Activity-Based Costing (ABC)


Activity-based Costing (ABC) is a dynamic and systematic accounting methodology for realistically calculating the actual cost of doing business, regardless of organizational structure. ABC originated from the efforts of Dr. Robert Kaplan of Harvard, who also conceptualized the Balanced Scorecard.


Activity-based costing involves the creation of models of the actual costs incurred by a company at each stage of its core processes.  In fact, a cost is attached to every activity, such that the cost of executing each activity may built into the cost of producing the products or services offered by the company.  As a result, the cost contribution of each activity to the total cost incurred by the company to manufacture its goods or render its services is determined, and a better understanding of the company's cost structures is achieved.  The drawback of implementing ABC is that it requires time and resources to implement it properly.


Proponents of ABC believe that the major thrusts of a company such as continuous process improvement and simplification to boost productivity can only be attained if the real cost and time required to produce its goods and services is determined.  This will prevent indiscriminate cost-cutting measures (such as miscalculated downsizing) that may actually result in worse performance and profitability.


An activity is defined as a process, function, task, or step that occurs over time and generates results that the company uses to produce and sell its products and services. An activity consumes resources as it transforms its inputs into outputs, and therefore incurs a 'cost' every time it occurs.  Allowing an organization, or even every employee involved, to understand the cost of doing each activity gives it a better chance to perform the activity better while minimizing costs.  In fact, the cost attached to an activity may be used as a metric for organizational or personnel performance.


ABC entails the complex task of identifying discrete activities and identifying the measure of output for each of these activities. Each activity also needs to be classified as either 'value-added' or 'non-value-added.'  Value-added activities are activities that add value to the product or service that the customer is willing to pay for.  Thus, all steps required to manufacture a product or enhance its quality or reliability are value-added activities.  On the other hand, non-value-added activities are activities that do not contribute any value to the final product, and are other activities that the customer doesn't really want to pay for.  Staging of products and unnecessary inspection are examples of non-value-added activities. Non-value added activities, in general, must be eliminated if possible.


Activity-based costing consists of the following steps: 1) analysis of activities; 2) cost data gathering; 3) tracing of costs to activities; 4) establishment of output metrics; and 5) cost analysis.


The analysis of activities of a company starts with identifying which activities will be covered by the analysis. Experts recommend the analysis of at least half a dozen organizational units with a common functional orientation to start the program. The analysis of each activity includes, among other things, determining the following: 1) whether it is value-adding or non-value-adding; 2) whether it is primary or secondary; and 3) whether it is absolutely required or not (discretionary).


As discussed earlier, value-adding activities contribute something of 'value' directly to the manufacture of the products or rendering of the services sold to the customer, while non-value-adding activities do not. Primary activities directly support the company's mission while secondary activities simply support the primary activities. Required activities need to be performed all the time, while discretionary activities are those that are only performed if allowed by management.


Cost data gathering involves the determination of the costs incurred by the activities being analyzed.  These costs include salaries of the people performing the activities, material costs, equipment and furniture costs, and even R&D costs. Actual cost data are preferred but if they're unavailable, estimates based on cost formulas may be used.  


The tracing of costs to activities refers to the process of determining where the total cost of each output comes from. Every output of an organization was produced by one or more activities, each of which incurred costs when undertaken. This step aims to determine where the costs are being incurred in producing an output, by determining which activities are needed to produce that output and what costs are incurred in each of these activities.


The establishment of output metrics pertains to determining the total cost of producing an output. It consists of the calculation of the actual activity unit cost for each primary activity and the generation of the bill of activities.  The activity unit cost of an activity is the total input cost divided by the primary activity output volume.  The total input cost should include both the costs incurred by the primary activity and its associated secondary activities.  The bill of activities is the list of activities (and their corresponding consumed amounts) needed to produce the output. The total cost of the bill of activities is the sum of each activity unit cost multiplied by its corresponding activity amount consumed.  


The analysis of costs is the step wherein the activity unit costs and bills of activities are analyzed to identify areas for further improvement in the companies' business processes.  This is where non-value added activities are properly identified for elimination, resulting in better business performance and greater efficiency.


See Also:   Knowledge Management Balanced Scorecard


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