Understanding Activity Based Costing


By

Bhargav Pandya
Lecturer
Shree Leuva Patel Trust Mba Mahila College
Chakkargadh Road, Amreli-365 601
E-mail:
bhpandya@rediffmail.com
 


Introduction:

Activity Based Costing (ABC) is an accounting technique that allows an organization to determine the actual cost associated with each product and service produced by the organization without regard to the organizational structure. It is developed to provide more-accurate ways of assigning the costs of indirect and support resources to activities, bushiness processes, products, services, and customers. ABC systems recognize that many organizational resources are required not for physical production of units of product but to provide a broad array of support activities that enable a variety of products and services to be produced for a diverse group of customers. The goal of ABC is not to allocate common costs to products. The goal is to measure and then price out all the resources used for activities that support the production and delivery of products and services to customers.

Concept of Activity-Based-Costing:

An organization performs activities to do its business. These activities define the kind of business you are in: a ship owner has an activity to unpack boats; an accounting firm prepares tax returns; a manufacturer produces products; a council delivers services; a university teaches students. All activities consume resources. It is the consumption of these resources that adds to overhead costs.

The basis of Activity Based Costing is: look at the activities required to produce the cost of the product or service. The activities consume resources and the cost of these can be calculated. The amount of activity required for each product and service is determined, hence the real cost can be determined.

What's what in ABC?

  • The activity is the work that is done.
  • The resource is what the activity uses to do the work e.g. people, equipment, and services. Resources cost money.
  • The cost of the activity depends on the quantity of resources used to accomplish the activity.
  • The cost driver for an activity is the factor that influences the amount of the resources that will be consumed by this activity.
  • Example: the activity is delivering goods. The costs of this activity include the truck drivers' wages, fuel, depreciation of the truck, insurance, etc. The quantities of the resources that will be consumed by this activity are influenced by the number of deliveries made per year. Hence the cost driver could be the number of deliveries. A cost driver is designed to allocate the delivery activity cost pool to the cost objects.

    (Note: The software has the facility to enter and change the cost drivers as better information becomes available).

  • The activity driver measures how much of the activity is used by the cost object. Example: Product A is delivered once a month, whereas product B is delivered once a week. Products A and B require a different number of deliveries, hence the cost of the delivery activity should be assigned to each product on the basis of the number of deliveries each uses.
  • The cost object is whatever it is you wish to cost. It could be a product, service, process, job or customer.

While traditional costing arbitrarily allocates overhead costs, ABC traces overhead costs by looking at the activities that each product and service calls upon. With ABC the products consume the activities. It is the activities that cost money.

If there were no activities, no resources would be consumed. It is the activities that you do that define your business.

Why use Activity-Based-Costing?

Activity-Based-Costing is necessary for the following reasons.

    * Understand TRUE profitability of your customers, products, or services

    * Quantify the cost of non-value added activities such as errors and reworks

    * Identify opportunities to reduce costs and/or increase efficiency

    * Obtain actionable information to negotiate price increases for unprofitable clients

    * Understand why profitability may be mediocre despite good strategic fundamentals

    * Stratify overhead costs so they can be managed more effectively

How Does ABC Work?

The first stage in an initial ABC study is to develop a fundamental understanding of the Resources (expenditures) and Activities (work performed) of an organization. The Resources are then mapped to the Activities, thereby quantifying the cost of performing each of these Activities. These costs are traced to Cost Objects (customers, products, or services) providing tremendous insight into where an organization is making and losing money.

ABC Model:

The objective of an ABC implementation is to relate all of the costs of doing business to products, services, or customers. Developing the initial model consists of the following five steps:

1. Identify the Resources (expenditures) of an organization

2. Determine Activities (work performed) that are supported by Resources

3. Define Cost Objects (products, services, customers)

4. Develop Resource Drivers to link Resources to Activities

5. Develop Cost Drivers to link Activities to Cost Objects

These steps are discussed in greater length below.

Step 1: Identify Resources

Resources represent the expenditures of an organization. Examples include production labor, sales and marketing labor, occupancy and utilities, equipment, and supplies. These are the same costs that are represented in a traditional accounting view; unlike traditional accounting, ABC links these costs to products, customers, or services.

Step 2: Identify Activities

Activities represent the work performed in an organization. ABC Activities for the sales department in a typical organization might include:

  •  Making sales calls to existing customers
  •  Making sales calls to potential customers
  •  Making customer service calls
  •  Training product representatives
  •  Evaluating products and improving product knowledge
  •  Distributing samples
  •  Attending trade shows and other events

Traditional accounting will often break the cost of the sales department into salaries, benefits, allocated rent, supplies, and so on. Unlike traditional accounting, which reports what the costs are (i.e. salaries, benefits, rent), ABC accounts for these costs based on what activities caused them to occur. By determining the actual activities that occur in various departments, such as accounting, customer service, and sales, it is then possible to more accurately relate these costs to customers, products, and services.

Step 3: Identify Cost Objects

ABC provides profitability by one or more cost object, usually represented by products, customers, and/or services.

Cost Object profitability is utilized to identify money losing customers, to validate separate divisions or business units, or to measure the performance of individual projects, jobs, or contracts. Defining the outputs to be viewed is an important step in a successful ABC implementation.

Step 4: Determine Resource Drivers

Resource Drivers provide the link between the expenditures of an organization and the Activities performed within the organization.

For example, the total salary of a customer service representative would likely be allocated to the Activities performed based on the amount of time spent performing the Activity. If 50% of her time is spent performing the activity, taking orders for existing customers, 50% of her salary (including all costs such as benefits, taxes, and insurance) would be allocated to this Activity.

Step 5: Determine Cost Drivers

Determination of Cost Drivers completes the last stage of the model. Cost Drivers trace, or link, the cost of performing certain Activities to Cost Objects.

For example, taking orders for existing customers may be linked to specific customers based on the number of orders taken, if each order takes approximately the same amount of time. If order taking time varies based on the customer, this cost may be linked based on another driver or multiple drivers.

Conclusion:

Today, companies are using ABC/M to make better-informed decisions about pricing, what type of customers to pursue, and what products or services to offer. Activity-Based Costing determines the TRUE COST & PROFITABILITY of customers, products, and/or services. While traditional accounting may provide your business with an accurate sense of the direct costs of your products or services, indirect costs are often less accurately applied. Overhead, such as customer support or marketing costs, tend to be allocated based on arbitrary factors.

Activity-Based Costing measures the costs and profits of an organization based on the activities performed within that organization. By focusing on processes that contribute to revenues and business operations, ABC can accurately determine how each process relates back to specific products, customers, or services. This can make a big difference after considering warehouse, sales, customer service, administration and other costs that are often applied at a standard rate, if at all. With ABC you can drill into profitability and performance by almost any factor you can think of.

Bibliography:

  • Kaplan Robert and Atkinson Anthony," Advanced Management Accounting", New Delhi, Prentice Hall of India,1998.
  • www.cashfocus.com
  • www.praport.com
     


Bhargav Pandya
Lecturer
Shree Leuva Patel Trust Mba Mahila College
Chakkargadh Road, Amreli-365 601
E-mail:
bhpandya@rediffmail.com
 

Source: E-mail October 9, 2005

  

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