Activity-Based Costing Systems (ABC)

Activity-Based Costing Systems

ABC = Activity-Based Costing
ABM = Activity-Based Management

Primary underlying concept of ABC is that activities cause costs to be incurred.

Therefore, the primary focus of ABM is to manage (control) costs by managing activities.

Please note that in its simplest form, ABC is an acceptable method for assigning/allocating manufacturing costs to products for purposes of valuing inventory under absorption costing. ABM often applies ABC techniques beyond manufacturing costs. In such cases the resulting information can and is used for decision-making purposes, but it CAN NOT be used for inventory valuation in accordance with GAAP.

ABC versus Traditional Costing

"Activity causes costs to be incurred."
Traditional costing uses broad cost drivers that do not reflect cause and effect.
1 hour of activity A has different costs than 1 hour of activity B

Accordingly, under traditional costing, cost targets (products, jobs, customers) involving complex (costly) activity tend to be under-costed while products involving simple (less costly) activities tend to be over-costed. (Recall the illustration and discussion of departmental vrs. Plant-wide burden rates.)
ABC, therefore, assigns costs to cost targets based on the specific activity that is used for a particular cost target.

ABC Methodology

• Step 1: Identify and classify the activities related to the company’s products

Alternative methods for identifying activities
Top-Down – Senior Management identifies what is done
Participative Approach – the “doers” identify what is done
Recycling Approach – using what is already documented
Time/Motion studies – outside consultants observe what is done
Classification of Activities
Value Added versus Non-Value Added Activities (JIT Processing)

Unit Level
Batch Level Note that as we move away from
Product-level unit level we begin to take in
Customer Level non-manufacturing costs
Facility Level

• Step 2: Determine the Estimated Cost of each Activity identified in step 1.

This step assigns/allocates total costs incurred during a particular observation period to the activities incurred during that observation period.

• Step 3: Calculate a Cost-Driver Rate for the Activity

Total cost of activity (from step 2)
Divided by the number of Cost Driver occurrences
Equals the cost per occurrence or Cost-Drive Rate

• Step 4: Assign Activity Costs to Cost Targets (jobs, products, customers)

Actual number of activity occurrences
Times the Cost Driver Rate (from step 3)
Equals Assigned (Traceable) Costs
Note that in this step the “costing systems” requires input (actual activities & target) and has an output, assigned or traceable cost of cost target.

ABC Output – ABM Decision Making Tools

Product and Customer Profitability
Revenues
Less Traceable Costs
Excess Revenues over Traceable Costs
Less Untraceable Costs (Total Costs less Traceable Costs)
Operating Income

Departmental Efficiency

Actual Costs Incurred versus Traceable Costs Assigned
If Traceable > Actual, department was efficient
If Traceable < Actual, department was inefficient

Activity Based Costing – Pro’s & Con’s

• Pro’s

Identifies Non-Value Added Activities
Identifies cost savings opportunities (untraceable costs)
Provides very detailed cost/profitability information
Differentiates complex versus simple processes
More data can lead to more information = better decisions

• Con’s

Very costly to implement and maintain
Historical in nature (same as traditional absorption costing)
Detail versus Accuracy (GIGO)
Discourages novel approach’s to processes
Encourages activity
Assumes equal and proportionate benefits result from common activity