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Ruhul amin
Tanvir Ahmed
Mofazzal Hossain
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Activity Based Costing
ACTIVITY-BASED COSTING
(ABC)
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Activity Based Costing
CONTENTS
PARTICULARS PAGE
LIST OF ILLUSTRATIONS
…………………………………………………………………………4
SUMMARY ……………………………………………………………………………………………5
INTRODUCTION ……………………………………………………………………………………6
HISTORICAL DEVELOPMENT…………………………………………………………………………6
METHODOLOGY……………………………………………………………………………………7
ACTIVITY-BASED MANAGEMENT………………………………………………………………………11
CONTINUOUS IMPROVEMENT………………………………………………………………… 19
CONCLUSIONS ……………………………………………………………………………… 20
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Activity Based Costing
ADDENDUM ……………………………………………………………………………………21
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Activity Based Costing
LIST OF ILLUSTRATIONS
FIGURE PAGE
TABLE
SUMMARY
Activity-based costing (ABC) is a technique to more accurately assign the indirect and direct
resources of an organization to the activities performed based on consumption. In the first stage,
resource costs are assigned to activities based on the amount of resources consumed in performing the
activity. In the second stage, activity costs are traced to the products, services, or customers based on
how frequently the activity is performed in support of these cost objects. This paper examines the best
practices that have emerged in the ABC implementation domain.
ABC analysis provides the information necessary to make business decisions such as determining if
investments in efficiency initiatives, such as just in time (JIT), are warranted. When implementing
ABC, management should use proven project management methodology to minimize the risk of
failure. ABC is an effective total quality management tool, and supports just-in-time manufacturing
methods in several companies as detailed in the paper.
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Activity Based Costing
INTRODUCTION
In this way an organization can precisely estimate the cost of its individual products and
services for the purposes of identifying and eliminating those which are unprofitable and
lowering the prices of those which are overpriced.
HISTORICAL DEVELOPMENT
The concepts of ABC were developed in the manufacturing sector of the United States during
the 1970s and 1980s. During this time, the Consortium for Advanced Management-
International, now known simply as CAM-I provided a formative role for studying and
formalizing the principles that have become more formally known as Activity-Based Costing.
Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to
these concepts in a number of articles published in Harvard Business Review beginning in
1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional
cost management systems. These traditional costing systems are often unable to determine
accurately the actual costs of production and of the costs of related services. Consequently
managers were making decisions based on inaccurate data especially where there are multiple
products.
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Activity Based Costing
Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause
and affect relationships to objectively assign costs. Once costs of the activities have been
identified, the cost of each activity is attributed to each product to the extent that the product
uses the activity. In this way ABC often identifies areas of high overhead costs per unit and
so directs attention to finding ways to reduce the costs or to charge more for costly products.
Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Burns as
a chapter in their book Accounting and Management: A Field Study Perspective. They
initially focused on manufacturing industry where increasing technology and productivity
improvements have reduced the relative proportion of the direct costs of labor and materials,
but have increased relative proportion of indirect costs. For example, increased automation
has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect
cost.
Like manufacturing industries, financial institutions also have diverse products and customers
which can cause cross-product cross-customer subsidies. Since personnel expenses represent
the largest single component of non-interest expense in financial institutions, these costs must
also be attributed more accurately to products and customers. Activity based costing, even
though originally developed for manufacturing, may even be a more useful tool for doing
this.
METHODOLOGY
d. Cost driver: Cost Drivers are the structural causes of the cost of an activity
performed in the Value Chain. They determine the behavior of costs within an
activity.
A cost driver can be completely or partly or not at all under the control of a firm.
A firm's cost performance in all of its major discrete activities adds up to establish its
relative cost position.
2. Learning and Spillovers. The cost of a value activity often declines over time due to
learning or improvements that increase its efficiency. Or due to knowledge acquired
from suppliers, consultants, former employees or reverse engineering.
4. Linkages. The cost of many value activities is affected by how other activities are
performed within the firm's own value chain or with the value chain of a supplier or a
channel ("Vertical Linkages"). Through combining these activities and their linkages,
their total cost can be reduced.
8. Discretionary Policies. The strategic choices a firm make, for example being a self-
service internet bank or being the fastest courier company.
9. Location. Geographic location where an activity is conducted and the prevailing costs
of personnel, materials, energy, etc.
e. Cost driver rate: cost driver in a system of activity-based costing, any factor such as
number of units, number of transactions, or duration of transactions that drives the
costs arising from a particular activity. When such factors can be clearly identified
and measured.
Direct labor and materials are relatively easy to trace directly to products, but it is more
difficult to directly allocate indirect costs to products. Where products use common resources
differently, some sort of weighting is needed in the cost allocation process. The measure of
the use of a shared activity by each of the products is known as the cost driver. For example,
the cost of the activity of bank tellers can be ascribed to each product by measuring how long
each product's transactions takes at the counter and then by measuring the number of each
type of transaction.
So what is really the difference between ABC and traditional cost accounting methods?
Despite the enormous difference in performance, there are three major differences:
This is discussed in more detail in the subsequent sections and illustrated below.
But first, the direction of the arrows are different because ABC brings detailed information
from the processes up to assess costs and manage capacity on many levels whereas traditional
cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost
objects without considering any 'cause and effect' relations.
Figure:
Difference between ABC & Traditional Costing
Hence, we see that the traditional usage of fixed and variable costs is totally meaningless. In
ABC, all costs are included. However, ABC employs a different usage and definition of fixed
and variable costs. A fixed activity cost is a cost that exists due to the very existence of the
activity whereas a variable activity cost changes as the output of the activity changes. This
distinction is very helpful in various improvement efforts.
ACTIVITY-BASED MANAGEMENT
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Activity Based Costing
It is a one-off exercise which measures the cost and performance of activities, resources and
the objects which consume them in order to generate more accurate and meaningful
information for decision-making. ABM draws on ABC to provide management reporting and
decision making. ABM supports business excellence by providing information to facilitate
long-term strategic decisions about such things as product mix and sourcing. It allows
product designers to understand the impact of different designs on cost and flexibility and
then to modify their designs accordingly.
ABM also supports the quest for continuous improvement by allowing management to gain
new insights into activity performance by focusing attention on the sources of demand for
activities and by permitting management to create behavioral incentives to improve one or
more aspects of the business.
ABC and ABM are a continuum of value. ABM is the application of ABC data to
manage product portfolios and business processes better.
Determine the true contributors to- and detractors from- financial performance.
Accurately predict costs, profits and resources requirements associated with changes
in production volumes, organizational structure and costs of resources.
With the costing now based on activities, the cost of serving a customer can be ascertained
individually. Deducting the product cost and the cost to serve each customer, one can arrive
at customer's profitability. This method of dealing separately with the customer costs and the
product costs enables the identification of the profitability of each customer and Positioning
the products and services accordingly.
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Activity Based Costing
Even in activity-based costing, some overhead costs are difficult to assign to products and
customers, such as the chief executive's salary. These costs are termed 'business sustaining'
and are not assigned to products and customers because there is no meaningful method. This
lump of unallocated overhead costs must nevertheless be met by contributions from each of
the products, but it is not as large as the overhead costs before ABC is employed.
Although some may argue that costs untraceable to activities should be "arbitrarily allocated"
to products, it is important to realize that the only purpose of ABC is to provide information
to management. Therefore, there is no reason to assign any cost in an arbitrary manner.
To get a better understanding of how an ABC estimate is developed, assume that it has been
asked to prepare a cost estimate for a site evaluation. To verify that there is no contamination
at the site, subsurface soil samples will have to be collected. The area of the site is known,
and the guideline for the number of samples per unit area has also been given.
Overhead % Total
Customer
70% $ 392000
Orders
Customer
10% 56000
Complaints
Credit Checks 20% 112000
Total $ 560000
Activity Cost
Activity Cost
Activity % Assigned Cost Driver
Driver Rate
Quantity
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Activity Based Costing
Handle orders 70% $392,000 9,800 $ 40/order
Process
10% 56,000 280 $200/complaint
complaints
$224/credit
Check credit 20% 112,000 500
check
Total 100% $ 560,000
The project team then uses the calculated activity cost driver rates to assign the expenses of
the three activities to individual customers based on the number of orders handled,
complaints processed, and credit checks performed for each customer.
MATHEMATICAL ILLUSTRATION
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Activity Based Costing
Returning to the numerical example, suppose that the analyst obtains estimates of the
following average unit times for the three customer-related activities:
We can now simply calculate the activity cost driver rate for the three activities:
$ 32
Handle customer order 40
$176
Process customer complaint 220
$200
Perform credit check 250
Table: Calculate Activity Cost Driver Rates
These rates are lower than those estimated before. The reason for this discrepancy
becomes obvious when we calculate the cost of performing these activities during the
recent quarter.
The report at the end of the period is both simple and informative:
The report reveals the estimated time spent on the three activities, as well as the
resource costs required to handle the activity demands. It also highlights the difference
between capacity supplied (both quantity and cost) and the capacity used. Managers can
review the $85,120 cost of the 106,400 minutes (1,773 hours) of unused capacity and
contemplate actions to reduce the supply of resources and the associated expense.
Rather than reduce currently unused capacity, managers may choose to reserve that capacity
for future growth. As managers contemplate new product introductions, expansion into new
markets, or just increases in product and customer demand, they can forecast how much of
the increased business can be handled by existing capacity, and where capacity shortages are
likely to arise that will require additional spending to handle the increased demands. For
example, the vice president of operations at Lewis-Goetz, a hose and belt fabricator based in
Pittsburgh, saw that one of his plants was operating at only 27% of capacity. Rather than
attempt to downsize the plant, he decided to maintain the capacity for a large contract he
expected to win later that year.
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Activity Based Costing
CONTINUOUS IMPROVEMENT
The implementation of ABC can make the employees understand the various costs involved.
This will then enable them to analyze the cost, and to identify the activities that add value and
those that do not add value. Finally, based on this, improvements can be implemented and the
benefits can be realized. This is a continuous improvement process in terms of analyzing the
cost, to reduce or eliminate the non-value added activities and to achieve an overall
efficiency.
ABC has helped enterprises in answering the market need for better quality products at
competitive prices. Analyzing the product profitability and customer profitability, the ABC
method has contributed effectively for the top management's decision making process. With
ABC, enterprises are able to improve their efficiency and reduce the cost without sacrificing
the value for the customer. Many companies also use ABC as a basis for a balanced
scorecard.
This has also enabled enterprises to model the impact of cost reduction and subsequently
confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method
for continuous improvement. With Activity Based Costing any enterprise can have a built-in
competitive cost advantage, so it can continuously add value to both its stakeholders and
customers.
The implementation of Activity Based Costing is not easy - not an ABC. Special activity
based costing software can be helpful.
CONCLUSION
Over the past 15 years, activity-based costing has enabled managers to see that not all revenue is
good revenue, and not all customers are profitable customers. Unfortunately, the difficulties of
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Activity Based Costing
implementing and maintaining traditional ABC systems have prevented activity-based cost
systems from being an effective, timely, and up-to-date management tool. The time-driven ABC
approach has overcome these difficulties. It offers managers a methodology that has the
following positive features:
These characteristics enable activity-based costing to move from a complex, expensive financial
systems implementation to becoming a tool that provides meaningful and actionable data, quickly
and inexpensively, to managers.
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Activity Based Costing
BIBLIOGRAPHY
Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective
(Harvard Business School Press, 1987).
Sapp, Richard, David Crawford and Steven Rebishcke, Journal of Bank Cost and
Management Accounting (Volume 3, Number 2), 1990, Journal of Bank Cost and
Management Accounting (Volume 4, Number 1), 1991.
Police Service National ABC Model Manual of Guidance Version 2.3 June 2007.
Sir Ronnie Flanagan, The Review of Policing Final Report, February 2008.
DR jake, mitchell; alan price (2003). Economics: Principles in action. Upper Saddle River,
New Jersey 07458: Pearson Prentice Hall.
Innes, J and Mitchell, F (1995), Activity-based costing in the UK's largest companies: a
survey, CIMA.
Innes J, and Norris, G (1997), The use of activity-based information: a managerial
perspective, CIMA.
‘Activity-based management’, Management Accounting Issues Paper 10, SMAC, 1995.