Activity Based Costing

Activity Based Costing (ABC) is the division of total production process into activities and then assigning the costs on those products based on the rate of production use of these activities into making the product. Among the top companies that have been using the ABC analysis includes the American Express, Dell and Coca-cola. Such companies focus on activities as the fundamental object costs. These companies’ traces direct materials and labor to the cost object. Companies using Activity Based Costing will notice the difference as compared to the use of traditional method in that the traditional way puts effort in allocating indirect costs, for example manufacturing overheads, to the customers, products or services that cause such costs.

This is done through estimation of indirect cost on each activity, allocating the indirect costs based on the causes.

Development of Activity Based Costing System

Activity Based Costing occurs in the following steps:

  1. Identifying each activity
  2. Estimate the total indirect cost for each activity
  3. Establish the allocation base for each activity’s’ indirect cost (usually the cost driver)
  4. Estimate the totals quantity for each of the allocation base
  5. Calculate each activity’s cost allocation rate
  6. Rate of cost calculation for activity= Estimated total indirect cost of the activity / Estimated total quality of allocation base
  7. Obtain actual quantity of each base of allocation used by the cost objective
  8. Allocate indirect costs to the cost objective

Allocated activity cost=cost allocation rate for each activity X actual quantity of cost allocation used by cost objective

In this part, we shall have an in-depth of the first three stages of the Activity Based Costing development.

The first stage of ABC is finding out key activities that utilizes resources, which gives rise to overheads. These key activities include planning, purchasing, marketing, quality and testing, maintenance among other broad headings.

Specific jobs that need to be carried out on daily or weekly basis may need to be defined in full details. For example, in a Purchasing department, there may be several activities being undertaken by different staff members; sending out orders, checking of delivery notes, receiving of quotations, may also be measured.

Observation, conducting of interviews, reviewing job specifications and distribution of questionnaires to the workers can help in identifying specific tasks/undertakings.

The second stage is the measuring of costs. Once key activities have been identified, the next step would be to measure the costs associated to the specific activities. This information is mostly within the company’s system of accounting.

The accounting systems, nevertheless, are designed to show departmental costs rather than activities within the respective departments. If that’s the case, the accounts system may need to be redesigned, to provide costs for specific activities and tasks.

The third stage is identifying the cost driver these are wide range of factors, among them inflation. Cost driver is a term reserved to describe factors reflecting the work volume carried out in a given department or activity. These cost drivers should be accurate and in addition easy to measure.

Measuring the number of transactions undertaken is a common drive on cost e.g. number of delivery, notes, invoices, cheque and orders.

Some of the questions that would help in identifying the cost drives include;

  • What are the services provided by the activity?
  • Who are the recipients of the services?
  • What determines the staff number for the activity?
  • What types of events necessitate overtime
  • Are there cases when the activity accommodates idle periods?

In most cases, more than one cost driver is available. In this situation, the one having more direct casual relationship with the work level should be preferred for selection. Cost drivers in at this stage are also known as activity cost drivers. The drivers are classified into 3 as discussed below.

Types of activity cost drivers

  • Transaction drivers
  • Duration drivers
  • Intensity drivers

Transaction drivers

These includes the number of invoices, delivery notes, checks etc. the transaction drivers are least expensive compared to cost drivers, but also likely to be less accurate because they assume the same amount of resources is required each time an activity is performed.

Nevertheless, if the difference in amount of resources required by each cost object is not a great transaction driver will give reasonably accurate measurements of activity and the resources consumed. If the condition doesn’t apply, duration cost should then be used.

Duration drivers

These represent the amount of time required for an activity to be performed. Examples of duration drivers include inspection hours and set-up hours. For example, if now product needs a shot set-up time while another one require long time, then using set-up time as cost drivers would be more accurate as compared to the use of transaction drivers which assume that equal activity resources are consumed by both parties.

Intensity drivers

The drivers’ accounts for the resources used each time an activity is performed. Whereas the duration drivers establishes average hourly rates for an activity performance, intensity drivers are used In direct charging based on the actual resources committed to the product.

For example, if there are activities that require both skilled and unskilled personnel, a duration driver would be opted to provide the rate of hours for the projects while intensity driver would be used to record estimated or actual time for each type of personnel and assign specific resources directly to the products.

Differences between Traditional and Activity Based Costing System

Traditional costing system

  1. Low level of competition
  2. Non-volume related costs that are low proportion of the total indirect costs
  3. Fairly standardized product range, all consuming organization resources in a similar way
  4. The system allocates indirect costs to the cost centers (normally the departments)
  5. The costing is unable to calculate time cost of products since it uses overhead pool that arbitrary calculated as expenses e.g. salary

Activity Based Costing System

  1. Intensive competition
  2. Non-volume related costs that are high proportion of total indirect cost
  3. A diverse range of products, all consuming resources in different proportions
  4. The system allocates indirect costs to cost centers based on activities rather than departments
  5. Is more accurate and preferred to calculate the cost of product since the method is more cost assigning

Pros and Cons of Activity Based Costing System

Pros

  1. Activity Based Costing recognizes the fact that overheads are caused by activities; not products
  2. The system is more accurate on product costs
  3. The Activity Based costing provides a base for sub-contracting and outsourcing decisions
  4. Provides useful non-financial information and ratio
  5. Can be easily implemented by each department
  6. Can help in reducing overheads through identifying causes and responsibility for cost

Cons

  • Time consuming
  • Expensive
  • Complex
  • Creates attention away from quality of the finished products
  • It’s often impossible to choose the best cost driver

Activity Based Costing system should only be used where the cost drivers and activities have clearly been illustrated. Alternatively, Activity Based Costing can be used to reduce cost or money value rather than being used for costing products.

Activity-Based Costing in decision making

Activity-based management; shortened ABM uses ABC to make decisions that leads to increase in profits by satisfying the customers.

Activity Based Costing and cost reduction

Most companies adopt the ABC system in order to achieve more accurate costs of pricing products and product mix decisions. However, they often reap greater results through use of ABM to pinpoint opportunities to lower costs.

ABC can also help organizations using the value engineering to reduce the cost. Value engineering is the re-evaluation of activities to cut the costs while achieving the satisfaction to the customer needs.

Value engineering requires different teams coming together;

  • Marketers identifying customer needs
  • Production personnel and engineers in designing more efficient products
  • Accountants estimating on the impact on the changes in price

Application of ABC in Different Sectors

In Service Business:The service companies have had challenges with the cost accounting systems as they have been modeled after system found in the manufacturing companies and firms. The problem here is that the manufacturing firms emphasizes on the inventory value, which the service industry do not have in the first place, and use the standard costs that are calculated for direct labor and materials.

The direct labor and direct materials costs are not the majors in the service firms and hence makes it difficult to calculate the standard cost in such a setting.

Nevertheless the service industry needs to have accurate costs for profitability analysis of products. They need to establish;

  • Which products are more profitable?
  • Which products need to be given more emphasis?
  • The trend of profitability of a product over time
  • The product cost as a bases to set prices

But according to Kaplan and copper (1996), the service companies are the ideal candidates for ABC use even more than the manufacturing companies. Their justification behind this is that most of the cost in service organization are indirect as compared to manufacturing companies and can trace important components that have been discussed above.

Indirect costs are likely to have smaller proportion of the total cost. The service industry must also supply most of their resources in the fluctuations and advance in the usage of activity resources by individual services and customers do not influence short term spending to supply the resources. Such costs are treated by the traditional costing system as fixed and irrelevant for decisions. This resulted to situation where the profitability analysis was never considered helpful to be used for decision making. Little has therefore been given tot eh developing costing system such as ABC that accurately measures costs and profitably of individual services.

Privatization of the government owned monopolies; intensive competition and deregulation as well as expanding product range created a need for the service organizations to develop management accenting g systems that enables them understand the cost base and determine the profitability sources for their products, services, customers and markets.

Most service organizations are hence operated using the ABC system of costing in their management.

In Financial Sector: As regulation ended in the banking sector, cot became a more important factor as the banks increased competition levels from one to the other. The banking costs are not customer-driven but rather focus on the number of processed transactions. Traditional volume based costing has become inappropriate in such cases. Banks are now shifting on the concept of users paying for the cost of services used, to ensure that bill is shared evenly. In order to do so, there must be accurate reflection of the services.

The Healthcare Sector: In the past the healthcare providers used to increase their prices so as to increase their profitability and revenues. Today, managed care firms set revenues with their Prospective payment System (PPS). Healthcare providers only need to make good decisions with accurate information on cost to improve their profitability. The PPS improved the sophistication of the healthcare accounting systems. Important information needed by the healthcare and hospitals include;

  • Accurate allocation of administration costs to products
  • Information on cost of various activities
  • Cost of episode of care
  • Comparison of cost over time

All of this information is available from ABC systems.

Insurance Industry:This industry is moving forward in terms of management due to the increased levels of competition. Workers spend time working on a single task, but the time varied depending on the case. The discussion here is on the ABC systems and hospital malpractice insurance. A study has shown that variety of factors lead to malpractices cost and that malpractice risks were tied on geographical locations.

ABC systems are all about management of cost. The service companies using it can reduce and control the costs t make correct pricing and other related decisions, to increase their profitability. The system has the flexibility to provide special reports so as to ensure that management take decisions on the designing, selling and delivering of products and services. The key aspect is that ABC focuses on cost accumulation via activities which helps in minimizing or avoiding the product costs that may come from the arbitrary allocation of the overhead costs.

It is surprising how the management practices and methods have evolved over time, and will continue to change. Organizations are also moving from vertical management to horizontal potion. There has also been a shift from the function orientation to process orientation. Further, management systems are one needed to track information about the horizontal business aspects that have lagged behind the needs of the managers. ABM and ABC fills the information gap by providing operation and cost information that mirrors the progress of such firms and companies, giving the way forward to company success.