Definition of Activity Based Costing

Introduction

Activity-Based Costing (ABC) is a costing model that identifies activities in an organization and allocates the indirect resources to each activity for completion of the production of goods and services. It relates indirect cost to the activities that drive them to be incurred.

In traditional costing system, the indirect costs are allocated on the basis of volume of output. Over a period of time, the technology has been improved and it requires adopting a change in method of cost structures for the allocation of overhead on the basis of cost drivers.

Definition

Activity Based costing is “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.”

-- Peter B. B. Turney

Some examples of indirect costs and their drivers are:

Maintenance costs are indirect costs and the possible driver of thiscost may be the number of machine hours,

Handling raw-material cost is another indirect cost that may bedriven by the number of orders received

Inspection costs that are driven bythe number of inspections or thehours of inspection or production runs.

Generally, the cost driver for short term indirect variable costs may be the volume of output/ activity; but for long term indirect variable costs, the cost drivers cannot be related to volume of output/ activity.

Example

The activity is delivering goods. The costs of this activity include the truck drivers’ wages, fuel, depreciation of the truck, insurance, etc. The quantities of the resources that will be consumed by this activity are influenced by the number of deliveries made per year. Hence the cost driver could be the number of deliveries. A cost driver is designed to allocate the delivery activity cost pool to the cost objects.

The activity driver measures how much of the activity is used by the cost object. Example: Product A is delivered once a month, whereas product B is delivered once a week. Products A and B require a different number of deliveries, hence the cost of the delivery activity should be assigned to each product on the basis of the number of deliveries each uses.

We can classify the cost drivers into two categories such as structural and execution. Structural cost drivers that are derived from the business strategic choices about its underlying economic structure such as scale and scope of operations, complexity of products, use of technology, etcand Execution cost drivers that are derived from the execution of the business activities such as capacity utilization, plant layout, work-force involvement, etc.

The establishment of cost drivers are essential for the different cost pool stream to carry out Activity based costing. It is developed to provide more-accurate ways of assigning the costs of indirect and support resources to activities, business processes, products, services, and customers.

ABC systems recognize that many organizational resources are required to provide a wide arrangement of support activities that enable a variety of products and services to be produced for a varied group of customers. The ABC goal is to measure and then price out all the resources used for activities that support the production and delivery of products and services to customers.

The basis of Activity Based Costing is

Identify the activities required to produce the cost of the product or service.

Allocate the resources on each activity

Establish the cost drivers on each activity and count its numbers,

Determine the cost per cost drivers,

Determine the amount of activity required for each product and service

Determine the real cost for a single product or services.

Difference between Traditional Cost System and Activity Based costing system

From the following Diagram we can compare the system of traditional and ABC:-

In Traditional cost models the resources are applied to products in two ways. That is known as direct costs and indirect cost. The direct cost is the cost which is attributed directly to the product e.g., material and direct labor whereas the indirect cost like sales, marketing and administrative costs are not included in product costs.

Activity Based Costing (ABC) does not change the way material and direct labor are attributed to manufactured products. The primary task of activity based costing is to break out indirect activities into meaningful pools which can then be assigned to processes in a manner which better reflects the way costs are actually incurred. The system must recognize that resources are consumed by processes or products in different proportions for each activity.

All costs are existed in resources like material, labor, space, equipment and services. Resources are consumed by activities which have no inherent cost. The cost associated with activities represents the amount of resource they consume per unit of activity. Resources and activities are then applied to cost objects, that is, the purpose for which the resource is consumed and the activity is performed.

The resource and activity is measured in terms of units which defines the amount of the resource consumed or activity required by a unit of demand for it. Resources can be consumed by resources (e.g. office space resource is consumed by an employee resource), by activities (e.g. telephone resource is consumed by a customer service call activity) or by cost objects (e.g. material resource is consumed by a product cost object).

Activities can be performed in support of another activity (e.g. invoice printing activity supports the billing activity) or in response to a cost object (e.g. purchase orders are issued to support the material acquisition process). A cost object can be a process or product and either an interim cost object or an end user (customer) cost object. For example, hiring personnel may be a cost object of Human Resources Department utilizing space, utility, telephone, supply and labor resources and performing advertising, calling, interviewing and orientation activities. That cost object may be a resource used by other departments to secure labor resource for their department.

A network of resources, activities and cost objects are to be constructed in the operational flow of the process. Each resource and activity has a unit of measure which converts them at a unit of demand rate. First, we need to understand the business process and it is to be identified and develop a cost model. The cost model is essential and it must be useful and effective in determining the process. The costs are attached to determine the cost of the defined process.

Activity-Based-Costing is necessary for the following reasons.

To Understand True profitability of the customers, products, or services

To Quantify the cost of non-value added activities such as errors and reworks,

To Identify opportunities to reduce costs and/or increase efficiency,

To Obtain actionable information to negotiate price increases for unprofitable clients,

To Understand why profitability may be mediocre despite good strategic fundamentals,

To Stratify overhead costs so they can be managed more effectively

ABC Model

The objective of an ABC implementation is to relate all of the costs of doing business to products, services, or customers. Developing the initial model consists of the following five steps:

Identification of the Resources (expenditures) of an organization

Determination of Activities (work performed) that are supported by Resources

Description of the Cost Objects (products, services, customers)

Development of Resource Drivers to link Resources to Activities

To Develop the Cost Drivers to link Activities to Cost Objects

Identification of Resources

Resources represent the expenditures of an organization.

Example: production labour, sales and marketing labor, occupancyand utilities, equipment, and supplies. These are the same costs that are represented in a traditional accounting view; unlike traditional accounting, ABC links these costs to products, customers, or services.

Determination of Activities

Activities represent the work performed in an organization.

Example: ABC Activities for the sales department in a typicalorganization might include: Making sales calls to existing customers, Making sales calls to potential customers, Making customer service calls, Training product representatives, Evaluating products and improving product knowledge, Distributing samples, Attending trade shows and other events.

In traditional accounting, the cost of the sales department is breaking into salaries, benefits, allocated rent, supplies, and so on. Unlike traditional accounting, which reports what the costs are (i.e. salaries, benefits, rent); ABC accounts for these costs based on what activities caused them to occur. By determining the actual activities that occur in various departments, such as accounting, customer service, and sales, it is then possible to more accurately relate these costs to customers, products, and services.

Description of the Cost Objects

ABC provides profitability by one or more cost object, usually represented by products, customers, and/or services. Cost Object profitability is utilized to identify money losing customers, to validate separate divisions or business units, or to measure the performance of individual projects, jobs, or contracts. Defining the outputs to be viewed is an important step in a successful ABC implementation.

Determination of Resource Drivers

Resource Drivers provide the link between the expenditures of an organization and the Activities performed within the organization.

For example, the total salary of a customer service representativewould likely be allocated to the Activities performed based on the amount of time spent performing the Activity. If 50% of her time is spent performing the activity, taking orders for existing customers, 50% of her salary (including all costs such as benefits, taxes, and insurance) would be allocated to this Activity.

Determination of Cost Drivers

Determination of Cost Drivers completes the last stage of the model. Cost Drivers trace, or link, the cost of performing certain Activities to Cost Objects.

For example, taking orders for existing customers may be linkedto specific customers based on the number of orders taken, if each order takes approximately the same amount of time. If order taking time varies based on the customer, this cost may be linked based on another driver or multiple drivers.

Conclusion

Today, companies are using ABC to make better-informed decisions about pricing, what type of customers to pursue, and what products or services to offer. Activity-Based Costing determines the TRUE COST &PROFITABILITY of customers, products, and/or services. While traditional accounting may provide the business with an accurate sense of the direct costs of the products or services, indirect costs are often less accurately applied. Overhead, such as customer support or marketing costs tend to be allocated based on arbitrary factors.