Controlling Cost Using Activity-Based Costing

Since activity-based costing focuses on activities that cause the incurrence of cost, the information
acquired and maintained can be used to control cost. The use of activity based costing information
manages costs by improving processes in the operation in support of organizational strategy is called
Activity Based Management or ABM. ABM combines the concept of activity-based costing and value
analysis. It evaluates the costs of performing an activity and the value in the whole process of such
activity in order to identify the opportunities to improve efficiency.

Activity Based Costing

Resource Costs

Activity Based Management

Root Cause and Performance
Activities
Activity Trigger Measurement

Cost Object

In the diagram above, we can see that the focus of activity based costing is to allocate resource cost to
cost objects through the activities while activity based management uses the activities to trace the root
cause of the incurrence of resource costs and what triggers the activity in order to set performance
measurement guidelines that aims to for a companys operation to become more efficient, in the end,
lowering costs, thus maximizing profits. For example, gasoline and hourly wages of drivers and delivery
personnel will be most likely be influenced by the number of deliveries made in a day. Under activity
based management, the focus is to determine why do companies need to incur gasoline and wages
costs, the answer is when customer request the goods to be delivered, what triggers the increase in
gasoline and wages will be the time taken to go to the customers location and back which will depend
on the route to be taken (i.e. density of traffic, kilometers, etc.) hence, the performance measurement
may be the time taken to deliver goods to customers.

It is to be noted that the step in ABM will start where ABC finished. The ABM process will start with
classifying activities as Value or Non-Value Adding, to be followed by selection of activity and cost
control method and lastly, setting performance measurement policies.
Identifying Value and Non-Value Adding Activities

In identifying value and non-value activities, we can consider two point of view, the traditional or the
customer perspective and the internal perspective. Under the customer perspective activities will be
classified as value adding if it is necessary to the point that the company cannot eliminate such since it
may affect a products value to the customer, two question will be the guide, first, would a customer
encourage the company to do more of the activity?, second, would the company would be more likely
to reach its goal by performing such activity meaning is the activity necessary and unavoidable in
producing and delivering goods and services to customers? The focus here is to determine whether the
activity will add reasons for the customers to avail all the products and services of the company, all
other activities will be considered as non-value adding, which will be viewed as unnecessary costs that a
company tries to minimize and eliminate without t affecting a products value to the customer. The
problem with this perspective is that a lot of support activities like accounting and human resource that
helps in the general management of the business will be classified as non-value adding that will be
subjected to cost control measures which may affect the departments performances since resources
will be limited.

Under the internal perspective, we recognize the inter-relationships between the different functions
and their activities, meaning, in order for sales to their job, they need the support of the production
department in order for them to sell the goods, sales will also need the human resource department for
the recruitment of employees, accounting for performance report and budgeting, and treasury for the
needed operational fund to transact and execute other business activities. In this perspective, activities
are considered as value adding as long as it is not considered as waste and the activities are done with
efficiency, stating it differently, non-value adding activities are waste and activities t6hat are done
inefficiently. Waste is any activity or process that requires costs but does not add value to the company.
The following are considered as waste:

1. Over-production producing even if there were no orders from customers or producing more
than what the customers require.
2. Inventory quantity of items required by customers or in the production process that are being
kept in the warehouse or storage room before it is used, finished or delivered to customers 5hat
may become obsolete, damaged or stolen.
3. Defects (scrap, rework) goods are produced not within the required specification. Scrap are
those parts that will be disposed and without any value while reworks are units that will be
reprocessed again.
4. Over-processing goods are produced beyond the required specification that customers will not
be willing to pay or not needed by the organization.
5. Waiting time the amount of time that raw materials or work in process spend waiting for the
next operation.
6. Unnecessary transportation or unnecessary transfer of products, equipments, people from
one location to another.
7. Unnecessary motion or unnecessary movements by people while doing an activity. This is due
to poo working standard practices, poor process design, or work-area layout.
Generally, only processing time or the time during which a product is undergoing conversion activity or
products are being processed efficiently based on customer requirements are considered to be value
adding.

Cost Reduction Efforts

In reducing costs under the ABM concept, there are two areas that managers need to focus on, control
of activities and control over waste. Control of activities means that any activity that is classified as non-
value adding will be managed that will either result to activity reduction, elimination, selection or
sharing. Activity Reduction means scaling back the activity by reducing the time devoted to it or the
resources that is being allocated to it. This mean that activities or functions will be receiving less
allocation in the budget, request for resources will be carefully scrutinized and will not always be
approved and as much as possible, personnel will be encouraged avoiding the performance of such
activities. Activity Elimination means that activities that are unnecessary are totally removed from the
process. This means that the performance of the activity or function will be completely forbidden.
Activity Selection requires the selection and prioritization of the most efficient activity. Personnel will be
given a hierarchy of preferred activities to be executed, non-value adding activities will be their last
priority. Activity Sharing means combining activities into one function to be more efficient.

In controlling waste, the first logical step is to identify what are the different waste that is being incurred
by the company. This can be done by statistical analysis, process documentation and analysis, motion
studies, etc. When the wastes are identified, the next step is to determine how waste is being incurred,
for example in terms of over-production, managers should be able to trace why there are excess
production, it is because of the nature of the manufacturing process? Or is it due to the mindset of
people in the production? Or is it a result of miscommunication? After determining the reason for the
incurrence of waste, the next logical step is to try to impose policies that will prevent the activities that
results to waste. This might require the change in process or the standard operating procedure of the
company or even re-assignment of personnel.

Performance Management

It is important to note that any improvement efforts of management should always have a point of
evaluation in order to determine whether the efforts are being executed as planned and whether the
outcome is turning out as expected. Performance measurement at its most basic form is simply
comparing what was planned versus what actually occurred and determining the areas for adjustments.
Hence, planned improvement efforts should have at its minimum requirement, the quantifiable target
like cost reduction rate, target manufacturing efficiency, target level of scrap and rework, etc. Also, it
should also include the method of monitoring, like physical count, reporting of managers and superiors,
source documents that are needed to be accomplished, etc.
IMPLEMENTING ACTIVITY BASED COSTING

The process of designing an activity based costing system is as follows:

1. Identify the relevant cost object

It is advisable that when a company will be implementing activity based costing and
management for the first, it should have a pilot project, meaning it should focus its attention to
one aspect of the organization in order to provide a more concentrated approach in the design
of the system.
2. Identify activities
This can be done by accomplishing looking at the Bill of Activities which is a complete listing of
the activities associated with chosen cost driver.
3. Assign ( trace and allocate) costs to activity based cost pools
In order to trace and allocate costs to cost pool, the project team should be able to construct
the storyboard which is simply a process flow chart that shows the activities and relationships
among activities.

4. For each ABC cost pool, choose a cost driver

In choosing a cost driver for every cost pool, the project team should study how the costs in the
cost pool are correlated with a chosen activity.
5. For each ABC cost pool, calculate an allocation way

Allocation Rate = Activity Cost Volume of Cost Driver

6. For each ABC cost pool, allocate activity costs to the cost object

Cost to be applied = Allocation Rate Actual Value of the Activity