Activity Based Costing

Activity Based Costing

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. Activity Based Costing (ABC) is actually a method for developing cost estimates in which the project is subdivided into discrete, quantifiable activities or a work unit. The activity must be definable where productivity can be measured in units (e.g., number of samples versus man-hours). After the project is broken into its activities, a cost estimate is prepared for each activity. These individual cost estimates will contain all labour, materials, equipment, and subcontracting costs, including overhead, for each activity. Each complete individual estimate is added to the others to obtain an overall estimate. Contingency and escalation can be calculated for each activity or after all the activities have been summed. ABC is a powerful tool, but it is not appropriate for all cost estimates. In this way an organization can establish the true 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.

Objectives of Activity Based Costing: The primary of objective of ABC systems are as follows: 1) To improve the accuracy of product costs by carefully changing the type and number of factors used to assign costs
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Methodology
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 attributed 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.

Activity Based Costing Definition

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ABC can be defined by the following equation: C/A = HD + M + E + S where C/A = Estimated cost per activity H = Number of labour hours required to perform the activity one time D = Wages per labour hour M = Material costs required to perform the activity one time E = Equipment costs to perform the activity one time S = Subcontracting costs to perform the activity one time

Limitations
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Even in activity-based costing, some overhead costs are difficult to assign to products and customers, for example 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.

Use of Activity Based Costing Methodology

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ABC methodology is used when a project can be divided into defined activities. These activities are at the lowest function level of a project at which costs are

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tracked and performance is evaluated. Depending on the project organization, the activity may coincide with an element of the work breakdown structure (WBS) or may combine one or more elements of the WBS. However, the activities must be defined so there is no overlap between them. After the activity is defined, the unit of work is established. All costs for the activity are estimated using the unit of work. The estimates for the units of work can be done by performing detailed estimates, using cost estimating relationships, obtaining outside quotes for equipment, etc. All costs including overhead, profit, and mark-ups should be included in the activity cost. It helps to identify inefficient product, department and activity It helps to allocate more resources on profitable product, department and activity It helps to control the cost at individual level and on departmental level It helps to find unnecessary costs

Identification of Activities
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When defining an individual activity, the cost estimator must balance the need for accuracy with the amount of time available to prepare the estimate. An estimator may be able to develop an extremely accurate cost estimate by defining smaller and smaller activities; however, the amount of time required to prepare ABC estimates for each of these activities may not justify the increased accuracy. The total estimated project cost may be sufficiently accurate if 10 activities are used instead of 15. On the other hand, reliable cost information may not be accessible if the activity categories are too general. Since the activity is the basis for the estimate, it is very important that the activity be selected correctly.

Application of activity based costing

ABC can be a useful cost estimating tool for nonconventional and construction projects. However, there are some activities that are more appropriately estimated using other cost estimating techniques. For example, site security may always be required at some facilities regardless of the number of employees at the facility or work being conducted at the facility. ABC estimating is especially useful in instances where the number of activities is uncertain or may change during the estimate process.