An intelligent cost system design is one that is simple while still providing managers with information they need to make decisions. As most manufacturing processes were labor intensive at the turn of the century, a majority of cost management systems relied on direct labor to assign indirect costs to products and services. Indirect or overhead costs are costs that are associated with or caused by two or more operating activities jointly but are not traceable to each of them individually. Direct costs, on the other hand, are specifically traceable to or caused by a specific project or production operation.
The emergence of highly automated machines, which replaced direct labor with support labor, reduced the accuracy of direct labor as an estimator of indirect costs. This reduction first led to the emergence of machine hour-based cost systems. But both, labor based and machine hour based cost systems, rely on unit-level cost drivers and can provide adequate insights to managers about the costs of their products only in very simple manufacturing systems. As competition faced by firms increased, profit levels began to fall, and it became more important for the firm’s cost system to report accurate product costs. More accurate products costs enable firms to fine tune its product mix so it is inherently more profitable. Activity based costing or management is a tool that more accurately identifies and allocates indirect costs to the products they support because it identifies the drivers of the indirect costs. This identification allows management to identify and implement cost savings opportunities.
Sources: Cooper, R., & Slagmulder, R. (1999). Intelligent cost system design. Strategic Finance, 80(12), 18-20.
Dobler, D.W., & Burt, D.N. (1996). Purchasing and Supply Management. (6th ed.). New York: McGraw Hill.