ACTIVITY BASED COSTING

Introduction

A powerful tool for measuring performance, Activity-Based Costing (ABC) is used to

identify, describe, assign costs to, and reports on agency operations. A more accurate cost

management system than traditional cost accounting. ABC identifies opportunities to

improve business process effectiveness and efficiency by determining the ‘true’ cost of a

product or service.

ABC principles are used to focus management attention on the total cost to produce a

product or service, and as the basis for full cost recovery. Support services are

particularly suitable for activity-based resourcing because they produce identifiable and

measurable units of output.

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

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

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

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

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

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

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

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

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

that cause the cost-consuming activity.

1
In both traditional costing methods and ABC, the direct labor costs are allocated to each

project, product or service. So if a person has worked a certain number of hours in a

project, then the cost incurred by the company for that person for that much time is the

direct labor cost. This is a reasonably straightforward part if the company has accurate

records of who has worked in each project and for how many hours. The allocation of

utilities proves to be a bit more challenging. In the absence of a metering mechanism the

utilities are allocated to the different projects based on some factor like size, head count

and so on. But this creates a problem. Suppose there is a project that uses the telephone a

lot; the client is in another country and there is a daily teleconferencing. The team size of

the project is 3. So if the organization is using the team size as the allocation factor, this

project will be allocated only a portion of what it has spent by way of communication

expenses. This results in wrong cost information.

ABC does not allocate overheads based on one or two arbitrary methods such as team

size, project duration and so on that have little or no relationship to how a product or

project uses the overhead services. Instead, ABC systems identify how these resources

are consumed by each product or project and attach values according to this consumption

pattern.

Traditional Costing System

Traditional cost management systems often allocated service overhead costs to services

or departments primarily to distribute the overhead for financial reporting purposes. Costs

are attributed by a one step process (costs per services or customers) using simplistic

2
allocation methods often producing inaccurate and misleading information. In many

service institutions the distribution of overhead was seen to be unimportant or irrelevant.

 Direct labour hours

 Machine hours

 Provide little insight into the causes of variances

 Report information that is accounting-oriented, inaccurate, not flexible and not

timely.

 Are not easily understood by operational managers, since the focus is fiscal.

 Do not associate the cost of a product or service with the actual effort expended

ABC is not a replacement for traditional costing. Rather, it's supportive. (Kaplan, Robert

S. and Bruns, W. Accounting and Management: A Field Study Perspective, Pg. 141-143)

Limitations of Traditional Costing System

The problem with Traditional costing is that it can easily over allocate overhead to cost

objectives. Traditional costing is production volume driven so its would be easy but yet

inaccurate to assign the company’s production with more overhead than say at the

division within the same company that makes custom pies. Activity based costing

accounts for the multiple costs that go into making a product or service thus making

allocation of overhead more efficient and allowing managers to make better business

decisions.

ABC corrects for the limitations of traditional costing by identifying all the work

activities and their costs that go into manufacturing a product, delivering a service or

3
performing a process. When the individual costs are added up, a clear picture of the total

cost of a process comes into view. ABC can even distinguish the cost of servicing

different customers. The traditional cost management approach in which cost allocation is

based on labor hours, gallons, pounds or other units of output rarely reflects the true

cause-and-effect relationship between indirect and overhead costs and individual

products, services, channels or customers. ABC was developed as a practical solution for

problems associated with traditional cost management a technique that usually fails to

allocate costs correctly because:

 Too many of the costs are lumped together in some categories.

 The average rates selected for many costs tend to be excessively broad.

 Often irrelevant factors are used to allocate indirect costs. For example, should

product-inspection costs be spread among all products or only those products

being inspected

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

Perspective, Pg. 177-180)

Importance of Activity-Based Costing

ABC is a cost accounting methodology that can define processes, identify the cost drivers

of those processes, determine the unit costs of products and services, and create reports

on agency components that can be used to generate activity- or performance-based

budgets.

4
A major advantage of using ABC is that it avoids or minimizes distortions in product

costing that result from arbitrary allocations of indirect costs. Unlike more traditional line

item budgets, which can’t be tied to specific outputs, ABC generates useful information

on how money is spent, if a department is cost-effective, and how to benchmark

(compare oneself against others) for quality improvement.

Activity-Based Costing:

 Is a management tool that provides better allocation of resources

 Is applicable to both appropriations and revolving funds

 Relates total cost (resources consumed) to work accomplished (outputs

produced)

 Aligns costs to outputs, thereby increasing cost visibility

 Is useful in forecasting financial baselines

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

Companies, pg. 71-77)

The Unit Cost Formula

Activity-Based Costing uses cost drivers to assign the costs of resources to activities and

unit cost as a way of measuring an output. Unit cost is the "average total cost" of

producing one unit of output. It is calculated by dividing the total cost of production by

the total number of units of output produced.

5
For example, if an automobile manufacturer produces 50 vehicles for a total cost of

$1,250,000, then the cost-per-unit (vehicle) is $25,000.

Making clear connections between costs and outputs creates a truer financial picture.

Costs that are visible and explicit are essential to wise allocation of resources. Total cost

visibility takes into account all of the costs involved in producing and delivering a

product or service. For example, military personnel, paid from a separate military pay

appropriation account, were considered ‘free’ assets. If military labor is required in a

production process, the cost of military labor should be captured as part of the total cost

associated with that production process from the mechanic who repairs the vehicle to the

finance clerk who processes a travel voucher. These are direct labor hours expended in

order to meet a customer requirement. (Hicks, Douglas T. Activity-Based Costing:

Making it Work for Small and Mid-Sized Companies, pg. 82-84)

Activities of Activity Based Costing

1. Unit-level: For any given product, these costs change in a more-or-less linear fashion

with the number of units produced. For example, fabric and thread are unit-level costs for

an apparel manufacturer: if the company wants to double production, it will need twice as

much fabric and thread.

2. Batch-level: These costs change in a more-or-less linear fashion with the number of

batches run. Machine setup costs are often batch-level costs. The time required to prepare

a machine to run one batch of product is usually independent of the number of units in

6
the batch: the same time is required to prepare the machine to run a batch of 100 units as

a batch of 50 units. Hence, batch-level costs do not necessarily vary in a linear fashion

with the number of units produced.

3. Product-level: These costs are usually fixed and direct with respect to a given

product. An example is the salary of a product manager with responsibility for only one

product. The product manager’s salary is a fixed cost to the company for a wide range of

production volume levels. However, if the company drops the product entirely, the

product manager is no longer needed.

4. Customer Level: They are the non-manufacturing costs.

5. Organization Level: These costs are usually fixed and direct with respect to the

facility. An example is property taxes on the facility, or the salaries of front office

personnel such as the receptionist and office manager.

The Four Steps to ABC Implementation

1. Identify activities: Perform an in-depth analysis of the operating processes of

each responsibility segment. Each process may consist of one or more activities

required by outputs.

2. Assign resource costs to activities: This is sometimes called ‘tracing.’ Trace-

ability refers to tracing costs to cost objects to determine why costs were incurred.

Costs are categorized in three ways:

7
 a. Direct: Costs that can be traced directly to one output. Example: the

material costs (varnish, wood, paint) to build a chair.

b. Indirect: Costs that cannot be allocated to an individual output; in other

words, they benefit two or more outputs, but not all outputs. Examples:

maintenance costs for the saws that cut the wood, storage costs, other

construction materials, and quality assurance.)

c. General & Administrative: Costs that cannot reasonably be associated

with any particular product or service produced (overhead). These costs

would remain the same no matter what output the activity produced.

Examples: salaries of personnel in purchasing department, depreciation on

equipment, and plant security.

3. Identify outputs: Identify all of the outputs for which an activity segment

performs activities and consumes resources. Outputs can be products, services, or

customers (persons or entities to whom a federal agency is required to provide

goods or services).

4. Assign activity costs to outputs: Assign activity costs to outputs using activity

drivers. Activity drivers assign activity costs to outputs based on individual

outputs’ consumption or demand for activities. For example, a driver may be the

number of times an activity is performed (transaction driver) or the length of time

an activity is performed (duration driver).

Activity-Based Costing encourages managers to identify, which activities are value-

added; those that will best accomplish a mission, deliver a service, or meet a customer

demand. It improves operational efficiency and enhances decision-making through better,

8
more meaningful cost information. (Henricks, Mark. "Beneath the Surface."

Entrepreneur, Pg. 111-117)

Activity Based Costing within the Manufacturing Industry

Over time, as manufacturers received more pressure from customers and competitors,

manufacturing overhead costs continued to increase often without a corresponding

increase in machine hours. For example, a customer might demand that its products be

shipped in unique batches. While this requires additional costs in the factory for special

scheduling and handling, it does not require any additional machine hours or direct labor

hours. Under traditional cost accounting the effect of this is an increase in the overhead

rate per productive machine hour (or direct labor hour). Since this higher rate will be

applied via all of the machine hours, all of the products manufactured in the factory will

be allocated more manufacturing overhead. In other words, the additional scheduling and

handling costs caused by a specific customer will be spread or assigned to all of the

products manufactured via the higher overhead rate per machine hour or direct labor

hour.

In contrast to the above situation, assume that a company manufactures a few items that

are produced in huge quantities, but require very little special attention in the factory.

These easy-to-produce items will generate large amounts of machine hours but will cause

proportionately less manufacturing overhead costs. Under traditional costing this will

have three effects:

9
 1. The overall manufacturing overhead rate per machine hour is less because of the

large amount of machine hours

2. There will be a large amount of manufacturing overhead being assigned to these

large-volume, easy-to-produce products, even though these products are not

causing much additional overhead

3. The other products will be assigned less manufacturing overhead from the lower

overhead rate, even though the other products are not causing any less overhead

than before.

An unfortunate consequence is that a competitor might offer to manufacture your

customer’s easy-to-produce items at a lower price, because the competitor knows that the

cost is less than what your company has computed and assigned to them. If your

company loses these high-volume, easy-to-produce items, you will have a significant

problem. Think of what might happen to the overhead rate if a significant number of

machine hours disappears and only a few overhead costs disappear: all remaining

products will be assigned more overhead dollars through the resulting higher overhead

rate.

In the 1980s, companies worked to find a costing method that would eliminate product

cost distortions caused by allocating manufacturing overhead costs solely on the basis of

machine hours. Manufacturers concluded that activities generated overhead costs and

there were many more activities involved in manufacturing than just production machine

hours. Some of the other activities included such things as setting up the production

machines; procurement and handling of materials; developing new products and new

10
processes in the factory; making engineering changes to existing products; and

scheduling. An improvement to the traditional methods of allocation would be

1. To define the activities that cause company resources to be used up

2. To measure the costs of those activities

3. To assign the costs of the activities to those products and customers those were

actually requiring the activities.

This process became known as activity based costing or ABC. A technique for allocating

costs to a product, service, customer, etc. The premise is that activities cause an

organization to incur costs. Once the cost of the activities have been identified and each

activity's cost has been determined, the cost of the activities is then allocated to the

product, service, customer, etc. that required the activity. This technique is more logical

for allocating overhead than simply allocating costs based on machine hours or direct

labor hours. (Chutchain-Ferranti, Joyce. "Activity-Based Costing." Computerworld.

August 1999, Pg. 211-219)

11
CONCLUSION

Activity-based costing is a high-powered decision support tool that is well within the

means of small and mid-sized manufacturers. The key to its effective use is to understand

that it is a concept, not a system. Although large manufacturers may need complex and

costly systems to benefit from the concept due to the disadvantages of largeness, the

small and mid-sized manufacturer can gain the same benefits by exploiting the

advantages of smallness and using ‘ABC’ to create an economic model of the

organization that will provide the accurate and relevant cost information it needs to

support critical management decisions of all types.

12
REFERENCES

 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 "Article title?" Journal of

Bank Cost and Management Accounting (Volume 3, Number 2), 1990.

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

1999.

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

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

Sized Companies. 1998.

13