Activity Based Costing (ABC) is an alternative to the traditional way of accounting.

Traditionally it is believed that high volume customers are profitable customers, a loyal customer is also a profitable one, and profits will follow a happy customer. Studies on customer profitability have unveiled that the above is not necessarily true. ABC is a costing model that identifies the cost pools, or activity centers, in an organization and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service. As a result, Activity Based Costing can support managers to see how to maximize shareholder value and improve corporate performance.

Historically, cost accounting models related indirect costs on the basis of volume. Typical benefits of Activity-Based Costing (also: 'Activity Based Management') include:

Identifying the most and least profitable customers, products and channels. Determine the true contributors to- and detractors from- financial performance. Accurately predict costs, profits and resource requirements associated with changes in production volumes, organizational structure and resource costs. Easily identify the root causes of poor financial performance. Track costs of activities and work processes. Equip managers with cost intelligence to drive improvements. Facilitate better Marketing Mix Enhance the bargaining power with the customer. Achieve better Positioning of products

With the costing based on activities, the cost of serving a customer can be ascertained individually. Deducting the product cost and the cost to serve each customer, one can arrive at customers profitability. This method of dealing with customer cost and product cost separately has lead to identifying the profitability of each customer and to position products and services accordingly.

ABC implementation can help make employees to understand the various costs involved, which will in turn enable them to analyze the cost, identify the Value Added and Non Value Added Activities, implement the improvements and realize the benefits. This is a continuous improvement process in terms of analyzing the cost, to reduce or eliminate the Non Value Added activities and to achieve an overall efficiency. ABC has helped enterprises in answering the market need of better quality products at competitive prices. Analyzing the product profitability and customer profitability, the ABC method has contributed effectively for the top managements decision making process. With ABC, enterprises are able to improve their efficiency and reduce the cost without sacrificing the value for the customer. Many companies also use ABC as a basis for a balanced scorecard.

This has also enabled enterprises to model the impact of cost reduction and subsequently confirm the

savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method for continuous improvement. With Activity Based Costing, any enterprise will have a built in competitive cost advantage and can continuously add value to both its stakeholders and customers.

The implementation of Activity Based Costing is not easy - not an ABC. However special activity based costing software can be helpful.

Furthermore, Robert Kaplan and Steven Anderson have suggested Time-Driven Activity-Based Costing. This is a new approach to sidestep the difficulties associated with large-scale ABC implementation (HBR November 2004). In this revised model, managers estimate the resource demands imposed by each transaction, product, or customer, rather than relying on time-consuming and costly employee surveys. The Time-Driven Activity-Based Costing method is simpler since it requires, for each group of resources, estimates of only two parameters: how much it costs per time unit of capacity to supply resources to the business activities (the total overhead expenditure of a department divided by the total number of minutes of employee time available) and an estimation of the unit times of activities -how much time it takes to carry out one unit of each kind of activity - (as estimated or observed by the manager). This Time-Driven ABC approach also overcomes a serious technical problem associated with employee surveys: the fact that, when asked to estimate time spent on activities, employees invariably report percentages that add up to 100. Managers should take into account time that is idle or unused. The method also supports time equations, a feature that enables the ABC model to reflect the complexity of real-world operations by showing how specific order, customer, and activity characteristics cause processing times to vary.
Activity-Based Costing Definition Activity-Based Costing (ABC) is a method of allocating costs to products and services. It 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, that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. With these defiencies managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services. ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods. The activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity. Some of the advantages ABC offers is an improved means of identifying high overhead costs per unit and finding ways to reduce the costs. The way it works is first major activities are identified in the process system. Next cost pools are created for groups of activities that can be allocated together. Following this cost drivers are identified. The number of cost drivers used vary depending on the balance between accuracy and complexity. After determining the cost drivers, rates are calculated. The rates are then applied to

the respective cost drivers for each product or service that is being considered. The overhead cost per unit is then derived by dividing the total cost for the product by the total product units.

The Issues One of the basic issues surrounding ABC is the difficulty of implementation. Identifying activities or processes to be allocated properly is cumbersome and takes a lot of effort. It requires that processes are adequately mapped throughout the organization. For a company that has undertaken a quality effort, or an effort to reengineer business processes, a major part of the work may already be completed. But for those who have not it is likely to be a major undertaking. Just as anything else, Activity-Based Costing is no panacea, nor should it be embraced as a religion, or a fad. It is an operational strategy that needs to be carefully reviewed for applicability. The best way to approach the situation is to first rationalize a facility and its processes, identify the opportunities, and then conceptualize a solution. If this fits, use it.

Pragmatic Applications Activity-Based Costing makes a lot of sense for companies with multiple products or services who are suffering from inaccurate costing information and need to know which products are really winners and which are losers. For these companies the effort required to successfully implement ABC is worth the time and resources. ABC can identify high overhead costs per unit and find ways to reduce the costs, avoid decreases in head counts due to inaccurate allocation of costs, and measure profitability with higher accuracy than traditional costing that uses direct-labor hours as the only cost driver.

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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 establish the true cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which 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 and identification and measurement of process improvement initiatives.

Historical development
Traditionally cost accountants had arbitrarily added a broad percentage of expenses onto the direct costs to allow for the indirect costs. However as the percentages of indirect or overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognised when the same broad 'on-cost' percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.[1]

Robin Cooper and Robert S. Kaplan, proponent of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products. Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products. Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. [2] They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost. Like manufacturing industries, financial institutions also have diverse products and customers which can cause cross-product cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this.[3][4]

[edit] Methodology

Cost center Cost allocation Fixed cost Variable cost Cost driver Cost driver rate

Direct labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions takes at the counter and then by measuring the number of each type of transaction.

[edit] Uses

It helps to identify inefficient product,department and activity It helps to allocate more resources on profitable product,department and activity It helps to control the cost at individual level and on departmental level It helps to find unneccesary costs

[edit] Limitations
Even in activity-based costing, some overhead costs are difficult to assign to products and customers, for example 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.

[edit] Cost
ABC is considered a relatively costly accounting methodology, and whether it is good value is questioned.[5] ABC has been found to be a very high-cost accounting technology. Installing an ABC system is technically complex, requiring talented personnel and a considerable amount of time and money

Public sector use

ABC is widely used in the public sector,[6] including by the United States Marine Corps.[5] Its use by the UK Police has been mandated since the 2003-04 UK tax year as part of England and Wales National Policing Plan, specifically the Policing Performance Assessment Framework.[6] An independent 2008 report concluded that ABC was an inefficient use of resources: it was expensive and difficult to implement for small gains, and a poor value, and that alternative methods should be used

Activity Based Costing Advantages

More accurate costing of products/services, customers, SKUs, distribution channels Better understanding overhead

Easier to understand for everyone Utilizes unit cost rather than just total cost Integrates well with Six Sigma and other continuous improvement programs Makes visible waste and non-value added Supports performance management and scorecards Enables costing of processes, supply chains, and value streams Activity Based Costing mirrors way work is done Facilitates benchmarking

Activity Based Costing Disadvantages

More time consuming to collect data Cost of buying, implementing and maintaining activity based system Makes waste visible which some executives and managers don't want their boss to see

Activity Based Costing (ABC): Reasons to Implement

Activity Based Costing (ABC): Drucker Tells Why
Peter Drucker for a long time has supported Activity Based Costing because it gives superior information about the costs of an organization thus enabling managers to make better decisions. In the book:

Activity Accounting: Activity Based Costing Approach

Brimson identifies benefits from Activity Accounting:

Providing insight into the fastest-growing and least visible element of costoverhead Improving profitability by monitoring total life-cycle cost and performance Improving the effectiveness of budgeting by identifying the cost/performance relationship of different service levels Encouraging continuous improvement and total quality control because planning and control are directed at process level Linking corporate strategy to operational decision making Facilitating elimination of waste by providing visibility of non-value added activities Improving make/buy, estimating, and pricing decisions that are based on product cost that mirrors the manufacturing process