Activity-Based Costing

Activity-based costing (ABC) is a

costing method that is designed
to provide managers with cost
information for strategic and other
decisions that potentially affect
capacity and therefore “fixed”
costs. ABC is ordinarily used as a
supplement to, rather than as a
replacement for the company’s usual
costing system.
Activity based costing (ABC) assigns
manufacturing overhead costs
to products in a more logical manner
than the traditional approach of
simply allocating costs on the basis of
machine hours. Activity based

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costing first assigns costs to the
activities that are the real cause
of the overhead. It then assigns the
cost of those activities only to
the products that are actually
demanding the activities.
In activity-based cost accounting, a
budgeting process employing
knowledge of activities and driver
relationships to predict workload
and resource requirements in
developing a business plan. Budgets
show
the predicted consumption and cost of
resources using forecast
workload as a basis. The company
can use performance to budget in

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evaluating success in setting and
pursuing strategic goals; this
activity is part of the activity-based
planning process
Activity-Based Costing
Activity-based costing (ABC) is a
costing method that is designed
to provide managers with cost
information for strategic and other
decisions that potentially affect
capacity and therefore “fixed”
costs. ABC is ordinarily used as a
supplement to, rather than as a
replacement for the company’s usual
costing system.
Activity based costing (ABC) assigns
manufacturing overhead costs

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to products in a more logical manner
than the traditional approach of
simply allocating costs on the basis of
machine hours. Activity based
costing first assigns costs to the
activities that are the real cause
of the overhead. It then assigns the
cost of those activities only to
the products that are actually
demanding the activities.
In activity-based cost accounting, a
budgeting process employing
knowledge of activities and driver
relationships to predict workload
and resource requirements in
developing a business plan. Budgets
show

4|Page
the predicted consumption and cost of
resources using forecast
workload as a basis. The company
can use performance to budget in
evaluating success in setting and
pursuing strategic goals; this
activity is part of the activity-based
planning process
Chapter 6

Activity-Based Costing and Management

Definition of terms:

 Unit levels activities- which are performed each time a unit is produced
 Batch-level activities- which are performed each time a batch of goods is handled or processed
 Product-level activities- which are performed as needed to support the production of each different type
of product
 Facility- level activities- which simply sustain a facility’s general manufacturing process.
 Operational ABM- enhances operation efficiency and asset utilization and lowers cost. It focuses on
doing things right and performing activities more efficiently. Among the management techniques that are
applied in operational ABM are activity management, business process reengineering total quality
management and performance management.
 Strategic ABM- on the other hand, attempts to alter demand for activities and increase profitability at the
current or improved activity efficiency. It focuses on choosing the activities for the operations.
 Bench marking- involves the search for the best practices anywhere to identify ways to improve the
operation for a task, activity, or process.
 Cause-and-effect diagram- maps out causes that affect an activity, process, stated problem or desire
outcome.
 A Pareto analysis- is a histogram of the cost drivers that contribute to the total cost. Most analyses under
this technique show that 20 percent of the cost drivers are responsible for 80 percent of the total cost
incurred.

6.1 Activity-Based Costing

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Activity-based costing (ABC) is a costing method that is designed to provide managers with cost information for
strategic and other decisions that potentially affect capacity and therefore “fixed” costs. ABC is ordinarily used as
a supplement to, rather than as a replacement for the company’s usual costing system. Activity based costing
(ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of
simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that
are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually
demanding the activities. In activity-based cost accounting, a budgeting process employing knowledge of activities
and driver relationships to predict workload and resource requirements in developing a business plan. Budgets
show the predicted consumption and cost of resources using forecast workload as a basis. The company can use
performance to budget in evaluating success in setting and pursuing strategic goals; this activity is part of the
activity-based planning process.

6.1.1 Advantages and Limitations of ABC

Activity-based costing provides several benefits to the manager, namely

1. More accurate products costs

2. Better data for decision making

3. Tighter cost control

ABC has also several limitations,

 The chief of which are the difficulty and high costs involved with gathering data relating to activity centers
and cost drivers.

6.1.2 Design of an Activity-Based Costing System

The steps or activities required in designing an ABC system are

1. Process Value Analysis (PVA)

2. Identifying Activity Centers

3. Assigning Costs to activity Centers

4. Selecting Cost Drivers

Step 1. Process Value Analysis involves the following steps.

a.) Analyze activities required to make the product or perform the service.

b.) Classify each activity as value-added or non-value-added.

c) Identify ways to either reduce or eliminate the non-value-added activities.

Step 2. Identify activity Centers An activity center can be defined as a part of the production process for which
management wants a separate reporting of the cost of the activity involved.

Step 3. Assign Cost to Activity Centers Assign costs to the activity centers where they are accumulated while
waiting to be applied to products.

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Step 4. Select Cost Drivers

This involves assigning costs from the activity center to the product using appropriate cost drivers.

6.2 Activity based profitability analysis

Activity based profitability analysis can be linked to ABC techniques. By comparing the costs of products,
customers and distribution channels with revenues, a tier of contribution levels can be established by applying the
concept of the activity-based cost hierarchy.

The activity based analysis therefore assigns the costs to the appropriate level in the hierarchy (depending on
whether a cost is incurred in relation to an activity that supports a product, product line/customer/distribution
channel) and then aggregates the costs down the hierarchy to determine contribution margins by product, product
line, customer and distribution channel.

Direct Product Profitability (DPP)

As traditional absorption costing, which normally uses labour hours as a basis for absorption, is rarely suitable for
service and retail organisations other methods had to be devised. One relatively new way of spreading overheads in
retail organisations, which is used in the grocery trade in particular, is direct product profitability (DPP).

Directly-attributable costs are grouped and are deducted from the gross margin to determine the product’s direct
product profit (DPP).

The benefits of DPP may be summarized as:

 Better cost analysis;

 Better pricing decisions;
 Better management of store and warehouse space;
 The rationalization of product ranges;
 Better merchandising decisions.

Pareto Analysis

Pareto analysis simply aims to identify the most significant areas within one aspect of the business, thus allowing
management to focus on and control these most important areas.

The 80/20 rule as it is known is often illustrated by drawing a component percentage bar chart. The 80/20 rule
states that for example, the majority of a firm’s profit or revenue may be generated by a small percentage of total
number of customers/product lines/divisions

Procedure

The first step is to rearrange the products in descending order of contribution

Calculate the cumulative contribution.

Turn this into a cumulative percentage.
Draw a diagram to illustrate the principle

The term ‘Pareto diagram’ usually refers to a histogram or frequency chart on product quality.

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The position of the products with most contributions needs protecting, perhaps through careful attention to
branding and promotion. The other products require investigation to see whether their contribution can be
improved through increased prices, reduced costs or increased volumes.

Customer Profitability Analysis (CPA)

Customers use some activities but not all, and different groups of customers have different activity profiles.
Different customers or groups of customers differ in their profitability. This is a relatively new technique that ABC
makes possible because it creates cost pools for activities. Service organizations such as a bank or a hotel in
particular need to cost customers. A bank’s activities for a customer will include the following types of activities:

 Withdrawal of cash;
 Unauthorized overdraft;
 Request for a statement;
 Stopping a cheque;
 Returning a cheque because of insufficient funds.

Different customers or categories of customers will each use different amounts of these activities and so customer
profitability profiles can be built up, and customers can be charged according to the cost to serve them.

6.3 Activity-Based Management

Activity-based management (ABM) is a management tool that involves analyzing and costing activities with the
goal of improving efficiency and effectiveness. Activity-based management (ABM) is a procedure that originated
in the 1980s for analyzing the processes of a business to identify strengths and weaknesses. Specifically, activity-
based management seeks out areas where a business is losing money so that those activities can be eliminated or
improved to increase profitability. ABM analyzes the costs of employees, equipment, facilities, distribution,
overhead and other factors in a business to determine and allocate activity costs. Activity Analysis: To be
competitive a firm must assess each of its activities based on its need by the product or customer, its efficiency,
and its value content. A firm performs an activity because it is:

 Required to meet the specification of the product or service or satisfy customer demand
 Required to sustain the organization
 Deemed beneficial to the firm Cost-driver analysis. This technique examines, quantifies and explains the
effects of the cost driver on the cost of an activity. Performance measurement. This involves the
identifications of the work perform and the results achieved by an activity process, or organizational unit.
Performance measure include both financial and nonfinancial. Examples of financial performance
measures are the cost per unit of output, return on sales, and cost of every department’s high-value-added
and low-valued-added activities. Nonfinancial performance measures evaluate operating characteristics of
manufacturing process and measures of or feedbacks from customers or personnel. Examples of
nonfinancial performance measures are the:
 number of customer complaints
 customer satisfaction
 number of defective parts or output
 number of output unit
 cycle-time
 on-time delivery rate
 number of employee suggestion
 scores on employee morale

Organizations that are designing and implementing ABM will find there are five basic information outputs:

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The cost of activities and business processes – the basic output of the ABM system must be to provide relevant
cost information about what a business does. Instead of reporting what money is spent for and by whom, costs are
assigned to activities.

The cost of non-value-added activities – Identification of these wasteful activities is invaluable to management as
it provides a crucial focal point for management.

Activity based performance measures – Knowing the total cost of an activity is insufficient to measure activity
performance. Activity measures of quality, cycle time, productivity and customer service may also be required to
judge performance. Measuring the performance of activities provides a scorecard to report how well improvement
efforts are working and is an integral part of continuous improvement.

Accurate product/service cost – costs must be accurately determined.

Cost drivers – With this information it is possible to understand and manage these activity levels

ABM can be used in assessing strategic decisions such as:

 Whether to continue with a particular activity;

 How cost structures measure up to those of competitors;
 How changes in activities and components affect the suppliers and value chain.

ABM and employee empowerment take a critical step forward beyond ABC by recognising the contribution that
people make as the key resource in any organization’s success:

 It nurtures good communication and team work.

 It develops quality decision making.
 It leads to quality control and continuous improvement.

*ABM will not reduce costs; it will only help the manager understand costs better.
Implementing ABM
 Get the support of senior management.
 Know what ABM can achieve and what information you want from the system.
 Involve people in the field.
 Do not underestimate the need to manage the change process.

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