Activity-Based Costing (ABC)

Understanding What Really Drives Costs

Activity-Based Costing (ABC) - Understanding What Really Drives Costs

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There are many benefits to an Activity-Based Costing system.

Whether you manage an organization, a department, or a project, one of your principal objectives is to be as profitable as you can. To accomplish this, you'll probably seek to minimize your costs and other outgoings.

In practice, you may be able to contain your direct costs by keeping tight control of your supplies, or by using your labor hours very efficiently. But you'll also need to take into consideration the indirect costs that are shared across the company. For example, how do you track the cost of shared overhead expenses like customer service, maintenance, or insurance?

The full cost to build a specific product, run a specific project, or even manage a specific department includes all of the direct costs associated with it – plus a fair share of other indirect costs. However, the idea of what's "fair" isn't always clear. In this article you'll learn about a model for overhead costing – Activity-Based Costing – that calculates the true, "fair" costs.

The "Real" Costs

Let's imagine you manage a computer repair company. Some jobs you carry out may require you to run and maintain expensive equipment, while others may not. Therefore, you may end up assigning expenses like maintenance and depreciation "unfairly" if you apply these costs evenly, or average them, across all the jobs you do.

In reality, even though two jobs may take the same number of direct labor hours, the other costs involved will be different. For the bottom line, this means that some jobs are more profitable than others. However, if you only take labor hours into consideration, you might not see that difference.

Traditional accounting systems address the issue of "fair share" product costing by using an overhead rate to assign indirect costs. This overhead rate is reset periodically, and it's applied consistently to the various cost centers (which may be specific products or activities within the organization). Variables such as the amount of space occupied, the number of staff, or the quantity of material used are common bases of cost allocation.

For example, let's say you have three sales offices. The European office accounts for 42 percent of revenue, the office in Asia generates 37 percent, and the North American office provides the remaining 21 percent. You use sales volume as your overhead rate to spread the costs associated with customer service, marketing, and human resources.

The problem with bases like these is that, at the individual product or service level, some items are allocated too much cost, and some are allocated too little. In the 1980s, with the shift from labor-intensive to capital-intensive operations, these inaccuracies became more significant. This led to product lines being continued when, in reality, they were unprofitable; and to product lines being cut when they made a positive contribution to the bottom line.

As a result, Robert Kaplan of Harvard Business School developed a costing process to address the true cost implications for different products and services – rather than using simple averages, which may hide those true costs. He called his process Activity-Based Costing (ABC).

See Words Used In... Financial Accounting for a more detailed discussion of costs and expenses.

Activity-Based Costing

ABC isn't dramatically different from traditional overhead costing, because it also allocates indirect costs to various cost centers. However, ABC identifies many more cost "activities" to use in the overall process of assigning those costs.

Let's explain that with an example: In a traditional system, engineering support might be one cost center. With the ABC model, engineering support could be divided into various activities, such as equipment layout, process improvement, and new equipment purchasing.

By identifying more of these cost activities, ABC turns many indirect overhead costs into direct costs. This is done using cost drivers. A cost driver is something that causes an expense to occur. For example, when a manufacturing plant switches products on the line, or when an order is processed, or when engineering is asked to make a design change – these are all drivers of cost. These cost drivers can then be valued. By determining how much each product, project, or department uses, you can more accurately determine the costs associated with each.

ABC uses the number of transactions as the basis for allocating costs associated with each cost driver. Let's consider again our example of the three sales offices. If 42 percent of the calls to customer service were about the North American team, then you would assign 42 percent of the costs associated with operating the customer service phone line to the North American office. You might also learn that the North American office generated only 22 percent of the service requests that needed special handling by a customer service supervisor. You would therefore assign the costs associated with that specific cost driver accordingly – i.e. 22 percent.

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An Activity-Based Costing system provides a much more detailed view of the actual costs associated with a particular product or service. However, do bear in mind that it can be expensive to set up and maintain an ABC system. Your decision to introduce it would depend on the complexity and nature of your operations, and you would have to consider whether having a very detailed description of costs might or might not be worth the extra work.

There are four main steps for creating an ABC System:

  1. Identify the key activities performed within the operation, and the associated cost drivers.
  2. Create a process map to show the flow of activities within the operation, how resources are used, and how these relate to one another.
  3. Using accounting records and other methods, collect usage data for each of the cost drivers.
  4. Complete the ABC calculations, and analyze the cost information so you can identify opportunities for improvement.

One of the drawbacks of ABC is that it's a complicated and labor-intensive system to create and maintain, and the high level of detail can be confusing and frustrating. ABC has therefore decreased in popularity since it was first introduced. In 2004, Kaplan and Steven Anderson – founder and chairman of Texas-based software firm Acorn Systems – introduced a simpler process called "Time-Driven ABC." Here, managers estimate how many resources each product or service will need. Then they assign an amount for what it costs to provide that resource. It takes less time to gather this information, and it's easier to update as operations change. To read Kaplan and Anderson's overview of this new approach, see Rethinking Activity-Based Costing.

Activity-Based Management

Companies with ABC models have generally found the process to be very useful, however. That's because when you make the decision to set up an ABC system, you also create an opportunity to take a detailed look at what's truly driving costs within the business. It can also help you identify areas of wastage and inefficiency.

For example, if it costs $25 to process an order, and the revenue generated by that order is $20, then something is very wrong. You might not be able to figure that out with traditional cost allocation – especially if you have two different product lines: one with a higher average order amount than the other. When you do too much cost averaging, the results risk becoming more and more meaningless.

ABC, therefore, is useful for process analysis and continuous improvement initiatives. That's what Activity-Based Management (ABM) is all about. ABM uses the fundamentals of Activity-Based Costing, and looks at how to perform tasks more efficiently. It shows what an organization is doing right and wrong, and it looks at how that information can be used to create more value within the business.

Total Quality Management and process reengineering are similar processes that use the principle of identifying and improving activities that add value – and eliminating activities that don't.

Key Points

There are many benefits to an Activity-Based Costing system. Rather than assign overhead costs in large amounts that are averaged across the company, it assigns more costs directly to a particular product or service. These items can then be managed more effectively. This more accurate costing system provides more opportunities for managers to identify ways to improve value and profitability.

ABC is a complex process that needs a great deal of preparation and investigation, but the end result is a cost system that's very accurate. Simply starting to look at cost drivers and related activities – and learning what is, and is not, profitable – can be very beneficial to the business.