Activity Based Costing

and

Real Time Cost Monitoring

Activity Based Costing (ABC) is a cost accounting philosophy which links cost elements to production activities for a detailed and consistent cost allocation. Storing detailed cost information in the same database with quality and production data results in increased possibilities for tracking and analysis, cost and value calculation for each product unit, and the ability to determine profit margins for specific orders. Real Time Cost Monitoring (RTCM) is the integrated acquisition, processing and reporting of product and process cost data in approximate real time. RTCM makes activity based costing possible by detecting cost variances early in a multi-step production process and facilitating solutions to cost problems in conjunction with quality and production constraints. The result is detailed and consistent cost allocation, a thorough understanding of the cost structure throughout the production process. Business becomes more profitable as quality requirements are met while costs fall and production increases.

MIKON Systems. Inc. 6 Concourse Parkway, Suite 1400 Atlanta, Georgia 30328 770.804.5885 770 804.5886 fax www.mikon.com

Copyright MIKON Systems, Inc. All rights reserved.

Page 2

ACTIVITY BASED COSTING

There are strong demands in the process manufacturing industries for providing correct and detailed cost information from daily plant operations. The state of the art is well described by H.T. Johnson and R.S. Kaplan: Todays management accounting information, driven by the procedures and cycle of the organizations financial reporting system, is too late, too aggregated and too distorted for managers planning and control decisions. The cost of operation is typically calculated once a month. While this is good for financial reporting purposes, manufacturing wants to allocate the real cost in the production process to the end product. Rather than distribute cost top-down following certain standards, manufacturing wants to calculate cost bottom-up based on real consumption of resources in the process. Linking cost to the activities in the production process is one of the benefits of doing Activity Based Costing (ABC). ABC is a philosophy for cost accounting and not a detailed methodology. Hence, the principles of ABC can be applied several ways. ABC is per definition linking all cost elements to production activities. Cost of resources like materials, energy and chemicals are easily calculated but also services like quality inspection and production setups should be handled similarly. The result is detailed and consistent cost allocation.Cost is not considered to be only variable or fixed, but also semi-fixed depending on the time frame of analysis. The clue is to identify the correct cost pools and cost drives for various cost types. There are multiple solutions, and careful analysis of the production process should be carried out to ensure a good implementation. For details regarding Activity Based Costing, please refer to one of the publications listed below. Storing detailed cost information in the same database as quality and production data has strong advantages. Cost is calculated from the input resources in the process and stored with the same time stamps as quality and production data, and gives unique possibilities for tracking and analysis. Cost could be used as an alarm indicator analogous to process related signals, and analysis should be carried out to find real causes of cost variance. All process steps can be linked together, adding cost and value to the product as it moves through the process. Finally, profit margins can be calculated for specific orders. This will identify which products and customers contribute to the profit. Using real time activity based cost monitoring will give reduced cost and increased production. By getting early warnings of cost variances, problems in the process can be solved in conjunction with quality and production aspects. This is obtained through detailed and consistent cost allocation, which also gives a good understanding of the cost structure in the production process. Common cost and quality objectives for all process departments can be established, creating increased understanding and motivation for the common goal: a profitable business. Real Time Cost Monitoring (RTCM) is based on the concepts of Activity Based Costing, and may be defined as integrated data acquisition, processing and reporting of product and process cost in approximate real time. RTCM has a strong basis in business problems and solves them in a flexible and thorough way. Some of these aspects are described and discussed below.

Page 3

REAL TIME COST MONITORING (RTCM) CONCEPT

Real Time Cost Monitoring (RTCM) is based on the concepts of Activity Based Costing, and may be defined as integrated data acquisition, processing and reporting of product and process cost in approximate real time. RTCM has a strong basis in business problems and solves them in a flexible and thorough way. Some of these aspects are described and discussed below. Production, Quality and Cost In the production process there are strong inter-relationships between production, quality and cost. The objective is to achieve high production at low cost with quality according to the customers requirements. Despite this objective, the three issues are often handled separately due to historical reasons, organization, etc. There are obvious advantages by working systematically with them in one system. The cost and revenue of a product is related to the complexity of matching the customers requirements of the production process to trade offs among production speed, quality properties and cost of resources. It is always possible to meet the requirements by adding enough resources in the production process. A systematic approach will have a long term goal of getting detailed knowledge about all process variables and cost elements related to the customers orders. The best way to achieve this is by storing cost, quality and production data in one system. These requirements are supported by the RTCM concept. Production and Servicing Departments Todays production plants are integrated production processes with several departments, and the product follows certain routes through the production process. In addition there exist several servicing departments like quality inspection, maintenance, sales and accounting. A profitable business requires that these functions are well integrated and that quality, cost and productivity are correctly perceived in all departments. The organization network is complex, and open for suboptimization. The RTCM concept has the objective to present detailed and correct information based on well accepted rules for cost calculation and presentation. Based on detailed cost information, the departments may have different requirements for reporting the data. In the long run a homogeneous view will develop of what constitutes profitable production. Presenting information relevant for decision makers in each department is important, and the operators and managers must observe cost effects of their process actions. RTCM has the capabilities to support this process.

Page 4 Integrated Concept Cost information is typically calculated at the monthly level with few or no possibilities to study the underlaying details. The traceabilty from end products to raw materials is also very restricted. The goal should be a model where detailed and aggregated cost is consistently calculated and accumulated through production departments. A paper manufacturing example is shown in the figure below. The figure can best be explained by an example. An alarming cost situation for the end product paper is observed on day aggregates, and needs further investigations. Zooming down on the details (batches) in the day aggregates, gives access to detailed production and quality information. A thorough analysis of the underlaying details in the aggregated alarm situation can be carried out. The reason RTCM: An integrated concept could be caused by the cost in the previous production department, and the cost variances can be traced back and further analyzed. This flexibility in analysis is indicated by the arrows in the figure, where forward-backward analysis is taken care of by traceability and up-down analysis is a change in aggregation levels. This functionality is one one of the key aspects in the RTCM concept.

Cost Model The RTCM concept is implemented in a cost model by calculating on line the necessary cost data and mapping the cost elements to the activities and entities in the production process. This can be explained by looking at the paper manufacturing example presented in the figure below. The example shows a mechanical pulp mill integrated with a paper mill producing paper reels. These reels are cut into rolls, and rolls are related to specific orders. The pulp mill is an independent production department, and an unit cost for mechanical pulp is calculated. This cost is input to the paper mill where it is handled as a price of mechanical pulp. The cost of a paper reel is then calculated at reel Cost model turnup time. A link from the reel turnup time to the production time in the pulp mill is established for traceability reasons. Later the rolls are linked to specific reels, and the related cost is calculated. An order is then entered for a group of rolls, and the total order cost is calculated. By entering the orders sales price, the net profit margin can be calculated. So far only the cost calculation has been outlined. Along the process line usage, price and capacity variances have been calculated for all resources, and this information also ends up on the order level. This opens for the possibility to zoom down into the process details from aggregated order data. In the example above RTCM is configured into a mill specific system. However, the concept is generic in its form, and may fit any production process in multiple steps following the guidelines above.

Page 5 Operation, Reporting and Analysis RTCM is a tool for several levels in the organization, each with different requirements. The operators may use it for taking cost effective decisions in the process. This strongly depends on high data quality and user friendly presentations through forms and graphs. Production and accounting management wants to look at the same basis data at an aggregated level using reports. Graphics of key process variables should be included in the reports. In specific problem situations the process engineers and accountants need to perform detailed analysis and tracking. They want to look at actions taken in the process by the operators which can be logged in the database and form a solid basis for knowledge acquisitions. A consistent mapping and integration of several functions like data input and presentation, reporting, analysis and tracking and knowledge acquisition is implemented in the RTCM concept. These functions form a learning cycle for continuous improvement in the production process.

MIKON/RTCM APPLICATIONS
The mission for MIKON/RTCM is: presenting, detecting tracking and analyzing cost variances by linking product cost to production and quality This functionality is implemented in a set of applications concentrating on calculation, monitoring, reporting and analysis of net profit margin, production cost, cost variance, capacity utilization and process performance. These issues are presented below by showing examples from MIKON/RTCM. The presentation intends to give an overview of some of the functionality, and is not a complete documentation of MIKON/RTCM. Order and Product Cost and Revenue To allow profit monitoring for separate orders, all cost added to the product through the process must be aggregated consistently to the units in the order. In the figure shown below, the cost is calculated from the paper mill for separate rolls of paper before selected rolls are entered into an order. Cost calculations are based on a detailed consumption of resources (bottom-up), and the orders sales price can be entered to calculate net profit margin. The figure to the left is an on line spreadsheet where one column represents one order and the rows are cost signals related to the orders. The top lines indicate date and time for finishing the order, and product, customer and order number. The form is a sales price input form to enable calculation of net profit margin. The form is live, and any changes in the underlaying data will cause update of the data in the form. Several submenus can be selected for a detailed study of the data displayed in the on line spreadsheet.

Order, cost and revenue. (currency = NOK)

Page 6 The figure to the left is an example of a graphic zoom. A graphic zoom from the order level will include roll details of selected signals from the on line spreadsheet. This is shown in the figure, where the total cost for single rolls is displayed together with the cost usage variance. Several information details can be read from the graph by using a graphic crosshair. An example for reading sum cost variances for roll number 22000065 is displayed to the left.

Detailed cost of rolls in order

Detailed Cost for Single Units (Batches) in the Production Process The cost of units (batches) in the various process steps can be viewed using on line spreadsheets and graphics similar to the ones shown above. This is used for paper rolls and reels and 8 hour production batches of mechanical pulp. The model is generic in form and any production process can be modeled in a similar way, but the examples focus on an example cost model. The detailed cost usage variances of single rolls can be presented as in the figure to the left. A negative variance indicates that the usage of resources has been greater than the standard (budget) recommended value. For roll number 22000065 all the detailed variances can be observed adding up to the total presented in the previous figure.

Cost usage variance for rolls The usage variances can be further studied and analyzed through trend graphs which furnish cost per ton as shown to the left. By zooming down on the details in the graph, single values and related information can be read out. The figure to the left is a product traceability zoom, showing batches from the pulp mill and rolls cut from the specific reel. The reel number 21000054 has provided paper for roll number 22000065 analyzed earlier. Furnish cost for reels

Page 7

Production cost in pulp mill

The cost of mechanical pulp presented on the graph above can be investigated further. The cost at reel level is a function of usage and the unit cost of mechanical pulp. The figure to the left shows how to monitor the production cost in the pulp department. In the pulp department the cost of production is calculated at shift level since there is no defined production units. The total cost and the cost per ton is calculated as well as the variances. The production batch number 11000025 has provided pulp for the reel analyzed in the earlier figure. Quality and production data can be included and traced forward to separate orders

Cost Analysis Cost analysis has been shown in the previous figure by zooming down on detailed information and by tracking certain variances. MIKON/RTCM also includes more dedicated analysis tools like cost variance analysis and Advanced QUery Analysis. The figure to the left shows a graphical analysis of cost variances. Top left is shown the cost variance of paper cost per ton which is a master signal. The other five graphs show the contribution from variances in different input resources. All graphs are displayed with the same scales giving a concise view of the various components contribution. There is an oval circle in the right corner of each graph giving the degree of correlation between the master and one of the input resources. The diagram may therefore be used as a cause and effect chart. Cost variance analysis

Page 8

MIKON/AQUA is a form based query module which is used to find units of production (batches) qualifying certain restrictions. Batches with cost or process alarms can be selected by defining limits for cost and process variables. In the example shown to the left, we have selected paper reels with quality properties (tensile strength) below a recommended value and a negative cost usage variance for chemical pulp. Hence, these paper reels are low quality and high cost. The query is carried out as a filter to find the batches qualifying the query. Later Advanced QUery Analysis Cost, Production and Quality reports, graphs a n d o n l i n e spreadsheets can be displayed using the defined filter. The figure shows the two non-consecutive paper reels qualifying the query. MIKON/AQUA is a strong tool for process analysis involving integrated cost, quality and production aspects. The strong benefits of having cost, quality and production data in the same database have been pointed out earlier. Some of the following figures indicate how these data can be integrated and presented. The graphs to the left are trends of usage and cost of chemical pulp and the quality property tensile strength. All these data are stored in the database with the same timestamps. The graphs give a unique possibility for studying interrelated cost and quality effects. The white bands indicate the recommended value. The figure shows paper reels with low quality and high cost and the opposite. Comparing other process variables the same way will provide knowledge about costequality interrelationships in the process. To the left is presented a customer order display showing which customers and orders that got paper from the highlighted reel.

Effects of chemical pulp

Page 9 The on line spreadsheet for order related information can be used to view cost, production and quality properties at the order level. The cost is aggregated through the production process, while the quality properties are mean values for the various process steps. Only values for batches linked to the order through the production process are calculated using the product tracking model. Brightness is such an example which is measured on paper reels and pulp production batches. To the left is a product tracking display showing all paper rolls and reels and pulp production batches related to the currently highlighted order.

Order, cost, production and quality data

Reports Production, cost and quality information customarily appears on printed reports for the various levels in the organization. In MIKON, reports are configured by the user and may be run cyclically (e.g. every morning). In MIKON/RTCM an enhancement has been developed allowing graphic displays on reports. The figure to the left shows a graphic report where a standard report is combined with a trend chart of the cost of chemical pulp. Also displayed are the standard (budget) values for chemical pulp. Any standard text report may be configured as a graphic report.

SUMMARY

Page 10

In this document MIKON Real Time Cost Monitoring (RTCM) is presented based on a cost model for an integrated pulp and paper mill. RTCM has a basis in Activity Based Costing and allows integrated monitoring of cost, production and quality data. This will give strong benefits such as increased production and reduced cost, still meeting the quality requirements. Calculation of product cost and analysis of cost variances have been shown for separate orders based on details from all the production departments. The presentation is done using graphics, forms and reports showing how product cost can be traced back using the product tracking module. RTCM is an integrated concept with a flexible model. This provides decision support for all levels in the organization through daily operations, analysis and reporting. The RTCM concept is generic in its form, and may be configured into any specific production system.

LITERATURE
R.S. Kaplan and H.T. Johnson. Lost Relevance. Harvard Business School Press (1987). R.S. Kaplan. One Cost System Isnt Enough. Harvard Business Review :January February 1988. R. Cooper and R.S. Kaplan. Measure Costs Right: Make the Right Decision. Harvard Business Review: September-October 1988. R. Cooper and R.S. Kaplan. Profit Priorities from Activity Based Costing. Harvard Business Review: May-June 1991. R. Cooper. Does Your Company Need A New Cost System? Journal of Cost Management: Spring 1987. R. Cooper. The Two Stage Procedure in Cost Accounting: Part One. Journal of Cost Management: Summer 1987. R. Cooper. The Two Stage Procedure in Cost Accounting: Part Two. Journal of Cost Management: Fall 1987.