Activity-based costing
Encyclopedia
Activity-based costing is a special costing model that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. This model assigns more indirect costs
(overhead
) into direct costs compared to conventional costing models.
In a business organization, the ABC methodology assigns an organization's resource cost
s through activities to the product
s and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.
and economic value added
. An independent 2008 report concluded that manually driven ABC was an inefficient use of resources: it was expensive and difficult to implement for small gains, and a poor value, and that alternative methods should be used. Other reports show the broad band covered with the ABC methodology.
However, application of an activity based recording may be applied without change in methodology to an extension as an incremental activity based accounting, not replacing any synoptic and retrospective modeling process with costing, but to transform concurrent process accounting into a most authentic approach.
s had arbitrarily added a broad percentage of analysis into the indirect cost.
In addition, activities include actions that are performed both by people and machine.
However, as the percentages of indirect or overhead costs rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all 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, additional cost for use of the machine is not being recognized 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.
ABC is based on George Staubus' Activity Costing and Input-Output Accounting. 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 institution
s 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.
Activity-based costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. He states that traditional cost accounting focuses on what it costs to do something, for example, to cut a screw thread; activity-based costing also records the cost of not doing, such as the cost of waiting for a needed part. Activity-based costing records the costs that traditional cost accounting does not do.
The overhead costs assigned to each activity comprise an activity cost pool.
methods have been developed in recent years to provide relevant and thorough accounting, control, and measurement systems without the complex and costly methods of manually driven ABC. However lean accounting is a snapshot concept for capturing just partial derivatives or differentials of selected cost functions. Lean accounting takes an opposite direction from ABC by working to eliminate peculiar cost allocations rather than apply complex methods of resource allocation.
Lean accounting is primarily used within lean manufacturing
. The approach has proven useful in many service industry areas including healthcare, construction, financial services, governments, and other industries.
Application of Theory of constraints
(TOC) is analysed in a study showing interesting aspects of productive coexistence of TOC and ABC application. Identifying cost drivers in ABC is described as somewhat equivalent to identifying bottlenecks in TOC. However the more thorough insight into cost composition for the inspected processes justifies the study result: ABC may deliver a better structured analysis in respect to complex processes, and this is no surprise regarding the necessarily spent effort for detailed ABC reporting.
in operational management. ABC helps to segregate
The split of cost helps to identify cost driver
s, if achieved. 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 cost driver
is a factor that creates or drives the cost of the activity. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions (cost driver
) takes at the counter and then by measuring the number of each type of transaction. For the activity of running machinery, the driver is likely to be machine operating hours. That is, machine operating hours drive labour, maintenance, and power cost during the running machinery activity.
A reports summarises reasons for implementing ABC as mere unspecific and mainly for case study purposes (in alphabetical order):
Beyond such selective application of the concept, ABC may be extended to accounting, hence proliferating a full scope of cost generation in departments or along product manufacturing. Such extension, however requires a degree of automatic data capture that prevents from cost increase in administering costs.
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.
An escape from costly procedures may be found with transition from coarse scale cost modeling to fine scaled data capture for concurrent accounting. The implementing of respective means shall redirect from the managerial level of the planning for entities of an activity type to the simply automated data capture technically detectable entities of paired events: Each two events of starting and ending an activity determine the duration of the very same activity.
The clock time of events plus identification of the persons involved and assets used may be notified easily with technical means. In contrast to locating technologies the identity and time capture always performs with desired precision and hig reliability. Application of classical logic supports for pairing the respective event times supported by captured identities. All modes of context and contributing assets and resources may be allocated and quantified for detailed costing in conjunction with such event detection. Hence agglomerating of collected data is suited to contribute to the costing model for activity based costing in all desirable detail. Modern identification technologies (e.g. RFID) provide the necessary instruments.
The state of the art approach with authentication and authorization in IETF standard RADIUS gives an easy solution for accounting all workposition based activities. That simply defines the extension of the Authentication and Authorization (AA) concept to a more advanced AA and Accounting (AAA) concept. Respective approaches for AAA get defined and staffed in the context of mobile services, when using smart phones as e.a. intelligent agent
s or smart agents
for automated capture of accounting data .
and strategies.
Usage in the US Marine Corps started in 1999.
Its use by the UK Police has been mandated since the 2003-04 UK tax year as part of England and Wales’ National Policing Plan, specifically the Policing Performance Assessment Framework.
Indirect costs
Indirect costs are costs that are not directly accountable to a cost object . Indirect costs may be either fixed or variable. Indirect costs include taxes, administration, personnel and security costs, and are also known as overhead.There are two types of Indirect Costs...
(overhead
Overhead (business)
In business, overhead or overhead expense refers to an ongoing expense of operating a business...
) into direct costs compared to conventional costing models.
Aims of model
With ABC, an organization can soundly estimate the cost elements of entire products and services. That may prepare decisions on- either identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim)
- or identify and eliminate production or service processes that are ineffective and allocate processing concepts that lead to the very same product at a better yield (process re-engineering aim).
In a business organization, the ABC methodology assigns an organization's resource cost
Cost
In production, research, retail, and accounting, a cost is the value of money that has been used up to produce something, and hence is not available for use anymore. In business, the cost may be one of acquisition, in which case the amount of money expended to acquire it is counted as cost. In this...
s through activities to the product
Product (business)
In general, the product is defined as a "thing produced by labor or effort" or the "result of an act or a process", and stems from the verb produce, from the Latin prōdūce ' lead or bring forth'. Since 1575, the word "product" has referred to anything produced...
s and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.
Prevalence
Following initial enthusiasm, ABC lost ground in the 1990s, to alternative metrics, such as Kaplan's balanced scorecardBalanced scorecard
The Balanced Scorecard is a strategic performance management tool - a semi-standard structured report, supported by proven design methods and automation tools, that can be used by managers to keep track of the execution of activities by the staff within their control and to monitor the...
and economic value added
Economic value added
In corporate finance, Economic Value Added or EVA, a registered trademark of Stern Stewart & Co., is an estimate of a firm's economic profit – being the value created in excess of the required return of the company's investors . Quite simply, EVA is the profit earned by the firm less the cost of...
. An independent 2008 report concluded that manually driven ABC was an inefficient use of resources: it was expensive and difficult to implement for small gains, and a poor value, and that alternative methods should be used. Other reports show the broad band covered with the ABC methodology.
However, application of an activity based recording may be applied without change in methodology to an extension as an incremental activity based accounting, not replacing any synoptic and retrospective modeling process with costing, but to transform concurrent process accounting into a most authentic approach.
Historical development
Traditionally cost accountantAccountant
An accountant is a practitioner of accountancy or accounting , which is the measurement, disclosure or provision of assurance about financial information that helps managers, investors, tax authorities and others make decisions about allocating resources.The Big Four auditors are the largest...
s had arbitrarily added a broad percentage of analysis into the indirect cost.
In addition, activities include actions that are performed both by people and machine.
However, as the percentages of indirect or overhead costs rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all 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, additional cost for use of the machine is not being recognized 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.
ABC is based on George Staubus' Activity Costing and Input-Output Accounting. 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
Robert S. Kaplan
Robert S. Kaplan is Baker Foundation Professor at Harvard Business School, United States, and co-creator, together with David P. Norton, of the balanced scorecard, a means of linking a company's current actions to its long-term goals...
, proponents of the Balanced Scorecard
Balanced scorecard
The Balanced Scorecard is a strategic performance management tool - a semi-standard structured report, supported by proven design methods and automation tools, that can be used by managers to keep track of the execution of activities by the staff within their control and to monitor the...
, 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
Factors of production
In economics, factors of production means inputs and finished goods means output. Input determines the quantity of output i.e. output depends upon input. Input is the starting point and output is the end point of production process and such input-output relationship is called a production function...
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
Robert S. Kaplan
Robert S. Kaplan is Baker Foundation Professor at Harvard Business School, United States, and co-creator, together with David P. Norton, of the balanced scorecard, a means of linking a company's current actions to its long-term goals...
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 institution
Financial institution
In financial economics, a financial institution is an institution that provides financial services for its clients or members. Probably the most important financial service provided by financial institutions is acting as financial intermediaries...
s 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.
Activity-based costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. He states that traditional cost accounting focuses on what it costs to do something, for example, to cut a screw thread; activity-based costing also records the cost of not doing, such as the cost of waiting for a needed part. Activity-based costing records the costs that traditional cost accounting does not do.
The overhead costs assigned to each activity comprise an activity cost pool.
Alternatives
Lean accountingLean accounting
The purpose of Lean Accounting is to support the lean enterprise as a business strategy. It seeks to move from traditional accounting methods to a system that measures and motivates excellent business practices in the lean enterprise.- Introduction :...
methods have been developed in recent years to provide relevant and thorough accounting, control, and measurement systems without the complex and costly methods of manually driven ABC. However lean accounting is a snapshot concept for capturing just partial derivatives or differentials of selected cost functions. Lean accounting takes an opposite direction from ABC by working to eliminate peculiar cost allocations rather than apply complex methods of resource allocation.
Lean accounting is primarily used within lean manufacturing
Lean manufacturing
Lean manufacturing, lean enterprise, or lean production, often simply, "Lean," is a production practice that considers the expenditure of resources for any goal other than the creation of value for the end customer to be wasteful, and thus a target for elimination...
. The approach has proven useful in many service industry areas including healthcare, construction, financial services, governments, and other industries.
Application of Theory of constraints
Theory of constraints
The theory of constraints adopts the common idiom "A chain is no stronger than its weakest link" as a new management paradigm. This means that processes, organizations, etc., are vulnerable because the weakest person or part can always damage or break them or at least adversely affect the...
(TOC) is analysed in a study showing interesting aspects of productive coexistence of TOC and ABC application. Identifying cost drivers in ABC is described as somewhat equivalent to identifying bottlenecks in TOC. However the more thorough insight into cost composition for the inspected processes justifies the study result: ABC may deliver a better structured analysis in respect to complex processes, and this is no surprise regarding the necessarily spent effort for detailed ABC reporting.
Methodology
Methodology of ABC focuses on cost allocationCost allocation
Cost allocation is a process of attributing cost to particular cost centers. For example the wage of the driver of the purchasing department can be allocated to the purchasing department cost center. It is not necessary to share the wage cost over several different cost centers...
in operational management. ABC helps to segregate
- Fixed costFixed costIn economics, fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month, and are often referred to as overhead costs...
- Variable costVariable costVariable costs are expenses that change in proportion to the activity of a business. Variable cost is the sum of marginal costs over all units produced. It can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct Costs, however,...
- Overhead cost
The split of cost helps to identify cost driver
Cost driver
A cost driver is the unit of an activity that causes the change of an activity cost.The Activity Based Costing approach relates indirect cost to the activities that drive them to be incurred....
s, if achieved. 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 cost driver
Cost driver
A cost driver is the unit of an activity that causes the change of an activity cost.The Activity Based Costing approach relates indirect cost to the activities that drive them to be incurred....
is a factor that creates or drives the cost of the activity. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions (cost driver
Cost driver
A cost driver is the unit of an activity that causes the change of an activity cost.The Activity Based Costing approach relates indirect cost to the activities that drive them to be incurred....
) takes at the counter and then by measuring the number of each type of transaction. For the activity of running machinery, the driver is likely to be machine operating hours. That is, machine operating hours drive labour, maintenance, and power cost during the running machinery activity.
Application in routine business
ABC has proven its applicability beyond academic discussion. ABC is applicable throughout company financing, costing and accounting:- ABC is a modeling process applicable for full scope as well as for partial views.
- ABC helps to identify inefficient products, departments and activities.
- ABC helps to allocate more resources on profitable products, departments and activities.
- ABC helps to control the costs at any per-product-level level and on a departmental level.
- ABC helps to find unnecessary costs that may be eliminated.
- ABC helps fixing the price of a product or service with any desired analytical resolution.
A reports summarises reasons for implementing ABC as mere unspecific and mainly for case study purposes (in alphabetical order):
- Better Management
- Budgeting, performance measurement
- Calculating costs more accurately
- Ensuring product /customer profitability
- Evaluating and justifying investments in new technologies
- Improving product quality via better product and process design
- Increasing competitiveness or coping with more competition
- Management
- Managing costs
- Providing behavioural incentives by creating cost consciousness among employees
- Responding to an increase in overheads
- Responding to increased pressure from regulators
- Supporting other management innovations such as TQM and JIT systems
Beyond such selective application of the concept, ABC may be extended to accounting, hence proliferating a full scope of cost generation in departments or along product manufacturing. Such extension, however requires a degree of automatic data capture that prevents from cost increase in administering costs.
Limitations
Applicability of ABC is bound to cost of required data capture. That drives the prevalence to slow processes in services and administrations, where staff time consumed per task defines a dominant portion of cost. Hence the reported application for production tasks do not appear as a favorized scenario.Tracing Costs
Even in ABC, 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.
Reducing cost of ABC modeling
ABC is considered a relatively costly accounting methodology. As long as cost elements would have to be taken and notified just manually, the activity based costing approach would remain arduous and the obtained completeness would be poor.An escape from costly procedures may be found with transition from coarse scale cost modeling to fine scaled data capture for concurrent accounting. The implementing of respective means shall redirect from the managerial level of the planning for entities of an activity type to the simply automated data capture technically detectable entities of paired events: Each two events of starting and ending an activity determine the duration of the very same activity.
The clock time of events plus identification of the persons involved and assets used may be notified easily with technical means. In contrast to locating technologies the identity and time capture always performs with desired precision and hig reliability. Application of classical logic supports for pairing the respective event times supported by captured identities. All modes of context and contributing assets and resources may be allocated and quantified for detailed costing in conjunction with such event detection. Hence agglomerating of collected data is suited to contribute to the costing model for activity based costing in all desirable detail. Modern identification technologies (e.g. RFID) provide the necessary instruments.
Transition to automated ABC accounting
The prerequisite for lesser cost in performing ABC is automating the data capture with an accounting extension that leads to the desired ABC model. Known approaches for event based accounting simply show the method for automation. Any transition of a current process from one stage to the next may be detected as a relevant event. Paired events easily form the respective activity.The state of the art approach with authentication and authorization in IETF standard RADIUS gives an easy solution for accounting all workposition based activities. That simply defines the extension of the Authentication and Authorization (AA) concept to a more advanced AA and Accounting (AAA) concept. Respective approaches for AAA get defined and staffed in the context of mobile services, when using smart phones as e.a. intelligent agent
Intelligent agent
In artificial intelligence, an intelligent agent is an autonomous entity which observes through sensors and acts upon an environment using actuators and directs its activity towards achieving goals . Intelligent agents may also learn or use knowledge to achieve their goals...
s or smart agents
SMART Agent
SMART Agents are a new form of software agent that interface with other agents forming an artificial intelligence system.The acronym "SMART" stands for "System for Managing Agents in Real Time"....
for automated capture of accounting data .
Public sector usage of ABC
When ABC is reportedly used in the public administration sector, the reported studies do not provide evidence about the success of methodology beyond justification of budgeting practise and existing service managementService management
Service management is integrated into supply chain management as the joint between the actual sales and the customer. The aim of high performance service management is to optimize the service-intensive supply chains, which are usually more complex than the typical finished-goods supply chain...
and strategies.
Usage in the US Marine Corps started in 1999.
Its use by the UK Police has been mandated since the 2003-04 UK tax year as part of England and Wales’ National Policing Plan, specifically the Policing Performance Assessment Framework.