The ABC Costing Method vs. Traditional Costing in Logistics Systems

THE ABC COSTING METHOD VS. TRADITIONAL COSTING IN LOGISTICS SYSTEMS.

Logistics systems in many organizations, generally speaking, used the traditional method of cost. This method considers the basic concepts of costs, such as total cost, variable cost, fixed cost, and the corresponding unit costs (average cost, unit variable cost and fixed cost per unit). It also takes into account the marginal costs and other cost items such as sunk costs, direct costs, indirect costs and mixed costs. This traditional costing, generally speaking, is governed by the norms and standards of cost accounting.

Despite the utility of this traditional system, some analysts have found that this method of costing has some inconsistencies that could lead to wrong decisions. The traditional costing determines the direct costs (labor and raw materials), as the quantities used and unit costs of each of these elements. Indirect costs are allocated primarily by the volume of units produced. The latter has been found inconvenient.

Therefore, it has been proposed for several years a new system called “Costing ABC – Activity Based Costing”. This is a management system, and it is based on the allocation of indirect costs to activities related to the units produced. Direct costs are calculated in the same way, since there is no difficulty for their calculation. The ABC Costing includes these elements: Resources needed, such as direct labor, machinery, equipment and energy, among others; the Activities such as production management, operation of machinery and the recruitment of the machinery; and Products (product 1, product 2, and so on).

Therefore, the ABC Costing broadly includes the following phases:
1. Analyze, systematically, all activities required to produce a product or service.
2. Decide how to group them in Activity Centers.
3. The third step in the design of an ABC costing system is the association of costs with activity centers.
4. The fourth step in the design of a costing system ABC is the selection of inductors cost, also called drivers, since they are generating costs.

An important advantage of ABC Costing is that let determine the unnecessary activities, which can be eliminated without affecting the structure of the enterprise, leading to a rationalization of costs. Another significant advantage is that the allocation of indirect costs is more suited to the different units produced, which facilitates cost analysis and decision making. The debate on this issue would be to discern and review the advantages and disadvantages of each of the two sets of costs, based on the issues presented herein and the knowledge and experience of the bloggers.

One thought on “The ABC Costing Method vs. Traditional Costing in Logistics Systems

  1. Unfortunately, getting a firm grip on net margins is a black hole for many managers.Traditional costing and management accounts are of little help.The use of ABC can often be fundamental to uncovering the hidden causes of massive losses. The following example is not that uncommon.

    A wholesale mobile phones business in the UK had done well in the early days of high demand, growing both its customer base of retail outlets and levels of service to become a large and impressive business. But with the proliferation of customer types and enhanced levels of service there came another change. On a turnover of £250m it began to make £1.5m per month losses. As sales volumes increased so profitability plummeted. Its share price followed. A tumble to 3% of its highest level. Shareholders became highly concerned.

    Eliminating the root causes of the problem became the key to turning the business round. The CEO set down two objectives:
    1. reduce the unit costs of all the processes
    2. eliminate any characteristics of doing business that made them a loss

    As the company experienced rapid growth it started to miss deadlines, suffer re-work, lose data, and fail on promises to customers. The lack of process robustness was at the root of a growing blame culture and the source of high process costs. A core team of people drawn from each function
    set to work analyzing each process to uncover the problems and gauge what could be done to fix them. By working with groups of people representing each process, rapid agreements to changes were brokered followed by an eager desire to get the improvements in place. But the process analysis pointed ominously to more serious issues.

    Suspicion fell on the order quantities that customers were placing. The customers who ordered the highest order quantities, around 2,000 products at a time, were very rare. The majority ordered far fewer phones per order and about 20% of them were only ordering one product at a time. An analysis showed that about 50% of the customers ordered 4 or less units per order. These orders only added the last 5% of sales value and gross margin. But was the last 5% of gross margin sufficient to cover the cost of processing the orders? The truth was that some types of orders created overheads far higher than the gross margin.

    The ABC analysis found that the overriding cost driver in the business was the number of orders. Almost irrespective of the size of the order, each order drove much the same set of activities such as ‘order entry’, then ‘credit check’, then ‘pick & pack’, then ‘dispatch, then ‘invoicing’. So for any orders where the gross margin was less than the order processing costs, those orders made a loss. Suddenly the key issue dawned on everyone – far from believing that a positive gross margin was always good because it was making a contribution to overheads, if the real net profit was negative then more volume meant ever-increasing losses!

    Attention now turned to resolving two questions:
    1. Were there particular customers who were placing orders which just lost them money every time?
    2. Why when volumes were increasing did growth seem to lead to declining overall profitability?

    The analysis looked at the characteristics of various customer segments. One particular segment, small High Street Dealers, mostly ordered small quantities of phones with an average order gross margin of only £15. For the company as a whole the analysis had shown that the average cost to process an order was around £50 which meant that for the High Street Dealer segment, on average each order lost the company £35. This segment placed 87% of the orders accounting for over 50% of sales value! Taken together with other analyses, these customers were the source of the falling profitability of the business as overall volumes and number of customers increased. The company’s apparent successful growth had really been in ever increasing unprofitable business. By setting the minimum order value such that the gross margin was always greater than £50 ensured no unprofitable orders were taken. Most customers complied with the new minimum order values. Those that threatened to take their business to competitors were encouraged to do so. The competitors would welcome the business but unwittingly would be taking on a significant loss.

    The key lesson for this company was the ease by which they were blinded by apparent success. The founder and CEO of the business realised that he had grown the physical size of the company to service unprofitable business. The standard financial reports didn’t report on net profit at the product or customer level or on the relationship between costs and cost drivers, so even the finance function were blind to the underlying drift to disaster. Tracking the changes to net profit is not ordinarily shown in the management reports. It takes time and effort to unearth the real relationships between costs and the drivers of costs, and to understand how the relationships to certain customer segments sow the seeds of disaster as volumes increase.

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