What is Activity Based Costing?

Activity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs (overhead) into direct costs. In this way, an organization can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced. In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.

Concept of Activity-Based-Costing in layman terms:

An organization performs activities to do its business. These activities define the kind of business you are in: a ship owner has an activity to unpack boats; an accounting firm prepares tax returns; a manufacturer produces products; a council delivers services; a university teaches students. All activities consume resources. It is the consumption of these resources that adds to overhead costs. The basis of Activity Based Costing is: look at the activities required to produce the cost of the product or service. The activities consume resources and the cost of these can be calculated. The amount of activity required for each product and service is determined, hence the real cost can be determined.

What's what in ABC?

The activity is the work that is done. The resource is what the activity uses to do the work e.g. people, equipment, and services. Resources cost money. The cost of the activity depends on the quantity of resources used to accomplish the activity. The cost driver for an activity is the factor that influences the amount of the resources that will be consumed by this 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. (Note: The software has the facility to enter and change the cost drivers as better information becomes available). 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. The cost object is whatever it is you wish to cost. It could be a product, service, process, job or customer. While traditional costing arbitrarily allocates overhead costs, ABC traces overhead costs by looking at the activities that each product and service calls upon. With ABC the products consume the activities. It is the activities that cost money.

How Does ABC Work?

The first stage in an initial ABC study is to develop a fundamental understanding of the Resources (expenditures) and Activities (work performed) of an organization. The Resources are then mapped to the Activities, thereby quantifying the cost of performing each of these Activities. These costs are traced to Cost Objects (customers, products, or services) providing tremendous insight into where an organization is making and losing money.

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: 1. Identify the Resources (expenditures) of an organization 2. Determine Activities (work performed) that are supported by Resources 3. Define Cost Objects (products, services, customers) 4. Develop Resource Drivers to link Resources to Activities

5. Develop Cost Drivers to link Activities to Cost Objects

Uses
It helps to identify inefficient products, departments and activities It helps to allocate more resources on profitable products, departments and activities It helps to control the costs at an individual level and on a departmental level It helps to find unnecessary costs It helps fixing price of product or service scientifically

Limitations
Even in activity-based costing, some overhead costs are difficult to assign to products and customers, such as the chief executive's salary. These costs are termed 'business sustaining' and are not assigned to products and customers because there is no meaningful method. This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed. Although some may argue that costs untraceable to activities should be "arbitrarily allocated" to products, it is important to realize that the only purpose of ABC is to provide information to management. Therefore, there is no reason to assign any cost in an arbitrary manner.

Cost
ABC is considered a relatively costly accounting methodology. Lean accounting methods have been developed in recent years to provide relevant and thorough accounting, control, and measurement systems without the complex and costly methods of ABC.

Prevalence
Following initial enthusiasm, ABC lost ground in the 1990s, to alternative metrics, such as Kaplan's balanced scorecard and economic value added.
ABC has stagnated over the last five to seven years, Kaplan, 1998

ABC with Example

Lets illustrate the concept of activity based costing by looking at two common manufacturing activities: (1) the setting up of a production machine for running batches of products, and (2) the actual production of the units of product. We will assume that a company has annual manufacturing overhead costs of $2,000,000of which $200,000 is directly involved in setting up the production machines. During the year the company expects to perform 400 machine setups. Lets also assume that the batch sizes vary considerably, but the setup efforts for each machine are similar. The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost. This means that $200,000 will first be allocated to batches of products to be manufactured (referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per unit for setup will be $0.01 ($500 divided by 50,000 units). For simplicity, lets assume that the remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate with the companys 100,000 machine hours. For our simple two-activity example, let's see how the rates for allocating the manufacturing overhead would look with activity based costing and without activity based costing: With ABC Mfg overhead costs assigned to setups Number of setups Mfg overhead cost per setup $200,000 Without ABC $0

400 Not applicable $500 $0

Total manufacturing overhead costs Less: Cost traced to machine setups Mfg O/H costs allocated on machine hours Machine hours (MH) Mfg overhead costs per MH

$2,000,000 200,000 $1,800,000 100,000 $18

$2,000,000 0 $2,000,000 100,000 $20

Mfg Overhead Cost Allocations

$500 setup cost per batch + $18 per MH

$20 per MH

Next, let's see what impact these different allocation techniques and overhead rates would have on the per unit cost of a specific unit of output. Assume that a company manufactures a batch of 5,000 units and

it produces 50 units per machine hour, here is how the cost assigned to the units with activity based costing and without activity based costing compares: With ABC Mfg overhead for setting up machine No. of units in batch Mfg O/H caused by Setup Per Unit $500 5,000 $0.10 Without ABC $0 Not applicable Not applicable

Mfg overhead costs per machine hour No. of units produced per machine hour Mfg O/H caused by Production Per Unit

$18 50 $0.36

$20 50 $0.40

Total Mfg O/H Allocated Per Unit

$0.46

$0.40

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how the cost assigned to the units with ABC and without ABC compares: With ABC Mfg overhead for setting up machine No. of units in batch Mfg O/H caused by Setup Per Unit $500 50,000 $0.01 Without ABC $0 Not applicable Not applicable

Mfg overhead costs per machine hour No. of units produced per machine hour Mfg O/H caused by Production Per Unit

$18 50 $0.36

$20 50 $0.40

Total Mfg O/H Allocated Per Unit

$0.37

$0.40

As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch.