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Effects of Activity-Based Costing on Purchasing

Author(s):

Mary Lu Harding, C.P.M., CPIM, CIRM
Mary Lu Harding, C.P.M., CPIM, CIRM, Harding & Associates, Bristol, VT 05443, 802/453-5379.

80th Annual International Conference Proceedings - 1995 - Anaheim, California

ABSTRACT. In the late 1980's, a 1000-person plant converted its financial systems to Activity-Based Costing (ABC). All functions within the plant were involved in and affected by the change. Purchasing was required to define its activities and the drivers of those activities. Costs were established for most activities. Decisions began to be made on a clearer and much more intelligent basis.

The most drastic effect on purchasing was in the process of budgeting and the justification of headcount. Prior to the change to Activity-Based Costing, purchasing budgets and headcount were justified by an internal tax set as a percentage of dollars of purchased goods. This method led to problems when the dollars of purchased goods went down and the workload went up. With Activity-Based Costing, budgets and headcount were justified on the basis of work volume. This was a much better match to reality. Also, understanding the cost of bureaucracy led to a shift in focus regarding cost savings and opened visibility into new areas where savings were available.

A major piece of work for purchasing was to define its activities and their drivers. This generated much healthy discussion before a final list was agreed upon. The process and the results of this work provided benefits far beyond the event itself.

ACTIVITY-BASED COSTING. Activity-Based Costing is both a philosophy and the accompanying techniques that engender a simple but profound shift in thinking about the way we do business. ABC says that products are not the generators of costs.....products are the generators of work. Work is the generator of cost. At first this distinction looks like, "So what?" But as it plays out in our businesses, the difference reaches all levels of decision-making.

BEFORE ABC. Before Activity-Based Costing, purchasing was measured on delivery performance, quality of purchased goods and adherence to standard costs (Variance from standard cost was considered bad.) Predictability was a very strongly held value throughout the organization. In purchasing that meant predictability of costs, delivery and quality. Buyers who had the opportunity to take advantage of a cost savings that arose unexpectedly, looked at it very carefully - often being reluctant to look bad in the measurement system by being unpredictable. There was no focus on the cost of administrative processes or on any savings opportunities there. Purchasing was subjected to frequent and often drastic changes in the production schedule to which they were pressured to respond. (Since this was a manufacturing plant, schedules were driven from the master schedule in MRP [Material Requirements Planning].)

The budget for purchasing (and therefore the level of staff that the budget would support) were derived by putting an internal tax on the materials coming in the door. This tax was called the "Materials Acquisition Rate." The belief was that the more materials coming in = the more work to be done. (Note the philosophy that the product [material in] causes costs.) This system worked uneventfully as long as the forecasted volume of material to be purchased was the same or greater each year.

However, the dollar volume of material needed was declining due to a delay in release of anticipated new products and the end of life of some current ones. Purchasing was told that the company could not afford the existing level of staff, and some people would have to go. In fact, the work load in purchasing was going up because the other materials functions were under cost pressures also, especially inventory. Those in charge of inventory were attempting to micro-manage the schedules in order to get the inventory down. The number of deliveries and the number of change orders were skyrocketing.

The purchasing manager knew what the work load was and knew what needed to be done, but she was unable to justify her beliefs in the current cost accounting system. She was in something of a bind.

IMPLEMENTATION OF ABC. The initiative for implementation of ABC was started by the plant controller. She had studied the concepts and decided that in light of what was happening to the plant, ABC was a more realistic way to manage the business than the existing cost accounting system. She became the champion of the effort.

Her first approach was to convert the plant staff and get their support for the implementation. The rest of the company was not interested in ABC and was insistent that the existing standard measures be reported. (In the implementation of any change, there will be a champion and there will be boundaries. Translation of information across those boundaries is critical to success.) In this case, she protected the plant from the rest of the company since she was the gate through which financial information flowed between the two. She agreed to be the translator - converting internal ABC information into the standard format that corporate entities wanted and expected. Since she agreed to do this and the plant manager would be taking no risk externally, he and the plant staff agreed to the implementation.

Level by level training in the concepts of ABC was the next step. Managers and front line people would be involved in the implementation process. After the training, each function began the work of determining:

  • What do we do (specifically)? [Activities]
  • What triggers that work to happen? [Drivers]

In purchasing, the activities broke down into the management of materials (PO's, deliveries, etc.) and the management of suppliers (contracts, performance reviews, etc.). The whole group participated in generating the activities and drivers and everyone learned a great deal by the time they were satisfied that they had properly defined all their parameters.

Some activities had more than one driver. For example, placement of purchase orders and change orders were driven by (1) the number of part numbers managed, (2) the number of schedule changes, and (3) the number of suppliers per part number. Schedule changes was the biggest driver by far, but the other two were significant, especially with impending new products coming into the plant. Once this driver was recognized, the purchasing manager had more ammunition to defend her belief that dollars of material in the door was not the correct measure of purchasing's work load.

Since each function was doing the same work to identify their activities and drivers, they began to roll up a collective picture of the activities within the plant. All functions began to see more clearly how they affected one another. Plant staff developed a much better sense of how to control plant costs.

One major cost to the plant that surfaced was drastic schedule changes. Purchasing was not the only function severely affected. Production and all materials functions had schedule changes as a major driver of activity.

Each function determined the costs of its activities. At the plant staff level, these costs were rolled up for each of the major processes 1. The total cost of changes to schedule was staggering. As a result of this information, the plant staff began to consider policies regarding what schedule changes they would accept, how they would handle them, and how to make the associated costs visible to the rest of the corporation.

There are two ways to determine the cost of an activity - the peanut butter method and the detail method. The peanut butter method uses an aggregate cost (such as a departmental budget) and divides it by the number of occurrences of the activity. For example, the cost of paying an invoice:

Cost of paying an invoice = Budget of the accounts payable department Number of invoices paid in the same period

The detail method calculates cost from one occurrence of the activity by flow charting the process, identifying who does each step and how long it takes and costing each step based on the mean salary of the labor grade of the person doing the work (calculated per minute) times the time (in minutes) that the task takes. Adding up the cost of each step yields the cost of the activity. The detail method takes a little longer, but it is much more accurate.

RESULTS OF IMPLEMENTING ABC. The most noticeable result of implementing ABC was a shift in thinking and decision-making on a plant-wide basis. The question, "What is this going to do to us?" began to be asked regularly when major events were pending, and at last, they were able to really answer that question.

The purchasing manager was able to appropriately present her case for determining budget and headcount based on anticipated real work, not on purchase dollars. She was successful in changing the process.

The process of determining activities and drivers laid the groundwork for continuing process improvement activities. Most functions used the detail method to cost their activities. This gave them the information to both simplify the processes and dollarize the changes. (How can we do the activity with less work and less cost?) On a plant-wide basis, eliminating work became a recognized (and dollarized) form of cost savings.

Major plant processes flow through many different functions. As a result of rolling up the functional data by major process, everyone began to understand their effect on other functions and other people. Cross-functional understanding and support were enhanced significantly. Also, process simplification was viewed cross-functionally. Saving costs in one area by shifting the work to another area did not yield any benefits.

A subtle but major benefit was a shift in thinking from being locked inside a system to looking at what is really happening. Victim thinking began to shrink and people felt like they were safe in an environment where decisions would be made based on reality, not on warped belief.

If any of the issues presented here strike a chord of familiarity, then Activity-Based Costing may be a concept that you will want to investigate more carefully.

FOOTNOTE
1 The major plant processes analyzed included:

  • the cost of schedule changes
  • the cost of quality failures (called the Price Of Non-Conformance, PONC)
  • the cost of new product introductions
  • the cost of new part numbers

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