'Activity-Based
Costing - ABC'
Introduction
A
powerful tool for measuring performance, Activity-Based Costing (ABC) is used to identify, describe, assign costs to, and report on
agency operations. A more accurate cost management system than traditional cost
accounting;ABC identifies
opportunities to improve business process effectiveness and efficiency by
determining the "true" cost of a product or service. Activity Based
Costing is a method for developing cost estimates in which the project is
subdivided into discrete, quantifiable activities or a work unit. ABC systems
calculate the costs of individual activities and assign costs to cost objects
such as products and services on the basis of the activities undertaken to
produce each product or services. It accurately identifies sources of profit
and loss.
Activity-Based Costing
The concepts of ABC were developed in the manufacturing
sector of the United States during the 1970s and 1980s.It is a
practice in which activities are identified and all related costs of performing
them are calculated, providing actual costs chargeable. The focus of activity
based costing is activities. Thus identifying activities is a logical first
step in designing an activity based costing. An activity is an event, task or
unit of work with a specified purpose. For example; designing products, setting
up machines, operating machines and distributing products.
Definition of 'Activity-Based Costing -
ABC'
An accounting method
that identifies the activities that a firm performs, and then assigns indirect
costs to products. An activity based costing (ABC) system recognizes the
relationship between costs, activities and products, and through this relationship
assigns indirect costs to products less arbitrarily than traditional
methods.
Activity-based
costing (ABC) (From Wikipedia) is a special costing model that identifies activities in an
organization and assigns the cost of each activity with resources to all
products and services according to the actual consumption by each. This model
assigns more indirect costs (overhead) into direct costs compared to conventional costing
models.
Aims of model
With
ABC, an organization can soundly estimate the cost elements of entire products
and services. That may help informa company's decision to either:
§ Identify and eliminate those products and services that are
unprofitable and lower the prices of those that are overpriced (product and
service portfolio aim)
§ Or identify and eliminate production or service processes
that are ineffective and allocate processing concepts that lead to the very
same product at a better yield (process re-engineering aim).
In
a business organization, the ABC methodology assigns an organization's resource costs through
activities to the products and services provided
to its customers. ABC is generally used as a tool for understanding product and
customer cost and profitability based on the production or performing
processes. As such, ABC has predominantly been used to support strategic
decisions such as pricing, outsourcing, identification and measurement of
process improvement initiatives.
Prevalence
Following
initial enthusiasm, ABC lost ground in the 1990s, to alternative metrics, such
as Kaplan's balanced scorecard and economic value added. An
independent 2008 report concluded that manually driven ABC was an inefficient
use of resources: it was expensive and difficult to implement for small gains,
and a poor value, and that alternative methods should be used. Other reports show the broad band covered with
the ABC methodology.
ABC has stagnated over the last five
to seven years,
— Kaplan, 1998
However,
application of an activity based recording may be applied as an addition to activity based accounting,
not as a replacement of any costing model, but to transform concurrent process accounting into a
more authentic approach.
Historical
development
Traditionally
cost accountants had
arbitrarily added a broad percentage of analysis into the indirect cost. In
addition, activities include actions that are performed both by people and
machine. However, as the percentages of indirect or overhead costs rose, this technique became
increasingly inaccurate, because indirect costs were not caused equally by all
products. For example, one product might take more time in one expensive
machine than another product—but since the amount of direct labor and materials
might be the same, additional cost for use of the machine is not being
recognized when the same broad 'on-cost' percentage is added to all products.
Consequently, when multiple products share common costs, there is a danger of
one product subsidizing another.
ABC
is based on George Staubus' Activity Costing and Input-Output Accounting. The
concepts of ABC were developed in the manufacturing sector of
the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I, provided a formative role for studying and formalizing the
principles that have become more formally known as Activity-Based Costing.
Robin
Cooper and Robert S. Kaplan,
proponents of the Balanced Scorecard,
brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan
described ABC as an approach to solve the problems of traditional cost management systems. These traditional
costing systems are often unable to determine accurately the actual costs of production and
of the costs of related services. Consequently managers were making decisions
based on inaccurate data especially where there are multiple products.
Instead
of using broad arbitrary percentages to allocate costs, ABC seeks to identify
cause and effect relationships to objectively assign costs. Once costs of the
activities have been identified, the cost of each activity is attributed to
each product to the extent that the product uses the activity. In this way ABC
often identifies areas of high overhead costs per unit and so directs attention
to finding ways to reduce the costs or to charge more for costly products.
Activity-based
costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as
a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where
increasing technology and productivity improvements have reduced the relative
proportion of the direct costs of labor and materials, but have increased
relative proportion of indirect costs. For example, increased automation has
reduced labor, which is a direct cost, but has increased depreciation, which is
an indirect cost.
Like
manufacturing industries, financial
institutions have diverse products and customers, which can cause
cross-product, cross-customer subsidies. Since personnel expenses represent the
largest single component of non-interest expense in financial institutions,
these costs must also be attributed more accurately to products and customers.
Activity based costing, even though originally developed for manufacturing, may
even be a more useful tool for doing this
Activity-based
costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. He states that traditional cost accounting focuses on what
it costs to do something,
for example, to cut a screw thread; activity-based costing also records the
cost of not doing, such as the
cost of waiting for a needed part. Activity-based costing records the costs
that traditional cost accounting does not do.
The overhead costs assigned to each
activity comprise an activity cost pool.
The CIMA
technology defines ABC as a cost attribution to cost units on the basis of
benefit received from indirect activities. Peter B. B. Turney defines ABC as
"a method of measuring the cost and performance of activities and cost
objects. Assigns cost to activities based on their use of resources and assigns
cost to cost objects based on their use of activities. ABC recognizes the
causal relationship of cost drivers to activities." ABC can be defined by
the following equation:
C/A = HD
+ M + E + S
Where C/A
= Estimated cost per activity
H =
Number of labor hours required to perform the activity one time
D = Wages
per labor hour
M =
Material costs required to perform the activity one time
E =
Equipment costs to perform the activity one time
S =
Subcontracting costs to perform the activity one time
The total
cost for performing the activity will be based on the number of times the
activity
is performed during a specific time frame. An activity based costing system
first traces costs to activities and then to products and other cost objects.
The following figure diagrammatically explains the basic flow of Activity-Based
Costing.
Important Terms in Activity
Based Costing
The
operation of the ABC system involves the use of the following terms:
Cost object: It
refers to an item for which cost measurement is required.e.g. a product, a
service, or a customer.
Cost pool: A cost
pool is a term used to indicate grouping of costs incurred on a particular
activity which drives them.
Cost driver: A cost
driver is any factor or force that causes a change in the cost of activity.
Cost driver may be involved two parts:
1.
Resource cost driver 2. Activity cost driver
A
resource cost driver is a measure of the quantity of resources consumed by an
activity. An activity cost driver is a measure of the frequency and intensity
of demand, placed on activities by cost objects. The cost drivers for various
functions i.e., production, marketing, research, and developments are given
below.
|
roduction
|
Number of units
Number
of set-ups
|
|
Marketing
|
Number of sales personnel
Number
of sales orders
|
|
Research&
development
|
Number of research projects
Personnel hours spend on projects
Technical
complexities of the projects
|
|
Customer
service
|
Number of service calls
Number of products serviced
Hours
spend on servicing products
|
Stages of Activity Based Costing
The
different steps or stages in ABC system can be given as follows:
1.
Identify the chosen cost
objects
The cost
objects of any organization are the products or services and the goal is to
first calculate the total cost of manufacturing and distributing these products
and their unit cost.
2. Identify the different activities within the organization
After the
identification of cost objects, the main activities, which are being performed
in the organization, have to be identified. Usually the number of activities
over cost centers in ABC will be much more as compared to traditional overhead
system. The exact number will depend on how the management subdivides the
organizations activities.
3. Identifying the direct cost of products
The
direct cost of products or objects may comprise direct material cost, direct
labor cost and direct expenses. Classification of as many of the total costs as
direct costs as is economically feasible should be made. It reduces the amount of
costs classified as indirect.
4. Relating the overhead to the activities
After
identifying the organizations activities, the various items of overhead are
related to activities both support and primary, that caused them. As a result
of relating the items of overhead to various activities, cost pool or cost
buckets are created.
5. Spreading the support activities across the primary activities
The
spreading of support activities (i.e., activities which support or assist
manufacturing) across the primary activities (correlated to the number of units
produced) is done on some suitable base which reflects the use of support
activity. The base is the cost driver and is measured of how the support
activities are used.
6. Determining the activity cost drivers
The
determination of the activity cost drivers is done in order to relate the
overhead collected in cost pools to the cost objects of products. It is done on
the basis of the factor that drives the consumption of the activities.
7. Calculating the activity cost driver rates
The
activity cost rates for each activity are calculated in the way in which
overhead absorption rates would be calculated under the traditional system. It
can be presented as follows:
Activity
cost driver rate = Total
cost of activity
Activity driver
These
activity cost driver rates are to be used for ascertaining the amount of
overhead chargeable to various cost objects or products.
8. Computing the
total cost of products or cost objects
The total
costs of the products shall be computed by adding all direct and indirect costs
assigned to them. The amount of overhead chargeable to a product or cost object
shall be calculated by multiplying the activity cost drivers rates by different
amounts of each activity that each product or other cost object consumes.
Traditional Costing and Activity Based Costing
Traditional
costing can lead to undercosting or overcosting of products or services. Over
or under costing of products distorts cost information. A poor quality of cost
information causes management to make poor decisions for pricing, product
emphasis, make or buy etc. ABC differs from the traditional system only in
respect of allocations of overheads or indirect costs. Direct costs are
identified with, or assigned to, the cost object, in the same manner as is done
in case of traditional costing system. Overhead costs are linked to the cost
objects based on activities. This is shown in the following figure:
Alternatives
Lean accounting methods have been developed in
recent years to provide relevant and thorough accounting, control, and
measurement systems without the complex and costly methods of manually driven
ABC. However lean accounting is a snapshot concept for capturing just partial
derivatives or differentials of selected cost functions. Lean accounting takes
an opposite direction from ABC by working to eliminate peculiar cost
allocations rather than apply complex methods of resource allocation.
Lean
accounting is primarily used within lean manufacturing. The
approach has proven useful in many service industry areas including healthcare,
construction, financial services, governments, and other industries.
Application
of Theory of
constraints (TOC) is analysed in a study showing interesting aspects of
productive coexistence of TOC and ABC application. Identifying cost drivers in
ABC is described as somewhat equivalent to identifying bottlenecks in TOC.
However the more thorough insight into cost composition for the inspected
processes justifies the study result: ABC may deliver a better structured
analysis in respect to complex processes, and this is no surprise regarding the
necessarily spent effort for detailed ABC reporting.
Methodology
The
split of cost helps to identify cost drivers, if achieved.
Direct labor and materials are relatively easy to trace directly to products,
but it is more difficult to directly allocate indirect costs to products. Where
products use common resources differently, some sort of weighting is needed in
the cost allocation process. The cost driver is
a factor that creates or drives the cost of the activity. For example, the cost
of the activity of bank tellers can be ascribed to each product by measuring
how long each product's transactions (cost driver) takes at the counter and then
by measuring the number of each type of transaction. For the activity of
running machinery, the driver is likely to be machine operating hours. That is,
machine operating hours drive labour, maintenance, and power cost during the
running machinery activity.
Application in routine business
ABC
has proven its applicability beyond academic discussion. ABC is applicable
throughout company financing, costing and accounting:
§ ABC is a modeling process applicable for full scope as well
as for partial views.
§ ABC helps to identify inefficient products, departments and
activities.
§ ABC helps to allocate more resources on profitable products,
departments and activities.
§ ABC helps to control the costs at any per-product-level
level and on a departmental level.
§ ABC helps to find unnecessary costs that may be eliminated.
§ ABC helps fixing the price of a product or service with any
desired analytical resolution.
A
reports summarises reasons for implementing ABC as mere unspecific and mainly
for case study purposes[11] (in alphabetical order):
§ Better Management
§ Budgeting, performance measurement
§ Calculating costs more accurately
§ Ensuring product /customer profitability
§ Evaluating and justifying investments in new technologies
§ Improving product quality via better product and process
design
§ Increasing competitiveness or coping with more competition
§ Management
§ Managing costs
§ Providing behavioural incentives by creating cost
consciousness among employees
§ Responding to an increase in overheads
§ Responding to increased pressure from regulators
§ Supporting other management innovations such as TQM and JIT
systems
Beyond
such selective application of the concept, ABC may be extended to accounting,
hence proliferating a full scope of cost generation in departments or along
product manufacturing. Such extension, however requires a degree of automatic
data capture that prevents from cost increase in administering costs.
Steps to implement Activity-Based costing
1.
Identify and assess ABC needs -
Determine viability of ABC method within an organization.
2.
Training requirements - Basic
training for all employees and workshop sessions for senior managers.
3.
Define the project scope - Evaluate
mission and objectives for the project.
4.
Identify activities and drivers -
Determine what drives what activity.
5.
Create a cost and operational flow
diagram – How resources and activities are related to products and services.
6.
Collect data – Collecting data where
the diagram shows operational relationship.
7.
Build a software model, validate and
reconcile.
8.
Interpret results and prepare
management reports.
9.
Integrate data collection and
reporting.
National Policing Plan, specifically the
Policing Performance Assessment Framework
Activity Based Costing: A Decision Making Tool
Prior to
the emergence of ABC, companies typically calculated profitability using the
allocation method. This allocation method involves allocating costs to a
product or customer using metrics such as the total number of accounts,
customers, products produced, or transactions. Table 1 gives a hypothetical
example of how this method calculates the profitability of three customer
channels: store, catalog, and internet. In this example, the company allocates
overhead costsincluding accounting, IT, marketing, and call-center coststo
customer channels, based on the number of customers per channel.
Table 1.
Simple Allocation of Call-Center Overhead
|
Total
|
Store
|
Catalog
|
Internet
|
|
|
Revenue
|
$3,500,000
|
$2,000,000
|
$1,000,000
|
$500,000
|
|
Number of Customers
|
50,000
|
35,000
|
10,000
|
5,000
|
|
Cost per Customer
|
$10
|
$10
|
$10
|
$10
|
|
Call-Center Costs
|
$500,000
|
$350,000
|
$100,000
|
$50,000
|
|
Net Revenue
|
$3,000,000
|
$1,650,000
|
$900,000
|
$450,000
|
|
Margin
|
85.7%
|
82.5%
|
90.0%
|
90.0%
|
From the example above, management might
conclude that all channels are performing relatively well, but the big
opportunity lies in growing the catalog and internet channels through
additional investments. These two channelsthough smaller in overall revenueappear
more attractive after cost allocations and could realize explosive, profitable
growthgiven management attention and aggressive investments.
Table 2
shows the more realistic outcome when an organization applies ABC and
apportions call center expenses to each customer channel, based on the number
of incoming calls each channel generates. Since catalog customers create 80% of
the incoming call-center volume, this channel should incur a greater proportion
of the total cost.
Table 2.
ABC Allocation of Call-Center Overhead
|
Total
|
Store
|
Catalog
|
Internet
|
|
|
Revenue
|
$3,500,000
|
$2,000,000
|
$1,000,000
|
$500,000
|
|
Number of Calls
|
100,000
|
0
|
80,000
|
20,000
|
|
Cost Per Call
|
5
|
5
|
5
|
5
|
|
Call-Center Costs
|
$500,000
|
$0
|
$400,000
|
$100,000
|
|
Net Revenue
|
$3,000,000
|
$2,000,000
|
$600,000
|
$400,000
|
|
Margin
|
85.7%
|
100%
|
60.0%
|
80%
|
The
insight from this analysis is far different. After allocating costs based on
the consumption of resources, management can see that the catalog channel uses
far more resources and is actually less profitable than other channels. Rather
than throwing away additional investment to grow this channel, management
should take corrective action to bring this segment up to acceptable
profitability levels.
Software Packages for ABC
ABC Focus
It is
tool for costing products and services and improving efficiencies. "ABC Focus is a
tool which makes ABC concepts simple to understand and use. It is a very
attractive package because its flexible costing model, consolidated reporting
and a very competitive pricing regime make it suitable for large and small
business in virtually any industry." ABC Focus provides a structured approach to cost products, services,
processes, activities and unused capacity. It provides a platform on which to
confidently adjust pricing and activities for competitive advantage.
QPR Cost Control
The
user-friendly QPR Cost Control system helps to understand the real cost
structure of the company and identify how the business really works. Using the
proven approach Activity Based Costing / Management, the software identifies
exactly what costs are linked to each individual customer, product, service or
activity. QPR Cost Control gives the information to make decisions about the
most profitable path for the business. QPR Cost Control is used successfully by
all types of organizations, from large international corporations to
universities, hospitals and government agencies.
Growing Interest in Activity Based Costing
Activity
based costing is being implemented by a growing number of companies around the
globe. Specific ABC applications vary from organization to organization. A few
organizations use ABC as their basic, ongoing cost accounting system. But many
ABC applications are selective- special studies within subparts of the
organization, such as business divisions or particular functions.
A survey
of US companies in the food and beverage industry found 18% of the respondents
implementing ABC and 58% considering it. A survey of Dutch companies in the
food and beverage industry found 12% currently using ABC and another 25% are considering
it. Among Canadian companies one survey indicates that 14% of the interviewed
businesses have implemented ABC and another 15% are considering using ABC it.
The ABC system has replaced existing system for 24% of the Canadian respondents
and it is a supplementary (off-line) system for 76%. A United Kingdom survey
found that just under 20% of 251 respondents had used ABC. An Australian survey
found that 43% of the respondents were either using ABC or implementing it. A
survey of Irish manufacturing companies that have implemented ABC reported the
following percentages for the actual benefits experienced:
|
1
|
More
accurate cost information for product costing and pricing
|
71%
|
|
2
|
Improved
cost control and management
|
66%
|
|
3
|
Improved
insight into cost drivers
|
58%
|
|
4
|
Better
performance measures
|
46%
|
|
5
|
More
accurate customer profitability analysis
|
25%
|
A survey
of Irish service-sector companies reports similar percentages for the benefits
experienced .Results from similar studies in developed economies around the
world indicate that ABC is not a passing fad. A majority of companies still use
traditional costing methods, but the use of ABC appears to be increasing.
Significance of Activity Based Costing
The
following list reflects the results of several surveys of practice in the
United States, the United Kingdom, and Canada to determine why companies choose
ABC.
- Cost Reduction: - ABC measures how
much activities that are costly and then take steps to reduce their costs
by changing the productions process or outsourcing those activities.
- Product pricing and decisions of
whether to continue producing a product or keeping a particular customer.
ABC implementers generally believe that that ABC provides more accurate
cost information than conventional costing does. Management can use this
information to negotiate price increases with customers or to drop unprofitable
products.
- Budgeting and performance
measurement: - Management can use more accurate cost information to
improve budgets and measures of department and division performance.
Limitations
Applicability of ABC is bound to
cost of required data capture. That drives the prevalence to slow processes in
services and administrations, where staff time consumed per task defines a
dominant portion of cost. Hence the reported application for production tasks
do not appear as a favorized scenario.
Tracing Costs
Even in ABC, some overhead costs are
difficult to assign to products and customers, such as the chief executive's
salary. These costs are termed 'business sustaining' and are not assigned to
products and customers because there is no meaningful method. This lump of
unallocated overhead costs must nevertheless be met by contributions from each
of the products, but it is not as large as the overhead costs before ABC is
employed.
Although some may argue that costs
untraceable to activities should be "arbitrarily allocated" to
products, it is important to realize that the only purpose of ABC is to provide
information to management. Therefore, there is no reason to assign any cost in
an arbitrary manner.
Reducing cost of ABC modeling
ABC is considered a relatively
costly accounting methodology. As long as cost elements would have to be taken and notified
just manually, the activity based costing approach would remain arduous and the
obtained completeness would be poor.
An escape from costly procedures may
be found with transition from coarse scale cost modeling to fine scaled data capture for
concurrent accounting. The implementing of respective means shall redirect from the
managerial level of the planning for entities of an activity type to the simply automated data capture technically
detectable entities of paired events: Each two
events of starting and ending an activity determine the duration of the very
same activity.
The clock time of events plus
identification of the persons involved and assets used may be notified easily
with technical means. In contrast to locating technologies the identity and
time capture always performs with desired precision and high reliability.
Application of classical logic supports for pairing the respective event times
supported by captured identities. All modes of context and contributing assets
and resources may be allocated and quantified for detailed costing in
conjunction with such event detection. Hence agglomerating of collected data is
suited to contribute to the costing model for activity based costing in all
desirable detail. Modern identification technologies (e.g. RFID)
provide the necessary instruments.
Transition to automated ABC
accounting
The prerequisite for lesser cost in
performing ABC is automating the data capture with an accounting extension that
leads to the desired ABC model. Known approaches for event based accounting
simply show the method for automation. Any transition of a current process from
one stage to the next may be detected as a relevant event. Paired events easily
form the respective activity.
The state of the art approach with
authentication and authorization in IETF standard RADIUS gives an easy solution for
accounting all workposition based activities. That simply defines the extension
of the Authentication and Authorization (AA)
concept to a more advanced AA and Accounting (AAA) concept. Respective approaches
for AAA get defined and staffed in the context of mobile services, when using smart phones as e.a. intelligent agents or smart agents for automated capture of accounting
data .
Public sector usage of ABC
When ABC is reportedly used in the public
administration sector, the reported studies do not provide evidence about the
success of methodology beyond justification of budgeting practise and existing service management and strategies.
Usage in the US Marine Corps started in 1999. Its use by the UK Police has been mandated since the 2003-04 UK tax year as part of England and Wales’
Conclusion
Activity
based costing has revolutionized product costing, planning, and forecasting in
the last decade. It is based on a philosophy of estimation that: "it is
better to be approximately right, than precisely wrong." In summary,
activity-based costing is a management decision-making tool. It provides
financial support data structured in a fashion fundamentally different from
accounting data provided in the general ledger. By associating cost to the
activity, a clear relationship can be established between sources of activity
demand and the related costs. This association can benefit the distributor in
determining where costs are being incurred, what is initiating the costs and
where to apply efforts to curb inflationary costs. This can be of particular
value in tracking new products or customers.
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