Activity based costing - a brief note

The main textbook to read on activity based costing (ABC) is Bhimani et al. (2008; Chapter 11). ABC system collects costs to activity cost pools, which are assigned to cost drivers to arrive at activity charging rates.  For example, the actvity driver for "drilling assembly holes" is the number of holes; for "equipment clean-up" is the total processing time and for "maintenance" is the number of reworked parts, etc.. (Akyol et al., 2005). These activity cost drivers are not necessarily production volume-related. Thus, these activity cost drivers become the cost allocation bases for other cost objects, e.g. products, service, and customer, etc. As a result, activity costs are assigned to these cost objects based on the calculated activity charging rates, depending on the volume of activity performed on them. It is recognized that ABC drivers occur at different levels of cost hierarchy. (See a worked example on ABC: http://business.fortunecity.com/discount/29/abcworkex.htm). The calculation of actual activity volumes for activity resources (with specific capacities) also reveals unused capacities and activity bottlenecks. This knowledge is also useful for operational and tactical decision support.

Main notions and topic areas of ABC are:

1. Cost hierarchy: ie output-unit-level costs; batch-level costs, cost object (e.g. product/ service) -sustaining cost, and facility-sustaining cost
2. Activity based budgeting
3. Activity based management

ABC mitigates the problem of misallocation of indirect costs in conventional costing methods. Cost misallocation and distortion becomes a more severe problem for enterprises with increasing business complexity, e.g. in terms of increased product range and increased scope of market coverage. Misallocation of indirect cost is an increasingly serious problem when it makes up a larger proportion of the total cost of a business as a consequence of higher business complexity. Cost distortions in product costing can lead to product pricing distortions, which are increasingly serious corporate tactical mistakes when more intense competition in the marketplaces is experienced by company concerned.

ABC thinking appears to be readily endorsed by production managers as they tend to treat staff activities like production activities. An ABC analysis could also reveal non value-added staff costs in the process (Armstrong, 2002). Using ABC to assign more service overhead more accurately appears especially vital for consumer products as marketing and distribution costs are very often much higher than the manufacturing costs of these products (Baxendale, 2001). ABC is useful for service businesses as a cost accounting system whereas conventional cost accounting, being focused on material costing, is much less relevant to them (Baxendale, 2001).  ABC has also been applied in project management as projects tend to possess a high proportion of indirect costs and substantial activity variety (Raz and Elnathan, 1999). Raz and Elnathan (1999), however, recommend a different cost hierarchy for ABC in project cost management, namely, unit level, delivery package level, project level and organization level.

Employing ABC requires additional costs to a company which needs to be weighted by the company concerned with the benefits of using it. For example, when process outputs are basically identical, the net benefit of using ABC does not exist, thus ABC should not be implemented in this case. Naturally, more sophisticated ABC systems are more expensive to develop and maintain.

By doing an internet search, I am able to find information on ABC softwares, e.g. http://activitybasedcostingsoftware.com/. These softwares make ABC adoption by companies technically and economically more feasible. Such software systems on ABC are very often not integrated with the main accounting systems of companies.

Main usages of ABC systems:

1. Pricing and product-mix decisions
2. Process improvement decisions
3. Product and process design decisions
4. Planning and control activities, e.g. used in budgeting.

Related study notes
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References

1. Akyol, D.E., Tuncel, G. Bayhan, G.M. (2005) "A comparative analysis of activity-based costing and traditional costing", World Academy of Science, Engineering and Technology 3, pp. 44-47.
2. Armstrong, P. (2002) "The cost of activity-based management", Accounting, Organizations and Society 27, pp. 99-120.
3. Baxendale, S.J. (2001) "Activity-based Costing for the Small business: A Primer", Business Horizons, Jan-Feb. 61-68.
4. Bhimani, A., Horngren,C.T., Datar, S.M. and Foster, G. (2008) Management and Cost Accounting, FT Prentice Hall.
5. Brimson, J.A. and Antos, J. (1999) Driving value using activity-based budgeting, Wiley.
6. Morrow, M. (editor) (1992) Activity-based management, Woodhead-Faulkner.
7. Raz, T. and Elnathan, D. (1999) "Activitiy based costing for projects", International Journal of Project Management Vol 7(1) pp. 61-67.