Implementing activity-based costing (ABC) in logistics

Journal of Business Logistics, 1994 by Pohlen, Terrance L, La Londe, Bernard J

The accounting and control of logistics costs will become increasingly important to firms seeking a competitive advantage in the 1990s. Managers will require more accurate and focused costing of logistics functions to ensure profitability and to reflect the total demands placed on the firm. Companies will need more detailed financial and nonfinancial information to identify opportunities for taking costs out of the supply channel and for re-engineering their logistics processes. Success of these efforts will largely depend on the ability of the firm's cost accounting system to trace costs to specific products, customers, supply channels, or logistics activities.

Activity-based costing (ABC) can assist logistics managers by revealing the links between performing particular activities and the demands those activities make on an organization's resources.(1) ABC differs from traditional cost accounting by tracing costs to products according to the activities performed on them.(2) Traditional approaches allocate direct and indirect costs on a proportionate basis using volume-based cost drivers such as direct labor hours, machine hours, or material dollars. Volume-based cost drivers will distort costs whenever products consume resources in disproportionate amounts. ABC has gained acceptance within manufacturing as an effective technique for accurately assigning product costs; however, most companies have not extended ABC to logistics,(3) and only a few leading-edge companies have attempted to apply ABC to reduce costs and improve logistics performance.(4)

A survey of leading-edge firms within the United States indicates a trend towards implementing ABC within logistics. The survey requested information regarding whether the firm had implemented ABC, the extent of their implementation, the impediments and benefits encountered, and plans for expansion. The results suggest a gaining acceptance of ABC within logistics, and most firms expect the ABC applications in logistics to produce results similar to those experienced in manufacturing.

THE NEED FOR MORE ACCURATE AND FOCUSED COSTING WITHIN LOGISTICS

The growth in the importance of the logistics function has significant implications for a firm's cost accounting system. Physical distribution cost estimates range from 7.93% to 30% of sales,(5,6) and the management of logistics costs has become increasingly important due to their significant impact on product profitability, product pricing, customer profitability, and ultimately, corporate profitability. Logistics can offer a key source of competitive advantage through service differentiation or by reducing costs and increasing corporate profitability.(7) Despite the magnitude and importance of logistics costs, accountants have not pursued the development of the quantitative data necessary for improving logistics cost analysis.(8) Two studies performed by Ernst & Whinney (later Ernst & Young) under the National Council of Physical Distribution Management (later renamed the Council of Logistics Management) and the National Association of Accountants (later the Institute of Management Accountants) support this position. The studies found firms had increasingly asked logistics managers to plan and manage complex operations and networks while reducing cost and enhancing service; however, available cost and financial information often proved inadequate.(9) The implications for cost accounting include the requirement to cost logistics functions more accurately and to support an integrated logistics management approach.

Firms will require more accurate and detailed logistics cost information from their cost accounting systems.(10) Logistics managers require detailed information to determine how different products, customers, or supply channels affect the costs of providing logistics services. The detail and complexity of the cost information will correspond to the diversity products handled, customer requirements, or supply channels used. The increased visibility of logistics costs will serve several purposes for the firm: the identification of more direct costs, a better understanding of price/volume relationships, the opportunity to address significant cost reduction opportunities, better evaluation and justification of investments in new technologies, and focusing more attention on these costs.(11) Logistics cost will become more important in product pricing decisions as firms seek to reduce costs and attain a competitive advantage.(12) The requirement for more accurate information will drive several changes in the firm's cost accounting system. Tyndal indicates firms will require a more sophisticated cost allocation system to reflect accurately how costs are incurred and to perform profitability analyses of customers.(13) However, logistics cost data generally does not usually exist in readily accessible or useable form.(14) Many of the costs required for a product or customer profitability analysis remain hidden in vendor invoices or buried in other cost centers such as manufacturing or marketing.(15) As a result, the cost accounting system may need to consider a reclassification of logistics costs along organizational lines.(16) Schiff identified the problem as early as 1970. He suggested that "the late development of the P.D. (physical distribution) concept, accompanied by an identification of the uniqueness of the P.D. function, may be the reason for the failure to generally assemble P.D. costs into a single functional classification."(17) Stock and Lambert found the problems identified by Schiff continued to exist almost 20 years later and stated that "the challenge is not so much to create new data, since much of it already exists in one form or another, but to tailor existing data in the accounting system to meet the needs of the logistics function."(18) However, cost systems frequently do not capture some logistics costs such as material handling due to the difficulty in tracing and reporting logistics activities.(19) Quillian suggested cost accounting can increase the visibility of logistics costs through a three-phase approach: (1) conduct a process value analysis of key processes; (2) develop costs for key activities required by the customer; and (3) develop precise costs associated for logistics processes and develop an on-going cost management system to monitor process costs.(20)