Activity Based Costing

Activity Based Costing is not a new concept, and many organizations have struggled with it in the past. Activity Based Costing was primarily used by the manufacturing industry to monitor and reduce costs. Activity Based Costing has had a mixed reputation with many connecting the term with overly complex calculations and laborious manual measurements of time, units and other operational measures.

With the advent of improvements in technology during the 1980’s most notably MS Excel & MS Access, multiple different Activity Based Costing methodologies came about as planners looked to utilise the powers of computers. As they did they quickly became bogged down in the detail and found that the models which were built were laborious, unrepeatable and some times outside the capabilities of early hardware and software.

Today with the advent of high performance processors and best of breed Activity Based Costing software such as Metify and Performance Optimisation, Activity Based Costing has started to gain momentum.

For example the concepts of Activity Based Costing are used today in modern business for:

1. Profitability Modelling (or EBIT Modelling)

Profitability modelling is based on exactly the same principles as Activity Based Costing; the only difference is that revenue and costs are allocated to customers, segments, products, suppliers and distribution channels, instead of activities. Profitability Modelling aims to understand the individual contribution to profit (EBIT) by customers, products, channels, suppliers etc and is widely used in Wholesale, Distribution, FMCG, Banking, Insurance, Wealth Management and Manufacturing. Focus 8020 is a widely adapted form of profitability modelling.

2. Performance Management

Performance management is the study of rates and units over time. Activity based costing allocations are used to come up with the cost or unit pools which are measured over time. Performance Management forms the basis of KPI’s in financial, government, sales and marketing businesses.

3. Predictive Modelling

Predictive Modelling starts by developing an Activity Based Costing baseline. The baseline typically depicts a recent period in time. The baseline model is then fed “what if” style questions. Examples could include:

i) What happens to the businesses cost structure if we sell 20% more product B

ii) What happens to the overall profitability of the business if we close the Wollongong sales branch.

The model will then produce a calculation based on the baseline model and the changes in variables to come up with an answer to these “What If” questions.

4. Predictive Budgeting

Predictive or Activity Based Budgeting is based on feeding predicted volumes into an established Activity Based Costing Model. The model has in built smarts to know that if the volume of outputs increases by 20%, then the volume of related activities will increase which will then in turn create variances to the baseline General Ledger.

5. Targeted Pricing

Targeted Pricing is can be performed utilising Cost to Serve knowledge. Cost to Serve is calculated via an Activity Based Costing Model and is the amount of costs (expenses) which go into servicing a customer account or product line. Targeted pricing uses Cost to Serve numbers for customers and products to establish an effective price.

E.g. Customer A is a regional customer who orders many times a day in small quantities and demands free delivery. The Cost to Serve on Customer A may be 32% (of Sales Revenue) and the average may be 21% across the business. Targeted pricing would increase the price to Customer A so that an effective Net Margin (Profit) can be made on this customer.

In conclusion the theory of Activity Based Costing is well and truly alive in modern business. It is used in many industries and is a key management tool.

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