Activity Based Costing

There are two main reasons why managers undertake ABC/M projects; explicitly to save costs – or more generally to provide support for decision making at both the strategic and operational level.

Initiatives to save costs may be variously described as downsizing, right-sizing, business process review, re-engineering, process improvement, shared services or a host of other titles. Regardless of their title, the objective is to ensure that the enterprise has a resource base that is efficient and cost-effective.

These projects may be short-lived with the purpose of achieving a step change in costs – or may be ongoing providing costing information to drive continual improvements across the enterprise. But an increasing number of enterprises are deploying ABC/M to reliably identify true end-to-end product, customer or channel profitability. Using the ABC/M information, such enterprises are able to make informed commercial decisions such as:

- Pricing their products and services more accurately

− Identifying the most profitable groups of customers to be the focus of future CRM activity

− Identifying how to price sales coming from e-commerce against regular business

− Providing detailed costing information as the basis for negotiating discounts with key accounts

Where the information generated by ABC/M is made available to front line managers to support their business decisions, it is common for them to quickly appreciate the value of the insight that it provides, acting more confidently and driving the enterprise to ever-higher levels of competitiveness. No matter what drove the initiative in the first place, it is clear that well thought out ABC/M initiatives can have a major impact on the key financial drivers of maximizing sales, increasing margins and optimizing investments, all of which impact shareholder value.

ABC methodology has been around since early 1980s, but it’s only relatively

recently that it has begun to gain acceptance. This recent enthusiasm for the

methodology is largely because the make-up of the cost base has changed over

the last 30 years or so.

Over the last 30 years there has been a proportionate decline in direct costs and

an increase in overheads (notably technology, sales, marketing and other

support costs). At the same time the creation of products, whether traditional

manufactured products or individual services, has become more and more

sophisticated. The importance of customer-service functions has also increased,

with a commensurate cost increase in those areas, as companies seek to

maintain a competitive edge.

As a result of all this change, overheads form a much more significant part of

corporate expenditure and it is perhaps not surprising that ABC has been

adopted as a more robust way of allocating cost.

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Tags: Activity Based Costing, Importance of 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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Tags: Activity Based Costing, Activity based Costing Introduction, activity based management

This post contains a step-by-step illustration of a very simple ABC modeling exercise, which illustrates many of the aspects of the methodology. We will be using a credit control function as our example, for three main reasons:

• 1. Most organizations operate such a function, so it should be reasonably familiar;

• 2. Credit control is often the responsibility of an accountant;

• 3. Most managers know that this function’s costs are caused by sales activity, although they are not always in a position to make the connection between the costs and specific customers.

Our starting assumptions are as follows:

1. Property costs have already been charged to credit control on the basis of space occupied.

2. The cost and number of calls can be identified from the telephone system.

3. There are six members of staff, all of whom work full-time.

The following tables contain the base data that we will use in the calculation

From Figure 3b, you will see that we have identified 5 activities. First of all, we need to calculate the cost of each of these activities.

A simple assumption might be that the total cost of the resources is $140,000 and should, therefore, be allocated to all the activities. On this simplistic basis, the cost of print & mail invoices, for instance, would be $7,000 (140,000 x 30% ÷ 600%).

This assumption isn’t necessarily a good one, though. It’s fine for the staff costs, and arguably for the property costs, where we might take the view that the staff occupy the space in something like equal proportions, and therefore all activities should bear a proportion of the cost related to time spent on each related activity. However, this approach allocates telephone cost to each of the five activities when in fact only two activities, “chase customers on telephone” and “issue credit notes” would actually consume those costs.

A more realistic solution would have telephone costs allocated to only those two activities.

Obtaining driver volumes for this split would probably require the staff to estimate the proportion of calls associated with each of the two activities, because it’s unlikely that this proportion would have been captured historically (though the organization might want to start collecting this data from now on). Suppose that the split has been estimated at 75%/25%, so that 5,625 minutes are spent on the phone carrying out the “chase customers on telephone” activity, and 1,875 minutes are spent on the activity “issue credit notes”.

So now we have the staff costs and property costs (total cost $125,000) to be allocated across all five activities according to time spent, and the telephone costs ($15,000) to be allocated across just two activities in the ratio of 75/25.

On this basis activity costs would be as follows.

The next stage is to allocate activity costs to customers and products. We’ll take the activity “chase customers on telephone” as an example.

We need to decide what activity driver to use. In other words, what is the most direct cause of the activity? Possible candidates might be the number of overdue invoices, or the number of overdue accounts.

The latter assumes that each overdue account receives the same length of telephone call, while the former assumes that the number of overdue invoices lengthens the call proportionately. Furthermore, in practice neither driver may be easily available and a “best fit” driver, such as the average value of overdue accounts, might need to be used.

Figure 5 (above) shows activity driver volumes for customers A, B and C. Since any relationship between late paid invoices and the products being invoiced would be unlikely, there is no breakdown by product.

Using the number of late paid invoices as the activity driver for the activity “chase customers on telephone”, we would calculate the following customer costs:

Traditional costing methodology might allocate $10,694 to each customer ($32,083 ÷ 3). However ABC gives us a fairer result. The larger proportion of the activity cost is incurred by customer B who is a slow payer. Customer C, who pays promptly by direct credit, and is the cause of none of this activity, is attributed with none of the cost. ABC highlights that Customer B is costing our organization more than our other customers, and this knowledge allows management to take appropriate action, whether that be working with Customer B to improve his payment schedule or compensating in some other way.

Now let us examine the activity “issue credit notes”. We shall assume that each credit note is issued as a result of a customer return, so a suitable activity driver would be “number of return notes”. (The number of credit notes might be an alternative choice, but we want to drive the costs to products, and the returns data by product is more easily available. This kind of consideration is made a lot in real-world ABC implementations.)

The driver volumes for the “number of return notes” driver are shown in Figure 7.

Note: “Number of return notes” is referred to as a multi-dimensional cost driver, because there is a real relationship between the driver and more than one cost object dimension – in this case customer and product.

The allocation of costs with a multi-dimensional driver is shown in Figure 8 below.

Depending on the activity, as you can see, costs can be allocated to different combinations of cost object dimensions. Some activities will be allocated to just products, with no customer- or channel-based element. Others may be allocated to just customers or just channels. Some may be allocated to products and customers and channels. Some may be allocated to products and customers, but not to channels, and so on. Basically, the important thing is to determine what drives the cost of each activity, and then to select an appropriate cost driver. Remember that a fundamental consideration is that the data should be available from some source within the organization!

Vitally, the whole ABC approach focuses on the way resources are consumed rather than the traditional financial presentation of the way resources are spent.

It is this that permits ABC to be used to manage costs.

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Tags: Activity Based Costing Example, Activity Based Costing Worked Example, Activity Based Management Example

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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