Activity-Based Costing – ABC

Definition
Activity-based costing (ABC) is an accounting method that identifies the activities that a firm performs
and then assigns indirect costs to products. An activity-based costing (ABC) system recognizes the
relationship between costs, activities and products, and through this relationship, it assigns indirect
costs to products less arbitrarily than traditional methods.

ABC offers a structure and methodology that enables management to understand

- What causes work

- When work is completed
- Where work comes from and where it goes
- How work is performed
- Why work is performed

ABC emphasizes the total quality management elements of

- Total focus on the customer

- Continuous improvement
- Employee ownership and empowerment
- Waste elimination by identifying non-value-added activities
- Prioritization of improvement efforts
- Delivery of decision-making information to all employees

Activity-based management (ABM) utilizes the data gathered by activity-based costing methodology
to

1. Improve the value received by the customer

2. Reengineer business process
3. Improve company profitability
4. Enhance activity performance by identifying productivity improvement opportunities in
functional work areas
 5. Identify the factors that cause waste
6. Measure the activities that are doing well (value-added activities)
7. Determine which activities are not essential (non-value-added activities)

Why Activity Based Costing – ABC?

Some costs are difficult to assign through this method of cost accounting. Indirect costs, such as
management and office staff salaries are sometimes difficult to assign to a particular product produced.
For this reason, this method has found its niche in the manufacturing sector.

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability
of cost data, hence producing nearly-true costs and better classifying the costs incurred by the company
during its production process.
The Role of the Management
Management accountants can perform an important role in the design of an ABC system. Based on
their skills and training, they can help identify what is appropriate for analysis (product, customer,
process, etc.) and explain the probable causes of an existing cost system’s deficiencies. In addition,
based on their detailed knowledge of the information in their company’s costing information systems,
they are uniquely qualified to judge the level of aggregation appropriate to the ABC costing system. They
can use their under-standing of costing methods to recommend appropriate methodologies for the
assignment of costs to activities and cost objects. Finally, they will be able to use their understanding of
thein formation and cost relationships to support the system once it is implemented.

IMPLEMENTING ABCINVOLVES BEHAVIORALCHANGE MANAGEMENT

The change management process needs to specifically address the “people” issues that will arise in the
implementation of the new costing system. This includes addressing commitment to the existing system
that various managers may have, and their reluctance to change. It is also important to address the
effect of the new system on performance measurement and compensation systems. New performance
metrics may need to be devised, or existing ones revised, based on information obtained during the ABC
system implementation. An example of an effect of reporting the “new” cost data from ABC is the shift
in costs among products. Some products that were effectively subsidizing others will now be reported
with lower costs and higher profit margins. The opposite effect will occur with other products, which will
now show lower profit margins or even losses

Elements of an Organization’s Activity-Based Hierarchy

Business Process – an orderly arrangement of related activities operating under a set of procedures or
business rules in order to accomplish a specific objective, such as marketing products or processing
customer orders.

Activity – Group of tasks which are a combination of elements of how work is performed.

Task – A task is the smallest unit of work within activity

Determination of an Activity’s Cost Basis

Budgeted Cost – budgeted cost reflects functional work area management’s opinion regarding future
financial expenditures and profitability.

Standard Cost – Standard cost is predetermined cost based on normal conditions of efficiency and
volume of production.

Planned Cost – Output from a planned cost approach is a set of theoretical, what-if assumptions
providing the basis for computing activity cost in an effort to achieve a predetermined goal.

Engineered Cost – derived from an industrial engineering study that provides insight into how an activity
is performed and whether any method and/or work flow improvements can increase performance
and/or reduce cost.

Actual cost – exact cost paid for a factor of production or service.

Work Drivers & Non Value Added Activities

Work drivers are factor that cause consumption of resources in performing activities.