Global Journal of Management and Business Research, D: Accounting and Auditing, Volume 21 Issue 2

1 Global Journal of Management and Business Research Volume XXI Issue II Version I Year 2021 ( ) D © 2021 Global Journals Cost Hierarchy: Evidence and Implications Abstract- Empirical evidence on the association between overhead costs and non-volume related cost drivers is mixed. Anderson and Sedatole (2013) offer possible explanations for the lack of evidence and find that the cost hierarchy is descriptive of the association between resource consumption and production activity. In this paper, we provide evidence on the presence of the cost hierarchy by studying the behavior of indirect production labor costs using daily data for five years from seven production departments of an industrial equipment manufacturer. We find that in addition to direct labor costs, the number of setups and number of distinct parts are also significantly associated with indirect production costs in at least six out of the seven production departments. Interestingly, despite our evidence for the existence of the cost hierarchy, the simple method of estimating these indirect costs as a proportion of only direct labor costs performs remarkably well in predicting costs. Keywords: cost hierarchy, activity based costing, cost drivers, cost allocation, manufacturing overhead costs. I. I ntroduction ost accounting textbooks and extant studies claim that indirect manufacturing costs vary not just with volume-related cost drivers such as direct labor cost, but also with batch and product- related cost drivers (e.g. Lanen et al., 2013). However, the collective empirical evidence to date on the association between overhead costs and non-volume related cost drivers is mixed (Labro, 2004; Anderson and Sedatole, 2013). If non-volume related activities are a key driver of indirect production costs, then managerial decisions based on the traditional product cost information are believed to be suboptimal, as the measured product costs are likely to be distorted (Hilton and Platt, 2014). In this paper, we provide detailed evidence on the presence of the cost hierarchy by studying the behavior of daily indirect production labor costs in multiple departments of an industrial equipment manufacturer. Anderson and Sedatole (2013) summarize reasons provided in the literature for the failure to detect the association between indirect costs and non-volume related cost drivers. The first reason is due to the innovations in manufacturing that create a correlation between volume-related and non-volume related activities. These innovations restore the relevance of traditional volume- based cost allocation (Ittner and MacDuffie, 1995; Ittner et al., 1997: Abernethy et al. 2001). The second set of reasons pertain to the limitations of accounting data (Balakrishnan et al.,2004; Cooper and Kaplan, 1992), measurement error in proxies for activities (Foster and Gupta, 1990; Kaplan and Anderson 2004, 2007), and the timing differences between production activities (with shorter, perhaps, daily variations) and typical accounting data collection (with monthly or quarterly variations). Many prior empirical papers that fail to detect the association between non-volume related activities have relied on cross-sectional data (Foster and Gupta, 1990; Noreen and Soderstrom, 1994; Ittner and MacDuffie, 1995; Ittner et al., 1997). Time-series analysis can address many of the limitations of cross-sectional studies. Our study, similar to Anderson and Sedatole (2013), utilizes daily production and cost data pertaining to direct and indirect labor over a period of five years from seven production departments in two manufacturing plants operated by a Fortune 500 company. Indirect production labor activities comprise materials handling, machine setup and team meetings undertaken within individual production departments and exclude common support activities provided by a separate organizational unit such as engineering and maintenance. The short cycle times (0.05 to 0.14 day, on average) in the production departments at our research site imply a tight matching between indirect labor costs incurred each day in production departments and the daily activity measures that drive these costs. This tight association between daily indirect production labor costs and production activity presents an excellent opportunity to examine the time-series behavior of these variables using daily data. We provide evidence on the positive association between indirect costs and batch and product-level activities at the daily level, as predicted by the cost hierarchy. We also document that aggregation of data at weekly and monthly level reduces the association between indirect costs and batch and product-level activities. Our research site represents a common manufacturing environment involving multiple production departments ranging from fabrication to assembly, enhancing the external validity of our analysis. In addition, data identified with individual production departments allow us to better match costs with activities and examine patterns in these relations that vary across different production departments with different process characteristics. Few, if any, studies have explicitly investigated how different production processes moderate cost driver effects (Ittner and Larcker, 2001). Although not C Rajiv D. Banker α , Gordon S. Potter σ & Dhinu Srinivasan ρ Author α : Temple University. Author σ : Cornell University. Author ρ : University of Pittsburgh. e-mail: DHINUS@pitt.edu