Activity-based costing (ABC)

It refers to a cost accounting system that aims to identify money losers or winners by linking cost drivers directly to products or services that require activities consuming resources. ABC begins with the dissection of supply chain activities in terms of their causal relationship with cost objects and then specifies where non-value-adding activities exist.

In other words, ABC helps the firm uncover the root causes of cost increases that do not contribute to profit increases. Therefore, the ultimate purpose of ABC is to increase profit margin by eliminating non-value-adding activities that cost money. Examples of non-value-adding activities include the use of nonstandard materials, components, and parts; red tape (too much paperwork); lengthy purchase approval processes; redundancy; defects, rework, and scrap; split shipments, emergency/rush shipments, and damaged shipments; and an excessive number of suppliers.

Assumptions

ABC makes the following fundamental premises

• Cost objects consume activities.
• Activities consume resources.
• The consumption of resources drives costs.
• The understanding of cost drivers is critical for managing overhead expenses and minimizing cost errors.

These premises indicate that a company’s outputs give rise to the need for various supply chain activities that incur costs. To make ABC more meaningful, these costs should be accurately defined and measured, while the cause-and-effect relationship between the company’s supply chain activities and resultant costs should be examined carefully.

Implementation

Under these premises, ABC can be implemented by taking the following steps

• Define activities.
• Develop a “bill of activities” (or activity/process mapping).
• Determine cost drivers for each cost component.
• Calculate the total activity cost.
• Estimate the cost driver (or activity allocation) rate (= total activity cost / total number of activities performed) for each cost component.

The advantages of ABC are

• Closer analysis of the cause of costs in production or service processes, which helps develop a better budget plan and more meaningful performance standards
• Identification of non-value-adding activities, which helps cost reduction

The disadvantages of ABC, are

• Difficulty in gathering relevant data because it no longer uses variable/fixed cost dichotomy and therefore relies heavily on historical data.
• Difficulty in breaking down some activities. For instance, it is difficult to discern value-adding activities from non-value-adding activities consistently.
• Declining employee morale because every activity performed by employees is under scrutiny.