Understanding Activity Based Costing

Introduction:
Activity Based Costing (ABC) is an accounting technique that allows an
organization to determine the actual cost associated with each product and
service produced by the organization without regard to the organizational
structure. It is developed to provide more-accurate ways of assigning the costs of
indirect and support resources to activities, business processes, products,
services, and customers. 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. The goal of ABC is not
to allocate common costs to products. The goal 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.
Concept of Activity-Based-Costing:
An organization performs activities to do its business. These activities define the
kind of business you are in: a ship owner has an activity to unpack boats; an
accounting firm prepares tax returns; a manufacturer produces products; a
council delivers services; a university teaches students. All activities consume
resources. It is the consumption of these resources that adds to overhead costs.
The basis of Activity Based Costing is: look at the activities required to produce
the cost of the product or service. The activities consume resources and the cost
of these can be calculated. The amount of activity required for each product and
service is determined, hence the real cost can be determined.
What's what in ABC?

The activity is the work that is done.

The resource is what the activity uses to do the work e.g. people, equipment,
and services. Resources cost money.
The cost of the activity depends on the quantity of resources used to accomplish
the activity.
The cost driver for an activity is the factor that influences the amount of the
resources that will be consumed by this activity.
Example: the activity is delivering goods. The costs of this activity include the
truck drivers' wages, fuel, depreciation of the truck, insurance, etc. The
quantities of the resources that will be consumed by this activity are influenced
by the number of deliveries made per year. Hence the cost driver could be the
number of deliveries. A cost driver is designed to allocate the delivery activity
cost pool to the cost objects.

(Note: The software has the facility to enter and change the cost drivers as
better information becomes available).

The activity driver measures how much of the activity is used by the cost object.
Example: Product A is delivered once a month, whereas product B is delivered
once a week. Products A and B require a different number of deliveries, hence
the cost of the delivery activity should be assigned to each product on the basis
of the number of deliveries each uses.
The cost object is whatever it is you wish to cost. It could be a product, service,
process, job or customer.
While traditional costing arbitrarily allocates overhead costs, ABC traces
overhead costs by looking at the activities that each product and service calls
upon. With ABC the products consume the activities. It is the activities that cost
money.
If there were no activities, no resources would be consumed. It is the
activities that you do that define your business.
Why use Activity-Based-Costing?
Activity-Based-Costing is necessary for the following reasons.
* Understand TRUE profitability of your customers, products, or services
* Quantify the cost of non-value added activities such as errors and reworks
* Identify opportunities to reduce costs and/or increase efficiency
* Obtain actionable information to negotiate price increases for unprofitable
clients
* Understand why profitability may be mediocre despite good strategic
fundamentals
* Stratify overhead costs so they can be managed more effectively
How Does ABC Work?
The first stage in an initial ABC study is to develop a fundamental understanding
of the Resources (expenditures) and Activities (work performed) of an
organization. The Resources are then mapped to the Activities, thereby
quantifying the cost of performing each of these Activities. These costs are
traced to Cost Objects (customers, products, or services) providing tremendous
insight into where an organization is making and losing money.
ABC Model:

The objective of an ABC implementation is to relate all of the costs of doing

business to products, services, or customers. Developing the initial model
consists of the following five steps:
1. Identify the Resources (expenditures) of an organization
2. Determine Activities (work performed) that are supported by Resources
3. Define Cost Objects (products, services, customers)
4. Develop Resource Drivers to link Resources to Activities
5. Develop Cost Drivers to link Activities to Cost Objects
Conclusion:
Today, companies are using ABC/M to make better-informed decisions about
pricing, what type of customers to pursue, and what products or services to offer.
Activity-Based Costing determines the TRUE COST & PROFITABILITY of customers,
products, and/or services. While traditional accounting may provide your
business with an accurate sense of the direct costs of your products or services,
indirect costs are often less accurately applied. Overhead, such as customer
support or marketing costs tend to be allocated based on arbitrary factors.
Activity-Based Costing measures the costs and profits of an organization based
on the activities performed within that organization. By focusing on processes
that contribute to revenues and business operations, ABC can accurately
determine how each process relates back to specific products, customers, or
services. This can make a big difference after considering warehouse, sales,
customer service, administration and other costs that are often applied at a
standard rate, if at all. With ABC you can drill into profitability and performance
by almost any factor you can think of.