What is Activity Based Costing?
The activity-based costing (ABC) system is a method of accounting you can use to
find the total cost of activities necessary to make a product. The ABC system assigns
costs to each activity that goes into production. It is a costing method that identifies
activities in an organization and assigns the cost of each activity to all products and
services according to the actual consumption by each. The Institute of Cost &
Management Accountants of Bangladesh (ICMAB) defines activity-based costing as
an accounting method which identifies the activities which a firm performs and then
assigns indirect costs to cost objects.
ABC is used to improve the accuracy of cost analysis by improving the tracing of
costs to products or to individual customers. It is a system which focuses on activities
performed to produce product. In this system, first costs are traced to activities and
then to products, where as in traditional system, costs are first traced not to activities
but to an organisational unit, such as department or plant and then to products. In
ABC system, activity means a unit of work; here cost driver is a factor, such as the
level of activity or volume that affects costs. Cost drivers signify factors, forces or
events that determine the costs of activities. This system brings accuracy and
reliability in product cost determination by emphasizing on cause and effect
relationship in the cost incurrence.
Objectives of Activity Based Costing
The major objectives of Activity Based Costing are as follows-
To identify value added activities in transactions.
To focus high cost activities.
To distribute overheads on the basis of activities.
To identify the opportunities for improvements and reduction of
costs. To validate the success of the quality drive with ABC.
To ensure accurate product costing for decision making.
To use information to improve product mix and pricing decisions.
Steps in ABC System
For allocating/absorbing overheads to products/services under Activity-Based
Costing, the following steps are to be taken:
1. Identifying Activities: The first stage is to identify the functional areas or major
activities involved in the production. Examples of activities include machine
related activities, divert labour related activities and various support activities
like ordering, receiving, material handling, packing, despatching etc. Various
activities are identified
by carrying out activity analysis. The activities may be basically fall into four
categories as suggested by Cooper and Kaplan’.
a) Unit Level Activities or Primary Activities: The cost of primary activities
(like use of indirect materials and consumables, testing of every item
produced) may be correlated to number of units produced (i.e. on
volume-basis).
b) Batch Level Activities: These are manufacturing support activities (like
material ordering, machine set-up costs, inspection of products etc).
The cost of such activities is driven by number of batches of units
produced.
c) Product Level Activities: Activities like designing of the product, keeping
technical drawings of product, activities up to date, advertising of a
specific product are called product level. The cost of these activities is
driven by the creation of a new product line and its maintenance.
d) Facility Level Activities: Certain activities cannot be related to a particular
product, instead may be related to certain facilities like maintaining the
building, security of plant, salaries of production manager,
advertisement to promote organisation etc.
It may be noted that unit level activities and facility level activities are the
same as those in traditional absorption costing which will be allocated on
physical volume basis, ABC will be more useful if there is significant size of
batch level and product level activities.
2. Assigning Costs to Activity Cost Centres: The second stage requires that a cost
centre (also called a cost pool) be created for each activity. After the activities
have been identified the cost of resources consumed over a specified period
must be assigned to each activity. These costs will have to be apportioned on
some suitable basis. For example, the total costs of all set ups might
constitute one cost centre for all setup related costs.
3. Selecting Appropriate Cost Drivers: The third stage of designing ABC system is
to identify the factors that influence the cost of a particular activity. The term
cost-driver is used to describe the significant determinant of the cost of the
activity. The most suitable cost driver in each activity under functional areas
should be identified. A cost driver is any factor that influences costs.
4. Assigning the Cost of the Activities to Products: The final stage is to trace the
cost of the activities to products according to each product’s demand for these
activities using cost drivers as a measure of demand. A product’s demand for
the activities is measured by the number of transactions it generates for the
cost driver. The cost driver should be measurable in a way that enables it to
be identified with individual products.
Cost Driver
Activity based information may be non-financial but concerns activities across the
entire chain of value adding process and focuses the attention of managers on
activities that cause rather than the costs themselves. These activities are known as
cost drivers.
Cost drivers are used to describe the events or forces that are the significant
determination of the cost activities, e.g., production scheduling cost is generated by
the number of productions runs that each product generates. Thus, cost drivers are
factors that drive consumption of resources. Therefore, management of cost drivers
is essential to manage costs.
Cost Pools/Centres
A cost pool is a grouping of individual costs, typically by department or service centre.
Cost allocations are then made from the cost pool. For example, the cost of the
maintenance department is accumulated in a cost pool and then allocated to those
departments using its services.
Cost pools are commonly used for the allocation of factory overhead to units of
production, as required by several accounting frameworks. They are also used in
activity-based costing to allocate costs to activities. An activity cost pool is an
aggregate of all the costs associated with performing a particular business task, such
as making a particular product. By pooling all costs incurred in a particular task, it is
simpler to get an accurate estimate of the cost of that task. A business that wants to
allocate costs at a highly-refined level may choose to do so using a number of cost
pools.
What benefits does ABC provide?
Activity-based costing provides a more accurate method of product/service costing,
leading to more accurate pricing decisions. It increases understanding of overheads
and cost drivers; and makes costly and non-value adding activities more visible,
allowing managers to reduce or eliminate them. ABC enables effective challenge of
operating costs to find better ways of allocating and eliminating overheads. It also
enables improved product and customer profitability analysis. It supports
performance management techniques such as continuous improvement and
scorecards.
ABC has been accepted as very useful for product costing where production
overheads are high in relation to direct cost, where there is diversity in the product
range, where products consume different amount of overhead and where
consumption of overhead is not basically driven by their volume.
In brief following are main benefits of using ABC technique:
1. ABC helps to reduce costs by providing meaningful information for
cost-management. It helps in making the right decision.
2. ABC technique provides due importance to non-manufacturing cost which
constitute a substantial portion of total cost. Traditionally non-manufacturing
costs have been allocated under volume basis and thus, high volume
products have been overvalued.
3. ABC technique provides accurate and reliable cost information. This cost
information is essential for recent approaches in productivity improvement like
Total Quality Management (TQM) and Business Process Reengineering.
4. ABC enables the management in formulating an effective pricing policy while
fixing prices.
5. Cost of each activity is determined with the help of ABC. There is accuracy in
indirect cost-allocation to products. This technique is helpful in make or buys
decisions and transfer pricing.
Reasons for adopting Activity Based Costing System
The fundamental advantage of using an ABC system is to more precisely determine
how overhead is used. Once you have an ABC system, you can obtain better
information about the following issues:
Activity costs. ABC is designed to track the cost of activities, so you can use it
to see if activity costs are in line with industry standards. If not, ABC is an
excellent feedback tool for measuring the ongoing cost of specific services as
management focuses on cost reduction.
Customer profitability. Though most of the costs incurred for individual
customers are simply product costs, there is also an overhead component,
such as unusually high customer service levels, product return handling, and
cooperative marketing agreements. An ABC system can sort through these
additional overhead costs and help you determine which customers are
actually earning you a reasonable profit. This analysis may result in some
unprofitable customers being turned away, or more emphasis being placed on
those customers who are earning the company its largest profits.
Distribution cost. The typical company uses a variety of distribution channels to
sell its products, such as retail, Internet, distributors, and mail order
catalogues. Most of the structural cost of maintaining a distribution channel is
overhead, so if you can make a reasonable determination of which distribution
channels are using overhead, you can make decisions to alter how distribution
channels are used, or even to drop unprofitable channels.
Make or buy. ABC provides a comprehensive view of every cost associated with
the in-house manufacture of a product, so that you can see precisely which
costs will be eliminated if an item is outsourced, versus which costs will
remain.
Margins. With proper overhead allocation from an ABC system, you can
determine the margins of various products, product lines, and entire
subsidiaries. This can be quite useful for determining where to position
company resources to earn the largest margins.
Minimum price. Product pricing is really based on the price that the market will
bear, but the marketing manager should know what the cost of the product is,
in order to avoid selling a product that will lose a company money on every
sale. ABC is very good for determining which overhead costs should be
included in this minimum cost, depending upon the circumstances under
which products are being sold.
Production facility cost. It is usually quite easy to segregate overhead costs at
the plant-wide level, so you can compare the costs of production between
different facilities.
Clearly, there are many valuable uses for the information provided by an ABC
system. However, this information will only be available if you design the system to
provide the
specific set of data needed for each decision. If you install a generic ABC system and
then use it for the above decisions, you may find that it does not provide the
information that you need. Ultimately, the design of the system is determined by a
cost-benefit analysis of which decisions you want it to assist with, and whether the
cost of the system is worth the benefit of the resulting information.
Weakness of ABC System
Despite of various advantages, following are the weaknesses of adopting ABC system
1. It is based on historical costs; while for planning decisions future costs are
more relevant.
2. For many short-term decisions, identification of variable costs is very important.
But ABC system does not partition variable and fixed elements of overhead costs.
3. The accuracy of ABC system fully depends upon the quality of cost drivers. The
allocation and absorption of costs may become an arbitrary allocation process, if
the cost drivers are not associated with the factors causing costs.
4. ABC system tends to be more costly than the traditional methods of applying
costs to products.
Conclusion
Activity-based costing (ABC) is a costing method that identifies activities in an
organization and assigns the cost of each activity to all products and services
according to the actual consumption by each. ABC has attracted a considerable
amount of interest because it provides not only a basis for calculating more accurate
product cost but also a mechanism for managing overhead costs. By collecting and
reporting on the significant activities in which a business engages, it is possible to
understand and manage costs more effectively. It is the area of cost
management rather than product costing, where activity-based systems may have
their greatest potential.