Traditional cost accounting practices ignore the fact that the purchase cost of raw materials, components, and items bought for resale is not the only cost incurred in having those items on-hand and available when needed. Individuals in forecasting, materials planning, purchasing, transportation, receiving, quality control, inventory control, accounts payable, and warehousing are often involved.

In addition to the efforts of employees, warehouse space and equipment is tied up in inventory. Finally, not all of the purchased items get used. Some become obsolete after purchase, and are eventually written off.

Some companies recognize the cost of incoming freight in the cost of purchased items. Even in those rare instances where some indirect support costs are included in the cost of purchased items, they are accumulated in a single "material overhead" cost pool, and assigned to the purchased items as a percentage of acquisition cost.

Because "what gets measured gets done," these traditional practices fail to provide any insight into benefits that can be gained from initiatives such as build-to-order and mass customization. Other than the general observation that less inventory means less "carrying cost," most companies are blind to the effect purchased items have on the overall cost of their operation.

Calculating this precise estimate of the returns from different investment vehicles requires a significant investment of time and effort.

In the late 1980s, the powerful concept of activity-based costing (ABC) was developed to correct deficiencies in traditional costing practices. Unfortunately, this concept was immediately turned into complex and expensive software packages designed to replace outdated, traditional costing systems. Usually, this process required investing thousands of hours of employee time and six or seven-figure consulting fees. It's no wonder that most companies have avoided implementing ABC systems despite the soundness of the concept.

Lost in the "ABC system frenzy" were certain facts:

• Cost information used by a company to support decisions is not the same thing as the cost accounting system used to report its overall results.
• Fully absorbed product-cost information is only one of the many types of cost information required to run a company well.
• Most of the information required to support sound management decisions does not require an activity-based costing system.
• Obtaining such information requires the application of activity-based principles in a way appropriate for the company.

More often than not, developing cost information to support management decisions requires no more than an activity-based view of the company's operation, and the development of a computer spreadsheet-based model. Such is the case with cost information designed to support build-to-order and mass-customization efforts.

Precision is the enemy of accuracy and relevance. The purpose of activity-based costing is not precision in calculating costs; its purpose is improving management's insight. A functioning organization is too dynamic to measure anything precisely. Changes occur day-to-day, if not minute-to-minute, that alter the precise costing of any process or product. As a result, the quest for precision in cost information is foolish.

On the other hand, accuracy and relevance are desirable and readily attainable. Let's take the simple example of an investor with $1,000,000 to invest. This investor has an opportunity to invest in any four of ten $250,000 investment vehicles. This investor knows that the average return on this group of ten investment vehicles is 15%. How much insight does this investor have to help in making his investment decisions? None at all!

What if the investor spent a great deal of time and effort and developed the information shown in Table 1? Would he be better able to make an investment decision?

Obviously, with this information the investor could select Investments B, D, F, and H, and earn an estimated return of 24.099% on his investment. But was it necessary to develop such detailed information to support the decision? Suppose our investor knew the right questions to ask about each potential investment, spent his time finding reasonably accurate answers to those questions, and developed the information shown in Table 2.

Using this less-intensive analysis he would have still chosen investment vehicles B, D, F, and H. He would have estimated his return at about 24% instead of precisely 24.099%. Given that the future is unknowable, would the 24% estimated return be any less accurate than the 24.099% return?

A reasonably accurate estimate of the returns produced by different investment vehicles can be achieved as shown, and provides as much insight into relative returns as a rigorous precision estimate.

Let's look at the same example in a different light. A company purchases $2,500,000 of components annually--$250,000 each of ten different types of items. If the company does not attribute any support costs to these items, can it determine the savings that would be gained through mass customization or build-to-order? Obviously not. Its costing methods assume there are no costs involved in having these items on hand other than their purchase costs.

Now let's assume the company takes the next step, calculates the cost of supporting the purchase and warehousing of these items, and finds that cost to be $375,000. Interesting information, but it implies that the cost of supporting all purchased components is the same relative to their purchased cost. That doesn't help direct the effort to reduce total component cost (purchase cost plus support cost).

The company implements a new, activity-based costing system. Software is purchased, consultants hired, and after thousands of hours of work the company has a new system that provides the information in Table 3.

This new cost information shows the differences in the effort required to support the various types of components purchased by the company--but at what price? Investing in the new system might turn out to be worthwhile in the long run, but was it necessary to gain the insights that were uncovered?

Instead of investing in a new accounting system, what if our company developed a well-reasoned spreadsheet that calculated component support cost and came up with the results in Table 4?

Is the insight gained from the costly and complex activity-based cost accounting system any better than it is from the activity-based worksheet? It doesn't appear so. It's insight that counts in adopting activity-based concepts for management's use, not the level of computational virtuosity and technical prowess shown in implementing an ABC software package. The same insight can be gained at a fraction of the cost when activity-based costing is used to build a spreadsheet-based model for supporting management decisions.

Precisely calculating indirect support costs for different components can be expensive.

The two most important elements in constructing an activity-based model to support mass customization and build-to-order initiatives are:

• Identifying those support activities and costs that relate to purchased items and manufactured components and sub-systems, and

• Developing subsets of those items that require similar levels of support from the support activities, require similar levels of direct support costs, and have similar levels of obsolescence.

The level of detail required depends upon the size and nature of the organization, as well as the planned use of the information. Once these items are established, the activity-based cause-and-effect linkages to connect them can be developed.

Most, but not all, of the cost of support activities can be derived from existing accounting records. In most cases, those activities that cannot be derived from accounting records can be estimated--remember, we're after accuracy, not precision. The important point is that we take them into account. The portion of each support activity related to purchased and manufactured items can then be distributed to the various subsets of those items using a "driver" appropriate for that activity.

Here's an example: a purchasing department (a support activity) costs one company $1,000,000 per year. Fully 80% of the department's work relates to purchasing direct and indirect materials (the other 20% relates to developing quotations and proposals), leaving $800,000 that must be distributed among the various subsets of purchased items. The department's work can be accurately measured by the purchase orders and releases it issues. Although the effort involved in a release is almost always the same, all purchase orders are not created equal--some are the result of complex, drawn-out negotiations, others are issued after a formal bid solicitation, and still others are items ordered from a catalog. The company decides that the appropriate way to distribute costs to items purchased is as a cost per release, per catalog purchase order, per bid purchase order, and per negotiated purchase order.

The company then determines the "relative" amount of effort required by each of these four types of transactions. By using the simplest transaction, a release (it issues 5000 annually), as the base (an effort level of "1.0"), it then estimates the relative effort level of the other three transactions. Purchases from a catalog (3000 transactions) were estimated to be five times more difficult than a release, those resulting from the bidding process (2000 transactions) fifteen times more difficult, and those issued after negotiations (500) fifty times more difficult. The result is a cost of $10.67 per release, $53.33 per catalog order, $160.00 per bid order, and $533.33 per negotiated order.

Using similar logic, the company can also determine how transactions relate to headcount. There are fifteen employees in the company's purchasing department. Because 20% of the work relates to non-procurement activities, only twelve full-time equivalent (FTE) employees are involved in procurement. By substituting FTE's for cost in the calculation, the company can measure employee effort for each of the transaction types. The results are 0.0002 FTE per release, 0.0008 FTE per catalog order, 0.0024 FTE per bid order, and 0.008 FTE per negotiated order.

Using the FTE per transaction measure, the company can estimate the impact of its mass customization effort on purchasing. For example, if by reducing the number of SKUs purchased the company can process 1250 fewer releases, issue 1000 fewer catalog purchase orders, 500 fewer bid purchase orders, and 100 fewer negotiated purchase orders, it reduces the demand for purchasing personnel by three heads.

The company can calculate the savings that would result from this headcount reduction. Potential savings should not be estimated by multiplying the four transaction rates by the number of transactions eliminated. Not all of the purchasing department's costs are directly proportional to headcount. Instead, the salary, fringe benefit, payroll tax, and supply-cost savings that are directly related to the individuals in the purchasing department can be included in the savings estimate.

In a similar manner, the cost of all other support activities can be measured and their relationship to the items purchased and manufactured quantities.

As a general rule, the more SKUs maintained by a company, the greater the risk for obsolescence. If a company maintains a safety stock of 1000 units for each of two similar items with annual volumes of 50,000 units, the risk is twice what it would be if the company maintained a 1000-unit safety stock for a single common item with a 100,000-unit annual volume. In measuring the total cost of a purchased or manufactured item, these obsolescence risks must be considered.

Initially, consider the risk of obsolescence when developing the subsets of purchased and manufactured items. Items that are only purchased when an order is received for the end product have a very low level of obsolescence risk. Items whose purchase is based on a forecast, however, run a much higher risk of never being used. If history shows that 10% of forecast-based purchased items are never used, but only 1% of order-based items are unused, these two types of purchases should not be included in the same subset. The difference in cost is at least 9%, even before considering cost of capital, insurance, taxes, and other "carrying costs." If a company can pay more to be able to order the high-risk items only after an order is received, reduced obsolescence risk may offset the higher price, and result in overall lower total cost.

A spreadsheet can be used to produce a reasonably accurate estimate of the cost of supporting components.

To include obsolescence in cost calculations, a company needs to estimate the percentage of a category of purchased products that's never used, and add the "unused" products' cost as a percentage of the "used" products' costs. Let's say that 10% of one forecast-based product type is never used. To include the obsolescence cost of this product type, 11.1% {1- [1 / (1-0.10)]} should be added to the cost of each item used. Only by including such costs as part of total product cost can the benefits of mass customization and build-to-order be properly measured.

Cost of capital and other support costs must be considered as well as support activities and obsolescence to understand the total cost of purchased and manufactured items, and measure the benefits of mass customization and build-to-order. These costs are driven directly by the purchase or manufacturing cost of the item, and the amount of time it remains in inventory. Although there are many such costs--such as property insurance and personal property taxes--the primary cost in this category is the cost of capital.

Cost of capital is not simply the interest expense paid on funds borrowed to finance the inventory. It also includes the business owners' opportunity cost. Any calculation that includes only interest expense severely understates the cost to the organization of tying up its capital in inventory.

Here's an example of how to calculate cost of capital. The company in question has $3,500,000 in interest-bearing debt and $1,000,000 in trade credit. The average interest rate of the debt is 8%, and the company's value is $10,000,000, although the net book value of its assets is only $8,000,000. If the company's investors could put their funds to work in another investment of equal risk, they could expect a 15% return.

Interest expense is tax deductible. As a result, approximately 35% (the company's incremental tax rate) of the 8.0% interest expense will be offset by income tax savings, making the net cost of company debt 5.2%. Trade credit carries no interest-from a cost-of-capital standpoint, it's free.

The business owners' equity is not the amount shown as the company's "shareholders equity" on the balance sheet. That's just an accounting calculation, not a measure of the owners' true investment in the company. The owners' investment is the amount they cannot invest elsewhere because it's tied up in the company. That amount equals the difference between the company's value ($10,000,000) and the amount of that value borrowed from someone else ($4,500,000)--a net investment of $5,500,000. It's this amount that the owners' could invest elsewhere for 15%.

The total cost of capital for this company amounts to $1,007,000. Based on the net book value of the company's assets, the company needs to earn a return of 12.6% of book asset value for the owners to break even at a 15% return. As a result, the cost of capital is not the net interest expense of 5.2%, it's more than double that amount at 12.6%.

Applying the cost of capital to inventory investment is a simple calculation--the average inventory investment times the cost of capital. By applying cost of capital to the example used in our discussion of obsolescence, we can see its impact.

Assume the unit cost of each of the two similar products is $5 and the average inventory investment in each is 10,000 units. This means the cost of capital related to these 10,000 units is $12,600 (20,000 units X $5 X 12.6%), or $1.26 per unit. If by substituting a single common unit for these two different units the company can reduce its inventory investment by half, just as it reduced its safety stock by half, the cost of capital can be reduced to $6300 or $0.63 per unit. Adding the savings in insurance and property taxes will reduce costs even more.

Individually, the potential savings in each of these areas can make mass customization and build-to-order cost-effective initiatives for a company. Taken together, the savings can be spectacular.

Consider the cost impact of having fewer SKUs to forecast, schedule, plan, purchase, transport and receive. Consider the effect of a reduction in incoming inspection, transactions to record, bills to pay, and warehouse space to occupy. Consider the impact on the cost of funds tied up in inventory as well as taxes and insurance. All of these benefits accrue to companies that can take advantage of mass customization and build-to-order concepts.