Activity Based Costing (ABC) is a generic name for a different approach to costing and production control which grew out of a number of articles and publications in the mid 1980's critical of existing approaches to management accounting and the production of costing information, particularly from three USA based professors; R. Cooper, H.T. Johnson and R.S. Kaplan, and also an influential book;
"Relevance Lost; The Rise and Fall of Management Accounting". - (Johnson & Kaplan, 1987)
The basic tenet of problem identified by Johnson and Kaplan was;
"typical 1980's cost accounting systems are helpful neither for product costing nor operational control"
The remedy proposed by Cooper, Johnson and Kaplan was that companies should adopt Activity Based Costing.
ABC takes a rational approach to product, service and customer costing, identifying what major activities are performed in each function across the business. An assessment is made of how much company resource is actually consumed by each activity, resource meaning anything that is a cost to the business, i.e., employee time, assets, money, etc. These are allocated to activities using appropriate methods dependent on the type of resource to be allocated, for example;
Cost Type Allocation method to activity
Employee Costs - %age of time spent on each activity
Occupancy Costs - M 2 occupied by employees performing activity
I.T. Network Costs - Number of P.C.'s by department, Network Volume
and so on…………the aim being to establish a true cost for each activity, based on the consumption of all resources.
ABC approach to product profitability.
An advantage of ABC is that it involves the line managers with responsibility for production and marketing in the costing process in all aspects, data collection, analysis and accountability. One problem with Traditional Cost Accounting (TCA) is they do not involve the line managers and the accountants are seen as detached “beancounters” producing detailed variance analysis which line managers do not understand or own and therefore do not use for decision making.
The answer lies in the limitations of the TCA approach which was developed during the Industrial Revolution when most organisations had a narrow product range with long Product Life Cycles (PLC). Direct labour and materials were the dominant factory costs, whilst the overhead element was relatively small. As a result of high information processing costs and the fact that the distortions arising from the inappropriate allocation were insignificant it was difficult to justify more sophisticated methods than Absorption Costing (AC).
This entailed establishing a budgeted rate at which the manufacturing plant could recover, usually on a direct labour hour basis, all the organisation’s overheads, when working at normal capacity. Such a method assumes aggregated levels and is inexpensive to operate. However as the American academic Professor Cooper observed;
“If volume related bases are used, high volume products will be allocated with an excessively high proportion of costs whenever overhead costs are driven by forces which are not proportional to the volume of output.
Therefore high volume products will subsidise the low volume products whenever volume-based allocation methods are used. Inevitably this would in the long run with increased low volume activity lead to reduced high volume margins and perhaps, erroneous product mix decisions.” (R. Cooper 1990)
Examples of non-volume related support activities include;
• Material handling and procurement
• Production scheduling and set-ups
• First item inspection procedures etc;
The behavioural implications of AC are well known and documented resulting in dysfunctionally increased overhead recoveries, “profits” and, without the turnover subsequently higher inventories.
The Traditional Costing Approach (TCA) was developed in the early 1990’s by FW Taylor and others in conjunction with work study analysis which provided the impetus for the development of Standard Costing systems. These systems were developed to meet the needs of a business environment drastically different from that which exists today. The main reasons for its predicted demise are;
• Changing cost structure
• Behaviour is encouraged which is inconsistent with just-in-time philosophy
• Inconsistency with a continuos improvement philosophy
• Over - emphasis on the importance of direct labour
• Delay in feedback reporting
ABC takes a different approach;
ACTIVITIES lead to the consumption of overhead resources.
The amount of resource consumed depends on the COST DRIVER of activity.
The definition of ABC in “Management Accounting - Official Terminology” is “Cost attribution to cost units on the basis of benefit received from indirect activities; e.g. ordering, setting-up, assuring quality.” - 1991
“An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilises cost drivers to attach activity costs to outputs” - 1996
ABM - Activity Based Management is a widely accepted process using activity based cost data to manage businesses. It seeks to promote continual improvement through improved knowledge and information. A key apex of this approach is the internal selling process by which all branches of the organisation understand and embrace the results as appropriate and applicable to their tasks.
The definition of ABM in “Management Accounting - Official Terminology” is “System of management which uses activity-based cost information for a variety of purposes including cost reduction, cost modelling and customer profitability analysis.” - 1996
ABB - Activity Based Budgeting
ABB is defined by the ABC model of the organisation. It is, in essence running forecasted demand levels through the existing organisational model to determine the constraining resources, the effect on activities in the organisations, and the overall implications of meeting the defined demand levels.
ABC - Its Relevance to Modern Business.
Traditional accounting was invented in the Middle Ages by monks and has severe limitations in today’s business world. It has a conservative bias, difficulty in reflecting the time value of money and focuses on accuracy to the detriment of speed. ABC often shows that some products and some customers are profitable and are unwittingly used to subsidise others which are making a loss. In a competitive environment, not understanding the profitability or customers will result in competitors picking out the cherries.
Many companies using ABC have found that their view of the business is turned upside down and many previously held beliefs are shattered. Numerous cases exist where highly prized customers (usually prized because of high gross margins or revenue) are found to be amongst the most unprofitable following an ABC analysis, because the true costs of all the hoops we jump through for them are determined. The same applies to products. Some thought to be highly profitable turn out to be the complete opposite when all the hidden costs (warranty, returns processing, set-up time and frequency, handling and storage difficulties, obsolescence or deterioration, customer complaint, etc., etc.) are allocated.
Similarly, the insights gained from understanding activities and drivers within the business reveal areas of inefficiency and waste where little or no value is created, more appropriate metrics on which to base business planning and forecasting, smarter and more accurate ways to construct a budget and powerful metrics on which to base performance measurement structures such as Balanced Scorecards.
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