Activity Based Costing
The stakes are high when it comes to cost accounting. That’s because the activities we choose to measure define our understanding of overhead and cost allocation. And that ultimately shapes our operating and financial performance. So, because costing is critical to our performance as whole enterprises, and as organizations within, it is essential that we explore different methods for achieving cost transparency (e.g., activity based costing). Again, what and how we measure affects our investment decisions and our performance. So gaining greater insight and control is indeed fundamental.
Let’s dive in. One of the prevalent Costing models for manufacturing and government is Activity Based Costing, or ABC. This method gained popularity in the 1980s, a time when production had become sufficiently complex that cost-center managers were looking for better ways to contain overhead. First, they had to identify the true sources of overhead. They looked beyond just machine time and started focusing on the multiple indirect costs from production activities such as setup, procurement, handling, rent, depreciation, and home-office salaries.
Let’s back up a minute. In traditional cost accounting, we allocate a fixed percentage to all products, service lines, or segments for indirect costs. A fixed percent? The problem with this method is inaccuracy: our per-unit calculation of overhead reflects neither the time nor the resource intensity of the product assembly.
That’s why most companies these days use some form of ABC methodology or Responsibility Accounting for internal management reporting, budgeting, and forecasting – and sometimes for measuring the performance of departments, managers, or divisions.
Often, this means pooling costs and then cascading them to cost centers and Strategic Business Units (SBUs) through sometimes complex allocation spreadsheet models. Cost allocations are done for any one of the following reasons:
- Fully Loaded P&L statements by Customer, Product, or Segment
- Activity Based Costing (ABC)
- Managerial Cost Accounting
- Performance Measurement or Bonus Payout
In an activity based costing process, we assign manufacturing costs (both direct and indirect) to the individual activities driving the overhead. There’s one additional step. After we identify our true manufacturing overhead– we allocate costs to the manufacturing processes that demand the activities causing the overhead. This identification, accumulation, measurement, analysis, interpretation, and reporting of cost information is useful both to internal and external stakeholders. It enables greater transparency of how resources are consumed, and what drives the cost or price of a good or service.
The picture below offers an activity-based costing view of how both direct and indirect costs are allocated based on consumption. This is the total cost to produce and serve ice cream. All of these activities have associated costs that add up to the true total cost.
ABC 101 Example
Let’s say our company produces two products: Product A and product B. They are both produced by the same type of machine. Product A is a low volume, highly customized product that requires substantial engineering time, testing, and machine setups. Product B is quite the opposite, high volume, continuously running, but with very few options and therefore very few stoppages or special configurations. The machine that produces product A runs only a small percentage of each day, but is constantly being updated for new specifications for each run.
Now, if we look at the costs to run each machine in traditional cost accounting, which uses “machine hours” to allocate overhead costs, Product A will look great because it won’t have much overhead cost assigned to it due to the fact that the machine has not run much. On the other hand, Product B’s machine is running continuously, and ends up bearing the vast majority of overhead cost allocation, at least when traditional cost accounting methods are used. And it gets worse. Hidden in the costs are all of the special activities that Product A required, thus distorting the “true” cost picture.
When we look at this product’s cost picture through the lens of Activity Based Costing, we see a completely different view. Machine hours are assigned overhead costs in a more logical manner; through the multiple activities involved in creating the product, end to end.
These special activities we described (engineering, testing, set-up) are not accounted for in traditional accounting. But they are with Activity-Based Costing, reveals the “true” cost of a discrete manufacturing process. Each cost driver is identified, accounted for, and measured, from inception to final delivery.
Product A, through Activity Based Costing, would see a completely different allocation of costs (increase), that would be 100% aligned to the resources consumed; while Product B would see a similar allocation change, just a decrease in costs. This proper cost allocation of the total cost of production is imperative for organizations to determine where to invest, where to scale back and overall performance and economic health.
While Manufacturers and Governments have been a long time users of Activity Based Costing; it is actually growing in popularity given the rise of Integrated Business Planning platforms. Now, with platforms like Vanguard’s Forecast Server, organizations are able to extend the linkage of strategic and performance goals to costs. Shared services, such as IT, have widely adopted Activity Based Costing and organizations have created “price lists” for these shared services. When organizations improve cost transparency and insight into cost drivers; they can measure costs more effectively and improve financial performance through better decision making in pricing, cost control, quality improvement, and forecasting.
In summary, Activity Based Costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. It increases understanding of overheads and cost drivers; and makes costly and non-value adding activities more visible. This allows managers to reduce or eliminate low-value activities and reduce overhead. It also enables improved product and customer profitability analysis. It supports performance management techniques such as continuous improvement and scorecards, all of which are supported by Vanguard Forecast Server.