Activity-based costing

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Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. Therefore, this model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

Contents

The UK's Chartered Institute of Management Accountants (CIMA), defines ABC as an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs. [1]

The Institute of Cost Accountants of India says, ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of the activities undertaken to produce each product or services. It accurately identifies sources of profit and loss. [2]

The Institute of Cost & Management Accountants of Bangladesh (ICMAB) defines activity-based costing as an accounting method which identifies the activities which a firm performs and then assigns indirect costs to cost objects. [3]

Objectives

With ABC, a company can soundly estimate the cost elements of entire products, activities and services, that may help inform a company's decision to either:

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.

Prevalence

Following strong initial uptake, ABC lost ground in the 1990s compared to alternative metrics, such as Kaplan's balanced scorecard and economic value added. An independent 2008 report concluded that manually driven 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. [4] Other reports show the broad band covered with the ABC methodology. [5]

However, application of an activity based recording may be applied as an addition to activity based accounting, not as a replacement of any costing model, but to transform concurrent process accounting into a more authentic approach.

Historical development

Traditionally, cost accountants had arbitrarily added a broad percentage of analysis into the indirect cost. In addition, activities include actions that are performed both by people and machine.

However, as the percentages of indirect or overhead costs rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all 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, additional cost for use of the machine is not being recognized 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.

ABC is based on George Staubus' Activity Costing and Input-Output Accounting. [6] 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. [7]

Robin Cooper and Robert S. Kaplan, proponents 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 more 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. [8] 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 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. [9] [10]

Activity-based costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. [11] He states that traditional cost accounting focuses on what it costs to do something, for example, to cut a screw thread; activity-based costing also records the cost of not doing, such as the cost of waiting for a needed part. Activity-based costing records the costs that traditional cost accounting does not do.

The overhead costs assigned to each activity comprise an activity cost pool.

From a historical perspective the practices systematized by ABC were first demonstrated by Frederick W. Taylor in Principles of Scientific Management in 1911 (1911. Taylor, Frederick Winslow (1919) [1911]. The Principles of Scientific Management. Harper & Brothers – via Internet Archive (Prelinger Library) Free access icon. LCCN 11-10339; OCLC 233134 (all editions). The Principles of Scientific Management – via Project Gutenberg Free access icon.). Those were the basis of the famous time and motion studies (Time and motion study) that predated the later work by Walter Shewhart (Walter A. Shewhart) and W Edwards Deming (W. Edwards Deming). Kaplan's work tied the earlier work to the modern practice of accounting.

Alternatives

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 manually driven ABC.

Lean accounting is primarily used within lean manufacturing. The approach has proven useful in many service industry areas including healthcare, construction, financial services, governments, and other industries.

Application of Theory of constraints (TOC) is analysed in a study [12] showing interesting aspects of productive coexistence of TOC and ABC application. Identifying cost drivers in ABC is described as somewhat equivalent to identifying bottlenecks in TOC. However the more thorough insight into cost composition for the inspected processes justifies the study result: ABC may deliver a better structured analysis in respect to complex processes, and this is no surprise regarding the necessarily spent effort for detailed ABC reporting.

Methodology

Methodology of ABC focuses on cost allocation in operational management. ABC helps to segregate

If achieved, the split of cost helps to identify cost drivers. 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 cost driver is a factor that creates or drives the cost of the activity. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions (cost driver) take at the counter and then by measuring the number of each type of transaction. For the activity of running machinery, the driver is likely to be machine operating hours, looking at labor, maintenance, and power cost during the period of machinery activity.

Application

ABC has proven its applicability beyond academic discussion.[ citation needed ]

ABC

A report summarizes reasons for implementing ABC as mere unspecific and mainly for case study purposes [13] (in alphabetical order):

Beyond such selective application of the concept, ABC may be extended to accounting, hence proliferating a full scope of cost generation in departments or along product manufacturing. Such extension, however requires a degree of automatic data capture that prevents from cost increase in administering costs.

Implementation

According to Manivannan Senthil Velmurugan, Activity-based costing must be implemented in the following ways: [14]

  1. Identify and assess ABC needs - Determine viability of ABC method within an organization.
  2. Training requirements - Basic training for all employees and workshop sessions for senior managers.
  3. Define the project scope - Evaluate mission and objectives for the project.
  4. Identify activities and drivers - Determine what drives what activity.
  5. Create a cost and operational flow diagram – How resources and activities are related to products and services.
  6. Collect data – Collecting data where the diagram shows operational relationship.
  7. Build a software model, validate and reconcile.
  8. Interpret results and prepare management reports.
  9. Integrate data collection and reporting.

Public sector usage

When ABC is reportedly used in the public administration sector, the reported studies do not provide evidence about the success of methodology beyond justification of budgeting practise and existing service management and strategies.

Usage in the US Marine Corps started in 1999. [15] [16] [17] [18]

Use of ABC 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. [19]

Integrating EVA and process based costing

Recently, Mocciaro Li Destri, Picone & Minà (2012) [20] proposed a performance and cost measurement system that integrates the economic value added (EVA) criteria with process based costing (PBC).

Authors note that activity-based costing system is introspective and focuses on a level of analysis which is too low.[ citation needed ] On the other hand, they underscore the importance to consider the cost of capital in order to bring strategy back into performance measures.[ citation needed ]

Limitations

Applicability of ABC is bound to cost of required data capture. [1] That drives the prevalence to slow processes in services and administrations, where staff time consumed per task defines a dominant portion of cost. Hence the reported application for production tasks do not appear as a favorized scenario.

Treating fixed costs as variable

The potential problem with ABC, like other cost allocation approaches, is that it essentially treats fixed costs as if they were variable. This can, without proper understanding, give some people an inaccurate understanding which can then lead to poor decision making. For example, allocating PPE to individual products, may lead to discontinuation of products that seem unprofitable after the allocation, even if in fact their discontinuation will negatively affect the bottom line.

Tracing costs

Even in ABC, 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.

Transition to automated activity-based costing accounting

The prerequisite for lesser cost in performing ABC is automating the data capture with an accounting extension that leads to the desired ABC model. Known approaches for event based accounting simply show the method for automation. Any transition of a current process from one stage to the next may be detected as a relevant event. Paired events easily form the respective activity.

The state of the art approach with authentication and authorization in IETF standard RADIUS gives an easy solution for accounting all workposition based activities. That simply defines the extension of the Authentication and Authorization (AA) concept to a more advanced AA and Accounting (AAA) concept. Respective approaches for AAA get defined and staffed in the context of mobile services, when using smart phones as e.a. intelligent agents or smart agents for automated capture of accounting data .

Related Research Articles

Cost accounting is defined by the Institute of Management Accountants as "a systematic set of procedures for recording and reporting measurements of the cost of manufacturing goods and performing services in the aggregate and in detail. It includes methods for recognizing, allocating, aggregating and reporting such costs and comparing them with standard costs". Often considered a subset of managerial accounting, its end goal is to advise the management on how to optimize business practices and processes based on cost efficiency and capability. Cost accounting provides the detailed cost information that management needs to control current operations and plan for the future.

In management accounting or managerial accounting, managers use accounting information in decision-making and to assist in the management and performance of their control functions.

<span class="mw-page-title-main">Inventory</span> Goods held for resale

Inventory or stock refers to the goods and materials that a business holds for the ultimate goal of resale, production or utilisation.

Environmental full-cost accounting (EFCA) is a method of cost accounting that traces direct costs and allocates indirect costs by collecting and presenting information about the possible environmental costs and benefits or advantages – in short, about the "triple bottom line" – for each proposed alternative. It is one aspect of true cost accounting (TCA), along with Human capital and Social capital. As definitions for "true" and "full" are inherently subjective, experts consider both terms problematic.

Cost of goods sold (COGS) is the carrying value of goods sold during a particular period.

<span class="mw-page-title-main">Throughput accounting</span> Principle of management accounting

Throughput accounting (TA) is a principle-based and simplified management accounting approach that provides managers with decision support information for enterprise profitability improvement. TA is relatively new in management accounting. It is an approach that identifies factors that limit an organization from reaching its goal, and then focuses on simple measures that drive behavior in key areas towards reaching organizational goals. TA was proposed by Eliyahu M. Goldratt as an alternative to traditional cost accounting. As such, Throughput Accounting is neither cost accounting nor costing because it is cash focused and does not allocate all costs to products and services sold or provided by an enterprise. Considering the laws of variation, only costs that vary totally with units of output e.g. raw materials, are allocated to products and services which are deducted from sales to determine Throughput. Throughput Accounting is a management accounting technique used as the performance measure in the Theory of Constraints (TOC). It is the business intelligence used for maximizing profits, however, unlike cost accounting that primarily focuses on 'cutting costs' and reducing expenses to make a profit, Throughput Accounting primarily focuses on generating more throughput. Conceptually, Throughput Accounting seeks to increase the speed or rate at which throughput is generated by products and services with respect to an organization's constraint, whether the constraint is internal or external to the organization. Throughput Accounting is the only management accounting methodology that considers constraints as factors limiting the performance of organizations.

Project accounting is a type of managerial accounting oriented toward the goals of project management and delivery. It involves tracking, reporting, and analyzing financial results and implications, and sometimes the creation of financial reports designed to track the financial progress of projects; the information generated by this analysis is used to aid project management.

Activity-based management (ABM) is a method of identifying and evaluating activities that a business performs, using activity-based costing to carry out a value chain analysis or a re-engineering initiative to improve strategic and operational decisions in an organization.

Indirect costs are costs that are not directly accountable to a cost object. Like direct costs, indirect costs may be either fixed or variable. Indirect costs include administration, personnel and security costs. These are those costs which are not directly related to production. Some indirect costs may be overhead, but other overhead costs can be directly attributed to a project and are direct costs.

The Chartered Institute of Management Accountants defines a cost driver as:

[A] cost driver is any factor which causes a change in the cost of an activity.

In business, overhead or overhead expense refers to an ongoing expense of operating a business. Overheads are the expenditure which cannot be conveniently traced to or identified with any particular revenue unit, unlike operating expenses such as raw material and labor. Therefore, overheads cannot be immediately associated with the products or services being offered, thus do not directly generate profits. However, overheads are still vital to business operations as they provide critical support for the business to carry out profit making activities. For example, overhead costs such as the rent for a factory allows workers to manufacture products which can then be sold for a profit. Such expenses are incurred for output generally and not for particular work order; e.g., wages paid to watch and ward staff, heating and lighting expenses of factory, etc. Overheads are also a very important cost element along with direct materials and direct labor.

Total absorption costing (TAC) is a method of Accounting cost which entails the full cost of manufacturing or providing a service. TAC includes not just the costs of materials and labour, but also of all manufacturing overheads. The cost of each cost center can be direct or indirect. The direct cost can be easily identified with individual cost centers. Whereas indirect cost cannot be easily identified with the cost center. The distribution of overhead among the departments is called apportionment.

Job costing is accounting which tracks the costs and revenues by "job" and enables standardized reporting of profitability by job. For an accounting system to support job costing, it must allow job numbers to be assigned to individual items of expenses and revenues. A job can be defined to be a specific project done for one customer, or a single unit of product manufactured, or a batch of units of the same type that are produced together.

Cost allocation is a process of providing relief to shared service organization's cost centers that provide a product or service. In turn, the associated expense is assigned to internal clients' cost centers that consume the products and services. For example, the CIO may provide all IT services within the company and assign the costs back to the business units that consume each offering.

Cost pools is an accounting term that refers to groups of accounts serving to express the cost of goods and service allocatable within a business or manufacturing organization. The principle behind the pool is to correlate direct and indirect costs with a specified cost driver, so to find out the total sum of expenses related to the manufacture of a product.

Standard cost accounting is a traditional cost accounting method introduced in the 1920s, as an alternative for the traditional cost accounting method based on historical costs.

<span class="mw-page-title-main">J. Lee Nicholson</span> American economist

Jerome Lee Nicholson was an American accountant, industrial consultant, author and educator at the New York University and Columbia University, known as pioneer in cost accounting. He is considered in the United States to be the "father of cost accounting."

<span class="mw-page-title-main">Cost breakdown analysis</span> Method of cost analysis, which itemizes the cost of a certain product into its components

In business economics cost breakdown analysis is a method of cost analysis, which itemizes the cost of a certain product or service into its various components, the so-called cost drivers. The cost breakdown analysis is a popular cost reduction strategy and a viable opportunity for businesses.

Customer Profitability Analysis is a management accounting and a credit underwriting method, allowing businesses and lenders to determine the profitability of each customer or segments of customers, by attributing profits and costs to each customer separately. CPA can be applied at the individual customer level or at the level of customer aggregates / groups.

The UVA method is an accounting and decision-making tool, based on calculating the cost of sales. Unlike management accounting, which calculates product margins, the UVA method calculates the result generated by each sale. The UVA method relies on a very detailed analysis of all costs related to products, customers, orders, and deliveries. It introduces the notion of a single measure unit, which applies to all the operations in the company. The method relies on an equivalent-based approach.

References

  1. 1 2 CIMA official Terminology, 2005 (PDF). p. 3.
  2. ↑ "(pdf) Pg: 231" (PDF).
  3. ↑ Bangladesh Cost Accounting Standards-14: Activity Based Costing.
  4. ↑ The Review of Policing Final Report by Sir Ronnie Flanagan February 2008
  5. ↑ Activity-based costing: A Case study
  6. ↑ Staubus, George J. Activity Costing and Input-Output Accounting (Richard D. Irwin, Inc., 1971).
  7. ↑ Consortium for Advanced Manufacturing-International
  8. ↑ Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective (Harvard Business School Press, 1987) ISBN   0-87584-186-4
  9. ↑ Sapp, Richard, David Crawford and Steven Rebishcke "Article title?" Journal of Bank Cost and Management Accounting (Volume 3, Number 2), 1990.
  10. ↑ Author(s)? "Article title?" Journal of Bank Cost and Management Accounting (Volume 4, Number 1), 1991.
  11. ↑ Drucker Peter F.Management Challenges of the 21st Century. New York:Harper Business, 1999.
  12. ↑ Who Wins in a Dynamic World: Theory of Constraints Vs. Activity-Based Costing?
  13. ↑ The design and implementation of Activity Based Costing (ABC): a South African survey Archived 13 August 2011 at the Wayback Machine
  14. ↑ Velmurugan, Manivannan Senthil. "The Success And Failure of Activity-Based Costing Systems", Journal of Performance Management, 23.2 (2010): 3–33. Business Source Complete. Web. 15 March 2012.
  15. ↑ MARINE CORPS ACTIVITY BASED COSTING (ABC)
  16. ↑ "Activity-Based Costing (ABC)". Archived from the original on 4 October 2011. Retrieved 31 May 2011.
  17. ↑ SAS helps Marine Corps budgets get lean
  18. ↑ Energizing cost accounting: Marine Corps financial managers conduct a thorough analysis
  19. ↑ Police Service National ABC Model Manual of Guidance Version 2.3 June 2007
  20. ↑ Mocciaro Li Destri A., Picone P. M. & Minà A. (2012), Bringing Strategy Back into Financial Systems of Performance Measurement: Integrating EVA and PBC, Business System Review, Vol 1., Issue 1. pp.85-102 https://ssrn.com/abstract=2154117.
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