Case Studies on Project Cost Management
Contents:
• What is Project Cost Management?
• Importance of project cost Management?
• Steps in Project Cost Management?
• Case 1: Public Sector Cost management practices in the Netherlands
• Case 2: Cost management of IT beyond the cost of ownership models: a state of the art overview of the Dutch financial services industry
• Case 3: A case study of an automotive company
• Case 4: Case Study on An application based costing in the air conditioner manufacturing industry
• Case 5: Cost Management in Sri Lanka: A Case Study on Volume, Activity and Time as Cost Drivers
• References
What is Project Cost Management?
Project cost management is the process of estimating, budgeting and controlling costs throughout the project life cycle, with the objective of keeping expenditures within the approved budget.
For a project to be called successful, it’s necessary that
- it delivers on the requirements and scope
- its execution quality is of a high standard
- it’s completed within schedule and
- it’s completed within budget.
Hence, project cost management is one of the key pillars of project management and is relevant regardless of the domain, be it manufacturing, retail, technology, construction and so on. It helps to create a financial baseline against which project managers can benchmark the current status of their project costs and realign the direction if needed.
Importance of project cost management
The importance of cost management is easy to understand. To take a simple, real-life example, if you decide to build a house, the first thing to do is set the budget.
When you have a sense of how much to spend on the project, the next step is to divide the high-level budget into expenses for sub-tasks and smaller line items.
The budget will determine critical decision points such as: which designer to hire — a high-end one who will construct and deliver the project end-to-end, or someone who can help with a few elements and be able to work for a smaller budget? How many stories should the house have? What quality of materials should be used?
Without a predefined budget, not only is it difficult to answer these questions, but it becomes impossible to assess whether you are progressing in the right direction once the project is underway.
By implementing efficient cost management practices, project managers can:
· Set clear expectations with stakeholders
· Control scope creep due to transparencies established with the customer
· Track progress and respond with corrective action at a quick pace
· Maintain expected margin, increase ROI, and avoid losing money on the project
· Generate data to benchmark for future projects and track long-term cost trends
Steps in project cost management
While cost management is viewed as a continuous process, it helps to split the function into four steps: resource planning, estimation, budgeting and control. They are mostly sequential, but it’s possible that some resource changes happen midway through the project, forcing the budgets to be adjusted.
Project Resource Planning
Resource planning is the process of identifying the resources required to execute a project and take it to completion.
Resource planning is done at the beginning of a project before any actual work begins.
To get started, project managers first need to have the work breakdown structure (WBS) ready. They need to look at each subtask in the WBS and ask how many people, what kind of skills are needed to finish this task, and what sort of equipment or material is required to finish this task.
By adopting this task-level approach, it becomes possible for project managers to come up with an accurate and complete inventory of all resources, which is then fed as input into the next step of estimating costs.
Cost Estimation
Cost estimation is the process of quantifying the costs associated with all the resources required to execute the project. To perform cost calculations, we need the following information:
· Resource requirements (output from the previous step)
· Price of each resource (e.g., staffing cost per hour, vendor hiring costs, server procurement costs, material rates per unit, etc.)
· Duration that each resource is required
· List of assumptions
· Potential risks
· Past project costs and industry benchmarks, if any
· Insight into the company’s financial health and reporting structures
Estimation is arguably the most difficult of the steps involved in cost management as accuracy is the key here. Also, project managers have to consider factors such as fixed and variable costs, overheads, inflation and the time value of money.
The greater the deviation between estimation and actual costs, the less likely it is for a project to succeed. However, there are many estimation models to choose from. Analogous estimation is a good choice if you have plenty of historical cost data from similar projects. Some organizations prefer mathematical approaches such as parametric modelling or program evaluation and review techniques (PERT).
Cost Budgeting
Cost budgeting can be viewed as part of estimation or as its own separate process. Budgeting is the process of allocating costs to a certain chunk of the project, such as individual tasks or modules, for a specific time period. Budgets include contingency reserves allocated to manage unexpected costs.
Budgeting creates a cost baseline against which we can continue to measure and evaluate the project cost performance. If not for the budget, the total estimated cost would remain an abstract figure, and it would be difficult to measure midway. Evaluation of project performance gives an opportunity to assess how much budget needs to be released for future phases of the project.
Cost Control
Cost control is the process of measuring cost variances from the baseline and taking appropriate action, such as increasing the budget allocated or reducing the scope of work, to correct that gap. Cost control is a continuous process done throughout the project lifecycle. The emphasis here is as much on timely and clear reporting as measuring.
Along with the cost baseline, the cost management plan is an essential input for cost control. This plan contains details such as how project performance will be measured, what is the threshold for deviations, what actions will be done if the threshold is breached, and the list of people and roles who have the executive authority to make decisions.
Public Sector Cost management practices in the Netherlands:
Abstract:
Purpose — The purpose of this research project is to validate the claim that recent developments in the public sector have increased the demand for and use of cost management information in public sector organizations.
Findings — The findings indicate that the design and use of cost management systems differ across branches. In addition, the results suggest that information from cost management systems is used to legitimate the organization’s activities to external stakeholders rather than to manage public sector organizations. Finally, cost management information is used mostly by financial managers yet hardly used by political managers. The results defy claims that cost management information has become important in managing public sector organizations. Research limitations/implications — All limitations of survey research apply. The survey is based on a non-random sample of public sector organizations in The Netherlands; findings may not be transferable to other countries.
Introduction:
Recent efforts to improve public sector performance (also known as new public management (NPM)) have focused on private sector management practices to improve efficiency and effectiveness in the public sector. Key aspects of NPM include a focus on the reduction of budgets, decentralization of activities to corporatized units, an emphasis on performance management and the prominence of managerial accountability. In addition, NPM suggests that the activities of public sector organizations should be “marketized”, i.e. that organizations should define products and services which are sold to “customers”.
Literature review:
Cost management can be defined as the application of management accounting concepts, methods of data collection, analysis and presentation in order to provide the information needed to plan, monitor and control costs.
Cost allocation design choices-
The first purpose of a cost management system is to attribute direct costs and allocate indirect costs to products and services.
Purposes of cost management information:
Cost management systems provide information (for example cost per product, use of resources, number of activities, etc.) that can be used for several purposes. Amongst other things, cost management systems provide information to (re)formulate strategy, translate strategy into plans and budgets, coordinate and communicate activities within the organization, set prices and value inventory, and provide a benchmark for evaluating performance.
Cost management in different public sector branches:
Several branches in The Netherlands have experienced a political as well as a managerial focus on cost reduction and effectiveness. At the central government level, there is a project to set clear and measurable goals and to evaluate whether these performance targets have been achieved within the budget that is available. At the municipality level, there have been initiatives to separate the political process from the financial management process. The main purpose of this initiative has been to reduce the amount of detail for members of the city council, in order to keep them focused on the general policies rather than on financial details.
Methodology:
Research design and data collection:
The analysis is based on survey data from a total of 57 organizations in the public sector. Instruments validated in previous studies have been used where possible in building the survey. Also, the survey instrument has been pre-tested by asking two public sector managers to complete the questionnaire; this led to some minor adjustments in the original survey design. Respondents are the people in the organization who are responsible for all the processes associated with the efficient acquisition and deployment of both short- and long-term financial resources. The job titles of the respondents are generally financial managers and controllers of these organizations.
Measurement of variables:
Three sets of variables are examined:
(1) the design of the cost system (costing methods);
(2) the use of cost accounting data; and
(3) the financial manager’s satisfaction with the cost system.
Design & Use of Cost Management System:
4 measures have been taken by the people to determine the level of cost management, Respondents have been asked what cost allocation method they use, they were asked which method is used to calculate product cost, the no. of supporting and general cost pools & also asked about methods to allocate overhead cost pools. Cost management information can be used:
• for financial reporting purposes (accountability);
• for managing programs, departments or activities;
• for evaluating the performance of a program;
• department or activity;
• to determine the price of internal sales;
• to determine the costs of inventory;
• to determine the costs of sales;
• to prepare privatization analyses;
• to benchmark with external market parties;
• to allocate budgets (planning);
• to compare budget to actual results (control); and
- to satisfy legislative requirements
respondents have been asked to identify which managers in the organization (general managers, program managers, financial managers, operational managers and political managers) use cost management information. Anchors for both questions included 0 ¼ not relevant, 1 ¼ not at all, and 5 ¼ to a very large extent. Respondents have also been asked to indicate whether management decisions (pricing of services, promotion of managers or privatization decisions) are based upon cost management information (ranging from 1 ¼ never, to 5 ¼ always).
Satisfaction with cost accounting information:
Respondents were asked three questions on their satisfaction with cost accounting information. First, financial managers were asked to indicate whether cost accounting information fulfils the information demands of potential users in the organization (ranging from 1 ¼ not at all, to 5 ¼ ½almost complete). Second, respondents were asked whether they get feedback about the usefulness of information from the cost management system (ranging from 1 ¼ never, to 5 ¼ ½almost always). Finally, financial managers were asked whether the financial system is up to standards (1 ¼ not at all, to 5 ¼ ½almost completely).
Results:
The table provides insight into the sophistication of the design of the cost management system.
The table suggests that about half of most public sector organizations (46 percent) use full-cost accounting. In 25 percent of organizations, cost accounting is based on direct costs plus an allocation of indirect costs (either a percentage or total indirect costs). Almost 18 percent solely trace direct costs to products and services, while about 10 percent use another method (mostly a mix of several methods, depending on the costs and purposes of the allocation). The use of direct costing is higher than in the sample by Geiger and Ittner (1996); one reason may be that public sector organizations in The Netherlands are generally allowed to freely establish selling prices for (a limited number of) products and services, as long as the income generated by these services does not exceed full costs (see Groot and Budding, 2004).
Purposes of cost management information :
The table suggests that cost accounting information is mostly used for planning and control, and financial reporting purposes. Cost management information is — to a lesser extent — also used to satisfy legislative requirements and to manage programs, departments or activities. Cost management information is hardly used for other managerial purposes, such as performance evaluation, privatization analyses, benchmarking with external parties or to determine sales prices or user fees. This last result may explain the relatively low use of full-cost accounting and the lack of allocation of cost pools.
Users of cost management information:
The table indicates that financial managers use cost management information most frequently; who notes that “[…] financial managers are the key persons in analyzing and presenting the information to the rest of the managers”. General managers and operational managers also use cost management information on a regular basis; Finally, program managers and political managers hardly use cost management information. However, Paulsson (2006) suggests that while politicians and senior managers do not read or analyze the cost management information themselves, this should not be interpreted as they do not use it.
Conclusion:
Cost management information is generally argued to be important to public sector organizations as it provides insights to reduce costs, decentralize activities, provide opportunities for performance management and increase managerial accountability.
Large-scale empirical evidence that validates these claims is hardly available; the purpose of this article is to provide such evidence based on a survey of Dutch public sector organizations. The results indicate that activity-based costing is not used on a widespread scale in The Netherlands.
A fair number of organizations do not allocate costs to products or services; one reason may be that such allocations are not required by legislation or regulations, or that organizations are not funded based on the products and services that are produced and/or delivered.
Case 2: Cost management of IT beyond the cost of ownership models: a state of the art overview of the Dutch financial services industry
Abstract
Controlling costs is an essential part of value-driven information technology (IT) management. This paper gives a state-of-the-art overview of IT cost management practice. Both theoretical and empirical approaches are taken. The theoretical approach is based on both general accounting literature and a study of the comprehensive and total cost of ownership models as propagated by various consultants. IT cost management in practice is studied through case studies at IT departments in 10 major financial services companies in the Netherlands.
Introduction
Cost management of information technology (IT) exists since the early days of computers (Bannister & McCabe, 1999). Given this amount of time, one might expect that the area of cost management would be well established. Profound knowledge of IT costs is in any case necessary in order to value and evaluate IT.
The study described in this paper provides a state-of-the-art overview of IT cost management. Both theory and practice are analyzed. The analysis of the theory is based on general accounting literature and cost of ownership models as propagated by various consultants. IT cost management in practice is studied through case studies at IT departments in 10 major financial services companies.
Most concepts regarding IT cost management are not uniquely defined. For example, costs may refer to cash flows or the accounting registration of costs. In this paper costs are defined as:
…the financial representation of the sacrifices an organisation makes in order to produce.
2. IT cost management theory
In this section, an overview is given of cost management literature and total cost of ownership models (TCO) in particular. Given the fact that most of the targeted audience of this paper is knowledgeable in the area of accounting, this section will be focused on the various TCO models and include accounting literature when appropriate.
TCO is a term that is frequently used in IT cost management literature, although often with different meanings and definitions. Most of the time the term TCO applies either to the costs of an information system or to the IT costs of an organizational unit.
The TCO of an information system is defined here as:
…all the costs associated with owning and using the information system throughout its life cycle.
The TCO of an organisation can be defined as:
…all the costs associated with owning and using IT by the organisation over a certain period of time.
TCO assessment and benchmarking:
Assessment of the TCO of a workplace is only mentioned in two cases. Most of the benchmarks concern either the costs of data centres or systems development. These benchmarks do not only look at the costs but, also consider the effectiveness and the price/performance ratio. In five cases, the IT organizations benchmark their costs externally, comparing themselves to IT organizations in other companies. In three of these cases, this is done on a regular basis. In the same three cases, the organizations periodically compare a number of high-level metrics directly with a number of their competitors in the Dutch financial market. In three cases models have recently been developed that should make internal benchmarking possible between different IT organizations within the same company.
There is disagreement on whether the benchmarking activity is actually worthwhile. The added value is questioned, because of the high costs of particularly external benchmarking and the questionable influence on strategic and tactical decision-making.
Overview of budgeting in case studies
Budgeting
Regarding budgeting, the following observations were made. All IT organisations in this study make yearly budgets. Most of them estimate the costs per client, however, in two cases the client also receives actual freedom to spend this budget. Internally, most IT departments make budgets per project and for going concern activities. This is closely related to the fact that project cost management and operational cost management are distinct activities in most IT departments. Some organisations make budgets per cost centre, i.e. organisational-unit. The number of budgets ranges from three internal departments in one case to over a hundred cost centres in another case.
Analysis of case studies:
From the case studies, it can be concluded that IT cost management is currently going through a phase of major changes, i.e. all organisations are busy making significant improvements. The most noticeable conclusions from the case studies are that:
A lack of historic data and experience with IT makes it difficult to pre-calculate costs for budgeting and investment evaluation purposes.
User departments indicate that they are unable to relate the costs of IT that they are charged, to their business processes. Therefore, the evaluation of whether the costs of operational IT are worthwhile is also difficult.
In seven cases the IT departments use traditional bookkeeping and budget procedures to control costs. Their financial administration does not provide them with adequate management information to control the costs of IT.
In three cases the IT departments use more advanced accounting models. These models share the similar feature that they are able to incorporate the business processes (internal processes) of the IT department into the model. This gives a better insight into the specific characteristics of both IT projects and IT operations and the costs involved.
The level of automation and alignment of the different administrative systems seems to be a critical success factor when using advanced cost models.
Given the first three points, we may conclude that in the majority of case organisations there is hardly a structured control of IT costs against benefits. Costs and benefits of projects are planned for, however, not evaluated afterwards. Costs of projects are controlled to the extent that these should stay within budget. Costs of operational information systems are hardly ever evaluated (planned or controlled) against benefits.
Summary and conclusions :
The theoretical approach is primarily based on the cost of ownership models. IT cost management in practice is studied through case studies at the IT departments of 10 major financial services companies. From the theoretical study, it can be concluded that existing cost of ownership models:
Provide insight into the IT costs of a single object (information system or organizational unit). Are applicable in TCO assessments and benchmarking. Do not support other cost management activities (i.e. budgeting, controlling project costs, controlling operational systems costs, and charging). These activities require insight into either the distribution of the costs over several objects or on a more continuous basis. From the 10 case studies, it can be concluded that:
· A lack of historic data and experience with IT makes it difficult to pre-calculate costs for budgeting and investment evaluation purposes.
· User departments indicate that they are unable to relate the costs of IT that they are charged, to their business processes. Therefore, the evaluation of whether the costs of operational IT are worthwhile is also difficult. In seven cases the IT departments use traditional bookkeep- ing and budget procedures to control costs. Their financial administration does not provide them with adequate management information to control the costs of IT.
· In three cases the IT departments use more advanced accounting models. These models share the similar feature that they are able to incorporate the business processes (internal processes) of the IT department into the model. This gives a better insight into the specific characteristics of both IT projects and IT operations and the costs involved
· Overall it is concluded that IT cost management is currently entering a new Nolan-like development stage. Traditional bookkeeping is experienced as being inadequate and the ad hoc use of cost-of-ownership models or benchmarking are unable to provide adequate cost control.
Case 3 : A case study of an automotive company :
Abstract:
Target Cost Management is well known as the Japanese companies’ competitive tool. Some studies claim that it is very hard to implement it outside Japan. The purpose of this paper is to explore how TCM is being practised and what the major factors are that influence TCM in the non-Japanese environment. By using a case study approach, this paper compares TCM practices at a Malaysian automotive manufacturer with the previous case studies of Japanese automotive manufacturers. The results found that although the fundamental concept is similar, there are differences in details processes due to the adaptation to the contextual constraints.
Introduction
Under the current global competitive market, companies must offer the right products at the right prices and must manage their cost and profit to remain profitable. Studies show that many established Japanese companies use Target Cost Management (TCM), one form of Strategic Management Accounting (SMA), as their competitive tool since the 1970s. The TCM implementation helps Japanese companies to manage their strategies and operate speedily at a profitable margin. This is because TCM ensures products are sufficiently profitable when launched by managing the cost during the design stage while ensuring the products meet the quality and reliability standards, and other customers’ needs. It also reduces the risk of not making a sufficient profit and makes better and faster product development
The lack of explanation of TCM differences has caused a misunderstanding in TCM practices. In terms of TCM practices in Malaysia, a survey study by Tho et al. (1998) found that 41 per cent of 241 companies claim that they have implemented TCM. On the other hand, a survey study made by Nishimura (2005) in Singapore, Malaysia and Thailand found that the TCM implementation and its definition in Japanese affiliated companies of these three countries are not the same as in Japan. Nevertheless, since both studies only focused on the exploratory descriptive research of TCM, the actual TCM practices in Malaysia remain comparatively unknown because no in-depth empirical case study has been made to investigate it.
Accordingly, the current study attempts to address the following questions:
1. How is TCM being practised in the Malaysian environment?
2. What are the major factors that influence the design of the TCM implementation process in Malaysia?
Results
4.1. Plan Stage- Step 1: Setting the target-selling price
The literature indicates that Japanese companies set a tentative target selling price for their product by considering various internal and external factors such as top management strategies, profitability objectives, product attributes and functionality, and competitors’ reactions. Concurrently based on the overall corporate planning, thorough market research was conducted to identify the product features and specifications required by the customers. Company A did not conduct a new product market survey to identify each feature and specification the customers required for the new product nor did it decide on the features and specifications solely from the customers’ feedback.
Proposition 1: The degree of customer orientation may influence the design of the TCM implementation process.
The subsidiary companies in Malaysia have limited scope in determining the design or making major changes from the base design. Accordingly, the degree of customer orientation in terms of identifying and integrating all customer requirements in products’ features and specifications might be different compared with Japanese companies. Thus, this research suggests that the degree of customer orientation may influence the design of the TCM implementation process.
4.2. Plan stage-Step 2: Setting the target profit
The second step involves setting the target profit for future products. In setting the target profit, Japanese companies consider two important elements, of which the target profit must be realistic and must be able to offset the product life cycle cost. There is a lack of explanation in the literature concerning the prerequisite of the target profit selection method. This case study found that in setting the target profit, the case company used the base model profit ratio from a particular month of historical accounting statement with some adjustments. Then, the monthly average base model profit level and the monthly average budget-based business plan profit level were used as reference points to justify the target profit of the new products. This simple method was used due to the absence of long or mid-term profit planning, which considers the future competitive market condition and target profit guidelines information.
Proposition 2: The degree of information availability may influence the design of the TCM implementation process.
Many Malaysian companies still rely on financial accounting information for management accounting activities (Nishimura, 2005). Since TCM implementation requires a considerable amount of information (Kato et al., 1995), the unavailability of cost management information forced the case company to use financial accounting information with some adjustments. Thus, as proposed in proposition two, the degree of information available may influence the design of the TCM implementation process.
4.3. Plan stage-Step 3: Setting the target cost
In general, the total target cost can be derived by subtracting the target profit from the target-selling price. However, previous research found that Japanese companies differentiate the target cost and allowable cost. Target cost is more realistic compared with the allowable cost, which motivates the employees to achieve it. Unlike the Japanese companies, the case company did not differentiate the allowable cost and target cost. After deducting the target profit from the target-selling price, no adjustment was made to make the target cost more attainable.
In terms of setting the target cost, the literature highlight that Japanese companies break down the target cost into each cost item and major functions such as engine, transmission, and audio system. Then, cost engineers for each design group decompose the target cost to the group component and parts level to set each purchased part's target cost. At the case company, the process of setting the target cost was more complex. This was because usually from the initial stage, the total estimated cost was unable to meet the total target cost.
4.4. Plan stage- Step 4: Making the profitability feasibility study
This fourth step represents the assessment of project profitability. The special department, i.e. Cost Management Department compiles all the cost items and calculates the profitability feasibility study to assess the target profit achievability.
4.5. Do stage -Step 5: Achieving the target cost
In this stage, all the cost reduction plans are implemented to achieve the target cost. The literature indicates that usually, the total estimated cost does not achieve the target cost. Accordingly, further cost reduction is required to reduce the cost to meet the target cost level. This cost-reduction process is a continuous activity until it meets the target cost. Japanese suppliers also proactively participate to achieve the target cost by suggesting alternative design prospects. Compared with the Japanese company's close relationship with its suppliers, this research found that the case company's relationship with its suppliers was rather low. Furthermore, unlike the Japanese suppliers, the suppliers of the case company hardly suggested any cost reduction ideas. Accordingly, attaining this target cost upon initial quotation submission was the main criterion for the selection of suppliers.
Proposition 3: The degree of supplier relationship may influence the design of the TCM implementation process
TCM companies will reach a full integration stage when they have a close supplier relationship. The close relationship between the Japanese companies and their suppliers helps the Japanese companies to transmit down the competitive pressure to their suppliers and generate cost reduction throughout the supply chain. However, unlike Japan, the supplier relationship in Malaysia is rather low. Thus, as proposed in proposition three, a loose supplier relationship environment may influence the design of the TCM implementation process.
4.6. Check stage-Step 6: Monitoring and reporting the cost achievement status
The literature highlights that Japanese companies continuously monitor and report the target cost achievement status to ensure that corrective actions could be taken before the actual cost exceeds the target cost. This case study found that instead of monitoring and reporting the achievement status of all the cost items at the same frequency, the case company reported and monitored the locally purchased parts cost achievement status more frequently — on a monthly basis — than other cost items. However, due to the absence of the target cost for each individual part, Company A monitored the cost achievement status of the locally purchased parts on a design group basis only.
4.7. Action stage-Step 7: Cost improvement
After mass production, Japanese companies evaluate the overall TCM results against the original targets. The objective is to evaluate the degree of target cost achievement status. If the target cost is not achieved, a detailed analysis and study will be conducted to find the causes, where the gap occurs and the department’s responsibility. As the case company used the actual costing method, no comparison was made concerning the standard cost and target cost variance at the mass production stage. Accordingly, there was a lack of an accurate cost information cycle between the design and the production stages. Since the case company did not continue the cost reduction activities in the mass production stage by using Kaizen Costing or Cost Maintenance activities, the case company introduced Model X2, a new development project for the model X1, as the cost reduction project to make the product cost more competitive.
Proposition 4: The degree of integration with other systems may influence the design of the TCM implementation process.
The ideal situation for TCM is full integration with the other activities. The successful implementation of TCM requires the implementation of a lean manufacturing system and Advance Manufacturing Technologies (AMT). Nevertheless, not all organizations have the resources and support to create the ideal situation. Thus, as proposed in the fourth proposition, the degree of integration with other systems may influence the design of the TCM implementation process.
Conclusion
This single case study specifically explored how TCM is being practised in Malaysia compared with the Japanese theoretical model, and the major factors influencing the design of the TCM implementation process. This case study research was based on Yin’s (2003) case study method in which the data were collected through multi-sources of data collection. This case study found that the fundamental concept of TCM practices at the case company was similar to the Japanese companies’ practices. This research gives useful insight to the potential implementers in a non-Japanese environment context to understand the major factors that may influence the design of the TCM implementation process for more successful implementation specifically in the Malaysian context. Given the findings of this research, future research directions could cover the followings. First, the propositions on the factors influencing TCM should be statistically tested using various industries and large respondents. Second, since TCM is a dynamic process, how the TCM implementation process evolves over time in the same organization could be an interesting topic to explore.
Case Study on An application based costing in the air conditioner manufacturing industry:
Introduction:
Activity-based costing (ABC) has helped many manufacturing and Services organizations improve their competitiveness by enabling them To make better decisions based on an improved understanding of their Product cost behaviour. The main premise behind ABC is to classify Overhead or indirect costs and to allocate them to end products or services based on the activities required to produce these products. ABC takes a two-stage approach to allocating overhead Costs to products based on multiple cost drivers at various levels of activity. In the first stage, overhead costs are assigned to cost pools within an activity centre based on activity-driven cost drivers. There is no equivalent step in traditional costing accounting (TCA). In the second stage, overhead costs are allocated from the cost pools to the products based on the product’s consumption of indirect activities. This stage is similar to TCA except that the traditional approach uses a single volume-based cost driver to allocate overhead costs to products without consideration for non-volume-related characteristics. Experts believe that ABC can provide more accurate product costing information than TCA When products are diverse in size, complexity, material requirements, And/or setup procedures.
COMPANY DESCRIPTION
Located in Arkansas, AIRCO produces and sells high-quality, high-End industrial air conditioner units to a wide variety of customers. The Company has exhibited moderate growth during its 25-year existence. An Increased number of product lines over the years have been supported by Increasing the number of machines, workstations, and assembling lines. In addition, the number of operators and material handlers involved in The production process has increased. An information support team was Introduced to support the use of computerized production planning and Data management systems. AIRCO produces a variety of industrial air conditioner units that Range in power from 5 to 20 tons. Each unit consists of more than 200 parts including tubes, wires, metal sheets, cooling coils, insulation Materials, a controlling processor, and freon holding tanks. Some parts Are manufactured in-house, while others are purchased from outside Suppliers. There are currently more than 460 employees working for AIRCO. Eighty-eight percent of them are hourly workers; the remaining 12% Are classified as salaried employees. AIRCO operates two shifts per Day, 7:30 AM to 4:30 PM and 4:00 PM to 12:00 AM. The majority of workers (70%) are employed during the first shift. Direct labourers are broken down into 280 skilled and 80 unskilled workers, whose hourly rates are $18 and $14, respectively. AIRCO also employs 32 indirect labourers at an hourly rate of $10, who perform material handling and other support activities. The employment of these hourly workers cost AIRCO $11,827,200 in direct labour and $614,400 in indirect labour last year.
COMPANY STRUCTURE
AIRCO is structured into seven departments. Each department is managed by a department manager who works closely with upper plant management. In addition, the assembly & Testing and fabrication areas are overseen by workstations and line Supervisors.
Purchasing Department
The primary responsibility of the purchasing department is the selection of vendors that perform best in terms of cost, quality, and services. The purchasing department also monitors the arrival of raw materials to the factory, maintains the inventory levels of these materials, and manages scrap materials.
Engineering Department
The engineering department is divided into three functional areas: fabrication, assembly & testing, and quality control. This department is responsible for improving production processes, designing tools, and redesigning products according to customer specifications. The fabrication and assembly & testing areas are responsible for fabricating parts, assembling parts, monitoring production operators, maintaining machines, and testing final products. The quality control area is responsible for ensuring final product quality, performing quality studies, and processing customer complaints regarding product quality.
Financial Department
The financial department is responsible for maintaining the integrity of all financial data. This department also tracks the expenditures of all seven departments and ensures that departmental spending is within budgetary limitations. Furthermore, the department maintains wage rates for hourly and salaried employees.
Scheduling Department
The key functions of the scheduling department are to forecast product demand, collect and analyse production data at the shop floor level, monitor inventory levels, and manage work-in-process.
Material Control Department
This department is responsible for determining and handling materials according to specified orders, maintaining and monitoring delivery time, completing purchase orders, negotiating the price of the materials with the suppliers, and finding new material sources. The material control department plays an important role in decreasing costs and assuring the availability of materials by monitoring vendor performance in terms of cost, delivery, and quality.
Shipping Department
Human Resources Department
ACTIVITY-BASED COSTING SYSTEM DESIGN
The ABC system for AIRCO was developed using a five-step process:
1) Identification of overhead cost categories, 2) identification of cost Pools and drivers, 3) assignment of overhead costs to cost pools, 4)Product data collection and 5) final ABC analysis. The development process and results of each of these five steps are described in this Section.
Identification of Overhead Cost Categories
Identifying the overhead cost categories is the first and one of the most important steps in developing an ABC system. Expenses vary From department to department as most departments perform distinct Job functions with various consumptions of indirect resources. It is vital To investigate each department separately and identify what indirect resources are consumed and by how much. Most of the indirect resources at AIRCO are consumed by supplying power to machines, machine maintenance, wages paid to indirect labourers, computer and software systems, And marketing. Additional overhead costs include rent for facilities and Vehicles, transportation costs including the transport of raw material Purchases to the warehouses, customer service, and data management.
Identification of Cost Pools and Drivers
In practice, one can identify a large number of activities performed to Produce end products. For example, a setup punching machine process can be decomposed into numerous micro-activities Such as identifying tools required, cutting tools for each shape and size, Going to the tool crib, selecting the tool, bringing the tool to the machine, etc. Such A detailed process description is rarely practical in the development of An ABC system. If too many activities are defined, the cost of measurement for the ABC system grows disproportionately high. Activities should be aggregated into cost pools based on similar cost driver behaviour. Table 3 shows the eight cost pools that were Identified as primary indirect activities for AIRCO. These cost pools Were developed from the examination of overhead-related data, cost driver Analysis, and employee interviews. Two factors drive the cost of measurement associated with the number of cost pools in an ABC system. The first one is that the system Designer must specify the resources consumed by each activity and how Many times the same activity is used for the same output. If the number of outputs is high, identifying numerous activities can lead to a huge data collection task. Second, as the number of cost pools gets larger, the activity–output relationships become more difficult and costly to measure. In order to reduce complexity, key activities that are most important and highly related to indirect resource consumption should be identified.
Machines are the primary equipment used in the production and fabrication of parts and their assembly. Maintaining data records for all Products, designs, and customers is an important activity and were found To be driven by the number of products administered. Material handling Involves the movement of parts throughout the production and assembly Processes. This activity consumes a significant amount of indirect labour hours as it is currently performed manually at AIRCO. This manual Movement of materials is thought to be inefficient and may warrant the adoption of an automatic conveying system to move parts and materials within The facility. AIRCO produces multiple product lines that vary in design And volume; therefore, multiple changeovers occur as machines are set up between production runs. Scheduling and production preparation is Driven by the number of production runs as the number of production Runs and associated scheduling and preparation activities increase due To increases in customer orders. Receiving raw materials and outsourced Parts is an important activity that must be considered, as it consumes A lot of indirect labour. This activity also requires vehicles to transport The material and administrative assistance in scheduling and preparing Receipts, contacting suppliers, and managing warehouses. Final products must be shipped on time to customers in order to avoid penalties And reduce inventory costs. AIRCO customers are located throughout The United States, and therefore product shipping costs depend on the Distance travelled. There are frequent interactions with customers that occur between the time that the contract is signed and the final products.
Assignment of Overhead Costs to Cost Pools
Since machines consume most of the electricity, and other electricity consumption such as lighting and climate control is assumed to be negligible in comparison, all the energy expenses are assumed to be Consumed by the machine's cost pool. In addition, the machine's cost Pool is consuming all of the depreciation and maintenance expenses And a large amount of the computer and software and miscellaneous Resources. Thirty-five percent of the transportation costs are assigned to Raw material receiving & handling, while the remaining 65% are consumed in product shipping. Forty percent of facility and vehicle rent Is used in material receiving & handling; the remaining 60% is used In shipping finished goods to customer destinations. All business travel And advertising costs are consumed by customer service. Indirect labour was consumed across five cost pools with the majority consumed by the Material handling cost pool (55%). There are various consumptions of Computer & software and office & utility resources among the cost Pools. Miscellaneous expenses were assigned to cost pools based on Employee approximation and educated guesses. The study contains the resulting overhead cost of each AIRCO cost pool. Observation Indicates that the majority of overhead costs are being incurred by the Material handling and raw material receiving & handling cost pools. This confirms AIRCO’s suspicion that their material handling processes Are inefficient and supports investigation into the economic feasibility Of implementing automatic material handling systems.
Product Data Collection
AIRCO manufactures seven distinct product types, which can be classified according to their power specifically 5-ton, 6-ton, 7.5-ton, 10-ton,12.5-ton, 15-ton, and 20-ton. Production volume, unit selling price, direct costs, and cost driver levels for each product type were collected And are provided in Table.
CostPool Overhead cost ($)
Machines 435,425.00
Data record maintenance. 132,596.90
Material Handling 1,560,027.53
Product changeover. 723,337.75
Scheduling & production preparation 24,876.63
Raw material receiving & handling. 877,106.90
Product shipment 561,013.75
Customer service. 144,220.55
SUMMARY
An ABC system was successfully developed for AIRCO, a manufacturer of industrial air conditioner units. It was apparent from the ABC analysis that AIRCO products do not consume overhead costs on an A volume basis as represented by their current TCA system and valuable overhead cost driver information was obtained. The ABC analysis showed that the majority of their overhead cost was incurred to support indirect labour activities. When appropriately allocated to activity Driven cost pools, AIRCO found that a tremendous proportion (55%) Of their overhead expenditures was associated with material handling Activities. AIRCO was encouraged to streamline its material handling Processes by reducing raw material and part transport distances within The facility layout. AIRCO should conduct an economic analysis to determine the feasibility of implementing automatic material handling systems. Reduction of product changeovers through improved production Scheduling and more efficient product shipping practices were also recommended. The ABC analysis indicated that three of their seven products are losing money at their current selling prices. AIRCO should Investigate the market feasibility of increasing the selling prices of the 5-ton, 6-ton, and 12.5-ton units in conjunction with reducing the overhead resource consumption of these products. While the development process required a significant investment of time and effort from AIRCO employees, it was determined that the Development effort was worthwhile, as valuable process and product Information was obtained. In general, the required effort to develop an ABC system is strongly dependent on the amount and quality of available Data. In this ABC application, the use of estimation techniques, like the Expense activity dependence matrix, reduced the development effort to An acceptable level. The current ABC overhead rates will be valid until a Major process or product change occurs. The ABC overhead rates should Be updated to reflect any major operational or administrative changes. For example, if AIRCO changes their material handling process, this will likely change its overhead cost generation. In addition, the addition or Subtraction of a major product line may also dictate an update to the ABC System. The AIRCO ABC system was implemented in a spreadsheet, Which was designed to facilitate efficient updating.
References:
• Cost management of IT beyond the cost of ownership models: a state of the art overview of the Dutch financial services industry, Henno van Maanena, Egon Berghoutb,*
• Public sector cost management practices in The Netherlands Frank H.M. Verbeeten Rotterdam School of Management, Erasmus University, Rotterdam, The Netherlands
• https://www.ecosys.net/knowledge/project-cost-management/
• Cost Management in Sri Lanka: A Case Study on Volume, Activity and Time as Cost Drivers Janek Ratnatungaa, Michael S.C. Tseb, Kashi R. Balachandranc
• AN APPLICATION OF ACTIVITY BASED COSTING IN THE AIR CONDITIONER MANUFACTURING INDUSTRY Heather Nachtmann Mohammad Hani Al-Rifai Department of Industrial Engineering, University of Arkansas, Fayetteville, Arkansas, USA
Target Cost Management (TCM): A case study of an automotive company, Norhafiza Baharudin, Ruzita Jusoh
