Management Guide: Activity-Based
Costing (continued)
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Links Related Links ABM Resources (Armstrong Laing) |
Contents Overview of
Activity-Based Costing What is
Activity-Based Costing (ABC) Implementing
ABC – Convincing the Organisation to Change |
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Designing
the ABC System
After
identifying the organisation's activities and elements of cost, determining
the relationships between those activities and elements of cost, combining
the activities into logical activity centres, and identifying and measuring
the organisation's cost drivers, the system developer must then determine how
these pieces of the puzzle can best be put together so that costs logically
flow through the organisation's activities to the products or services that
it provides. In
developing the ABC system, the designer should place particular emphasis on
expensive resources, resources whose consumption varies significantly by
product or product type, and those resources whose demand patterns are
uncorrelated with traditional allocation measures, such as direct labour,
processing time and materials. The first
step in developing the ABC system's cost flow is to organise its elements of
cost into two categories: material costs and activity costs.
Material costs are all non-payroll costs that are obviously related and
conveniently traceable to a specific product or service. Most of these types
of costs are obvious and have traditionally been treated as direct. Examples
are the steel in a manufactured part, outside processing costs that are
charged on a per unit basis, a title search fee paid to an outside firm in
processing a real estate loan, the medication delivered to a hospital
patient, or an expert witness' fee in a legal proceeding. There
are, however, many other costs meeting this definition that have been treated
as indirect. This is especially true in manufacturing industries. These are
the cost elements that vary with an activity's throughput, not the amount of
time needed by an activity to process the throughput. For example, coating
material is often applied to a part before it is extruded or forged. Although
such material is no longer present in the finished product, it is obviously
related and specifically and easily traceable to the part. The amount of
coating material consumed is a function of the product's square inches of
surface area. It is not related to the length of time it takes to apply the
coating. If the amount is significant, this coating material can and should
be treated as direct. Other examples of this type of cost are perishable
foods, masking materials and x-ray film. Activity
costs are the conversion costs involved in performing or supporting the
activities that take place within the organisation except for any non-payroll
costs that might better be classified as material costs. These costs would
include all labour and fringe benefit costs, as well as other costs treated
as overhead in a traditional cost accounting system. Once the
elements of cost have been divided into these two categories, the next step
is to classify or code the organisation's identified activities so that their
information can be summarised. Three common coding schemes used are:
Activity Hierarchies Activities
performed to produce outputs can be classified into a hierarchy. For example,
some manufacturing companies use the following hierarchy.
Process
activities are
those activities that relate directly to the products or services provided by
the organisation. They are part of the chain of events that must take place
to produce the product or provide the service. These processes can be
effectively identified using “process mapping” techniques. Process activities
can be further sub-divided into unit-level activities or batch-level
activities. Unit-level activities are performed in the
same manner for each unit produced and they vary proportionately with
production or sales. Examples of unit-level activities are the basic series
of procedures associated with each auto loan processed by a bank or with each
complete physical examination given by a physician. Batch-level activities, such as setting up a
machine or billing a group of invoices, are performed for each batch produced
(or invoiced) but are independent of the number of units in the batch. Thus
the cost of using batch-level activities is independent of the number of
units processed in the batch but varies with the number of production runs or
invoice runs made. Process-support activities are those activities
that provide support to other activities within the organisation, but do not
relate directly to the organisation's products or services. These activities
are not part of a chain of events that takes place when a product is produced
or a service is provided. In a manufacturing setting, equipment maintenance,
quality assurance, production control, and scheduling are activities that
often fall into this category. Organisation
and facility-support activities are those activities involved in the organisation’s general
management and in providing a facility in which other activities can take
place, including planning, general supervision, building and grounds
maintenance, heating, and so forth. Customer
or market-related activities are those activities that exist to support sub-sets of the organisation's
customer base or marketplace. One customer or group of customers may require
activities that are not required by others or the level of certain activities
may vary greatly between customers. In the same manner, administrative and
marketing efforts may be quite different for different markets. For example,
the administrative demands of one customer might far surpass those of any of
the organisation's other customers. It may require substantially more effort
to gain each dollar of sales in some markets than in others. Some customers
have a firm product design when the order is placed and others constantly
deluge the organisation with engineering changes. Each of these types of
activities relate to the customer or marketplace in which the organization's
products or services are being sold. There can be several levels of cost for
customer or market-related activities. They could be customer-level,
distribution channel-level, market-level, or enterprise-level. Product
al product line-related activities are those activities that exist to support
sub-sets of the organisation's product base. Certain products, services, or
product/service lines may require support activities that are not required by
others, or some may demand much greater levels of certain activities than
others. For example, some services provided by professional firms or products
produced by manufacturing firms have a great deal more liability exposure
connected with them than others. Certain products or services may require a
higher level of ongoing engineering support than others. Comparative values
and portability might make security activities much more intensive with some
product lines than with others. Each of these types of activities relates to
the product, services, or product/service lines that are part of the
organization's business. Product or product line-related activity costs can
also be broken into levels similar to the process activities: unit-level,
batch-level, product-level, and plant-level. Activity Centres
Activity
centres are groups of activities that make up a business process. They are
particularly useful when functional areas have been decomposed into large
numbers of activities and a major objective of the system is to understand
the cost of business processes. For
example, an organisation wants to know the costs involved in the business
processes used to obtain needed raw materials, purchased components, indirect
materials, and outside processing services. To determine these costs,
functional areas such as purchasing, material handling, shipping, receiving,
inspection, accounts payable, and quality control will be decomposed into
activities that include their efforts relating to the four business processes
identified. The activities from each functional area can then be combined
into activity centres for each business process to arrive at the desired cost
information. Activity
centres can also be used to simplify an ABC system by taking activities with
similar cost behaviour and the same cost driver and combining them into
macro-activities. This must be done with care, however, if an objective of
the system is to provide relevant performance measurement information as well
as more accurate cost assignment. Activity centres can be customised to
provide the particular information needed to meet the objectives of an
organisation's ABC system. Value Rankings
Some
firms elect to rank the activities that contribute to the output of goods or
services according to whether or not the activity is either necessary or performed
efficiently. They use various coding methods for this ranking, from the very
simple value-added/non-value-added to very complex multi-criteria methods. Establishing the Flow of Costs
Material
costs are traced
directly to the products or services whose throughput measures drive the
costs. For example, the raw materials, purchased components, and outside
services that go into a manufactured product are all driven by the units of
throughput of that particular part. Similarly, each x-ray of a particular
type will require the same variety and size of film, each instant oil change
for a particular type of automobile will require the same amount of oil, and
each unit of a particular size and variety of consumer product requires the
same packaging when shipped to a retailer. Activity
costs, on the
other hand, are traced to the activities whose drivers make the costs
necessary. Once accumulated in the activities, the cost of each activity is
traced to each product, service, or other activity whose drivers make the
activity necessary. Depending
on the situation and use to be made of the information, it may or may not be
appropriate to trace the cost of organisation and facility-support activities
through to products and services. Since these types of activities are, for
the most part, independent of the other activities that take place within the
organisation, it may be appropriate to exclude them when looking at the cost
of any particular sub-set of the organisation's products or services. On the
other hand, the cost of many of these activities must be included in the cost
of the organisation's products and services to comply with generally accepted
accounting principles or other financial and tax reporting regulations. If
their costs are to be traced, organisation and facility-support activities
are traceable to process and process-support activities. Their general nature
makes it almost impossible to identify a driver that would trace them
directly to a product or service. Costs
accumulated in process-support activities can be traced to process activities
that contain the drivers that make the support activity necessary. Equipment
maintenance for a machining activity, nursing support for an operating room,
engineering support for a welding activity, or human resources support for an
entire organisation can be traced by drivers such as machine hours, number of
operations, number of new weld operations, or number of employees. Process
activity costs
can be traced to products or services using the 95 drivers most
representative of each product's or service's consumption of the activity,
keeping in mind that some activities support each batch, and some each unit. Drivers
can also be selected to trace costs accumulated in the various customer,
market, product, service, or product/service line activities to those
sub-sets of the organisation 's products and services that make them
necessary. In cases where there are multiple drivers for a single activity, a
decision must be made as to whether the most representative driver will be
used to trace the entire cost of the activity or whether the single activity
should be broken down further to accommodate the need for the various
drivers. |
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ABC
Example
Suppose
that a company has 2 products:
Using
traditional cost accounting (TCA), since total overheads is $100,000, and
total labour hours of 2,000 hours, the average labour cost is (100,000/2,000)
$50/hour. Hence, TCA overhead allocation is as follows:
ABC
focuses on indirect costs (in this case, overhead), and traces
rather than allocates each expense category to the particular
cost object. Hence, this makes “indirect” expenses “direct”. The basic
premise of ABC is that cost objects consume activities, and activities
consume resources. This consumption
of resources is what drives costs. Understanding this relationship is
critical to successfully managing overhead. The key steps for ABC are: 1) identify key activities 2) determine cost for each activity 3) determine cost drivers 4) collect activity data, and 5) calculate product cost.
Step 4)
Activity data
Step 5)
Product cost calculation
Comparing
Product cost between TCA vs ABC:
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Ensuring
Successful Use
The best
ABC system in the world will be useless if no one understands how to use its
information. As important as it is to design and implement a theoretically
sound and properly kept system, it is just as important to make sure that 1)
management has been trained in the use of ABC, 2)
management receives reports that are not only useful, but understandable, and
3) ABC
information is kept up-to-date. Quite
frequently, ABC's concepts will contradict fundamental principles that many
managers thought were indisputable. For others, ABC might generate
information that looks just like the old information, but has a totally
different meaning. Hopefully, these managers "signed on" to the ABC
project at the beginning after being convinced that the old methodology was
incorrect. After the new system has been developed, these individuals need to
be shown how this new system overcomes the old one's problems and how it will
provide information that will enable each manager to make better decisions. One way
to accomplish this is through the development of entirely new reports that
not only have current, relevant information, but look nothing like the old
reports. A change to ABC is a good opportunity for cutting out the 80% to 90%
of regularly published cost data that is never used. In
planning the implementation of ABC, the organisation should have developed a
fairly precise definition of the project's purpose. During the process of
interviewing the organisation's managers and other employee, the system
designer should also have developed an understanding of what information is
important to each decision maker. With this information in mind, reports
should be developed that present only relevant information in a clear,
understandable form. To be
clear and understandable, the ABC reports cannot just be computer printouts
containing words and numbers. Summary tables and graphs that highlight
important information should be developed. Extraneous information and
technical language should be avoided. These reports are ABC's language for
communicating accurate and relevant cost information to those who need it to
be effective in carrying out their responsibilities. Failure to communicate
its results effectively will negate the benefits of the superior information
available through ABC. A
well-designed ABC system can also be used as an effective budgeting and
planning tool. The improved understanding of costs, activities, and their
drivers make the ABC model a flexible tool for use in these and a wide
variety of other management tasks. The ABC
system must also be kept up-to-date or the information it provides will
become just as inaccurate and irrelevant as that provided by the old,
traditional system. The old system was probably once accurate and relevant,
but no one changed it as the organization it was designed to support,
changed. The basic underlying assumption of the ABC system should be tested,
and when necessary, revised on a regular basis. Constant vigilance is
required if the ABC system is to remain an effective management tool. The
following are a few of the occurrences that could require an update of the
ABC system's basic design. New activities are undertaken by the organisation
and other activities are dropped. Product mix or volume changes to the extent
that some activities that were once immaterial become material while other
once significant activities become immaterial. New production or management
philosophies are adopted that change the way products are manufactured or services
are provided. The customer bases is expended or contracted. |
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ABC
Software
ABC
models can be developed from scratch using a personal computer and business
spreadsheet software, or they can be developed using one of the many ABC
software packages available on the market. Companies
usually purchase ABC packages if their activity-based cost systems have too
many activities or outputs that can be reasonably maintained on commonly
available spreadsheet or data base managers. Generally,
ABC packages have the facility or interface with the general ledger. Once
driver information is loaded, they can convert resource data into activity
costs and perform the laborious calculations required to determine activity
and output costs. In
purchasing software, it is important that the package supports the ABC
approach being implemented. A review of some of the available ABC software
appears in |
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Conclusion
ABC is a
powerful management tool that has evolved in response to the ineffectiveness
of traditional cost accounting and cost management practices. ABC not only
helps an organisation accurately measure its product, process, and activity
costs, but it also provides the financial and non-financial information
necessary to identify opportunities for cost reductions and operating
improvements. As
important as it is, however, ABC is not a panacea. It is one of the important
tools necessary for any organisation that hopes to thrive and grow into the
next century. |
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Updated on Feb 25, 2004
©
Copyright 2002 Allan Low. All rights reserved. Reproduction of this Web Site,
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