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Activity-Based Costing

The definition of Activity-Based Costing: a means of attempting to accurately apply costs of running a business to a specific product or service. It entails identifying the ‘cost drivers’, or the things that drive the consumption of shared resources, and using them to apply a logical proportion of overhead costs to specific products.

In traditional costing methods, overhead may be applied by a broad brushstroke. All overhead costs may be applied, for example, at the same ratio as the ratio of direct labor costs. The danger of this method is that one product may, in effect, subsidize another product that uses resources in a different manner. In some cases, this may simply skew the understanding of how much profit each product contributed. In other cases, the incorrect allocation of costs may actually make an unprofitable product group appear profitable.

As an example, one product may use a significant footprint (floor space) of a factory, yet have a relatively low number of direct labor employees building the product. As a result, the applied overhead may be charged at a much lower rate than it should be (using traditional methods). In effect, the product would be getting free rent, electricity, etc., making its cost structure appear better than it really is. (Activity-Based Costing would account for the specific drivers that add cost.)

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Obviously, the danger is that this incorrect understanding of the nature of the company’s profitability may drive poor decisions. For example, managers may focus on growing an unprofitable product line, or use faulty assumptions for a capital equipment purchase.

Having a good understanding of costs is critical to properly applying limited continuous improvement resources. If you don’t know where the trouble spots are, how can you eliminate them?

OK, you’re sold, right? Not so fast. There is a down-side. It is much harder to manage. First of all, the cost drivers have to be identified, then quantified, and then applied. And, of course, as your process improves, the floorspace goes down. So, the cost drivers have to be managed. And the reported information has to be reconciled so it comes out correctly (i.e. the floorspace has to add up to the size of the facility).

Managers may also end up arguing over who used the aisle way more, or what cost drivers should be used to divvy up a call center. It gets even murkier when there is not a clear dividing line for costs. It may be hard to apply the costs of awareness building advertising to a specific product line. For example, how are the costs of an ad for a car manufacturer applied if the ad features several cars in it? The point: there’s extra cost in managing more costs.

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2 Comments

  • Bill Clark says:

    Activity-based costing is not, nor will it ever be, the “be-all, end-all” in a managerial cost accountant’s bag of tricks. There is no “one-size-fits-all” system that can answer all of management’s questions regarding product, channel, or customer profitability. ABC is, simply put, an accounting tool. And like any other tool, it has its advantages and disadvantages, its plusses and minuses, its successes and failures, its costs and savings.

    What is management trying to accomplish? Where do they want the business to be in five, seven, ten years? How can we identify potential cost savings opportunities? Which customers are the most profitable? Which customers should we terminate? How can we better price the many products offered? Can an activity be outsourced or returned in-house? These questions are the starting point for any cost accounting methodology.

    First, let me confess that I am an Activity-Based Costing practitioner with over twenty-five years experience bringing ABC solutions to business problems and issues. I have used ABC, or some modified form of ABC, to help management solve everything from start-up costs and profitability, to automated underwriting fees, to product outsourcing, to segment reporting for SEC registration, to government aviation repair costs. It is my preferred managerial cost accounting methodology; it brings clarity to product, customer and channel costing that is simply unavailable from standard general ledger reporting and analytics.

    And while this pains me to say it, the truth is… you can’t bring ABC to every business problem. Yes, it is a unique and effective costing methodology that can answer many questions. Still, there are often other ways to solve for the same business issue, and we do the customer no service by implementing a full-blown ABC model when a simple spreadsheet would get at the same answer. A good managerial cost accountant should have a bag full of tricks: rapid proto-types, time-driven ABC, lean accounting, earned value, and yes, Activity-Based Costing. “Peanut Butter” spreading of overhead defeats the purpose of implementing a cost accounting tool and is really no better than past methodologies that spread overhead costs based on labor hours and/or headcount and contribute to many, if not most, of the incorrect business decisions you noted.

    It’s valid to note that any successful ABC implementation starts with the end in mind. Our choice of tool should resolve a business issue quickly, coherently, and repeatedly. Should a manufacturing organization have only one or two products, then ABC is probably a worthless solution and should not be implemented. If there are several products and many complexities, then ABC will bring some clarity to the economic situation. It’s the ABC consultant or internal management team who must understand the company’s requirements and tailor a managerial accounting solution to fit those needs. And yes, sometimes that answer is not ABC, but… sometimes it is.

    • Jeff Hajek says:

      Hi Bill,
      Thanks for sharing your thoughts. Every business decision has alternatives and pros and cons. That said, from my experience, you can always find a reason not to do something. I also find people think their experience is far more unique than it actually is.
      Truth be told, though, I am not an accountant, so I don’t know the nuances of accounting methods. I do recall, though, a comment an instructor in one of my MBA classes said though. Something like “an accountant would rather be precisely wrong than imprecisely right.” I suspect a big part of the rationale against ABC accounting is that it relies on a lot of assumptions and competing data collection methods by managers, adding uncertainty.
      Again, thanks for contributing your thoughts.
      Jeff

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