Activity-based Costing (ABC)

According to its pioneers - Robin Cooper, Robert Kaplan, and H. Thomas Johnson - activity-based costing (ABC) is a costing methodology used to trace overhead costs directly to cost objects, i.e., products, processes, services, or customers, and help managers make the right decisions regarding product mix and competitive strategies.

ABC also makes it very clear that integrated costs associated with the services that the customer demands play a crucial role in determining each customer's contribution to net profit.

The basic premise of ABC:

• Cost objectives consume activity
  
  
• Activities consume resources
  
  
• This consumption of resources is what drives costs
  
  
• Understanding this relationship is critical to successfully managing overhead

 

When Should You Use ABC?

• Overhead is high
• Products are diverse
  (complexity, volume, amount of direct labor)
• Costs of errors are high
• Competition is stiff

 

How Should You Use ABC?

Here are the steps in performing ABC:

1. Identify activities (Analyze activities)

First, the scope of the activities to be analyzed must be identified. It is suggested that the program includes at least a half-dozen organizational units having a common functional orientation, and preferably also a common budget somewhere in the reporting chain.

Example:

• Set-up
• Machining
• Receiving
• Packing
• Engineering

 

2. Determine cost for each activity (Gather costs)

In this step, costs are gathered for the activity producing the products or services provided as the outcome. These costs can be salaries, expenditures for research, machinery, office furniture, etc. These costs are used as the baseline activity costs. When documents for the costs incurred are not available, cost assignment formulas may be used.

Example:

Set-up	$10,000.00
Machining	$40,000.00
Receiving	$10,000.00
Packing	$10,000.00
Engineering	$30,000.00

 

3. Determine cost drivers (Trace cost for each activity)

In this step, the results of analyzing activities and the gathered organizational inputs and costs are brought together, which produces the total input cost for each activity. A simple formula for costs is provided - outputs consume activities that in turn have consumed costs associated with resources. This leads to a simple method to calculate total costs consumed by an activity - multiply the percent of time expended by an organizational unit, e.g., branch, division, on each activity by the total input cost for that entity. Here we are not calculating costs, just finding where they come from.

Example:

Set-up	Number of set-ups
Machining	Machining hours
Receiving	Number of receipts
Packing	Number of deliveries
Engineering	Engineering hours

 

4. Collect activity data (Establish output measures)

In this step, the actual activity unit cost is calculated. Even though activities may have multiple outputs, only one is identified as the primary output. Activity unit cost is calculated by dividing the total input cost, including assigned costs from secondary activities, by the primary activity output volume; the primary output must be measurable and its volume or quantity obtainable. From this, a bill of activities can then be calculated which contains or lists a set of activities and the amount of each activity consumed. The amount of each activity consumed is extended by the activity unit cost and is added up as a total cost for the bill of activity.

Example:

Activities	Cost ($)	Product A	Cost ($)	Product B	Cost ($)
Set-up	10,000.00	1	2,500.00	3	7,500.00
Machining	40,000.00	100	2,000.00	1,900	38,000.00
Receiving	10,000.00	1	2,500.00	3	7,500.00
Packing	10,000.00	10	2,500.00	3	7,500.00
Engineering	30,000.00	500	15,000.00	500	15,000.00
		TOTAL	24,500.00	TOTAL	75,500.00

 

5. Calculate product cost (Analyze costs)

   In the final step, the calculated activity unit costs and bills of activity are used to identify candidates for improving the business processes. Managers can use the information by stratifying, for a Pareto analysis, the activity costs and identifying a certain percentage of activities that consume the majority of costs. The thing to keep in mind is that the identification of non-value added activities occurs through this process with a clarity that allows us to eliminate them, and at the same time, permits the product or service to be provided to the customer with greater efficiency.

   Example:

   Overhead for product A:	$24,500 : 100 = $245
   Overhead for product B:	$75,500 : 950 = $79.47

   Sources:

   http://www.pitt.edu/~roztocki/abc/abctutor/index.htm
   
   
   http://www.faa.gov/ait/bpi/handbook/chap5.htm#costing
   

    

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