Activity Based Costing (ABC) – Definition, Benefits and Weakness

Traditional or Absorption Costing System reflects full cost pertaining to a product. It is easy to use and, therefore, is practiced widely. The allocation of overhead costs under the system is based on a rate determined by either a percentage of direct labor cost or number of labor hours worked or another. Therefore, the reported allocation of overheads for a given product may be incorrect. It is the main defect of absorption costing.

During 1980’s, the limitations of absorption costing system were felt with severity. Companies were looking for a system that could reflect true product cost in order to fight competition. The absorption costing system was designed decades ago, when most companies produced narrow range of products. Further, overhead costs were small enough to make a big difference in the identification of cost of a product. This criticism of absorption costing led to generation of the idea of ABC system. David Cooper and Robert Kaplan wrote articles on the idea of ABC system in 1990 and 1992. The new system was accepted widely and became reality of the day. Now ABC system has become part of every management accounting text book and being implemented the world over.

Activity-Based Costing (ABC) Definition

Applying overhead costs to each product or service based on the extent to which that product or service causes overhead cost to be incurred is the primary objective of accounting for overhead costs. In many production processes, overhead is applied to products using a single predetermined overhead rate based on a single activity measure. With Activity-Based Costing (ABC), multiple activities are identified in the production process that are associated with costs. The events within these activities that cause work (costs) are called cost drivers. Examples of overhead cost drivers are machine set-ups, material-handling operations, and the number of steps in a manufacturing process. Examples of cost drivers in non-manufacturing organizations are hospital beds occupied, the number of take-offs and landing for an airline, and the number of rooms occupied in a hotel. The cost drivers are used to apply overhead to products and services when using Activity-Based Costing.

Activity-Based Costing

Activity-Based Costing Activities

The following five steps are used to apply costs to products under an  Activity-Based Costing (ABC) system.

  1. Choose Appropriate Activities: The first step of ABC is to choose the activities that result in incurring of overhead costs. These activities do not necessarily coincide with existing departments but rather represent a group of transactions that support the production process. Typical activities used in ABC are designing, ordering, scheduling, moving materials, controlling inventory, and controlling quality. Each of these activities is composed of transactions that result in costs. More than one cost pool can be established for each activity. A cost pool is an account to record the costs of an activity with a specific cost driver.
  2. Trace Costs to Activities: Once the activities have been chosen, costs must be traced to the cost pools for different activities. To facilitate this tracing, cost drivers are chosen to act as vehicles for distributing costs. These cost drivers are often called resource drivers. A predetermined rate is estimated for each resource driver. Consumption of the resource driver in combination with the predetermined rate determines the distribution of the resource costs to the activities.
  3. Determine Cost Drivers for Activities: Cost drivers for activities are sometimes called activity drivers. Activity drivers represent the event that causes costs within an activity. For example, activity drivers for the purchasing activity include negotiations with vendors, ordering materials, scheduling their arrival, and perhaps inspection. Each of these activity drivers represents costly procedures that are performed in the purchasing activity. An activity driver is chosen for each cost pool. If two cost pools use the same cost driver, then the cost pools could be combined for product-costing purposes.
  4. Estimate Application Rates for each Activity Driver: An application rate must be estimated for each activity driver. A predetermined rate is estimated by dividing the cost pool by the estimated level of activity of the activity driver. Alternatively, an actual rate is determined by dividing the actual costs of the cost pool by the actual level of activity of the activity driver. Standard costs, could also be used to calculate a predetermined rate.
  5. Applying Costs to Products: The application of costs to products is calculated by multiplying the application rate times the usage of the activity driver in manufacturing a product or providing a service.

Value-Added versus Non-value-Added Activities

Every organization requires information to allocate resources, monitor the actions taken, set priority and make decisions. Activity-base costing provides the accurate cost information by allocating overhead costs. However, activity-based management is focusing on enhance the use of ABC from product costing to a comprehensive management tool that concentrate on decreasing the costs and concurrently improving processes and decision making. After that, a refinement of ABC used in activity based management is the classification of activities to value-added and non-value-added. A non-value-added activity can de defined as the production or service related activities that can be eliminated with no deterioration of product attributes. Non-value-added activities are activities that simply add cost to or increase the time spent on a product without increasing the market value of the products. Activities such as the storage of inventory, building maintenance; inspection and inventory control are examples of non-value-added activities in manufacturing companies. Examples of non-value-added activities in service industry consist of bookkeeping, billing, traveling, advertising, cleaning, taking appointment, reception etc. Making non-value-added activities visible is one of the advantage of activity based management but it is the most difficult to achieve.

Value-added activities are activities that increase the worth or market value of a product or service to customers. For instance, activities like engineering design, machining, packaging, performing surgery, providing legal research for legal services and etcetera are categorized as value-added activities. When people understand and accept the reasons why an activity is classified as non-value added or value added then the clarity and understanding between value-added and non-value-added activities are achieved.

Cost Hierarchy In Activity-Based Costing

A cost hierarchy classifies costs into different cost pools on the basis of different type of cost driver or cost allocation bases or different degrees of difficulty in identifying cause-and-effect or benefits-received relationships. There are four levels to identify cost allocation bases or cost drivers, the classification is shown as follow:

  1. Unit-level activities: these activities can be defined as resources sacrificed on activities performed on each individual unit of a product or service. For instance, manufacturing operating costs such as energy and repair which have relationship with the activity of running a machine are unit-level activities.
  2. Batch-level activities: Activities performed for a group of product units or services rather than to each individual unit of product or service. Examples of batch-level cost in manufacturing are setup cost and procurement costs. Then, the number of setups or setup time is examples of cost drivers in batch-level activities.
  3. Product-sustaining activities: These activities are defined as resources sacrificed on activities that performed in support of an entire product line, but not performed every time when a new batch or unit of products is produced. Design costs and engineering costs are examples of product-sustaining activities in manufacturing industry.
  4. Facility-level activities: Activities required to support or sustain the organization as a whole and cannot be traced to individual product. The example of this activity includes home office general administration costs.

In fact, the successful classification of these activities provide managers a structured way of thinking about the relationships between activities and the resources they consume.

Benefits of Activity-Based Costing

Activity-Based Costing is valuable for planning, because the establishment of an ABC system requires a careful study of the total manufacturing or service process of an organization. ABC highlights the causes of costs. An analysis of these causes can identify activities that do not add to the value of the product. These activities include moving materials and accounting for transactions. Although these activities cannot be completely eliminated, they may be reduced. A recognition of how various activities affect costs can lead to modifications in the planning of factory layouts and increased efforts in the design process stage to reduce future manufacturing costs.

An analysis of activities can also lead to better performance measurement. Workers on the line often understand activities better than costs and can be evaluated accordingly. At higher management levels, the activities can be aggregated to be in line with responsibility centers. Managers would be responsible for the costs of the activities associated with their responsibility centers.

Weaknesses of Activity-Based Costing

First,  Activity-Based Costing is based on historical costs. For planning decisions, future costs are generally the relevant costs. Second, ABC does not partition variable and fixed costs. For many short run decisions, it is important to identify variable costs. Third, ABC is only as accurate as the quality of the cost drivers. The distribution and application of costs becomes an arbitrary allocation process when the cost drivers are not associated with the factors that are causing costs. And finally, ABC tends to be more expensive than the more traditional methods of applying costs to products.

Mini Case Study:  Activity-Based Costing at Boeing

Boeing Commercial Airplane Group (BCAG) is the world’s largest manufacturer of commercial airplanes. It comprises approximately 60% of Boeing’s total revenues. BCAG Wichita is a cost center manufacturing plant producing fuselages, noses, struts, nacelles, and thrust reversers for 737, 747, 757, 767, and 777 airplane models. In May 1999, the plant employed approximately 16,835 employees directly, and was responsible for indirect employment of 53,100 workers within the state of Kansas. As part of its overall drive to gain and retain world-class aerospace manufacturing status, BCAG Wichita is focused on developing a lean, efficient design and production system supported by an effective cost management strategy.

The cost management strategy supports initiatives designed to link the manufacturing process and support activities so as to simplify the whole production process, while maximizing benefits from the use of lean business practices. Cost management strategy initiatives include simplifying production, shortening flow and cycle times, increasing quality and inventory turnover, identifying core products and processes, and linking the design and manufacturing process to decrease product time-to-market. Activity-Based Costing links and supports the manufacturing process. It provides information to tailor business streams and material management, costs of activity and processes, value added versus non-value added analysis and profitability analysis used to improve the make versus buy decision-making process. ABC also provides analysis of set-up and run costs, costs of scheduled and unscheduled maintenance, costs of asset failure, and costs of manufacturing capacity, thereby allowing manufacturing managers to manage the assets under their control more effectively. Finally, ABC provides analysis on the costs of design changes in configuration as impacted on the manufacturing floor, costs of incorporating complexity into a configuration design, and the costs of quality.

The highest hurdle in achieving this type of cost management architecture lies in moving the corporate financial department from its classic accounting role as scorekeeper or policeman to the role of business partner. In a business partner role, the corporate financial department can support strategic decisions relevant to the company’s continued competitive advantage by providing financial data that highlights the impact of these decisions. BCAG Wichita views a successful implementation of ABC as one that fulfills three major roles:

  • Addresses the size, complexity, and diversity of the manufacturing process,
  • Facilitates the integration of financial decision makers into a more supportive business partnership role, and
  • Implements effective cost management strategy initiatives.

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