This essay introduces activity-based costing (ABC) as a management tool that improves decision-making by linking costs to the activities that consume resources, rather than to production volume. It explains how ABC differs from volume-based costing systems and illustrates its benefits through a real-world example involving the Hospice of Central Kentucky. The paper also covers activity-based management and compares ABC to three alternative efficiency frameworks: lean manufacturing, just-in-time inventory control, and the theory of constraints. Each alternative system is described in terms of its core philosophy and key organizational benefits.
Organizations seeking greater efficiency and cost effectiveness turn to a variety of management concepts for guidance. One such concept is activity-based costing (ABC). ABC is used to manage an organization more effectively and is designed to improve decision-making by generating better information about the cost and performance of activities, resources, and the objects that consume those resources ("Activity-based management — an overview," 2001). This essay discusses ABC and activity-based management, explains how ABC differs from other systems, and describes three alternative frameworks: lean manufacturing, just-in-time, and theory of constraints.
ABC is used across a range of sectors, including manufacturing industries, the financial services industry, and communications and public service sectors (Blocher, 2008). Activity-based management developed as a natural extension of ABC. Drawing on data gathered through ABC, it applies that information to manage products, portfolios, and business processes in more effective ways ("Activity-based management — an overview," 2001).
Several other costing systems attempt to achieve goals similar to those of ABC, but they differ in important respects. Many traditional systems are volume-based rather than activity-based. The information gathered by ABC is grounded in the activities performed for the cost object, rather than in the volume of products produced — a metric that bears little relationship to actual resource cost consumption (Blocher, 2008). This distinction makes ABC a more accurate tool for understanding where costs truly originate within an organization.
Activity-based costing tends to be most beneficial for larger industrial firms that produce more than one product or service (Blocher, 2008). Companies using ABC benefit because the control they gain over activities allows them to manage and reduce costs ("Activity-based management — an overview," 2001). However, ABC is not limited to large industrial firms. One notable example is the Hospice of Central Kentucky. After implementing activity-based costing, the hospice was able to negotiate improved payment terms with its insurance company. It was also encouraged to educate its referral sources to bring patients in before acute care became necessary, potentially avoiding more expensive procedures and generating significant cost savings (Chung, n.d.).
"Lean manufacturing, JIT, and theory of constraints compared"
Lean Manufacturing is a philosophy used by management to pursue the continual elimination of waste in every business process through kaizen, or small, incremental improvements (Gembutsu Consulting, 2007). The benefits of lean manufacturing include the elimination of waste, improved quality, reduced inventory, less space required, enhanced flexibility, easier identification of future kaizen opportunities, and a safer work environment (Gembutsu Consulting, 2007).
Just-in-Time (JIT) is a production and inventory control system in which materials are purchased and units are produced only as needed to meet customer demand ("Just in time (JIT) manufacturing and inventory control system," 2011). The benefits of JIT include freeing up inventory funds for use elsewhere, making inventory storage areas available for more productive uses, reducing throughput time, and decreasing defects ("Just in time (JIT) manufacturing and inventory control system," 2011). More information on JIT principles is available through resources on just-in-time manufacturing.
Theory of Constraints (TOC) is a method for production scheduling. The theory holds that every organization has at least one constraint that dominates the performance of the entire system (Balderstone, n.d.). Benefits of applying TOC include reductions in lead times, improvements in cycle times, better on-time delivery performance, and reduced inventory levels (Balderstone, n.d.). A broader overview of this framework can be found in resources covering the theory of constraints.
Activity-based costing can help organizations become more efficient and cost effective by providing detailed insight into the activities that drive costs within their operations. Many organizations across diverse industries have found success with ABC. However, depending on their specific needs and circumstances, some organizations may find that lean manufacturing, just-in-time, or theory of constraints offers a more suitable path to improved efficiency and reduced costs.
Accounting for Management. (2011). "Just in time (JIT) manufacturing and inventory control system." Retrieved December 5, 2011, from www.accountingformanagement.com/just_in_time.htm.
Balderstone, Steven J., and Victoria J. Mabin. "A review of Goldratt's theory of constraints (TOC) — lessons from international literature." Retrieved December 3, 2011, from http://www.orsnz.org.nz/conf33/papers/p79.pdf.
Blocher, Edward J., et al. (2008). Cost Management: A Strategic Emphasis (4th ed.). McGraw-Hill: 119–169.
Chartered Institute of Management Accountants. (2001). CIMA. "Activity-based management — an overview." Retrieved December 3, 2011, from www.cimaglobal.com/Documents/ImportedDocuments/ABM_techrpt_0401.pdf.
Chung, H.M., and M.B. Khan. "An analysis of activity-based costing (ABC) project implementations." Retrieved December 5, 2011, from www.decisionsciences.org/Proceedings/DSI2008/docs/438-8435.pdf.
Gembutsu Consulting. (2007, August 8). Improvement and Innovation. "The benefits of lean manufacturing: single piece flow." Retrieved December 5, 2011, from www.improvementandinnovation.com/features/article/benefits-lean-manufacturing-single-piece-flow/.
You’re 94% through this paper. Sign up to read the remaining 1 section.
Sign Up Now — Instant Access Already a member? Log inAlways verify citation format against your institution’s current style guide requirements.