Report on
Activity Based Costing A Tool to Aid Decision Making
Submitted Submitte d by
Md. MahabubAlam Ruhulamin Md. MehediHasan Tanvir Ahmed MofazzalHossain
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Activity Based Costing
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Activity Based Costing
SUMMARY
Activity-based costing (ABC) is a technique to more accurately assign the indirect and direct resources of an organization to the activities performed based on consumption. In the first stage, resource costs are assigned to activities based on t he amount of resources consumed in performing the activity. In the second stage, activity costs are traced to the products, services, or customers based on how frequently the activity is performed in support of these cost objects. This paper examines the best practices that have emerged in the ABC implementation domain. ABC analysis provides the information necessary to make business decisions such as determining if investments in efficiency initiatives, such as just in time (JIT), are warranted. When implementing ABC, management should use proven project management methodology to minimize the risk of failure. ABC is an effective total quality management tool, and supports just-in-time manufacturing methods in several companies as detailed in the pap er.
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Activity Based Costing
INTRODUCTION
Activity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs (overhead) into direct costs. In this way an organiza organization tion can precisely precis ely estimate estima te the cost of its individual products pr oducts and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced. In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.
HISTORICAL DEVELOPMENT
The concepts of ABC were developed in the t he manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced ManagementInternational, now known simply as CAM-I provided a formative role for studying and formalizing the principles that have ha ve become more formally known as Activity-Based Costing.
Robin Cooper and Robert S. Kaplan, proponents proponents of the Balanced Balanc ed Scorecard, brought notice to to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products.
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Acti it B
C ti
t i it cent es t all cate costs, ABC seeks to i enti cause and affect relationshi s to ob jecti el ass i n cos ts. Once costs of the acti ities have been identif ied, the cost of each activit is a ttr i bu buted to each produc t to the ext ent that the produc t uses the activit . In this way ABC of ten identif ies areas of hi h overhead costs per unit and so directs attention to f inding ways to reduce the costs or to charge more for cos tly products.
Activity-based cos ting was f irst clear ly def ined in 1987 by R ober ober t S. Kaplan and W. Burns as a chapt er in their book Accounting and Management: A Field Study Perspective. They initially focused on manufac tur ing industry where increasing technology and produc tivit y improvements have reduced the relative propor ti tion of the d irect costs of labor and ma ter ials, but have increased relative propor ti tion of indirec t costs. For examp le, increased automation has reduced labor, which is a direct cost, but has increased deprec iation, which is an indirect cost.
Like manufactur ing industr ies, f inancial institutions also have diverse produc ts and cus tomers which can cause cross-produc t cross-customer subsidies. Since personnel expenses represen t the largest single component of non- int erest expense in f inancial institutions, these cos ts mus t also be attr i bu buted more accura tely to products and customers. Ac tivity based cos ting, even though or iginally developed for manufactur ing, may even be a more usefu l tool for doing this.
MET
L G
a. Cost allocation:
Cost allocation is a process of a ttr bu i buting cost to par ti ticular cost centers. For examp le the wage of the dr iver of the purchas ing depar tment can be allocated to the purchasing depar tment cost center. It is not necessary to share the wage cost over severa l different cost centers. Cost and services are not identical t o each other.
b. Fixed cost: In economics, f ixed costs are bus iness expenses
that are not dependen t on the activities of the bus iness they tend to be b e ti me-related, such as sa lar ies or rents be ing pa id per month. This is in contrast to var iable costs, which are volume-relat ed (and are pa id per quantity). In management accounting, f ixed costs are def ined as tion to the activity of a expenses that do not change in propor ti
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Activity Based Costing business, within the relevant period. For example, a retailer must pay rent and utility bills irrespective of sales. c. Vari Variable cost:
Variable costs are expenses that change in proportion to the activity of a business. In other words, variable cost is the sum of marginal costs. It can also be considered normal costs. Along with fixed costs, variable costs make up the two components of total cost. Direct Costs, however, are costs that can easily be associated with a particular cost object. Not all variable costs are direct costs, however; for example, variable manufacturing overhead costs are variable costs that are not a direct costs, but indirect costs. Variable costs are someti mes called unit-level costs as they vary with the number of units produced.
d. Cost driver: Cost Drivers are the structural causes of the cost of an activity
performed in the Value Chain. They determine the behavior of costs within an activity. A cost driver can be completely or partly or not at all under the control of a firm. A firm's cost performance in all of its major discrete activities adds up to establish its relative cost position.
Accordi g to Michael Porter, the there are 10 major cost drivers: 1. Economies or Diseconomies of Scale. 2.
Learning and Spillovers. The cost of a value activity often declines over time due to
learning or improvements that increase its efficiency. Or due to knowledge acquired from suppliers, suppliers, consultants, former f ormer employees or reverse engineering. 3.
Pattern of Capacity Utilization. Different ways of configuring a value activity will
affect its sensitivity for capacity capa city (under)utilization. (under)utilization. 4.
Linkages. The cost of many value activities is affected by how other activities are
performed within the firm's own value chain or with the value chain of a supplier or a channel ("Vertical Linkages"). Through combining these activities and their linkages, their total cost can be reduced. 5.
Interrelationships between business units within a firm in the form of shared activities.
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Activity Based Costing 6.
Vertical Integration. Doing more a ctivities within the firm.
7.
Timing, such as First Mover Advantage or Second Mover Advantage.
8.
Discretionary Policies. The strategic choices a firm make, for example being a selfservice internet bank or being the t he fastest courier company.
9.
Location. Geographic location where an activity is conducted and the prevailing costs
of personnel, materials, energy, etc. 10. Institutional Factors. Government regulation, tax regimes, financial incentives, unionization, tariffs and levies, local content rules also affect the costs of a value activity.
e. Cost driver rate:cost
driver in a system of activity-based costing, any factor such as number of units, number of transactions, or duration of transactions that drives the costs arising from a particular activity. When such factors can be clearly identified and measured.
Direct labor and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions takes at the counter and then by measuring the number of each type of transaction.
DIFFERENCE BETWEEN ABC AND TRADITIONAL COST ACCO ACCOUN UNTI TIN N
METH METHOD ODS S
So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there are three major differences:
In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that t hat cost objects consume activities. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels. Traditional cost accounting is structure-oriented structure-oriented whereas ABC is process proc ess-oriented. -oriented. Activity-based costing is a more accurate cost c ost management system than TCA. One would use the ABC method when overhead is high, products are diverse, cost of errors high and competition is stiff.
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Activity Based Costing
Traditional Cost Accounting is unable to calculate the 'true' cost of the product. TCA arbitrarily allocates overhead to the costs of objects.
This is discussed in more detail in the subsequent sections and illustrated below. But first, the direction of the arrows are different because ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations.
Figur igure: Diff erenc ence between tween ABC & Traditional Costing
Hence, we see that the traditional usage of fixed and variable costs is totally meaningless. In ABC, all costs are included. However, ABC employs a different usage and definition of fixed and variable costs. A fixed activity cost is is a cost that exists due to the very existence of the activity whereas a variable activity cost changes changes as the output of the activity changes. This distinction is very helpful in various improvement efforts. Therefore, in Activity-Based Management (ABM)a (ABM)a third type of drivers is employed in addition to the two aforementioned drivers. This type of drivers is called cost drivers and they are the underlying causes of costs of activities and measured by non-financial performance measures. Today, the most important of these measures can be presented in a balanced scorecard and they represent the process view in ABM. These are possibly the most difficult drivers to identify.
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Activity Based Costing
ACTI ACTIVI VITYTY-BA BASE SED D MANA MANA EMENT MENT
Activity-based management and activity-based costing (ABM/ABC) have brought about radical change in cost management systems. ABM has grown largely out of the work of the Texas-based Consortium for Advanced Manufacturing-International Manufacturing-International (CAM-I). The principles and philosophies of activity-based thinking apply equally to service companies, government agencies and process industries. Activity-based costing and activity-based management have been around for more than fifteen years. It is a one-off exercise which measures the cost and performance of activities, resources and the objects which consume them in order to generate more accurate and meaningful information for decision-making. ABM draws on ABC to pr ovide management reporting and decision making. ABM supports business excellence by providing information to facilitate long-term strategic decisions about such things as product mix and sourcing. It allows product designers to understand the impact of different designs on cost and flexibility and then to modify their designs designs accordingly. accor dingly. ABM also supports the quest for continuous improvement by allowing management to gain new insights into activity performance by focusing attention on the sources of demand for activities and by permitting management to create behavioral incentives to improve one or more aspects of the t he business. y
y
y
y
y
y
y y
ABM is a fundamental shift in emphasis e mphasis from traditional costing and performance measurement. People undertake activities which consume resources r esources ± so controlling activities allows you to control costs at a t their source. The real value and power of ABM comes from the knowledge and information that leads to better decisions and a nd the leverage it provides to measure imp i mprovement. rovement. ABM enables management to make informed decisions about lines of business, product mix, process and product design, what services ser vices should be offered, capital investments, investments, and a nd pricing. ABM is more than an a n accounting tool; it's a system for continuous continuous improvements. It is not a single answer but merely one of the many tools that can be used to enhance organizational performance management. ABM will not reduce costs, it will only help you understand costs better to know what to correct. The process of ABM does consume resources, and the manpower costs can be significant. _ Other priorities, top management commitment, IT capabilities and integration with financial fina ncial and budgeting systems should be considered before implementation i mplementation..
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Activity Based Costing y
y
Organizations have begun to look at ABM for a variety of reasons. Among the most commonly cited are: top-down pressure to reduce costs; o Competitive pressure/market condi c onditions; tions; o organization-wide programmed; o The introduction of benchmarking; o Regulatory issues; o Seeking world-class status through process management. mana gement. o ABC and ABM are a continuum of value. ABM is the application of ABC data to manage product portfolios and business processes better.
BENEFITS OF ACTIVITY-BASED COSTIN
Typi Typical benefits of A f Activity-Based Costing: y
Identify the most profitable customers, products and channels.
y
Identify the least profitable profita ble customers, products and channels.
y
Determine the true contributors to- and detractors fr om om-- financial performance.
y
Accurately predict costs, profits and resources requirements associated with changes in production volumes, volumes, organizational orga nizational structure and costs of resources.
y
Easily identify the root causes of poor financial financia l performance.
y
Track costs of activities and work processes. proc esses.
y
Equip managers with cost intelligence to stimulate improvements.
y
Facilitate a better Marketing Mix
y
Enhance the bargaining power with the customer.
y
Achieve better Positioning of products
With the costing now based on activities, the cost of serving a customer can be ascertained individually. Deducting the product cost and the cost to serve each customer, one can arrive at customer's profitability. This method of dealing separately with the customer costs and the
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Activity Based Costing product costs enables the identification of the profitability of each customer and Positioning the products and services accordingly. acc ordingly.
USES OF ACTIVITY BASED COSTIN
It helps to identify inefficient products, departments and a ctivities It helps to allocate more resources on profitable products, departments and a nd activities It helps to control the costs at an individual level and on a departmental level It helps to find unnecessary costs
ACTIV ACTIVITY ITY BASED BASED COST COSTIN IN
PRACT PRACTICE ICE-- BE CAUTIO CAUTIOUS US
Even in activity-based costing, some overhead costs are difficult to assign to products and
customers, such as the chief executive's salary. These costs are termed 'business sustaining' and are not assigned to products and customers because there is no meaningful method. This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed. Although some may argue that costs untraceable to t o activities should be "arbitrarily allocated" to products, it is important to realize that the only purpose of ABC is to provide information to management. Therefore, there is no reason to assign any cost in an arbitrary manner.
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Activity Based Costing
STEPS OF ACTIVITY BASED COSTIN Follow f Activity Based Costing Estimate llowing an Example of A
To get a better understanding of how an ABC estimate is developed, assume that it has been asked to prepare a cost estimate for a site evaluation. To verify that there is no contamination at the site, subsurface soil samples will have to be collected. The area of the site is known, and the guideline for the number of samples per unit area has also been given.
Figur igure: Overhead Cost Analysis 1. Define activities, activity cost pool ools, and activity meas ures
Assume that the cost of supplying resources ± personnel, supervision, information technology, telecommunications, and occupancy í to perform these activities is $560,000 per quarter. In building an ABC model for the customer service department, the system designer designer asks employees to estimate the percentage of their time spent (or that they expect to spend) on the three principal activities they perform. Suppose they estimate these percentages as 70%, 10% and 20%, respectively. The ABC system designer also learns that the actual (or estimated) quantities of work for the quarter in these three activities are: 9,800 customer orders 280 customer complaints 500 credit checks
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Activity Based Costing 2.
Assign overhead costs to activity cost pool ools The system assigns the $560,000 resource cost to activities, based on the time percentage, and calculates activity cost driver rates as shown below:
Overhead
%
Total
Customer Orders
70%
$ 392000
Customer Complaints
10%
56000
Credit Checks
20%
112000
Total
$ 560000
Table: le: Overhead Cost
Figur igure: ABC Syste stem
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Activity Based Costing 3.
Calculate activity rates
Activity
%
Assigned Cost
Activity Cost Driv Driver Quantity
Handle orders
70%
$392,000
9,800
$ 40/order
10%
56,000
280
$200/complaint $200/complaint
Check credit
20%
112,000
500
$224/credit check
Total
100%
$ 560,000
Process
complaints
Activity Cost Driv Driver Rate
Table: le: Calculated Activity Rates
The project team then uses the calculated activity cost driver rates to assign the expenses of the three activities to individual customers based on the number of orders handled, complaints processed, and credit checks chec ks performed for each customer.
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Activity Based Costing
MATHEMATICAL ILLUSTRATION
Returning to the numerical example, suppose that the analyst obtains estimates of the following average unit times for the three customer-related a ctivities: Handle customer orders 40 minutes Process customer complaints 220 minutes Perform credit check 250 minutes
We can now simply calculate the activity cost driver rate for the three activities:
Activity
Unit Time (minutes)
Handle customer order
40
Process customer complaint
220
Perform credit check
250
Activity Cost Driver Rate @ $0.80/minute $ 32 $176 $200
Table: Driver Rates le: Calculate Activity Cost Driv
These rates are lower than those estimated before. The reason for this discrepancy becomes obvious when we calculate the cost of performing these activities during the recent quarter.
Activity Unit
Time
Quantity
Total Minutes
Total Cost
Handle customer order
40
9800
392000
$ 313600
Proce ocess customer complaint
220
280
61600
49280
250
500
125000
100000
578600
$ 462880
Perf orm credit che check
Total
Table: le: Calculated Overhead Cost
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Activity Based Costing The analysis reveals that only 83% of the practical capacity (578,600/700,000) of the resources supplied during the period was used for productive work (and hence only 83% of the total expenses of $560,000 are assigned to customers during this period). The traditional ABC system over-estimates the costs of performing activiti es because its distribution of effort survey, while quite accurate í 70%, 10% and 20% of the productive work is the approximate distribution across the three activities í incorporates both the costs of resource capacity used and the costs of unused resources. By specifying the unit times to perform each instance of 14
the activity the organization gets both a more valid signal about the cost and the underlying efficiency of each activity as well as the quantity (121,400 hours) and cost ($97,120) of the unused capacity in the t he resources supplied to perform the activity. With estimates of the cost of r esource supply, the practical capacity of the resources supplied, and the unit times for each activity performed by the resources, resourc es, the reporting system becomes quite simple for each period. Suppose the quantity of activities shifts, in the subsequent period, to 10,200 orders handled, 230 customer complaints, and 540 credit checks chec ks performed. During the period, the costs of each of the three activities are assigned based on the standard rates, calculated at practical capacity: $32 per order, $176 per complaint, and $200 per credit check. This calculation can be performed in real time to assign customer administration costs to individual customers, as transactions from customers occur.
The report at the the
end of the the
period is both simple and inf ormative:
Activity
Quantity
Unit Time
Total Time
Unit Cost
Total Cost Assigned
Handle Customer Orders
10,200
40
408,000
$ 32
$ 326,400
Process Complaints
230
220
50,600
176
40,480 40,480
540
250
135,000
200
108,000
Perform Credit
Checks TotalUsed
593,600
$ 474,880
Total Supplied
700,000
$560,000
Unused Capacity
106,400
$ 85,120
Table: le: Analysis R eport
The report reveals the estimated time spent on the three activities, as well as the resource costs required to handle the activity demands. It also highlights the difference between capacity supplied supplied (both quantity and cost) cost) and the capacity used. used. Managers can review the $85,120 cost of the 106,400 minutes (1,773 hours) of unused capacity and contemplate actions to reduce the supply of resources a nd the associated expense. Rather than reduce currently unused capacity, managers may choose to reserve that capacity for future growth. As managers contemplate new product introductions, expansion into new markets, or just increases in product and customer demand, they can forecast how much of
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Activity Based Costing the increased business can be handled by existing capacity, and where capacity shortages are likely to arise that will require additional spending to handle the increased demands. For example, the vice president of operations at Lewis-Goetz, a hose and belt fabricator based in Pittsburgh, saw that one of his plants was operating at only 27% of capacity. Rather than attempt to downsize the plant, he decided to maintain the capacity for a large contract he expected to win later that year.
CONTINUOUS IMPROVEMENT
The implementation of ABC can make the employees understand the various costs involved. This will then enable them to analyze the cost, and a nd to identify the activities that add value and those that do not add value. Finally, based on this, improvements can be implemented i mplemented and the benefits can be realized. This is a continuous improvement process in terms of analyzing the cost, to reduce or eliminate the non-value added activities and to achieve an overall efficiency. ABC has helped enterprises in answering the market need for better quality products at competitive prices. Analyzing the product profitability and customer profitability, the ABC method has contributed effectively for the top management's decision making process. With ABC, enterprises are able to improve their efficiency and reduce the cost without sacrificing the value for the customer. Many companies also use ABC as a basis for a balanced scorecard.
This has also enabled enterprises to model the impact of cost reduction and subsequently confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method for continuous improvement. With Activity Based Costing any enterprise can have a built-in competitive cost advantage, so it can continuously add value to both its stakeholders and customers.
The implementation of Activity Based Costing is not easy - not an ABC. Special activity based costing software can be helpful.
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Activity Based Costing
CONCLUSION Over the past 15 years, activity-based costing has enabled managers to see that not all revenue is good revenue, and not all customers are profitable customers. Unfortunately, the difficulties of implementing and maintaining traditional ABC systems have prevented activity-based cost systems from being an effective, timely, and up-to-date management tool. The time-driven ABC approach has overcome these difficulties. It offers managers a methodology that has the following positive features: y
y y y y
y y
Easy and fast to implement
Integrates well with data now available from recently installed ER P and CRM systems Inexpensive and fast to maintain and update Ability to scale to enterprise-wide models Easy to incorporates specific features for particular orders, processes, suppliers, and customers More visibility to process efficiencies and capacity utilization Ability to forecast future resource demands based on predicted order quantities and complexity
These characteristics enable activity-based costing to move from a complex, expensive financial systems implementation to becoming a tool that provides meaningful and actionable data, quickly and inexpensively, to managers.
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Activity Based Costing
BIBLIO RAPHY
Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective (Harvard Business School Press, 1987). Sapp, Richard, David Crawford and Steven Rebishcke, Journal of Bank Cost and Management Accounting (Volume 3, Number 2), 1990, Journal of Bank Cost and Management Accounting (Volume 4, Number 1), 1991. David M. Katz, Activity-Based Costing (ABC). Police Service National ABC Model Manual of Guidance Version 2.3 June 2007.
Sir Ronnie Flanagan, The Review of Policing Final Report, February 2008. Tiffany Bradford, Types of Accounting Costing Systems, 2008 Weygandt / Kieso / Kimmel, Ki mmel, Managerial Accounting (Second Edition)
[email protected] with questions or comments about this web site. Copyright © 2000 Jan E mblemsvag DR jake, mitchell; alan price (2003). Economics: Principles in action. Upper Saddle River, New Jersey 07458: Pearson Prentice Hall. DR Alex, Suleman. "A controversial-issues approach to enhance management accounting education.".Journal of Accounting Education 1994. Ali, H. F. "A multi-contribution activity-based income statement.´Journal of Cost Management 1994. Innes, J and Mitchell, F (1995), Activity-based costing in the UK's largest companies: a survey, CIMA. Innes J, and Norris, G (1997), The use of activity-based information: a managerial perspective, CIMA. µActivity-based management¶, Management Accounting Issues Paper 10 , SMAC, 1995. Statement of Management Management Accounting , NAA/IMA, 1998. http://www.pitt.edu/~roztocki/abc/abc.htm ABM Internet website guide, by NarcyzRoztocki of the Pittsburgh University. Comprehensive internet web links covering all areas of ABM http://www.pitt.edu/~roztocki/abc/abctutor/ Introduction to Activity-based Costing (ABC) Internet ABC online presentation. University of Pittsburgh
