Activity-Based Costing

A Proven Approach to Profitability

Activity Based Costing - ABC Costing Approach is a management accounting method that has helped many companies improve their profitability and cost structure. ABC costing identifies opportunities for management to improve pricing, products, services, operations and key business processes in order to improve competitiveness. Critical information that has been hidden by using traditional accounting approaches can be discovered by using activity based costing. To compete in the marketplace management must change the cost and profit management and reporting practices.

What is Activity-Based Costing?

Activity Based Costing is a management accounting approach which allocate all direct and indirect (overhead) costs to cost objects (products and services) in order to help management understand critical business information. ABC allocates direct and indirect costs to products and services based on the level of activities used to create and deliver those products and services. Activities such as purchasing, design, production, sales, marketing and customer service are utilized by different products and services (cost objects) based on their complexity and business requirements. Compared to traditional accounting, activity based costing is a decision making tool which provides more accurate cost and profit information and allows management to understand the cost and profit drivers and improve their business.  

Activity Based Management

Activity Based Management uses activity based costing information to maximize value for the customers and other stakeholders and improve profitability. Management allocates resources to critical business processes, products and customers and improves overall efficiency as well as create opportunities for cost reduction and product, service and process improvement. By identifying costs of activities and activity utilization by different products and services decision makers have accurate and timely information and are able to make better and more effective business decisions. Activity Based Costing also identifies value added activities (activities which create value for the customer and the company) and non value added activities (activities which are currently performed but they do not create value for the customer nor for the company).

How Activity Based Costing Works?

The overall objective of ABC Costing System is better understanding the overhead / indirect costs and profitability. What will change with ABC? While the overall costs and profit will remain the same the ABC Costing will inform management about profitability at the product level. Activity Based Costing will allocate costs to products and services based on the level of resource utilization by different company activities. Each indirect cost is driven and at the same time can be controlled, planned and managed based on the business model and processes used by the company. For example, the costs of each department and activity is driven by the company's business model or the way the company does business (employee hours, number of machine hours or number of shifts will drive the cost of each activity). Manufacturing as well as service companies can use ABC to assign costs to activities and activities to products and services in order to measure profitability.

The ABC approach includes allocation of indirect costs to departments, costs from departments to activities and costs from activities to cost objects. For example, every business has departments which will vary based on the business (groups / teams such as sales function / department , warehouse department, purchasing department, administration, etc.). Indirect Costs from General Ledger can be assigned by using percentage based on utilization level - for example, the rent cost can be allocated 70% to the warehouse department, 20% to administration and 10% to Sales and Marketing Department depending on the square feet used by each department. Next, each department performance activities - for example, the design department may perform product development activities, the sales department will perform sales calls, quoting and sales presentations. Depending on the time spent by the sales force on each of these activities their indirect costs can be allocated to each activity - for example, 30% sales calls, 30% to quoting and 40% to sales meetings and presentations. Finally, the costs of each activity is allocated to the cost objects (products and services). For example, let's consider the sales meetings and presentations activity performed by the sales department: based on the time spent by the sales force on selling and promoting each product or service the cost of sales meetings and presentations activity can be allocated 50% to Product 1, 30% to Product 2 and 20% to Product 3. Different products and services require more or less activities in creating them and selling them to the customers. This simple example demonstrates the way ABC allocates and calculates indirect costs and assign them to cost objects which is the overall objective - each cost object / each product and service will be measures at the net profit level.

Gross Margins / Gross Profit can be misleading because some products and services will be profitable at the gross margin level but they might be losers at the net profit level if they consume too much of the company's activities. On the other hand, some products and services with lower gross margins might be very profitable at the net profit level because they are simple to create and deliver to the customers. The following example demonstrates this point:

Activities 

Business processes and operations are performed by different activities. Each activity has cost drivers which are used to calculate or estimate the cost of activities. Here are some examples of activities and cost drivers:

Activities

• Purchasing

• Product Design

• Quoting

• Sales Calls

• Product Delivery

• Receiving

• Stocking

Cost Drivers

• Number of Calls

• Percent of time spent on stocking each product

• Square Feet

• Labor Hours per Product

• Machine Hours per Product

• Number of Shipments per Product

• Receiving Hours per Product

• Stocking Hours per Product

There are different activity levels such as unit level activities (activities performed on each unit such as packaging), batch level activities (activities performed on batch level such as scheduling and set up), product level activities (activities performed on each product such as design, engineering and marketing) and facility level activities (activities performed at each facility such as safety and maintenance).

Designing Activity Based Costing System

Designing and implementing ABC Costing System involves identifying and defining all direct and indirect costs, company's departments, activities, cost objects and defining ABC reporting.

The first step in designing ABC System is defining the indirect costs and departments and allocating the indirect costs to each department based on cost drivers.

Next, the cost from the departments are allocated to Activities based on how much activities are consumed by each department.

Finally, costs from activities are assigned to cost objects.

Benefits of Activity Based Costing

Compared to traditional accounting, Activity Based Costing reports accurate product and service costs and provides insight into the cost drivers and identifies value added and non value added activities providing opportunities for improvements on geneal company level as well as product and customer level.

MR Dashboard ABC Software for Excel

MR Dashboard Activity Based Costing Software for Microsoft Excel is automated Excel Application allowing users to develop ABC system and create ABC reports with a click of a button in Excel. Used by hundreds of companies worldwide this application has helped business users make better business decisions, better understand their businesses, improve business processes and operations, improve profitability and increase competitiveness. Activity Based Costing for Excel