Activity based accounting systems and their applications

Activity-Based Costing

Cost accounting is the process of tracking, recording and analyzing costs associated with the activity of an organization, where cost is defined as required time or resources. By convention, costs are measured in units of currency. Activity-based costing (ABC) is a method of allocating costs to products and services. ABC is costing by activities. In this case, activities are those regular actions performed inside a company. "Talking with customer regarding invoice questions" is an example of an activity performed inside most companies. This enables resource and overhead costs to be more accurately assigned to the products and the services that consume them.

Activity-based costing is now an accepted element of the accounting and control systems of industrial and service firms, and it has been employed in both governmental and not-for-profit organizations. ABC is a product of the technological era. Conventional managerial information systems can trace their roots to the industrial age, when labor was the dominant factor of production. Within these systems, overhead cost is first allocated from service departments to production departments and then distributed, using an "overhead charging rate," to specific products. This method was developed to measure manufacturing processes in which overhead was either immaterial or was mainly a function of direct labor, which, in turn, was dependent upon production volume.

Traditional accounting systems are inaccurate in the way that they allocate costs. Large batch or high volume products and services typically incur 50 to 200% less overhead than they are assigned. Small batch or low volume products and services typically incur 200 to 1000% more overhead than they are assigned. This means that products and services that are considered highly profitable may in fact be profit eaters. This inaccuracy is becoming more and more critical as companies move toward customer-defined products and services, which often means a batch size of one. In order to correctly associate costs with products and services, ABC assigns cost to activities based on their use of resources. It then assigns costs to objects, such as products or customers, based on their use of activities. This information assists in making decisions about pricing, outsourcing, capital expenditures and operational efficiency. For example:

Traditional

ABC

Salaries $100

Clean door $40

Equipment $80

Paint door $75

Supplies $20

Inspect door $75

Overhead $45

Send door to assembly $55

TOTAL $245

ABC is generally used as a tool for planning and control. It was developed as an approach to address problems associated with traditional cost management systems, that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. With these deficiencies, managers can be exposed to making decisions based on inaccurate data. Companies with multiple products or services have higher exposure. ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods. The activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity. Some of the advantages ABC offers is an improved means of identifying high overhead costs per unit and finding ways to reduce the costs. "There is a positive association between ABC and improvement in ROI when implemented in complex and diverse firms, in environments where costs are relatively important, and when there are limited numbers of intra-company transactions to constrain benefits."

Accountants assign 100% of each employee's time to the different activities performed inside a company. Many will use surveys to have the workers themselves assign their time to the different activities. The accountant then can determine the total cost spent on each activity by summing up the percentage of each worker's salary spent on that activity. Each product or service is produced and delivered via the activities performed in the company. The accountant can then assign the different activities to the different products using an appropriate allocation method.

Activities can be defined as a named process, function, or task that occurs over time and has recognized results. Activities use up assigned resources to produce products and services. Inputs are transformed into outputs under the perimeters set by controls performed by the organization's employees and their tools. Activities can be perceived as consumers of resources in production of materials, services, events, or information. Activities are the common denominator between business process improvement and information improvement.

Documenting and understanding activities is necessary in order to improve the business process, since activities are the building blocks of business processes. When employees understand the activities they perform, they can better understand costs based on the activities. ABC reorganizes traditional financial information into a form that makes sense to the casual functional user; in addition to the usual information that tells them how they spend money. It also tells them what to do with the money. This ability to place costs on activities and their outputs provides a clear metric for improvement, whether for determining improvement priorities in the long-term or for measuring near-term success. ABC allows functional users to characterize the value of, or need for, each activity, getting rid of the waste before automating (or reautomating) activities.

A company can use the resulting activity cost data to determine where to focus their operational improvement efforts. "By monitoring the costs - by comparing actuals with targets - you will be able to see whether your plans and targets are being achieved. Corrective action can be taken relatively quickly. This might involve rethinking your business goals and strategies for the foreseeable period." For example, a job-based manufacturer may find that a high percentage of their workers are spending their time trying to figure out a hastily written customer order. Via ABC, the accountants now have a dollar amount that will be associated with the activity of "Researching Customer Work Order Specifications." Senior management can now decide how much focus or money to budget for the resolutions of this process deficiency. The use of activity-based costing to manage a business is called activity-based management.

Before performing ABC, a baseline or a starting point ("as-is") is needed for business process improvement model, and a baseline can be expressed in some form of model. A baseline is a documentation of the organization's or agency's policies, practices, methods, measures, costs and their interrelationships at a particular location at a particular point in time. Through baselining, activity inputs and outputs across functional lines of business can be identified. ABC is the only improvement methodology that provides output or unit costs.

There are five activities that need to occur in order to determine activity costs. First the scope of the activities to be analyzed must be identified. It is suggested that the program include at least a half-dozen organizational units having a common functional orientation, and preferably also a common budget somewhere in the reporting chain. The depth and detail of analysis will be determined by activity decomposition, since activity decomposition is complete when one common or homogeneous primary output per activity is reached. A determination then is made if an activity is value or non-value added; also if the activity is primary or secondary, and required or not needed. Value added is determined if the output of the activity is directly related to customer requirements, service or product, as opposed to an administrative or logistical outcome that services the providing organization. For instance, if the output of an activity were an inventory report or update for products (for which there are customers), the output would be non-value added, but necessary to the organization, i.e., "overhead." A major goal of reengineering is to reduce non-value added activities and eliminate those that are not necessary. Primary activities directly support the organization's mission while secondary activities support primary activities. Required activities are those that must always be performed while discretionary activities are performed only when allowed by the operating management.

Costs are then gathered for the activity producing the products or services provided as the outcome. "The most accurate and most costly procedure for computing proportions is the collection of real data. In most cases, a data collection procedure must be developed and data collection equipment may need to be purchased. Moreover, collection of the data will need to be timely and skilled collectors may be required. The results often have to be analyzed using statistical methods." These costs can be salaries, expenditures for research, machinery, office furniture, etc. These costs are used as the baseline activity costs. When documents for the costs incurred are not available, cost assignment formulas may be used. This is sometimes called "tracing." Traceability refers to tracing costs to cost objects to determine why costs were incurred.

Costs can be categorized in three ways. Direct costs are those that can be traced directly to one output. For example, the material costs (varnish, wood, paint) to build a chair. Indirect costs are those that cannot be allocated to an individual output; in other words, they benefit two or more outputs, but not all outputs. An example would be maintenance costs for the saws that cut the wood, storage costs, other construction materials, and quality assurance. General & Administrative-costs cannot reasonably be associated with any particular product or service produced (overhead). These costs would remain the same no matter what output the activity produced. An example would be salaries of personnel in purchasing department, depreciation on equipment, and plant security.

In the next step the results of analyzing activities and the gathered organizational inputs and costs are brought together, which produces the total input cost for each activity. A simple formula for costs is provided - outputs consume activities that in turn have consumed costs associated with resources. This leads to a simple method to calculate total costs consumed by an activity - multiply the percent of time expended by an organizational unit, e.g., branch, division, on each activity by the total input cost for that entity. Here we are not calculating costs, just finding where they come from.

Next, the actual activity unit cost is calculated. Even though activities may have multiple outputs, only one is identified as the primary output. Activity unit cost is calculated by dividing the total input cost, including assigned costs from secondary activities, by the primary activity output volume; the primary output must be measurable and its volume or quantity obtainable. From this, a bill of activities can then be calculated which contains or lists a set of activities and the amount of each activity consumed. The amount of each activity consumed is extended by the activity unit cost and is added up as a total cost for the bill of activity. Below is an example of a form used to capture first stage cost drivers.

Expense Category

Cost ($)

Cost Drivers

Administration

Time (hours)

Depreciation

Dollar use of resources ($)

Rent and utilities

Space (ft2)

Office expenses

Level of use of office resources (%)

Transport

Distance (miles)

Interest

Cost of the activity ($)

Product shipment

Weight (Lb)

Business travel

Distance (miles)

Business insurance and legal expenses

Cost of resource used by the activity ($)

Advertising

Level of benefit (%)

Entertainment

Level of importance of customer (%)

Miscellaneous expenses

The organization assigns activity costs to outputs using activity drivers. Activity drivers assign activity costs to outputs based on individual outputs' consumption or demand for activities. For example, a driver may be the number of times an activity is performed (transaction driver) or the length of time an activity is performed (duration driver). Below is example of a form used to capture second stage cost drivers where activities are traced to products.

Activity

Cost Driver

Customer contact

Number of customer contacts

Quote preparation

Number of quotes

Engineering work

Engineering hour

Material purchasing

Number of purchase orders

Production preparation

Number of production runs

Material receiving and handling

Number of receptions

Production management and supervision

Product complexity

Quality assurance

Product complexity

Product shipping

Distance

Customer payment administration

Number of payments

General management and administration

Intensity of activities

In the final step, the calculated activity unit costs and bills of activity are used to identify candidates for improving the business processes. Managers can use the information by stratifying, for a Pareto analysis, the activity costs and identifying a certain percentage of activities that consume the majority of costs. The identification of non-value added activities occurs through this process with a clarity that allows the organization to eliminate them, and at the same time permits the product or service to be provided to the customer with greater efficiency.

It is an unwritten rule respected by many in the business world that you generally treat your best customers the best. The problem is, does an organization really know who their best customers are, or do they think you know? The majority of business people have the false perception that the best customer is the one that accounts for the largest portion of their income every year. This is not always the case because that same customer may also be responsible for the biggest part of their expenses. Activity-based costing is a costing method that provides managers with useful information they need regarding the contribution that each customer makes to overall profitability. Also, ABC allows managers to see how to maximize performance and implement sound profit-growth strategies.