Cost Impacts of Broadening from Simplicity to Complexity
One of the fundamental concepts in economics describes the market price of a good or service as being determined by the quantity of both supply and demand for it. In 1890, the English economist Alfred Marshall published his famous work, Principles of Economics, and many of us remember Marshall's graph that appeared in our college economics textbooks (see Figure 1).2 The graph displays two lines that cross as an "X" with the declining line representing customer demand and the ascending line supply. The intersection of the two lines denotes an equilibrium point toward which the market price will move to equalize the supply quantity to exactly match the demand quantity. Any higher price above this equilibrium creates a surplus where sellers would inevitably lower their price to sell more of the product. A lower price creates a shortage where sellers would increase price to earn more profit.
Figure 1: Supply and Demand
The economists like graphs such as the supply and demand model and extend its principles to the popular cost-volume-profit (CPV) break-even profit graphs for an individual enterprise. The break-even graph, with sales volume increasing across the horizontal axis, denotes where, beyond an intersection of revenues exactly matching fixed plus variable costs, the enterprise becomes profitable.
Can this universally accepted economic theory be misleading to business managers? Recent advances in managerial accounting have demonstrated flaws in the economists' thinking. The economists apply the logic of economies of scale - where it is assumed that as production volume increases based on a fixed level of production assets and a workforce headcount that only gradually increases with volume, the unit cost of the product declines. The management accountant agrees with this outcome only when there is the special condition of few and similar products, but that special case rarely exists. To remain competitive, most organizations have broadly expanded the diversity and variation of their products - more colors, sizes, ranges and so on. What the economists have failed to consider is the overall rate of cost impact from the proliferation of offering different types of products and services through different channels to various types of customers which, in combination, disproportionately place different types of demands on the workers and production assets - including overhead (more appropriately called indirect expenses).
By clinging to their economies-of-scale thinking, the economists are deluded into thinking that as the enterprise sells more volume, the unit costs of products decrease. This is rarely true. Counterintuitive to the economists, there are diseconomies of scale that are not obvious until you examine cost behavior more closely. The flaw in the economists' thinking has to do with allocating indirect expenses into product costs using broad averages. The managerial accountants introduced the concept of activity-based costing (ABC), which traces how disaggregated groupings of indirect expense work activities are uniquely consumed by products (and any form of process output) based on cause-and-effect relationships. The adoption of ABC reveals that as more diverse products and services are introduced for sale, additional indirect expenses are required, such as product managers and extra storage space. The result is that each product and service has its own unique unit cost - and the newly added items typically have larger unit costs compared to the baseline product. Hence, expanding from a simple and narrow set of products to complex and broadly varying ones can accelerate expenses faster than the incremental revenues received. The accurate cost measurement of profit margins calculated by ABC surprises managers; they discover they are making and losing money on products and services much differently than their beliefs.
Managing Supply with Activity-Based Costing (ABC)
In short, ABC contributes to the economists' body of knowledge by better explaining the supply line of Marshall's supply and demand model. ABC influences the unit costs of the items the supply curve comprises as noted in Figure 1, but there is more.
To an economist, the interesting decisions are those that occur at the margin - the point at which one additional employee is hired or an additional piece of equipment is purchased to satisfy growing demand. Advances in activity-based costing address marginal cost analysis as well. As just described, ABC information provides great insight with high costing accuracy into what things cost in past periods (as well as insights into the cost drivers that created those costs); but advances in ABC, referred to as activity-based planning, have introduced the capability to calculate ABC backward. That is, based on forecasts of future period volume and mix demands, the more comprehensive costing relationships captured in ABC models allow for determining the level and type of resource expenses (i.e., capacity) needed to satisfy demand in the future. As a bonus, ABC motivates productivity initiatives to create efficiencies so future production can result at lower costs.
In short, the management accountants have gone beyond the economists' simplistic thinking of those single lines in the supply and demand model to quantify and reveal both the cost of using capacity (i.e., current supply) and the cost of acquiring future capacity (i.e., future supply) for each individual product and service. The accountants have discovered that much different conclusions are reached when you broaden the view of an enterprise from a single product, aggregated resource view to a multiproduct view drawing on diverse resources.