1. Using Activity-Based Costing to Implement Supply Chain Improvements Terrance L. Pohlen Lt Col, USAF, PhD

2. Overview Why transportation and logistics managers require more accurate cost information How activity-based costing can provide greater management insight Using ABC to support transportation and logistics decision-makers Applying ABC to supply chain management

3. Critical link exists between corporate profitability and logistics costs and performance Many logistics costs and effects of logistics decisions buried in overhead costs Logistics particularly requires accurate costing – Diversity in resource consumption – Products and resource consumption not correlated with unit based allocation measures Identifying and costing activities may reveal opportunities to improve operating efficiencies Transportation and logistics managers need more accurate cost information

4. Problems typically encountered in transportation and logistics accounting systems Visibility frequently lost--included as part of SG&A Allocated using cases shipped, miles, or sales Costs not available by product, customer, or supply channel Affect of logistics decisions/improvements not readily apparent Output measures frequently not captured

5. “The imaginary profits--and losses--that arise from flawed cost systems can lead to very expensive blunders. We may be giving away the best business (high volume, but supposedly low margin products) to foreign companies. Competitors don’t want your cats and dogs--they want the volume business. Once the high volume products are abandoned, those that remain must carry a greater share of overhead, and thus they too become less profitable.” Fortune Magazine 12 October 1997

6. Activity DIRECT MATERIALS Direct Labor Activity DIRECT MATERIALS Activity DIRECT MATERIALS Activity DIRECT MATERIALS OUTPUT $$ Traditional Cost Accounting Direct Labor Direct Labor Direct Labor Overhead

7. Problems with Traditional Costing of Transportation & Logistics Unit based allocation suggests costs will vary with volume-- cannot accurately determine how changes in customer service effect total costs No reward for reducing indirect cost categories--benefits diffused across all products Costs “reduced” by eliminating direct labor Overhead costs appear “fixed” and not affected by management action Rewards based on cost center performance and not on total product/customer/channel profitability

8. Are U.S. Manufacturers’ Accounting Systems a Major Tool Used in Management Decision-Making? Source: National Center for Manufacturing Sciences, Focus, 1993 Yes 82% No 18%

9. Warning Signals: Division managers want to drop seemingly profitable lines Product or customer profitability is hard to explain Departments develop internal costing systems The accounting department performs many special projects Competitors’ prices appear unrealistically low You have a high-margin niche all to yourself Customers don’t mind price increases Adapted from Cooper, Robin, “You Need a New Cost System When...,” Harvard Business Review, January-February 1989, pp 77-79.

10. Supervision OfficeSupport UtilitiesSupplies Equipment Equipment ReceivingPut-AwaySet-Ups Resources Activities Cost Objects Packing & Shipping Product Division A Product Division B Product Division C Product Division D a technique to assign more accurately direct and indirect costs to the activities, customers or products which consume an organization’s resources Activity-Based Costing

11. IS: An overhead allocation technique which generates the cost of activities IS NOT: A bookkeeping system A consolidation system

12. General Ledger (account balances) ABC Model Data Decision Makers Activity-based information Cost data translated by ABC ABC translates traditional costing into actionable information for decision-makers

13. Supervision OfficeSupport UtilitiesSupplies Equipment Equipment ReceivingPut-AwaySet-Ups Resources Activities Cost Objects Packing & Shipping Product Division A Product Division B Product Division C Product Division D How Does ABC Assign Costs? ABC uses a two-stage process to assign costs –Resource costs are assigned to activities based on use –Activity costs are assigned to the products or customers consuming the activity

14. Activity DIRECT MATERIALS Direct Labor Activity DIRECT MATERIALS Activity DIRECT MATERIALS Activity DIRECT MATERIALS OUTPUT $$ Activity-based costing approach Overhead Direct Labor Overhead Direct Labor Overhead Direct Labor Overhead

15. Resources Resources are usually derived from the general ledger accounts Represent the resources the organization has to perform its mission Many ABC models use budget information to determine resources Office Labor 9% Dock Labor 32% Yard Labor 5% Utilities 1% Pickup & Delivery Drivers 18% License 1% Fuel 7% Maintenance 5% Depreciation 4% Insurance 2% Terminal 13% Supervision 3%

16. Assigning Resource Costs Resource drivers used to assign costs to activities Interviews frequently used for making the cost assignments Activity costs are sum of all resources needed to perform the activity Office Labor 9% Dock Labor 32% Yard Labor 5% Utilities 1% Pickup & Delivery 18% License 1% Fuel 7% Maintenance 5% Depreciation 4% Insurance 2% Terminal 13% Supervision 3%

17. Activity Cost An activity’s cost is the sum of the resources used in performing the activity Consumption used to trace resource costs to the activities Labor 47% Facility 36% Supplies 10% MHE 2% Supervision 4% Maintenance 1% LTL Shipping Activity

18. Identification and Number of Activities Activities identified by implementation team Level of detail determined by: Cost Diversity Management Focus Most DCs using 20-40 activities for costing Pick lists Placed in Window Pallet picks sent by RF to Fork lifts Warehouse Signs for and Takes Pick List Property picked and Palletized Pallet moved to Shrink Wrap Area Pallet Shrink-Wrapped Pallet moved to Staging Area Pallet picks sent by RF to Fork lifts Warehouseman Annotates Work Log Orders Requiring CHEP Pallets Re-palletized

19. ReceivingCartage Unload and inspect Putaway StorageBulk storage Aerosol storage Transp PlanningPre-shipment scheduling Truckload planning Post-shipment support Transportation Administration PickingManual picking Mechanical picking Stage pallet for order Build pallet Special HandlingAdjust pallet height Clamp off/slip sheet Spec Hdling/Warehouse office ShippingLoad pallet Check full pallet Check mixed pallet Ship international order Ship small package order AdministrationReturns Rework Administration Product Customer Brand

20. Assigning Activity Costs Activity costs assigned using cost drivers Costs assigned on a per activity basis (per case, shipment, bill of lading) Desired behavior should be considered when selecting a cost driver

21. Assigning Distribution Center Costs We assign the cost of this activity Manual picking Rework Unload & inspect Truckload plng Bulk storage Administration to this cost object: customer brand product customer product brand using this activity driver cartons mech picked cartons reworked pallets unloaded pounds shipped avg pallet on hand no. of cartons shipped

22. Cost Objects The final output of the organization Typically a customer, product, service, or distribution channel Provides total cost of logistics support

23. Cost Object: Bill of Activities Pickup 15% Billing 2% Line Haul 55% Delivery 6% Dockhandling-Origin 10% Processing Claims 1% Dockhandling- Destination 8% Scheduling 3% Breakout of Customer A Costs

24. Product Division A 31% Product Division B 40% Product Division C 16% Product Division D 13% ABC Results Product Division A 29% Product Division B 30% Product Division C 20% Product Division D 21% Traditional Costing Results

25. Comparison of ABC and Traditional Costing Focus shifts from correlating unit level cost drivers (direct labor hours) to correlating cost drivers at the unit, batch, and process levels Overhead assigned to activities based on consumption--costs assigned to products based on the consumption of the activities performed “Fixed costs” viewed as long-term variable costs affected by short-term management decisions Isolation of costs enables managers to trace cost reduction efforts to specific products, customers, or supply channels--benefits no longer diffused Managers can trace the effect of decisions on product or customer profitability--ABC captures the effects of diversity ABC provides significant amounts of non-financial information--useful for integrating cost management with performance management

26. How ABC Can Assist Logistics Decision-makers Can more accurately determine how changes in service requirements will affect logistics costs Provides ability to trace indirect resources to logistics activities and outputs Focus on high cost activities or processes Translate logistics performance into corporate profitability Greater visibility over logistics costs--better trade-offs within the firm Simulate changes and impact on logistics costs

27. Benefits Obtained From ABC Identify cost driver Performance measures Improved cost info Better pricing Elim redundant work Cost control 65% 59% 47% 41% 23% LaLonde and Pohlen, Journal of Business Logistics, 1994

28. Office Labor 9% Dock Labor 32% Yard Labor 5% Utilities 1% Pickup & Delivery Drivers 18% License 1% Fuel 7% Maintenance 5% Depreciation 4% Insurance 2% Terminal 13% Supervision 3% Load delivery Billing 4% Handling 10% Pickup 6% Deliver LTL 17% Deliver TL 8%Accessorial Services 5% Line haul 8% Scheduling 3% Load line haul 6% Unload 8% Maintain vehicles 10% Process Claims 4% Marketing 5% Customer A 32% Customer B 26% Customer C 17% Customer D 10% Customer E 8% Others 7% ABC demonstrates how logistics resources and activities are consumed

29. Problems frequently encountered during ABC implementation Management and employee buy-in A new “system” and stand alone initiative Accuracy versus precision Delay in immediate pay-off Multiple views on cost allocations and costs Putting controller in charge Too much detail--costing vs reengineering Cost and effort required during implementation

30. Where ABC best practices are being implemented General Analysis:Nabisco, Roundy’s, Food Lion, Tops, Coca-Cola, Pepsi-Cola, Dial Corp, Bozzotos, Kroger, Shaw’s Category Analysis:Procter & Gamble, Super Valu, Fleming, H.E. Butt Menu Pricing:Spartan, Fleming, Super Valu

31. Application of activity-based costing to supply chain management ABC can evaluate alternative supply chains Activity analysis can achieve a sustainable competitive advantage by lowering costs or differentiating services Supply chain analysis enables firms to exploit linkages and perform trade-offs across the entire supply chain ABC/ABM provides means for assessing individual firm as well as supply chain performance

32. Vendor (Upstream) Customer (Downstream) Perspective of the Firm Marketplace Landed Cost Total Cost of Ownership DPP, ABC Supply Chain Costing

33. Why supply chain costing? Determine overall effectiveness of the supply chain Identify opportunities for improvement Measure performance Evaluate alternative supply chain structures Select supply chain partners Support “make versus buy” decisions Negotiate prices Evaluate effects of technology improvements Reengineer the supply chain Supplier Materiels Management Operations Physical Distribution Customer Transaction costs Information costs Physical flow costs Supply Chain Costs Inventory Carrying Costs

34. Why use supply chain costing?: customer and channel profitability Type of customer and distribution channel generally have greater affect on costs than product type ABC can determine how customers/ channels drive indirect costs Customer/channel costing provides technique for assessing profitability Joint action between supply chain members can reduce costs

35. Using ABC to simulate cost changes within the supply chain Target Setting Activity Analysis Process redesign Activity- based costing Performance measurement & benchmarking Problem solving TimeQualityCostFlexibility The Continuous Improvement Cycle, Paul Sharman, CMA Magazine, Vol 66, No. 4

36. Distribution Center Application: Activity Volume Change Determine how anticipated shifts in activity volumes will affect distribution center costs. Use cost per activity and activity volume to assess effect Example: Customers order more frequently but in smaller quantities

37. Activity volume example Activity Load Whse Transfer Load Pool Shipment Load LTL/UPS Storage Process Orders Process Returns Pull/Put Full Pallets Ship Priority Ship Routine Pick/Build Orders Receive Whse Transfer Cost per Activity $150/truck 210/truck 16/shipment 125/pallet/year 18/order 75/return 4/pallet $40/shipment 36/order 95/WT Activity Volume +300 -2,100 4,800 +5,400 $10,800 -10 +300 Net change to the DC: +$18,900 $25/shipment Change

38. Using ECR scorecards to determine supply chain capabilities and costs

39. Activity-Based Management Use non-financial data provided by ABC to drive continuous improvement and reengineering Link performance measurement system to changes in process costs or profitability ABC can trace effect of management decisions to changes in total process cost or profitability

40. The Two-Dimensional ABC Model Activities Performance Measures Cost Drivers Cost Objects Resources Process View Peter B. B. Turney, Common Cents Cost Assignment View

41. Focus of early ABC efforts Objective - more accurate product costs for product mix, sourcing and product design decisions Activities Cost Objects Resources Cost Assignment View

42. Process View Focus of newer ABC implementations Objective - improving operational processes by identifying (and eliminating) non-value-added activities Activities Performance Measures Cost Drivers Process View

43. Balanced scorecard approach Financial Perspective GoalsMeasures Internal Business Perspective GoalsMeasures Innovation and Learning Perspective GoalsMeasures Customer Perspective GoalsMeasures How do we look to shareholders? What must we excel at? Can we continue to improve and create value? How do customers see us? Kaplan, Robert S., and David P. Norton, “The Balanced Scorecard - Measures That Drive Performance,” Harvard Business Review, January-February 1992, pp. 71-79.

44. Vendor/Carrier Evaluation Vendor selection affects the costs of ordering, expediting, receiving, inspection, production, and distribution ABC provides a means of more accurately tracing how vendor decisions affect total costs Purchasing managers can use “total cost of ownership” in vendor selection and evaluation Activity analysis opens potential for exploiting vendor-buyer linkages to reduce costs and differentiate service Use ABC to assess current carriers and vendors:

45. Key References Turney, Peter B. B., Common Cents: The ABC Performance Breakthrough, Portland, OR: Cost Technology, 1993. Player, Steve and David Keys, Activity-Based Management: Arthur Andersen’s Lessons from the ABM Battlefield, New York: Mastermedia Ltd., 1995 Journal of Cost Management published by Warren, Gorham & Lamont Brinker, Barry, editor, Emerging Practices in Cost Management: 1996 Edition, Warren, Gorham & Lamont, 31 St. James Avenue, Boston, MA 02116, (800) 950-1213 Cokins, Gary, Activity-Based Cost Management: Making It Work, Chicago, IL: Irwing Professional Publishing, 1996