What ERP can offer ABC

Strategic Finance, August, 2003 by Sidney J. Baxendale, Farah Jama

One of the greatest stumbling blocks in implementing an activity-based costing (ABC) system is finding the right activity cost driver to use in attributing the cost of an activity to products or other cost objects. The nonfinancial measures that are typically used as activity cost drivers are rarely found in the accounting system. Measures such as number of sales orders, number of material moves, and number of engineering change notices per type of product are more likely found elsewhere.

Because the activity cost drivers aren't under the control of the accounting system, the activity cost-driver information isn't subject to the same process controls used to add reliability to the accounting numbers. In the early days of ABC-based costing, activity cost-driver information was often derived from a "back-of-an-envelope" information system.

ENTERPRISE RESOURCE PLANNING SYSTEMS

Enterprise resource planning (ERP) systems can significantly increase the availability and reliability of activity cost-driver information. ERP systems have become popular in recent years because they typically integrate financial accounting, managerial accounting, cost accounting, production planning, materials management, sales and distribution, human-resource management, quality management, and customer service using a relational database. The use of a relational database permits functional areas to share information without reentering the data or duplicating the data in databases throughout the organization.

One of the more dramatic ways that ERP systems provide reliable activity cost-driver information is by integrating production planning, materials management, and cost and management accounting. In cost and management accounting, activity-based costing is used to increase the accuracy of the product-cost information and to develop activity-based budgets. Before ABC, the materials handling costs and other materials management costs were often allocated to products based on a percentage of the direct material costs associated with each product. The percentage amount used in the allocation was based on the relationship between budgeted materials management costs and the expected total cost of direct materials.

TURNING OVERHEAD COSTS INTO DIRECT COSTS

To simplify this presentation, we will focus on ABC support in the widely used R/3 System from SAP. It's important to note that ERP systems from other vendors typically include an ABC feature with degrees of integration that vary from company to company. Check your vendor's support team for specifics.

SAP's R/3 system links production planning's bill of materials with material movement information that is available in the materials management portion of the system. It permits the establishment of standards for material handling. In fact, in many respects, the use of the R/3 system results in material handling cost as a direct cost rather than as the traditional indirect (overhead) cost.

The R/3 system is capable of regarding materials handling as a process whose activity cost driver is the "number of pallet moves." The cost of the materials handling process is then attributed to a product based on the various direct materials that are moved in the manufacture of the product specified in a production order. The bill of materials (BOM) for the production order will reveal direct material part numbers that will be needed. Materials management personnel will have already entered into the R/3 system information about the number of units of each direct material part number that will fit on a pallet. One unit of direct material part number B123 might require 1/20th of a pallet (20 units per pallet), and one unit of direct material part number A456 might require 1/50th of a pallet (50 units per pallet).

If we assume that a unit of product PDQ requires one unit of direct material B123 and one unit of direct material A456, then the R/3 system can calculate a standard direct cost that includes material handling costs. Those material handling costs formerly would have been regarded as indirect (overhead) costs. Table 1 shows the direct costs associated with a production order for 1,000 units of product PDQ. Those direct costs were calculated using an activity-based costing approach to product costing.

In costing the bill of materials for the production of 1,000 units of product PDQ, the R/3 system would link production planning's BOM for PDQ with material management's "bill of services," which specifies the portion of a pallet required by each unit of the various raw materials. That BOM would be related to the standard direct material costs maintained by the financial accounting portion of the R/3 system for inventory costing purposes. The associated bill of services would be related to the activity cost-driver charging rate for the materials handling process as determined by the ABC system. These relationships are possible because the data resides in the R/3 system's relational database. Using this relational database, each direct material part number on the BOM is converted to its related cost based on the standard direct material costs maintained by the financial accounting portion of R/3 for inventory valuation purposes. Further, the quantity of required direct materials is converted into required pallet moves, and the required pallet moves are costed using the activity cost-driver charging rate calculated by the ABC system.