Activity-Based Costing (Encyclopedia of Management)
To support compliance with financial reporting requirements, a company's traditional cost-accounting system is often articulated with its general ledger system. In essence, this linkage is grounded in cost allocation. Typically, costs are allocated for either valuation purposes (i.e., financial statements for external uses) or decision-making purposes (i.e., internal uses) or both. However, in certain instances costs also are allocated for cost-reimbursement purposes (e.g., hospitals and defense contractors).
The traditional approach to cost-allocation consists of three basic steps: accumulate costs within a production or nonproduction department; allocate nonproduction department costs to production departments; and allocate the resulting (revised) production department costs to various products, services, or customers. Costs derived from this traditional allocation approach suffer from several defects that can result in distorted costs for decision-making purposes. For example, the traditional approach allocates the cost of idle capacity to products. Accordingly, such products are charged for resources that they did not use. Seeking to remedy such distortions, many companies have adopted a different cost-allocation approach called activity-based costing (ABC).
WHAT IS ACTIVITY-BASED COSTING?
In contrast to traditional cost-accounting systems, ABC systems first accumulate overhead costs for each organizational activity, and then assign the costs of the activities to the products, services, or customers (cost objects) causing that activity. As one might expect, the most critical aspect of ABC is activity analysis. Activity analysis is the processes of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service. Significantly, as discussed in the next section, activity analysis provides the foundation for remedying the distortions inherent in traditional cost-accounting systems.
TRADITIONAL COST-ACCOUNTING SYSTEMS VERSUS ABC
Geared toward compliance with financial reporting requirements, traditional cost-accounting systems often allocate costs based on single-volume measures such as direct-labor hours, direct-labor costs, or machine hours. While using a single volume measure as an overall cost driver seldom meets the cause-and-effect criterion desired in cost allocation, it provides a relatively cheap and convenient means of complying with financial reporting requirements.
In contrast to traditional cost-accounting systems, ABC systems are not inherently constrained by the tenets of financial reporting requirements. Rather, ABC systems have the inherent flexibility to provide special reports to facilitate management decisions regarding the costs of activities undertaken to design, produce, sell, and deliver a company's products or services. At the heart of this flexibility is the fact that ABC systems focus on accumulating costs via several key activities, whereas traditional cost allocation focuses on accumulating costs via organizational units. By focusing on specific activities, ABC systems provide superior cost allocation informationspecially when costs are caused by non-volume-based cost drivers. Even so, traditional cost-accounting systems will continue to be used to satisfy conventional financial reporting requirements. ABC systems will continue to supplement, rather than replace, traditional cost-accounting systems.
In most cases, a company's traditional cost-accounting system adequately measures the direct costs of products and services, such as material and labor. As a result, ABC implementation typically focuses on indirect costs, such as manufacturing over-head and selling, general, and administrative costs. Given this focus, the primary goal of ABC implementation is to reclassify most, if not all, indirect costs (as specified by the traditional cost-accounting system) as direct costs. As a result of these reclassifications, the accuracy of the costs is greatly increased.
According to Ray H. Garrison and Eric W. Noreen, there are six basic steps required to implement an ABC system:
- Identify and define activities and activity pools
- Directly trace costs to activities (to the extent feasible)
- Assign costs to activity cost pools
- Calculate activity rates
- Assign costs to cost objects using the activity rates and activity measures previously determined
- Prepare and distribute management reports
COSTS AND BENEFITS
While ABC systems are rather complex and costly to implement, Charles T. Horngren, Gary L. Sundem, and William O. Stratton suggest that many companies, in both manufacturing and nonmanufacturing industries, are adopting ABC systems for a variety of reasons:
- Margin accuracy for individual products and services, as well as customer classifications, is becoming increasingly difficult to achieve given that direct labor is rapidly being replaced with automated equipment. Accordingly, a company's shared costs (i.e., indirect costs) are becoming the most significant portion of total cost.
- Since the rapid pace of technological change continues to reduce product life cycles, companies do not have time to make price or cost adjustments once costing errors are detected.
- Companies with inaccurate cost measurements tend to lose bids due to over-costed products, incur hidden losses due to under-costed products, and fail to detect activities that are not cost-effective.
- Since computer technology costs are decreasing, the price of developing and operating ABC systems also has decreased.
In 2004 John Karolefski cited the following benefits realized by foodservice distributors and restaurants that have converted to activity-based costing practices:
- Understanding the true costs and productivity of capital equipment
- Understanding which products are most profitable and where to focus sales efforts
- More accurate pricing and determination of minimum order size
- Less time, money, and effort spent on the wrong products
Implementation costs are an obstacle to some, who feel that ABC is just a fad or will show little benefit. According to Karolefski, "ABC works better if it's kept simple" (2004, pp. 18). Nevertheless, when implemented properly ABC yields benefits to the company, its business partners, and to consumers.
In order to manage costs, a manager should focus on the activities that give rise to such costs. Accordingly, given the activity focus of ABC, managers should implement ABC systems in order to facilitate cost management. Using ABC systems to improve financial management is called activity-based management (ABM). The goal of ABM is to improve the value received by customers and, in doing so, to improve profits.
The key to ABM success is distinguishing between value-added costs and non-value-added costs. A value-added cost is the cost of an activity that cannot be eliminated without affecting a product's value to the customer. In contrast, a non-value-added cost is the cost of an activity that can be eliminated without diminishing value. Some value-added costs are always necessary, as long as the activity that drives such costs is performed efficiently. However, non-value-added costs should always be minimized because they are assumed to be unnecessary. Examples of non-valued-added activities include storing and handling inventories; transporting raw materials or partly finished products, such as work-in-process inventory items, from one part of the plant to another; and redundancies in production-line configurations or other activities. Oftentimes, such non-value activities can be reduced or eliminated by careful redesign of the plant layout and the production process.
Brimson, James A. Activity Accounting: An Activity-Based Costing Approach. New York: Wiley, 1997.
Cokins, Gary. "ABC Can Spell a Simpler, Coherent View of Costs." Computing Canada 24, no. 32 (September 1998): 345.
Cokins, Gary. "Why Is Traditional Accounting Failing Managers?" Hospital Material Management Quarterly 20, no. 2 (November 1998): 720.
Daly, John L. Pricing for Profitability: Activity-Based Pricing for Competitive Advantage. New York: Wiley, 2001.
Dolan, Pat, and Karen I. Schreiber. "Getting Started With ABC." Supply House Times 40, no. 4 (June 1997): 412.
Garrison, Ray H., and Eric W. Noreen. Managerial Accounting. 9th ed. Boston: Irwin McGraw-Hill, 1999.
Hicks, Douglas T. Activity-Based Costing: Making It Work for Small and Mid-Sized Companies. 2nd ed. New York: Wiley, 2002.
Horngren, Charles T., Gary L. Sundem, and William O. Stratton. Introduction to Management Accounting. 11th ed. Upper Saddle River, NJ: Prentice Hall, 1999.
Karolefski, John. "Time Is Money: How Much Are Your Customers Costing You?" Food Logistics 15 June 2004, 18.
Lindahl, Frederick W. "Activity-Based Costing Implementation and Adaptation." Human Resource Planning 20, no. 2 (1997): 626.
Activity-Based Costing (Encyclopedia of Small Business)
Activity-based costing (ABC) is an accounting method that allows businesses to gather data about their operating costs. Costs are assigned to specific activitiesuch as planning, engineering, or manufacturingnd then the activities are associated with different products or services. In this way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses. Managers are then able to generate data to create a better budget and gain a greater overall understanding of the expenses that are required to keep the company running smoothly. Generally, activity-based costing is most effective when used over a long period of time, as opposed to shorter-term solutions such as the theory of constraints (TOC).
Activity-based costing first gained notoriety in the early 1980s. It emerged as a logical alternative to traditional cost management systems that tended to produce insufficient results when it came to allocating costs. Harvard Business School Professor Robert S. Kaplan was an early advocate of the ABC system. While mainly used for private businesses, ABC has recently been used in public forums, such as those that measure government efficiency.
HOW ACTIVITY-BASED COSTING WORKS
Activity-based costing programs require proper planning and a commitment from upper management. If possible, it is best to do a trial study or test run on a department whose profit-making performance is not living up to expectations. These types of situations have a greater chance of succeeding and showing those in charge that ABC is a viable way for the company to save money. If no cost-saving measures are determined in this pilot study, either the activity-based costing system has been improperly implemented, or it may not be right for the company.
The first thing a business must do when using ABC is set up a team that will be responsible for determining which activities are necessary for the product or service in question. This team should include experts from different areas of the company (including finance, technology, and human resources) and perhaps also an outside consultant.
After the team is assembled and data on such topics as utilities and materials is gathered, it is then time to determine the elements of each activity that cost money. Attention to detail is very important here, as many of these costs may be hidden and not entirely obvious. As Joyce Chutchian-Ferranti wrote in an article for Computerworld: "The key is to determine what makes up fixed costs, such as the cost of a telephone, and variable costs, such as the cost of each phone call." Chutchian-Ferranti goes on to note that even though in many instances technology has replaced human labor costs (such as in voice-mail systems), a business manager must still examine the hidden costs associated with maintaining the service. Nonactivity costs like direct materials and services provided from outside the company usually do not have to be factored in because this has previously been done.
Once all of these costs are determined and noted, the information must be input into a computer application. Chutchian-Ferranti explains that the software can be a simple database, off-the-shelf ABC software, or customized software. This will eventually give the company enough data to figure out what they can do to increase profit margins and make the activity more efficient.
After a business has had enough time to analyze the data obtained through activity-based costing and determine which activities are cost effective, it can then decide what steps can be taken to increase profits. Activities that are deemed cost prohibitive can then be outsourced, cut back, or eliminated altogether in an effort to make them more profitable. The implementation of these changes is known as activity-based management (ABM).
POTENTIAL PITFALLS OF ACTIVITYBASED COSTING
Companies that implement activity-based costing run the risk of spending too much time, effort, and even money on gathering and going over the data that is collected. Too many details can prove frustrating for managers involved in ABC. On the other hand, a lack of detail can lead to insufficient data. Another obvious factor that tends to contribute to the downfall of activity-based costing is the simple failure to act on the results that the data provide. This generally happens in businesses that were reluctant to try ABC in the first place.
In 1999, Gary Cokins wrote an article aimed at certified public accountants who have difficulty embracing activity-based costing. In "Learning to Love ABC," Cokins explains that activity-based costing usually works best with a minimum amount of detail and estimated cost figures. He backs this up by stating that "typically, when accountants try to apply ABC, they strive for a level of exactness that is both difficult to attain and time-consumingnd that eventually becomes the project's kiss of death."
In 2000, Cokins wrote another article entitled "Overcoming the Obstacles to Implementing Activity-Based Costing." In this work Cokins noted that "activity-based costing projects often fail because project managers ignore the cardinal rule: It is better to be approximately correct than to be precisely inaccurate. When it comes to ABC, close enough is not only good enough; close enough is often the secret to success." Cokins also notes that the use of average cost rates, the use of overly detailed information, and the failure to connect information to action can also hinder ABC projects. By understanding these concepts, Cokins feels that CPAs can enhance their roles as business partners and consultants.
Another limiting factor is that activity-based costing software can be pricey. As Mark Henricks wrote in a 1999 article for Entrepreneur: "Most ABC practitioners find that special-purpose ABC software is required to make the task manageable. At $6,000 and up for one package sold by ABC Technologies, software can add significantly to outlays for this type of accounting technique. There are, however, some pilot packages available for $500."
Time can also be a factor for businesses seeking a quick fix. Henricks notes that "although some companies see results almost instantly, it typically takes three months or so for most businesses to experience the benefits of ABC. And depending on your product or business cycle, it could take much longer."
ACTIVITY-BASED COSTING AND SMALL BUSINESSES
It used to be that large corporations were the only businesses involved in activity-based costing. Not so today. Service industries such as banks, hospitals, insurance companies, and real estate agencies have all had success with ABC. But since its inception, activity-based costing has seemed to have been more successful when implemented by larger companies rather than by smaller ones. As Henrick noted, "Companies with only a few products and markets aren't likely to get as much benefit from basing costs on activities as companies operating with diverse products, service lines, channels and customers." But since setting up activity-based costing for a business usually takes less time for a smaller project, a small business that is unsure about the effectiveness of ABC can consider a simple test program to determine whether it is right for them.
Douglas T. Hicks is one expert who feels that the time is right for small businesses to implement activity-based costing. In a 1999 Journal of Accountancy article entitled "Yes, ABC is for Small Business, Too," Hicks presented a case study for one of his clients, a small manufacturer that builds components for the automobile industry. Hicks detailed how they were able to triple sales and increase profits fivefold in a four-year span after adopting ABC. "Much of this improvement came from a profitable mix of contracts generated by a costing/quoting process that more closely reflects the actual cost structure of the company," Hicks stated. "This has enabled the company to improve the management of its contracts." Isolating and measuring the cost of material movement and using the data to justify many operational changes were other factors Hicks cited for the success his client had with ABC.
Hicks also noted a change in management's attitude after the success of ABC: "On an important but less tangible level, management's knowledge of and attitude toward cost information have undergone a substantial change. Where once managers had their own way of measuring the cost impact of management actions, they now measure those costs in a formal, uniform way. When managers contemplate changes, they have a mental model that directs them toward changes that truly benefit the organization."
Hicks went on to say that "any small or midsize organization can develop an ABC system. It doesn't require a great commitment of time or financial resources. Nor does it require the implementation of special software integrated into the general ledgerlthough for larger organizations that may be a benefit. It requires only that management view its operations through 'the lens of ABC' and create a model that will enable it to measure costs in accordance with that view."
Gary Cokins, director of industry for a noted ABC software and services firm, tends to agree with Hicks. In his book Activity-Based Cost Management: Making It Work, he proclaimed that "Within 10 to 20 years, everyone will have some sort of ABC. It's a matter of when, not if."
Cokins, Gary. Activity-Based Costing: Making It Work. 1998.
Cokins, Gary. "Learning to Love ABC." Journal of Accountancy. August 1999.
Cokins, Gary. "Overcoming the Obstacles to Implementing Activity-Based Costing." Bank Accounting and Finance. Fall 2000.
Chutchain-Ferranti, Joyce. "Activity-Based Costing." Computerworld. August 1999.
Henricks, Mark. "Beneath the Surface." Entrepreneur. October 1999.
Hicks, Douglas T. Activity-Based Costing: Making it Work for Small and Mid-Sized Companies. 1998.
Hicks, Douglas T. "Yes, ABC Is for Small Business, Too." Journal of Accountancy. August 1999.
Lobo, Yane R.O., and Paulo C. Lima. "A New Approach to Product Development Costing." CMAhe Management Accounting Magazine. March 1998.
SEE ALSO: Overhead Costs; Product Costing