This paper examines activity-based costing (ABC) as an alternative to traditional volume-based cost allocation systems. It traces ABC's historical roots from Alexander Hamilton Church's early 20th-century writings to its formal introduction by Johnson and Kaplan in 1987 and its global adoption by 1992. The paper outlines Henry Yennie's six-step ABC process, contrasts ABC with traditional costing methodologies, and argues that ABC provides more accurate indirect cost allocation by linking costs to the activities that drive them. The paper concludes that ABC enables managers to make better strategic decisions in an environment of rising overhead and declining direct labor costs.
In today's global marketplace, manufacturing firms face ever-increasing competition. Due to the fluidity of the business environment, companies must react quickly to change while manufacturing high-quality, low-cost products in order to remain competitive. Traditional costing systems that utilize a volume-based allocation of overhead have lost relevance in a manufacturing environment that has seen a sharp increase in overhead costs and a subsequent decline in direct labor. These traditional costing systems tend to distort product costs and lead to poor strategic decision-making. To make proper decisions, senior managers must have accurate and up-to-date costing information (Roztocki, Porter, Thomas, & Needy, 2004).
One innovative costing method designed to address the deficiencies of traditional costing systems is activity-based costing (ABC).
The United States dominated the world's economy from the end of World War II until the 1980s. During the period from the 1950s to the 1970s, American companies needed only to concentrate on output in order to achieve growth and profitability. Little attention was paid to quality or cost control. In the 1980s, Japanese manufacturers began to produce low-cost, high-quality goods, forcing U.S. companies to find ways to reduce costs and increase quality in order to compete. Managers began to employ activity-based costing, which helped identify cost-reduction opportunities. By 1992, activity-based costing had gained worldwide recognition and was being used in America, Europe, Asia, and Australia.
Activity-based costing was first introduced as an improved way to calculate cost by H. Thomas Johnson and Robert S. Kaplan in their 1987 book Relevance Lost: The Rise and Fall of Management Accounting (Naughton-Travers, 2001). ABC was presented as a way to solve the problems of traditional costing systems, which were unable to accurately determine the actual costs of production. The original focus was on the manufacturing industry, where new technology and process improvements had reduced the proportion of direct labor and material costs while increasing the proportion of indirect costs.
Alexander Hamilton Church originally suggested what would become activity-based costing methods in 1901. Church began writing on the subject of overhead, arguing that overhead represented the cost of several factors of production and that each should be traced individually to products. He believed that information about a product's cost should reflect all the resources used to make it (Boyns, 2003).
Henry Yennie (1999) describes six key steps in the ABC process. The first step is to identify activities by interviewing those involved in performing the work. Yennie suggests focusing on key and significant activities, and advises against having management staff identify activities, since management's perception of what is happening on the production line is often out of alignment with actual events.
The second step is to determine how resources are related to activities. Resources are consumed as activities are performed; the relationship between resource costs and activities is called a resource driver. Yennie suggests analyzing the general ledger to determine how costs are currently reported. Once these relationships have been defined, cost and utilization data are collected and applied to the model. Financial data can be drawn from the general ledger and income statements, while some utilization data may need to be gathered if it is not routinely recorded. Useful questions for quantifying the relationship between resources and activities include: How much time is spent performing each activity? What equipment is used? Do some activities have dedicated equipment? Do some activities require more space than others?
The third step is to calculate activity costs. This is accomplished by assigning specific drivers to activities based on interviews and logical associations. The fourth step is to identify cost objects — the products, services, or customers to which costs will ultimately be assigned. The fifth step is to determine how activities are related to those cost objects in terms of time and resources invested. The sixth and final step is to calculate the total cost for each cost object.
"Comparing overhead allocation methodologies"
Activity-based costing offers a more accurate and actionable alternative to traditional costing systems by tracing indirect costs to the activities that generate them. As overhead has grown and direct labor has declined in modern manufacturing, the limitations of volume-based cost allocation have become increasingly apparent. ABC equips managers with the detailed, reliable cost information needed to make sound strategic decisions, reduce waste, and improve competitiveness in a demanding global marketplace.
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