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Activity Based Costing

Activity Based Costing

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Published by Mahabub Alam
Activity-based costing (ABC) is a technique to more accurately assign the indirect and direct resources of an organization to the activities performed based on consumption. In the first stage, resource costs are assigned to activities based on the amount of resources consumed in performing the activity. In the second stage, activity costs are traced to the products, services, or customers based on how frequently the activity is performed in support of these cost objects. This paper examines the best practices that have emerged in the ABC implementation domain.
Activity-based costing (ABC) is a technique to more accurately assign the indirect and direct resources of an organization to the activities performed based on consumption. In the first stage, resource costs are assigned to activities based on the amount of resources consumed in performing the activity. In the second stage, activity costs are traced to the products, services, or customers based on how frequently the activity is performed in support of these cost objects. This paper examines the best practices that have emerged in the ABC implementation domain.

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Activity Based Costing
A Tool to Aid Decision Making


Submitted by
Md. MahabubAlam
Ruhulamin
Md. MehediHasan
Tanvir Ahmed
MofazzalHossain
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Activity Based Costing
SUMMARY

Activity-based costing (ABC) is a technique to more accurately assign the indirect and direct
resources of an organization to the activities performed based on consumption. In the first stage,
resource costs are assigned to activities based on the amount of resources consumed in performing the
activity. In the second stage, activity costs are traced to the products, services, or customers based on
how frequently the activity is performed in support of these cost objects. This paper examines the best
practices that have emerged in the ABC implementation domain.
ABC analysis provides the information necessary to make business decisions such as determining if
investments in efficiency initiatives, such as just in time (JIT), are warranted. When implementing
ABC, management should use proven project management methodology to minimize the risk of
failure. ABC is an effective total quality management tool, and supports just-in-time manufacturing
methods in several companies as detailed in the paper.















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Activity Based Costing

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.




HISTORICAL DEVELOPMENT

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.

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Acti it B C ti
t i it cent es t all cate costs, ABC seeks to i enti cause
and affect relationshi s to objecti el assi n costs. Once costs of the acti ities have been
identified, the cost of each activit is attributed to each product to the extent that the product
uses the activit . In this way ABC often identifies areas of hi h 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. 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.


MET L G

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
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Activity Based Costing
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.




Accordi g 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.
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Activity Based Costing
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
ACCOUNTIN 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.
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Activity Based Costing
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.

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Activity Based Costing
ACTIVITY-BASED MANA EMENT

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.

y 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.
y 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.
y 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.
y 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.
y ABM will not reduce costs, it will only help you understand costs better to know what
to correct.
y The process of ABM does consume resources, and the manpower costs can be
significant.
y _ Other priorities, top management commitment,
y IT capabilities and integration with financial and budgeting systems should be
considered before implementation.
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Activity Based Costing
y 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.

y 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 COSTIN

Typical benefits of Activity-Based Costing:
y Identify the most profitable customers, products and channels.
y Identify the least profitable customers, products and channels.
y Determine the true contributors to- and detractors from- financial performance.
y Accurately predict costs, profits and resources requirements associated with changes
in production volumes, organizational structure and costs of resources.
y Easily identify the root causes of poor financial performance.
y Track costs of activities and work processes.
y Equip managers with cost intelligence to stimulate improvements.
y Facilitate a better Marketing Mix
y Enhance the bargaining power with the customer.
y 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
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Activity Based Costing
product costs enables the identification of the profitability of each customer and Positioning
the products and services accordingly.


USES OF ACTIVITY BASED COSTIN

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 COSTIN PRACTICE- BE CAUTIOUS

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.






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Activity Based Costing
STEPS OF ACTIVITY BASED COSTIN

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
1. Define activities, activity cost pools, and activity measures
Assume that the cost of supplying resources ± personnel, supervision, information
technology, telecommunications, and occupancy í to perform these activities is $560,000
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 70%, 10% and 20%, respectively. The ABC system designer also learns
that the actual (or estimated) quantities of work for the quarter in these three activities
are:
‡ 9,800 customer orders
‡ 280 customer complaints
‡ 500 credit checks
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Activity Based Costing
2. Assign overhead costs to activity cost pools
The system assigns the $560,000 resource cost to activities, based on the time
percentage, and calculates activity cost driver rates as shown below:



Overhead % Total
Customer
Orders
70% $ 392000
Customer
Complaints
10% 56000
Credit Checks 20% 112000
Total $ 560000


Table: Overhead Cost





Figure: ABC System

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Activity Based Costing
3. Calculate activity rates
Activity % Assigned Cost
Activity Cost
Driver
Quantity
Activity Cost
Driver Rate
Handle orders 70% $392,000 9,800 $ 40/order
Process
complaints
10% 56,000 280 $200/complaint
Check credit 20% 112,000 500
$224/credit
check
Total 100% $ 560,000

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.


















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Activity Based Costing
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 orders 40 minutes
Process customer complaints 220 minutes
Perform credit check 250 minutes

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

Activity

Unit Time (minutes)
Activity Cost Driver Rate @
$0.80/minute

Handle customer order 40
$ 32

Process customer complaint 220
$176

Perform credit check 250
$200

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 9800 392000 $ 313600
Process
customer
complaint
220 280 61600 49280
Perform credit
check
250 500 125000 100000
Total 578600 $ 462880
Table: Calculated Overhead Cost
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Activity Based Costing
The analysis reveals that only 83% of the practical capacity (578,600/700,000) of the
resources supplied during the period was used for productive work (and hence only 83% of
the total expenses of $560,000 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 í 70%, 10% and 20% of the productive work is the approximate
distribution across the three activities í 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 activity
14
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, $176 per complaint, and $200 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 Quantity
Unit
Time
Total
Time
Unit Cost
Total Cost
Assigned
Handle Customer
Orders
10,200 40 408,000 $ 32 $ 326,400
Process Complaints 230 220 50,600 176 40,480
Perform Credit
Checks
540 250 135,000 200 108,000
TotalUsed 593,600 $ 474,880
Total Supplied 700,000 $560,000
Unused Capacity 106,400 $ 85,120
Table: 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 $85,120 cost of the 106,400 minutes (1,773 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
P a g e | 19
Activity Based Costing
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.



P a g e | 20
Activity Based Costing

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:

y Easy and fast to implement
y Integrates well with data now available from recently installed ERP and CRM systems
y Inexpensive and fast to maintain and update
y Ability to scale to enterprise-wide models
y Easy to incorporates specific features for particular orders, processes, suppliers, and
customers
y More visibility to process efficiencies and capacity utilization
y 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.

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Activity Based Costing
BIBLIO RAPHY

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

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