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

Without knowing which activities are causing variances, responsibility for them cannot be assigned correctly when evaluating and rewarding performance. By capturing cost variance sources and causes in real time, Jackie and Julie do not have to spend extra time investigating variances after they occur, interrupting workers and then trying to figure out how much of each resource variance (for example, materials usage, labor usage, overhead spending and usage) is caused by a particular activity. Second-generation ABC systems are based on the argument that ex-post investigation is a nonvalue-adding activity. Identifying the sources and causes of cost variances can be done more efficiently and effectively through a real-time reporting system.

Unlike traditional management accounting systems, a second-generation ABC system also provides the cost variance information needed for many appraisal, internal failure, and external failure costs in the Costs of Quality report. This information also is needed for Pareto charts and performance evaluations.

PHASE 2: CREATE ABM MEASURES OF SUPPLIER PERFORMANCE

Installing a second-generation ABC system was the first phase of Julie's new SCM system. As she now knew the nonvalue-added costs for activities caused by Woodsman Lumber, Julie's second phase involved developing a vendor performance index (VPI) to measure the "real" cost of Multree Homes' purchases from Woodsman. This ABM measure relates purchase costs to the nonvalue-added costs created by the supplier. It is simply the ratio of purchase and nonvalue-added costs to purchase costs. Woodsman Lumber's VPI for last week is illustrated in Table 1.

The optimal VPI value is 1.0, which means that the supplier creates no nonvalue-added activities. Woodsman Lumber's VPI is 1.4. This means that for every dollar of purchases from Woodsman, Multree Homes really incurs $1.40 in costs.

VPI requires that the user define which activities should be classified as nonvalue adding. In practice, the distinction between value-adding and nonvalue-adding activities can be blurred. It is really a function of use. A strict distinction focuses on the customer. Nonvalue-adding activities do not enhance the customer's value. A more liberal distinction may include all necessary activities as value adding.

For example, ordering activities are nonvalue adding under a strict definition, but value adding under the liberal definition. The Multree Homes management team decided that original ordering activities are value adding but that return authorization activities ("backwards logistics" activities) are nonvalue adding. Consistent with Total Quality Management (TQM), Multree Homes' continuous improvement projects should increase the efficiency of value-adding activities. Thus, Julie is working on an EDI (electronic data interchange) purchasing system to replace Multree's paper-based purchasing system.

IMPROVE QUALITY OR ELSE

TQM also includes eliminating nonvalue-adding costs. Backwards logistics costs are caused by supplier quality problems and should be included in the supplier's VPI. By incorporating VPI in long-term supplier contracts (described below), purchasers require suppliers to assume the responsibility for fixing their quality problems or risk having their contracts cancelled.