Management Guide: Activity-Based Costing

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Overview of Activity-Based Costing

Accurate and relevant cost information is critical to any organisation that hopes to maintain or improve its competitive position. For years, organisations operated under the assumption that their cost information actually reflected the costs of their products and services when, in reality, it did nothing of the kind. While hiding their shortcomings behind a cloak of precision, over-generalised cost systems were actually misleading decision makers, causing them to make decisions inconsistent with their organisations' needs and goals.

Activity-based costing (ABC) is a valuable concept that can be used to correct the shortcoming sin the over-generalised cost systems of the past. It is a means of creating a system that ultimately directs an organisation’s costs to the products and services that required those costs to be incurred.

At many organisations, ABC has evolved beyond the point of simply developing more accurate and relevant product, process, service, and activity costs. These organisations use ABC as a means of improving operations by managing the drivers of the activities that cause costs to be incurred. They are using ABC to support major decisions on product lines market segments, and customer relationships, as well as to simulate the impact of process improvements organisations involved in Total Quality Management processes are using both the financial and non-financial intermission of ABC as a measurement system.

ABC can be used this way because it provides across-functional, integrated view of the firm, its activities, and its business processes.

What is Activity-Based Costing (ABC)

The basic distinction between traditional cost accounting and ABC is as follows: Traditional cost-accounting techniques allocate costs to products based on attributes of a single unit. Typical attributes include the number of direct labour hours required to manufacture a unit, purchase cost of merchandise resold, or number of days occupied. Allocations, therefore, vary directly with the volume of units produced, cost of merchandise sold, or days occupied by the customer. In contrast, ABC systems focus on activities required to produce each product or provide each service based on each product's or service's consumption of the activities.

Using ABC, overhead costs are traced to products and services by identifying the resources, activities, and their costs and quantities to produce output. A unit of output (a driver) is used to calculate the cost of each activity. Cost is traced to the product or service by determining how many units of output each activity consumed during any given period of time.

ABC does not only apply to manufacturing organisations: it is also appropriate for service organisations such as financial institutions, medical care providers, and government units. In fact, some banking organisations have been applying the concept for years under a different name - unit costing. Unit costing is used to calculate the cost of banking services by determining the cost and consumption of each unit of output of functions required to deliver the service.

Implementing ABC – Convincing the Organisation to Change

Implementation of an effective ABC system will never occur unless it is supported at all levels within the organisation. Management must first be shown that existing cost accounting practices do not meet all of its cost information requirements. This may be because the current system no longer reflects the organisation's operations or it may be due to a change in the type of information management needs to support its decisions in today's ever more competitive environment. Management can then be shown how ABC can be used to effectively fulfil those unmet requirements. Management, particularly senior management, must be persuaded that ABC belongs on top of everyone's agenda.

It is important when selling the concept of ABC to the organisation that not only the accounting issues be emphasised, but that the people issues be stressed. This is particularly true in the area of performance measures, which undoubtedly will need to be revised to incorporate the ABC concepts that will be included in the new system.

Organisation-wide education will be an important element in convincing management to change as well as in effecting the change. To accomplish this, the organisation's managers should be shown:

how one or more of the dysfunctional portions of their organisation's cost system works or how it does not address an important management information need;
how these conditions can lead to inaccurate and misleading information; and
how that information can lead them to make decisions at variance with both the organisation's goals and their own individual goals.

With the existing system's shortcomings understood, management can then be shown how cost distortions and inappropriate decisions can be dramatically reduced by using basic ABC concepts. During this process, it is important that any objections raised by managers be resolved to everyone's satisfaction. Organisation-wide management commitment is essential if the implementation is to be successful.

Finally, conversion to an ABC system must be shown to be cost-effective, just like any other investment. Although the benefit calculations may be less straightforward than something like the labour cost reductions resulting from a new piece of capital equipment, they must, nevertheless, be estimated to show how the conversion to ABC can be one of the organisation's most profitable investment opportunities.

Planning the Implementation

Before embarking on any project, it is important to know what the project is expected to accomplish. A project to implement ABC is no exception. Without a fairly precise definition of its purpose, the project will result in an ABC system designed to solve the general problems of some hypothetical organisation, not the specific problems of a real organisation.

There are various approaches for designing and implementing an ABC system. There is no "one approach fits all" solution. Without a clearly stated purpose, the ABC system resulting from the project will not meet the needs of the organisation in a cost-effective manner.

Although a small or mid-sized organisation might be able to move straight into an implementation of ABC, a full organisation-wide implementation of ABC at a larger firm is usually ill advised unless preceded by one or more pilot studies. Such pilot studies take apportion of the organisation and use its actual or budgeted costs for a specific period. In the pilot study, activities are identified as are cost drivers and their related volumes. Cost attachment points are defined, and costs are attached. The insights gained from the pilot study can then be used to save time and resources when a full implementation of ABC is begun.

If full implementation is intended from the start, a staged approach should be followed. The structure of the staged approach is much the same as the pilot approach; only it includes more areas, more data, and more analysis. The scope and number of stages will depend on the project’s desired outcome, but the stages will move from a new awareness of cost system design throughout the organisation, through the development of improved costs, margin and performance information across the organisation, to better information for improved performance in the organisation's activities themselves.

If the objective of the ABC system is simply to provide improved information for evaluating pricing opportunities, a different solution would be required than if one of the objectives was to devise and track new methods of performance measurement on a day-to-day basis. Similarly, if the objective is to develop the system either in stages or through a pilot project rather than on an organisation-wide basis, a different approach might be in order.

The organisation must be cautious, however, with any approach that addresses only a sub-set of its activities. Such an approach contains the danger of overlooking activities or costs from areas in the organisation not being studied.

Once the system's objectives are determined, several questions should be answered before the project moves forward.

Who will own the new ABC system?

Ownership of the new system should be consistent with its primary objective. In many situations, it will be desirable for someone outside of finance to take ownership. For example, if improving operations is the primary objective, the system might be best placed under the control of operating personnel. As their system, it is more likely to be properly maintained and used than if they perceive themselves as depending on finance's system.

How complex and detailed should the system be?

To be effective, the ABC system must make the appropriate trade-offs between accuracy, flexibility and cost. Here again, the system's primary objectives must be kept in mind. If the system is to be used to support the improvement process, more details will be required than if its main objective is to understand product line profitability. If the system is to remain relatively fixed, more details can be accommodated than if it is to he flexible. Too simple a system may not be accurate enough, while a system that is too complex may end up costing more than it is worth.

What degree of accuracy is required and what precision level will it produce?

Again, the system's objectives are key to making the precision versus accuracy determination. If the new system is to be used to support strategic decisions, a lower level of precision can be acceptable than if the system is to be used to support tactical and other day-to-day decisions.

Will the system be integrated into the day-to-day financial accounting system, or will it be a stand-alone system maintained off-line?

In many organisations, a well-designed, periodically updated model of their operation is sufficient for their ABC needs. An off line implementation enables them to improve their cost information substantially without disrupting their day-to-day information system activities. Although it may be advisable to accumulate certain information under ABC that had previously been ignored, these data are used only for testing and updating the model, not for recording transactions. This scope is especially appropriate for small and mid-sized organisations, but it could also be an effective first step toward implementing ABC in a larger organisation.

At the other end of the spectrum from the use of an off-line model, is the full integration of ABC in the organisation's day-to-day accounting and management systems. In these situations, ABC would go beyond the traditional role of cost accounting and become a primary source of information for improving business processes and forward planning, and eliminating or reducing non-value-adding activities. Under such a system, all floor reporting is adjusted to meet the requirements of the ABC system, as are the chart of accounts, cost centre structure, inventory/cost of sales accounting procedures, interdepartmental charges, accounts payable and payroll cost distribution practices, financial and management reports, and every other cost-related facet of the accounting system. Obviously, major changes will also need to be made in the data processing system that supports the cost-accounting effort.

An ABC system can be viewed in two different ways. There is the cost assignment view and the process view. The cost assignment view provides information about resources, activities and cost objects. The process view provides operational (often non-financial) information about activities.

What approach to the cost assignment view should be taken?

The approaches to the cost assignment view fall into two general categories: a two-stage approach and a multiple-stage approach.

In the two-stage approach, sub-accounts of the general ledger are distributed to the various activities in the appropriate proportions using ''first-stage" cost drivers. The costs accumulated in these activities are then distributed to cost objects using ''second-stage" cost drivers. For example, costs like health insurance and electricity might be distributed to activities using employee head count and machine hours as first-stage drivers. Costs accumulated in the various activities might then be distributed to products using second-stage drivers such as set-ups, orders, purchase orders, machine hours, labour hours and so forth. This approach can be visualised as in Exhibit 2 below.

Source: Adopted from Peter B.B. Turney, Common Cents: The ABC Performance Breakthrough, Hillsboro, OR: Cost Technology, 1991, P.96.

The multiple-stage approach attempts to mirror more closely the actual flow of costs through an organisation. Instead of trying to move costs from incurrence to cost objects in just two stages, this approach places its emphasis on the relationships between activities, and other activities, as well as between activities and cost objects. Following this approach, costs move from incurrence to cost objects in a series of steps, all based on cause/effect relationships.

For example, the activities "maintenance" and "tool room" will accumulate the costs directly related to those activities. The two-stage approach would then identify second-stage drivers for distributing the costs of these activities to cost objects. The multiple-stage approach, however, recognises that the maintenance activity does not support cost objects directly. It supports other activities (including the tool room), and the tool room directly supports both cost objects and other activities. The costs accumulated in those activities would be distributed to either cost objects or other activities based on the demand for those activities, services, or resources. This can be visualised as in Exhibit 3 below.

Either the two-stage or multiple-stage approach to ABC can be used to develop information about an organisation's resources, activities and cost objects and either one can also provide data to support the process view of ABC.

Once these questions are answered, planning for the ABC project can move forward. Like any major organisation-wide systems project, a formal project management structure and project plan is necessary for an effective implementation. The structure would include a steering committee composed of upper management whose main role is to ensure that the ABC system is consistent with the organisation's business strategy and needs, and that there is participation and cooperation from all affected areas of the organisation. A project manager would report to the steering committee and be supported by a cross-functional team. The size of the team and level of involvement of the various members would depend on the specifics of the project. The important point is that all affected functions of the organisation must participate in the ABC system's development and implementation in order to foster commitment to the new system throughout the organisation and also to improve the design of the new system.

A formal project plan, schedule, and budget should be developed. The plan should state what tangible outputs the project will deliver, summarise the tasks that need to be performed, and estimate the time requirement for each. These tasks should then be sequenced to develop a schedule for performing the project in a logical step-by-step manner. Internal and external costs should be estimated and consolidated with the plan and scheduled to develop a time-phased budget for monitoring the progress and cost performance of the project.

Another important element of a successful implementation of ABC is training. Although it is not necessary for management to become ABC experts, they must understand the need for ABC, its benefits, and its key concepts. On the other hand, members of the project team, those actually designing and implementing the system do need to develop a thorough understanding of both the "hows" and "whys" of ABC. Because ABC is as much an art as it is a science, it is not enough to master the mechanics. The designers and implementors must comprehend the various approaches, levels of scope, and system mechanics available in order to select and integrate those that will result in the most cost-effective system for their particular organisation.

Those who will be providing input for the system, both during its development stages and its execution, must understand the significance of the data they provide. Incorrect answers given to questions asked by the project team during the development stages can lead to an improper system design. A lack of understanding of the proper input required once the system is operational will lead to inaccurate costs. Training sessions, designed for the specific needs of each major group of employees, should be provided to insure the accuracy of input.

Finally, the system will not be effective unless its users understand the new information that ABC provides. At some organisations, ABC will contradict many of the fundamental principles that managers thought were indisputable. For example, most manufacturing firms have believed for decades that direct labour efficiency was the key measurement of productivity. Under ABC, many of these firms find that direct labour is an immaterial component of the cost equation and that focusing on direct labour efficiency draws attention away from important issues. Some even learn that there is really little or no true direct labour involved in their operation. To make sure these individuals make effective use of the improved information that will be available, the project team must insure that they understand the new system's output and how it can best be put to use in improving the organisation 's operations.

Gathering the Information

The information required for an ABC project is of two types: conceptual and statistical. Conceptual information is needed to develop the overall design of the ABC system, while statistical information is needed to simulate the cost flows through the system model. Statistical information also serves as raw data from which to develop and validate some of the conceptual information.

The goal of the data-gathering activity is to accumulate the, information necessary to:

Identify those activities performed by the organisation (for both the cost assignment and process views); -
Identify the organisation's elements of cost (for the cost assignment view) and performance measures (for the process view);
Determine the relationships between the various activities and elements of cost (for the cost assignment view); and
Identify and measure the cost drivers that determine the work load (for the process view), cause costs to flow into activities, and cause accumulated activity costs to flow to other activities or to the organization's products and services (for the cost assignment view).

Identifying Activities

EXHIBIT 4

DECOMPOSITION OF PURCHASING FUNCTION INTO ACTIVITIES

Theoretically, even a small organisation can identify an almost limitless number of activities. The identification process should, however, be guided by materiality and the objectives of the ABC system. For example, if the objective is strategic (e.g., product line profitability, pricing policies), the primary need is to accurately assign costs to cost objects. In such cases, activities can be broadly defined. If, on the other hand, the intent is to improve operations (e.g. eliminate non-value-added processes), the need is for information about activities as well as cost objects. In these cases, activities must be defined more narrowly.

Materiality will also impact activity definitions. For example, an organisation with only two individuals in the purchasing function will not gain as much by dividing the function into twenty separate activities, as will an organisation with fifty individuals.

Activities can be identified by decomposing functional areas into their constituent activities. For example, a purchasing function could be decomposed into micro-activities as shown below.

BASIC FUNCTION	FIRST DECOMPOSITION	SECOND DECOMPOSITION	THIRD DECOMPOSITION
Purchasing	Indirect services	Annual Contracts	Estimate annual requirements
			Select alternative vendors
			Negotiate contracts
			Facilitate timely delivery
		Spot Buys	Receive and process purchase requests
			Select and solicit alternative suppiers
			Select supplier and place order
			Facilitate timely delivery
		Etc.	Etc.
	Direct services	Etc.	Etc.

The likely composition of activity centres (discussed in Section VIII. Designing the ABC System) should be kept in mind while determining the level of detail to which the identification of activities should be carried.

Identifying Elements of Cost

Elements of cost are the costs of the organisation's resources including labour, capital, machinery, buildings, materials, supplies, equipment, and utilities. An organisation's general ledger is usually a good source of information about these cost elements, but it seldom breaks those cost elements down by activity performed.

Performance measures are indicators of the work performed and the results achieved in an activity. They can be financial or non-financial and indicate how well the activity meets the needs of its internal and external customers.

Determining the Relationship Between Activities and Elements of Cost

The ABC system designer must assign the cost information contained in the general ledger to activities. This assignment is determined by the relationships between the various activities and the elements of cost.

The elements of cost can be assigned to activities by charging them in some directly measurable manner (e.g., metering electric consumption, charging maintenance via a work order, charging requisitioning activities for supplies) or estimation (as determined through questionnaires and interviews).

Arbitrary allocations should be minimised whenever possible because they do not improve the understanding of the economics of activities.

Identifying and Measuring Cost Drivers

Cost drivers are the variables that can be used to explain the behaviour of activity costs. They reflect the consumption of costs by activities and the consumption of activities by other activities, products, or services. The following example illustrates several possible cost drivers associated with different purchasing activities.

Purchasing Function, Indirect, Spot Buys

1.	Receive and process purchase requests	No. of requests
2.	Select and solicit alternative suppliers	No. of supplier orders
		No. of suppliers
		No. of new parts
3.	Select supplier and place order	No. of supplier orders
		No. of items
		No. of suppliers
4.	Facilitate timely delivery	No. of deliveries

Six different cost drivers are suggested in the above example with as many as three for any one activity. Decisions must be made as to the trade-offs between accuracy and cost, as well as the difficulties of operating a more complex costing system. Although all of the example's cost drivers are quantifiable, there are also non-quantifiable cost drivers that must be considered where appropriate. In the example, these could include the scarcity of the item being purchased, the variability of the item's cost in the market, or the relative materiality of the cost involved.

Sources of ABC System Information

There are three primary sources for the information needed to develop an ABC system: people, the general ledger, and the organisation's computer system.

The people who do the work are a major source of information. They can provide information about the organisation's activities, the resources consumed, and the performance measures used.
The general ledger provides information about the organisation's elements of cost and the outputs produced.
The organisation's system should contain information about some of the cost objects and cost drivers. For example, the number of invoices paid (a potential cost driver) should be available through the accounts payable system.

A review of organisation charts, facility floor plans, marketing materials, and detailed financial information can also give some clues as to the organisation's major activities and costs. They are helpful in getting the information-gathering process started and also provide the basis for selecting strategic cost drivers around which the subsequent interview process can be designed.

Including representatives from Management Information Systems (MIS) on the cross-functional ABC project team will also help to determine whether the required information is already available in the system and will facilitate the capturing and processing of information.

The majority of the information to be used in developing the system, however, should come from interviews and questionnaires directed to the organisation's personnel because they are the best source to ensure that all the bases are covered.

If there are hundreds of individuals to interview, questionnaires may be the only feasible alternative. Such questionnaires must be carefully designed if they are to be effective. They must be complete and they must ask the right questions in an appropriate manner. For example, if a question relates to cost drivers without first defining cost drivers, an incorrect answer may result. However, the main drawback to questionnaires is that they do not provide for dialogue that may lead to important insights.

The most critical components of the interview process are a prepared interviewer and a prepared interviewee. The interviewer must understand ABC's basic underlying concepts and how they relate to the scope of the project at hand. He or she should also learn as much as possible in advance about the interviewee's area and have developed a flexible plan for the conduct of the interview. Only by looking at the responses of the person being interviewed against the background of ABC's concepts will the correct follow-up questions be asked to gain the information necessary for an effectively designed system.

For example, in questioning an organisation's sales administration staff, an interviewer learned of the various activities required to fulfil the department's responsibilities and the types of costs involved. Because of his understanding of ABC's underlying concepts, he was also able to follow up with non-standard questions that uncovered the fact that 50% of the department's effort was in support of one customer who accounted for only 10% of the organisation's revenues. This turned out to be a significant factor in the ultimate design of the ABC system. Standardised or other questionnaires prepared in advance are helpful tools, but they are no substitutes for a knowledgeable interview.

Before being interviewed, interviewees should be introduced to ABC and be made familiar with the purpose of the project and the type of information that will be required. An excellent way to do this is through a project "kick off" meeting that potential interviewees would be asked to attend. Another method is by distributing introductory literature to the interviewees in advance. The difficulty in this method, however, is the high probability that the time will not be found (or made) to read the literature before the interview.

It is important that the ABC project team be reasonable regarding the level of detail needed to design the system properly. In most cases, it is much better to be approximately right than to be precisely wrong. Knowledgeable estimates of the relevant items are much preferable to precise calculations of irrelevant ones. As a result, team members must not become too detail-oriented and should keep the concept of materiality and Pareto's "80-20" rule (80% of what you care about is covered by 20% of what you do) in mind at all times.

The interview process can be supplemented with such tools as "process mapping'' and "value chain analysis", which help to document the results of the data collection process and organise the information to ensure it is complete and understandable and can be readily analysed.

Value chain analysis, as it relates to activity-based costing, requires the division of the organisation into its distinct strategic activities. These activities provide the building blocks by which the organisation creates value for its customers. Strategic activities should be considered distinct and, therefore, isolated if they represent a significant percentage of operating cost, the behaviour of their cost is unique, they are different from the activities performed by competitors, or they have potential for differentiating the product or services in the market place.

Process mapping provides a way to summarise activities according to the organisation whether they can be directly identified with particular products as a process activity or instead must be included as a process support, organisation and facility support, customer/market support or product/product line activity.

Other useful data can often be found in the records that support operating employee's unofficial systems, the ones they maintain because they do not believe the official system. This data can be of a financial or non-financial nature. Since these employees needed to get the job done in spite of an ineffective cost system, they will often have accumulated a wealth of relevant data that will support a properly designed system.

Finally, informed observation is a valuable information-gathering tool. With a sound understanding of ABC's basic philosophy, an observer can see inconsistencies between the cost system and the real world when watching the organisation's product being manufactured or service being performed. Sometimes it might even be appropriate to work along with the people for a period of time to make the observations. For example, seeing a warehouse worker experience different degrees of difficulty in handling different products, noting that a particular piece of equipment is not always operated by the same number of workers, hearing clerical personnel complain about the administrative nightmares caused by one particular customer, or having a salesperson express how difficult it is to sell one of his/her product lines should all raise red flags in the mind of the ABC system developer. These all suggest characteristics of the business that need to be incorporated into the design of its ABC accounting system.

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Updated on August 29, 2002