Activity-based costing is a costing methodology that identifies activities in an organization
and assigns the cost of each activity with resources to all products and services according
to the actual consumption by each. This model assigns more indirect costs into direct costs
compared to conventional costing. 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.
Aims of model 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
Or identify and eliminate production or service processes that are ineffective and allocate
processing concepts that lead to the very same product at a better yield.
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 initial enthusiasm, ABC lost ground
in the 1990s, 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. Other reports show the broad band covered
with the ABC methodology.
ABC has stagnated over the last five to seven years,
— Kaplan, 1998
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. 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. 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 costly products. Activity-based costing was first clearly defined
in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management:
A Field Study Perspective. 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. Activity-based costing was later explained
in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. 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. Alternatives
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. However lean accounting is a snapshot concept for capturing just partial
derivatives or differentials of selected cost functions. Lean accounting takes an opposite
direction from ABC by working to eliminate peculiar cost allocations rather than apply
complex methods of resource allocation. 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 is analysed in a study 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.
For a complete listing of alternatives, please refer to:
Methodology Methodology of ABC focuses on cost allocation
in operational management. ABC helps to segregate Fixed cost
Variable cost Overhead cost
The split of cost helps to identify cost drivers, if achieved. 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
takes 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. That
is, machine operating hours drive labor, maintenance, and power cost during the running machinery
activity. Application in routine business
ABC has proven its applicability beyond academic discussion. ABC is applicable throughout company
financing, costing and accounting: ABC is a modeling process applicable for full
scope as well as for partial views. ABC helps to identify inefficient products,
departments and activities. ABC helps to allocate more resources on profitable
products, departments and activities. ABC helps to control the costs at any per-product-level
level and on a departmental level. ABC helps to find unnecessary costs that may
be eliminated. ABC 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:
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. Steps to implement Activity-Based costing
Identify and assess ABC needs - Determine viability of ABC method within an organization.
Training requirements - Basic training for all employees and workshop sessions for senior
managers. Define the project scope - Evaluate mission
and objectives for the project. Identify activities and drivers - Determine
what drives what activity. Create a cost and operational flow diagram
– How resources and activities are related to products and services.
Collect data – Collecting data where the diagram shows operational relationship.
Build a software model, validate and reconcile. Interpret results and prepare management reports.
Integrate data collection and reporting. Integrating EVA and PBC
Recently, Mocciaro Li Destri, Picone & Minà proposed a performance and cost measurement
system that integrates the EVA criteria with Process Based Costing. Authors note that activity-based
costing system is introspective and focuses on a level of analysis which is too low. On
the other hand, they undescore the importance to consider the cost of capital in order to
bring strategy back into performance measures. Limitations
Applicability of ABC is bound to cost of required data capture. 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. 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 ABC 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 concept to a more advanced
AA and Accounting 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 . Public sector usage of ABC
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. Its use 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. References
^ CIMA official Terminology, 2005. p. 3. ^ The Review of Policing Final Report by Sir
Ronnie Flanagan February 2008 ^ Activity-based costing: A Case study
^ Y Overhead cost allocation ^ Staubus, George J. Activity Costing and
Input-Output Accounting. ^ Consortium for Advanced Manufacturing-International
^ Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective
ISBN 0-87584-186-4 ^ Sapp, Richard, David Crawford and Steven
Rebishcke "Article title?" Journal of Bank Cost and Management Accounting, 1990.
^ Author(s)? "Article title?" Journal of Bank Cost and Management Accounting, 1991.
^ Drucker Peter F.Management Challenges of the 21st Century. New York:Harper Business,
1999. ^ Who Wins in a Dynamic World: Theory of Constraints
Vs. Activity-Based Costing? ^ The design and implementation of Activity
Based Costing: a South African survey ^ Velmurugan, Manivannan Senthil. "The Success
And Failure of Activity-Based Costing Systems." Journal of Performance Management 23.2: 3-33.
Business Source Complete. Web. 15 Mar. 2012. ^ Mocciaro Li Destri A., Picone P. M. & Minà
A., Bringing Strategy Back into Financial Systems of Performance Measurement: Integrating
EVA and PBC, Business System Review, Vol 1., Issue 1. pp.85-102 http:papers.ssrn.compapers.cfm?abstract_id=2154117.
^ MARINE CORPS ACTIVITY BASED COSTING ^ Activity-Based Costing
^ SAS helps Marine Corps budgets get lean ^ Energizing cost accounting: Marine Corps
financial managers conduct a thorough analysis ^ Police Service National ABC Model Manual
of Guidance Version 2.3 June 2007
Drucker, Peter F.. Management Challenges of the 21st Century. New York:Harper Business,
1999. External links
Who Wins in a Dynamic World: Theory of Constraints Vs. Activity-Based Costing? article on SSRN
International Federation of Accountants proposed International Good Practice Guidance on Costing
to Drive Organizational Performance