20

Logistics Costing: Impacting Product Profitability

After reading the chapter, the students should be able to understand:

• Logistics cost components
• Importance of costing in logistics
• Costing methods and logistics performance measurement
• Traditional vs. activity-based costing
• Activity-based costing—benefits, process and implementation

Logistics supply chain is a source of competitive advantage. The differentiations through costs and service can be leveraged for the competitive edge. Hence accounting and control of logistics costs has become increasingly important to firms seeking a competitive advantage. Accurate and focused costing of logistics functions to ensure profitability is very critical for the firms today. Companies will need more detailed financial and non-financial information to identify opportunities for taking costs out of their logistics activity. Therefore, the success of these efforts will largely depend on the ability of the firm’s cost accounting system and the methods they adopt to address the various costing issues to trace costs to a specific sub-activity.

“In logistics, big is beautiful and scale is more important, particularly when you have got infrastructural assets. But it is also having the scale to reduce processes and have a cost-effective operations.”

—Paul Little

20.1 INTRODUCTION

M. Porter mentioned cost leadership as one of the three strategies the business firms should adopt for gaining a competitive edge. Logistics is the area where the firm has a lot of scope for cost control and reduction. Logistics cost varies from 5 to 35 per cent of sales for different product-market configurations in different industries. Hence the management of logistics costs has become increasingly important due to its 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. The firms were increasingly focusing on planning and managing complex logistics operations and networks, while reducing cost and enhancing service. However, the available cost data and financial information often proved inadequate because of the prevailing costing methods. The implications for cost accounting include the requirement to cost logistics functions more accurately and to support an integrated logistics management approach. Basically, there are three reasons why costing is required:

1. It is needed for valuation of inventory and measurement of the cost of goods sold for financial reporting.
2. For estimation of the costs of activities, products, services and customers.
3. To provide economic feedback to managers and operators about process efficiency.

20.2 LOGISTICS COST

In a competitive market, firms require more accurate and detailed logistics cost information from their cost accounting systems to work out the cost-benefits analysis of their logistics strategies in order to design a cost-effective supply chain. 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 depend on the diversity of products handled, customer requirements or supply channels used. The cost components that are considered for computation of logistics cost are listed in Table 20.1.

Table 20.1 Components of Logistics Costs

The increased visibility of logistics costs will serve several purposes for the firm, such as identification of direct costs, better understanding of price/volume relationships, opportunity to address significant cost reduction measures, better evaluation and justification of investments in new technologies and giving more attention to these costs.

Logistics cost will become more important in product pricing decisions, as firms seek to reduce costs and attain a competitive advantage. The requirement for more accurate information will drive several changes in the firm’s cost accounting system. Today, with competitive pressure, firms require a more sophisticated cost allocation system to reflect accurately how costs are incurred and to perform profitability analyses of customers. However, logistics cost data generally do not exist in readily accessible or useable form. Many of the costs required for a product or customer profitability analysis remain hidden in vendor invoices or buried in other cost centres such as manufacturing or marketing. Hence, to increase the visibility of logistics costs, firms should adopt the following approach:

• Conduct a process value analysis of key processes
• Develop costs for key activities in logistics
• Develop precise costs associated with logistics processes
• Develop an ongoing cost management system to monitor process costs

The accounting and control of logistics costs must also make some additional adaptations to support integrated logistics management within the firm and across the supply chain. The evaluation of possible cost trade-offs within logistics requires the identification, measurement and comparison of several factors such as:

• Identifying cost drivers or logistics activities and their behaviour
• Measuring cost drivers in sufficient detail to understand the cause and its effect on activities
• Measuring the interaction of cost
• Identifying specific service levels for the customer
• Finding out the correct trade-offs among the logistics and service levels
• Evaluating the above without compromising service quality

The information obtained on costing supports key logistics decisions on warehouse space, warehouse locations, choosing the type of warehouse and implementing automation. The integrated logistics management approach will require not only more accurate costing of logistics functions from its cost accounting system, but the integration of available cost data and the ability to perform total cost analysis, both within logistics and across all major processes (such as production and marketing) to reduce the incidence of cost to the firm. Porter argued that:

“A firm must look beyond its internal actions to reduce costs and explore the linkages between suppliers’ value chains and a firm’s value chain to identify opportunities for enhancing a competitive advantage.”

The logistics system must be viewed as a complete system, from the sourcing of raw materials to delivery of products to customers. Each component of the logistics system is linked with, and influences, the operations of the other components. Traditional costing systems have typically ignored costs outside the factory in product costing. Hence, the costing methodology for analyzing costs and value in the product distribution chain must deal effectively with the following elements of distribution:

• Various functions performed by each party in the distribution chain
• Principles that guide operations and operating practices
• Implications of operating practices on resource effectiveness
• Resources deployed for performing the operations
• Units of resource consumption

The management of logistics costs will also require the capability to evaluate the value of alternative channel structures. Logistics analysis will require a cost trade-off capability within the channel to determine the most cost-effective allocation of resources or to exploit linkages within the channel by eliminating non-core activities. Customer costing necessitates identifying and determining all of the costs involved in supporting and maintaining a customer.

20.3 TRADITIONAL COSTING METHOD

Logistics is a source of competitive advantage. According to Porter, with cost leadership the business firm can gain competitive edge over its business rivals. Logistics has much scope for cost reduction and enhance the customer service simultaneously. Hence, logistics management must understand how the behaviour of one cost differs from the other.

The conventional method of cost accounting refers to the allocation of manufacturing overhead costs to the products manufactured. The conventional method assigns the factory’s indirect costs to the items manufactured on the basis of volume such as the number of units produced, the direct labour hours or the production machine hours. In the production process, the machine hours are used as the base for allocation of the manufacturing overheads to products.

Hence, it is implied that the machine hours are the underlying cause of factory overheads. The only cost driver in this case is machine hours. In case a manufacturer wants to know the true cost to produce specific products for specific customers, the traditional method of cost accounting is inadequate. In activity-based costing (ABC) many cost drivers are used to allocate a manufacturer’s indirect costs. A few of the cost drivers that would be used under ABC are machine hours, number of machine set-ups, the quantity of material purchased/used, the number of engineering change in the order and so on.

20.4 ACTIVITY-BASED COSTING

Activity-based costing is defined as:

“[a] methodology that measures the cost and performance of activities, resources, and cost objects. Resources are assigned to activities, then activities are assigned to cost objects based on their use. Activity-based costing recognizes the causal relationships of cost drivers to activities.”²

ABC assumes that activities cause cost and that cost objects create the demand for activities. The assumption enables ABC to determine product costs by summing the costs of activities required to manufacture or deliver a product.

ABC assigns overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. ABC first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities (see Figure 20.1).

Fig. 20.1 Onventional vs. activity-based costing

The advantages of activity-based costing are:

• Assigns costs to products according to the activities performed on them
• Tracks cost to activities and work process
• Reveals the links between performing particular activities and the demands those activities make on available resources
• Has activities as cost drivers (as against the traditional approaches that allocate direct and indirect costs on a proportionate basis using volume-based cost drivers). Volume-based cost drivers will distort costs whenever products consume resources in disproportionate amounts
• Identifies the profitable/non-profitable customer, product and channel
• Finds the root cause of poor financial performance for a firm

In ABC the first stage focuses on determining the costs of activities within an organization. The second stage traces activity costs to the products consuming the work performed. The two-stage assignment process enables ABC to overcome the problems encountered with using traditional volume-based allocation techniques. This approach addresses the management and control of overhead costs within an organization. ABC increases management visibility about how products, customers, or supply channels consume resources. The assignment technique recognizes different cost relationships and uses multiple cost drivers to assign costs. The non-financial information produced by the ABC model facilitates the development of performance measures and continuous process improvement. However, the basics of the ABC system are:

• Cost of a product is the sum of the costs of all activities required to manufacture and deliver the product
• Products do not consume costs directly
• Money is spent on activities
• Activities are consumed by product/services
• Assigns costs to products by tracing expenses to activities
• Assigns costs that reflect the physical dynamics of the business
• Provides ways of assigning the costs of indirect support resources to activities, business processes, customers and products
• Many resources are required not for the physical production of the product, but to provide a broad array of support activities

ABC can improve the management and control of overheads by determining the factors driving the requirement for overhead resources. The ABC approach divides overhead into separate resources supporting the work performed in the organization. The resources could include categories such as general administration, supervision, supplies, direct labour or utilities. Resource drivers trace costs to the activities consuming the resources. The costs may reflect actual consumption or may result from an estimate of the effort expended on each activity. The sum of the resource costs becomes the cost of performing an activity. ABC uses an activity driver to assign the activity costs to specific cost objects. Analysis of the activities and cost objects may identify free resources. ABC costing normally addresses the following questions:

• What activities the organizational resources are performing?
• How much does it cost to perform activities?
• Why does the organization need to perform those activities?
• How much of each activity is required for the organization’s products, services and customers?

An ABC analysis will allow managers to pinpoint the activities, products, services or customers consuming overhead resources. Managers can examine ways to reduce or eliminate resource consumption. Cost reduction methods can focus on improving activity efficiency by:

• Reducing the number of times the activity must be performed
• Eliminating unnecessary or redundant activities
• Selecting a less costly alternative, or using a single activity to accomplish multiple functions

Thus, the freed resources can be redeployed for additional output or eliminated to achieve cost saving.

20.5 IMPLEMENTATION OF ABC

Implementation of ABC can provide greater visibility of the profitability impacted by different products, customers or supply channels. The company can more accurately trace costs and determine areas generating the greatest profit or loss. The product and customer profitability analysis performed by firms using ABC has significantly altered management perceptions. Profitability analyses using ABC can focus on management effort on non-value-added activities. Managers can target high-cost products or customers for reduction efforts, and they can use other techniques such as pricing modifications, minimum buy quantities, or charging by service to improve profitability (see Figure 20.2).

Fig. 20.2 Steps in building activity-based costing model

ABC achieves greater accuracy than traditional costing techniques. In ABC costing there are multiple cost drivers. Traditional techniques typically rely on the volume-based cost drivers to trace overhead costs to products. ABC uses multiple cost drivers to reflect different relationships occurring between activities and the resources they consume. The cost drivers fall into two broad categories. The first category includes cost drivers related to production volume wherein costs vary in direct proportion to production volume. The second category includes cost drivers unrelated to production volume wherein no direct relationship exists between production volume and the resources consumed. The areas where ABC can be used to get insights into the non-value-added costs and reduce the costs burden on the products/customers in competitive markets are:

• High overheads
• Product diversity or multiple products
• Customer diversity
• Service diversity
• Stiff competition

The major steps in ABC system implementation are:

1. Form cost pools. This means form groups or categories of individual expense items.
2. Identify activities. In developing an ABC system, the organization identifies the various activities being performed such as move material, schedule production, purchase material, inspect items, respond to customers, improve products, introduce new products and explore new markets and so on. There are various types of activities that can be categorized as follows:
   • Unit level: Performed each time a unit is produced
   • Batch level: Performed each time a batch is produced
   • Product level: Performed to support production of different types of products
   • Customer level: Performed to support servicing customers
   • Facility level: Residuary head
3. Map resource costs to activities. Financial accounting categorizes expenses by spending code, salaries, fringe benefits, utilities, travel, communication, computing, depreciation and so on. ABC collects expenses from this financial system and drives them to the activities performed.
4. Define activity cost drivers. The linkage between activities and cost objects, such as products and customers, is accomplished by using activity drivers. An activity driver is a quantitative measure of the output of an activity. The selection of an activity driver reflects a subjective trade-off between accuracy and cost of measurement (see Table 20.2).

    

   Table 20.2 Defining Activities and Drivers

   Activities	Drivers
   Unit Level
   Acquire and use material for container Acquire and use material for soap	Number of containers Number of products
   Batch Level
   Set up manually controlled machine Set up automatically controlled machine	Number of batches of containers Number of batches of soaps
   Product Level
   Design and manufacture mould Use manually controlled machines Use computer-controlled machines	Number of containers required Product type (containers) Product type (soaps)
   Customer Level
   Consult customer Provide warehouse for service	Number of consultations Number of warehouses
   Facility Level
   Manage workers	Salaries

5. Calculate cost. Finally, cost calculations should be done considering the activity driver and resource driver quantities. The following example will give a clear understanding of traditional versus activity-based costing records.

20.6 PERFORMANCE MEASUREMENT

Performance measures appear as a logical consequence of an ABC system. Activity descriptions include financial and non-financial information. The financial view indicates the costs or resources necessary for performing the activity. The non-financial view describes the activity in terms such as the time required, quality, number of transactions, or schedule attainment. The company can use the non-financial information to develop performance measures for the activity. The performance measures describe the work done and the results achieved in an activity. Performance measures can be used to track product returns, damage, claims or data entry errors. The linkage between the performance measures and the activity provides a relatively straightforward means for computing the cost of poor or improved performance.

The ABC model can be used to re-engineer business processes by eliminating redundant or unnecessary tasks and optimizing resource allocations to activities adding the most value to the product or customer. The ABC baseline model identifies the inputs, outputs, resources, costs and activities employed in the enterprise. The information can be used to concentrate on “big cost items” for improvement or to develop actions to simultaneously attack waste at multiple levels within the organization.

20.7 ADVANTAGES OF ABC TO LOGISTICS

ABC appears well suited for costing and measuring the performance of logistics processes. Many logistics costs remain buried in overheads; and logistics managers do not have adequate visibility or control over their costs. ABC would more clearly depict the critical linkage existing between corporate profitability and logistics costs and performance. Logistics confronts many of the same conditions that make manufacturing enterprises good. Logistics can benefit from the costing and measuring of performance at the activity level. Activity analyses may identify opportunities where process re-engineering could reduce operating costs and improve service performance.

Logistics also provides an opportunity to extend ABC across the supply chain. ABC, in a supply chain setting, could identify opportunities for eliminating redundant activities existing within the supply chain, channel members with excessive resource consumption patterns, or analyze alternative channel structures. The supply chain could use ABC to re-engineer inter-organizational processes to obtain a competitive advantage through cost reduction or service differentiation. However, logistics does pose several distinct challenges that may make ABC implementation more difficult than in the manufacturing environment.

SUMMARY

Because of stiff competition, logistics organizations have begun to look into the different methods of costing other than the traditional one. They have come to a conclusion that the ABC method measures more accurately. The firms indicated a need for more accurate pricing and performance measures and have achieved these benefits as a result of incorporating an ABC methodology. Implementation has not typically occurred on a system-wide basis with ABC replacing the previous cost system. The sophistication and extent of ABC implementation has taken many forms based on the particular problems confronted and the information desired by the firm.

The level of ABC sophistication will vary with the proportion of overhead costs and the amount of diversity experienced within the firm. The proportion of indirect to direct costs and the diversity of products or services can also signal the level of sophistication required. Companies with low proportions of indirect costs indicated fewer benefits or changes in cost assignments. Larger proportions of indirect costs and greater diversity in products or services may signal the need for a more sophisticated model.

Through the implementation of ABC, processes can be re-engineered to take costs out of their logistics processes. ABC has provided the leading logistics firms with a more accurate system for costing activities and measuring performance. It may take many forms, from a relatively simple model to a very elaborate model. The level of ABC sophistication employed appears to be based on the firms’ objectives, ongoing capability to track activity information, the proportion of indirect costs and the diversity of products, services, customers or supply channels.

REVIEW QUESTIONS

1. Differentiate between the effectiveness of traditional costing and activity-based costing methods in the context of logistics costs.
2. Explain the steps in activity-based costing model.
3. Discuss the various cost drivers in logistics costing.
4. Explain how costing methods can help managers to manage and control logistics cost.

INTERNET EXERCISE

1. Study the elements of logistics cost in “Logistics Costs and U.S. Gross Domestic Product” prepared by the U.S. Federal Highway Administration and Department of Transportation. http://ops.fhwa.dot.gov/freight/freight_analysis/econ_methods/lcdp_rep/index.htm
2. Visit http://www.accountingcoach.com/online-accounting-course/35Xpg01.html for online coaching on ABC costing.
3. Visit http://www.pitt.edu/~roztocki/abc/abctu-tor/index.htm for ABC application.

BIBLIOGRAPHY

Akyol, Derya Eren, Tuncel Gonca and Bayhan G. Mirac. 2005. ‘A Comparative Analysis of Activity Based Costing and Traditional Costing.’ Proceedings of World Academy of Science Engineering and Technology, Vol. 3, January 2005, www.waset.org/pwaset/v3/v3–22.pdf

A.T. Kearney Inc. 1991. Improving Quality and Productivity in the Logistics Process—Achieving Customer Satisfaction Breakthroughs. Oak Brook, IL: Council of Logistics Management, pp. 274–275.

Cooper, Robin. 1988. ‘The Rise of Activity-Based Costing—Part One: What is an Activity-Based Cost System?’ Journal of Cost Management 2 (Summer 1988). 2(2): 45–54.

Cooper, Robin and Robert S. Kaplan. 1991. ‘Profit Priorities from Activity-Based Costing.’ Harvard Business Review 69 (May–June 1991).

Harrington, Lisa. 1995. ‘Its Time to Think Your Logistics Costing’ Transportation and Distribution. 36th issue 7 (July): 27–30.

Herr, John D. 1990. ‘Managing Logistics Costs as a Business Investment.’ In Barry J. Brinker, ed., Emerging Practices in Cost Management. Boston, MA: Warren, Gorham & Lamont, p. 222.

Lewis, Ronald J. 1991. ‘Activity-Based Costing or Marketing.’ Management Accounting 72 (November) 73(5): 29–33.

Miller, John A. 1996. Implementing Activity Based Costing in Daily Operations. New York: John Wiley & Sons.

Pohlen, Terrance and Bernard Lalonde. 1994. ‘Implementing Activity-Based Costing (ABC) in Logistics.’ Journal of Business Logistics. 15(2): 1–23.

Shank, John K. and Vijay Govindarajan. 1992. ‘Strategic Cost and Management and the Value Chain.’ Journal of Cost Management. 5(4): 5–21.

Tyndal, Gene R. 1990. ‘Logistics Costs and Service Levels.’ In Barry J. Brinker, ed. Emerging Practices in Cost Management. Boston, MA: Warren, Gorham, and Lamont, p. 215.

Turney, Peter B. B. 1991. ‘How Activity-Based Costing Helps Reduce Cost.’ Journal of Cost Management (Winter) 4(4): 29–35.