Activity-based costing

Activity-based costing (ABC) is a special costing model 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 (overhead) into direct costs compared to conventional costing models.

Aims of model

With ABC, an organization can soundly estimate the cost elements of entire products and services. That may prepare decisions on:

• either identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim)
• 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 (process re-engineering aim).

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.^[1] Other reports show the broad band covered with the ABC methodology.^[2]

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.^[3] 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.^[4] 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.^[5]

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.^[6] 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.^[7][8]

Activity-based costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century.^[9] 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 (TOC) is analysed in a study^[10] 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.

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 labor 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 (cost driver) 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 labour, 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 reports summarises reasons for implementing ABC as mere unspecific and mainly for case study purposes^[11] (in alphabetical order):

• 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 behavioural 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^[12]

1. Identify and assess ABC needs - Determine viability of ABC method within an organization.
2. Training requirements - Basic training for all employees and workshop sessions for senior managers.
3. Define the project scope - Evaluate mission and objectives for the project.
4. Identify activities and drivers - Determine what drives what activity.
5. Create a cost and operational flow diagram – How resources and activities are related to products and services.
6. Collect data – Collecting data where the diagram shows operational relationship.
7. Build a software model, validate and reconcile.
8. Interpret results and prepare management reports.
9. Integrate data collection and reporting.

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.

Reducing cost of ABC modeling

ABC is considered a relatively costly accounting methodology.^[13] As long as cost elements would have to be taken and notified just manually, the activity based costing approach would remain arduous and the obtained completeness would be poor.

An escape from costly procedures may be found with transition from coarse scale cost modeling to fine scaled data capture for concurrent accounting.^[14] The implementing of respective means shall redirect from the managerial level of the planning for entities of an activity type to the simply automated data capture technically detectable entities of paired events: Each two events of starting and ending an activity determine the duration of the very same activity.

The clock time of events plus identification of the persons involved and assets used may be notified easily with technical means. In contrast to locating technologies the identity and time capture always performs with desired precision and high reliability. Application of classical logic supports for pairing the respective event times supported by captured identities. All modes of context and contributing assets and resources may be allocated and quantified for detailed costing in conjunction with such event detection. Hence agglomerating of collected data is suited to contribute to the costing model for activity based costing in all desirable detail. Modern identification technologies (e.g. RFID) provide the necessary instruments.

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 (AA) concept to a more advanced AA and Accounting (AAA) 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.^{[15][16][17][18]} 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.^[19]

References

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