Activity Based Costing

An overhead cost allocation system that allocates overhead to multiple activity cost pools and assigns the activity cost pools to products or services by means of cost drivers that represent the activities use.

Activity

Any event, action, transaction, or work sequence that causes a cost to be incurred in producing a product or providing a service.

Any factor or activity that has a direct cause-effect relationship with the resources consumed.

In ABC cost drivers are used to assign activity cost pools to products or services.

Calculate unit cost

•         Identify activities

•         Identify cost driver

•         Compute overhead rate

Assign overhead cost

Benefits of Activity BASED accounting

More accurate product costing which necessitates:

é         More cost pools used to assign overhead

é         Enhanced control over overhead

é         Better management decisions

Limitation

é         Can be expensive to use.

é         Some arbitrary allocations continue.

Value Added Activities

An activity that increases the worth of a product or service such as...

é         engineering design

é         machine set-ups

é         machining

é         assembling

é         painting

é         packaging

Non Value Added Activities

An activity that adds cost to or increases the time spent on, a product/service without increasing its market value such as:

é         Repair of machines

é         Storage of inventory

é         Moving of materials

é         Building maintenance

é         Inspections

é         Inventory Control

Just in Time Processing

A processing system dedicated to having the right amount of materials, products, or parts arrive as they are needed, thereby reducing the amount of inventory.

•         Requires

–        Dependable suppliers

–        A multiskilled work force

–        A total quality control system

•         Reduced inventory

•         Enhanced product quality

•         Reduced rework and storage costs

•         Savings from improved flow of goods

•         Unit Level  activities

Activities performed for each unit of production

 Batch ;level Activities

Activities performed for each batch of products.

Product Level activities

Activities performed for and identifiable with an entire product line

FACILITY level ACTIVITIES

Activities required to support or sustain an entire production process and not dependent on number of products, batches, or units produced.

ABC systems addresses the following Questions

•         What activities are being performed by the organizational resources?

•         How much does it cost to perform activities?

•         Why does the organization need to perform those activities?

How much of each activity is required for the organization’s products, services, and customers

Basis of ABC

Steps:

1. Form cost pools
2. Identify activities
3. Map resource costs to activities
4. Define activity cost drivers
5. Calculate cost

Activity Items

•         Unit level: Performed each time a unit is         
                    produced

•         Batch level: Performed each time a batch is
                     produced

•         Product level: Performed to support production
                   of different type of product

•         Customer Level: Performed to support servicing                                      customers

•         Facility level: Residuary head

•         Activity Drivers

•         The linkage between activities and cost objects, such as products, customers,, is accomplished by using activity drivers.

•         An activity driver is a quantitative measure of the output of an activity.

•         The selection of an activity driver reflects a subjective trade-off between accuracy and cost of measurement.

Ascertaining Cost-

 

Where TO use ABC- 

•         High Overheads

•         Product Diversity or Multiple Products

•         Customer Diversity

•         Service Diversity

•         Stiff Competition

Activity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today. However, from the 1960s - particularly 1980s - this changed rapidly. For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised.

The question of course is whether ABC has overcome these deficiencies or not?  It has. In fact, ABC has been called one of the most important management innovations the last hundred years.

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

1. In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.
2. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.
3. Traditional cost accounting is structure-oriented whereas ABC is process-oriented.

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.

Consumption of resources versus consumption of activities

ABC acknowledges that you cannot manage costs, you can only managed what is being done and then costs will change as a consequence. In traditional cost accounting, however, the underlying assumption is that costs can be managed, but as most managers have found out the hard way - managing costs is almost impossible.

The benefit of the ABC mindset is that it opens up for a much wider array of measures when it comes to improving productivity. By investigating systematically what is being done, i.e. the activities, one will not only be able to identify surplus capacity if it occurs, but also lack of capacity and misallocation of capacity. A result of this might be that costs are cut the traditional way, but it might as well lead to a reallocation of capacity to where it is most needed which will yield high productivity more effectively than the traditional way.

Volume related allocation bases versus drivers at many levels

Due to the historic background of traditional cost accounting methods, they tend to use direct labor - or other volume related allocation bases - for cost assignment purposes. But as overhead has grown and new technologies have come, it goes without saying that assigning costs based on only 5 - 15% (in most companies) of total costs is highly risky. In fact, the incurred errors are up to several hundred percent!

In ABC, however, costs are assigned according to the 'cause and effect' relationship between activities (the actual process) and cost objects, which is captured using drivers. The drivers are therefore not allocation bases in the traditional sense, although they work the same way mathematically - drivers are estimates of actual cost behavior and can therefore also be used to identify, or they are themselves, the critical cost factors. Because the drivers are related to the actual processes, they occur on several levels. The four most common levels are;

1. 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.
2. 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.
3. 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.
4. 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.

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. 

While we discuss drivers it is important to mention that in ABC there are two types of drivers w.r.t. cost assignment;

1. Activity drivers that keep track of how cost object behavior influences activity levels, i.e., the level of activity for each activity. 
2. Resource drivers that keep track of how the subsequent activity level affects the resource consumption.

Before we continue it is important to mention that in early terminology activity drivers were referred to as 'second stage cost drivers' whereas resource drivers were denoted 'first stage cost drivers'.  But it is evident that the word 'cost driver' is misleading in this context because activity- and resource drivers do not tell what drives costs in the general case. 

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. 

Structure-orientation versus process-orientation

Traditional costing systems are more concerned about the organizational charts than the actual process. Traditional cost accounting systems are therefore structurally oriented and the process view is completely missing. The result is that one cannot ask 'what needs to be done?', because the process is unknown. The only questions such costing systems can give answers to, although often off the mark, is 'what do we have at our disposal to do the job?'.

The latter question is a question of capacity, that is, how capacity is managed. Capacity is measured as an expense and found easily in the accounting system. The first question is a question of resource management, because resources is what you need in order to do a job and measured as a cost, but the resource measures can only be found by investigating the processes.

Thus, because ABC is process-oriented and gathers information from the processes it can be used to identify both 'what needs to be done?' and how to allocate resources most productively. ABC can therefore give managers the ability to match the resource needs with the available capacity as closely as possible, and hence improving productivity. From this we understand that the structure oriented approach of traditional costing systems gives no decision support in allocating capacity to match resource needs. Over time this leads to cost inefficient organizations and poor profitability.

There is also another aspect to process-orientation; how ABC is used and implemented. Because ABC can direct attention towards the causes of costs (critical success factors) related to both cost objects and processes and not to mention the cost of quality, ABC is viewed as more than a method for cost accounting - it invites to a whole new way of management, such as;

The identification of critical success factors that enables continuous improvement of product- and process design.

	The link between cost information and other information enables a much wider array of improvement strategies than traditionally acknowledged.
	The identification of the cost of quality and the process-orientation in ABC open up for a very powerful link to various  quality management methods.

From the above discussion it should be evident that not only is ABC useful and powerful to any organization, but a need for companies that want to excel, and efficiently and effectively increase their Sustainable Competitive Advantage (SCA). As one marketing executive said: "This is revolutionary!".