Strategic Management Accounting

Introduction to Activity Based Costing (ABC):

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 individual products and
services so they can identify and eliminate those that are unprofitable and lower the prices of
those that are overpriced.

Activity Based Costing (ABC) is an alternative to the traditional way of accounting.

Traditionally it is assumed that high volume customers are profitable customers. A loyal
customer is also a profitable customer. And profits will follow a happy customer. Studies
about customer profitability have unveiled that the above ideas are not necessarily true. ABC
is a costing model that identifies the cost pools, or activity centers, in an organization. It
assigns costs to products and services (cost drivers), based on the number of events or
transactions that are taking place in the process of providing a product or service. As a result,
Activity Based Management can support managers to see how shareholder value can be
maximized and how corporate performance can be improved. Historically, cost accounting
models related indirect costs on the basis of volume.

Kaplan and Cooper (in Kaplan, R. S., & Cooper, R. (1998). Cost and effect: Using integrated
cost systems to drive profitability and performance. Boston: Harvard Business School Press.)
divide ABM into operational and strategic:

Operational ABM is about “doing things right”, using ABC information to improve
efficiency. Those activities which add value to the product can be identified and improved.
Activities that don’t add value are the ones that need to be reduced to cut costs without
reducing product value.
Strategic ABM is about “doing the right things”, using ABC information to decide which
products to develop and which activities to use. This can also be used for customer
profitability analysis, identifying which customers are the most profitable and focusing on
them more.

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Continuous Improvement of ABC:

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.
Example:
Let’s illustrate the concept of activity based costing by looking at two common manufacturing
activities: (1) the setting up of a production machine for running batches of products, and (2)
the actual production of the units of product.

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We will assume that a company has annual manufacturing overhead costs of $2,000,000—of
which $200,000 is directly involved in setting up the production machines. During the year
the company expects to perform 400 machine setups. Let’s also assume that the batch
sizes vary considerably, but the setup efforts for each machine are similar.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups
per year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-
level cost. This means that $200,000 will first be allocated to batches of products to be
manufactured (referred to as a Stage 1 allocation), and then be assigned to the units of product
in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of 5,000
units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is
50,000 units, the cost per unit for setup will be $0.01 ($500 divided by 50,000 units). For
simplicity, let’s assume that the remaining $1,800,000 of manufacturing overhead is caused
by the production activities that correlate with the company’s 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing
overhead would look with activity based costing and without activity based costing:

With ABC Without ABC

Mfg overhead costs assigned to setups $200,000 $–0–
Number of setups 400 Not applicable
Mfg overhead cost per setup $500 $–0–

Total manufacturing overhead costs $2,000,000 $2,000,000

Less: Cost traced to machine setups 200,000 –0–
Mfg O/H costs allocated on machine
$1,800,000 $2,000,000
hours
Machine hours (MH) 100,000 100,000
Mfg overhead costs per MH $18 $20

$500 setup cost per batch + $18 per

Mfg Overhead Cost Allocations $20 per MH
MH

Next, let's see what impact these different allocation techniques and overhead rates would
have on the per unit cost of a specific unit of output. Assume that a company manufactures a

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batch of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned
to the units with activity based costing and without activity based costing compares:

With ABC Without ABC

Mfg overhead for setting up machine $500 $–0–
No. of units in batch 5,000 Not applicable
Mfg O/H caused by Setup – Per Unit $0.10 Not applicable

Mfg overhead costs per machine hour $18 $20

No. of units produced per machine hour 50 50
Mfg O/H caused by Production – Per Unit $0.36 $0.40

Total Mfg O/H Allocated – Per Unit $0.46 $0.40

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour,
here is how the cost assigned to the units with ABC and without ABC compares:

With ABC Without ABC

Mfg overhead for setting up machine $500 $–0–
No. of units in batch 50,000 Not applicable
Mfg O/H caused by Setup – Per Unit $0.01 Not applicable

Mfg overhead costs per machine hour $18 $20

No. of units produced per machine hour 50 50
Mfg O/H caused by Production – Per Unit $0.36 $0.40

Total Mfg O/H Allocated – Per Unit $0.37 $0.40

As the tables above illustrate, with activity based costing the cost per unit decreases from
$0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units instead of
5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number of units in each
batch. If companies base their selling prices on costs, a company not using an ABC approach
might lose the large batch work to a competitor who bids a lower price based on the
lower, more accurate overhead cost of $0.37. It’s also possible that a company not using

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ABC may find itself being the low bidder for manufacturing small batches of product, since
its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid
price based on manufacturing overhead of $0.40—but a true cost of $0.46—the company may
end up doing lots of production for little or no profit.

Implementing an Activity Based Costing System:

An Activity-based costing system follows two steps. The first step identifies major
activities and appropriates overhead costs to each activity depending on the proportion of the
resources that are employed in that activity. The overhead costs that are assigned to each
activity form an activity cost pool. After the assigning of overhead costs is complete,
identification of cost drivers relevant each cost pool ensues.
Then in step two, division of overhead costs from each cost pool to each product line
in proportion to the cost driver consumed by the product line. (Diagram 1) (Roztocki, 2000)
To do this, companies can create a new department called ‘activity accountancy. This
accounting mechanism calculates revenues and costs for each activity. They manage and
control the planned activities of the business. In accordance with the requests managers of the
company, they can organize each activity as a profit centre. The job of an activity accountant
is broken down into three parts mentioned below:
I. Resources determined on activities and then planning.
II. Renewable activities are first determined and then planned.
III. Costs are determined as based on functions.
To do this, companies can create a new department called ‘activity accountancy’.

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This accounting mechanism calculates revenues and costs for each activity. They
manage and control the planned activities of the business. In accordance with the requests of
the managers of the company, they can organize each activity as a profit centre. The job of an
activity accountant is broken down into three parts mentioned below:
i. Resources determined on activities and then planning.
ii. Renewable activities are first determined and then planned
iii. Costs are determined as based on functions.
As a result, the differentiation of above aids allocation of costs to costs places.
General Motors Company practiced this system in their 50 of 193 factories and succeeded in
decreasing overheads especially at high production factories. Activity based costing has also
been extended into activity-based management (ABM) to include other considerations, such
as customer profitability, workforce utilization, distribution channels, and other management
issues. Therefore, activity based costing is the system that shows the cost and profitability
structure of products in a firm, whereas activity based management explains the actions to
improve quality and reduce costs and production time.

To sum up, we can see that activity based costing is not essentially a groundbreaking
accounting concept; it just endeavors to look at the costing mechanisms from an entirely
different perspective. Cost drivers which are determined in accordance with each organization

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certainly have their benefits which we have adequately determined in our paper, but the most
important aspect of activity based costing which is sometimes overlooked is the readily ad-
hoc system that comes as part and parcel of implementing an activity based costing system;
the ability to change the entire system a any step of the way is certainly a benefit which
cannot and preferably should not be ignored whilst one is conducting a cost/benefit analysis
of the usage of an activity based costing system.

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.

Basic Steps of Development of Activity Based Costing

Designing an Activity-based costing system includes 3 steps which are:-
• Identifying resource costs and activities.
• Assigning resource costs to activities.
• Assigning activity costs to cost objects.
Step 1: Identify Resource Costs and Activities

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A firm engages in activities to manufacture products or provide services. Activities consume

resources and which bear some costs. First we need to identify the activities which bear costs
and resource costs. Examples of accounts where resource cost are recorded are materials,
supplies, purchasing, materials handling etc. Special efforts needed to be made to determine
appropriate resource costs for Activity-based costing as costs for a single activity may be
recorded in different accounts.
Proper activity analysis needed to be done which will help the firm to identify work it
performs to carry out its operations.

All activities are needed to be classified according to the way in which they consume
resources. They are as follows:
• A Unit Level Activity is performed on each individual unit of products or
services of the firm. Examples of unit-level activities are using direct materials,
using direct labor-hours etc.

• A Batch Level activity is performed for each batch or group of units of

products or Services scheduled to be processed together.

• A product-sustaining activity supports the production of a specific product or

service.

• A facility sustaining activity supports the operation in general.

Step2: Assign Resource Costs to Activities

Activity-based costing uses resource consumption cost drivers to assign resource costs to
activities. Because activities drive the cost of resources used in operations, a firm should
choose resource consumption cost drivers based on cause and effect relationship.

Examples are:
a) Labor for labor intensive activities.
b) machine-hours for machine repairs and maintenance.

Step3: Assign Activity Costs to Cost Objects:

The last step is to assign costs of activities or activity cost pools to outputs based on the
appropriate activity consumption cost drivers. Outputs are the cost objects for which the firms
or organizations perform activities.
Characteristics of Activity Based Costing

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• More accurate costing of products/services, customers, SKUs, distribution channels

• Better understanding overhead
• Easier to understand for everyone
• Utilizes unit cost rather than just total cost
• Integrates well with Six Sigma and other continuous improvement programs
• Makes visible waste and non-value added
• Supports performance management and scorecards
• Enables costing of processes, supply chains, and value streams
• Activity Based Costing mirrors way work is done
• Facilitates benchmarking

Use Of ABC In An Organization Is Determined By The Following Factors:

 Indirect costs are significant in proportion to direct costs and use only one or two cost-
drivers.
 Goods are complex, requiring many inputs and processes.
 Simple, high-volume products perform more poorly than complex, low-volume
products.
 Different departments believe costs are assigned inaccurately.
 The company loses bids it thought were low, and wins bids it thought were high.
 Operations have changed significantly, but the costing system has not changed.

The limitations or disadvantages of Activity Based Costing are briefly discussed

below:
• Huge requirement of resources: Implementing an ABC system is a major project
that requires substantial resources. Once implemented an activity based costing system
is costly to maintain. Data concerning numerous activity measures must be collected,
checked, and entered into the system.
• Use in performance evaluation: ABC produces numbers such as product margins
that are odds with the numbers produced by traditional costing systems. But managers
are accustomed to using traditional costing systems to run theirs operations and
traditional costing systems are often used in performance evaluations.

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• Misinterpretation of data: Activity based costing data can be

easily misinterpreted and must be used with care when used in making decisions.
Costs assigned to products, customers and other cost objects are only potentially
relevant. Before making any significant decision using activity based costing data,
managers must identify which costs are really relevant for the decisions at hand.
• Non conformation by GAAP: Reports generated by these systems do not conform
to generally accepted accounting principles (GAAP). Consequently, an organization
involved in activity based costing should have two cost systems - one for internal use
and one for preparing external reports.

EXAMPLE of Activity Based Costing (ABC):

• Yazz, Inc. produces 130,000 units of Product A and 400,000 units for Product
B. Using the following cost information, how much overhead should be
allocated to Product A?

A c tiv ity C o
F a c t o r y F l o o rS Sq pu
Solution of the problem is given above:

E le c tric ity K ilo

W a te r
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SOLUTION
Activity Cost- Cost- Resources Used by Product A Cost
Driver Driver Assigned
Base Rate
Factory Floor Square $ 50.000 20,00 Sq. Ft. $1,000,000.00
Space Footage 0
Electricity Kilowatts $ 0.050 15,00 KW $ 750.00
0
Water Gallons $ 80,00 Gal. $ 12,800.00
0.160 0
Quality Units $ 135,00 Units $ 114,750.00
Control Inspected 0.850 0
Packaging - Ounces $ 270,00 Oz. $ 6,750.00
Inner of 0.025 0
popcorn
Packaging - Boxes $ 135,00 Boxes $ 168,750.00
Outer 1.250 0
Total Cost Assigned to $1,303,800.00
Product A

Introduction to Activity Based Management (ABM):

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.

ABC prompts managers to ask the right questions. ABC becomes ABM (management)
when it is used to:

 Design products and services that meet or exceed customers' expectations and can be
produced and delivered at a profit;
 Signal where either continuous or discontinuous(re-engineering) improvements in quality,
efficiency and speed are needed;
 Guide product mix and investment decisions;
 Choose among alternative suppliers;
 Negotiate about price, product features, quality, delivery and service with customers;

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 Employ efficient and effective distribution and service processes to target market and
customer segments;
Improve the value of an organization’s products and services

Importance of ABM:
 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.

 Companies considering or already implementing ABM should realize that although

certain product or market factors might make it potentially beneficial, those same factors
might not lead to a successful implementation. ABM gives us a much better chance of
establishing a useful costing for outputs. But there is a price to pay. It can be difficult to
find out what costs apply in a particular activity, and those involved may be suspicious of
others charged with finding out. Some areas of activity overlap and are difficult to
separate. And, of course, ABM is a costly exercise in its own right.

 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:
 Top-down pressure to reduce costs;
 Competitive pressure/market conditions;
 Organization-wide programme

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 The introduction of benchmarking;

 Regulatory issues;
 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.

STEPS FOR IMPLEMENTING ABM

• Cost allocation
• Fixed cost
• Variable cost
• Cost driver
• Cost driver rate

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. Other example, for the running machinery activity, the driver is likely to be
machine operating hours. That is, machine operating hours drive labor, maintenance, and
power cost during the running machinery activity.

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
centre. It is not necessary to share the wage cost over several different cost centers. cost and
services are not identical to each other.

Fixed Cost & Variable Cost

In economics, fixed costs are business expenses that are not dependent on the level of goods
or services produced by the business. They tend to be time-related, such as salaries or rents

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being paid per month. This is in contrast to variable costs, which are volume-related (and are
paid per quantity produced).

Cost Driver
A "cost driver" is the unit of an activity that causes the change of an activity cost. A cost
driver is any activity that causes a cost to be incurred. The Activity Based Costing (ABC)
approach relates indirect cost to the activities that drive them to be incurred. In traditional
costing the cost driver to allocate indirect cost to cost objects was volume of output. With the
change in business structures, technology and thereby cost structures it was found that the
volume of output was not the only cost driver

Uses
• 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
• It helps fixing price of product or service scientifically

REALTION BETWEEN ABC AND ABM

It has promised companies a new way to understand costs and a new way to limit these costs
to the products and customers driving them. It has been heralded as the cost accounting model
that would help management improve profitability. And it is fair to say that it does do that if:
• Management gains a thorough understanding of its business processes and cost
behaviour during the ABC analysis process.
• Management applies the insights gained during ABC fact gathering and analysis to
improve decision making at both operating and strategic levels. This is the essence of
ABM.

How ABC helps ABM

Organizations that are designing and implementing ABM will find there are five basic
information from ABC.
• The cost of activities and business processes;

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• The cost of non-value-added activities;

• Activity-based performance measures;
• Accurate product/service cost (cost objects);
• Cost drivers

1) The cost of activities and business processes

Since activities form the very core of what a business does, the basic output of the ABM
system must be to provide relevant cost information about what a business does. Instead of
reporting what money is spent for and by whom, costs are assigned to activities.

2)The cost of non-value-added activities

Some activities add value to a product or service, while some do not. A non-value added
activity is an activity that is considered not to contribute to customer value or to the
organization’s need. This is defined as waste. Identification of waste is valuable to
management. This crucial information output provides a focal point for improvement efforts.

3)Activity-based performance measures

In addition to cost information for business processes and activities, the ABM system must
report information and data on activity performance. Knowing the total cost of activity is
insufficient to measure activity performance. Activity measures of quality, cycle time,
productivity and customer service may also be required to judge activity Performance.
Measuring the performance of activities provides a scorecard to report how well improvement
efforts are working and is an integral port of continuous.

4)Accurate product/service cost (cost objects)

Products and services are provided to markets and customers through various distribution
channels or contractual relationships. Because products and services consume resources at
different rates and require different levels of support, costs must be accurately determined.
Accurate product and service cost information is vital for selecting the individual and
segmented markets where an organization competes and for pricing in those markets.
Accurate product and service cost information is a key information output of the ABM
systems.

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5)Cost drivers
The final output of an ABM system is cost driver information. A cost driver is any factor that
causes a change in the cost of an activity. For example, the quality of parts received by an
activity, for example the percentage, which are defective is a determining factor in the work
required by that activity, because the quality of parts received affects the resources required to
perform the activity. An activity may have multiple cost drivers associated with it.

VOLUME BASED COSTING:

Volume based costing system has served well since the inception of cost accounting. These
systems were developed by introduction of direct labor cost in direct cost. In short volume
based costing focus on measuring & controlling direct labor cost.

Comparison of Volume-based and ABC

One major limitation of a traditional volume-based costing system is that it tends to under
cost complex low-volume products and over cost high-volume products
• Referred to as cross-subsidization

Distorted or inaccurate product costing can lead to inappropriate inventory valuations,

unrealistic pricing, ineffective resource allocations, misplaced strategic focus, misidentified
CSFs, and lost competitive advantage
• The ABC system presents a more accurate measurement of product costs by
tracing overhead consumption.

LIMITATIONS OF VOLUME BASED COSTING ARE:

• It not relate to unique manufacturing characteristics in different operations.
• It only uses a common plant wide or departmental cost driver and ignores differences
in activities for different products or productions runs with in the plant.
• Employs a common activity volume of all products.
• It tends to under cost complex low-volume products and over cost high-volume
products
• It is sufficient when technology is stable, when the range of products is limited &
when the direct labor & material costs dominate product cost.

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• It perform very poor in reflecting supporting costs for manufacturing & distributing of
products & services.
• Volume-based costing is often inadequate because indirect costs do not always occur
in proportion to output volume
• Volume-based costing can create inappropriate incentives for managers
o e.g., more volume equates to more overhead expense

• Inaccurate cost information can lead to undesirable strategic results

o Wrong product-line decisions

o Unrealistic pricing

o Ineffective resource allocations

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