Mike Lucas, of the University of Buckingham, describes how absorbing
certain fixed overhead costs into unit product costs can complement Kaplan and Coopers approach to !BC, to improve the "uality of planning and decision making #eceived wisdom has it that absorption costs should not be used for decisionmaking, i$e$ non%volume related costs should not be allocated to the product unit level$ &f such costs are allocated down to the product unit level, the resultant unit cost will be a function of production volume$ 'ake, for example, the cost of performing a machine set%up$ 'his will be independent of the number of units to be produced$ Conse"uently, if the si(e of a production run is halved, the per unit cost of a machine set%up is doubled) *uch a cost is therefore only valid for one particular volume of output, whereas most planning or decision%making deliberations involve potential changes in volume$ 'he supposed raison detre of !BC is to improve the "uality of planning and decision%making+ an !BC unit cost is therefore of little value$ 'his principle is recognised by Kaplan and Cooper in their advocacy of !BC for planning and decision%making purposes$,-. &t is also acknowledged by /rury in his fourth edition,,0. in which he describes Kaplan and Coopers approach to !BC$ 'he principle is still largely disregarded by a number of textbook writers, who continue to present !BC as primarily a product costing system%%a more sophisticated absorption costing system, using a number of absorption bases 1cost drivers2, rather than 3ust one volume related basis such as labour hours$ Kaplan and Gooper's approach to ABC Kaplan and Cooper, in their exposition of !BC, explicitly condemn the practice of allocating nonvolume related costs to the product unit level$ Conse"uently, their conception of !BC is as a more sophisticated marginal costing system%%employing contribution analysis at several different levels$ &n their approach to !BC, the firm is envisaged as a hierarchy of costs with each level representing a different type of cost variability%%as shown in 4igure -$ 'he lowest three levels in the hierarchy are concerned with product related costs$ Unit level costs are short term variable costs such as direct material, direct labour and so on$ 'hese costs vary in direct proportion to the number of units produced$ Many product related costs are not, however, driven by the number of units produced per se, but by the number of batches5production runs undertaken$ !n obvious example of such batch level costs is machine set%ups$ 'he third category of product sustaining costs relates to activities which are necessary to maintain the product in the firms product range$ 4or each product, a firm must maintain a bill of materials, a routing sheet, tooling and so on$ *uch product sustaining activities will increase as more products 1or product variants2 are added to the product range$ *uch costs, however, will be independent of the number of units produced in a particular period$ &n addition to the various product related costs, there are some expenses which do not relate to individual products, but to particular customers, e$g$ order processing and distribution costs$ 4inally, there are certain general overheads which do not relate to any particular product or customer, such as the chief executives salary$ 6ith Kaplans approach to cost analysis there is no need 1or 3ustification2 for any allocation downwards from a higher level, of non%volume related costs 1in 4igure -2 to the product unit level$ #ather, contribution should be rolled upward when considering a particular decision$ ! unit%level operating margin for individual products can be calculated by subtracting unit%level costs from sales revenue$ 4rom this unit%level margin can be subtracted batch%related and product%sustaining expenses to arrive at a product%level margin$ *uch a margin can be calculated for each product in the range and from this can be deducted any customer related expenses to determine the profitability of a particular sales order$ 'his approach can give managers better insights into the nature of their costs and thus facilitate better informed decisions when bidding for 3obs or deciding which orders to accept$ 'he method can also be applied in determining the profitability of a product over a period of time%%not by calculating a full unit cost to compare with the selling price, but by identifying the demands the product puts on service and support activities$ 'he estimated cost of these activities is then added to the short%run variable costs of producing the units sold and this total cost is then compared with the total revenue earned by the product$ 'hus, for example, it may be revealed that low volume products are unprofitable because of the disproportionate demands placed on batch level activities%% a machine set%up is necessary whether one unit or one thousand units are being manufactured) !n important implication of Kaplans analysis is that the non%volume related costs included in any decision analysis are not short%term incremental costs, but proxies for long%run incremental cost%based typically on existing average activity costs$ 'hus, for example, the total cost of machine setups is divided by the number of set%ups performed to arrive at average cost per set%up$ 'his is then used as an estimate of the long%term incremental cost that will arise by performing machine set%ups$ Kaplan and Cooper argue the superiority of this approach on two grounds$ 4irst, they contend that it is probably not feasible to identify all the actual incremental costs of each decision in a complex, multi%product environment$ *econd, they argue that, during a particular period, numerous decisions are made independently of each other but the collective impact can be to drive up fixed costs over time, even though these longer%term cost increases are not incremental 1and hence relevant2 to$ any one particular decision$ 'he argument is that, if only actual incremental costs are considered when looking at a particular decision, a positive contribution is likely to lead decision%makers to embark upon actions 1e$g$ accepting marginal business2 which place demands on service and support functions$ 7ver time this consumption of service5support activities will start to drive up costs$ 'he current actual cost of support activities can be viewed as acting as a proxy for these long%run incremental costs$ 'he !BC approach is essentially a long%term one aimed at curbing the excesses which can result from traditional marginal costing%%which ignores potential long term increases in cost$ 'hus, although Kaplan and Cooper assert that !BC is not a decision% making tool 1but an attention directing one2, it is difficult to escape the conclusion that it is) &t is nearer to the truth to say that !BC is a tool for planning5decision%making, but one which uses proxies for long%term incremental cost rather than strictly decision%relevant incremental costs$ The role o cost allocat!on 'he 8immerman approach 'he Kaplan and Cooper approach is based on the received wisdom that non%volume related costs should not be allocated to the product unit level$ 'here is, however, a school of thought in favour of such allocations, suggesting that cost allocations have an important role to play in motivating and controlling managers$ 8immerman,,9. for example, suggested that there are certain service5support costs which are fixed with respect to short%run changes in production volume, but which are related, in the longer term, to the level of primary inputs 1e$g$ labour2$ *uch costs would typically be classified under the general overhead category in 4igure -$ !n example would be a works canteen$ :very additional worker employed places additional demands on the canteen$ !lthough actual cost of the canteen may be fixed in the short% term, opportunity costs arise in the form of delays and5or degradation of service to other users$ !s time goes by, management will tend to ad3ust the actual level of service provided, in order to reduce delays5degradation of service, and hence costs rise$ 8immerman argues that these opportunity costs and conse"uent long% term incremental actual costs should be taken into account by individual managers when deploying labour resources$ *uch costs are hard to observe5measure, but allocating current average cost can serve to proxy them$ 'hus, for example, a production manager deciding on the optimal mix of factor inputs will be induced to take into account the additional costs of using labour%%in terms of the demands it places on the works canteen%%if labour hours are made to carry the burden of recovering this overhead cost$ 'he resultant factor input mix, it is argued, will be closer to the optimal one than would be the case if such costs were ignored$ 'his principle can be illustrated by 4igure 0, which shows how the selection of input factors 1in this example, capital and labour2, to produce a given output, depends on the relative prices of those factors$ 'he iso"uant shows all the possible combinations which could be used to produce a particular output$ !ll points assume technical efficiency 1i$e$ no waste2+ the optimal combination 1i$e$ that producing the lowest unit product cost2 will depend on the slope of the isocost line which represents the relative prices of input factors$ &socost line - represents relative prices if the demands placed by labour on service departments such as the canteen are ignored and only the actual cost of labour itself is taken into account$ 'he true cost of using labour resource is understated and in conse"uence more labour hours are used than would otherwise be the case$ 'he manager is, in effect, basing his decision on false price information$ &f the true cost of using labour is proxied by means of charging labour hours with service department overhead, the relative price of labour increases, as shown by isocost line 0, and less of it should be used$ 'he resultant input mix 1point 02 is closer to the real optimum, because the hidden costs of using labour are recognised$ By charging labour hours with fixed overhead burden, overhead is factored into the unit product cost$ &f a unit re"uires one labour hour, a corresponding amount of overhead will be included in the unit cost$ !ccording to the logic of 8immermans argument, this is 3ustified since, in the longer term, actual costs of the service resource will tend to rise in relation to the number of labour hours worked and the allocated fixed cost is a proxy for these additional costs, i$e$ one labour hour gives rise to x canteen cost$ 'he "uestion naturally arises as to which costs should be classified as long%run volume%related costs and thus allocated to the product unit level% after all, virtually all costs change if volume is increased enough) 6hat about, for example, rent; 8immermans argument appears to relate to those areas where there is additional consumption of resources as a result of an increase in a primary input such as labour$ !s a conse"uence of this consumption of resources, delays5degradation of service to other users occurs$ 'hese opportunity costs give rise to additional actual costs in the longer term as management ad3usts the level of service provision$ 'his is unlikely to apply to rent, unless a huge increase in labour force was being contemplated%necessitating a new factory) 'herefore an assumption about the likely volume level over the planning hori(on is re"uired in deciding whether to allocate or not to allocate$ &f, over the anticipated volume range, significant delays5 degradation of service%%as a result of increasing primary inputs%%are considered a realistic possibility, then there is a good case for cost allocation$ 6here, over the anticipated volume range, it is considered unlikely that delays5degradation of service to other users will result%%as a conse"uence of increasing primary inputs%%there is not a good case for cost allocation$ !pplying this criterion, it may be appropriate to allocate works canteen, payroll and personnel costs, for example+ it will probably not be appropriate to allocate rent and so on$ 'he <apanese approach ! slightly different rationale for cost allocation is that apparently adopted by a number of <apanese manufacturing firms; 'hese firms load labour hours with overhead burden%%not because they believe this will result in an optimal mix of inputs, but to encourage the substitution of capital for labour as part of their advanced manufacturing technology 1!M'2 strategy$ !ll production overhead%%including non%volume related costs 1i$e$ batch level, product%sustaining level costs etc2 are allocated using labour hours$ Conse"uently, the resultant unit costs are of little use for either longterm or short%term decisions%%since they are neither the short%term nor long%term incremental costs of producing a unit) <apanese managers do not believe that the resultant product costs are a reasonable proxy for long run incremental costs+ rather, they believe that the behavioral benefits accruing from cost allocation outweigh the disadvantages, namely inaccurate product costs and possible erroneous decisions) <apanese companies tend to use estimated product costs produced outside the management accounting system and based on managers past experience or intuition$,=. &t appears that the primary purpose of management accounting in <apan is to influence behaviour rather than to provide accurate product costs$ &t is not clear that the 6est is ready to sacrifice its penchant for accurate product cost information, which has been the cornerstone of western management accounting since its beginning$ Concl"s!on Kaplan and Cooper argue that if higher%level, nonvolume related costs such as batch level costs etc are allocated to the product unit level the resultant unit cost will be largely meaningless$ Clearly, their approach to !BC cannot be reconciled to that of the <apanese companies$ 'here is, however, no necessary contradiction between the Kaplan5Cooper approach and that of 8immerman$ 8immerman merely introduces a category of long%run volume related costs which are effectively ignored in Kaplan and Coopers analysis$ 'he only necessary difference is that, with 8immerman, the unit level cost would include a proxy for the hidden costs of using labour that arise in the longer term$ 'here would appear to be a good case, therefore, for including 8immerman type allocations in a Kaplan and Cooper style !BC system$ /&!>#!M? 4igure -? 'he firms cost structure 1adapted from Kaplan and Cooper,l.2 >#!@A? 4igure 0? 'he selection of the optimal mix of input factors @oint - shows the least cost combination of inputs when no account is taken of the demands placed on a service function by the employment of labour$ !t this point, L- of labour will be used in con3unction with C- of capital$ &f labour is charged with the burden of service cost recovery, the least cost combination shifts to point 0$ !t this point, less labour will be employed%% L0, and more capital%%C0 -$ K!@L!B, #$? Contribution margin analysis? no longer relevant *trategic cost management? the new paradigm, from a paper presented at annual meeting of 'he !merican !ccounting !ssociation$ <ournal of Management !ccounting #esearch, 0, 4all -CCD$ 0$ /#U#E, C$? Management and Cost !ccounting 1Fth ed2$ 'hompson Business @ress, -CCG$ 9$ 8&MM:#M!B, <$L$? H'he costs and benefits of cost allocations, 'he !ccounting #eview, L&I, 9, <uly -CJC$ F$ M!K&/7, '$? #ecent trends in <apans cost management practices in <apanese Management !ccounting, edited by M7B/:B, E$ and *!KU#!&, M$ @roductivity @ress, Cambridge, Mass, -CKC$ =$ E7*A&K!6!, '$? Characteristics and practical applications of <apanese cost accounting systems in <apanese Management !ccounting edited by M7B/:B, E$ and *!KU#!&, M$ @roductivity @ress, Cambridge, Mass, -CKC$ Copyright of Management !ccounting? Maga(ine for Chartered Management !ccountants is the property of Caspian @ublishing and its content may not be copied or emailed to multiple sites or posted to a listserv without the copyright holders express written permission$ Aowever, users may print, download, or email articles for individual use$ Bac#