ACTIVITY-BASED COSTING AND PROCESS MODELING FOR PRODUCT DESIGNERS

Transcription

1 ACTIVITY-BASED COSTING AND PROCESS MODELING FOR PRODUCT DESIGNERS Miikka Jämsen, Jari Paranko, Katja Tornberg Tampere University of Technology Tampere, Finland ABSTRACT The most effective way to control costs is to design them out of products. However, cost data is rarely available for product designers in a usable form. The aim of this study was to investigate the possibilities of activity-based costing and process modeling in providing useful cost information for product designers. The hypothesis was that activity-based costing and process modeling might provide an effective tool for the evaluation of different design options in advance. The study was conducted in a large Finnish machine manufacturer. Firstly, the most costly items of one product sub-assembly were selected and analyzed in order to identify the activities needed to produce the items. Secondly, R&D, purchasing and manufacturing processes were modeled to define the cost drivers associated with the activities. Finally, the applicability of activity-based costing and process modeling to product designing practices was tested. In addition, the usefulness of this kind of cost estimation tool for product development on a larger scale was assessed. The results of the study suggested that process modeling and activity-based costing could provide usable cost information for product designers. The models should be simple at first sight, but should also enable more detailed information to be obtained when needed. The models should be easy to use and provide information on line. Key words: Activity-Based Management, Cost Management, Process modeling, R&D 1 INTRODUCTION Product development has recently received a lot of attention. Product and process technologies are evolving rapidly. Competition is becoming more global. Customers are placing increasing emphasis on quality and reliability, but at the same time they are looking for good value. Time to market is

2 2 becoming a paradigm in world-class manufacturing. To respond to this increasingly dynamic and challenging environment, manufacturers are forced to improve product development processes. The competitive environment demands the development of sophisticated cost management practices to keep costs down, and from early on, the Japanese recognized that the most efficient way to keep costs down was to design them out of products, not to try to reduce costs after products entered production (Cooper, Slagmulder, 1997). The potential for cost reduction via product design is enormous. For example, Ford Motors and others have estimated that as much as 60-80% of costs over the product s life cycle are already locked in by the time product design is completed (Figure 1). This rises to 90-95% by the time design of the production process is completed. (Turney, 1991). Product Design Process Design 0% 100% = Costs Committed Figure 1. Costs committed in design process The important role of product development in cost management is undeniable. However, product development s need for economic information has not been sufficiently met. It can be argued that product development does not get the cost information it needs. Problems include both the content as well as the form of information. Given a lack of relevant cost information, decisions on product development are based mainly on technical criteria. Taking into consideration the influence of product development s decisions on the total costs of the product, there is a great need to improve the quality of cost information so that it serves better the needs of product designers. 1.1 Aim of the study The aim of this study was to investigate the possibilities of activity-based - costing and process modeling in providing useful cost information to product designers. The hypothesis was that activity-based costing and process modeling might provide an effective tool for the evaluation of different design

3 3 options in advance. For example, Cooper and Turney (1990) have argued that activity-based costing provides cost information on each of the company s processes so that the costs of different designs can be compared. According to them, ABC (activity-based costing) puts product costs on the backs of the engineers (Cooper, Turney, 1990). 1.2 Method of the study The study was carried out in a large Finnish machine manufacturer. The company has a significant position globally within its own business area. An example product sub-assembly was chosen. The costs of the sub-assembly and its items were analyzed. The processes needed to produce the subassembly were modeled and activity-based costs were calculated for the subassembly from purchasing, R&D and manufacturing. Administration and sales & marketing were left outside the scope of this study. Data for process modeling and activity-based costing were gathered by personal interviews. Calculations of activity-based costs and process models of two example items were presented to a group of five product designers. The designers had four days to explore the given material. At this point, a questionnaire with structured questions was administered. The questionnaire had two objectives: Firstly to ascertain the company s product designers needs and attitudes regarding cost information, and secondly to ascertain the product designers opinions about the usefulness of activity-based costs and process models. In order to obtain a better understanding of the matter, the questionnaires were complemented with personal interviews. Interviews were conducted with all five product designers. However, answers to the questionnaire were received from only three designers. In the personal interviews special emphasis was given to the role of calculations of activity-based costs and process models. 2 PRODUCT DEVELOPMENT AND COST ACCOUNTING 2.1 The state of cost accounting in Finnish metal companies Uusi-Rauva and Paranko (1998) examined the present state of cost accounting from the designers point of view in four Finnish metal companies. During the study both accounting professionals (information producers) and managers of designers (users of information) were interviewed. As a result eleven improvement opportunities were presented:

4 4 1. Cost accounting should be able to give reliable information on the product s total costs. 2. Cost accounting should be able to support designers in solving standardization and modulation problems. 3. Cost accounting should support make or buy decisions. 4. Cost accounting should support the search for raw materials or suppliers. 5. Designers should be able to estimate the affects of their decisions on different functions. 6. Designers should receive cost information in the same form as they normally receive other important information in their daily work. 7. Cost information should be provided on time. 8. It should somehow be possible to simulate costs of alternative construction options. 9. It could be useful for a designer to have some kind of model construction with cost information. It would make it easier to analyze costs of product variations. 10. Product designers are not very cost-conscious. 11.The cost accounting function should somehow be organized more satisfactorily from the designer s perspective. Designers would like to know true product costs (problem 1). The system that produces accurate product costs identifies the key activities performed in an organization, providing a defensible and transparent measure of their associated costs and causes. Designers would like to be able to calculate if standardization makes sense economically (problem 2). As standardization almost inevitably leads to an increase in direct labor and material costs, solutions based only on direct labor and direct raw material costs are not rational. It should be possible to look at the impact of standardization on all costs. In addition to standardization, the risk of partial optimization also concerns make or buy decisions and purchasing decisions in general (problems 3 and 4). Traditional cost accounting, with its emphasis on purchase price variations, encourages purchasing people to continually scan the population of potential

5 5 suppliers to obtain low price quotations. Most companies have learned, the hard way, that many of their low-price suppliers are actually extremely highcost suppliers. The purchase price of items delivered is only one cost element in the total purchase cost (Kaplan, 1992). Designers would like to see how the total costs of the product differ between alternative solutions (problem 5). Problems 1-4 all stress the importance of being able to estimate the affects of design decisions widely on different functions. The question is: How does the design of this product affect all costs associated with the product from its inception to its final disposal? To include all costs, and not just manufacturing costs, may appear far-fetched at first. However, many downstream costs such as distribution, selling, warehousing, service, support, and recycling can be greatly affected by product design. (Ansari, Bell, 1997) Product development should receive cost information according to the structure that is important to them in their daily work (problem 6). Product designers prefer to operate with product structure and operations flow documents (Uusi-Rauva, Paranko, 1997). Cost information should be better combined with these structures. Designers need a system to manage costs before they are incurred rather than afterward (problem 7). Information should be provided to product designers at the time of relevance, that is, when the decisions on the design are being made, before the actual manufacturing of the product. This heavily stresses the importance of preliminary cost calculations compared to post calculations. It should be possible to evaluate the costs of alternative construction options (problem 8). Powerful tools are needed to enable a quick and easy investigation of possible solutions. A designer today will rarely design a new product from scratch. On the contrary, he will try to use as many existing components as possible. It would be possible to create libraries of predefined solutions with standard structures (model construction), which only need to be adjusted to a given task (problem 9). Product designers are not very cost-conscious especially when it comes to overheads (problem 10). This means that design decisions are mainly based on technical criteria. Consequently, there is a need to increase the cost awareness of product designers. Although the important role of product development in cost management is also recognized in the financial department, product development, however, is not considered one of its major customers (problem 11). Cost accounting should be better organized to meet the needs of product designers.

6 6 The results of the study of Uusi-Rauva and Paranko (1998) were not surprising. Johnson and Kaplan made the poor state of the cost accounting known as early as in 1987 with their book Relevance Lost. Today s management accounting information, driven by the procedures and cycle of the organization s financial reporting system, is too late, too aggregated, and too distorted to be relevant for managers planning and control decisions. The management accounting system also fails to provide accurate product costs (Johnson, Kaplan, 1987). To sum up, cost accounting should help product development to design products that carry the lowest possible total costs while also taking into consideration other important design criteria. Process models that cross the lines of company s departments together with the cost information provided by activity-based costing create preferable circumstances to evaluate the impact of different design options on total product costs (Uusi-Rauva, Paranko, 1998). Consequently, several companies have developed an ABC model primarily to provide economic information to product designers (Kaplan, 1992). 2.2 ABC and process modeling Activity-based costing is a method of measuring the cost and performance of activities and cost objects. The idea behind activity-based costing is that cost objects, which may be products, services, jobs, projects, units, batches, customers, distribution channels or anything the management accountant is trying to cost, consume activities. In turn, activities consume resources. Activity drivers measure the activities consumed, and resource drivers measure the resources consumed. Activity-based costing systems try to determine what is really driving costs and charge a cost object for only the overhead it actually consumes (Burch, 1994). The process view of activity-based costing allows management to focus on activities. It permits managers to recognize the horizontal flow of products, services and activities through an organization. A business process is a combination of activities needed to produce a product or perform a service. It is a combination of people, machines, materials and methods. Typical business processes include purchasing, R&D, manufacturing, order handling, delivery and customer service. (Symons, Jacobs, 1997). Process modeling is descriptive, rather than normative, and the focus is on describing the process as it actually exists rather than how it is supposed to be (Symons, Jacobs, 1997). Process modeling is an effective way to develop a picture of the specific activities occurring within an existing process. Process modeling gives the whole picture of what goes on in the organization.

7 7 3 RESULTS OF THE STUDY 3.1 Product designers attitudes and needs The product designers cost accounting knowledge varied a lot. Even the basic concepts were confused among some designers. For example, when the purchasing costs of an item were discussed, the only cost that was mentioned was the purchasing price of the item. However, this is only part of the total purchasing cost of an item. Product designers make their daily designing decisions purely based on products technical features. From the designer s point of view the most important criteria for products to be designed are: top quality, durability, ergonomics and correspondence with the customer s specifications. Only one interviewee mentioned the future costs of the product as a criterion for the designing decision. On the other hand, the designers thought that their supervisors appraise them for instance on the basis of timely delivery and warranty costs. The questionnaire, however, indicated that product designers generally think cost information is important for them. Product designers felt the cost information of manufacturing and product development functions to be most important. Costs of purchasing, sales & marketing and administration functions were seen as less significant. Product designers were very doubtful about whether their decisions could have any impact on indirect costs. Therefore they did not have a major interest in the cause-effect relationships of these costs. Despite all this, the currently available cost information was seen to have both qualitative and quantitative deficiencies. The problems and needs found here support the study of Uusi-Rauva and Paranko (1998). 3.2 Process models and activity-based cost calculations Examples of the material given to product designers are shown here. Figure 2 presents one of the given process models. Process models are formatted into horizontal bands to illustrate where and by whom an activity is performed. This way the involvement of various constituents of the overall process can be isolated. The process goes simultaneously from left to right and from up to down. The activities are presented with a rectangle and the branches of the process are presented with a diamond. The shadow under the rectangle indicates that it consists of several sub-processes. Hereby the process model becomes a hierarchical entity. Table 1 presents one of the given activity-based cost calculations. The numbers in the table are fictitious.

8 8 Yes Scheduling the production Manufacture No Spesification of the product Has the product been manufactured before? Manufacturing Is there capacity? database Outsourcing Making the capacity desicions Foremen and Production planning No Spesification of production process Designing the fastener Testing the program Yes Yes Routing the production Is fastener needed? No Designing the tools Programming the machines Manufacturing Manufacturing the product Manufactured product Figure 2. Process model Table 1. Calculation of activity-based costs Example item Batch size Unit price ( EUR ) Use of activity Costs per Item ( EUR ) % Materials % Life-cycle activities Designing the fastener Programming the machines Testing the program Checking the drawing Selecting the suppliers Designing the tools Routing the production Drawing the item Making the annual contract Reviewing the annual contract % Batch activities Setting up the machine Ordering the materials Checking the bill 8 2 0,5 1 Loading the FMS Transferring the production lot Receiving the materials Ending the production phases % Volume activities Inspection of delivery 67 0,5 34 Machining with a turning unit 252 1, % Activity costs % Total costs 1 306

9 9 3.3 The role of process models and activity-based cost calculations As one of the major benefits of the cost calculations the interviewees rated the fact that cost information was presented by item and by process operations. With traditional cost accounting it has been too difficult and too slow to get the information about the activities needed to produce an item. The designers acknowledged the fact that activity-based costing reveals a lot of important information that traditional accounting hides. With the help of process models and cost calculations it was possible to estimate the chain effects of different design options. The cost information was available at once, which enabled the use of this information in preliminary calculations. The classification of activities as volume, batch and life-cycle activities in the cost calculations was considered useful. However, at present the cost calculations include too many activities, which makes the calculations too complicated. According to the designers, it would make sense to categorize the activities into bigger groups. For example, all the life-cycle activities used by an item could be presented as only three activities: the life-cycle activities in manufacturing, the life-cycle activities in R&D and the life-cycle activities in purchasing. However, it was also considered extremely important to get more detailed information about the activities when needed. The role of process models was seen as getting the whole picture of what goes on in the company. The models reflected the actual steps that the product takes in the organization as it is being produced. This made the operations transparent to all the viewers. As with cost calculations, the problem of the level of information was seen to apply also to process models: the first picture should be quite simple, but it should also be possible to get more detailed information about the processes when needed. According to the product designers it could be useful to combine the information of the cost calculations with the process models. An activity may be easy or more difficult to perform due to certain circumstances. Therefore it would make sense that each step of the process model be given three different activity options: easy, usual or difficult, each one with its own cost. The designers also pointed out the limitations of the process models and activity-based cost calculations. The information gathered was focused only on one product sub-assembly and a limited amount of activities (R&D, purchasing and manufacturing). Thus the scope of the study was quite narrow and did not as such provide a sufficient basis for evaluating the cost of other product components than this one. As such the cost calculations and process models were seen to be too complicated and too slow to use. In addition to over-accurate classification of

10 10 the activities, this was also due to the model s appearance; it was just a bundle of papers. During the interviews there was one particular point which emerged repeatedly: the importance of cost information by product features such as roughness of the surface and measure tolerances. Product designers were keen to know how the costs of a product were affected when, for example, tolerance was altered. The cost comparison between different production methods such as welding and machining was also seen as extremely important. 4 CONCLUSIONS The results of this study lend support to the results of Uusi-Rauva and Paranko (1998) as regards the needs of product development for cost information: Information does not include the right things, nor is it represented in a usable form. On the basis of this study it can be argued that process modeling and activity-based costing can provide usable cost information for product designers. The calculations and models created so far, however, are too complicated for daily use. The categorization of activities into bigger groups and the attachment of cost information to the process models provide basis for solving this problem. The cost estimation model should be simple at first sight, but it should also enable more detailed information to be obtained when needed. The model should be easy to use and provide information on-line. The improvement of the model as suggested takes place in the framework of this study. Moreover, there is a great need to increase the cost awareness of product designers, especially regarding indirect costs. The improvement of the model also serves this purpose. Compared to the survey of Uusi-Rauva and Paranko (1998), the need for feature based cost information was emphasized in this study. This may be due to the fact that their interviewees were from managerial level, while in this study the interviewees were operational product designers. Product features and manufacturing methods are an important part of their daily work. Feature based cost estimation model provides a challenge for future research.

11 11 References Ansari, Shahid L., Bell, Jan E. and the CAM-I Target Cost Core Group (1997): Target Costing. The Next Frontier in Strategic Cost Management. A CAN- I/CMS Model for Profit Planning and Cost Management. Irwin Professional Publishing, USA. Burch, J. (1994): Cost and management accounting. Modern approach. West Publishing Company, St. Paul, MN. Cooper, Slagmulder (1997): Target Costing and Value Engineering. Productivity Press. Portland, Oregon. Cooper, Turney (1990): Internally Focused Activity-Based Cost Systems. Performance Excellence in Manufacturing and Service Organizations. Proceedings of the Third Annual Management Accounting Symposium. San Diego, California, March Johnson, Kaplan (1987): Relevance Lost. The Rise and Fall of Management Accounting. Harvard Business School Press, Boston, Massachusetts. Kaplan, Robert S. (1992): In Defense of Activity-Based Cost Management. Management Accounting, Nov. 1992, p Symons, Jacobs (1997): Multi-level process mapping: A tool for crossfunctional quality analysis. Production and Inventory Management Journal, Falls Church, Fourth Quarter Turney, P. (1991): Common Cents. The ABC Performance Breakthrough, Cost Technology, Hillboro, OR. Uusi-Rauva, Paranko (1998): Cost Accounting and Needs of Product Development (in Finnish). Report no 1/1998/Industrial Management. Tampere University of Technology. Uusi-Rauva, Paranko (1997): The Role of Cost Accounting in Engineering. International conference in engineering design, ICED 97 Tampere. Proceedings volume 2 pp