Activity Based Costing

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Overview of Activity Based Costing

An activity based costing system is designed to match overhead costs as closely as possible with a company's activities. By doing so, overhead costs can be reasonably associated with products, departments, customers, or other users of activities, which tells managers where overhead costs are being used within a company. This results in much better control over overhead costs.

Activity based costing involves a two-step process where overhead costs are first assigned to those activities that generate the overhead costs; the costs are then further allocated to those products, customers, and so forth that use the activities.

Cost Allocation Examples

There are several ways to allocate overhead costs. Some overhead costs, such as utilities, are associated with specific machines. For example, a machine may require ten cents of electricity per minute. If so, this overhead cost can be charged out to those products that are run through the machine, based on the time spent being worked upon it. Other overhead costs are associated with a specific product line, and can reasonably be allocated to the activities performed within that product line. For example, there is typically a supervisor who is assigned to a single product line. If so, the fully burdened salary of this person can be charged to such related activities as production and maintenance scheduling. Still other overhead costs may be grouped by commodity used in the production process. For example, each member of the purchasing staff may be responsible for the procurement of a specific commodity. If so, this overhead cost can be distributed to individual products based on their usage of the commodity. Clearly, there are many valid ways to allocate overhead costs to various activities, and from there to users of those costs. An activity based costing system creates a structured approach to the accumulation, storage, and allocation of overhead costs using many of these activity measures.

The Activity Based Costing System

An activity based costing system is a difficult and complex one to create, because of the wide variety of costs that must be accumulated, tracked in relation to different types of activities, and charged off. Here are the primary steps involved in creating such a system:

Determine the scope of the system. A fully developed activity based costing system that encompasses all costs throughout a company is a massive undertaking that may not yield any results for several years. A better approach is to conduct a gradual rollout of the system that produces results more quickly. Accordingly, a key factor is limiting each incremental rollout of the system to a carefully defined segment of the business. The determination of scope should also include a review of the level of detailed analysis that the system is to produce, since an excessive focus on detail may result in a system that is too expensive in relation to the utility of the information produced.
Set aside direct costs. There will be several direct costs that can be clearly and indisputably traced to specific products. These costs should be identified early in the design phase, so that they will not be erroneously added to the ABC allocation system.
Locate costs in the general ledger. The next step is to identify each of the overhead costs in the general ledger that will be allocated by the ABC system. This can be a difficult undertaking, for the required costs may be lumped together in the ledger, and must be segregated through a new data collection system that involves the creation of a new general ledger account number. Alternatively, the split may be achieved less accurately by allocating a percentage of the cost in a single general ledger account to several overhead cost items which will then be allocated.
Store costs in cost pools. All of the costs that have been identified within the general ledger must now be stored in a series of cost pools. Each cost pool accumulates costs that are similar to each other. For example, a building cost pool will include the costs of insurance and maintenance for a building, whereas a product line cost pool may include the marketing and supervisory costs that can be traced to a specific product line. A third type of cost pool is one that is related to a specific production batch, and can include such costs as production control labor, tooling, materials handling, and quality control. The total number of cost pools used will have a direct impact on the maintenance costs of an ABC system, so the design team must balance the increased allocation accuracy associated with more cost pools with the extra labor needed to maintain them.
Determine activity drivers. Having summarized overhead costs into a set of cost pools, we must now allocate them, which we do with an activity driver – this is a variable that reasonably explains the consumption of costs from a cost pool. For example, some accounts payable costs are closely associated with the number of checks printed and mailed, while some engineering costs vary directly with the number of design changes added to a product. Examples of other activity drivers are the number of machine setups, the number of maintenance work orders, the number of purchase orders, and the number of customer orders processed. Whichever activity driver is chosen as the basis for cost pool allocation should be easy to calculate, require minimal data collection, and have a reasonably close cause-and-effect relationship with a cost pool.
Spread costs from secondary to primary cost pools. Some of the cost pools include costs that are, in turn, distributed to other cost pools. These costs are usually for internal company services, such as management information systems services that are provided to other departments. These secondary cost pools must be allocated to primary cost pools.
Calculate the overhead cost per activity unit. Divide the total number of occurrences of each activity driver into the total amount of costs in the primary cost pools for the accounting period, which results in a dollar figure per unit of activity.
Assign activity costs to cost objects. The final step is to calculate the usage of each activity driver by a cost object (which is anything that uses activities, such as products or customers). For example, if a product requires the creation of two purchase orders (which are activity drivers) and the ABC system has determined that each purchase order requires $32.15 to create, then the amount of overhead charged to the product will be $64.30.

In brief, the ABC process involves taking costs out of the general ledger and assigning them to either secondary or primary cost pools, which are then distributed to cost objects through the use of activity drivers.

Uses of Activity Based Costing

There are many questions that an ABC system can answer, such as the following:

How do we increase shareholder value? When an ABC analysis is combined with a review of investment costs for various tactical or strategic options, you can determine the return on investment to be expected for each of the investment options.
How much does a distribution channel cost? An ABC system can accumulate all of the costs associated with a particular distribution method, which allows managers to compare this cost to the profit margins earned on sales of products that are sold through it. You can then determine if the distribution channel should be reconfigured or eliminated in order to improve overall levels of profitability.
How do product costs vary by plant? An ABC analysis will itemize the costs of each plant, and correctly allocate these costs to the activities conducted within them, which allows a company to determine which plants are more efficient than others.
Should we make or buy an item? An ABC analysis includes all activity costs associated with a manufactured item, which yields a comprehensive view of all costs associated with it, and which can then be more easily compared to the cost of a similar item that is purchased.
What acquisition is a good one? By using internal ABC analyses to determine the cost of various activities, a company can create a benchmark for what these costs should be in potential acquisition targets. If the targets have higher costs than the benchmark levels, then the acquiring company knows that it can strip out costs from the acquisition candidate by improving its processes, which may justify the cost of the acquisition.
What does each activity cost? An ABC analysis can reveal the cost of each activity within an organization. The system is really designed to trace the costs of only the most significant activities, but its design can be altered to itemize the costs of many more activities. This information can then be used to determine which activities are so expensive that they will be the main focus of management attention, or which can be profitably combined with other activities through processing centering. This is a primary cost-reduction activity.
What price should we charge? An ABC analysis reveals all of the costs associated with a product, and so is useful for determining the minimum price that should be charged. However, the actual price charged may be much higher, since this may be driven by the ability of the market to absorb a higher price, rather than the underlying cost of a product.
What products should we sell? An ABC analysis can be combined with product prices to yield a list of margins for each product sold. When sorted by market, product line, or customer, it is then easy to see which products have low or negative returns, or which yield such low margin volume that they are not worth keeping.
Which customers do we want? An ABC analysis can itemize the costs that are specific to each customer, such as special customer service or packaging issues, as well as increased levels of warranty claims or product returns. When added to the margins on products sold to customers, this reveals which customers are the most profitable after all costs are considered.

Problems with Activity Based Costing

Many companies initiate ABC projects with the best of intentions, only to see a very high proportion of the projects either fail, or eventually lapse into disuse. There are several reasons for these issues, which are:

Cost pool volume. The advantage of an ABC system is the high quality of information that it produces, but this comes at the cost of using a large number of cost pools – and the more cost pools there are, the greater the cost of managing the system.
Installation time. ABC systems are notoriously difficult to install, with multi-year installations being the norm when a company attempts to install it across all product lines and facilities. For such comprehensive installations, it is difficult to maintain a high level of management and budgetary support as the months roll by without installation being completed.
Project basis. Many ABC projects are authorized on a project basis, so that information is only collected once; the information is useful for a company’s current operational situation, and it gradually declines in usefulness as the operational structure gradually changes over time. Management may not authorize funding for additional ABC projects later on, so ABC tends to be “done” once and then discarded.
Reporting of unused time. When a company asks its employees to report on the time spent on various activities, they have a strong tendency to make sure that the reported amounts equal 100% of their time. However, there is a large amount of slack time in anyone’s work day that may involve breaks, administrative meetings, playing games on the Internet, and so forth. Employees usually mask these activities by apportioning more time to other activities. These inflated numbers represent misallocations of costs in the ABC system, sometimes by quite substantial amounts.

Similar Terms

Activity based costing is also known as abc costing, the abc method, and the abc costing method.

Related Questions

What is a cost object?