Activity Based Product Costing (ABPC)

For profitability measurement and improvement Author: Raj Gaonkar

Activity-Based Costing (ABC) is a commonly used methodology of allocating costs to activities. ABC determines the unit cost of activities or products. ABC evaluates how resources are consumed on activity outputs for different customers, products, or distribution channels. ABC provides information to understand activities and their associated costs that lead to improved process efficiency and profitability. ABC looks at activity costs from a horizontal viewpoint. This technique analyzes activities by linking activity outcomes to performance measures. The horizontal perspective of ABC distinguishes from conventional costing methodologies. A conventional (full absorption) costing methodology views costs from the vertical or cost allocation perspective. It attempts only to assign costs more accurately and does not specifically address how efficiently an activity is performed. Initially ABC was used in manufacturing operations. ABC initiatives concentrate on product costing and product profitability. The size and type of customer will place different demands on customer service. In the manufacturing industry, product pricing varies according to the customer. In the service industry as the competition grew tougher, ABC concept was used by the banking and insurance companies extensively. However, many major banks do not correctly manage the ABC concept. Many financial institutions are not confident of activity-based costing. They think that the conventional unit costing systems, which are based on allocation plans, provide sufficient information to run their business. The idea of switching to new costing system poses insecurity of newness to some managers. Questions are often asked whether time spent on analyzing activity costs would yield any tangible results. One of the major banks had developed a horizontal branch activity database, which was used to compute unit costs using full absorption costing methodology. Their costing department believed that their unit costing methodology as a dynamic Activity Based Costing methodology. This approach was costing the bank two times more than what it would have costed for ABC. In addition, fully absorbed unit costing system was unable to provide product performance information to customer profitability or pricing or reengineering efforts. Traditional cost accounting does not distinguish customers. Two customers with similar products can differ substantially in their service requirements. It develops average product cost for both the customers. ABC allocates cost according to their service demands. ABC is an effective tool for structuring variable product price to maximize customer profitability. Reengineering efforts can be initiated to reallocate or reduce resources on specific products based on customer profitability. Activity-Based Costing (ABC) is a method of allocating costs to activities instead of products and services. In retail banking, with shrinking operating margins and competitive product pricing, it is essential to understand product costs. In order to make profitability equations easier ProductFlow added an extra step to its ABC model, Activity Based Product Costing (ABPC). ABPC consolidates activities into products. ABPC model converts the direct and indirect activity costs to provide fixed and variable costs of retail banking product. ProductFlow applies end-to-end workflow analyses to ABPC, which helps to focus on cost drivers. Measuring the costs of key processes helps to bring together various departments participating within the span of end-to-end workflow and collaborate to improve the product and

customer profitability. End-to-end workflow establishes a common language to share financial and non-financial activity data among all participating departments.

An end-to-end workflow is analyzed in reverse order to assess how each activity performed by each department adds cost and process time. The analysis can also identify unnecessary duplications of activities occurring between departments that add cost or time but no value to the customer. It can also identify opportunities to reposition or shift functions from one department to another that result in restructuring. ABPC provides valuable cost information that is just tailored for an end-to-end workflow analysis. ABPC greatly expands the tools available to back office departments to improve their operations. ABPC calculates the contribution of cost by each department within the end-to-end workflow. High-cost departments are targeted for cost reduction. Process reengineering is a commonly used practice for minimizing cost. The recent trend has been outsourcing functions where they can be performed most efficiently at a minimum cost. ABPC provides groundwork for the value chain analysis, which is the first step in determining process outsourcing and selecting outside partners. ABPC measures economic efficiency and excess capacity of processes, products and departments that is selectively applied for cost reduction. ABPC provides quick insight into the cost components that need to be adjusted to improve profitability. ABPC is a transparent costing model that estimates the potential effect on profitability due to changes in policies. ABPC is a resourceful tool in finding solutions for management issues such as: Profitability Optimization Branch network restructuring Capital allocation plan Cost of repair minimization Product Pricing structures Process performance Business Process Outsourcing/ In-sourcing Product portfolio strategy Customer segmentation Distribution Channel selection