34327041 Activity Based Costing

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Report on

Activity Based Costing

A Tool to Aid Decision Making

Submitted by

Md. MahabubAlam

Ruhulamin

Md. MehediHasan

Tanvir Ahmed

MofazzalHossain



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SUMMARY

Activity-based costing (ABC) is a technique to more accurately assign the indirect and direct

resources of an organization to the activities performed based on consumption. In the first stage,

resource costs are assigned to activities based on the amount of resources consumed in performing theactivity. In the second stage, activity costs are traced to the products, services, or customers based on

how frequently the activity is performed in support of these cost objects. This paper examines the best

practices that have emerged in the ABC implementation domain.

ABC analysis provides the information necessary to make business decisions such as determining if

investments in efficiency initiatives, such as just in time (JIT), are warranted. When implementing

ABC, management should use proven project management methodology to minimize the risk of

failure. ABC is an effective total quality management tool, and supports just-in-time manufacturing

methods in several companies as detailed in the paper.



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INTRODUCTION

Activity-based costing (ABC) is a costing model that identifies activities in an organization

and assigns the cost of each activity resource to all products and services according to the

actual consumption by each: it assigns more indirect costs (overhead) into direct costs.

In this way an organization can precisely estimate the cost of its individual products and

services for the purposes of identifying and eliminating those which are unprofitable and

lowering the prices of those which are overpriced.

In a business organization, the ABC methodology assigns an organization's resource costs

through activities to the products and services provided to its customers. It is generally used

as a tool for understanding product and customer cost and profitability. As such, ABC has

predominantly been used to support strategic decisions such as pricing, outsourcing and

identification and measurement of process improvement initiatives.

HISTORICAL DEVELOPMENT

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.



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Acti it B C ti

t i it cent es t all cate costs, ABC seeks to i enti cause

and affect relationshi s to ob jecti el assi n costs. Once costs of the acti ities have been

identif ied, the cost of each activit is attr i buted to each product to the extent that the product

uses the activit . In this way ABC of ten identif ies areas of hi h overhead costs per unit and

so directs attention to f inding ways to reduce the costs or to charge more for costly products.

Activity-based costing was f irst clear ly def ined in 1987 by R ober t S. Kaplan and W. Burns as

a chapter in their book Accounting and Management: A Field Study Perspective. They

initially focused on manufactur ing industry where increasing technology and productivity

improvements have reduced the relative propor tion of the direct costs of labor and mater ials,

but have increased relative propor tion 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 manufactur ing industr ies, f inancial institutions also 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 f inancial institutions, these costs must

also be attr i buted more accurately to products and customers. Activity based costing, even

though or iginally developed for manufactur ing, may even be a more useful tool for doing

this.

MET L G

a. Cost allocation: Cost allocation is a process of attr i buting cost to par ticular cost

centers. For example the wage of the dr iver of the purchasing depar tment can be

allocated to the purchasing depar tment cost center. It is not necessary to share the

wage cost over several different cost centers. Cost and services are not identical to

each other.

b. Fixed cost: In economics, f ixed costs are business expenses

that are not dependent on the activities of the business they

tend to be time-related, such as salar ies or rents being paid

per month. This is in contrast to var iable costs, which are

volume-related (and are paid per quantity).

In management accounting, f ixed costs are def ined as

expenses that do not change in propor tion to the activity of a



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business, within the relevant period. For example, a retailer must pay rent and utility

bills irrespective of sales.

c. Variable cost: Variable costs are expenses that change in proportion to the activity of

a business. In other words, variable cost is the sum of marginal costs. It can also be

considered normal costs. Along with fixed costs, variable costs make up the two

components of total cost. Direct Costs, however, are costs that can easily beassociated with a particular cost object. Not all variable costs are direct costs,

however; for example, variable manufacturing overhead costs are variable costs that

are not a direct costs, but indirect costs. Variable costs are sometimes called unit-level

costs as they vary with the number of units produced.

d. Cost driver: Cost Drivers are the structural causes of the cost of an activity

performed in the Value Chain. They determine the behavior of costs within an

activity.

A cost driver can be completely or partly or not at all under the control of a firm.

A firm's cost performance in all of its major discrete activities adds up to establish its

relative cost position.

Accordi g to Michael Porter, there are 10 major cost drivers:

1. Economies or Diseconomies of Scale.

2. Learning and Spillovers. The cost of a value activity often declines over time due to

learning or improvements that increase its efficiency. Or due to knowledge acquired

from suppliers, consultants, former employees or reverse engineering.

3. Pattern of Capacity Utilization. Different ways of configuring a value activity will

affect its sensitivity for capacity (under)utilization.

4. Linkages. The cost of many value activities is affected by how other activities are

performed within the firm's own value chain or with the value chain of a supplier or a

channel ("Vertical Linkages"). Through combining these activities and their linkages,

their total cost can be reduced.

5. Interrelationships between business units within a firm in the form of shared

activities.



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6. Vertical Integration. Doing more activities within the firm.

7. Timing, such as First Mover Advantage or Second Mover Advantage.

8. Discretionary Policies. The strategic choices a firm make, for example being a self-

service internet bank or being the fastest courier company.

9. Location. Geographic location where an activity is conducted and the prevailing costs

of personnel, materials, energy, etc.

10. Institutional Factors. Government regulation, tax regimes, financial incentives,

unionization, tariffs and levies, local content rules also affect the costs of a value

activity.

e. Cost driver rate:cost driver in a system of activity-based costing, any factor such as

number of units, number of transactions, or duration of transactions that drives the

costs arising from a particular activity. When such factors can be clearly identified

and measured.

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 measure of

the use of a shared activity by each of the products is known as the cost driver. For example,

the cost of the activity of bank tellers can be ascribed to each product by measuring how long

each product's transactions takes at the counter and then by measuring the number of each

type of transaction.

DIFFERENCE BETWEEN ABC AND TRADITIONAL COST

ACCOUNTIN METHODS

So what is really the difference between ABC and traditional cost accounting methods?

Despite the enormous difference in performance, there are three major differences:

In traditional cost accounting it is assumed that cost objects consume resources

whereas in ABC it is assumed that cost objects consume activities.

Traditional cost accounting mostly utilizes volume related allocation bases while

ABC uses drivers at various levels.

Traditional cost accounting is structure-oriented whereas ABC is process-oriented.

Activity-based costing is a more accurate cost management system than TCA. One

would use the ABC method when overhead is high, products are diverse, cost of

errors high and competition is stiff.



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Traditional Cost Accounting is unable to calculate the 'true' cost of the product. TCA

arbitrarily allocates overhead to the costs of objects.

This is discussed in more detail in the subsequent sections and illustrated below.

But first, the direction of the arrows are different because ABC brings detailed information

from the processes up to assess costs and manage capacity on many levels whereas traditional

cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost

objects without considering any 'cause and effect' relations.

Figure: Diff erence between ABC & Traditional Costing

Hence, we see that the traditional usage of fixed and variable costs is totally meaningless. In

ABC, all costs are included. However, ABC employs a different usage and definition of fixed

and variable costs. A fixed activity cost is a cost that exists due to the very existence of the

activity whereas a variable activity cost changes as the output of the activity changes. This

distinction is very helpful in various improvement efforts.

Therefore, in Activity-Based Management (ABM)a third type of drivers is employed in

addition to the two aforementioned drivers. This type of drivers is called cost drivers and they

are the underlying causes of costs of activities and measured by non-financial performance

measures. Today, the most important of these measures can be presented in a balanced

scorecard and they represent the process view in ABM. These are possibly the most difficult

drivers to identify.



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ACTIVITY-BASED MANA EMENT

Activity-based management and activity-based costing (ABM/ABC) have brought about

radical change in cost management systems. ABM has grown largely out of the work of theTexas-based Consortium for Advanced Manufacturing-International (CAM-I). The principles

and philosophies of activity-based thinking apply equally to service companies, government

agencies and process industries. Activity-based costing and activity-based management have

been around for more than fifteen years.

It is a one-off exercise which measures the cost and performance of activities, resources and

the objects which consume them in order to generate more accurate and meaningful

information for decision-making. ABM draws on ABC to provide management reporting and

decision making. ABM supports business excellence by providing information to facilitate

long-term strategic decisions about such things as product mix and sourcing. It allows

product designers to understand the impact of different designs on cost and flexibility and

then to modify their designs accordingly.

ABM also supports the quest for continuous improvement by allowing management to gain

new insights into activity performance by focusing attention on the sources of demand for

activities and by permitting management to create behavioral incentives to improve one or

more aspects of the business.

y ABM is a fundamental shift in emphasis from traditional costing and performance

measurement. People undertake activities which consume resources ± so controlling

activities allows you to control costs at their source.y The real value and power of ABM comes from the knowledge and information that

leads to better decisions and the leverage it provides to measure improvement.

y ABM enables management to make informed decisions about lines of business,

product mix, process and product design, what services should be offered, capital

investments, and pricing.

y ABM is more than an accounting tool; it's a system for continuous improvements. It is

not a single answer but merely one of the many tools that can be used to enhance

organizational performance management.

y ABM will not reduce costs, it will only help you understand costs better to know what

to correct.y The process of ABM does consume resources, and the manpower costs can be

significant.

y _ Other priorities, top management commitment,

y IT capabilities and integration with financial and budgeting systems should be

considered before implementation.



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y Organizations have begun to look at ABM for a variety of reasons. Among the most

commonly cited are:

o top-down pressure to reduce costs;

o Competitive pressure/market conditions;

o organization-wide programmed;

o The introduction of benchmarking;o Regulatory issues;

o Seeking world-class status through process management.

y ABC and ABM are a continuum of value. ABM is the application of ABC data to

manage product portfolios and business processes better.

BENEFITS OF ACTIVITY-BASED COSTIN

Typical benefits of Activity-Based Costing:

y Identify the most profitable customers, products and channels.

y Identify the least profitable customers, products and channels.

y Determine the true contributors to- and detractors from- financial performance.

y Accurately predict costs, profits and resources requirements associated with changes

in production volumes, organizational structure and costs of resources.

y Easily identify the root causes of poor financial performance.

y Track costs of activities and work processes.

y Equip managers with cost intelligence to stimulate improvements.

y Facilitate a better Marketing Mix

y Enhance the bargaining power with the customer.

y Achieve better Positioning of products

With the costing now based on activities, the cost of serving a customer can be ascertained

individually. Deducting the product cost and the cost to serve each customer, one can arrive

at customer's profitability. This method of dealing separately with the customer costs and the



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product costs enables the identification of the profitability of each customer and Positioning

the products and services accordingly.

USES OF ACTIVITY BASED COSTIN

It helps to identify inefficient products, departments and activities

It helps to allocate more resources on profitable products, departments and activities

It helps to control the costs at an individual level and on a departmental level

It helps to find unnecessary costs

ACTIVITY BASED COSTIN PRACTICE- BE CAUTIOUS

Even in activity-based costing, 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.



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STEPS OF ACTIVITY BASED COSTIN

Following an Example of Activity Based Costing Estimate

To get a better understanding of how an ABC estimate is developed, assume that it has beenasked to prepare a cost estimate for a site evaluation. To verify that there is no contamination

at the site, subsurface soil samples will have to be collected. The area of the site is known,

and the guideline for the number of samples per unit area has also been given.

Figure: Overhead Cost Analysis

1. Define activities, activity cost pools, and activity measures

Assume that the cost of supplying resources ± personnel, supervision, information

technology, telecommunications, and occupancy í to perform these activities is $560,000

per quarter. In building an ABC model for the customer service department, the system

designer asks employees to estimate the percentage of their time spent (or that they expect

to spend) on the three principal activities they perform. Suppose they estimate these percentages as 70%, 10% and 20%, respectively. The ABC system designer also learns

that the actual (or estimated) quantities of work for the quarter in these three activities

are:

9,800 customer orders

280 customer complaints

500 credit checks



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2. Assign overhead costs to activity cost pools

The system assigns the $560,000 resource cost to activities, based on the time

percentage, and calculates activity cost driver rates as shown below:

Overhead % Total

Customer

Orders 70% $ 392000

Customer

Complaints 10% 56000

Credit Checks 20% 112000

Total $ 560000

Table: Overhead Cost

Figure: ABC System



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3. Calculate activity rates

Activity % Assigned Cost

Activity Cost

Driver

Quantity

Activity Cost

Driver Rate

Handle orders 70% $392,000 9,800 $ 40/order Process

complaints10% 56,000 280 $200/complaint

Check credit 20% 112,000 500$224/credit

check

Total 100% $ 560,000

Table: Calculated Activity Rates

The project team then uses the calculated activity cost driver rates to assign the expenses of

the three activities to individual customers based on the number of orders handled,

complaints processed, and credit checks performed for each customer.



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MATHEMATICAL ILLUSTRATION

Returning to the numerical example, suppose that the analyst obtains estimates of the

following average unit times for the three customer-related activities:

Handle customer orders 40 minutes

Process customer complaints 220 minutes

Perform credit check 250 minutes

We can now simply calculate the activity cost driver rate for the three activities:

ActivityUnit Time (minutes)

Activity Cost Driver Rate @$0.80/minute

Handle customer order 40$ 32

Process customer complaint 220$176

Perform credit check 250$200

Table: Calculate Activity Cost Driver Rates

These rates are lower than those estimated before. The reason for this discrepancy

becomes obvious when we calculate the cost of performing these activities during the

recent quarter.

Activity Unit Time Quantity Total Minutes Total Cost

Handle

customer order40 9800 392000 $ 313600

Process

customercomplaint

220 280 61600 49280

Perf orm credit

check 250 500 125000 100000

Total 578600 $ 462880

Table: Calculated Overhead Cost



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The analysis reveals that only 83% of the practical capacity (578,600/700,000) of the

resources supplied during the period was used for productive work (and hence only 83% of

the total expenses of $560,000 are assigned to customers during this period). The traditional

ABC system over-estimates the costs of performing activities because its distribution of effort

survey, while quite accurate í 70%, 10% and 20% of the productive work is the approximate

distribution across the three activities í incorporates both the costs of resource capacity usedand the costs of unused resources. By specifying the unit times to perform each instance of

the activity14

the organization gets both a more valid signal about the cost and the underlying

efficiency of each activity as well as the quantity (121,400 hours) and cost ($97,120) of the

unused capacity in the resources supplied to perform the activity.

With estimates of the cost of resource supply, the practical capacity of the resources supplied,

and the unit times for each activity performed by the resources, the reporting system becomes

quite simple for each period. Suppose the quantity of activities shifts, in the subsequent

period, to 10,200 orders handled, 230 customer complaints, and 540 credit checks performed.

During the period, the costs of each of the three activities are assigned based on the standard

rates, calculated at practical capacity: $32 per order, $176 per complaint, and $200 per credit

check. This calculation can be performed in real time to assign customer administration costs

to individual customers, as transactions from customers occur.

The report at the end of the period is both simple and inf ormative:

Activity Quantity Unit

Time

Total

Time Unit Cost

Total Cost

Assigned

Handle Customer

Orders 10,200 40 408,000 $ 32 $ 326,400

Process Complaints 230 220 50,600 176 40,480

Perform Credit

Checks540 250 135,000 200 108,000

TotalUsed 593,600 $ 474,880

Total Supplied 700,000 $560,000

Unused Capacity 106,400 $ 85,120

Table: Analysis R eport

The report reveals the estimated time spent on the three activities, as well as the

resource costs required to handle the activity demands. It also highlights the difference

between capacity supplied (both quantity and cost) and the capacity used. Managers can

review the $85,120 cost of the 106,400 minutes (1,773 hours) of unused capacity and

contemplate actions to reduce the supply of resources and the associated expense.

Rather than reduce currently unused capacity, managers may choose to reserve that capacity

for future growth. As managers contemplate new product introductions, expansion into new

markets, or just increases in product and customer demand, they can forecast how much of



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the increased business can be handled by existing capacity, and where capacity shortages are

likely to arise that will require additional spending to handle the increased demands. For

example, the vice president of operations at Lewis-Goetz, a hose and belt fabricator based in

Pittsburgh, saw that one of his plants was operating at only 27% of capacity. Rather than

attempt to downsize the plant, he decided to maintain the capacity for a large contract he

expected to win later that year.

CONTINUOUS IMPROVEMENT

The implementation of ABC can make the employees understand the various costs involved.

This will then enable them to analyze the cost, and to identify the activities that add value and

those that do not add value. Finally, based on this, improvements can be implemented and the

benefits can be realized. This is a continuous improvement process in terms of analyzing the

cost, to reduce or eliminate the non-value added activities and to achieve an overall

efficiency.

ABC has helped enterprises in answering the market need for better quality products at

competitive prices. Analyzing the product profitability and customer profitability, the ABC

method has contributed effectively for the top management's decision making process. With

ABC, enterprises are able to improve their efficiency and reduce the cost without sacrificing

the value for the customer. Many companies also use ABC as a basis for a balancedscorecard.

This has also enabled enterprises to model the impact of cost reduction and subsequently

confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method

for continuous improvement. With Activity Based Costing any enterprise can have a built-in

competitive cost advantage, so it can continuously add value to both its stakeholders and

customers.

The implementation of Activity Based Costing is not easy - not an ABC. Special activity

based costing software can be helpful.



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CONCLUSION

Over the past 15 years, activity-based costing has enabled managers to see that not all revenue is

good revenue, and not all customers are profitable customers. Unfortunately, the difficulties of

implementing and maintaining traditional ABC systems have prevented activity-based cost

systems from being an effective, timely, and up-to-date management tool. The time-driven ABC

approach has overcome these difficulties. It offers managers a methodology that has the

following positive features:

y Easy and fast to implement

y Integrates well with data now available from recently installed ER P and CRM systems

y Inexpensive and fast to maintain and update

y Ability to scale to enterprise-wide models

y Easy to incorporates specific features for particular orders, processes, suppliers, andcustomers

y More visibility to process efficiencies and capacity utilization

y Ability to forecast future resource demands based on predicted order quantities and

complexity

These characteristics enable activity-based costing to move from a complex, expensive financial

systems implementation to becoming a tool that provides meaningful and actionable data, quickly

and inexpensively, to managers.



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BIBLIO RAPHY

Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective

(Harvard Business School Press, 1987).

Sapp, Richard, David Crawford and Steven Rebishcke, Journal of Bank Cost and

Management Accounting (Volume 3, Number 2), 1990, Journal of Bank Cost and

Management Accounting (Volume 4, Number 1), 1991.

David M. Katz, Activity-Based Costing (ABC).

Police Service National ABC Model Manual of Guidance Version 2.3 June 2007.

Sir Ronnie Flanagan, The Review of Policing Final Report, February 2008.

Tiffany Bradford, Types of Accounting Costing Systems, 2008

Weygandt / Kieso / Kimmel, Managerial Accounting (Second Edition)

[email protected] with questions or comments about this web site.

Copyright © 2000 Jan Emblemsvag

DR jake, mitchell; alan price (2003). Economics: Principles in action. Upper Saddle River,

New Jersey 07458:Pearson Prentice Hall.

DR Alex, Suleman. "A controversial-issues approach to enhance management accounting

education.".Journal of Accounting Education 1994.

Ali, H. F. "A multi-contribution activity-based income statement.´Journal of Cost

Management 1994.

Innes, J and Mitchell, F (1995), Activity-based costing in the UK's largest companies: a

survey, CIMA.

Innes J, and Norris, G (1997), The use of activity-based information: a managerial

perspective, CIMA.

µActivity-based management¶, Management Accounting Issues Paper 10, SMAC, 1995.

Statement of Management Accounting , NAA/IMA, 1998.http://www.pitt.edu/~roztocki/abc/abc.htm ABM Internet website guide, by NarcyzRoztocki

of the Pittsburgh University. Comprehensive internet web links covering all areas of

ABM

http://www.pitt.edu/~roztocki/abc/abctutor/ Introduction to Activity-based Costing (ABC)

Internet ABC online presentation. University of Pittsburgh

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