Activity-Based Costing for Purchasing Managers’ Cost and Pricing Determinations

INTRODUCTION Progressive firms today consider their key suppliers as an extension of the firm's in-house production processes.[1] An ongoing supplier's performance typically is evaluated on the basis of product quality, delivered cost, and manufacturing and service capabilities. Even though the emphasis today has shifted toward quality, price is still an important criterion in most cases. In some cases a supplier becomes a single source for the buying organization. In these cases, in addition to its commitment to the basic performance criteria just mentioned, a supplier is frequently expected to participate in the buying firm's product development efforts to improve the product's design, manufacturability, and cost characteristics. In addition, the supplier is expected to commit to a program of "continuous improvement," with a strong emphasis on continuing cost reduction.[2] A firm's purchasing professionals must be perceptive in analyzing a supplier's cost performance. They need to be able to determine and understand the likelihood of a supplier's ability to maintain effective cost performance. To do this, a buyer must utilize effectively the available information on a supplier's cost dynamics - that is, the factors that are likely to increase or decrease the supplier's delivered cost. The information produced by this type of analysis is vital for effective management of single sourcing situations. The type of information needed by purchasing professionals to accomplish this objective is much more readily available through the use of an activity-based costing system (ABC). This is a relatively new approach to product cost accounting. Many firms today are beginning to realize that the traditional approach to product cost accounting (TC) produces a distorted product cost. Consequently, many are selectively using ABC to recost their products and compute product profitability.[3] Many of these firms are also modifying their pricing strategies based on ABC. Consequently, to deal effectively with suppliers, a buyer really needs to understand the ABC system and the data that it produces. Although much has been written about ABC as a tool for managerial analysis, there has been relatively less emphasis on ABC's uses in costing and pricing decisions for purchasers. The purpose of this article, therefore, is to point up the differences between ABC and TC systems - and to illustrate how ABC can assist purchasing professionals in approaching cost/price and sourcing decisions. DIFFERENCES BETWEEN ABC AND TC THAT ARE IMPORTANT TO PURCHASERS The major differences between ABC and TC can be explained most effectively by using an example. In the following hypothetical case, a company called Diversified Products Inc. (DPI) is a job shop making custom products for its manufacturing customers. United Plastic Models (UPM), a customer, is interested in purchasing a part, EC-24, from DPI. The purchasing manager of UPM is involved in negotiations with DPI and has asked DPI to provide ABC-based cost breakdowns for an estimated annual volume of 10,000 units. DPI values its relationship with UPM and has agreed to provide requested ABC cost data. Internally, DPI is comparing TC with ABC and has developed the data in Table I (see p. 27). Distortion of Unit Costs Under TC As shown in Table I, the manufacturing cost per unit for EC-24 differs substantially between the TC and the ABC approaches, $55.56 and $42.88 respectively. Upon closer examination of the TC and ABC cost breakdowns, one can see that there are no differences in the direct material and direct labor components. There is, however, a big difference in manufacturing overhead per unit between TC and ABC, $30.56 and $17.88 respectively. The comparison of unit cost data under the TC and the ABC approaches reveals that EC-24 is overcosted under TC as compared with ABC; as a result, DPI may not be priced competitively in the market for EC-24. …