Understanding Activity Based Costing
Activity based costing (ABC) is an accounting technique that aims to clarify exactly how and where a company makes its profit.
ABC assigns costs to all the resources needed to carry out a particular business activity. It also accounts for indirect ("soft") operating costs. The result is a fuller financial picture than is usually produced with other accounting methods (for example, standard costing), and a useful distinction between activities that add value and those that do not. Advocates of ABC use it to inform strategy about issues as diverse as organizational change, pricing, product mix, and capital investment. They also use it to help pinpoint and control costs, increase efficiency, and grow profits.
Used in the right way, ABC can be such a powerful tool for assessing an organization's whole operation—and informing its strategy for the future—that it's also becoming known as ABM: Activity based management.
ABC came to prominence in the 1980s, as companies strove to improve their products and services at the same time as pare down costs. They achieved impressive results, with the consequence that ABC is increasingly popular—particularly in manufacturing sectors.
There are five basic stages involved in an ABC costing:
- Identify the product or service
- Identify every resource and process needed to make the product or service, and work out the cost of each
- Remember to include "cost drivers" for each resource and process
- Gather information such as the time taken up by each process or resource, as well as cost data
- Use all the information and data to work out the total cost of products and services.
ABC is very flexible. It can be used to access most kinds of activity—from industrial processes to business operations to service delivery. It also takes into account a much wider range of factors than other costing methods, so it results in a fuller picture.
ABC involves so much data collection that it can take up a lot of time. There's also a danger that managers get so wrapped up in tracking costs that they take their eyes off the activity itself.
A wide range of businesses and professions find ABC useful, although it can be particularly suitable for those relying on people-based resources, which can be much harder to cost using other accounting methodologies.
In order for ABC to succeed, everyone involved needs to be really committed. A test run on a smaller project is a good idea before attempting anything too ambitious. Also, the organization should have a clear grasp of all its activities and resources, what's involved in each, how much information they're going to need, and how much it's going to cost to collect it all. They also need agreement about how much detail and precision they're aiming for.
Before an organization can adopt ABC, they need to:
- convert to the accrual basis of accounting (if they're using the cash basis).
- set up cost centers and allocate costs. Cost centers will vary according to the type of business or service.
- agree a method for costing processes and procedures.
Companies have successfully used ABC to prove the financial benefits of e-commerce, by working out the relative costs of electronic versus more traditional methods of handling transactions. For example, banks used it to confirm that ATM cash machines both save money and provide customers with a service they want. Another example might be publishers considering the relative merits of online and paper-based publications.
Businesses offering services like consultancy or legal advice can use ABC to validate their charge-out costs, enabling them to work out more exactly how much profit they really make.
Healthcare providers have also used ABC very successfully, for example, to rationalize costs, measure profits, and get ready for change—and it's much easier for a medical practice to make decisions about pricing services if it understands the true cost of each component involved. In this example, individual physicians might be cost centers. Where costs are directly traceable to a specific service, they are allocated to the physician who generates income or incurs expense in relation to that service. Fixed overheads or indirect costs might be shared out equally between cost centers, or divided among them on a proportional basis.
Once cost centers are identified, companies can begin allocating the expenses incurred and the income generated by each one. These will include labor costs, equipment, premises, administrative support (such as personnel, office supplies, marketing and advertising, admin equipment, telecommunications expenses)—and so on. The aim is to be as comprehensive as possible, so that nothing that contributes to the balance sheet in any way is left out.
There are various procedures for tracking and allocating the cost of individual activities, some of which are more detailed and accurate than others. Not all companies will require the greatest level of detail—and although the most refined methods will result in the most accurate picture, they will also be the most time consuming and expensive to carry out.
One of the most effective methods involves undertaking time studies and allocating expenses directly. Time studies work out how long it takes to complete each task, taking an average based on a range of performances from best to worst. Often, such studies enable managers to allocate costs precisely to activities that have previously been expressed as a general overhead, or passed by completely.
It takes time to collect all the data needed for such studies, but proponents say it results in cost savings of up to 14 times more than the cost of the exercise itself. It may also provide evidence in favor of policies and procedures that previously had little more than a hunch to defend them.
A particular benefit of ABC lies in identifying under- or over-staffed activities within an organization. Knowledge-based businesses, whose highest costs are always its personnel, find such analysis very useful—the more efficient its deployment of staff, the higher its profits are likely to be.
Finally, ABC analysis can set valuable performance standards within an operation, or even enable a company to compare the costs of its own processes and procedures with those of the sector in general.
Common Mistakes
ABC is only a tool, but there's a danger that it can become all-consuming and dominate an organization.
Setting up and maintaining ABC can be a huge and daunting exercise. Organizations may need to estimate some costs to keep the exercise within realistic boundaries. Nevertheless, a certain level of detail is essential. For example, time studies are an accurate way to allocate costs relating to personnel, or indirect costs. Other methods may need less input, but they could be so subjective that the whole exercise is compromised. Moreover, they may not identify precisely where staffing is being used inefficiently (or vice-versa), or miss significant trends.
If a company tries to embark on ABC without the help of specially-developed computer software, it's almost certainly doomed to become a time-consuming waste of money and effort. ABC is a complex process and needs to be automated as much as possible, in the most appropriate ways.
Like any other accounting method, ABC is an ongoing activity that needs constant updating as circumstances develop and change.
ABC has the potential to turn the spotlight on any area of an organization and to expose its deficiencies, as well as to identify what works well. If an organization decides to adopt ABC, it needs to be ready to grasp the nettle and act on its findings, or the whole exercise becomes pointless.
Activity Based Costing Benchmarking Association: www.abcbenchmarking.com