What is Activity Based Costing?
Introduction to Activity Based Costing
In the modern business world, we are “blessed” with more management information than ever before. But how much of that information is really valuable or even useful? How much of the information that lands on our desks or arrives in our email in-boxes actually helps us to make decisions that will improve our organizations?
We dedicate a huge amount of work to supplying management teams with data, but how many decision makers can answer the following questions about their organization?
• Which customers are the most profitable?
• Which products are the least profitable?
• Which are our best and worst sales or distribution channels?
• How much of our activity is wasted?
• Which activities can be reduced or eliminated without loss of service?
Many managers think they know the answers to these questions, and will be prepared to offer a view based on gut instinct. But this instinctive view is frequently based on very little qualitative information. Activity based costing (ABC) can provide answers to these questions in a way that managers can understand, and which is supported by a methodology that is fair and justifiable.
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Basic Activity Based Costing Principles
ABC is often assumed to be complex, and consequently may seem rather impenetrable. This is something of a misconception, though. Although the various allocations of cost can be hard to unravel this is usually handled by software tools, while the methodology itself actually stems from a few basic principles, which are really just common sense.
Principle 1: Activities consume resources.
The more an activity is performed, the more resources will be consumed by it.
Principle 2: Activities have a cause.
All activities are performed for a reason or cause. In the most efficient organizations, activities are mainly attributable to external objects – customers, products or distribution channels. Usually, though, some activities will have an internal cause. For instance, internal support activities, such as those carried out in Personnel or IT functions, are generally caused by demand from other departments.
Principle 3: Customers, products, or channels cause different levels of activity.
Traditional costing methods, such as standard or absorption costing, allocate base costs directly to products, customers or distribution channels. These methods ignore the principle that resources are actually consumed by activities, and not by the products, customers and channels. Activity-Based Costing allocates costs to customers, products and channels in line with the proportion of activities they actually consume.
This paper uses a number of terms commonly used in ABC. Please refer to
Figure 1 for an explanation of these terms.
In Figure 2, the shaded boxes illustrate how some of the resource costs are allocated to activities. The costs associated with each activity can then be apportioned to customers and products based on what proportion of the appropriate driver volumes that they use.
For some activities, defining a sensible causal link to customers and products is not obvious, or may indeed not be a sensible thing to do at all. For example, most of the activities carried out by an organization’s CEO would probably not be attributable to particular products or customers. The right hand branch of Figure 2 shows non-specific costs which cannot be attributed to an activity and have no relationship with customers or products. Expenditure on corporate image, for example, would fall into this category.
Sometimes there will be resources that are directly attributable to products, customers or channels, but for which it makes little sense to attribute to activities. For instance, the cost of advertising space for a particular product can obviously be attributed directly to that product, and would not be associated with any particular activity. The left hand branch of Figure 2 shows costs that cannot be attributed to an activity.
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