Kaplan and Cooper’s Approach

Kaplan and Cooper of Harvard Business School, who have developed this new approach in costing to calculate product costs, claim that the costs should be classified as long-term variable costs and short-term variable costs. Traditionally short-term variable costs are known as variable costs and long-term are known as fixed costs.

Short-term variable costs are volume related and change proportionately with the volume of production. Long-term variable costs vary in long term but not instantaneously. For example, production scheduling costs can be changed in the long-term by changing number of runs rather than changing number of units produced.

They further claim that this approach relates overhead costs to the forces behind them. The forces behind overhead costs are named ‘cost drivers’. Costs drivers can be defined as those activities or transactions that are significant determinants of costs. Under ABC system, product cost is determined by obtaining a greater understanding of cost behaviour and using new measures of quantity of resources consumed by each product.

A cost driver is ‘an activity which generates cost’. ABC system is based on the belief that activities cause costs and that a link should, therefore, be made between activities and products by assigning costs of activities to products based on an individual product’s demand for each activity.

Cost Drivers and Cost Pools:

The assumptions underlying ABC is that virtually all of a company’s activities exist to support the production and delivery of goods and services. They should, therefore, all be considered as product costs. And because nearly all factory and corporate support costs are separable, they can be split apart and traced to individual products to product families. On the basis of this assumption, the philosophy of ABC is that costs can be controlled more effectively by focusing directly on managing the forces that cause the activities—the ‘cost drivers’ rather than costs.

The reporting of the costs consumed by the significant activities of business and their cost drivers provides the basis for understanding what causes overhead costs and direct attention to where steps can be taken to improve profitability. Knowing the high costs of material movements or the cost of producing, many different components or maintaining many different machines, highlights the need to carry out these activities more effectively. Thus, ABC provides better and more accurate information and decision making on prices and product mix and for the control of manufacturing operations.

The ABC technique aims at to overcome the drawbacks by cutting across conventional departmental boundaries. Costs are grouped into ‘pools’ according to the activities which drive them e.g. a cost pool may be of procurement of goods. In this, all the costs associated with the procurement (ordering, inspection, storing etc.) would be included in this cost pool and cost driver identified.

The procurement cost per requisition is then calculated and this provides a means of tracing the cost of procurement to product. The technique of ABC lays importance on different costs for different purposes and the identification of just those costs which are relevant to particular decision.