Activity Based Costing

Introduction

The need for companies to gain a competitive advantage in markets which have become more competitive over time has radically altered many businesses. ABC was developed to assist companies in focusing management attention and helping them to look at factors that drive all costs, whether they are direct or indirect.

Activity Based Costing (ABC) is a costing technique specifically designed to provide information to support decisions that affect fixed costs.  Typically, these are strategic decisions, involving significant change in the either the scale or nature of an organisation’s activities.

Rather than treating overheads as a block of cost that can be arbitrarily charged out per product or per hour, activity based costing attempts to identify what actually generates these costs. Activity-based costing takes the view that it is activities, not products or services, that create costs. Products and services can then be costed by calculating the amount of activities used.

Cost Objects

In traditional marginal and absorption costing systems costs are ultimately related back to units of product or service.  In activity-based costing cost objects, rather than cost units, are defined.  Cost objects have a broader definition than cost units and are simply something that a company wishes to cost.

Typical cost objects include:

  • Unit of product
  • Unit of service
  • Customer
  • Supplier

Using ABC for instance, it should be possible to cost maintaining a customer account, irrespective of how much they order, what it costs to maintain an account with a supplier and so on.  Costs do not just have to be assigned to outputs of product and service.  Again this provides a further useful source of information.

Stages of ABC system

There are a number of steps that organisations have to go through to establish an activity-based costing system.

  1. The first step in ABC includes identifying key activities within an organisation.
  2. The second step includes grouping cost together to relate to that activity- Which creates a cost pool.
  3. The third step includes identifying an activity measure- Which serves as a basis for allocating costs from cost pools to products, services and other cost objects.
  4. The fourth step includes charging costs out to cost objects.

The problem with ABC

Any business is potentially engaged in hundreds of different activities.

It is possible to establish an ABC system with hundred of activities and therefore hundreds of cost pools and activity measures.  Whilst this may produce highly accurate costings, it could prove very costly to set up and maintain.  Its complexity may also act as a barrier to understanding for non-accounting staff.