Supply chain management: monitoring strategic partnering contracts with activity-based measures: second-generation ABC systems may be the wave of the future, not just for TQM but now also in supply chain management. In a creative tale of a fictitious small-town business, the authors illustrate why

Management Accounting Quarterly, Fall, 2006 by Michael F. Thomas, James Mackey

* Unscheduled and extra material moves create unfavorable cost variances in the Warehouse.

* We frequently switch suppliers, searching for the best lumber prices, to avoid unfavorable purchasing variances.

* Cost variances are our primary evaluation and reward measure.

"Our people are very unhappy," Julie observed, "because they are being punished for variances occurring in their departments, which they believe are not controllable and are not caused by their activities."

PHASE 1: INSTALL A SECOND-GENERATION ABC SYSTEM

Once Julie identified the problems with this lumber supplier, she took a two-phased approach to solving them. First, she installed a second-generation activity-based costing (ABC) system to trace nonvalue-added costs (cost variances) back to Woodsman Lumber. Second, she created three critical ABM supplier measures to better monitor Woodsman Lumber's performance.

A second-generation ABC system requires workers to identify in real time the sources and causes of cost variances they are incurring. Poor quality necessitates activities to correct it. These activities result in cost variances. Through real-time input, nonvalue-added activities and their costs can be linked back to their causes (such as bad-quality lumber) and sources (such as Woodsman Lumber).

For example, too many warped studs cause framers to spend more time searching for good lumber. This activity causes unfavorable materials and labor usage variances and potentially labor rate and variable overhead variances within the Assembly Department. If extra lumber needs to be requisitioned from the Warehouse, further cost variances may result there. As these activities happen, the extra resource costs are coded as being caused by the supplier's poor lumber quality. Similarly, labor variances at the receiving dock caused by early or late deliveries and incomplete shipments are coded to the supplier. The variance reports then organize cost variances by source and cause.

In contrast, traditional cost variance systems report variances by resource within each department. For example, the Assembly Department may have a $250 unfavorable labor usage variance for the week. Traditional variance reports do not provide the relevant information needed for management to identify the sources and causes of this aggregate resource variance. Thus, the key information needed to monitor supply chain relationships cannot come from a traditional management accounting system.

To illustrate how a second-generation ABC system reports cost variances, assume warped studs caused $4,000 of unfavorable variances, which included $700 in extra materials usage, $750 in additional labor, and $250 in overhead, all within the Assembly Department. Another $800 in unfavorable labor and overhead variances occurred in the Warehouse. Another $500 of this variance happened in Shipping and Receiving for activities necessary to return the bad materials to Woodsman Lumber. The last $1,000 in unfavorable variances resulted in Shipping and Receiving due to early, late, and/or incomplete shipments. In total, Woodsman Lumber purchases created $4,000 in nonvalue-added costs. Instead of reporting these unfavorable cost variances as unknown, buried components within different resource cost variances assigned to departments, second-generation ABC systems report the entire $4,000 unfavorable variance attached to its sources and cause (Woodsman Lumber warped studs). (6)