Activity-based Costing

Table of contents

Table of figures

1. Introduction

2. Methodology
2.1 Internal setup within the organization
2.2 Conceptual implementation

3. Effects of cost allocation

4. Conclusion

References

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)

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.

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.

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

Most often ABC is used to get insight into costs and gaining control over cost allocation.

Furthermore process optimization and product profitability are main objectives for using ABC.⁵ To achieve those aims the project team should include experts from different areas of the company including Controlling, Finance, Process Management and Human Resources. This will help to gather necessary data throughout the different business areas. Furthermore external consultants could help in analysing the most important activities which are handled by employees. This will lead to a more objective analysis of processes and activities of the company, which can close the gap between processes as put on paper and current handling.

Before starting up the analysis, the cost allocation approach needs to be fixed. Two ways of implementation techniques need to be discussed. Either a top-down cost allocation or a bottom-up approach per activity is realizable.⁶ Both will lead to a solution, but each will present different hurdles which must be overcome. As depicted in the next figure, most companies prefer a combination of a top-down and bottom-up approach.

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Figure 2: implementation approach (BetterManagement, 2005)

If the project team assigns too much attention to detail while doing the bottom-up analysis, time will not be sufficient to deal with all the data gathered and conflicting activities will need to be resolved and discussed within the organization. Issues like how much time does someone spends regularly on an activity can lead to different personal opinions and leave the project member with no valuable information. The top-down approach of cost allocation can raise questions of how to assign specific overhead costs for technology, which replaces already human labor costs.⁷ These hidden costs need to be analysed and discussed with the functional departments. The necessary solution can be a mixed approach. Focusing on the most important production processes and costs and analysing these thoroughly, leaves enough time to gather and evaluate specific data of the necessary activities.

2.2 Conceptual implementation

There are various steps to take while starting the ABC calculation. The main work is related to analyse the business itself. The main important sources of information are gathered from the resources of a business, the activities done, and the products or services offered. Due to the fact that selling products or services are the main goal of the company to exist, the accumulated costs are assigned to them. Therefore the term cost object is used for a specific product or service.⁸

Step 1: identify the resources, major activities and cost objects in the organization

The output generated from a business organization is defined by the input or resources (1) it needs. Therefore it is necessary to know, which resources are used within the organization and how can they be differentiated. Main resources are cost of labour, machinery, supplies, facilities and travel contracts including internal and external sources.⁹

Identifying all major activities (2) is the next key element. Therefore an in-depth analysis of the operating processes of each responsibility segment is necessary. Starting points are organizational maps and payroll listings to get a first insight into resource consumption.¹⁰ Furthermore, existing process documentation can be used to identify activities and to check within the organization if these still exist or differ from the mapped processes.

The following chart displays how the business first can be subdivided into main processes. Focusing on one main process will again lead to other sub processes which are below this first level. Usually 3 or 4 process levels are needed to display the actual activity. Thus one sub process may consist of one or more activities.

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Figure 3: process example of a leasing business

The main object for ABC is to assign the activities to the specific cost objects (3). Therefore it is necessary to know, which cost objects exist, thus which products or services are offered to the customers and how are they differentiated. Whether cost measurement is needed for projects or on customer basis, it can be added as well to the cost object category.¹¹

Step 2: define cost drivers and make assignments

To proceed with the integration of an ABC system into an organization, two main stages of cost allocation can be identified.¹² As shown in figure 4, the main stages will connect the resources consumed by activities with the activities consumed by the cost objects.

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

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¹ Cokins, G.(1998), p. 15.

² Coenenberg, A.(1992), p. 12.

³ Tillema, K.H.(2002), p. 38.

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

⁵ Kaplan, R./Anderson, S.(2007), p.3.

⁶ Tillema, K.H.(2002), p.57.

⁷ Nolan, G.(2004), para. 1.

⁸ Mattfeld, B.(2003), p. 13.

⁹ Boons, A.N.A.M.(1998), p.9.

¹⁰ Innes, J/ Mitchell,F.(1995), p. 145.

¹¹ Mattfeld, B.(2003), p. 13.

¹² Coenenberg, A./Fischer, T.(1991), pp.21-38.