Activity-based costing (ABC) is an accounting method that allows businesses to gather data about their operating costs. Costs are assigned to specific activities—planning, engineering, or manufacturing—and then the activities are associated with different products or services. In this way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses. Managers are then able to generate data to create a better budget and gain a greater overall understanding of the expenses that are required to keep the company running smoothly.
Generally, activity-based costing is most effective when used over a long period of time.
Activity-based costing emerged in the 1980s as a way to more accurately measure all of a business’s costs and associate them to the goods and services produced.
Traditional cost accounting methods were designed for the companies operating in the early days of the 20th Century, a time when direct labor and materials were the two largest costs associated with producing goods and services. There was little automation at the time and overhead costs were very small as a percentage of total costs. Furthermore, most companies offered a narrow range of products and/or services. All this was changing by the middle of the century. Automation was being incorporated into all businesses and overhead costs rose as the support services needed to design and manage this automation were removed from the production floor. Yet traditional cost accounting methods stayed in place.
Owners continued to measure primarily the costs of direct labor and materials; they allocated overhead costs somewhat arbitrarily. As overhead costs grew as a share of total costs, the distortions that this method introduced also grew.
Harvard Business School Professor Robert S. Kaplan was among the first to articulate a need for a more sophisticated system with which to more accurately allocate costs directly to the goods and services produced by that business. ABC is based on the principle that the majority of business activities support the production and delivery of goods and services. Therefore, in order to get a true picture of the cost of producing a good or service, one must allocate the costs of all business activity to specific products and services. The ABC method does this by assigning factory and corporate overhead, as well as other indirect resource costs, to activity categories.
Then, an assessment is made as to how much overhead each product, product line, or service consumes. In this way, according to Professor Kaplan, in an article he wrote for The CPA Journal in 1990, “ABC offers management accurate information by delineating support costs and tracing them to individual products and product lines.”
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How Activity-based Costing Programs Work
Implementing an activity-based costing program requires planning by and a commitment from upper management. If possible, it is best to do a trial study or test run on a department whose profit-making performance is not up to snuff. These types of situations have a greater chance of succeeding and demonstrating that an ABC program is worth the effort. If the pilot study yields no savings in cost, the activity-based costing system has either been improperly implemented or, it may not be right for the company.
The first thing a business must do when using ABC is set up a team charged with determining which activities are necessary for the product or service in question.
This team needs to include experts from different areas of the company (including finance, technology, and human resources); an outside consultant may also be helpful.
After the team has assembled data on such topics as utilities and materials, it is time to determine the elements of each activity that cost money. Attention to detail is very important: many of these costs may be hidden and not entirely obvious. As Joyce ChutchianFerranti wrote in an article for Computerworld: “The key is to determine what makes up fixed costs, such as the cost of a telephone, and variable costs, such as the cost of each phone call.” Chutchian-Ferranti goes on to note that even though in many instances technology has replaced human labor costs (such as in voice-mail systems), a business manager must still examine the hidden costs associated with maintaining the service. Nonactivity costs like direct materials and services provided from outside the company usually do not have to be factored in because this has previously been done.
Once all of these costs are determined and noted, the information must be input into a computer application.
Chutchian-Ferranti explains that the software can be a simple database, off-the-shelf ABC software, or a customized software program written for the specific job. Over time, this accumulation of data will eventually give the company a detailed picture of exactly where in the process they are spending most and in which areas they are most efficient.
After a business has had enough time to analyze the data obtained through activity-based costing and to determine which activities are cost effective, it can decide what steps can be taken to increase profits. Activities deemed cost prohibitive can then be outsourced, cut back, or eliminated altogether. The implementation of these changes is known as activity-based management (ABM).
Activity-based Costing And Small Businesses
It used to be that large corporations were the only businesses involved in activity-based costing. Not so today.
Service industries such as banks, hospitals, insurance companies, and real estate agencies have all had success with ABC. But since its inception, activity-based costing has seemed to have been more successful when implemented by larger companies rather than by smaller ones.
As Henrick noted, “Companies with only a few products and markets aren’t likely to get as much benefit from basing costs on activities as companies operating with diverse products, service lines, channels and customers.”
But since setting up activity-based costing for a business usually takes less time for a smaller project, a small business that is unsure about the effectiveness of ABC can consider a simple test program to determine whether it is right for them.
Douglas T. Hicks is one expert who feels that the time is right for small businesses to implement activitybased costing. In a 1999 Journal of Accountancy article entitled “Yes, ABC is for Small Business, Too,” Hicks presented a case study for one of his clients, a small manufacturer that builds components for the automobile industry. Hicks detailed how they were able to triple sales and increase profits fivefold in a four-year span after adopting ABC. “Much of this improvement came from a profitable mix of contracts generated by a costing/ quoting process that more closely reflects the actual cost structure of the company,” Hicks stated. “This has enabled the company to improve the management of its contracts.” Isolating and measuring the cost of material movement and using the data to justify many operational changes were other factors Hicks cited for the success his client had with ABC.
Hicks also noted a change in management’s attitude after the success of ABC: “On an important but less tangible level, management’s knowledge of and attitude toward cost information have undergone a substantial change. Where once managers had their own way of measuring the cost impact of management actions, they now measure those costs in a formal, uniform way. When managers contemplate changes, they have a mental model that directs them toward changes that truly benefit the organization.”
Potential Pitfalls Of Activity-based Costing
Companies that implement activity-based costing programs run the risk of spending far too much time, effort, and even money on gathering and going over the collected data. Too many details can prove frustrating. On the other hand, too light a touch means lack of actionable information. Another obvious factor that tends to contribute to the downfall of activity-based costing is the simple failure to act on the results that the data provide.
In early 2005 the proponent of activity-based costing, Professor Robert S. Kaplan, published an article in the Harvard Business School Working Knowledge entitled “Rethinking Activity-Based Costing.” The article acknowledges problems with implementing ABC programs. It appears ABC has proven to be too much work for many and too complicated for many companies to use and maintain over time. The author insists that “the solution to problems with ABC is not to abandon the concept.” He goes on to outline a new ABC program which he and his co-author, Steven R. Anderson, call time-driven ABC. Although not fully developed in this article, the new time-driven ABC method is described as a simplification of the original ABC method.
Time-driven ABC requires, for each group of resources, estimates of only two parameters. First, the entire overhead expenditure of a single department divided by the total number of minutes of employee time available.
Second, an estimate of how much time it takes to carry out one unit of each kind of activity, for example, the time it takes to process one order. This simplifies greatly the work required t set up an ABC system and may make its implementation more feasible for smaller companies.
As the ways in which we make things change, so too will the systems and methods used to track costs and properly associate them with the products and services being produced. In order to efficiently produce goods and services it is important to know the price of the inputs to the system, both direct and indirect. The more accurately we are able to track these costs, the more efficiently we will be able to make our processes.