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The Selection of

Actionable Cost Objects


for an Activity-Based
Costing System
B Y S I D N E Y J . B A X E N D A L E , D B A , C M A , C F M , C P A ; P. S . R A J U , P H . D . ;
AND MAHESH GUPTA, PH.D.

THE AUTHORS DISCUSS THE ACTIONABLE COST OBJECT SELECTION CRITERIA THEY HAVE

DEVELOPED AS A RESULT OF SUPERVISING APPROXIMATELY 60 ACTIVITY-BASED COSTING

STUDIES OVER THE PAST NINE YEARS.

EXECUTIVE SUMMARY This article discusses the selection of cost objects that enable an activity-based costing (ABC)

system to provide meaningful information to those developing a coordinated operations and marketing strategy to

enhance company profits. As a result of having supervised many MBA student team projects that used ABC to help

create business plans for small businesses, the authors have developed some guidelines for selecting cost objects that

provide information to suggest profit-enhancing actions by the business. Those guidelines are discussed and examples

are provided from some of the more successful student projects conducted for small businesses.

or several years, we have team-taught an MBA team supplements the traditional accounting system of

F module that integrates marketing, operations


management, and management accounting.
The module involves a practicum in which the
students work in project teams to develop a
business plan for a small business of their choice. The
business plan focuses primarily on a coordinated opera-
tions strategy and marketing strategy for the small busi-
the small business with an activity-based costing (ABC)
system. The team is encouraged to use the information
from the ABC system as a basis for coordinating the
operations and marketing strategies in the business plan.
In the early years of this integrated module, the proj-
ect teams would choose the company’s various products
or services as the cost objects and develop their ABC
ness. As part of the practicum, however, the project information systems to determine the profitability of

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each product or service. The business plans that Other than products, the cost object featured most
focused on the products or services were often less than often in the Harvard Business School cases was the cus-
satisfactory because of the highly competitive environ- tomer.2 The overwhelming majority of the ABC litera-
ment in which the companies operated. ture has focused on using either a company’s various
As one might expect, the ABC information system products or services sold or the cost of serving the cus-
often revealed that some products or services were tomer as the cost objects. There is only limited discus-
unprofitable. From the project team’s viewpoint, the sion in the literature about using cost objects other than
obvious solution to enhancing the company’s profitabili- product or customer.
ty was to increase the prices of those products or servic-
es; but the owners of the small businesses were quick S E L E C T I N G AC T I O N A B L E CO ST O B J E C T S
to point out that the price is determined by the market In our instructions to the project teams in recent years,
and that their businesses were “price takers,” not “price we have stressed the need to be creative in specifying
makers.” This was especially true of products or servic- the cost objects selected as the focus of the ABC infor-
es that were like a commodity. If the business owner mation system. We encouraged the project teams to
were to raise the price above the market price, unit think beyond the obvious products or services of the
sales would drop off considerably. small businesses and to look to couple a product or
After supervising several project teams working with service with service elements related to the product or
small businesses during the early years of the module, service. Marketing makes a distinction between the pri-
we realized that the proper selection of the cost objects mary product and the related secondary service. The
could make a positive difference in the extent to which primary product is what the customer expects. The sec-
the resultant business plan could guide the small busi- ondary service is something bundled with the primary
ness owners to enhanced profitability. product that will enhance the product from the cus-
This article attempts to expand the definition of tomer’s perspective.
“cost object” in a manner that is meaningful to both We further encouraged the project teams to think in
operations and marketing management as they seek to terms of cost objects that would permit the small busi-
make better use of activity-based cost information to ness to carve out a niche in an otherwise competitive
enhance profits. The article also offers real world exam- market place and to seek market niches that were com-
ples to support our arguments related to the selection of plemented by unique operations capabilities. Identify-
“actionable” cost objects. An “actionable” cost object is ing a bundle of primary and secondary products and
one that, when used in conjunction with ABC, yields services that creates a market niche will likely provide
information that permits management to make deci- the small business with some pricing power.
sions that enhance company profits. As we will illustrate through real examples, the proj-
ect teams often chose order size or delivery time as the
TRADITIONAL COST OBJECTS secondary services to be bundled with the primary
When it was first introduced in the mid-1980s, ABC products. In selecting a cost object that focused on mar-
was touted as a cost assignment method that would keting products sold in small orders or with immediate
result in more accurate product costs. Robert S. Kaplan delivery, the project teams realized that such cost
wrote many Harvard Business School cases in which he objects would only be actionable to the extent that
demonstrated the power of ABC to get more accurate operations could produce small batches or deliver
product costs in situations where the various products immediately in a cost-effective manner. This required
used activities with differing intensities. Even though an assessment of the capabilities of the small company’s
the focus of many of the ABC cases was on product cost operations. The project teams had to assess the extent
and product profitability, Kaplan and others made it to which the operating environment supported the
clear that ABC could provide more precise cost infor- product and service bundling that was likely to con-
mation for any cost object.1 tribute to a profitable niche business strategy.

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P R I M A RY P R O D UC T AND D E L I V E RY ◆ Black paint to be delivered in one to two weeks
TIME AS COST OBJECT ELEMENTS ◆ Black paint with standing or otherwise scheduled
To illustrate the subtle marketing and operations con- orders
siderations that are important in settling on the bundle The ABC analysis using those cost objects revealed
of primary product and secondary services that are that black paint delivered in less than one week was
likely to enhance a small company’s profitability, we going to be 21% more costly to produce than the black
present three examples. The first is of a small manufac- paint with standing or otherwise scheduled orders. But
turer of powdered paint that saw a market for custom- limited market research revealed that the company
made industrial paint that could be produced and could sell the black paint to be delivered in less than
delivered to the customer who needed the paint almost one week at a 34% premium over the selling price of
immediately. It had not exploited this marketing oppor- the black paint with standing or otherwise scheduled
tunity, however, because it assumed that the production orders. The ABC system revealed that the profit per
interruptions necessary to market to that niche would unit for the black paint with standing or otherwise
cause the product to be too costly. The project team scheduled orders was $.86 per gallon, but the black
realized that the ABC information system could deter- paint to be delivered in less than one week would earn
mine the actual cost to produce and sell the custom a profit of $1.37 per gallon.
product to customers needing it almost immediately. The project team recommended that the business
Before settling on a cost object that bundled the alter its sales commission structure to encourage the
product and delivery lead time, the project team made salespeople to seek sales of the most profitable cost
an assessment of the operations capabilities of the small objects. The ABC system, coupled with an understand-
company. They found that the company had two pro- ing of marketing opportunities and operations capabili-
duction lines—one for black paint and one for colored ties, provided a well-supported business plan that
paint. Operations chose to have two production lines focused on actionable cost objects that enhanced busi-
because the clean-up associated with black paint was ness profits.
minimal, and changing from one customer’s custom
black paint to another customer’s custom black paint B A S E M AT E R I A L AND B AT C H S I Z E
could be done with minimum downtime for clean up. AS COST OBJECT ELEMENTS
The clean-up after each batch of the colored paint The next example examines a liquid paint manufactur-
product line was much longer because the significant er that had only limited unused capacity for its milling
differences in color necessitated significant cleaning of and filtering activities given the current level of market
the production equipment after each batch. For demand for the various products. Those two potentially
instance, a batch of red paint might be followed by a constraining production activities were used in varying
batch of white paint. That situation suggested an intensities depending on the base material required for
opportunity to select a cost object that combined a mar- making the paint. For example, a large batch of water-
ket demand (timeliness of delivery) with an operations based paint required 5.25 hours of filtering time vs. 2.25
capability (short clean-up time when a current job is hours of filtering time for a large batch of solvent or
interrupted to meet immediate customer demand for high-solids-based paint. Likewise, the batch size (in
black paint). most instances, the customer order size as well) had a
The project team chose the following cost objects for sizable differential impact on the time required in the
their ABC portion of the business plan development: milling activity. For example, 4.12 hours of milling time
◆ Colored paint to be delivered in less than one per 1,000 gallons for large batch sizes and 10.27 hours of
week milling time per 1,000 gallons for small batch sizes.
◆ Colored paint to be delivered in one to two weeks The potential that the milling and filtering activities
◆ Colored paint with standing or otherwise sched- could limit market growth suggested to the project
uled orders team that the cost objects selected for the ABC infor-
◆ Black paint to be delivered in less than one week mation system should somehow be sensitive to the dif-

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ferential demands placed on the milling and filtering strated that the paint company could enhance their
activities by the different base materials and batch operating profit considerably through the use of this
sizes. The project team chose to combine batch size coordinated operations and marketing strategy. The
and base material to define the cost objects. The com- choice of combining product characteristics (base mater-
bination of batch size (small, 50 to 150 gallons; medium, ial) and secondary service characteristics (timeliness of
151 to 750 gallons; and large, more than 750 gallons) delivery) for the cost objects was critical in the develop-
and base material (water, solvent, or high solids) used in ment of such a strategy.
making the liquid paint resulted in nine different cost
objects: P R O C E S S , P R I M A R Y P R O D U C T, AND

◆ Water-based, small batch ORDER SIZE AS COST OBJECT ELEMENTS


◆ Water-based, medium batch In the third example, a plastic parts manufacturer pro-
◆ Water-based, large batch duces thousands of different plastic parts. As the project
◆ Solvent-based, small batch team considered the ABC system design for the small
◆ Solvent-based, medium batch company, it was obvious that any attempt to use prod-
◆ Solvent-based, large batch ucts as the cost objects would require the aggregation of
◆ High solids, small batch the products into product lines, but there would be sig-
◆ High solids, medium batch nificant differences among the products in any product
◆ High solids, large batch line. More importantly, cost and profitability informa-
An assessment of the company’s operations revealed tion on products or product lines was not actionable
that there was a rather large unused storage area where from a marketing perspective because of the intense
paint could be stored. This unused storage capacity price competition in the plastics industry.
suggested a unique marketing strategy: an inventory Discussions with the company owners revealed that
management system that the company could offer its there was considerable diversity in the size of the orders
customers. If a customer would commit to a large annu- the company received. Also, some products were pro-
al sales quantity, the paint company would give them duced on an automated production line while others
the price for a large-volume purchase but would deliver were produced on a semi-automated production line
according to the customer’s production schedule in (some human intervention in the production process).
small batches. Thus, by planning the production, the Additionally, the owners suggested that the larger prod-
paint manufacturing company could minimize the pro- ucts (those weighing more than 25 grams for each unit
duction of small batch sizes and free some capacity in of product) used the various activities more intensely
the milling activity and filtering activities by minimiz- than the products that weighed 25 grams or less per
ing equipment setups. unit of product because of the additional complexity of
The company could produce large batches, inventory the larger products.
the product on site, and deliver it as the customer Because there were too many products to regard each
needs it. This strategy necessitated the additional as a cost object and the company had no pricing power
expense of inventory management and an added invest- in the competitive market for plastic parts, the project
ment in finished goods inventory. The milling and fil- team settled on the following cost objects:
tering activities, however, would have sufficient unused ◆ Automatic, small order, 25 grams or less
capacity to permit an aggressive market expansion. ◆ Automatic, small order, more than 25 grams
The project team recommended that the company ◆ Automatic, large order, 25 grams or less
expand their market by differentiating themselves from ◆ Automatic, large order, more than 25 grams
competitors in terms of timely delivery. By taking on ◆ Semi-automatic, small order, 25 grams or less
the inventory management function at no additional ◆ Semi-automatic, small order, more than 25 grams
cost to the customer, the paint company offered some- ◆ Semi-automatic, large order, 25 grams or less
thing that competitors were not offering. An ABC-based ◆ Semi-automatic, large order, more than 25 grams
computer model enabled an evaluation that demon- The ABC information system revealed that the

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semi-automatic, small order, 25 grams or less was expe- relative profitability of producing and selling each prod-
riencing a loss at the operating profit level. The semi- uct or serving each customer. But once the company
automatic, large order costs objects (all gram sizes) were knows this, the next area of concern is figuring out what
the most profitable on a per unit basis. All of the prod- to do with the unprofitable products or services. In
ucts produced in the automatic process were reasonably highly competitive industries, raising the price to cor-
profitable on a per unit basis. This suggested that the rect the situation may not be feasible.
company was not properly pricing the small orders it ABC information systems that are designed with a
accepted for production in the semi-automatic produc- focus on “actionable cost objects” consider market
tion process. niche opportunities and operational capabilities in the
According to the ABC system, the small cost objects selection of the cost objects for the ABC system.
were more costly to process because of the setup costs Thoughtful cost object selection increases the likeli-
and other disruptions caused by small batches. The com- hood that the ABC system will provide information to
pany was not charging extra for these additional costs facilitate the coordination of an operations and market-
associated with small orders. Because the competition ing strategy that will enhance the company’s profits. By
was focused on large orders, the company had an oppor- selecting cost objects that bundle the primary product
tunity to charge more for the small orders, a market niche with secondary services, a company can profitably
in which there were few competitors. The ABC informa- exploit market niche opportunities that are leveraged
tion system indicated the extent to which the selling by unique operational capabilities. ■
price of small orders would have to increase to render the
small orders as profitable as the large orders. Sidney J. Baxendale, DBA, CMA, CFM, CPA, is professor
Sales order size was an important cost differentiation of accountancy at the College of Business and Public Admin-
feature from an operations management perspective. istration of the University of Louisville in Louisville, Ky.
Large orders were less costly on a per unit product basis He can be reached at (502) 489-5236 or
because the setup costs associated with the batch could baxendale@louisville.edu.
be spread over a larger quantity. Small orders were very
costly on a per unit basis because the setup costs were P.S. Raju, Ph.D., is professor of marketing at the College of
spread over only a small number of units. The ABC sys- Business and Public Administration of the University of
tem that used order size as one element of the cost Louisville in Louisville, Ky. He can be reached at (502)
object properly recognized the cost differences between 852-4868 or psraju@louisville.edu.
large and small orders. By including the nature of the
production process (automatic vs. semi-automatic), Mahesh Gupta, Ph.D., is professor of operations manage-
however, the ABC system provided better and more ment at the College of Business and Public Administration of
accurate information that allowed the marketing strategy the University of Louisville in Louisville, Ky. He can be
to focus on small orders processed on the semi-automated reached at (502) 852-4783 or
production line as well as providing the cost information mcgupt01@gwise.louisville.edu.
that was necessary to implement a differential pricing
strategy for small orders processed on the semi-automated AC K N OW L E D G M E N T S
production line. The authors wish to acknowledge the efforts of our MBA
students in collecting and organizing the data for the studies
AC T I O N A B L E CO ST O B J E C T S cited in this article.
ABC information systems identify resource costs with
1 Robert S. Kaplan, Kanthal, Harvard Business School Case
activities and then attribute those activity costs to cost
#9-190-002, 1990; and Robert S. Kaplan and Artemis March,
objects. Historically, the most popular cost objects have John Deere Component Works, Harvard Business School Case
been the company’s products or its customers. Those #9-187-107, 1987.
2 Kaplan, 1990; and Robert S. Kaplan, Pillsbury: Customer Driven
are appropriate when the company wants to know the Reengineering, Harvard Business School Case #9-195-144, 1995.

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