Activity-based costing is a method that assigns costs to the different activities involved in making a product to allocate a company’s funds equitably.
The ABC approach was first developed by Robert S. Kaplan and David P. Norton, as well as the ABC Research Group at Harvard Business School (HBS), in 1976 and introduced by Kaplan and Norton in their seminal book, “Activity-Based Costing: A Management Tool for Use in Manufacturing, Service and Consultation Industries.”
For example, a furniture manufacturer makes two types of chairs. One chair is a straight-back kitchen chair with a solid yet plain design. The other chair is an overstuffed, leather, easy chair perfect for a recreation room.
An accountant using the activity-based costing system to evaluate the costs for these two chairs would find that the easy chair requires more materials, labour hours, and equipment to manufacture than the straight-back chair. Therefore, a more significant amount of funds must be allocated toward making the overstuffed chair than the simple kitchen chair.
Practical Applications of ABC Costing
Product Pricing and Profitability Analysis
Activity-based costing allows businesses to set better pricing policies as it identifies the actual cost of manufacturing each item. By backtracking overhead expense to activities and subsequently to particular products according to their usage of such activities, ABC gives better insights to the management on what products are really profitable and what products are unprofitable.
This detailed cost transparency enables firms to realign price strategies, stop unprofitable product lines, or re-engineer products to lower their consumption of resources so that they become more profitable overall and competitively priced in the market.
Process Improvement and Cost Reduction
Activity-Based Costing acts as an effective means to uncover wasteful procedures and potential areas of cost reduction by delineating which processes spend disproportionate resources. When the manager is able to view just how much an activity costs and how often it is done on different products or services, high-cost activities are areas that they can focus improvement initiatives on.
For instance, a production firm could find that activities for quality inspections are taking extensive resources because defect rates are too high, so they take measures at earlier points in the process.
Customer Profitability Management
Activity-Based Costing reveals real profitability among various customer segments by considering the different demands that customers make on the resources of an organization. Although normal costing systems may report high-volume customers as most profitable, ABC may demonstrate that some high-maintenance customers are losing money even though they generate huge revenues since they demand a lot of support activities, tailored services, or special care. This understanding enables firms to adopt focused strategies like minimum order quantities, service charges for high-resource customers, or higher service levels for genuinely profitable customers.
Strategic Decision Making
Activity-Based Costing delivers critical information for key strategic choices like outsourcing, make-or-buy decisions, and capacity planning by providing a complete picture of the actual costs involved. In deciding whether to produce a component internally or buy it from a supplier, conventional costing may only take into account direct labor and materials, but ABC takes into account the entire spectrum of support activities and overheads that would be impacted by the choice.
This total picture of cost avails businesses the opportunity to refrain from making irrational choices based on incomplete data. ABC can help organizations make capital investment opportunities assessment more precisely, find the optimal product mix decision, and look at the impact of entering a new market or offering a new service financially.
Performance Measurement and Management
Activity-Based Costing (ABC) transforms the way organizations monitor and control performance by developing measures that capture real value-adding activities instead of artificial departmental boundaries. By establishing clear cost drivers and setting performance measures tied to these drivers, businesses can develop more meaningful systems of accountability.
For instance, instead of merely measuring cost per department, ABC enables measurement of cost per customer order fulfilled, per engineering change made, or per quality inspection conducted. This activity-based performance measurement aligns incentives with value creation, promotes cross-functional collaboration, and offers a more direct link between individual actions and organizational objectives, leading to continuous improvement across the organization.
Also Read: What are the Objectives of Target Costing?
The Benefits of Activity-Based Costing
There are several reasons why activity-based costing is preferable to traditional methods of accounting.
Proper Allocation of Funds
One of the advantages of activity-based costing is it allows a business owner to see exactly where money needs to be allocated. This method paints a clear picture of the operations of a business. ABC helps an organization to understand where all activities are creating the most value. This can also help an organization to allocate its resources to activities that generate the most value.
Cost Cutting Opportunity
Another advantage of activity-based costing is that business owners can see where they can cut costs. Perhaps this method of accounting reveals that two activities can be combined to save on expenses. Activity-based costing may show a business owner where to direct more resources to increase product quality or speed up the manufacturing process.
Improved decision-making
The ABC approach also can improve decision-making in businesses. The ABC approach is based on the principle that all costs should be accounted for regardless of who or where they are incurred.
When a business understands the exact value-added per activity, it can make more informed decisions and measure how much it gains from activity more effectively.
Also Read: Target Costing and Lifecycle Costing Explained
Limitations of ABC
ABC systems can be expensive to set up. ABC systems necessitate collaboration across the organisation, so staff members must take time away from their regular duties to help with the ABC process (e.g., to identify costly activities). It takes time to locate and keep tabs on cost drivers and assign costs to activities. In the accounting department, it takes a lot of time to assign costs to products. Not an unrealistic example for a large company, but imagine having 15 cost pools (activities), each with a predetermined overhead rate used to assign overhead costs to the company’s 80 products. Accounting expenses incurred to keep such a system running can be unreasonably expensive.
Fixed cost unitization can be deceptive. Allocating costs from activity centres to products and figuring out a product cost per unit are both parts of the product costing process. The issue with this strategy is that the overhead costs being allocated frequently include a sizable portion of fixed costs (e.g., building and machinery depreciation and supervisor salaries). Recall that fixed costs are expenses that do not change overall as an activity changes.
