Activity Based Costing for Construction Companies Activity Based Costing for Construction Companies First Edition Yong‐Woo Kim University of Washington, Seattle, WA USA This edition first published 2017 © 2017 John Wiley & Sons Ltd All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, except as permitted by law. Advice on how to obtain permision to reuse material from this title is available at http://www.wiley.com/go/permissions. The right of Yong‐Woo Kim to be identified as the author of this work has been asserted in accordance with law. Registered Offices John Wiley & Sons Ltd, The Atrium, Southern Gate, Chichester, West Sussex, PO19 8SQ, UK Editorial Office 9600 Garsington Road, Oxford, OX4 2DQ, UK For details of our global editorial offices, customer services, and more information about Wiley products visit us at www.wiley.com. 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Limit of Liability/Disclaimer of Warranty Library of Congress Cataloging‐in‐Publication data applied for ISBN: 9781119194675 Cover image: Finbarr Carroll / EyeEm/Gettyimages Cover design by Wiley Set in 10.5/13.5pt Minion by SPi Global, Pondicherry, India 10 9 8 7 6 5 4 3 2 1 Contents Preface ix 1 Introduction 1 1.1 What comprises costs in a construction company? 2 1.1.1 Construction costs (project costs) 3 1.1.2 Overhead costs in a construction company 3 1.1.3 The cost classification in use and the duality of overhead costs 5 1.2 Overhead costs in new business environments 6 1.3 Role of overhead cost management 10 1.3.1 Overhead costing system should provide accurate costing on cost objects 10 1.3.2 Overhead costing system should contribute to reducing total costs without sacrificing value 11 1.4 Structure of this book 11 References 12 2 What Is Activity‐Based Costing? 15 2.1 Traditional accounting method: resource‐based costing with volume‐based allocation 16 2.1.1 Resource‐based costing 16 2.1.2 Overhead costs allocation 17 2.2 What are the problems with the current method? 18 2.2.1 Is the current method contributing to reducing total costs? 19 v vi Contents 2.2.2 Does the current method provide accurate pricing? 19 2.3 What is activity‐based costing? 20 2.3.1 Definition 20 2.3.2 Characteristics of ABC 21 2.3.3 Objectives of ABC system 25 2.4 Implementing activity‐based costing 26 2.4.1 Develop an activity‐based costing charter 26 2.4.2 Define cost objects 27 2.4.3 Identify activities 28 2.4.4 Assign resource costs to activities 29 2.4.5 Assign activity costs to cost objects 32 2.5 Chapter summary 35 References 36 3 Managing Overhead Costs in Construction Projects 39 3.1 Project overhead costs as profit points 40 3.2 I mplementing ABC to manage project overhead costs 42 3.3 Case study: xx Commercial Complex 42 3.3.1 Developing an activity‐based costing charter 43 3.3.2 Workshop 45 3.3.3 Defining cost objects 46 3.3.4 Identifying activities 47 3.3.5 Assigning resource costs to activities 48 3.3.6 Assigning activity costs to cost objects 53 3.4 Using ABC data for managerial purposes 58 3.4.1 Evaluating management areas with activity analysis 64 3.4.2 Evaluating subcontractors 68 3.5 Chapter summary 70 References 70 4 Managing Your General Overhead Costs 73 4.1 General overhead costs 74 4.2 Managing general overhead costs 75 4.2.1 Accurate general overhead allocation 75 4.2.2 Providing a process view for process improvements 79 Contents vii 4.3 Does current practice for managing general overhead costs work? 80 4.3.1 Resource‐based costing 80 4.3.2 Volume‐based assignment 80 4.4 How can ABC be implemented in managing general overhead costs? 82 4.4.1 C ase study: xx Construction (general contractor) 82 4.5 How can ABC data be used in managing general overhead costs? 92 4.5.1 Cost driver analysis 93 4.5.2 Profitability analysis for each project 93 4.5.3 Profitability analysis for each market sector 97 4.5.4 Profitability analysis for each customer 104 4.6 Chapter summary 105 References 105 5 Managing Overhead Costs in a Fabrication Shop 107 5.1 Rebar supply system 108 5.2 Case study: PQR Construction Inc. 111 5.2.1 The rebar fabrication shop’s cost structure 111 5.2.2 Allocation of rebar fabrication shop’s costs to projects 113 5.3 Analysis using traditional rebar costs allocation 113 5.3.1 Identify cost objects and direct costs 114 5.3.2 Identify the overhead costs to be allocated and calculate the allocation base 114 5.3.3 Calculate the overhead costs allocated to each project 116 5.4 Analysis using activity‐based costing 117 5.4.1 Determining system objectives and defining cost objects 118 5.4.2 Identifying resources and activities 119 5.4.3 Assigning resource costs to activities 120 5.4.4 Determining a cost driver for each activity 122 5.4.5 Calculating a unit rate of activity costs (cost driver rate) and allocating activity costs to cost objects 124 viii Contents 5.5 How can ABC data be used for managerial purposes? 125 5.5.1 Accurate cost information through overhead cost allocation 125 5.5.2 Cost information on processes 127 5.5.3 Cost driver analysis 129 5.5.4 Ways to reduce overhead costs 130 5.6 Chapter summary 130 References 132 6 Activity‐Based Costing in Your Organization 133 6.1 The benefits of the ABC journey 134 6.2 Implementation roadmap for ABC 138 6.2.1 Concept‐level roadmap 138 6.2.2 Implementation roadmap for a focused application 139 6.2.3 Phase 1. Planning stage: preparing for  your ABC journey 140 6.2.4 Phase 2. Execution stage: developing your ABC system 144 6.2.5 Phase 3. Internalization stage: final tune‐up 154 6.3 Common mistakes in the journey 156 6.3.1 Beginning your ABC journey without strong commitment from top management 156 6.3.2 Beginning your journey with poorly defined objectives and scope 157 6.3.3 Developing a task force that does not have the necessary authority 157 6.3.4 Developing more cost objects than needed 158 6.3.5 Making activities ambiguous 158 6.3.6 The effect of distorted time–effort % assigned to activities 159 6.3.7 Choosing cost drivers that are hard to measure 159 References 160 Index 161 Preface It was the mid‐1990s when I got my first project engineer job – my first job after I graduated from college. The first project was an industrial project (cement plant construction), where the general contractor I worked for experienced significant cost overruns, although all team members including labor crews worked hard. I learned that there was not much room for cost reduction since most work was subcontracted, with fixed price contracts. I did not learn how to effectively manage the activities of management staff and overhead costs, although I did learn how to effectively manage project direct costs, through the use of several tools such as the earned value method. Senior management at the project tried to reduce the number of management staff to reduce over- head costs, but it turned out that the lack of management staff caused more confusion and inefficiency on the site. My experiences as a practitioner prompted me to study p rocess improvement and management of overhead costs. As a graduate student of CAL, I was fortunate in two ways. First, I was very fortunate that I had chance to work with some of the great minds of Lean construction, a new construction management para- digm, which placed its focus on the production systems. Gaining knowledge and background in production systems helped me expand my horizons in studying overhead cost management. Second, I was fortunate that I had chance to study activity‐based costing – a new cost management paradigm – in the manufactur- ing industry in the late 1990s, when activity‐based costing had not yet been introduced in the construction industry. ix x Preface However, the application of activity‐based costing to the con- struction industry was not an easy job. Because of the difference between manufacturing and construction, namely the nature of the organizational structure and the production system, activity‐ based costing requires adaptation to suit the specifics of the construction industry. My understanding of the production system and organizational structure of the construction industry, and the principles of Lean construction, allowed me to apply activity‐based costing to this new context. My first ABC project was a commercial building project where ABC was applied to managing the general contractor’s project overhead costs; this became my PhD dissertation in 2002. Since then, my ABC journey has continued. I expanded my ABC expe- rience through consultation and research in different contexts, e.g., home office overhead costs, overhead costs at fabrication shops, etc. I have noted the lack of reference materials on managing overhead costs in our industry. I felt the same way regarding construction education. It is true that the majority of cost man- agement topics in the classroom in our industry still focus on managing direct costs such as earned value management and labor productivity. Although they are important, our industry and classroom need guidance on managing overhead costs. That is what motivated me to write this book. This book has two main objectives: 1) to outline activity‐based costing to be applied to different construction industry settings; and 2) to provide an implementation roadmap. I wanted to show the logic and simplicity behind ABC as well as the benefits of ABC. I hope that by reading the book, you will be able to create your own ideas about how to manage overhead costs in your organization. I did not intend to write a complete treatment of an accounting method with which your accounting system is to be replaced. I did not write this book from an accountant’s perspective. Instead, I wrote this book from the perspective of an operational manager who is concerned about their production system. Once people recognize increased overhead costs, some tend to reduce them by reducing workforce or replacing existing staff with a less experienced workforce. It can be dangerous to reduce the number of management staff or to replace existing manage- ment staff with less experienced (i.e., less expensive) staff without Preface xi fully examining the relationship between overhead costs and the production system. In this regard, the task of managing overhead costs should involve people who do understand the production system. That is the reason why this book was written for opera- tional management staff. I provide several case studies, each of which will give you an idea of how ABC can be implemented in a different setting. In each case, I tried to set out what I learned from my experience so that you can avoid pitfalls. Activity‐based costing is a powerful tool for managing overhead costs. I believe that the knowledge and experience of activity‐based costing which I gained through past consulting and research experiences are limited and need improvement. However, the compelling reason I wrote this book is that any advancement begins with a foundation, and somebody needs to pave the way for practitioners and researchers in the domain of managing overhead costs. Yong‐Woo Kim, Ph.D. University of Washington, Seattle