Business, Legal & Accounting Glossary
In a business organization, Activity-Based Costing (ABC) is a method of assigning the 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.
Traditionally cost accountants had arbitrarily added a broad percentage of expenses onto the direct costs to allow for the indirect costs.
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 labour 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 Manufacturing-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 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 the 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 labour and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labour, 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.
Direct labour 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 take at the counter and then by measuring the number of each type of transaction.
Even in activity-based costing, some overhead costs are difficult to assign to products and customers, for example, 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.
Activity-based costing is a managerial accounting method that traces overhead costs to activities and then assigns them to objects. In other words, it’s a way to allocate indirect, overhead costs to products or departments that generate these costs in the production process.
ABC costing focuses on identifying activities, or production processes, that are used to process a job. These individual activities are grouped together with similar processes into a cost pool that relates to single activity cost driver.
The cost pools are then analyzed and assigned a predetermined overhead rate that will eventually be assigned to individual jobs and products.
As you can see, this is a multi-step process, but activity-based costing is a much more accurate way of assigning indirect costs. It’s difficult to determine how much electricity or heat one department or job uses over another without some type of methodical allocation process.
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This glossary post was last updated: 28th December, 2021 | 30 Views.