The use of activity-based costing is most appropriate for

In order to continue enjoying our site, we ask that you confirm your identity as a human. Thank you very much for your cooperation.

Practice

CIMA Official Terminology describes activity-based costing as 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. The latter use cost drivers to attach activity costs to outputs.

ABC was first defined in the late 1980s by Kaplan and Bruns. It can be considered as the modern alternative to absorption costing, allowing managers to better understand product and customer net profitability. This provides the business with better information to make value-based and therefore more effective decisions.

ABC focuses attention on cost drivers, the activities that cause costs to increase. Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received. In this way, long-term variable overheads, traditionally considered fixed costs, can be traced to products.

The activity-based costing process:

The use of activity-based costing is most appropriate for

What benefits does ABC provide?

Activity-based costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. It increases understanding of overheads and cost drivers; and makes costly and non-value adding activities more visible, allowing managers to reduce or eliminate them. ABC enables effective challenge of operating costs to find better ways of allocating and eliminating overheads. It also enables improved product and customer profitability analysis. It supports performance management techniques such as continuous improvement and scorecards.

Questions to consider when implementing ABC

  • Do we fully understand the resource implications of implementing, running and managing ABC?
  • Do we have the resources to implement ABC?
  • Will the costs outweigh the benefits?
  • Can we easily identify all of our activities and costs?
  • Do we have sufficient stakeholder buy-in? What will it take to achieve this?
  • Will the additional information ABC provides result in action that will increase overall profitability?
Actions to take / Dos Actions to Avoid / Don'ts
  • Get buy-in from the rest of the business. ABC provides business managers, as well as the finance function, with the information needed to make value-based decisions
  • Use ABC for pricing and product prioritisation decisions
  • ABC should be implemented by management accountants as they are best placed to manage the process and to ensure benefits realisation
  • Do not get caught up in too much attention to detail and control. It can obscure the bigger picture or make the firm lose sight of strategic objectives in a quest for small savings
  • It is important not to fall into the trap of thinking ABC costs are relevant for all decisions. Not all costs will disappear if a product is discontinued, an example being building occupancy costs
   
 

How Xu Ji achieved standardisation in working practices and processes
(CIMA case study, 2011)

The Chinese electricity company Xu Ji used ABC to capture direct costs and variable overheads, which were lacking in the state-owned enterprise’s (SOE) traditional costing systems. The ABC experience has successfully induced standardisation in their working practices and processes. Standardisation was not a common notion in Chinese culture or in place in many Chinese companies. ABC also acts as a catalyst to Xu Ji’s IT developments – first accounting and office computerisation, then ERP implementation.

Prior to the ABC introduction in 2001, Xu Ji operated a traditional Chinese state-enterprise accounting system. A large amount of manual bookkeeping work was involved. Accounting was driven predominantly by external financial reporting purposes, and inaccuracy of product costs became inevitable. At this time, Xu Ji underwent a series of flotations following China’s introduction of free market competition.

The inaccuracy of the traditional costing information seriously impeded Xu Ji’s ability to compete on pricing. The two main tasks for the ABC system were to: trace direct labour costs directly to product and client contracts; and allocate manufacturing overheads on the basis of up-to-date direct labour hours to contracts.

Lessons learned

The common ‘top-down’ management style and organisational culture among SOEs worked well when instigating innovative ideas and inducing corporate-wide learning. Top management’s commitment to trying out new management ideas and investing in new technology has been the unique feature.

 

Companies need accounting systems to track the costs of their operations. Two of the most commonly used systems are traditional costing and activity-based costing. One of these is easy to use and inexpensive to implement, while the other costs more to use but gives you greater accuracy.

Traditional costing adds an average overhead rate to the direct costs of manufacturing products and is best used when the overhead of a company is low compared to the direct costs of production. Activity-based costing identifies all of the specific overhead operations related to the manufacture of each product.

Traditional costing adds an average overhead rate to the direct costs of manufacturing products. The overhead rate gets applied on the basis of a cost driver, such as number of labor hours required to make a product.

Traditional costing is best used when the overhead of a company is low compared to the direct costs of production. It gives reasonably accurate cost figures when the production volume is large, and changes in overhead costs do not create a substantial difference when calculating the costs of production. Traditional costing methods are inexpensive to implement.

Companies usually use traditional costing for external reports, because it is simpler and easier for outsiders to understand. However, it does not give managers an accurate picture of product costs because the application of overhead burden rates is arbitrary and applied equally to the cost of all products. Overhead costs are not allocated to the products that actually consume the overhead activities.

The traditional costing method is best used for manufacturers that only make a few different products.

Activity-based costing identifies all of the specific overhead operations related to the manufacture of each product. Not all products require the support of all overhead costs, so it is not reasonable to apply the same overhead costs to all products.

Accountants created the ABC method to solve the problems of inaccuracy that result from the traditional costing approach. Managers needed more accurate costing methods to determine which profits were actually profitable and which were not.

A fundamental difference between traditional costing and ABC costing is that ABC methods expand the number of indirect cost pools that can be allocated to specific products. The traditional method takes one pool of a company's total overhead costs to allocate universally to all products.

Activity-based costing is the most accurate, but it is also the most difficult and costly to implement. It is more suited to businesses with high overhead costs that manufacture products, rather than companies that offer services. Companies that manufacture a large number of different products prefer an activity-based system because it gives more accurate costs of each product. With activity-based allocation of overhead costs, it is easier to identify areas where expenses are being wasted on unprofitable products.

Deciding between traditional or activity-based costing is not easy. Your choice should depend on the purpose of the reporting and who will see the information. Managers need accurate product costs and prefer to use an activity-based accounting system. Even though this system is more costly, it provides better information that will enable managers to make more profitable decisions in the long-term.

For external reporting, companies still use the traditional costing system, but it is becoming obsolete as outsiders demand more accurate information about businesses.

The fundamental advantage of using an ABC system is to more precisely determine how overhead is used. Once you have an ABC system, you can obtain better information about the issues noted below.

Learn About Activity Costs

ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards. If not, ABC is an excellent feedback tool for measuring the ongoing cost of specific services as management focuses on cost reduction.

Identify Profitable Customers

Though most of the costs incurred for individual customers are simply product costs, there is also an overhead component, such as unusually high customer service levels, product return handling, and cooperative marketing agreements. An ABC system can sort through these additional overhead costs and help you determine which customers are actually earning you a reasonable profit. This analysis may result in some unprofitable customers being turned away, or more emphasis being placed on those customers who are earning the company its largest profits.

Calculate Cost of Distribution Channels

The typical company uses a variety of distribution channels to sell its products, such as retail, Internet, distributors, and mail order catalogs. Most of the structural cost of maintaining a distribution channel is overhead, so if you can make a reasonable determination of which distribution channels are using overhead, you can make decisions to alter how distribution channels are used, or even to drop unprofitable channels.

Decide When to Outsource

ABC provides a comprehensive view of every cost associated with the in-house manufacture of a product, so that you can see precisely which costs will be eliminated if an item is outsourced, versus which costs will remain.

Calculate Product Margins

With proper overhead allocation from an ABC system, you can determine the margins of various products, product lines, and entire subsidiaries. This can be quite useful for determining where to position company resources to earn the largest margins.

Set Minimum Price Points

Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order to avoid selling a product that will lose a company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold.

Determine Facility Production Costs

It is usually quite easy to segregate overhead costs at the plant-wide level, so you can compare the costs of production between different facilities. This can lead to the reapportionment of production work to those facilities incurring lower overhead costs, and possibly the shut-down of unusually high-cost facilities.

Identify Costs of Low-Volume Products

Low-volume products tend to have a high proportion of overhead and other setup costs associated with them. These additional costs are not noted in a normal costing system, but are assigned to the products in an ABC system. The result is a better understanding of the increased costs of low-volume products. This can result in either increased prices for these products, their outright termination, or more attention being paid to reducing their associated overhead and other setup costs.

Clearly, there are many valuable uses for the information provided by an ABC system. However, this information will only be available if you design the system to provide the specific set of data needed for each decision. If you install a generic ABC system and then use it for the above decisions, you may find that it does not provide the information that you need. Ultimately, the design of the system is determined by a cost-benefit analysis of which decisions you want it to assist with, and whether the cost of the system is worth the benefit of the resulting information.

Disadvantages of Activity Based Costing

Many companies initiate ABC projects with the best of intentions, only to see a very high proportion of the projects either fail or eventually lapse into disuse. There are several reasons for these issues, which are noted below.

Too Many Cost Pools

The advantage of an ABC system is the high quality of information that it produces, but this comes at the cost of using a large number of cost pools – and the more cost pools there are, the greater the cost of managing the system. To reduce this cost, run an ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of the resulting information. Doing so should keep the number of cost pools down to manageable proportions.

Difficult to Install

ABC systems are notoriously difficult to install, with multi-year installations being the norm when a company attempts to install it across all product lines and facilities. For such comprehensive installations, it is difficult to maintain a high level of management and budgetary support as the months roll by without installation being completed. Success rates are much higher for smaller, more targeted ABC installations.

Requires Data from Many Sources

An ABC system may require data input from multiple departments, and each of those departments may have greater priorities than the ABC system. Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time. This problem can be avoided by designing the system to only need information from the most supportive managers.

Information Only Collected Once

Many ABC projects are authorized on a project basis, so that information is only collected once; the information is useful for a company’s current operational situation, and it gradually declines in usefulness as the operational structure changes over time. Management may not authorize funding for additional ABC projects later on, so ABC tends to be “done” once and then discarded. To mitigate this issue, build as much of the ABC data collection structure into the existing accounting system, so that the cost of these projects is reduced; at a lower cost, it is more likely that additional ABC projects will be authorized in the future.

Avoidance of Slack Time Reporting

When a company asks its employees to report on the time spent on various activities, they have a strong tendency to make sure that the reported amounts equal 100% of their time. However, there is a large amount of slack time in anyone’s work day that may involve breaks, administrative meetings, playing games on the Internet, and so forth. Employees usually mask these activities by apportioning more time to other activities. These inflated numbers represent misallocations of costs in the ABC system, sometimes by quite substantial amounts.

Requires Additional Data

An ABC system rarely can be constructed to pull all of the information it needs directly from the general ledger. Instead, it requires a separate database that pulls in information from several sources, only one of which is existing general ledger accounts. It can be quite difficult to maintain this extra database, since it calls for significant extra staff time for which there may not be an adequate budget. The best work-around is to design the system to require the minimum amount of additional information other than that which is already available in the general ledger.

Only Needed in a Complex Environment

The benefits of ABC are most apparent when cost accounting information is difficult to discern, due to the presence of multiple product lines, machines being used for the production of many products, numerous machine setups, and so forth – in other words, in complex production environments. If a company does not operate in such an environment, then it may spend a great deal of money on an ABC installation, only to find that the resulting information is not overly valuable.

The broad range of issues noted here should make it clear that ABC tends to follow a bumpy path in many organizations, with a tendency for its usefulness to decline over time. Of the problem mitigation suggestions noted here, the key point is to construct a highly targeted ABC system that produces the most critical information at a reasonable cost. If that system takes root in your company, then consider a gradual expansion, during which you only expand further if there is a clear and demonstrable benefit in doing so. The worst thing you can do is to install a large and comprehensive ABC system, since it is expensive, meets with the most resistance, and is the most likely to fail over the long term.

Terms Similar to Activity-Based Costing

Activity based costing is also known as ABC costing, the ABC method, and the ABC costing method.