ACTIVITY BASED COSTING

Introduction

Activity-based costing (ABC) is an accounting method that allows businesses to gather

data about their operating costs. Costs are assigned to specific activities such as planning,

engineering, or manufacturing and then the activities are associated with different

products or services. In this way, the ABC method enables a business to decide which

products, services, and resources are increasing their profitability, and which are

contributing to losses. Managers are then able to generate data to create a better budget

and gain a greater overall understanding of the expenses that are required to keep the

company running smoothly. Generally, activity-based costing is most effective when

used over a long period of time, as opposed to shorter-term solutions such as the theory

of constraints (TOC).

Activity-based costing first gained notoriety in the early 1980s. It emerged as a logical

alternative to traditional cost management systems that tended to produce insufficient

results when it came to allocating costs. Harvard Business School Professor Robert S.

Kaplan was an early advocate of the ABC system. While mainly used for private

businesses, ABC has recently been used in public forums, such as those that measure

government efficiency.

In activity-based costing, some overhead costs are difficult to assign to products and

customers, for example the chief executive's salary. These costs are termed 'business

sustaining' and are not assigned to products and customers because there is no meaningful

1
method. This 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.

Traditional Costing

Traditional cost systems allocate costs based on direct labor, material cost, revenue or

other simplistic methods. As a result, traditional systems tend to overcost high volume

products, services and customers and undercost low volume.

Example: traditional cost analysis tends to average indirect and overhead costs and then

allocates the costs in a linear fashion to each cost object i.e. tests, procedures, therapies

and customers.

Traditional costing accumulates the cost of raw materials and direct labor, then applies

overhead costs using an arbitrary allocation factor such as size of the project, number of

employees in the project, etc. ABC relates resources to the actual activities that consume

them. Conventional wisdom states that the production of a product or service produces

costs. More accurately it is the activity involved in the production of a product or service

that creates the cost. So, if we agree that an activity involves cost, then it follows that the

actual cost of a product or service should be the sum total of the costs of each activity

required to produce it. By breaking down product cost according to individual activities

or events, costs can be controlled by managing each of the activities and / or the events

that cause the cost-consuming activity.

2
The problem of traditional costing

 Consumption of many activities is not related directly to physical volume.

 Cost Objects do not consume all resources in proportion to their volume.

 Small volume Cost Objects places a higher relative demand on resources.

 Numbers presented in an aggregated fashion; there is no transparency.

 Non-production triggered costs are rarely included.

Changes in manufacturing processes (due to automation & technology) and the

decreasing contribution of direct labor and material costs as a proportion of overall costs,

has made traditional costing systems increasingly irrelevant.

Traditional techniques tend to give wrong costing because they use simple methods to

allocate cost to products. This can lead to some products being penalized because of the

unfair basis of allocation chosen. A result of bad costing information can be management

taking wrong business decisions and losing business. (Cokins, Gary. Activity-Based

Costing: Making It Work. 1998, Pg. 141-142)

Activity Based Costing System

ABC is a systematic, cause & effect method of assigning the cost of activities to

products, services and customers (Cost Objects).

ABC uses a simple principle:

 Products, Services and Customers generate the need for activities.

 Activities consume resources.

3
  The more varied and diverse your Products, Services and Customers, the more

activities are generated, the more resources are needed.

ABC measures the cost and consumption of activities and assigns these costs only to the

Cost Object generating the activity.

ABC introduces the concept of Cost Drivers

A Cost Driver is any factor that causes a change in the level of activity. It is the choice

and use of Cost Drivers that enables users to accurately allocate the indirect and overhead

costs to the appropriate Cost Object.

Example: Assign the resource costs associated with Handling Deliveries (Activity) to

Products (Cost Object) using the Number of Deliveries (Cost Driver). The more product

deliveries, the more time (resource) is used to handle the deliveries, the more costs are

assigned to products.

(Cokins, Gary. "Learning to Love ABC." Journal of Accountancy. August 1999, pg. 121-

124)

Benefits of ABC

The benefits of ABC are well documented in modern cost management literature, and it

has become the method of choice for manufacturing and service costing.

Increasingly organizations use ABC today for product costing, target costing, service

pricing, and different types of analysis: resource capacity, customer profitability, and

product line profitability (with more deliveries).

4
Problems of Activity based Costing

Companies that implement activity-based costing run the risk of spending too much time,

effort, and even money on gathering and going over the data that is collected. Too many

details can prove frustrating for managers involved in ABC. On the other hand, a lack of

detail can lead to insufficient data. Another obvious factor that tends to contribute to the

downfall of activity-based costing is the simple failure to act on the results that the data

provide. This generally happens in businesses that were reluctant to try ABC in the first

place.

The activity-based costing usually works best with a minimum amount of detail and

estimated cost figures, typically, when accountants try to apply ABC, they strive for a

level of exactness that is both difficult to attain and time-consuming and that eventually

becomes the project's kiss of death.

Activity-based costing projects often fail because project managers ignore the cardinal

rule: It is better to be approximately correct than to be precisely inaccurate. When it

comes to ABC, close enough is not only good enough; close enough is often the secret to

success. It is also noted that the use of average cost rates, the use of overly detailed

information, and the failure to connect information to action can also hinder ABC

projects. By understanding these concepts, it is felt that CPAs can enhance their roles as

business partners and consultants.

5
Another limiting factor is that activity-based costing software can be pricey. Most ABC

practitioners find that special-purpose ABC software is required to make the task

manageable. At $6,000 and up for one package sold by ABC Technologies, software can

add significantly to outlays for this type of accounting technique. There are, however,

some pilot packages available for $500.

Time can also be a factor for businesses seeking a quick fix. It typically takes three

months or so for most businesses to experience the benefits of ABC. And depending on

the product or business cycle, it could take much longer. (Chutchain-Ferranti, Joyce.

"Activity-Based Costing." Computerworld. August 1999, pg. 97-101)

Activities of Accounting Based Costing System

An organization performs activities to do its business. These activities define the kind of

business you are in: a ship owner has an activity to unpack boats; an accounting firm

prepares tax returns; a manufacturer produces products; a council delivers services; a

university teaches students. All activities consume resources. It is the consumption of

these resources that adds to overhead costs.

Unit level:  Unit level drivers are triggered for every unit that is being produced. For

example, for a man and a machine that produces one unit at a time, the associated direct

labor will be a unit level cost driver. This is therefore a volume related driver similar to

the traditional allocation bases.

6
Batch level: Batch level drivers are triggered for every batch produced. A good example

of that is production planning, because the planning is done for each and every batch

regardless of the size of the batch. Here, number of batches can be a good driver.

Product level: Product level drivers are triggered for every product regardless of the

number of units and batches produced. These drivers occur by the sole existence of a

product. A good example of a driver is the number of product development hours per

product so that the more product development hours a product triggers, the more product

development costs should be assigned to that product.

Facility level: Facility level driver are drivers that are not related to the products at all.

Costs that are traced by such drivers will therefore be allocated to products and not

traced. The difference between allocation and tracing is that allocation is quite arbitrary

whereas tracing is based on ‘cause and effect’ relations.

The basis of Activity Based Costing is: look at the activities required to produce the cost

of the product or service. The activities consume resources and the cost of these can be

calculated. The amount of activity required for each product and service is determined,

hence the real cost can be determined.

 The activity is the work that is done.

 The resource is what the activity uses to do the work eg people, equipment, services.

Resources cost money.

7
 The cost of the activity depends on the quantity of resources used to accomplish the

activity.

 The cost driver for an activity is the factor that influences the amount of the resources

that will be consumed by this activity.  

Example: the activity is delivering goods. The costs of this activity include the truck

drivers’ wages, fuel, depreciation of the truck, insurance, etc. The quantity of the

resources that will be consumed by this activity are influenced by the number of

deliveries made per year. Hence the cost driver could be the number of deliveries. A cost

driver is designed to allocate the delivery activity cost pool to the cost objects.

 The activity driver measures how much of the activity is used  by the cost object.

Example: Product A is delivered once a month, whereas product B is delivered once a

week. Products A and B require a different number of deliveries, hence the cost of the

delivery activity should be assigned to each product on the basis of the number of

deliveries each uses.

 The cost object is whatever it is you wish to cost. It could be a product, service,

process, job or customer.

By using ABC an organisation will have a better appreciation of its costs and activities.

The program acts as a guide through the analysis process and assists with the

management of costs and activities. The program can identify value-adding (and value-

destroying) activities and products. It aids with cost management and control.

ABC analyses both direct and indirect costs. Direct costs include direct labour, materials

8
and expenses and these are assigned directly to the products and services, or cost objects,

which consume them. Indirect costs (sometimes called “overheads”) include service-

related costs such as administration, computer and personnel department, customer

related costs such as the sales department, maintenance and deliveries, etc. The program

refers to these activities as activity cost pools. In smaller organisations one or two people

may carry out the activities; in large organisations there may be several departments or

divisions that are responsible for services. Proper costing and cost management requires

that the cost pools or overheads be allocated in a meaningful way to the products or

services (cost objects) of the organisation.

ABC also provides a structured approach to re-engineering the activities carried out in the

business: resource consumption should be minimised while outputs are maximised.

Activity based costing allocates costs on the organization’s best estimate of the

appropriate cost drivers and involves many value judgments. Activity based costing

avoids costing distortions because realistic cost drivers are assigned individually to each

activity cost pool. Activities can be controlled, wastage can be measured and reduced,

unused capacity can be measured and managed, costs can be assigned to products and

services based on their “true” consumption of resources. Executives understand the costs

triggered by the cost objects and can manage them.

9
The costing produced by ABC will be more realistic because all of the resources are

assigned to the cost objects in a considered way. (Hicks, Douglas T. Activity-Based

Costing: Making it Work for Small and Mid-Sized Companies. 1998, pg. 76-85)

Activity Based Accounting in Manufacturing Industry

To the manufacturer industry, activity-based costing should be viewed as a concept

around which it can construct an economic model of its business that will provide the

accurate and relevant cost information necessary to support sound business decisions of

all types. This definition contains five critical points, which must be understood if

activity-based costing is to be of use to all types and sizes of manufacturers.

It is difficult, if not impossible; to generalize on the degree to which inaccurate or

irrelevant cost information might be putting a manufacturer's continued success, or even

its survival, at risk. Each manufacturer's circumstances are unique. There are, however,

certain characteristics that are frequently found to exist at manufacturers whose actions

are continually being misdirected due to inaccurate and irrelevant information.

It is very likely that a small or mid-sized manufacturer is putting itself at considerable

risk if:

 It has been incorporating new, technologically advanced manufacturing processes

into its operation without making corresponding changes in the way it costs its

products and processes

 It has only one basis for charging manufacturing costs to products (e.g., direct

labor hours, direct labor dollars, machine hours)

10
  It has only a few overhead rates, or perhaps only one plant-wide rate, in use

 It automatically changes its costing rates as volume levels and product mix

change

 It finds itself competitive on one end of its product line, but not on the other end

 It has manufacturing operations that do not always require the same number of

operators (e.g., variable crew sizes within one work center), but has not modified

its costing practices to incorporate this feature

 It has manufacturing operations that can be set-up, started, and then run with little

or no worker intervention, but has not modified its costing practices to incorporate

this feature

 It has cellularized some of its manufacturing processes without changing the way

it costs those processes

 It has some customers, markets, or product lines that require a disproportionate

amount of selling, scheduling, service, or other support activity, but includes all

non-factory costs in a company-wide "G & A" rate.

 Its percentage of value added (sales price less purchased materials and

components) varies considerably from product to product, but it uses total cost as

a base for applying "G & A" costs to individual products.

CONCLUSION

Because of advances in information technology, namely more powerful, inexpensive

computers and inexpensive modeling software, the time for ABC is here. A survey

conducted in November 1990 by the Cost Management Group of the National

Association of Accountants (now called the Institute of Management Accountants), found

11
that 11% of U.S. companies were using ABC while 19% were considering ABC

implementation. “A significant majority of the companies that have implemented ABC

say their experience has increased the quality of cost management information.”

REFERENCES

 Cokins, Gary. Activity-Based Costing: Making It Work. 1998.

 Cokins, Gary. "Learning to Love ABC." Journal of Accountancy. August 1999.

 Cokins, Gary. "Overcoming the Obstacles to Implementing Activity-Based

Costing." Bank Accounting and Finance. Fall 2000.

12
 Chutchain-Ferranti, Joyce. "Activity-Based Costing." Computerworld. August

1999.

 Henricks, Mark. "Beneath the Surface." Entrepreneur. October 1999.

 Hicks, Douglas T. Activity-Based Costing: Making it Work for Small and Mid-

Sized Companies. 1998.

13