Activity Based Costing

Activity-Based Costing Defined: Activity-Based Costing (ABC) is a method of allocating costs to products and services. It is generally used as a tool for planning and control. It was developed as an approach to address problems associated with traditional cost management systems that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. With these deficiencies managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services.

Activity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today. However, from the 1960s - particularly 1980s - this changed rapidly. For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised.

Activity Based Costing is a cost management method. Activity Based Costing handles the overhead cost and is more accurate than Traditional Cost Accounting (TCA). 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. Activity Based Costing can support managers to see how to maximize shareholder value and improve corporate performance.

Activity Based Costing is very important to your business because you can’t compete—or even begin to compare—until you know how to cost. Activity Based Costing is a cost accounting methodology that can provide definitions of processes, identify what the cost drivers of those processes are, determine the unit costs of various products and services, and create various reports on agency components that can be utilized to generate activity- or performance-based budgets.

A major advantage of using Activity Based Costing is that it avoids or minimizes distortions in product costing that result from arbitrary allocations of indirect costs. Unlike more traditional line item budgets which can’t be tied to specific outputs, ABC generates useful information on how money is being spent, if a department is being cost-effective, and how to benchmark (or compare oneself against others) for quality improvement

Activity Based Costing encourages managers to identify what activities are value–added—those that will best accomplish a mission, deliver a service, or meet a customer demand. It improves operational efficiency and enhances decision–making through better, more meaningful cost information.

Activity Based Costing makes a lot of sense for companies with multiple products or services who are suffering from inaccurate costing information and need to know which products are really winners and which are losers. For these companies the effort required to successfully implement ABC is worth the time and resources. ABC can identify high overhead costs per unit and find ways to reduce the costs, avoid decreases in head counts due to inaccurate allocation of costs, and measure profitability with higher accuracy than traditional costing that uses direct-labor hours as the only cost driver.

There are several misconceptions about Activity Based Costing. First it is not a software package but a costing methodology that can be supported with a software package. This can improve the results by enforcing a proven discipline to the over all process. Second, many believe that ABC calculates “true” product costs and will result in better business performance. In reality ABC can provide a more accurate estimate of cost information but how it is used is still up to the manager.

For example, it is possible to impact sales and profits of an organization by identifying a more accurate price value relationship for products and services. Firms that use gross margin pricing many not be competitive in the market place because they are over charging for certain items. Conversely they may not be charging enough for other items which are utilizing scarce resources that could be reallocated to provide more profitable services that were not previously identified.