logistics is an even better candidate for ABC owing to the diversity of activities and the differences in individual customers' or products' service requirements. "Customers frequently require tailored services to reduce cycle time, reduce costs, or improve support to their downstream customers," he says. "The tailoring of logistics services adds additional activities and costs to the supply chain. Logistics managers need to be able to assign these costs accurately to understand how these additional service requirements [affect] profitability."

ABC Roadblocks

Inadequate accounting systems represent a major obstacle when ABC is being implemented, according to survey respondents. "Companies quickly discover that traditional systems do not capture a large amount of the information required for ABC," says Pohlen.

Much of the information needed for ABC implementation is captured in operational systems. "A warehouse-management system, for example, captures large amounts of data about the number of orders picked, lines picked, and so on, but it provides no cost data," says Pohlen. "An accounting system provides information on the cost of labor and equipment. By matching these two sets of data, you can trace activity costs by product or customer."

Lack of technical expertise and cost-driver information is the next most frequently cited problem. "It is rare to find people with both high-level accounting skills and logistics skills," says LaLonde, "so it is not surprising that ABC implementations often encounter problems tracing costs and identifying meaningful cost drivers."

Yet another obstacle to ABC implementation often is posed by employees and middle managers who see the process as a no-win situation. According to Pohlen, middle managers have resisted ABC because it makes their performance and decision making much more visible to top management.

"Unless top management creates an incentive for all employees to embrace ABC, the middle manager sees only the negative sides of the measurement process," says Pohlen. "If management creates the right incentives, employees will support ABC implementation and find it useful to demonstrate how well they contribute to the firm's profitability or as a means to support recommended process improvements." (See Figure 3 for a list of other problems commonly encountered during ABC implementation.)

Future applications of ABC center on taking action on the cost information collected. (See Figure 4.) Thirty percent of survey respondents predict activity-based management (ABM) will be the next step in their implementation process. "ABM is the use of ABC to support specific management decisions and actions," says Pohlen. "It makes ABC information 'actionable.'"

Supply chain costing, or the application of ABC across all the activities and companies within a supply chain, emerged as the second most frequently cited area for future development. The respondents want information on how activity costs are driven by the services requested by other supply chain members or how actions affect the costs incurred by other channel members.

Activity-based budgeting (ABB) is a technique that capitalizes on the activity drivers developed during ABC implementation to budget for future periods. Companies can determine future resource requirements by knowing the current resources required to perform each activity and forecasting future activity volumes. "ABB works like ABC, only in reverse," says Pohlen. "It translates customer or product requirements into activity volumes, which, in turn, are converted into resource costs."

Future Directions

The survey suggests three future directions for ABC within logistics, says Pohlen. First, many companies are moving toward integrating ABC with their current financial systems or incorporating it as part of an Enterprise Resource Planning (ERP) initiative. Second, measuring customer profitability has become increasingly important as downstream channel members demand more logistics services without commensurate increases in price. Third, several companies are testing the notion of using supply chain costing to evaluate alternative channel structures to reduce total landed marketplace costs.

ERP may someday support ABC implementation, but it is not happening yet, says Pohlen, who explains that unlike legacy accounting systems, ERP captures both financial and non-financial data. "With ERP, you have the data, but unfortunately, few ERP systems have good ABC modules that allow adequate ABC analysis," he says.

Pohlen says some companies are taking separate ABC systems and linking them to their ERP systems. "This is costly and adds more complexity to the process," he says. He predicts there will be more strategic alliances between the major ERP vendors and the specialty ABC system vendors to allow easier ABC implementations.

LaLonde foresees ABC growing in unison with the increased attention commanded by supply chain management, which he says is "all about functional shiftability." LaLonde defines functional shiftability as having a specific function performed by the most efficient partner in a supply chain.

"Retailers used to receive volume loads from vendors, handle the breakbulk and order picking for stores, label the items, and cross-dock the outgoing pallets," says LaLonde. "Now, the vendor, carrier, third party, or whoever can perform the task the best is likely to be responsible. That is how supply chain management can build efficiency. ABC allows the cost visibility at the activity level to make these determinations. Not only does it allow you to understand and perhaps mitigate costs, but ABC also lets you see the cost drivers and raises the possibility of driving cost out of the supply chain."

The ABCs of ABC

Activity-based costing has its own unique vocabulary. Here's a list of some of the terms used in this article.

Activity-based costing (ABC). A method of calculating the costs of an organization's activities based on the time and financial resources devoted to them. ABC provides a means of allocating those costs to the customers and products that consume that organization's resources.

Activity cost. The total cost of all work required to perform a certain procedure or task. This might include labor, supplies, administration, and equipment.

Cost driver. A measure of how much work is done on a particular activity. When divided into the amount of money spent on an activity, it indicates how much it costs to perform that unit of work. The cost driver divides activity costs into fair shares for each activity consumer.

Customer/product profitability. The profit margin on business conducted with an individual customer or on sales of a particular product.

Resources. The time, money, objects, and labor--such as materials-handling equipment, office supplies, utilities, labor, and computer support--needed to perform business activities.

About the Survey

The 1998 activity-based costing (ABC) survey was conducted by Ohio State University's Supply Chain Management Research Group to update the results of a similar study done in 1993. The 1998 survey examines the changing role of cost information in logistics decision-making and how more accurate cost information can affect cost tradeoffs made throughout the supply chain.

The survey contained 33 questions focusing on four areas: ABC adoption and implementation, application to logistics decision-making, training, and future use of ABC. Questionnaires were mailed to 2,250 companies whose organizations included the title of vice president of logistics or distribution. The actual respondents, though, were finance managers or ABC project leaders. The response rate was 12.5 percent. Respondents were classified in four broad categories: carriers, public warehouses, manufacturers, and merchandising companies. Responses classified as a logistics component of a manufacturer accounted for more than 50 percent of the overall results.

A complete version of the survey results can be found on this magazine's Web site (www.logisticsmgmt.com).