Investigating circumstances which require the use of ABC

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The activity based costing initially began during the early's of the 60s, specifically when the staff of the finance and accounting departments of a company named General Electric's (GE) wanted to improve the usefulness of the accounting information in the controlling ever-increasing indirect costs. It was noticed by General electric's employees that indirect costs are commonly the outcome of "upstream" decisions, that are made long before the costs are actually incurred.

For example, engineering design and change orders often resulted in significant increases in parts ordering, machine changeovers, retooling and parts stocking. In addition, the engineering department was never informed of the consequences their actions had on the other parts of the organization. GE's work in this area could be considered what we now call, "activity-based management"

A few business consultants and manufacturing companies accomplished the second phase in the development of ABC in the 1970s and early 1980s. Their drive was to improve product cost information to assist pricing and product mix decisions.

During the 1970s and 1980s the idea of ABC were developed in the manufacturing sector of the United States. 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 move toward solving the problems of usual cost management systems. These usual costing systems are frequently unable to decide precisely the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data particularly where there are various products.

ABC search for identifying cause and affect relationships to objectively assign costs, instead of using wide random percentages to allocate costs, once costs of the activities have been known, the cost of each activity is recognized to each product to the extent that the product uses the activity thus ABC frequently recognizes areas of high overhead costs per unit and so directs attention to finding solutions to reduce the costs or to charge more for expensive products.


The definition of activity based costing

Activity based costing Activity-Based Costing (ABC) is a technique of assigning costs to products and services. It is generally used as a tool for planning and control. It was developed as an approach to address problems linked with traditional cost management systems that tend to have the incapability to precisely decide actual production and service costs, or provide useful information for operating decisions. With these deficiencies managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with various products or services.

Steps of activity based costing

Activity-based costing works from the bottom up, while usual methods of cost accounting operate as top-down systems, applying the ABC method involves two steps in order to trace costs back to activities, to the cost objects with which they can be associated. These steps are clearly shown in the following diagram:

The first step

The first step is to recognize and measure all of the costs expended in carrying out specific activities. Each group of resource (materials, labor and equipment) needs to be examined and allocated to the cost pool for a certain activity. The following points should be determined:

First, who carries out the work and how much time they give to it;

Second, what materials are necessary for the activity,

Third, what equipment is used in the activity.

The unit cost for each of these resources needs to be calculated, so that the total cost of the activity can be determined.

The second step

The second step in the ABC process involves assigning and attaching the costs of the activity to cost objects (for example, the students registered for a particular course). In many cases, this analysis can be done for a person unit of the cost object, but some activities (such as a face-to-face tutorial) will benefit two or more units at the same time. Still others (such as revising study materials) will benefit all of the units of a particular cost object at the same time.


Cost allocation

Fixed cost

Variable cost

Cost driver

Cost driver rate

Direct labor and materials are quite easy to trace directly to products, but it is harder to directly allocate indirect costs to products. Where products use common resources in a different way, 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.

Advantages of activity based costing.

There are many advantages of the activity based costing, as it:

Provides insight into the fastest-growing and least visible part and better understanding of cost-overhead

Improves profitability by checking total life-cycle cost and performance

makes the effectiveness of budgeting better by identifying the cost/performance relationship of different service levels

supports continuous development and total quality control because planning and control are directed at process level

Links corporate strategy to operational decision making

Facilitates the exclusion of waste by providing visibility of non-value added activities

Is easy to be understood for everyone

Makes use of unit cost rather than just total cost

Integrates well with Six Sigma and other continuous improvement programs

Supports performance management and scorecard

Allows costing of processes, supply chains, and value streams

D .Disadvantages of activity based costing.

On the other side, although the activity Based Costing has many advantages, it also has some drawbacks as it:

Takes a long period of time to collect data.

Is expensive to buy, implement and maintain activity based system

Makes waste visible which some executives and managers don't want their boss to see

E .Circumstances that require the use of activity based accounting

Activity-based costing used to be involved in large corporations rather than small ones. But nowadays activity based costing showed a great success when it is applied in service industries such as banks, hospitals, insurance companies, and real estate agencies have all had success with ABC. But since its start, activity-based costing has appeared to have been more successful when implemented by larger companies rather than by smaller ones. 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 activity-based costing. In a 1999 Journal of Accountancy article entitled "Yes, ABC is for Small Business, Too," Hicks offered a case study for one of his customers, a small manufacturer that constructs components for the car industry. Hicks explained in depth how they were able to triple sales and increase profits fivefold in a four-year span after adopting ABC. "Much of this development 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 activity based costing: "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."

Hicks went on to say that "any small or midsize organization can develop an ABC system. It doesn't require a great commitment of time or financial resources. Nor does it require the implementation of special software integrated into the general ledger-although for larger organizations that may be a benefit. It requires only that management view its operations through 'the lens of ABC' and create a model that will enable it to measure costs in accordance with that view."

Gary Cokins, director of industry for a noted ABC software and services firm, tends to agree with Hicks. In his book Activity-Based Cost Management: Making It Work, he proclaimed that "Within 10 to 20 years, everyone will have some sort of ABC. It's a matter of when, not if."


Finally we can conclude that activity based costing allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods. The activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity. Some of the advantages activity based costing offers are an improved means of identifying high overhead costs per unit and finding ways to reduce the costs. 

The way it works is first major activities are identified 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 numbers of cost drivers used vary depending on the balance between accuracy and complexity. 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. The overhead cost per unit is then derived by dividing the total cost for the product by the total product units. 

One of the basic issues surrounding ABC is the difficulty of implementation. Identifying activities or processes to be allocated properly is cumbersome and takes a lot of effort. It requires that processes are adequately mapped throughout the organization. For a company that has undertaken a quality effort, or an effort to reengineer business processes, a major part of the work may already be completed. But for those who have not it is likely to be a major undertaking.

Just as anything else, Activity-Based Costing is no panacea, nor should it be embraced as a religion, or a fad. It is an operational strategy that needs to be carefully reviewed for applicability. The best way to approach the situation is to first rationalize a facility and its processes, identify the opportunities, and then conceptualize a solution. If this fits, use it.