Lecture 10: Activity Based Costing and Management
Lecture 10: Activity Based Costing and Management
The use of technology has increased both in manufacturing and nonmanufacturing sectors over the past fifty years. As a consequence, many firms are
finding that indirect costs have become a higher proportion of total product costs.
Automation and computing systems have increased the indirect costs of many
organizations and in many cases have replaced significant amount of direct labor.
As the proportion of indirect costs to direct costs increases, firms are taking a closer
look at how indirect costs are related to the different products. Without an accurate
tracing of indirect costs to products, organizations are likely to make poor product
mix and pricing decisions. Activity Based Costing (ABC) is a procedure that
attempts to provide more accurate product costs. Activity Based Management
refers to a collection of techniques used by firms to enhance long term productivity
and profitability and these techniques use the information provided by activity
based costing systems.
ABC helps managers to dramatically enhance the accuracy of the product
costing systems. ABC systems recognize that many organizational resources are
required not for physical production of units of product but to provide a broad array
of support activities that enable a variety of products and services to be produced
for a diverse group of customers. In some sense, the goal of ABC is to measure and
then price out all the resources used for activities that support the production and
delivery of products and services to customers. In any ABC system, we can
potentially identify six crucial steps. They are
(1) identifying the costs of support resources to be allocated
(2) linking the support resources to a set of activities performed in the
organization
(3) find a mechanism to trace to cost of support resources to the identified
activities
(4) identify a physical measure for the activity (and this can be called cost
driver)
(5) based on the cost of activity identified in step (3) and the physical
measure of activity in step (4), calculate an activity cost driver rate
(6) finally, use this activity cost driver rate to allocate costs of support
resources to products.
While these steps seem very similar to the steps behind cost allocation
procedure discussed in modules 3 and 9, the principles behind ABC are vastly
different. Let us now see these differences in detail.
systems organize accounts by the kind of expense. For each kind of expense, we
will analyze the expense and segregate the expenses corresponding to each type of
activity so that we dont mix costs belonging to different types of activities.
Another difference between the ABC and non-ABC systems is the decision of
what costs should be allocated. Let us assume that we are trying to allocate a
particular capacity cost. Let us further assume that we are interested in measuring
the profit margin of a product as accurately as possible. In this case, we should
allocate only that part of the capacity cost that is controllable for the decision to
make or eliminate that particular product. If we do that, then the products profit
margin will reflect whether the product is profitable from the standpoint of the
decision to continue to offer or discontinue the product from the product portfolio.
On the other hand, in a non-ABC system, typically we allocate all capacity costs, not
just the controllable portion of the capacity costs. In an ABC system, we choose
that measure that has the strongest causal relationship to the underlying costs in
the cost pool. In a non-ABC system, we choose a cost driver more based on
convenience from the measurement perspective. Unlike a non-ABC system, ABC
systems use practical capacity as the denominator volume when calculating
allocation rates. In a non-ABC system, we always use the actual volume of activity
as the denominator volume. For example, assume that you are using labor hours to
allocate a particular cost pool. Also, assume that you have 10,000 labor hours of
maximum possible capacity but you are planning to use only 8,000 hours of labor
hours for the budgeted production. A non-ABC system will use 8,000 as the
denominator volume for the calculation of allocation rate but an ABC system will
use 10,000 hours as the denominator volume. This will lead to a part of the cost not
being allocated to products. The unallocated cost corresponds to the cost of
capacity that is not being used. Highlighting the cost of unused capacity is valuable
for managers for managing costs.
Now, let us consider a few aspects that you may want to keep in mind when
you design a ABC system. First, realize that an ABC system relies on the ability of
tracing back from any cost assignments to the underlying economic events. A
complex and expensive cost allocation system need not necessarily have this
capability. On the other hand, if activity drivers are chosen on the basis of causeand-effect relationship, then such as system is more likely to give you the capability
to relate the cost assignments to the underlying economic events. Finally, keep in
mind that there is always a tradeoff between accuracy of the costing system and
the cost of running the costing system. All other things remaining the same, you
should try to economize on the number of activity cost drivers in the system and try
to keep the measurement cost of activity cost drivers as low as possible. Generally
speaking, we have three different types of activity cost drivers. Activity cost drivers
may be based on transactions or based on duration of activity or based on intensity
of activity. For example, assume that you are trying to choose quality assurance
costs to products. Two possible activity cost drivers for this activity are number of
inspections performed and the time spent on inspections. While the first driver is
based on transactions, the second driver is based on the duration of this activity.
The first is easier and less costly to measure than the second one. For tracking the
second activity cost driver, we need to measure the time that it takes to conduct
each and every quality inspection in the firm. It takes more effort and time to track
this driver than just counting the number of inspections performed. We should go
for the duration type of activity cost driver only if the time taken to perform quality
inspections drastically differs across products. Otherwise, it would suffice if we
allocate quality costs in proportion to the number of inspections performed for each
product. Finally, there is a third type of activity cost driver that is called intensity
cost driver and this is much more expensive to track than the duration type drivers.
This involves, measuring the cost of each and every inspection and charge it to the
products like a direct cost. Unless there is a solid reason to go for this option, one
should not be choosing this option.
Traditional cost accounting systems fail for three reasons. If the firm has a
large proportion of activities performed that are not unit-level activities, or if there is
tremendous product diversity in the product portfolio or if the consumption pattern
of common resources is not the same across the products, then an ABC system can
provide more accurate product costs than a traditional non-ABC system. If one or
more of these three conditions prevail in the organization, then a non-ABC system
will result in high volume or generic products being allocated more costs than what
they should be allocated and low volume or customized products being allocated
less than what they should be allocated. In other words, the high volume products
will subsidize the low volume products and this will make the low volume products
appear more profitable and the high volume products appear less profitable or even
loss making. Some of the indicators that you may need a ABC system include:
1) While sales are increasing, profits are declining. This is because the
increased activity associated with increasing sales increase the costs more
than proportionately.
2) Non-ABC system will usually undercost the complex products and overcost
simple products. Therefore the complex products will appear more
profitable than what it should be.
3) Competitors who realize the true cost of manufacturing the complex
products will refrain from offering them
4) You will notice that the overhead rates are very high and they tend to
increase even higher over time
5) Direct labor costs is relatively a minor part of overall cost structure and
you are assigning many indirect costs using direct labor hours or direct
labor cost.
6) When you bid for complex products with a huge profit markup you get the
business. However, you are not successful with bids for simple products
even with very low profit margin.