Activity-based costing A Case studyActivity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs (overhead) into direct costs.

In this way an organization can precisely estimate the cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced.

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.

Historical development

Traditionally cost accountants had arbitrarily added a broad percentage of expenses into the indirect cost

However as the percentages of indirect or overhead costs had risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognised when the same broad 'on-cost' percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.

The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.

Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products.

Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products.

Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.

Like manufacturing industries, financial institutions also have diverse products and customers which can cause cross-product cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this

Methodology Cost allocation Fixed cost Variable cost Cost driver Cost driver rate

Direct labor and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to

products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions takes at the counter and then by measuring the number of each type of transaction.

Uses It helps to identify inefficient products, departments and

activities It helps to allocate more resources on profitable products,

departments and activities It helps to control the costs at an individual level and on a

departmental level It helps to find unnecessary costs

The Importance of Activity-Based Costing in a Performance Management Strategy

Understanding customer and product profitability can mean the

difference between promoting products and services that generate the

greatest returns and wasting time and energy on a losing proposition.

Consequently, as companies look to leverage their investment in

enterprise performance management (EPM), improved profitability

analysis is a necessary component to complete the picture of an

organization’s performance. With the improved insight EPM gives into

strategic direction and the key performance indicators of every

business unit, management’s expectations for detailed insights are

increasing—and the search for the “Holy Grail” of profitability analysis

is intensifying

Cost

ABC is considered a relatively costly accounting methodology

Lean accounting methods have been developed in recent years to provide relevant and thorough accounting, control, and measurement systems without the complex and highly wasteful methods of ABC. Lean Accounting takes an opposite direction from ABC by working to eliminate cost allocations rather than find complicated methods of allocation.

While lean accounting is primarily used within lean manufacturing, the approach has proven useful in many other areas including healthcare, construction, financial services, governments, and other industries.

Limitations

Even in activity-based costing, some overhead costs are difficult to assign to products and customers, such as the chief executive's salary. These costs are termed 'business sustaining' and are not assigned to products and customers because there is no meaningful method. This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed.

Although some may argue that costs untraceable to activities should be "arbitrarily allocated" to products, it is important to realize that the only purpose of ABC is to provide information to management. Therefore, there is no reason to assign any cost in an arbitrary manner.

ABC analysis

ABC analysis is a business term used to define an inventory categorization technique often used in materials management. It is also known as Selective Inventory Control.

ABC analysis provides a mechanism for identifying items which will have a significant impact on overall inventory cost whilst also

providing a mechanism for identifying different categories of stock that will require different management and controls

When carrying out an ABC analysis, inventory items are valued (item cost multiplied by quantity issued/consumed in period) with the results then ranked. The results are then grouped typically into three bands. These bands are called ABC codes.ABC codes

1. "A class" inventory will typically contain items that account for 80% of total value, or 20% of total items.

2. "B class" inventory will have around 15% of total value, or 30% of total items.

3. "C class" inventory will account for the remaining 5%, or 50% of total items.

ABC Analysis is similar to the Pareto principle in that the "A class" group will typically account for a large proportion of the overall value but a small percentage of the overall volume of inventory.

Another recommended breakdown of ABC classes:

1. "A" approximately 10% of items or 66.6% of value 2. "B" approximately 20% of items or 23.3% of value 3. "C" approximately 70% of items or 10.1% of value

Activity Based Costing Worked Example

The following information provides details of the costs, volume and transaction cost drivers for a period in respect of XYZ Ltd:

  Products     A B C Total Sales and production (units)

90,000 30,000 15,000 135,00

0 Raw materials usage (units)

10 7 14 1,320,0

00 Direct materials cost (£)

30 40 15 4,125,0

00 Direct labour hours

2.5 3 1.5 337,50

0

Machine hours 5 3 7.5 652,50

0

Direct labour cost (£)

20 30 10 2,850,0

00 Number of production runs

5 10 50 65

Number of deliveries

18 7 50 75

Number of receipts

50 70 700 820

Number of production orders

45 25 60 130

Overhead costs

£

Set up 75,000

Machines 1,000,00

0 Receiving 900,000 Packing 650,000 Engineering 750,000

Total 3,375,0

00

You are required to

(a) calculate the total costs for each product if all overhead costs are absorbed on a labour hour basis; (b) calculate the total costs for each product, using activity based costing; (c) calculate and list the unit product costs from your figures in (a) and (b) above to show the differences between them and to comment briefly on any conclusions which may be drawn which could have pricing and profit implications.

Solution to the worked example

There is more extensive treatment of Activity Based Costing in my book

We will be working through these data three times. Firstly to see how traditional cost accounting methods might deal with them; secondly to look at the multiple volume based overhead method; and, finally, to look at the ABC method itself. Of the three approaches we will be looking at, only ABC will be using all of the data in any great detail.

This is consistent with the general nature of the traditional method, and the only slightly more advanced multiple volume method.

ABC method

As we said above, to apply the ABC method, we need to identify cost drivers for two stages:

1 cost drivers tracing the costs of inputs into cost pools; and 2 cost drivers tracing the cost pools into product costs

The workings that follow illustrate clearly how such cost drivers work through the ABC system in these two stages: an initial overhead rate or amount being further subdivided according the needs of the situation.

workings:

The calculations for each of the rates to be used are:

The machine hour rate is the only rate that is what we might call a traditional rate. All of the other rates we are about to use involve a two stage process. We will see the elements of these two stages as we get to them.

machine hour overhead rate

£1,000,000 =

£1.5326

652,500 machine

hours  

This rate is used as normal.

For the set up costs, we first devise a rate to tell us the cost per set up: total set up overheads divided by the number of set ups: in this case, this is

£75,000 = £1,153.85

65  

production runs

We will return to this rate shortly.

All of the other rates are calculated similarly. Hence they will be presented now without further comment.

Receiving rate

£900,000 =

£1,097.56

  820

receipts  

Packing rate £650,000 =

£8,666.67

  75

deliveries  

Engineering rate

£750,000 =

£5,769.23

  130

production orders

 

All of this information can now be put together into a cost per unit statement as follows.

The final stage in the whole ABC procedure, as far as product cost determination is concerned is to find out the costs per unit. The cost per unit statement follows, and then we will work through the calculations.

Unit costs A B C   £ £ £ Direct materials

30.0000

40.0000

15.000

Direct labour 20.000 30.000 10.000 Machine overheads

7.6628 4.5977 11.4943

Set up costs 0.0641 0.3846 3.8462 Receiving costs

0.6098 2.5610 51.2195

Packing costs 1.7333 2.0222 28.8889 Engineering costs

2.8846 4.8077 23.0769

Total Costs £62.95

46 £84.37

32 £143.5

257

workings:

Machine overheads are found by multiplying the machine hour rate by the number of machine hours per product per unit:

machine hour rate £1.5326 x

machine hours 5 3 7.5

gives £7.66

28 4.5977

11.4943

The set up costs rate we have already is the rate per machine set up, the cost per unit is calculated by multiplying the rate per set up by the number of set up per product and then dividing the results by the total number of units per product:

Set up cost per set up £1153.85 x

No of set ups 5 10 50

gives £0.00

10 0.005

9 0.059

2

Set up cost per set up £1,153.85 x

No of set ups 5 10 50

gives £5,769.

25 11,538

.50 57,692.

50

these values are then divided by the number of units per product to give us the cost per unit:

  £0.06

41 0.3846

3.8462

The receiving, packing and engineering costs are all calculated in the same way as the set up costs. There is no need to repeat these calculations, but check that they are understood. Summarising each of these methods now we can see the impact of the different methods on product costs, Assuming that the ABC method is really more effective than the traditional approach, product A shows a cost difference of £42.1085 per unit.

Summary 1: Total costs per unit using each of the three methods

  Product   A B C

DLH 75.00

00 100.00

00 40.000

0

Mult 69.57

53 83.940

3 104.66

78

ABC 62.95

46 84.373

2 143.52

57

Summary 2: Overheads per unit using each of the three methods

  Product   A B C

DLH 25.00

00 30.00

00 15.00

00

Mult 19.57

53 13.94

03 79.66

78

ABC 12.95

46 14.37

32 118.5

257

Summary 3: Overheads as a percentage of total costs

  Product

  A B C

DLH 33.33

% 30.00

% 37.50

%

Mult 28.14

% 16.61

% 76.11

%

ABC 20.58

% 17.04

% 82.58

%

Overall Activity Based Costing Sample

This example looks at the manufacture of PC boards. For the purpose of this example, we are only looking at the activity costs involved in the assembly of the PC boards. This example looks at the costs of developing two PC boards. The first board (Board XXX) is produced in a batch of 500 boards. The second board (Board YYY) is produced in a batch of 100 boards. 

Identify Activities

The process flowchart shows the flow of the following activities: 

Receive Materials - All parts required for the assembly of the PC boards are received, the parts are counted and distributed to the required physical locations throughout the assembly process. 

Setup Machine for Board Type - All machine setups for the particular board are done.  Start Board Assembly - Board assembly is started for each board. This includes the setup of the machine for each board and ensuring all parts are present.  Insert Machine Handled Components - Equipment inserts components into the PC boards.  Insert Manually Handled Components - Skilled personnel insert components into the PC boards.  Solder Components - All components inserted into the PC boards are soldered.  Complete Quality Assurance Testing of Assembled Boards - The boards are tested to ensure they have been assembled correctly. 

Identify Cost Measures 

In looking at the General/Ledger (G/L), the following cost accounts have been identified: 

direct costs for materials, direct costs for manufacturing labour, material receiving costs, machine setup costs, machine costs, resource costs, quality assurance costs. 

Additional information is required to determine how some of the costs should be allocated to the various activities. The information required includes:

  the composition of the PC board (e.g., number of parts to be inserted), 

time studies to determine how much time it takes to complete manual and machine activities,  metered use of resources for each relevant activity (e.g., electricity used in the solder components activity). These measures are used to allocate energy costs to activity cost pools.

 Identify Performance Measures

 The following performance measures have been identified for the activities in this process: 

number of rejected PC boards, cycle time required to assemble PC boards, process time required to assemble PC boards. 

The cycle and process times are used to evaluate the efficiency of the process. The reject rate is used to evaluate the effectiveness of the process. 

Identify Relationships between Costs and Activities This table summarizes the cost and activity measures gathered. Measures have been gathered for both boards produced in this manufacturing process. In looking at the activities and the G/L, the following activity cost pools have been identified and quantified. The values are contained in the model below. 

material receiving costs, machine setup costs, initial board assembly costs, machine insertion costs, manual insertion costs, soldering costs, quality assurance testing costs.

 

As well, the direct costs for this process have been quantified. These values are also contained in the model below. 

material costs, manufacturing labour costs.

 Identify Cost Drivers

 The cost drivers have been determined for the activity cost pools, and are summarized in this table. 

Model the Costs In this example the model is developed using a spreadsheet tool. 

Interpret Results The product cost varies depending on the use of the activities. Although the material costs for Board XXX are higher than those of Board YYY, the total cost for Board XXX is less. This is because Board XXX uses less of the more expensive activities. In looking at the activity costs (as calculated in the model), the number of machine insertions appears to be a key factor affecting the final cost. Board XXX has a higher percentage of machine insertions than Board YYY. Machine insertions are much cheaper than manual insertions (i.e., the cost to insert one component by machine is $0.60 compared to $3.75 to insert one component manually). As well, because there are fewer manual insertions, there is less chance of manual error, resulting in less testing time and fewer rejects. Therefore, if more components can be inserted by machine, the product cost will decrease. The component insertion costs will decrease, and the testing cost may decrease as well. The defect rate may also decrease, if there are more machine insertions. When examining the activity costs, the most expensive activity is Receive Materials. The more parts required for a board, the more expensive is the activity. One way to reduce costs is to reduce the

number of parts in the board. However, the goal here is to improve the process, NOT to change the product. To reduce costs, look closely at the activity Receive Materials to determine ways to improve this activity. Even a five cent reduction per part, results in a cost reduction of $2,375.00 (i.e., 47,500 parts * 0.05 dollar/part) in the Material Receiving Cost Pool.

Activity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today. However, from the 1960s - particularly 1980s - this changed rapidly. For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised.

The question of course is whether ABC has overcome these deficiencies or not?  It has. In fact, ABC has been called one of the most important management innovations the last hundred years.

So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there is three major differences:

1. In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.

2. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.

3. Traditional cost accounting is structure-oriented whereas ABC is process-oriented.

This is discussed in more detail in the subsequent sections and illustrated below. 

But first, the direction of the arrows are different because ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations.

References1. Consortium for Advanced Manufacturing-International 2. Kaplan, Robert S. and Bruns, W. Accounting and Management: A

Field Study Perspective (Harvard Business School Press, 1987) ISBN 0-87584-186-4

3. Sapp, Richard, David Crawford and Steven Rebishcke "Article title?" Journal of Bank Cost and Management Accounting (Volume 3, Number 2), 1990.

4. Author(s)? "Article title?" Journal of Bank Cost and Management Accounting (Volume 4, Number 1), 1991.

5. Activity-Based Costing (ABC): In recent years, ABC has lost ground in the metric wars. But it may be set for a resurgence, by David M. Katz

6. Police Service National ABC Model Manual of Guidance Version 2.3 June 2007

7. The Review of Policing Final Report by Sir Ronnie Flanagan February 2008

8. http://www.cxoamerica.com/images/pastissue/article/bo.jpg http://www.cxoamerica.com9. Costand Managemen tAccounting (1996) PrenticeHall ISBN 0-13-

205923-1 10. . http://maaw.info/Chapter7Solutions.htm

11. http://www.emblemsvag.com/abc.htm