8.03 - Activity Based Costing

Overview

Activity Based Costing (ABC) aims to provide more accurate costing for product costs, decision support and cost control purposes. Activity based costing is based on the approach that activities cause costs and a link can be made between activities and components and components to end products. Costs can therefore be assigned to products based on the products demand for the activities it uses.

Companies making discrete multiple products need to make important decisions about pricing, product mix, material selection and process technologies. Therefore cost allocation to parts and products should be made on that basis rather than one based solely on the amount of direct labour used in production. Direct labour now represents a relatively small part of the product cost. On the other hand the factory support operations, marketing, distribution and manufacturing and product engineering costs have expanded hugely.

Activity Based Costing Focus

Some companies have recognised the diminishing role of labour as a major focus for cost allocation and use two other allocation means – materials related expenses and machine hours or processing time. Both of these can be addressed in part by expanding the role of the Bill of Materials (see guide 6.13). The proliferation of computer based control and management systems has made the collection of the cost elements for ABC much easier to do. Cost control systems can record this data and can provide the frequent, accurate data needed for the ABC approach.

Company cost systems have to be re-designed to address the three major business requirements:-

• Inventory valuation for financial and tax statements that allocate period production costs between goods sold and goods in stock.
• Operational control to provide feedback to production department managers on the resources being consumed (labour, materials, energy, etc.) during an operating period.
• Individual product cost measurement to determine value-added and product commercial viability.

The philosophy of ABC is that virtually all of a company’s activities are (or should be) focused on the support of producing or delivering goods and services. The determining and reporting of the cost consumed by the key activities and their cost drivers, provides the basis for understanding what causes overhead costs and directs manager’s attention to areas for improvement in product, and ultimately business profitability. Knowing the costs of material movements or the cost of variety in production on many different machines enables realistic analyses to be performed to improve their effectiveness.

Developing and Activity Based Costing System

Activity based costing provides better, more accurate information for re-designing and controlling manufacturing operations. The steps to develop an activity based costing system are:-

• Identify the main activities performed by the company. For instance manufacturing and assembly. Include the support activities such as purchasing, packing and despatch.
• Identify the cost drivers for each activity.
• Collect accurate data on direct labour and material costs and on the various variable factors.
• Establish the demands that each product or product type makes on the activities using cost drivers measures of demand.
• Trace the cost of activities to the products and allocate according the products demand for the activity in question.

There are some rules to be followed enabling ABC to be utilised effectively:-

• Focus on expensive resources where ABC has the potential to make a big difference on product costs
• Emphasize resources where consumption varies significantly according to product or product type.
• Focus on resources whose demand patterns are uncorrelated with traditional cost allocation methods – such as direct labour, materials and processing time.

Of course this cannot be done with high precision, however according to Kaplan and Copper who developed Activity Based Costing “It is better to be basically correct with Activity Based Costing, (say within 5 or 10 percent), than to be precisely wrong (perhaps by 200 percent) with traditional cost allocation methods.”

ABC may not be appropriate for all product types. It is up to managers to determine what parts of the company costing would benefit from applying ABC. The method should not be used to produce monthly profit statements. Traditional methods are fine for that. ABC is used to support strategic decision making for product profitability analysis, and operational cost control.

Activity Based Costing – Benefits Summary

ABC ensures that internal costing information is not merely a by-product of external, legal, financial reporting requirements. It provides a more accurate basis for calculating product costs. It also provides an effective way for managing costs and planning resources. The particular benefits are:-

• Cost drivers established by the system can be used to measure activity performance and efficiency. It can also be used to provide a more suitable basis for budgeting.
• Accurate feedback can be provided to cost centre managers based on performance rather than on the arbitrary allocation of costs over which they have no direct control.
• The provision of product cost based on the activities they consume is more accurate and enables better decisions to be made with regard to pricing marketing, product design and product mix.

Notes:

Some IDEF0 process modelling software packages have ABC costing capabilities built-in enabling the direct allocation of costs whilst designing or re-designing business processes.

Example activity based costing for introduction of new parts (dated 1991).

Part Costs Calculation Based on Zenger & Cafone paper
Department	Labour rate/Year	Labour rate/hr	Actual Costs	No. People (Full Time Equivilents) FTE	Part Numbers	Cost /Part
Design Engineering	$85,000			40	2000	$1,700
Manufacturing Engineering	$85,000			50	2000	$2,125
Supplier Engineering	$85,000			25	2000	$1,063
Cost Estimating	$85,000			15	2000	$638
Quality Assurance	$85,000			45	2000	$1,913
Data Processing	$85,000			12	2000	$510
Purchasing	$85,000			20	2000	$850
Inventory	$85,000			1	2000	$43
Stock Personnel	$70,000	$35		35	15000	$163
Warehouse Space			$5,000,000		15000	$333
Shipping			$900,000		9000	$100
Totals				243		$9,437

This kind of work provides vital data to determine the value of Part Classification, DFM or DFA projects.