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Introduction about Activity-Based Costing (ABC)
Activity-Based Costing (ABC) is a method of allocating costs to products and services. Costs are assigned to specific activities-such as planning, engineering, or manufacturing-and then the activities are associated with different products or services. In such a way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses. It was also developed as an approach to overcome problems associated with traditional cost management systems in a more logical manner. Traditional costing tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. Therefore, managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services. To overcome this shortcomings, managers started using ABC to assign manufacturing overhead costs to products. ABC has grown in importance in recent decades because
Manufacturing overhead costs have increased significantly.
The manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours.
The diversity of products to all products.
How ABC benefits people?
Activity based costing allows managers to attribute costs to activities and products more accurately than traditional costs accounting methods. Besides, the activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity. Next, ABC is an improved means of identifying high overhead costs per unit and finding ways to reduce the costs. Lastly, it provides managers with useful information and also allows managers to see how to maximize company's overall performance and implement profit-growth strategies.
How ABC works?
Firstly, ABC identify major activities in the process system. Next, cost pools are created for groups of activities that can be allocated together. Following this cost drivers are identified. The number of cost drivers used vary depending on the accuracy and complexity of producing that particular products. After determining the cost drivers, rates are calculated. The rates are then applied to the respective cost drivers for each product or service that is being considered. Lastly, the overhead cost per unit is then derived by dividing the total cost of the product by the total product units.
Summary of ABC
1. Identify major activities
2. Create cost pools
3. Identify cost drivers
4. Calculate rates
5. Apply rates to cost drivers
6. Derive overhead cost
Activity-based costing (ABC) is a managerial accounting system that identifies activities in a company and assigns the cost of each activity resource to all products and services. The cost assigns are according to the cause and effect relationship between cost object and activities incurred. The ABC method s allows an organization to identify which products, and resources are increasing their profitability and which are inefficient and need to be eliminated in order to cut cost. In traditional costing, a broad amount of expenses had been added into the overhead cost. Causing the overhead cost to be actually overpriced. As the percentages of indirect cost had risen, this technique became inaccurate because the indirect costs were not caused same or equally by all the products and services.
The activity based costing is based on the George Staubus' Activity Costing and Input-Output Accounting. During the 1970s and 1980s, the concepts of ABC were developed in the manufacturing sector of the United States .At the same time, the Consortium for Advanced Management-International, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.
In 1987, Robert Kaplan and Robin Cooper first introduced activity based as a chapter in their book Accounting and Management: A Field Study Perspective. They are focused on manufacturing industry where improvement in technology and productivity have decrease the relative proportion of the direct costs of labor and materials, but have increase the proportion of manufacturing overhead costs. The sustainer of the Balanced Scorecard, Robin Cooper and Robert S. Kaplan 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 costing system that unprofitable and inefficient. These traditional costing systems are often unable to determine accurately the overhead costs of production and of the costs of related services. Based on the inaccurate information provided, the managers unable to make the right decisions especially when there is more than one product.
Instead of using traditional costing that have broad arbitrary percentages to allocate costs.ABC seeks to objectively assign costs to the product or services based on the cause and effect relationships. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so leads attention to finding ways to reduce the costs of products.
In 1990, the first extension of ABC into financial institutions was in an article appearing in the Journal of Bank Cost and Management Accounting (Volume 3, Number 2) by Richard Sapp, David Crawford and Steven Rebishcke. Financial institutions also have multiple products and customers which can cause cross-product cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be assigned more accurately to products or customers. In this and a subsequent article in 1991 in the same Journal (Volume 4, Number 1), the authors concluded that Activity based costing are more useful in allocating the cost accurately compare than the traditional costing, this result that company more profitable.
While in 1999, activity-based costing was later explained in the book Management Challenges of the 21st Century by Peter F. Drucker. He states that traditional cost accounting focuses on what it costs to do something. Activity-based costing records the costs that traditional cost accounting do not do.
Reasons for applying ABC
First reason will be economic downturn that happened in the recent decades. ABC is back in popular demand, as companies are operating in a not-so-good economy. They tend to focus more on their resources on existing customers, rather than seeking out new ones. ABC helps them to separate the profitable ones from the loss-making ones and also to figure out ways to raise profits without having to drastically raise prices of products and services.
Secondly, it will be driver-based budgeting. Traditional excel-driven budgeting and planning, based largely on gut feel is now under attack for its lack of business-driven focus. ABC is now seen as a subset of driver-based budgeting, rather than a distinct software application.
Last but not least, customer intelligence and valuation. Customer-centric sectors like banking and telecoms increasingly realize that that growing their top-line (i.e. organically) also means growing their customer base or ensuring that their customers stay loyal. ABC helps by allowing companies to better understand the value their customers bring to your bottom-line.
Implementation procedure of ABC
The implementation steps for the ABC is similar to those for a traditional ABC system. The main difference lies in the determination of the total cost for each activity (Step 4). This step will be discussed in greater detail, while remaining steps of the implementation procedure will be discussed briefly.
Step 1: Review the company's financial information. Nearly all of the needed financial information can be obtained from the company's income statement and balance sheet.
Step 2 : Identify main activities. Identify the main activities describing the manufacturing and business processes of the company that consume operating resources or are responsible for capital investments.
Step 3: Determine operating cost for each activity. Calculate the operating cost for each activity in the same way as would be done for a traditional ABC implementation. Costs should mirror overhead resource consumption by each activity.
Step 4: Determine capital charge for each activity using Activity-Capital Dependence Analysis. This step does not exist in a traditional ABC calculation. Since many activities consume not only resources but also capital investment, the full cost for many activities is higher than the cost calculated in an ABC system. As a result, ABC tends to underestimate the object cost. The integrated ABC-and-EVA system calculates the capital charge for activities demanding capital investments or tithing capital. This information is obtained by converting data on the company's balance sheet into capital costs or charges. These capital charges are then added to the cost for each activity previously calculated by the ABC system.
Step 5: Select cost drivers. This step is similar for a traditional ABC implementation. Cost drivers are used to trace the cost of activities to products based on their consumption rate. Thus, operating cost drivers can trace operating costs and capital cost drivers can trace capital charges to the products.
Step 6: Calculate product cost. Operating costs and capital costs are traced to the products.
Potential pitfalls of ABC
According to the journal "Learning to Love ABC." Journal of Accountancy. August 1999. by Cokins, Gary, companies that implement activity-based costing run the risk of spending too much time, effort, and even money on gathering and going over the data that is collected. Too many details can prove frustrating for managers involved in ABC. On the other hand, a lack of detail can lead to insufficient data. 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. This generally happens in businesses that were reluctant to try ABC in the first place.
In 1999, Gary Cokins wrote an article aimed at certified public accountants who have difficulty praticing activity-based costing. In "Learning to Love ABC," Cokins explains that activity-based costing usually works best with a minimum amount of detail and estimated cost figures. He backs this up by stating that "typically, when accountants try to apply ABC, they strive for a level of exactness that is both difficult to attain and time-consuming-and that eventually becomes the project's kiss of death."
In 2000, Cokins noted that "activity-based costing projects often fail because project managers ignore the cardinal rule: It is better to be approximately correct than to be precisely inaccurate. When it comes to ABC, close enough is not only good enough; close enough is often the secret to success." Cokins also notes that the use of average cost rates, the use of overly detailed information, and the failure to connect information to action can also hinder ABC projects. By understanding these concepts, Cokins feels that CPAs can enhance their roles as business partners and consultants.
Another limiting factor is that activity-based costing software can be pricey. As Mark Henricks wrote in a 1999 article for Entrepreneur: "Most ABC practitioners find that special-purpose ABC software is required to make the task manageable. At $6,000 and up for one package sold by ABC Technologies, software can add significantly to outlays for this type of accounting technique. There are, however, some pilot packages available for $500."
Not only that, time can also be a factor for businesses seeking a quick fix. Henricks notes that "although some companies see results almost instantly, it typically takes three months or so for most businesses to experience the benefits of ABC. And depending on your product or business cycle, it could take much longer."
Theory related theory
ABC VS Traditional Costing
One main related theory with ABC will be traditional costing. Now let's make some comparison between traditional cost accounting and activity-based methods. First of all, traditional cost accounting looks at what is spent, while Activity-Based Methods look at what is done in terms of activities. If we focus on the latter, it is much easier to identify opportunities to reduce costs and improve performance, while maintaining the quality of care provided.
Traditional based costing systems typically use only a single overhead pool - that is a single accumulation of costs that are not directly identifiable as product part costs or as labor. This would include supply and maintenance expenses, allocations of management salaries, depreciation, etc.
Activity based costing focus a lot of smaller more targeted cost buildups that are accumulated based on "activities". Therefore, it is a more accurate way of allocating costs to products.
Traditional Cost Systems:
Use cost allocation methods.
Do not focus on where or why costs occur.
Provide little insight into the causes of variances.
Information reported are mostly accounting-oriented, inaccurate, not flexible and not timely.
Since the focus is fiscal, it cannot be easily understood by operational managers.
Do not associate the cost of a product or service with the actual effort expended.
Activity-Based Costing (ABC):
Based on actual performance, consumption and expense data extracted from the organization's existing information systems and combined with the knowledge of those directly involved in the delivery of the product or service.
Assign costs to activities based on the resources they consume.
Provides insights into the sources of costs and the possible impact of different decisions.
Provides the information required to take action and realize performance breakthroughs.
Advantages & Disadvantages of ABC
Activity based costing is a more accurate costing system, it brings a lot of advantages to the company and organization compare to traditional costing system. The first advantages activity based costing is it allocates the overhead cost more accurately, it control the costs at an individual level and on a departmental level and find out the unnecessary cost. The manager can make right decision based on the accurate information. The profit of a company also increasing by using this costing system through identifies unprofitable products, departments and helps to allocate more resources on profitable products. Moreover, activity based costing focus more on unit product cost rather than the total cost, this is easier to understand for internal and external user. In addition, activity based costing is integrated well with six sigma and other continuous improvement activities, it identify the non value added activities and supports performance management and scorecards.
There are several limitation and disadvantages for this costing system. Implementing an ABC system in an organization is a major project that requires substantial resources. Once implemented an activity based costing system is time consuming to maintain. Data about multiple activity measures must be identified, checked, and recorded into the system. The others limitation is some overhead costs are difficult to assign to products and customers. These costs are not assigned to products or services because this will bring some error in the information, these cost should be met at the contribution of each product and services. Besides, the disadvantages of this system is activity based costing data must be used with care when used in making decisions and can be misinterpreted easily. Costs assigned to products, customers and other cost objects are only potentially relevant. Before making any significant decision using activity based costing data, managers must identify which costs are really relevant for the decisions at hand. In addition, generally accepted accounting principles (GAAP) do not conform the reports generated by this systems, an organization involved in activity based costing should have two cost systems ,one for internal usage and another for preparing external reports.
Activity-based costing is a method that assigned cost to activities based on resource consumption and then assigned to cost objects based on activity incurred. There are six assumption for activity based costing system .The first assumption is activities consume resources (and acquiring resources creates costs) .The second assumption is the products or customers consume activities. The third assumption states that ABC models consumption rather than spending, this assumption bring greatest impact, activity based costing does not recognize spending, but consumption. The fourth assumption is that there are numerous causes for the consumption of resources. These reflect a cause-and-effect relationship between cost object and activities incurred, because they enable multiple cost pools rather than just one. The fifth assumption is that cost pools are homogeneous. This means that each cost pool has only one activity. An ABC model would have multiple cost pools in comparison to the traditional system. The sixth assumption states that all costs in each cost pool are variable (strictly proportional to activity). This assumption identify that the only fixed costs in a traditional cost system, all other costs would be associated with a variable activity.
Theory of constraint (TOC)
The theory of constraints is one of a theory that can be comparing with ABC, it was developed by Goldratt and Fox in the 1980's. Goldratt developed a scheduling approach known as optimized production technology (OPT) that used TOC principles.TOC is usually explained using the Five Focusing Steps. The main purpose of these steps is to concentrate a manager's attention on the constraining resources, which promoting profit growth. The five steps are:
1. Identify the system's constraints.
2. Decide how to exploit the system's constraints.
3. Subordinate everything else to the decision made in Step 2.
4. Elevate the system's constraints.
5. Go back to Step 1 if the constraint is broken in Step 4.
There are a number of assumptions underlying the theory of constraints. The first is that the goal is to make money now and in the future. . The second assumption states that throughput is used as a way to measure money. Throughput is defined as revenue minus the variable cost of materials and energy. The third assumption is that there is always at least one constraint on each product that limits the company's revenue. The fourth assumption builds on this constraint-there are three types of resources: scarce bottleneck resources, non-bottleneck resources, and capacity constraint resources. The fifth assumption is that most manufacturing operations have only a few CCRs, and thus it is easy to control them.
When comparing activity based costing with the theory of constrains it seen clearly that the ABC has a long run horizon, while the TOC has a short-run horizon. The concept of short-run versus long run looks at whether the quantity of the production facility can be increased or decreased. These methods are based on several sets of assumptions with different time horizons; thus that one approach is superior over the other should be abandoned. There is room for both approaches when they are used appropriately. Accountants need to understand each tool and the way they work in order to know when one is suitable for the company and the other is not.
Components needed when calculating ABC
Cost allocation is a process of attributing cost to particular cost centers. For example the wages of the driver of the purchasing department can be allocated to the purchasing department cost centre. It is not necessary to share the wage cost over several different cost centers. Cost and services are not identical to each other.
Cost allocation is the assigning of a common cost to several cost objects. For example, a company might allocate or assign the cost of an expensive computer system to the three main areas of the company that use the system. A company with only one electric meter might allocate the electricity bill to several departments in the company.
Allocation implies that the assigning of the cost is somewhat arbitrary. Some people describe the allocation as the spreading of cost, because of the arbitrary nature of the allocation. Efforts have been made over the years to improve the bases for allocation. In manufacturing, the overhead allocations have moved from plant-wide rates to departmental rates, from direct labor hours to machine hours to activity based costing. The goal is to allocate or assign the costs based on the root causes of the common costs instead of merely spreading the costs.
Fixed costs are business expenses that are not dependent on the level of goods or services produced by the business. They tend to be time-related, such as salaries or rents being paid per month. This is in contrast to variable costs, which are volume-related (and are paid per quantity produced). Fixed costs will not change with the volume or production, unlike variable costs.
In management accounting, fixed costs are defined as expenses that do not change as a function of the activity of a business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales.
Along with variable costs, fixed costs make up one of the two components of total cost: total cost is equal to fixed costs plus variable costs.
Variable costs are expenses that change in proportion to the activity of a business. Variable cost is the sum of marginal costs over all units produced. It can also be considered normal costs. Fixed costs and variable costs make up the two components of total cost. Direct Costs, however, are costs that can easily be associated with a particular cost object. However, not all variable costs are direct costs. For example, variable manufacturing overhead costs are variable costs that are indirect costs, not direct costs. Variable costs are sometimes called unit-level costs as they vary with the number of units produced.
Direct labor and overhead are often called conversion cost, while direct material and direct labor are often referred to as prime cost.
A "cost driver" is the unit of an activity that causes the change of an activity cost. A cost driver is any activity that causes a cost to be incurred. The Activity Based Costing (ABC) approach relates indirect cost to the activities that drive them to be incurred. In traditional costing the cost driver to allocate indirect cost to cost objects was volume of output. With the change in business structures, technology and thereby cost structures it was found that the volume of output was not the only cost driver. Some examples of indirect costs and their drivers are: maintenance costs are indirect costs and the possible driver of this cost may be the number of machine hours; or, handling raw-material cost is another indirect cost that may be driven by the number of orders received; or, inspection costs that are driven by the number of inspections or the hours of inspection or production runs. Generally, the cost driver for short term indirect variable costs may be the volume of output/ activity; but for long term indirect variable costs, the cost drivers will not be related to volume of output/ activity. To carry out a value chain analysis, ABC is a necessary tool. To carry out ABC, it is necessary that cost drivers are established for different cost pools.
Activity based costing is a more accurate costing system, it brings a lot of advantages to the company and organization compared to the old traditional costing system. The first advantages activity based costing is it allocates the overhead cost more accurately, it control the costs at an individual level and on a departmental level and find out the unnecessary cost. The manager can make right decision based on the accurate information. The profit of a company also increasing by using this costing system through identifies unprofitable products, departments and helps to allocate more resources on profitable products. Moreover, activity based costing focus more on unit product cost rather than the total cost, this is easier to understand for internal and external user. In addition, activity based costing is integrated well with six sigma and other continuous improvement activities, it identify the non value added activities and supports performance management and scorecards.
ABC costing is normally used in a more complex line of production, while traditional costing is mostly used for simple productions. This study above shows that the ABC methodology can be applied successfully in all developing country nowadays. Estimates of time allocation to all activities, including support and administrative activities, were all obtained in all departments and traced through the organization and assigned to direct services, resulting in estimates of the full unit costs of services.
ABC methodology is enhanced by repeating the study periodically and feeding the results into the management decision making process of the organization. Due to the information provided by ABC, prices can be adjusted. This methodology also reveals the hidden costs associated with some non-value-added activities. ABC allows managers to measure the effectiveness and financial impact of quality improvement (QI) programs and compare thee against their costs. In the nutshell, ABC is widely used nowadays due to the accuracy information it is able to provide to managers in assisting them to make wise decisions that will bring the company more benefits.