Activity-based Costing

Table of contents

Table of  contents  II

Table of  figures  III

1.  Introduction  1

2.  Methodology  2

2.1  Internal setup within the organization  2

2.2  Conceptual implementation  4

3.  Effects of cost allocation  8

4.  Conclusion  10

  References  IV

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Table of  figures  

  Figure 1 : primary use of ABC (BetterManagement, 2005 )  

  Figure 2 : implementation approach  

  Figure 3 : process example of a leasing business  

  Figure 4 : methodology of an ABC calculation (Mattfeld, B , 2003 )  

  Figure 5 : relation of resource and activity drivers (Mattfeld, B , 2003 )  

  Figure 6 : assigning activities to respective cost objects (based on Mattfeld, B , 2003 )  

  Figure 7 : calculation of unit costs per cost object  

  Figure 8 : complexity effect (Coenenberg, A /Fischer,T , 1991 )  

  Figure 9 : product example for economies of scale (Coenenberg, A /Fischer, T , 1990 )  

  Figure 10 : main challenges implementing the ABC method (BetterManagement, 2005 )  

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1. Introduction

Activity-based costing first gained publicity in the early 1980s. It was developed as a logical alternative to traditional cost management systems that tended to produce insufficient results when it came to allocating costs. Harvard Business School Professor Robert S. Kaplan was an early advocate of the ABC system. 1

Due to a changing business world and strong competition, the cost structure in many companies changed, while facing an increased price pressure. When profit margins are decreasing, companies are focusing not only on external but also internal opportunities to improve their cost structures and to make hidden costs transparent. This leads to the introduction of Activity-based costing (ABC) as a new approach of process thinking to make the internal organization more flexible to react to changes in the production process and allocation of costs as well as to deal with overcapacities.

ABC is therefore a method to develop cost estimates into quantifiable activities or work units. Traditional costing systems, which are based on calculating direct costs and adding overhead costs proportionally, can lead to wrong business decisions. Due to a relatively small proportion of direct costs in today’s businesses and increased overhead costs, the cost allocation does not work properly. ABC has been designed to cope with the deficiencies of traditional costing systems and allows an organisation to determine the actual costs associated with each product or service. 2

Aiming at transparency, efficiency increase and improvement of the cost calculation system, the ABC method enables management to optimize the enterprise with detailed information for a thorough decision making process.

¹ Cokins, G.(1998), p. 15.

² Coenenberg, A.(1992), p. 12.

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2. Methodology

ABC is a method for developing cost estimates, based on the activities used within the production process per cost object. To develop a cost estimate the most important activities within the production cycle - the cost drivers - need to be identified. The activity must be definable and measured in units, e.g. number of man hours. ³ After all activities for producing the product are known, a cost estimate is prepared for each activity. These individual cost estimates contain all labour, materials and equipment costs, including overhead, for each activity. ⁴ Each complete individual estimate is added to the others to obtain an overall estimate. To gain sufficient cost estimates, data must be collected and verified to make ABC a functional and precise tool. This chapter leads through the necessary steps to implement the ABC approach and its methodology.

2.1 Internal setup within the organization

ABC programs need to be integrated as tool for management decision-making. Therefore management needs to commit to implementing the project as well as to support the responsible project team. The primary use will be defined by upper management to give the project team clear directions regarding what the aims of using ABC are. The figure below depicts what the main objectives are to install ABC in organizations.

³ Tillema, K.H.(2002), p. 38.

⁴ US Department of Energy (2007), p. 1.

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