Activity-Based Costing

Activity-Based costing (ABC) is a relatively new method of calculating total cost for products and services. Although in the classroom exercises and exam questions, this method may seem similar to Absorption Costing, in practice it is very different and much more precise technique than absorption costing.

ABC records all activities in an organisation and link those to product or service which is causing an activity to occur and causing costs to increase. This enables the management accountants to add different costs to different products and/or services resulting in accurate cost calculations unlike in Absorption Costing where overheads are first put together and then allocated and apportioned on the basis of an activity (e.g., labour hours) which is selected subjectively.

It is an immense work to Record all the activities in an organisation and link those to different products and/or services which has only been made possible with the widespread use of information technology since 1990s. The activities are monitored by using computers without causing disruption to the work processes. Unlike Absorption costing which relies on Departmental OARs to allocate overheads to the products and services, ABC use Cost pools and cost drivers to achieve precision in overheads allocation and apportionment.

Identification of Cost Pools and Cost Drivers

In absorption costing, we have looked at how overheads are accumulated for each department and then departmental OARs are calculated. Cost Pools are similar to departments in this regard. However, where there are only few departments in an organisation, there could be 100s of Cost Pools in each organisation which helps to narrow down the costs to link them to the right product or service. Cost pools are the total cost (£, $ etc) of the similar activities e.g., administration department. This similarity is usually established by the cost driver of each activity. A cost driver is a variable which causes costs to increase in a cost pool e.g., hiring a new person in admin department etc. This cost driver will trigger admin department to become a cost pool as there is cost associated with it. Once Cost pools total value and total number of drivers are known in each cost pool, a rate per driver is calculated using the formula below

Rate per Cost Driver = (Total Cost in Cost Pool)/(Total number of Cost Drivers)

ABC will record number of drivers for each product which will be multiplied with rate per driver to calculate the cost which should be added to a product from that cost pool. This will be repeated for all the cost pools which were associated with that product. This will give us the total overheads cost for each product. By adding material and labour cost we can calculate the total cost for a product.

Departmental cost pools:

Most of the departments including admin, marketing, HR, R&D, finance will be a cost pool as there are costs which can be clearly associated and accumulated in there.

Machines related costs:

This cost pool accumulates all costs related to running and maintaining machines in an organisation. For example, machine depreciation, lubrication, maintenance and repairs, parts, engineers’ salaries and any other machine related cost excluding new machine purchases which are not overheads but capital expenditures.

Batch related costs:

Imagine a Coca-Cola Factory where products are produced with different volumes, containers and flavours. Total demand for each product is produced in smaller chunks rather than in one go. For example, if the demand for 500ml bottle is 100 million in the UK, it is likely that it will be produced, let’s say, 10 times throughout the period. Producing the whole lot will be foolish as it can cause massive problems like storing the product, investment stuck in stock for the whole year, products getting out of date and so on. Each production run is called a batch. Every time a different batch is run, machinery requires resetting, whole system needs flushing to avoid flavours getting mixed, filters changing and so on. These costs are accumulated in a pool and apportioned on the basis of how many batches each product required. A Product with more batches but smaller quantities will receive higher costs, hence more expensive to produce. For example, 10 batches of 500ml bottles produced in the quantity of 100 million will be allocated the same batch costs as 10 batches of Coke Vanilla 330ml with total production of 1 million.

Ordering and distribution costs:

This includes staff costs involves with taking and processing orders. ABC will record number of staff/hours worked for each product. The costs will then be apportioned accordingly.

Distribution costs:

These costs include warehouse costs, workers and managers dealing with receiving and dispatching deliveries, maintaining stock, delivery trucks and associated costs etc. These costs will be monitored by ABC to identify how much was spent for each product.

Building related costs:

These costs include rent, rates, insurance, maintenance, depreciation and other building related costs. Usually these are apportioned on the same basis as absorption costing which is floor area occupancy. However, ABC can allocate costs to this cost pool more accurately.

Other costs:

After allocating all the costs to different cost pools, there will always be few items of costs which will be either too small to be made a separate costs pool or too unique to become a part of another pool. These costs are put together and are apportioned using the same philosophy as Absorption Costing. The critics of ABC use this to criticise this technique. However, the difference is that Absorption costing allocates 100% of the overheads using a basis whereas ABC does this to a small proportion (5-10%) of the overheads. If the proportion is too high then either ABC system was not devised properly or it should not have been implemented in the first place. As implementation of ABC requires huge financial investment, a Cost-Benefit Analysis must be carried out before implementing it.

Cost-benefit Analysis.

Implementing ABC is a huge decision which management should not take lightly. For medium to large size organisations, ABC’s implementation can cost in millions, disrupts the current processes and can cause social issues among staff e.g., anxiety and reluctance to change. Systems like ABC are implemented by management consultant firms which provide a plan for the implementation giving full details of what it will involve including costs for equipment, redundancies, further hiring and consultancy fees. A total figure must be calculated to establish the total cost of the new system.

The consultant reports also highlight the possible advantages of implementing the new system. However, the management must always exercise their own judgement on the matter as consultants are trying to sell their services after all and their reports could be biased.

The main advantage which ABC can bring to an organisation is accurate costing of different products and/or services which can make a business more competitive. ABC can identify the products and/or services which are more resource intensive as it monitors all activities in the organisation and links those to different products and/or services. Such information can help management to decide if they should continue providing a certain product/service or not if it is not making enough profits. A decision to drop a product can help management to focus on more profitable products and services and may reduce staff costs as well. A decision can also be made to increase the prices of those products if possible. On the other hand, prices could be reduced for the products/services which are cheaper to produce and provide than originally calculated under traditional costing method which will increase the sales and market share. In some cases, competition can be eliminated by enhanced processes like ABC. All the possible advantages must be calculated and accumulated to get a final figure for the benefits which can be derived by implementing ABC.

Total cost figure will be calculated and compared to the total benefits figure and a decision to implement the new system will only be made if the benefits exceed the costs. In some cases, social aspects of change can be so huge that the decision is still a NO even if the benefits exceed the costs. However, if a change is occurring throughout the sector then management has no option but to implement the new systems as the business may not be able to survive if they don’t embrace new systems and processes. Almost all the big companies have now implemented ABC in some form or another. Global competition has forced businesses to reduce costs to stay in business which is only possible with a robust costing system like ABC. Many businesses were shocked to find out the real costs of providing their products and services after implementing ABC where they were selling some of the products for less than the cost calculated under ABC while in some cases the prices were set too high based on traditional costing methods resulting in smaller market share. However, the research has also shown that some businesses did not find ABC useful to reduce costs and/or increase profits.

This article is written by Raja Mizan who is a senior lecturer in accounting & finance in a UK university. He is an ACCA member and also runs his own accountancy practice RMR Accountants & Business Advisors.