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Activity-based costing (ABC) is a
costing Cost accounting is defined 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, classifying, al ...
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 Indirect costs are costs that are not directly accountable to a cost object (such as a particular project, facility, function or product). Like direct costs, indirect costs may be either fixed or variable. Indirect costs include administration, ...
( overhead) into
direct costs Direct costs are costs which are directly accountable to a cost object (such as a particular project, facility, function or product). Direct cost is the nomenclature used in accounting. The equivalent nomenclature in economics is specific cost. By ...
compared to conventional costing. CIMA, the
Chartered Institute of Management Accountants The Chartered Institute of Management Accountants (CIMA) is the global professional management accounting body based out of the UK. CIMA offers training and qualification in management accountancy and related subjects. It is focused on accountan ...
, defines ABC as an approach to the costing and monitoring of activities which involves tracing
resource consumption Resource consumption is about the consumption of non-renewable, or less often, renewable resources. Specifically, it may refer to: * water consumption * energy consumption ** electric energy consumption ** world energy consumption * natural gas co ...
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. 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.


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: *Identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim), or *Identify and eliminate production or service processes which are ineffective, and allocate processing concepts that lead to the very same product at a better yield (process re-engineering aim) In a business organization, the ABC methodology assigns an organization's resource
cost In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something or deliver a service, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which ...
s through activities to the
product Product may refer to: Business * Product (business), an item that serves as a solution to a specific consumer problem. * Product (project management), a deliverable or set of deliverables that contribute to a business solution Mathematics * Produ ...
s and
services Service may refer to: Activities * Administrative service, a required part of the workload of university faculty * Civil service, the body of employees of a government * Community service, volunteer service for the benefit of a community or a p ...
provided to its customers. ABC is generally used as a tool for understanding product and
customer cost Customer cost refers not only to the price of a product, but it also encompasses the purchase costs, use costs and the post-use costs. Purchase costs consist of the cost of searching for a product, gathering information about the product and the c ...
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 A balanced scorecard is a strategy performance management tool – a well structured report, that can be used by managers to keep track of the execution of activities by the staff within their control and to monitor the consequences arising from t ...
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. Other reports show the broad band covered with the ABC methodology. 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
accountant An accountant is a practitioner of accounting or accountancy. Accountants who have demonstrated competency through their professional associations' certification exams are certified to use titles such as Chartered Accountant, Chartered Certifi ...
s 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 cost 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 r ...
s 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. The concepts of ABC were developed in the
manufacturing sector In macroeconomics, the secondary sector of the economy is an economic sector in the three-sector theory that describes the role of manufacturing. It encompasses industries that produce a finished, usable product or are involved in constructio ...
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. Robin Cooper and Robert S. Kaplan, proponents of the
Balanced Scorecard A balanced scorecard is a strategy performance management tool – a well structured report, that can be used by managers to keep track of the execution of activities by the staff within their control and to monitor the consequences arising from t ...
, 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 Production may refer to: Economics and business * Production (economics) * Production, the act of manufacturing goods * Production, in the outline of industrial organization, the act of making products (goods and services) * Production as a stati ...
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 W. may refer to: * SoHo (Australian TV channel) (previously W.), an Australian pay television channel * ''W.'' (film), a 2008 American biographical drama film based on the life of George W. Bush * "W.", the fifth track from Codeine's 1992 EP ''Bar ...
as a chapter in their book ''Accounting and Management: A Field Study Perspective''. 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 institution Financial institutions, sometimes called banking institutions, are business entities that provide services as intermediaries for different types of financial monetary transactions. Broadly speaking, there are three major types of financial insti ...
s 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. Activity-based costing was later explained in 1999 by
Peter F. Drucker Peter Ferdinand Drucker (; ; November 19, 1909 – November 11, 2005) was an Austrian-American management consultant, educator, and author, whose writings contributed to the philosophical and practical foundations of the modern business co ...
in the book ''Management Challenges of the 21st Century''. 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.


Alternatives

Lean accounting Lean, leaning or LEAN may refer to: Business practices * Lean thinking, a business methodology adopted in various fields ** Lean construction, an adaption of lean manufacturing principles to the design and construction process ** Lean governm ...
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 Lean manufacturing is a production method aimed primarily at reducing times within the production system as well as response times from suppliers and to customers. It is closely related to another concept called just-in-time 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 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 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 service ...
in operational management. ABC helps to segregate *
Fixed cost In accounting and economics, 'fixed costs', also known as indirect costs or overhead costs, are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be recurring, such as interest or r ...
*
Variable cost Variable costs are costs that change as the quantity of the good or service that a business produces changes.Garrison, Noreen, Brewer. Ch 2 - Managerial Accounting and Costs Concepts, pp 48 Variable costs are the sum of marginal costs over all un ...
*
Overhead cost 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 r ...
If achieved, the split of cost helps to identify
cost driver According to the most simple definition, a cost driver is the unit of an activity that causes a change in the activity's cost: A different meaning is assigned to the term by Michael Porter: "cost drivers are the structural determinants of the cost ...
s. 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. ABC *is applicable throughout company financing, costing and accounting: *is a modeling process applicable for full scope as well as for partial views. *helps to identify inefficient products, departments and activities. *helps to allocate more resources on profitable products, departments and activities. *helps to control the costs at any per-product-level level and on a departmental level. *helps to find unnecessary costs that may be eliminated. *helps fixing the price of a product or service with any desired analytical resolution. A report summarizes reasons for implementing ABC as mere unspecific and mainly for case study purposes (in alphabetical order): * Better Management * Budgeting, performance measurement * Calculating costs more accurately * Ensuring product /customer profitability * Evaluating and justifying investments in new technologies * Improving product quality via better product and process design * Increasing competitiveness or coping with more competition * Management * Managing costs * Providing behavioral incentives by creating cost consciousness among employees * Responding to an increase in overheads * Responding to increased pressure from regulators * Supporting other management innovations such as TQM and JIT systems 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 Velmurugan, Activity-based costing must be implemented in the following ways: #Identify and assess ABC needs - Determine viability of ABC method within an organization. #Training requirements - Basic training for all employees and workshop sessions for senior managers. #Define the project scope - Evaluate mission and objectives for the project. #Identify activities and drivers - Determine what drives what activity. #Create a cost and operational
flow diagram Flow diagram is a collective term for a diagram representing a flow or set of dynamic relationships in a system. The term flow diagram is also used as a synonym for flowchart, and sometimes as a counterpart of the flowchart.Harris. (1999, p. 156 ...
– How resources and activities are related to products and services. #Collect data – Collecting data where the diagram shows operational relationship. #Build a software model, validate and reconcile. #Interpret results and prepare management reports. #Integrate
data collection Data collection or data gathering is the process of gathering and measuring information on targeted variables in an established system, which then enables one to answer relevant questions and evaluate outcomes. Data collection is a research com ...
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 A budget is a calculation play, usually but not always financial, for a defined period, often one year or a month. A budget may include anticipated sales volumes and revenues, resource quantities including time, costs and expenses, environmen ...
practise and existing
service management Service management in the manufacturing context, is integrated into supply chain management as the intersection between the actual sales and the customer point of view. The aim of high-performance service management is to optimize the service- ...
and strategies. Usage in the
US Marine Corps The United States Marine Corps (USMC), also referred to as the United States Marines, is the maritime land force service branch of the United States Armed Forces responsible for conducting expeditionary and amphibious operations through combi ...
started in 1999. Use of ABC by the
UK Police Law enforcement in the United Kingdom is organised separately in each of the legal systems of the United Kingdom: England and Wales, Northern Ireland and Scotland. Most law enforcement is carried out by police officers serving in regional po ...
has been mandated since the 2003-04
UK tax year A fiscal year (or financial year, or sometimes budget year) is used in government accounting, which varies between countries, and for budget purposes. It is also used for financial reporting by businesses and other organizations. Laws in many ...
as part of England and Wales' National Policing Plan, specifically the Policing Performance Assessment Framework.Police Service National ABC Model Manual of Guidance Version 2.3 June 2007
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Integrating EVA and process based costing

Recently, Mocciaro Li Destri, Picone & Minà (2012)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. 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. On the other hand, they underscore the importance to consider the cost of capital in order to bring strategy back into performance measures.


Limitations

Applicability of ABC is bound to cost of required data capture. 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 The Internet Engineering Task Force (IETF) is a standards organization for the Internet and is responsible for the technical standards that make up the Internet protocol suite (TCP/IP). It has no formal membership roster or requirements and a ...
standard
RADIUS In classical geometry, a radius ( : radii) of a circle or sphere is any of the line segments from its center to its perimeter, and in more modern usage, it is also their length. The name comes from the latin ''radius'', meaning ray but also the ...
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 phone A smartphone is a portable computer device that combines mobile telephone and computing functions into one unit. They are distinguished from feature phones by their stronger hardware capabilities and extensive mobile operating systems, which ...
s as e.a.
intelligent agent In artificial intelligence, an intelligent agent (IA) is anything which perceives its environment, takes actions autonomously in order to achieve goals, and may improve its performance with learning or may use knowledge. They may be simple or c ...
s or smart agents for automated capture of accounting data .


References


External links


Who Wins in a Dynamic World: Theory of Constraints Vs. Activity-Based Costing?
article on SSRN
proposed International Good Practice Guidance on Costing to Drive Organizational Performance
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International Federation of Accountants The International Federation of Accountants (IFAC) is the global advocacy organization for the accountancy profession; mainly for the financial accounting and auditing professions. Founded in 1977, IFAC has more than 175 members and associates in ...
{{DEFAULTSORT:Activity-Based Costing Management accounting