ABC Activity Based Costing

ABC Activity Based Costing is...

... a methodology that measures the cost and performance of cost objects, activities and resources.

Cost objects (products or services) consume activities and activities consume resources.

Resource costs are assigned to activities based on their use of those resources, and activity costs are reassigned to cost objects (products or services) based on the cost objects' proportional use of those activities.

ABC Activity-based costing incorporates causal relationships between cost objects and activities and between activities and resources.

So what - you ask?

In contrast to traditional cost-accounting systems, ABC systems first accumulate overhead costs for each organizational activity, and then assign the costs of the activities to the products, services, or customers (cost objects) causing that activity.

Traditional costing methods tend to allocate indirect costs to products or product lines using a single volume related driver, for example direct labour hours or machine hours. This method, while simple, does not give the management any insight into what causes the overhead or indirect costs. Using traditional methods of allocating costs can distort product costs, making it appear that some products are less profitable than they actually are!

How does ABC Activity Based Costing Work?

As one might expect, the most critical aspect of ABC is activity analysis.

Activity analysis is the processes of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service. Significantly, activity analysis provides the foundation for remedying the distortions inherent in traditional cost-accounting systems.

In most cases, a company's traditional cost-accounting system adequately measures the direct costs of services, such as material and labour. As a result, Activity Based Costing implementation typically focuses on indirect costs, such as over-head and selling, general, and administrative costs.

Given this focus, the primary goal of ABC Activity Based Costing implementation is to reclassify most, if not all, indirect costs (as specified by the traditional cost-accounting system) as direct costs. As a result of these reclassifications, the accuracy of the costs is greatly increased.

There are six basic steps required to implement an Activity Based Costing system:

1) Identify and define activities and activity pools

2) Directly trace costs to activities (to the extent feasible)

3) Assign costs to activity cost pools

4) Calculate activity rates

5) Assign costs to cost objects using the activity rates and activity measures previously determined

6) Prepare and distribute management reports.

Risks and issues

Since its introduction in the late 1980’s, there has been an incredible amount of research about the implementation of activity based costing, most citing very low levels of success.

Despite evidence that Activity Based Costing can produce significant improvements to the financial management and strategic decision-making processes; the research indicates that a high percentage of the large organisations studied either abandoned or failed to complete ABC implementation programs.

Common implementation issues identified by the extensive body of research include:

• the failure to recognise the project as a major organisational change,
• allocating inadequate resources to the program,
• underestimating the extent of the work involved in the design and development phases, and employee resistance,
• resulting from a lack of understanding of the project and
• the belief that ABC ‘belongs’ to the accountants and therefore has no relevance to ‘the people on the floor actually doing the work’.

What Now?

If you are interested in finding out more about ABC Activity Based Costing you will find a wealth of information on the Internet. Some of it good, some of it, not so good.

Kaplan and Cooper of Harvard University are widely acknowledged as the 'fathers' of ABC so the Harvard Business School might be a good place to start!

Go to the School's website and type 'Cooper' or 'Kaplan' in the search box to locate many of the articles written by these two about Activity Based Costing.

If you are looking for a good book to use as a reference to use during your implementation of ABC, Activity Accounting by James A. Brimson would be a good investment.

Return to top of ABC Activity Based Costing

Return to top of Business Jargon

Home | Privacy Policy | Contact