Activity-Based Costing - Explained
What is Activity-Based Costing?
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Table of ContentsWhat is Activity-Based Costing?How is Activity-Based Costing Used?Steps Used in Activity-Based CostingHow it works (example)Benefits of Activity-Based Costing Problems Related to Activity-Based Costing Academic Research on Activity-Based Costing (ABC)
What is Activity-Based Costing?
Activity-based costing (ABC) refers to a methodology in accounting used to assign indirect costs to products and services. This is done by identifying each activity's cost involved in the process of production. Those costs are then assigned to products based on each activity's consumption. In other words, the method assigns costs to services projects, products, acquisition, or tasks based on its activities and its resource consumption.
How is Activity-Based Costing Used?
Activity-based costing is commonly applied in the manufacturing industry. This is because most manufacturing industries rely on it to enhance its cost data. This ensures that they produce actual costs. It also enables the company to classify the cost it incurs in the production process. The costing system is used in different areas of business such as:
- Product Costing
- Target Costing
- Customer profitability analysis
- Product line profitability
- Service pricing
Generally, ABC is widely used in organizations because it helps them to develop a better business focus as well as strategy. Note that this is only possible where the costs are well understood. However, it is sometimes difficult to assign some costs using the ABC method. This is so especially where indirect costs are involved. An example of indirect costs is the salary for office staff and management.
Steps Used in Activity-Based Costing
There are several steps that one must use when working with activity-based costing. They are as follows:
- Step one: Single out activities that enhance productivity in the organization. These are activities that are involved in the process of production. In this case, they are essential as far as production is concerned.
- Step two: Create a cost pool and then put each activity into its own pool. You should then go ahead to determine each cost pools total overhead. Costs pool here refers to the specific costs related to an activity. For instance, purchasing can be in its own separate cost pool.
- Step three: In this step, each cost pool is assigned activity cost drivers. Cost drivers here include things such as hours, units, batches, and so on. For instance, activity cost drivers for purchasing can be the quantity (number) of parts purchased.
- Step four: In step four, you are required to identify the most suitable cost driver for each activity.
- Step five: In step four, you are supposed to establish the rate of the cost driver. To get this, you will take the total overhead of every cost pool and then divide it by the total cost drivers.
- Step six: Here you are expected to calculate the number of hours, units, parts, etc. used by each activity. This is then multiplied by the rate of the cost driver. This will get you the activity rate.
- Step seven: This is the last step where you are supposed to apply each activitys cost to products. This is usually based on product activity usage.
How it works (example)
Lets take your total utility bill for the year to be $20,000. Then, you find out that your utility bills cost driver is the hours used to work. Lets then assume that the hours spent on work for the year amounted to 1,000 hours. To get your rate of a cost driver, you will have to divide the total number of utility bill by the cost driver. In this case, your application rate for overhead will be $20($20,000/1,000). Finally, lets also assume that for this particular product, the utilities used 3 hours. You, therefore, need to take the cost driver rate ($20) and multiply it by the number of hours (3 x $20). This will get you $60. Uses of Activity-Based Costing ABC can be used by an organization to achieve many things. Some of the ABC uses are as listed below:
- The companies us ABC to identify and do away with those services and products that are not profitable and also reduce the prices of those which are overpriced.
- ABC is used by companies to eliminate ineffective production or services. It instead assigns its resources to those processes that help ensure better product return.
- Many businesses use ABC in their manufacturing department to help them set accurate price on their products.
- Activity-based product is used to track activities cost so that the company can determine if the activity costs correspond well with the standards of the industry.
- It helps businesses to determine the cost of creating a product.
- ABC gives the management valuable information that helps it to make strategic decisions and planning like:
- Improvement measurement initiatives
Benefits of Activity-Based Costing
Activity-based costing has the following benefits to the organization:
- It helps the organization to find out those products that are not profitable.
- It helps the management to apply appropriate product pricing. This is because product cost information being used is always accurate.
- It is used to improve efficiency in the production process.
- It helps the organization to identify those costs that are not necessary so that they can be eliminated.
Problems Related to Activity-Based Costing
There are various problems that arise when using activity-based costing. They are as follows:
- The activity-based costing is expensive to manage. This is because it involves a large number of cost pools whose cost is much higher. This means that a company that wants to use the ABC system has to pump in a lot of its resources.
- Activity-based costing system is complex to install. A company may take years to try and install the system in all of its departments. The success rate of this system is, therefore, greater in smaller companies which have fewer departments. This means that the process of installing this system in small companies requires less time and effort.
- The ABC system requires a lot of data input of data from several departments. This may affect the process, especially when the departments being targeted have their own priorities that are much greater than the ABC system. This means that they are likely to put their focus on their sector priorities more than on the ABC system.
- The activity-based system is project-oriented meaning that information is collected only once. Note that this information becomes useful to the company only in the present situation. Its usefulness, however, declines gradually with the changes in the companys operations processes.
The Bottom Line
Generally, the route that ABC follows is somehow bumpy and, therefore, it has no consistency. Organizations that use this system should be prepared to see a decline in the systems usefulness as time goes by. To manage this, the organizations should ensure that they set a higher target when developing an ABC system. This will help generate more essential information at a reasonable cost.
Academic Research on Activity-Based Costing (ABC)
- Implementing activity-based costing (ABC) in logistics, Pohlen, T. L., & La Londe, B. J. (1994). Implementing activity-based costing (ABC) in logistics. Journal of Business Logistics, 15(2), 1.
- Factors influencing activity based costing (ABC) adoption in manufacturing industry, Maelah, R., & Ibrahim, D. N. (2007). Factors influencing activity based costing (ABC) adoption in manufacturing industry. Investment Management and Financial Innovations, 4(2), 113-124. In the 1980s much criticisms were raised regarding the ability of traditional cost accounting to provide relevant, timely, and accurate information to the management. During that period, ABC has emerged as one of the management accounting tools that recognizes such concern. Since then ABC has gained its popularity and has received substantial attention from various parties including the academicians, practitioners, and industries. ABC has also been studied from various perspectives for quite some time in many countries. Literatures are enriched with studies that have argued that the adoption of ABC benefits organizations. Unfortunately, studies have also found that the level of ABC adoption is still considered low. Many organizations still use the traditional cost accounting methods in dealing with overhead costs. This study investigates the status of ABC adoption among manufacturing organizations in Malaysia, and the factors influencing its adoption. Mail survey questionnaires were distributed to manufacturing organizations throughout the country using purposive judgment sampling. The questionnaires were directed to the accountants or heads of accounts of selected manufacturing organizations. The study found that ABC adoption in Malaysia is at infancy stage, with 36% adoption rate. The factors that influence ABC adoption are decision usefulness of accounting information, organization support, and internal measures of performance.
- The design and implementation of Activity Based Costing (ABC): a South African survey, Sartorius, K., Eitzen, C., & Kamala, P. (2007). The design and implementation of Activity Based Costing (ABC): a South African survey. Meditari Accountancy Research, 15(2), 1-21. Activity Based Costing (ABC) has been researched extensively in developed countries. Research on these issues in South Africa is limited. This article creates a better understanding of the design of ABC systems in South Africa, comparing ABC implementation in South Africa to that in several developed/developing countries. A quantitative methodology was adopted to evaluate the extent of ABC implementation. A surveycase study methodology was used to identify reasons for implementation/ nonimplementation, problems and critical success factors relating to implementation. The results show that the extent of ABC implementation in South Africa is lower than that found in developed countries, but the evidence is inconclusive. Nevertheless, the results suggest that the issues facing ABC implementers in South Africa are similar to those faced in many other countries. This study provides South African companies with a comparative framework of important variables to be considered in implementing ABC.
- Activity-based costing (ABC) and the Life Insurance Industry, Adams, M. (1996). Activity-based costing (ABC) and the Life Insurance Industry. Service Industries Journal, 16(4), 511-526. This paper describes the concept of activity-based costing (ABC) and examines its relevance to the life insurance industry. The paper contends that the high overheads and diversified product lines of many life insurance companies makes them appropriate environments within which to apply ABC. It is considered that ABC can provide at least three important benefits to a life insurance company, namely: more accurate cost information, closer insights into the costs of production and better information concerning the strategic consequences of business decisions. These attributes can help a life insurance company to achieve important business objectives, such as the management of expenses and the continuous improvement in the quality of its products and services. However; the transition to ABC is not easy and it cannot be seen as a panacea for all corporate woes. Nevertheless, the paper concludes that with sound project management, an ABC system can provide life insurance companies with much better information for activity management and the achievement of longer term strategic goals.
- The ABC's of EDI: The role of activity-based costing (ABC) in determining EDI feasibility in logistics organizations, Walton, L. W. (1996). The ABC's of EDI: The role of activity-based costing (ABC) in determining EDI feasibility in logistics organizations. Transportation Journal, 43-50.
- Why Activity Based Costing (ABC) is still tagging behind the traditional costing in Malaysia?, Rasiah, D. (2011). Why Activity Based Costing (ABC) is still tagging behind the traditional costing in Malaysia?. Journal of Applied Finance & Banking, 1(1), 83-106. This study compares activity-based costing (ABC) model and traditional costing method in Malaysia. Activity based costing (ABC) which was developed into the manufacturing/service sectors in Malaysia. It calculates the cost and performance of activities, resources and cost objects. It can be considered as an alternative model to Traditional Cost-based accounting systems. In this study the results indicated that most operations managers believed that their present cost systems were adequate for decision making. In certain circumstances, operations managers evaluated their cost systems as more effective than those using other cost systems. Activity-based costing systems were evaluated as somewhat more useful, but no relevant literature was found to indicate that either the external or internal environment of the firm was correlated with the choice of cost system.
- How activity accounting works in government, Harr, D. J. (1990). Strategic Finance, 72(3), 36.
- Note on activity accounting, Aiyathurai, G., Cooper, W. W., & Sinha, K. K. (1991). Accounting Horizons, 5(4), 60.
- Activity Accounting An Update-Part 2, Romano, P. L. (1989). Strategic Finance, 70(12), 63.
- The role of actor-networks and boundary objects in management accounting change: a field study of an implementation of activity-based costing, Briers, M., & Chua, W. F. (2001).
- The role of actor-networks and boundary objects in management accounting change: a field study of an implementation of activity-based costing. Accounting, organizations and society, 26(3), 237-269.
- Towards explaining activity-based costing failure: accounting and control in a decentralized organization, Malmi, T. (1997). Management accounting research, 8(4), 459-480.
- Satisfaction with activity-based cost management implementation, McGowan, A. S., & Klammer, T. P. (1997). Journal of Management Accounting Research, 9, 217.
- The benefits of activity-based cost management to the manufacturing industry, Swenson, D. (1995). Journal of management accounting research, 7, 167.
- Activity-based systems: Measuring the costs of resource usage, Cooper, R., & Kaplan, R. S. (1992). Accounting horizons, 6(3), 1-13.
- Activity-based costing in the UK's largest companies: a comparison of 1994 and 1999 survey results, Innes, J., Mitchell, F., & Sinclair, D. (2000). Management accounting research, 11(3), 349-362.
- Activity-based costing in Ireland: Barriers to, and opportunities for, change, CLlarke, P. J., Hill, N. T., & Stevens, K. (1999). Critical perspectives on Accounting, 10(4), 443-468.
- Cost driver optimization in activity-based costing, Babad, Y. M., & Balachandran, B. V. (1993). Accounting Review, 563-575.