Activity based costing - a tool for decision making

ABSTRACT

Activity Based Costing (ABC) is a method for developing costestimates in which the project is subdivided into discrete, quantifiableactivities or a work unit. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and1980s. ABCsystems calculate the costs of individual activities and assign costs to costobjects such as products and services on the basis of the activities undertakento produce each product or services. The CIMA technology defines ABC as a costattribution to cost units on the basis of benefit received from indirectactivities.

This paper is presented by the following topics,

• Activity-Based Costing
• Important Terms in Activity Based Costing
• Stages of Activity Based Costing
• Traditional Costing and Activity Based Costing
• Activity Based Costing In 1980s And 1990s
• Activity Based Costing Methodology
• ABC and Healthcare
• Activity Based Costing: A Decision Making Tool
• Software Packages for ABC
• Growing Interest in Activity Based Costing

Activity Based Costing is based on a philosophy ofestimation that: "it is better to be approximately right, than precisely wrong." In summary, activity-based costing is a management decision-making tool.By associating cost to the activity, a clear relationship can be establishedbetween sources of activity demand and the related costs. This association canbenefit the distributor in determining where costs are being incurred, what isinitiating the costs and where to apply efforts to curb inflationary costs.This can be of particular value in tracking new products or customers.

Introduction

A powerful tool for measuring performance, Activity-BasedCosting (ABC) is usedto identify, describe, assign costs to, and report on agency operations. A moreaccurate cost management system than traditional cost accounting; ABC identifies opportunities to improve business process effectiveness and efficiency by determining the "true" cost ofa product or service. Activity Based Costing is a method for developing costestimates in which the project is subdivided into discrete, quantifiableactivities or a work unit. ABC systems calculate the costs of individualactivities and assign costs to cost objects such as products and services onthe basis of the activities undertaken to produce each product or services. Itaccurately identifies sources of profit and loss.

Activity-Based Costing

The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and1980s.It is a practice in which activities are identified and all related costs of performing them arecalculated, providing actual costs chargeable. The focus of activity basedcosting is activities. Thus identifying activities is a logical first step indesigning an activity based costing. An activity is an event, task or unit ofwork with a specified purpose. For example; designing products, setting upmachines, operating machines and distributing products.

The CIMA technology defines ABC as a cost attribution to cost units on the basis of benefit received from indirect activities. Peter B. B. Turney defines ABC as "a method of measuring the cost and performance of activities and cost objects. Assigns cost to activities based on their use of resources and assigns cost to cost objects based on their use of activities. ABC recognizes the causal relationship of cost drivers to activities." ABC can be defined by the following equation:

C/A = HD + M + E + S

Where C/A = Estimated cost per activity

H = Number of labor hours required to perform the activity one time

D = Wages per labor hour

M = Material costs required to perform the activity one time

E = Equipment costs to perform the activity one time

S = Subcontracting costs to perform the activity one time

The total cost for performing the activity will be based on the number of times the

activity is performed during a specific time frame. An activity based costing system first traces costs to activities and then to products and other cost objects. The following figure diagrammatically explains the basic flow of Activity-Based Costing.

Important Terms in Activity Based Costing

The operation of the ABC system involves the use of the following terms:

Cost object: It refers to an item for which cost measurement is required.e.g. a product, a service, or a customer.

Cost pool: A cost pool is a term used to indicate grouping of costs incurred on a particular activity which drives them.

Cost driver: A cost driver is any factor or force that causes a change in the cost of activity. Cost driver may be involved two parts:

1. Resource cost driver 2. Activity cost driver

A resource cost driver is a measure of the quantity of resources consumed by an activity. An activity cost driver is a measure of the frequency and intensity of demand, placed on activities by cost objects. The cost drivers for various functions i.e., production, marketing, research, and developments are given below.

Stages of Activity Based Costing

The different steps or stages in ABC system can be given as follows:

1. Identify the chosen cost objects

The cost objects of any organization are the products or services and the goal is to first calculate the total cost of manufacturing and distributing these products and their unit cost.

2. Identify the different activities within the organization

After the identification of cost objects, the main activities, which are being performed in the organization, have to be identified. Usually the number of activities over cost centers in ABC will be much more as compared to traditional overhead system. The exact number will depend on how the management subdivides the organizations activities.

3. Identifying the direct cost of products

The direct cost of products or objects may comprise direct material cost, direct labor cost and direct expenses. Classification of as many of the total costs as direct costs as is economically feasible should be made. It reduces the amount of costs classified as indirect.

4. Relating the overhead to the activities

After identifying the organizations activities, the various items of overhead are related to activities both support and primary, that caused them. As a result of relating the items of overhead to various activities, cost pool or cost buckets are created.

5. Spreading the support activities across the primary activities

The spreading of support activities (i.e., activities which support or assist manufacturing) across the primary activities (correlated to the number of units produced) is done on some suitable base which reflects the use of support activity. The base is the cost driver and is measured of how the support activities are used.

6. Determining the activity cost drivers

The determination of the activity cost drivers is done in order to relate the overhead collected in cost pools to the cost objects of products. It is done on the basis of the factor that drives the consumption of the activities.

7. Calculating the activity cost driver rates

The activity cost rates for each activity are calculated in the way in which overhead absorption rates would be calculated under the traditional system. It can be presented as follows:

Activity cost driver rate =     Total cost of activity

                                 Activity driver

These activity cost driver rates are to be used for ascertaining the amount of overhead chargeable to various cost objects or products.

8. Computing the total cost of products or cost objects

The total costs of the products shall be computed by adding all direct and indirect costs assigned to them. The amount of overhead chargeable to a product or cost object shall be calculated by multiplying the activity cost drivers rates by different amounts of each activity that each product or other cost object consumes.

Traditional Costing and Activity Based Costing

Traditional costing can lead to undercosting or overcosting of products or services. Over or under costing of products distorts cost information. A poor quality of cost information causes management to make poor decisions for pricing, product emphasis, make or buy etc. ABC differs from the traditional system only in respect of allocations of overheads or indirect costs. Direct costs are identified with, or assigned to, the cost object, in the same manner as is done in case of traditional costing system. Overhead costs are linked to the cost objects based on activities. This is shown in the following figure:

Activity Based Costing In 1980s And 1990s

The activity based costing systems, described by Robin Cooper and Robert Kaplan in the 1980's and 1990's, has attracted much attention. These systems identify the major activities of a facilitys production process and then classify these activities into one of the following categories:

• unit-level activities;
• batch-level activities;
• product-sustaining level activities and;
• facility-sustaining level activities.

In the example below, described by Robin Cooper,

• the number of direct labor hours a product consumes is the cost driver for unit-level activities;
• the number of setups a product consumes is the cost driver of batch-level activities;
• and the number of parts a product consumes is the cost driver of product-sustaining level activities.

Consumption Patterns by product

Overhead costs reported by an ABC system

According to Robin Cooper activity based costing systems can be used to monitor how an organization's resources are consumed and help to manage consumption and spending in a company. With activity based costing systems managers can attempt to perform its activities more efficiently, reprice products or alter the company's product mix.

Activity Based Costing Methodology

The insight brought in by ABC methodology can be broadly categorized as:

• Customer Profitability
• Product Profitability
• Process Efficiency

Customer Profitability

Traditionally it is believed that:

• High volume customers are profitable customers
• Loyal customer is also a profitable one
• Profits will follow a happy customer.

The ABC studies on customer profitability have unveiled that the above are often exceptions. With the costing based on activities, the cost of serving a customer can be ascertained individually. Deducting the product cost and the cost to serve each customer one can arrive at customers profitability. This method of dealing customer cost and product cost separately has lead to identifying the profitability of each customer and to position their products or services accordingly.

Product Profitability

ABC costs the products based on the activities that goes into it. This facilitates arriving at the accurate cost of the products and enhances effective strategic decisions to:

Position their products better

Facilitate better Product mix for the market

Enhance the bargaining power with the customer

Process Efficiency

ABC implementation will make the employees, across functions, to understand the various costs involved, which will in turn enable them to

• Analyze the Cost.
• Identify the Value Added and Non Value Added Activities.
• Implement the improvements and realize the benefit.

This is a continuous improvement process in terms of analyzing the cost, to reduce or eliminate the Non Value Added activities and to achieve an over all efficiency.

ABC and Healthcare

More and more, healthcare enterprises are finding that their accounting systems do not provide useful operations management information. In their quest to reduce costs and develop an advantaged marketplace position, healthcare providers are discovering ABC. It offers an approach and the type of information required to realize performance breakthroughs:

• It recognizes that cost and quality are the direct result of the activities providers undertake to deliver services to their patients.
• It is business-process and end-product focused, and invites cooperation, rather than competition, between functional departments.
• It is developed based on the process knowledge and insight of those directly involved in the delivery of the service. In the case of patient care, physicians, nurses, therapists, et al, participate and contribute to its development.

As a result, activity-based cost information is both intuitive and logical. In short, it makes sense to those charged with the responsibility for improving performance and provides them with transparent information on the cost ramifications of their decisions. Example applications include:

• Evaluating the cost implications of alternative clinical pathways
• Streamlining care delivery practices across the care continuum
• Decision-making regarding management levels and spans of control
• Enhancing staff utilization by time of day
• Resourcing consolidated departments/deployed functions

A report by the US-aided Quality Assurance Project on Can ABC work in developing countries? with Peruvian Healthcare System as the case, says: Traditional cost accounting methods pool all indirect costs and then allocate them to the various services in proportion to service direct costs. This approach tends to overestimate the unit cost of high volume services and underestimate low-volume services. When indirect costs are large, often the case in healthcare, the cost of services may be misinterpreted. ABC solves this problem by estimating the cost of the work activity that consume resources and by linking these costs to the services that are provided. And even though the authors say that ABC may be difficult to implement, even in the US, it is still feasible in a developing country.

Activity Based Costing: A Decision Making Tool

Prior to the emergence of ABC, companies typically calculated profitability using the allocation method. This allocation method involves allocating costs to a product or customer using metrics such as the total number of accounts, customers, products produced, or transactions. Table 1 gives a hypothetical example of how this method calculates the profitability of three customer channels: store, catalog, and internet. In this example, the company allocates overhead costsincluding accounting, IT, marketing, and call-center coststo customer channels, based on the number of customers per channel.

Table 1. Simple Allocation of Call-Center Overhead

(Source: www.cxoamerica.com)

From the example above, management might conclude that all channels are performing relatively well, but the big opportunity lies in growing the catalog and internet channels through additional investments. These two channelsthough smaller in overall revenueappear more attractive after cost allocations and could realize explosive, profitable growthgiven management attention and aggressive investments.

Table 2 shows the more realistic outcome when an organization applies ABC and apportions call center expenses to each customer channel, based on the number of incoming calls each channel generates. Since catalog customers create 80% of the incoming call-center volume, this channel should incur a greater proportion of the total cost.

Table 2. ABC Allocation of Call-Center Overhead

(Source: www.cxoamerica.com)

The insight from this analysis is far different. After allocating costs based on the consumption of resources, management can see that the catalog channel uses far more resources and is actually less profitable than other channels. Rather than throwing away additional investment to grow this channel, management should take corrective action to bring this segment up to acceptable profitability levels.

Software Packages for ABC

ABC Focus

It is tool for costing products and services and improving efficiencies. "ABC Focus is a tool which makes ABC concepts simple to understand and use. It is a very attractive package because its flexible costing model, consolidated reporting and a very competitive pricing regime make it suitable for large and small business in virtually any industry." ABC Focus provides a structured approach to cost products, services, processes, activities and unused capacity. It provides a platform on which to confidently adjust pricing and activities for competitive advantage.

QPR Cost Control

The user-friendly QPR Cost Control system helps to understand the real cost structure of the company and identify how the business really works. Using the proven approach Activity Based Costing / Management, the software identifies exactly what costs are linked to each individual customer, product, service or activity. QPR Cost Control gives the information to make decisions about the most profitable path for the business. QPR Cost Control is used successfully by all types of organizations, from large international corporations to universities, hospitals and government agencies.

Growing Interest in Activity Based Costing

Activity based costing is being implemented by a growing number of companies around the globe. Specific ABC applications vary from organization to organization. A few organizations use ABC as their basic, ongoing cost accounting system. But many ABC applications are selective- special studies within subparts of the organization, such as business divisions or particular functions.

A survey of US companies in the food and beverage industry found 18% of the respondents implementing ABC and 58% considering it. A survey of Dutch companies in the food and beverage industry found 12% currently using ABC and another 25% are considering it. Among Canadian companies one survey indicates that 14% of the interviewed businesses have implemented ABC and another 15% are considering using ABC it. The ABC system has replaced existing system for 24% of the Canadian respondents and it is a supplementary (off-line) system for 76%. A United Kingdom survey found that just under 20% of 251 respondents had used ABC. An Australian survey found that 43% of the respondents were either using ABC or implementing it. A survey of Irish manufacturing companies that have implemented ABC reported the following percentages for the actual benefits experienced:

A survey of Irish service-sector companies reports similar percentages for the benefits experienced .Results from similar studies in developed economies around the world indicate that ABC is not a passing fad. A majority of companies still use traditional costing methods, but the use of ABC appears to be increasing.

Significance of Activity Based Costing

The following list reflects the results of several surveys of practice in the United States, the United Kingdom, and Canada to determine why companies choose ABC.

• Cost Reduction: - ABC measures how much activities that are costly and then take steps to reduce their costs by changing the productions process or outsourcing those activities.
• Product pricing and decisions of whether to continue producing a product or keeping a particular customer. ABC implementers generally believe that that ABC provides more accurate cost information than conventional costing does. Management can use this information to negotiate price increases with customers or to drop unprofitable products.
• Budgeting and performance measurement: - Management can use more accurate cost information to improve budgets and measures of department and division performance.

Limitations of Activity Based Costing

• More time consuming to collect data
• Cost of buying, implementing and maintaining activity based system
• In some cases, the establishment of cause and effect relationship between cost driver and costs not be a simple affair.
• ABC does not conform to generally accepted accounting principles in some areas.

Conclusion

Activity based costing has revolutionized product costing, planning, and forecasting in the last decade. It is based on a philosophy of estimation that: "it is better to be approximately right, than precisely wrong." In summary, activity-based costing is a management decision-making tool. It provides financial support data structured in a fashion fundamentally different from accounting data provided in the general ledger. By associating cost to the activity, a clear relationship can be established between sources of activity demand and the related costs. This association can benefit the distributor in determining where costs are being incurred, what is initiating the costs and where to apply efforts to curb inflationary costs. This can be of particular value in tracking new products or customers.

References:

1. Bhabatosh Baneerjee-Cost Accounting-Theory and Practice.
2. Hansen&Mowen-Cost Management Accounting and Control.
3. Hilton, Mahar&Selto-Cost Management Strategies for Business Decisions.
4. Horngren, Datar&Foster-Cost Accounting-A Managerial Emphasis.
5. M.E.Thukaram Rao-Cost Accounting
6. www.cashfocus.com
7. www.cxoamerica.com
8. www.greenbusinesscentre.com
9. www.managerialaccounting.org
10. en.wikipedia.org/activity based costing

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