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. Therefore, this model assigns more indirect costs (overhead)
into direct costs compared to conventional costing.
The UK's Chartered Institute of Management Accountants (CIMA),
defines ABC as an approach to the costing and monitoring of
activities which involves tracing resource consumption and costing
final outputs. Resources are assigned to activities, and activities to
cost objects based on consumption estimates. The latter utilize cost
drivers to attach activity costs to outputs. [1]
The Institute of Cost Accountants of India says, ABC systems
calculate the costs of individual activities and assign costs to cost
objects such as products and services on the basis of the activities
undertaken to produce each product or services. It accurately
identifies sources of profit and loss.[2]
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. [3]

Objectives
With ABC, a company can soundly estimate the cost elements of
entire products, activities and services, that may help inform a
company's decision to either:
 Identify and eliminate those products and services that are
unprofitable and lower the prices of those that are overpriced
(product and service portfolio aim), or
 Identify and eliminate production or service processes which are
ineffective, and allocate processing concepts that lead to the very
same product at a better yield (process re-engineering aim)
In a business organization, the ABC methodology assigns an
organization's resource costs through activities to
the products and services provided to its customers. ABC is
generally used as a tool for understanding product and customer
cost and profitability based on the production or performing
processes. As such, ABC has predominantly been used to support
strategic decisions such as pricing, outsourcing, identification and
measurement of process improvement initiatives.
Prevalence
Following strong initial uptake, ABC lost ground in the 1990s
compared to alternative metrics, such as Kaplan's balanced
scorecard and economic value added. An independent 2008 report
concluded that manually driven ABC was an inefficient use of
resources: it was expensive and difficult to implement for small
gains, and a poor value, and that alternative methods should be
used.[4] Other reports show the broad band covered with the ABC
methodology.[5]
However, application of an activity based recording may be applied
as an addition to activity based accounting, not as a replacement
of any costing model, but to transform concurrent process
accounting into a more authentic approach.
Historical development
Traditionally, cost accountants had arbitrarily added a broad
percentage of analysis into the indirect cost. In addition, activities
include actions that are performed both by people and machine.
However, as the percentages of indirect or overhead costs rose, this
technique became increasingly inaccurate, because indirect costs
were not caused equally by all products. For example, one product
might take more time in one expensive machine than another
product—but since the amount of direct labor and materials might
be the same, additional cost for use of the machine is not being
recognized when the same broad 'on-cost' percentage is added to
all products. Consequently, when multiple products share common
costs, there is a danger of one product subsidizing another.
ABC is based on George Staubus' Activity Costing and Input-Output
Accounting.[6] 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.[7]
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.
Instead of using broad arbitrary percentages to allocate costs, ABC
seeks to identify cause and effect relationships to objectively assign
costs. Once costs of the activities have been identified, the cost of
each activity is attributed to each product to the extent that the
product uses the activity. In this way, ABC often identifies areas of
high overhead costs per unit and so directs attention to finding ways
to reduce the costs or to charge more for more costly products.
Activity-based costing was first clearly defined in 1987 by Robert S.
Kaplan and William J. Bruns as a chapter in their book Accounting
and Management: A Field Study Perspective.[8] 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 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. [9]
[10]

Activity-based costing was later explained in 1999 by Peter F.

Drucker in the book Management Challenges of the 21st Century.
[11]
He states that traditional cost accounting focuses on what it costs
to do something, for example, to cut a screw thread; activity-based
costing also records the cost of not doing, such as the cost of
waiting for a needed part. Activity-based costing records the costs
that traditional cost accounting does not do.
The overhead costs assigned to each activity comprise an activity
cost pool.
From a historical perspective the practices systematized by ABC
were first demonstrated by Frederick W. Taylor in Principles of
Scientific Management in 1911 (1911. Taylor, Frederick Winslow
(1919) [1911]. The Principles of Scientific Management. Harper &
 Brothers – via Internet Archive (Prelinger Library) Free access icon.
LCCN 11-10339; OCLC 233134 (all editions). The Principles of
Scientific Management – via Project Gutenberg Free access icon.).
Those were the basis of the famous time and motion studies (Time
and motion study) that predated the later work by Walter Shewhart
(Walter A. Shewhart) and W Edwards Deming (W. Edwards Deming).
Kaplan's work tied the earlier work to the modern practice of
accounting.
Alternatives
Main article: Management accounting
Lean accounting methods have been developed in recent years to
provide relevant and thorough accounting, control, and
measurement systems without the complex and costly methods of
manually driven ABC.
Lean accounting is primarily used within lean manufacturing. The
approach has proven useful in many service industry areas including
healthcare, construction, financial services, governments, and other
industries.
Application of Theory of constraints (TOC) is analysed in a
study[12] showing interesting aspects of productive coexistence of
TOC and ABC application. Identifying cost drivers in ABC is described
as somewhat equivalent to identifying bottlenecks in TOC. However
the more thorough insight into cost composition for the inspected
processes justifies the study result: ABC may deliver a better
structured analysis in respect to complex processes, and this is no
surprise regarding the necessarily spent effort for detailed ABC
reporting.

Methodology
Methodology of ABC focuses on cost allocation in operational
management. ABC helps to segregate
 Fixed cost
 Variable cost
 Overhead cost
If achieved, the split of cost helps to identify cost drivers. Direct
labour 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) take at the counter and then by measuring the number of
each type of transaction. For the activity of running machinery, the
driver is likely to be machine operating hours, looking at labor,
maintenance, and power cost during the period of machinery
activity.

Application
ABC has proven its applicability beyond academic discussion. [citation
needed]

ABC
 is applicable throughout company financing, costing and accounting.
 is a modeling process applicable for full scope as well as for partial
views.
 helps to identify inefficient products, departments and activities.
 helps to allocate more resources on profitable products,
departments and activities.
 helps to control the costs at any per-product level and on a
departmental level.
 helps to find unnecessary costs that may be eliminated.
 helps fixing the price of a product or service with any desired
analytical resolution.
A report summarizes reasons for implementing ABC as mere
unspecific and mainly for case study purposes [13] (in alphabetical
order):
 Better Management
 Budgeting, performance measurement
 Calculating costs more accurately
 Ensuring product /customer profitability
 Evaluating and justifying investments in new technologies
 Improving product quality via better product and process design
 Increasing competitiveness or coping with more competition
 Management
 Managing costs
 Providing behavioral incentives by creating cost consciousness
among employees
 Responding to an increase in overheads
 Responding to increased pressure from regulators
 Supporting other management innovations such as TQM and JIT
systems
Beyond such selective application of the concept, ABC may be
extended to accounting, hence proliferating a full scope of cost
generation in departments or along product manufacturing. Such
extension, however requires a degree of automatic data capture
that prevents from cost increase in administering costs.

Implementation
According to Manivannan Senthil Velmurugan, Activity-based costing
must be implemented in the following ways:[14]
1. Identify and assess ABC needs - Determine viability of ABC method
within an organization.
2. Training requirements - Basic training for all employees and
workshop sessions for senior managers.
3. Define the project scope - Evaluate mission and objectives for the
project.
4. Identify activities and drivers - Determine what drives what activity.
5. Create a cost and operational flow diagram – How resources and
activities are related to products and services.
6. Collect data – Collecting data where the diagram shows operational
relationship.
7. Build a software model, validate and reconcile.
8. Interpret results and prepare management reports.
9. Integrate data collection and reporting.
Public sector usage
When ABC is reportedly used in the public administration sector, the
reported studies do not provide evidence about the success of
methodology beyond justification of budgeting practise and
existing service management and strategies.
Usage in the US Marine Corps started in 1999.[15][16][17][18]
Use of ABC by the UK Police has been mandated since the 2003-
04 UK tax year as part of England and Wales' National Policing Plan,
specifically the Policing Performance Assessment Framework. [19]

Integrating EVA and process based costing

Recently, Mocciaro Li Destri, Picone & Minà (2012) [20] proposed a
performance and cost measurement system that integrates
the economic value added (EVA) criteria with process based costing
(PBC).
Authors note that activity-based costing system is introspective and
focuses on a level of analysis which is too low. [citation needed] On the
other hand, they underscore the importance to consider the cost of
capital in order to bring strategy back into performance measures.
[citation needed]

Limitations
Applicability of ABC is bound to cost of required data capture. [1] That
drives the prevalence to slow processes in services and
administrations, where staff time consumed per task defines a
dominant portion of cost. Hence the reported application for
production tasks do not appear as a favorized scenario.
Treating fixed costs as variable
The potential problem with ABC, like other cost allocation
approaches, is that it essentially treats fixed costs as if they were
variable. This can, without proper understanding, give some people
an inaccurate understanding which can then lead to poor decision
making. For example, allocating PPE to individual products, may
lead to discontinuation of products that seem unprofitable after the
allocation, even if in fact their discontinuation will negatively affect
the bottom line.
Tracing costs
Even in ABC, 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.
Transition to automated activity-based costing accounting
The prerequisite for lesser cost in performing ABC is automating the
data capture with an accounting extension that leads to the desired
ABC model. Known approaches for event based accounting simply
show the method for automation. Any transition of a current process
 from one stage to the next may be detected as a relevant event.
Paired events easily form the respective activity.
The state of the art approach with authentication and authorization
in IETF standard RADIUS gives an easy solution for accounting all
workposition based activities. That simply defines the extension of
the Authentication and Authorization (AA) concept to a more
advanced AA and Accounting (AAA) concept. Respective approaches
for AAA get defined and staffed in the context of mobile services,
when using smart phones as e.a. intelligent agents or smart agents
for automated capture of accounting data .

References
External links
 Who Wins in a Dynamic World: Theory of Constraints Vs. Activity-
Based Costing? article on SSRN
 proposed International Good Practice Guidance on Costing to Drive
Organizational Performance - International Federation of
Accountants

In budgeting, and management accounting in general, a variance is

the difference between a budgeted, planned, or standard cost and
the actual amount incurred/sold. Variances can be computed for
both costs and revenues.
The concept of variance is intrinsically connected with planned and
actual results and effects of the difference between those two on
the performance of the entity or company.

Types of variances
Variances can be divided according to their effect or nature of the
underlying amounts.
When effect of variance is concerned, there are two types of
variances:
 When actual results are better than expected results given variance
is described as favorable variance. In common use favorable
variance is denoted by the letter F—usually in parentheses (F).
 When actual results are worse than expected results given variance
is described as adverse variance, or unfavourable variance. In
common use adverse variance is denoted by the letter U or the
letter A—usually in parentheses (A).
The second typology (according to the nature of the underlying
amount) is determined by the needs of users of the variance
information and may include e.g.:
 Variable cost variances
o Direct material variances
o Direct labour variances
o Variable production overhead variances
 Fixed production overhead variances
 Sales variances

Variance analysis
See also: Budget analyst and Cost analyst
Variance analysis, in budgeting or management accounting in
general, is a tool of budgetary control and performance evaluation,
assessing any variances between the budgeted, planned,
or standard amount, and the actual amount realized. Variance
analysis can be carried out for both costs and revenues.
Variance analysis is usually associated with explaining the
difference (or variance) between actual costs and the standard costs
allowed for the good output. For example, the difference in
materials costs can be divided into a materials price variance and a
materials usage variance. The difference between the actual direct
labor costs and the standard direct labor costs can be divided into a
rate variance and an efficiency variance. The difference in
manufacturing overhead can be divided into spending, efficiency,
and volume variances. Mix and yield variances can also be
calculated.
Variance analysis helps management to understand the present
costs and then to control future costs. Variance calculation should
always be calculated by taking the planned or budgeted amount and
subtracting the actual/forecasted value. Thus a positive number is
favorable and a negative number is unfavorable.

See also
 Budgeting
 Non-profit organization
 Standard budget
 Flexible budget
 Rolling budget
 Activity-based budgeting (ABB)
 Controllable items
 Non-controllable items
 Standards
 Motivation
 Performance evaluation
 Direct material total variance
 Direct material price variance
 Direct material usage variance

Cost–volume–profit (CVP), in managerial economics, is a form

of cost accounting. It is a simplified model, useful for elementary
instruction and for short-run decisions.

Overview
A critical part of CVP analysis is the point where total revenues
equal total costs (both fixed and variable costs). At this break-even
point, a company will experience no income or loss. This break-even
point can be an initial examination that precedes a more detailed
CVP analysis.
CVP analysis employs the same basic assumptions as in breakeven
analysis. The assumptions underlying CVP analysis are:
 The behavior of both costs and revenues is linear throughout the
relevant range of activity. (This assumption precludes the concept of
volume discounts on either purchased materials or sales.)
 Costs can be classified accurately as either fixed or variable.
 Changes in activity are the only factors that affect costs.
 All units produced are sold (there is no ending finished goods
inventory).
 When a company sells more than one type of product, the product
mix (the ratio of each product to total sales) will remain constant.
The components of CVP analysis are:
 Level or volume of activity.
 Unit selling prices
 Variable cost per unit
 Total fixed costs
 Manpower Cost Direct and indirect

Assumptions
CVP assumes the following:
 Constant sales price;
 Constant variable cost per unit;
 Constant total fixed cost;
 Units sold equal units produced.
These are simplifying, largely linearizing assumptions, which are
often implicitly assumed in elementary discussions of costs and
profits. In more advanced treatments and practice, costs and
revenue are nonlinear, and the analysis is more complicated, but
the intuition afforded by linear CVP remains basic and useful.
One of the main methods of calculating CVP is profit–volume ratio,
which is (contribution /sales)*100 = this gives us profit–volume
ratio.
 Contribution stands for sales minus variable costs.
Therefore, it gives us the profit added per unit of variable costs.

Model
Basic graph
The assumptions of the CVP model yield the following linear
equations for total costs and total revenue (sales):
Total costs = fixed costs + (unit variable cost × number of
units)
Total revenue = sales price × number of unit
These are linear because of the assumptions of constant costs and
prices, and there is no distinction between units produced and units
sold, as these are assumed to be equal. Note that when such a chart
is drawn, the linear CVP model is assumed, often implicitly.
In symbols:
 where
 TC = Total costs
 TFC = Total fixed costs
 V = Unit variable cost (variable cost per unit)
 X = Number of units
 TR = S = Total revenue = Sales
 P = (Unit) sales price
Profit is computed as TR-TC; it is a profit if positive, a loss if
negative.
Break down
Costs and sales can be broken down, which provide further insight
into operations.
One can decompose total costs as fixed costs plus variable costs:

Following a matching principle of matching a portion of sales against

variable costs, one can decompose sales as contribution plus
variable costs, where contribution is "what's left after deducting
variable costs". One can think of contribution as "the marginal
contribution of a unit to the profit", or "contribution towards
offsetting fixed costs".
In symbols:

where
 C = Unit Contribution (Margin)
Subtracting variable costs from both costs and sales yields the
simplified diagram and equation for profit and loss.
In symbols:
 Diagram relating all quantities in CVP.
These diagrams can be related by a rather busy diagram, which
demonstrates how if one subtracts variable costs, the sales and total
costs lines shift down to become the contribution and fixed costs
lines. Note that the profit and loss for any given number of unit sales
is the same, and in particular the break-even point is the same,
whether one computes by sales = total costs or as contribution =
fixed costs. Mathematically, the contribution graph is obtained from

the sales graph by a shear, to be precise , where V are unit

variable costs.

Applications
CVP simplifies the computation of breakeven in break-even analysis,
and more generally allows simple computation of target income
sales. It simplifies analysis of short run trade-offs in operational
decisions.

Limitations
CVP is a short run, marginal analysis: it assumes that unit variable
costs and unit revenues are constant, which is appropriate for small
deviations from current production and sales, and assumes a neat
division between fixed costs and variable costs, though in the long
run all costs are variable. For longer-term analysis that considers the
entire life-cycle of a product, one therefore often prefers activity-
based costing or throughput accounting.[1]
When we analyze CVP is where we demonstrate the point at which
in a firm there will be no profit nor loss means that firm works in
breakeven situation
1. Segregation of total costs into its fixed and variable components
is always a daunting task to do.
 2. Fixed costs are unlikely to stay constant as output increases
beyond a certain range of activity.
3. The analysis is restricted to the relevant range specified and
beyond that the results can become unreliable.
4. Aside from volume, other elements like inflation, efficiency,
capacity and technology impact on costs.
5. Impractical to assume sales mix remain constant since this
depends on the changing demand levels.
6. The assumption of linear property of total cost and total revenue
relies on the assumption that unit variable cost and selling price are
always constant. In real life it is valid within relevant range or period
and likely to change.[2]

See also
 Contribution margin
 CVP analysis

Notes