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• W133886450 abstract "As every management accountant knows, misallocating costs can devastate a business. If management can't determine the real cost of a product, pricing decisions are no better than guesswork. Because of this problem and because activity-based costing (ABC) has proven effective and been increasingly popular in determining real costs in the manufacturing arena, we decided to test the feasibility of applying this costing method to purchasing. The test showed that ABC works well when used to analyze a purchasing department, and the information it provides is especially helpful when establishing a product's price and in determining its contribution to profit. This article describes the method used in this test and the issues related to applying the ABC system to the operations of a purchasing department. BACKGROUND OF THE TEST To determine the feasibility of ABC to purchasing, we asked a midwestern company that was having costing problems if we could examine its purchasing data. The company agreed, with the proviso that neither its identity nor its product be disclosed. However, to understand the data, readers must know that the products are assembled from the company's own foundry parts and from components purchased from outside vendors. And while some products are produced for inventory, most are for customer orders. ABC is an accounting method in which costs are identified with the activities driving them. ABC establishes the all-important link between decisions that cause activities and activities that cause costs. By focusing on cost drivers, management is in a much better position to identify and eliminate costs that do not add value. As a resuit, costs can be better managed and products more accurately costed. For a more detailed discussion of ABC, see the book, Management Accounting, by Don R. Hansen and Maryanne M. Mowen (Cincinnati, Ohio: South-Western Publishing Co., 1992, pages 233-73). For many years, the company allocated purchasing department costs by using a rate based on direct labor costs. When this amount was combined with other overhead, it amounted to overhead costs of more than 800% of direct labor cost. Then, in 1986, management decided the system was inadequate when it realized that direct labor in the plant was less than 7% of total costs. It therefore switched to a percentage-of-product cost system, which assumes there is a relationship between the component price and purchasing department costs and price levels will remain constant. To come up with a new allocation for the percentage-of-product cost system, the company used actual data from 1985 for the total cost of purchased parts and the purchasing department's operating costs. By taking all costs assigned to the purchasing department--including wages, taxes, utilities, insurance, depreciation and corporate overhead allocations--and dividing this amount by the purchase price of all component parts, management determined a new allocation rate of 4%. Significant errors remained: The system either overallocated or underallocated department costs to the product by 24% to 79%. And purchase orders (POs) for expensive material were being charged with a much higher allocation than those with inexpensive material. HOW IT MISSED THE MARK The data in exhibit 1, page 61, show how the 4% figure was calculated. As the figures indicate, the company underallocated purchasing department costs in 1986 and 1987 and overallocated in 1988 and 1989. For example, in 1986 the actual percentage of purchasing department costs to total purchases was 7.8% ($422,000), yet only $217,640 (or 4%) was allocated to products. There were two reasons for this: * Purchasing department costs were over budget in both years because increased customer requirements necessitated that the company provide more vendor contact. This action naturally drove up expenses. * The price level of the items purchased declined, resulting in an underallocation. …" @default.
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• W133886450 date "1992-11-01" @default.
• W133886450 modified "2023-09-23" @default.
• W133886450 title "Yes, ABC Works with Purchasing, Too" @default.
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