Integrating activity-based costing and economic value added

Robin Cooper, Regine Slagmulder. Management Accounting. Montvale: Jan 1999.Vol.80, Iss. 7; pg. 16, 2 pgs
Abstract (Document Summary)

The two major advantages of integrating the ideas of economic value added (EVA) and activity-based costing (ABC) are: 1. The decision maker becomes sensitive to the economic return of products, customers, and channels. 2. It rewards the more efficient use of capital. After integration, the concept of dedicated and nondedicated capital emerges naturally. The capital assigned to primary and secondary activities is considered dedicated while the capital assigned to tertiary activities is nondedicated. It is necessary to compute the cost of capital for each major line of business, but for the purpose of developing EVA maps, a single rate for most enterprises is usually all that has to be determined. Copyright Institute of Management Accountants Jan 1999 The activity-based profitability maps described in last month's column can be improved by incorporating into them the concept of economic value added (EVA). The theory of EVA is elegantly simple: To be economically justified, an investment must earn at least its cost of capital. The ABC-based EVA of a product is given by: ABC-EVA = Revenue - (ABC Cost + Capital Employed X Cost of Capital) The EVA extension to ABC requires that the capital employed for each product (or other cost object) be determined and that a risk-adjusted rate for that capital be identified. The superiority of EVA can be demonstrated by considering two products. The first sells for $100, has an ABC cost of $30, but requires capital employed of $100. The second product also sells for $100 and has an ABC cost of $30, but it requires capital employed of $1,000. If the cost of capital is 10%, then the first product has a positive EVA of $60 ($100 - $30 10% X $100), whereas the second has a negative EVA of $30 ($100 - $30 - 10% X $1,000). The first product creates wealth, while the second destroys it. Yet both have the same $70 ABC profit! This simple example highlights the two major advantages of the integration of ABC and EVA. First, the decision maker becomes sensitive to the economic return of products, customers, and channels, and, second, it rewards the more efficient use of capital. Dedicated Capital. When ABC and EVA are integrated, the concept of dedicated and nondedicated capital emerges naturally. Dedicated capital can be traced meaningfully to cost objects while nondedicated capital cannot. There are two types of dedicated capital: direct and indirect. Direct dedicated capital1 can be unambiguously associated with a single cost object. For example, the investment in finished goods inventory for a given product or the accounts receivable balance for a particular customer are examples of directly dedicated capital. Indirect dedicated capital, in contrast, is associated with multiple cost objects. The easiest way to handle indirect dedicated capital is to assign it

to the activities that it supports and then, in the second stage, to the cost objects. For example, if the activity is "machining," then the capital employed includes the firm's investment in the machine(s) performing the "machining" activity. Similarly, if the activity is "set up," the investment in setup equipment and the space dedicated to the setup department is assigned to the "setup" activity. In many cases, the interest charges can be assigned to cost objects using the same activity driver as the ABC model; for example, the interest charges for the machining or setup activities can be assigned using machine hours and setup hours, respectively. But for some indirect dedicated capital such a simple equivalency cannot be identified, and a different capital driver will have to be established. The capital assigned to primary and secondary activities will be considered dedicated, and the associated interest charges are then assigned to cost objects. In contrast, the capital assigned to tertiary activities is considered nondedicated, and its interest charges are not assigned to cost objects. (For a definition of these classes of activity, see December's column.) Nondedicated Capital. Nondedicated capital is employed to support the facility or the enterprise, but it is not directly associated with the manufacture of products or the servicing of customers and channels. A good example of such capital is the short-term investment and cash war chest that firms accumulate to acquire other firms. The interest charges associated with this "infrastructure" class of capital are not assigned to cost objects because decisions involving cost objects typically will not alter the level of such investments. As the purpose of the EVA maps is to identify cost object-level decisions for further analysis, the inclusion of the interest charges associated with this class of capital is counterproductive. Definition of Capital. The book value (gross or net) of assets typically does not provide a good estimate of the current value of the firm's assets. For a more accurate EVA analysis it is better to use either market or replacement values.2 Cost of Capital. Theoretically, it is necessary to compute a cost of capital for each major line of business. But for the purpose of developing EVA maps, a single rate for most enterprises is usually all that has to be determined. EVA maps, like profitability maps, need to be approximately correct; they do not have to be highly accurate. Consequently, small variations in the cost of capital will not change the relative evaluation of products or customers. Only if the underlying risk level is significantly different will it be worth developing multiple estimates of the cost of capital. Special Studies. The purpose of special studies is to convert the analysis from resource usage to resource supply (see December's column). Such special studies are designed to provide better insights into the economic impact of decisions. The adoption of an EVA perspective does not change the need for special studies, but it does require that the analysis be expanded to include the likely effect on capital employed.

At the product and customer level, there are three ways in which capital can be employed more efficently. First, the assets can be used to support a different product or customer mix. For example, if a machine is used to produce an equal volume of the two products described above, it will generate an EVA of $30 ($60-$30) for every pair of products that it produces. If the mix can be changed so that it is 100% of the first product, then the EVA for a pair of products climbs to $120 ($60 X 2). Second, dedicated assets that are no longer required can be sold and the capital used for new investment purposes that have a higher EVA. Third, additional assets that are required to support the new product or customer mix can be acquired. Long-Term Versus Short-Term Decisions. Occasionally, the decision being considered will have long-term infrastructure implications. Then the special study will include some if not all of the nondedicated capital in the analysis. For example, if the decision centers on opening or closing a production facility or a sales office, then the nondedicated capital associated with the production facility or sales office will be incorporated into the decision. In the limit, if the decision deals with the entire enterprise, then all of the capital employed by the firm will be included, and the special study will be a classical EVA analysis with all capital and associated interest charges included. Decisions to modify a firm's infrastructure are considered from time to time, but decisions that affect the firm's shortterm product and customer mix are made continuously. The objective of these decisions is to take maximum advantage of a firm's existing infrastructure. Such decisions are influenced by bottleneck resources that limit the number of times an activity can be performed. A pure ABC system cannot shed insights into how to maximize shortterm profits when bottlenecks exist. To achieve that objective, we have to incorporate the theory of constraints into the general activity-based model. This extension is the subject of next month's column.
[Footnote] 1 The treatment of these capital costs is equivalent to the one for direct material in the ABC system. 2The adoption of ABC and EVA represents a considerable change in the managerial thinking. Many firms do not immediately shift to market or replacement values for assets to give their management teams time to first adapt to the ABC and EVA approaches. They can subsequently adopt new assets valuation approaches.