Activity Based Costing- A Basic Introduction

Activity Based Costing: A Basic Introduction


INTRODUCTION

Activity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs (overhead) into direct costs.

In this way an organization can precisely estimate the cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced.

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.

LITERATURE REVIEW

Traditionally cost accountants had arbitrarily added a broad percentage of expenses into the indirect cost

However as the percentages of indirect or overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the 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, the additional cost for the use of the machine would not be 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.

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.

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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 affect 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. Burns as a chapter in their book Accounting and Management: A Field Study Perspective.[2] 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 also 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.



METHODOLOGY

a. Cost allocation: Cost allocation is a process of attributing cost to particular cost centers. For example the wage of the driver of the purchasing department can be allocated to the purchasing department cost center. It is not necessary to share the wage cost over several different cost centers. Cost and services are not identical to each other.

b. Fixed cost: In economics, fixed costs are business expenses that are not dependent on the activities of the business they tend to be time-related, such as salaries or rents being paid per month. This is in contrast to variable costs, which are volume-related (and are paid per quantity).

In management accounting, fixed costs are defined as expenses that do not change in proportion to the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales.

c. Variable cost: Variable costs are expenses that change in proportion to the activity of a business. In other words, variable cost is the sum of marginal costs. It can also be considered normal costs. Along with fixed costs, variable costs make up the two components of total cost. Direct Costs, however, are costs that can easily be associated with a particular cost object. Not all variable costs are direct costs, however; for example, variable manufacturing overhead costs are variable costs that are not a direct costs, but indirect costs. Variable costs are sometimes called unit-level costs as they vary with the number of units produced.

d. Cost driver: Cost Drivers are the structural causes of the cost of an activity performed in the Value Chain. They determine the behavior of costs within an activity.

A cost driver can be completely or partly or not at all under the control of a firm.

A firm's cost performance in all of its major discrete activities adds up to establish its relative cost position.



According to Michael Porter, there are 10 major cost drivers:

1. Economies or Diseconomies of Scale.

2. Learning and Spillovers. The cost of a value activity often declines over time due to learning or improvements that increase its efficiency. Or due to knowledge acquired from suppliers, consultants, former employees or reverse engineering.

3. Pattern of Capacity Utilization. Different ways of configuring a value activity will affect its sensitivity for capacity (under)utilization.

4. Linkages. The cost of many value activities is affected by how other activities are performed within the firm's own value chain or with the value chain of a supplier or a channel ("Vertical Linkages"). Through combining these activities and their linkages, their total cost can be reduced.

5. Interrelationships between business units within a firm in the form of shared activities.

6. Vertical Integration. Doing more activities within the firm.

7. Timing, such as First Mover Advantage or Second Mover Advantage.

8. Discretionary Policies. The strategic choices a firm make, for example being a self-service internet bank or being the fastest courier company.

9. Location. Geographic location where an activity is conducted and the prevailing costs of personnel, materials, energy, etc.

10. Institutional Factors. Government regulation, tax regimes, financial incentives, unionization, tariffs and levies, local content rules also affect the costs of a value activity.

e. Cost driver rate: cost driver in a system of activity-based costing, any factor such as number of units, number of transactions, or duration of transactions that drives the costs arising from a particular activity. When such factors can be clearly identified and measured.

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 measure of the use of a shared activity by each of the products is known as the cost driver. For example, the cost of the activity of bank tellers can be ascribed to each product by



measuring how long each product's transactions takes at the counter and then by measuring the number of each type of transaction.

DIFFERENCE BETWEEN ABC AND TRADITIONAL COST ACCOUNTING METHODS

So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there are three major differences:

In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.

Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.

Traditional cost accounting is structure-oriented whereas ABC is process-oriented. Activity-based costing is a more accurate cost management system than TCA. One

would use the ABC method when overhead is high, products are diverse, cost of errors high and competition is stiff.

Traditional Cost Accounting is unable to calculate the 'true' cost of the product. TCA arbitrarily allocates overhead to the costs of objects.

This is discussed in more detail in the subsequent sections and illustrated below.

But first, the direction of the arrows are different because ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations.



Figure: Difference between ABC & Traditional Costing

Hence, we see that the traditional usage of fixed and variable costs is totally meaningless. In ABC, all costs are included. However, ABC employs a different usage and definition of fixed and variable costs. A fixed activity cost is a cost that exists due to the very existence of the activity whereas a variable activity cost changes as the output of the activity changes. This

distinction is very helpful in various improvement efforts.

Therefore, in Activity-Based Management (ABM)a third type of drivers is employed in addition to the two aforementioned drivers. This type of drivers is called cost drivers and they are the underlying causes of costs of activities and measured by non-financial performance measures. Today, the most important of these measures can be presented in a balanced scorecard and they represent the process view in ABM. These are possibly the most difficult drivers to identify.

ACTIVITY-BASED MANAGEMENT

Activity-based management and activity-based costing (ABM/ABC) have brought about radical change in cost management systems. ABM has grown largely out of the work of the Texas-based Consortium for Advanced Manufacturing-International (CAM-I). The principles and philosophies of activity-based thinking apply equally to service companies, government agencies and process industries. Activity-based costing and activity-based management have been around for more than fifteen years.

It is a one-off exercise which measures the cost and performance of activities, resources and the objects which consume them in order to generate more accurate and meaningful information for decision-making. ABM draws on ABC to provide management reporting and decision making. ABM supports business excellence by providing information to facilitate long-term strategic decisions about such things as product mix and sourcing. It allows product designers to understand the impact of different designs on cost and flexibility and then to modify their designs accordingly.

ABM also supports the quest for continuous improvement by allowing management to gain new insights into activity performance by focusing attention on the sources of demand for activities and by permitting management to create behavioral incentives to improve one or more aspects of the business.


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ABM is a fundamental shift in emphasis from traditional costing and performance measurement. People undertake activities which consume resources – so controlling activities allows you to control costs at their source.

The real value and power of ABM comes from the knowledge and information that leads to better decisions and the leverage it provides to measure improvement.

ABM enables management to make informed decisions about lines of business, product mix, process and product design, what services should be offered, capital investments, and pricing.

ABM is more than an accounting tool; it's a system for continuous improvements. It is not a single answer but merely one of the many tools that can be used to enhance organizational performance management.

ABM will not reduce costs, it will only help you understand costs better to know what to correct.

The process of ABM does consume resources, and the manpower costs can be significant.

_ Other priorities, top management commitment, IT capabilities and integration with financial and budgeting systems should be

considered before implementation. Organizations have begun to look at ABM for a variety of reasons. Among the most

commonly cited are:o top-down pressure to reduce costs;o Competitive pressure/market conditions;o organization-wide programmed;o The introduction of benchmarking;o Regulatory issues;o Seeking world-class status through process management.

ABC and ABM are a continuum of value. ABM is the application of ABC data to manage product portfolios and business processes better.



BENEFITS OF ACTIVITY-BASED COSTING

Typical benefits of Activity-Based Costing:

Identify the most profitable customers, products and channels.

Identify the least profitable customers, products and channels.

Determine the true contributors to- and detractors from- financial performance.

Accurately predict costs, profits and resources requirements associated with changes in production volumes, organizational structure and costs of resources.

Easily identify the root causes of poor financial performance.

Track costs of activities and work processes.

Equip managers with cost intelligence to stimulate improvements.

Facilitate a better Marketing Mix

Enhance the bargaining power with the customer.

Achieve better Positioning of products

With the costing now based on activities, the cost of serving a customer can be ascertained individually. Deducting the product cost and the cost to serve each customer, one can arrive at customer's profitability. This method of dealing separately with the customer costs and the product costs enables the identification of the profitability of each customer and Positioning the products and services accordingly.

USES OF ACTIVITY BASED COSTING

It helps to identify inefficient products, departments and activities

It helps to allocate more resources on profitable products, departments and activities

It helps to control the costs at an individual level and on a departmental level

It helps to find unnecessary costs

ACTIVITY BASED COSTING PRACTICE- BE CAUTIOUS of 18

Md. Abul HasnatM.H. School of BusinessPresidency University, Bangladesh


Even in activity-based costing, 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.

STEPS OF ACTIVITY BASED COSTING

Following an Example of Activity Based Costing Estimate

To get a better understanding of how an ABC estimate is developed, assume that it has been asked to prepare a cost estimate for a site evaluation. To verify that there is no contamination at the site, subsurface soil samples will have to be collected. The area of the site is known, and the guideline for the number of samples per unit area has also been given.

Figure: Overhead Cost Analysis of 18

Md. Abul HasnatM.H. School of BusinessPresidency University, Bangladesh


Define activities, activity cost pools, and activity measures

Assume that the cost of supplying resources – personnel, supervision, information technology, telecommunications, and occupancy − to perform these activities is $500,000 per quarter. In building an ABC model for the customer service department, the system designer asks employees to estimate the percentage of their time spent (or that they expect to spend) on the three principal activities they perform. Suppose they estimate these percentages as 80%, 5% and 15%, respectively. The ABC system designer also learns that the actual (or estimated) quantities of work for the quarter in these three activities are:

• 8,000 customer orders • 250 customer complaints • 550 credit checks

1. Assign overhead costs to activity cost poolsThe system assigns the $500,000 resource cost to activities, based on the time percentage, and calculates activity cost driver rates as shown below:

Overhead % Total

Customer Orders

80% $ 400000

Customer Complaints

5% 25000

Credit Checks 15% 75000

Total $ 500000

Table: Overhead Cost



Figure: ABC System

2. Calculate activity rates

Activity % Assigned CostActivity Cost

Driver QuantityActivity Cost Driver Rate

Handle orders 80% $400,000 8,000 $ 50/orderProcess

complaints5% 25,000 250 $100/complaint

Check credit 15% 75,000 550$136.36/credit

checkTotal 100% $ 500,000

Table: Calculated Activity Rates



The project team then uses the calculated activity cost driver rates to assign the expenses of the three activities to individual customers based on the number of orders handled, complaints processed, and credit checks performed for each customer.

MATHEMATICAL ILLUSTRATION

Returning to the numerical example, suppose that the analyst obtains estimates of the following average unit times for the three customer-related activities:

Handle customer orders40 minutes Process customer complaints110 minutes Perform credit check 150 minutes

We can now simply calculate the activity cost driver rate for the three activities:

ActivityUnit Time (minutes)

Activity Cost Driver Rate @ $0.80/minute

Handle customer order 40$ 32

Process customer complaint 110$88

Perform credit check 150$120

Table: Calculate Activity Cost Driver Rates



These rates are lower than those estimated before. The reason for this discrepancy becomes obvious when we calculate the cost of performing these activities during the recent quarter.

Activity Unit Time Quantity Total Minutes Total Cost

Handle customer order

40 8000 320000 $ 256000

Process customer complaint

110 250 27500 22000

Perform credit check

150 550 82500 66000

Total 430000 $ 344000

Table: Calculated Overhead Cost

The analysis reveals that only 78% of the practical capacity (430000/550,000) of the resources supplied during the period was used for productive work (and hence only 78% of the total expenses of $500,000 are assigned to customers during this period). The traditional ABC system over-estimates the costs of performing activities because its distribution of effort survey, while quite accurate − 80%, 5% and 15% of the productive work is the approximate distribution across the three activities − incorporates both the costs of resource capacity used and the costs of unused resources. By specifying the unit times to

perform each instance of the activity14 the organization gets both a more valid signal about the cost and the underlying efficiency of each activity as well as the quantity (121,400 hours) and cost ($97,120) of the unused capacity in the resources supplied to perform the activity.

With estimates of the cost of resource supply, the practical capacity of the resources supplied, and the unit times for each activity performed by the resources, the reporting system becomes quite simple for each period. Suppose the quantity of activities shifts, in the subsequent period, to 10,200 orders handled, 230 customer complaints, and 540 credit checks performed. During the period, the costs of each of the three activities are assigned based on the standard rates, calculated at practical capacity: $32 per order, $88 per complaint, and $120 per credit check. This calculation can be performed in real time to assign customer administration costs to individual customers, as transactions from customers occur.



The report at the end of the period is both simple and informative:

Activity QuantityUnit Time

Total Time

Unit CostTotal Cost Assigned

Handle Customer Orders

10,200 40 408,000$ 32

$ 326,400

Process Complaints 230 110 25300$88

20240

Perform Credit Checks

540 150 81,000$120

64800

TotalUsed 514300 $ 411440Total Supplied 550,000 $500,000

Unused Capacity 35700 $ 88560Table: Analysis Report

The report reveals the estimated time spent on the three activities, as well as the resource costs required to handle the activity demands. It also highlights the difference between capacity supplied (both quantity and cost) and the capacity used. Managers can review the $88,560cost of the 35700minutes (595 hours) of unused capacity and contemplate actions to reduce the supply of resources and the associated expense. Rather than reduce currently unused capacity, managers may choose to reserve that capacity for future growth. As managers contemplate new product introductions, expansion into new markets, or just increases in product and customer demand, they can forecast how much of the increased business can be handled by existing capacity, and where capacity shortages are likely to arise that will require additional spending to handle the increased demands. For example, the vice president of operations at Lewis-Goetz, a hose and belt fabricator based in Pittsburgh, saw that one of his plants was operating at only 27% of capacity. Rather than attempt to downsize the plant, he decided to maintain the capacity for a large contract he expected to win later that year.

CONTINUOUS IMPROVEMENT

The implementation of ABC can make the employees understand the various costs involved. This will then enable them to analyze the cost, and to identify the activities that add value and those that do not add value. Finally, based on this, improvements can be implemented and the benefits can be realized. This is a continuous improvement process in terms of analyzing the cost, to reduce or eliminate the non-value added activities and to achieve an overall efficiency.



ABC has helped enterprises in answering the market need for better quality products at competitive prices. Analyzing the product profitability and customer profitability, the ABC method has contributed effectively for the top management's decision making process. With ABC, enterprises are able to improve their efficiency and reduce the cost without sacrificing the value for the customer. Many companies also use ABC as a basis for a balanced scorecard.

This has also enabled enterprises to model the impact of cost reduction and subsequently confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method for continuous improvement. With Activity Based Costing any enterprise can have a built-in competitive cost advantage, so it can continuously add value to both its stakeholders and customers.

The implementation of Activity Based Costing is not easy - not an ABC. Special activity based costing software can be helpful.

CONCLUSION



Over the past 15 years, activity-based costing has enabled managers to see that not all revenue is good revenue, and not all customers are profitable customers. Unfortunately, the difficulties of implementing and maintaining traditional ABC systems have prevented activity-based cost systems from being an effective, timely, and up-to-date management tool. The time-driven ABC approach has overcome these difficulties. It offers managers a methodology that has the following positive features:

Easy and fast to implement

Integrates well with data now available from recently installed ERP and CRM systems Inexpensive and fast to maintain and update Ability to scale to enterprise-wide models Easy to incorporates specific features for particular orders, processes, suppliers, and

customers More visibility to process efficiencies and capacity utilization Ability to forecast future resource demands based on predicted order quantities and

complexity

These characteristics enable activity-based costing to move from a complex, expensive financial systems implementation to becoming a tool that provides meaningful and actionable data, quickly and inexpensively, to managers.



BIBLIOGRAPHY

Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective

(Harvard Business School Press, 1987).

Sapp, Richard, David Crawford and Steven Rebishcke, Journal of Bank Cost and Management Accounting (Volume 3, Number 2), 1990, Journal of Bank Cost and Management Accounting (Volume 4, Number 1), 1991.

David M. Katz, Activity-Based Costing (ABC).

Police Service National ABC Model Manual of Guidance Version 2.3 June 2007.

Sir Ronnie Flanagan, The Review of Policing Final Report, February 2008.

Tiffany Bradford, Types of Accounting Costing Systems, 2008

Weygandt / Kieso / Kimmel, Managerial Accounting (Second Edition)

[email protected] with questions or comments about this web site.Copyright © 2000 Jan Emblemsvag

DR jake, mitchell; alan price (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall.

DR Alex, Suleman. "A controversial-issues approach to enhance management accounting education.".Journal of Accounting Education 1994.

Ali, H. F. "A multi-contribution activity-based income statement.”Journal of Cost Management 1994.

Innes, J and Mitchell, F (1995), Activity-based costing in the UK's largest companies: a survey, CIMA.

Innes J, and Norris, G (1997), The use of activity-based information: a managerial perspective, CIMA.

‘Activity-based management’, Management Accounting Issues Paper 10, SMAC, 1995.

Statement of Management Accounting, NAA/IMA, 1998.http://www.pitt.edu/~roztocki/abc/abc.htm ABM Internet website guide, by NarcyzRoztocki

of the Pittsburgh University. Comprehensive internet web links covering all areas of ABM

http://www.pitt.edu/~roztocki/abc/abctutor/ Introduction to Activity-based Costing (ABC) Internet ABC online presentation. University of Pittsburgh


http://www.pitt.edu/~roztocki/abc/abctutor/

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Activity Based Costing- A Basic Introduction

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