What is Activity-Based Costing?
Activity-based costing (ABC) is an approach for measuring the costs of producing or delivering goods or services.
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.”
The original purpose of ABC was to increase the accuracy of manufacturing cost measurement. Activity-based costing is an accounting method that assigns costs to the different activities involved in making a product to allocate a company’s funds equitably.
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.
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Practical Applications of ABC Costing
The most prominent use of ABC is a tool for cost management. The ABC approach to cost measurement focuses on measuring all of the inputs needed to produce or deliver a product or service instead of relying solely on measuring direct labour inputs. This approach is used to more accurately measure actual costs, such as overhead and overheads, that are not directly measured by traditional cost accounting.
The ABC approach is also used as a way to measure the performance of the organization, as the ABC approach focuses on measuring all inputs needed to produce or deliver a product or service, which is a measure of the value created by an organization.
Service organizations also use the ABC approach to measure the performance of each activity and allocate resources effectively and in real time. For example, an organization may want to measure which staff member is most productive, as that individual can be moved to other tasks or activities.
Alternatively, the ABC approach may also be used to identify which staff member is the least efficient in order to reduce the burden on that individual.
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 one of 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.
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 they gain from activity more effectively.
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.