ACTIVITY BASED COSTING

INTRODUCTION

ABC came to prominence in the 1980s, as companies strove to improve their products
and services at the same time as pare down costs. They achieved impressive results, with
the consequence that ABC is increasingly popular—particularly in manufacturing sectors.

Activity-Based Costing (ABC) is a method for estimating the resources required to

operate an organization's business processes, produce its products and serve its
customers. It is a costing model that identifies the cost pools, or activity centres, in an
organisation and assigns costs to products and services (cost drivers) based on the
number of events or transactions involved in the process of providing a product or
service.

It is generally used as a tool for understanding product and customer cost and
profitability. As such, ABC has predominantly been used to support strategic decisions
such as pricing, outsourcing and identification and measurement of process improvement
initiatives.

METHODOLOGY

ABC as with other management accounting techniques has its own terminology.

Terms such as 'Activity', 'Cost Driver', 'Cost Pool', and 'Cost Driver Rate' all have
particular meanings.

An Activity is defined as "a value adding process which consumes resources".

A Cost Driver is "an activity or factor which generates cost" for example in our business
a cost driver could be inspections in the quality control function.

A Cost Pool is the "pooling of overhead cost which relates to a specific activity".

For example the overheads associated with the inspection process in quality assurance
would together form a 'cost pool'.
And finally a 'Cost Driver Rate' is the product of dividing the cost pool for the activity
by the cost driver volume - this for example could be the cost of the 'quality' pool,
divided by the number of inspections.

The application of ABC involves a set procedure:

• accounting for and collection of overhead

• allocation of overhead to form cost pools associated with ‘value adding’ activities
• identification of cost drivers
• determination of cost driver rates ie: pool / driver volume
• recovery and charging of overhead to product / service based upon the demand for
the activity.

The diagram below shows the broad steps in the ABC exercises carried out by
pathfinders. The grey boxes indicate stages that not all pathfinders carried out and the
numbers in circles indicate the number of pathfinders using this stage.

DIFFERENCE BETWEEN ABC AND TRADITIONAL COST ACCOUNTING

METHODS

In the more sophisticated businesses in flexible and rapidly changing product ranges
traditional techniques have proved to be in certain scenarios less than adequate.

Activity Based Costing or ABC offers a workable and more effective insight into
overhead allocation and recovery.

So what is really the difference between ABC and traditional cost accounting methods?
Despite the enormous difference in performance, there are three major differences:
 1. In traditional cost accounting it is assumed that cost objects consume resources
whereas in ABC it is assumed that cost objects consume activities.
2. Traditional cost accounting mostly utilizes volume related allocation bases while
ABC uses drivers at various levels.
3. Traditional cost accounting is structure-oriented whereas ABC is process-
oriented.

APPLICATION OF ACTIVITY BASED COSTING

The results generated by Activity Based Costing methods are frequently used to produce
reasonable standards on which future estimates can be calculated. For example, for years
construction firms and industry trade groups have collected cost data on a wide array of
construction projects. The amount of hours associated with those costs were also
collected. As an example, this data included the cost of the paint, labor, equipment, and
overhead to paint a room, the amount of surface area painted, and the manpower required
to paint the room. This practice has allowed contractors to calculate a cost per area and
manpower per area. These costs are based on an activity, such as painting, and are known
as ABC.

Activity Based Costing methods are also used to evaluate specific activities within an
organization to determine whether those activities are being conducted efficiently,
whether those activities are necessary, whether other groups within your organization are
performing those activities better than others, whether certain materials or tools help your
organization complete those activities more efficiently, etc.
ADVANTAGES OF ACTIVITY BASED COSTING

Activity Based Costing has the following typical benefits:

• Identifying the most and least profitable customers, products and channels.
• Determine the true contributors to- and detractors from- financial performance.
• Accurately predict costs, profits and resource requirements associated with changes in
production volumes, organizational structure and resource costs.
• Easily identify the root causes of poor financial performance.
• Track costs of activities and work processes.
• Equip managers with cost intelligence to drive improvements.
• Facilitate better Marketing Mix
• Enhance the bargaining power with the customer.
• Achieve better Positioning of products

However, ABC involves so much data collection that it can take up a lot of time. There’s
also a danger that managers get so wrapped up in tracking costs that they take their eyes
off the activity itself.

CONCLUSION

Some researchers would argue that compared with traditional approach to overhead
allocation, apportionment and absorption, ABC generates improved or more accurate
product costs - however, recent research suggests that by improving the quality of cost
and management accounting information, it also provides managers with a wider
understanding of the economies of production and those resource consuming activities
which when linked to the labour and capital provide the wealth we know as 'value added'.

ABC has helped enterprises in answering the market need of better quality products at
competitive prices. Analyzing the product profitability and customer profitability, the
ABC method has contributed effectively for the top management’s decision making
process. With ABC, enterprises are able to improve their efficiency and reduce the cost
without sacrificing the value for the customer. Many companies also use ABC as a basis
for a balanced scorecard.

This has also enabled enterprises to model the impact of cost reduction and subsequently
confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic
method for continuous improvement. With Activity Based Costing, any enterprise will
have a built in competitive cost advantage and can continuously add value to both its
stakeholders and customers.