Activity-Based Costing

Activity-Based Costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect cost (overhead) into direct costs.

In this way an organization can establish the true cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced. In a business organization, the ABC methodology assigns an organization’s resource costs through activities to the products and services provided to its customers. 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. Traditionally cost accountants easily added a broad percentage of expenses onto the Direct cost the indirect cost. However as the percentages of indirect or overhead cost is technique became increasingly inaccurate because the indirect costs were not caused equally by all the 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, the additional cost for the use of the machine would not be 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.

The concepts of ABC were developed in the manufacturing sector during the 1970s and 1980s.During this time, the Consortium of advanced learning idea a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.

Rob Robert S Kaplan Balanced score card 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 is often unable to determine accurately the actual costs of Production 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 also 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.

• Cost allocation
• Fixed cost
• Variable cost
• Cost driver
• Cost driver rate

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 measure of the use of a shared activity by each of the products is known as the cost driver, 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

Uses

• It helps to identify inefficient product, department and activity
• It helps to allocate more resources on profitable product, department and activity
• It helps to control the cost at individual level and on departmental level
• It helps to find unnecessary costs

Limitations

Even in activity-based costing, some overhead costs are difficult to assign to products and customers, for example 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.

Cost

ABC is considered a relatively costly accounting methodology, and whether it is good value is questioned. ABC has been found to be a very high-cost accounting technology. Installing an ABC system is technically complex, requiring talented personnel and a considerable amount of time and money.

Prevalence

Following initial enthusiasm, ABC lost ground in the 1990s, to alternative metrics, such as Kaplan’s balanced score card & economic score

Public Sector Use

ABC is widely used in the public sector, including by the United States and UK Police mandated since the 2003-04. An independent 2008 report concluded that 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.

Materials Management In An R & D Set Up

In a typical R & D set up, the following characteristics are easily visible w.e.f.. an R&D (research) project particular project is pursued only once or rarely more than once the project duration is small enough to provide the results at the earliest for use Project conceiving may or may not be predetermined. It may be sudden and resultant of the brain wave of a scientist Project findings may get early implementation for commercial production Projects, mostly, are of pilot nature i.e. of low value and less time duration. Many projects may need materials as tools for diagnosis, tests and trials. Obviously, based on the above characteristics which are essentially a way of working for any industrial R & D set up, the material requirement too is peculiar with the following characteristics:

Item is not repetitive, it may be required only once Purchase function should ensure speedy procurement Element of proper planning w.e.f. timely raising of indent, exact specification, correct estimated price may be missing Quantity of items to be purchased is small Sourcing may not be easy as items are developmental in nature, mostly new Often, the requirement of materials and the nature of purchases are at cross purpose. For example, an item is required urgently but the exact specification is not available, quantity is too small for the vendors to show interest, item is new and the sources are not known etc. These and other situations eventually become the limiting factors for the purchase man who wants to reduce the Lead time in purchasing. It is a fact of life for the Purchase man that the delivery gets delayed, sometimes enormously, as despite of the agreed delivery schedule the vendor could not complete the job solely because the item was of developmental nature and the time it took for completion could not be assessed precisely in the beginning’s & D purchases, therefore, are significantly different from those done in a manufacturing unit where there is enough control on the variables. At least, specification of an item that determines the item to be purchased is frozen. Sources, to a great extent, are also known and therefore constant in nature. The only variables can be price and delivery schedule. As against it, in an R&D set up there is lack of adequate information on sources, likely price and a justified delivery schedule. Specification often remains a variable until just prior to placement of order.

Considering that urgent need to procure the material that too on, say short notices at times is of primary concern in an R & D set up what should be the procurement system or put in other words, can there be a procurement system that can take care of urgent needs where exact specification, sources and likely delivery schedule are difficult propositions

Activity Based Costing Advantages

• More accurate costing of products/services, customers, SKUs, distribution channels
• Better understanding overhead
• Easier to understand for everyone
• Utilizes unit cost rather than just total cost
• Integrates well with Six Sigma and other continuous improvement programs
• Makes visible waste and non-value added
• Supports performance management and scorecards
• Enables costing of processes, supply chains, and value streams
• Activity Based Costing mirrors way work is done
• Facilitates benchmarking