Activity-Based Costing: Methods, Benefits, and Applications

Introduction to Activity-Based Costing

Cost accounting is the process of tracking, recording, and analyzing costs associated with the activities 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 — that is, by the regular actions performed inside a company. "Talking with a customer regarding invoice questions" is an example of an activity performed inside most companies. This approach enables resource and overhead costs to be more accurately assigned to the products and 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.

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, which tend to be unable 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 face higher exposure. ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods. The activities responsible for costs can be identified and passed on to users only when the product or service actually uses the activity. Among the advantages ABC offers is an improved means of identifying high overhead costs per unit and finding ways to reduce them. As one study notes, "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."

Traditional accounting systems are inaccurate in the way 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 1,000% more overhead than they are assigned. This means that products and services considered highly profitable may in fact be profit eaters. This inaccuracy is becoming increasingly 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 costs 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. The contrast between traditional and ABC cost assignment can be illustrated as follows:

Limitations of Traditional Cost Accounting

Traditional: Salaries $100 | Equipment $80 | Supplies $20 | Overhead $45 | Total: $245

ABC: Clean door $40 | Paint door $75 | Inspect door $75 | Send door to assembly $55 | Total: $245

While the totals are identical, ABC reveals exactly which activities drive costs, enabling targeted management action that the traditional summary cannot provide.

Accountants assign 100% of each employee's time to the different activities performed inside a company. Many use surveys to have workers themselves assign their time to the different activities. The accountant can then 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 different products using an appropriate allocation method.

How ABC Works: Core Concepts and Process

Activities can be defined as named processes, functions, or tasks that occur over time and have recognized results. Activities use up assigned resources to produce products and services. Inputs are transformed into outputs under the parameters set by controls performed by the organization's employees and their tools. Activities can be perceived as consumers of resources in the 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 those activities. ABC reorganizes traditional financial information into a form that makes sense to the functional user — in addition to the usual information about how money is spent, it also indicates what should be done with that money. This ability to place costs on activities and their outputs provides a clear metric for improvement, whether for determining long-term priorities or measuring near-term success. ABC allows functional users to characterize the value of, or need for, each activity, eliminating waste before automating or re-automating activities.

A company can use the resulting activity cost data to determine where to focus its operational improvement efforts. As one source notes, "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 its workers are spending their time trying to interpret a hastily written customer order. Via ABC, accountants now have a dollar amount associated with the activity of "Researching Customer Work Order Specifications." Senior management can then decide how much focus or budget to allocate toward resolving this process deficiency. The use of activity-based costing to manage a business is called activity-based management.

Before performing ABC, a baseline — or "as-is" starting point — is needed for the business process improvement model. A baseline is a documentation of the organization's policies, practices, methods, measures, costs, and their interrelationships at a particular location and 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 must 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 half a dozen organizational units having a common functional orientation and, preferably, a common budget somewhere in the reporting chain. The depth and detail of analysis will be determined by activity decomposition, which is complete when one common or homogeneous primary output per activity is reached. A determination is then made as to whether an activity is value-added or non-value-added, whether it is primary or secondary, and whether it is required or unnecessary.

Value-added status is determined by whether the output of the activity is directly related to customer requirements, service, or product — as opposed to an administrative or logistical outcome that serves the providing organization. For instance, if the output of an activity were an inventory report or update for products, the output would be non-value-added but still 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 permitted by operating management.

Costs are then gathered for the activities producing the products or services provided as outcomes. "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 include salaries, research expenditures, machinery, office furniture, and so on, and they serve as the baseline activity costs. When documents for incurred costs are unavailable, cost assignment formulas — sometimes called "tracing" — may be used. Traceability refers to tracing costs to cost objects to determine why costs were incurred.

In the next step, the results of analyzing activities and the gathered organizational inputs and costs are brought together, producing the total input cost for each activity. A simple formula applies: outputs consume activities, which in turn have consumed costs associated with resources. This leads to a straightforward method for calculating total costs consumed by an activity — multiply the percentage of time expended by an organizational unit (e.g., branch or division) on each activity by the total input cost for that entity. At this stage the goal is not to calculate new costs, but to find where existing costs originate.

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 be calculated, listing each activity and the amount of each activity consumed. The amount of each activity consumed is extended by the activity unit cost and totaled as the bill of activity cost.

In the final step, the calculated activity unit costs and bills of activity are used to identify candidates for business process improvement. Managers can stratify activity costs using a Pareto analysis, identifying the 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 while simultaneously delivering the product or service to the customer with greater efficiency.

Conclusion

The major objective of the ABC process is to objectively determine a better way of doing business. "ABC provides not only relatively accurate cost data, but also information about the origin of the cost. ABC has been implemented in numerous companies, and managers familiar with the ABC method were able to manage costs more successfully." The analysis of these costs and models serves to provide the basis from which decisions can be made and evaluated.