Activity Based Costing (ABC): A Neglected Management Tool
The manufacturing industry uses activity-based costing (ABC) as a tool for assigning costs to products. The ABC method has its place in the accounting world, but it’s a tool that is neglected because it is misunderstood.
This is not to say that the ABC method is able to be applied to every cost, but it can be effective in specific sectors.
The Process Activity Based Costing
Activity-Based Costing is considered an alternative accounting method. Accountants will apply this method by assigning costs to a product or service in correlation to the actual resources that they consume. Traditional accounting methods will include indirect costs of creating a product, for example. Lighting that is needed during production in a warehouse is normally calculated as direct costs utilizing traditional accounting methods.
By calculating these costs as direct costs, accounting gets more complex and often erroneous due to miscalculations.
It’s best to look at an example to fully understand how indirect assigning of costs can result in losses for businesses.
- The Widget Company produces blue widgets utilizing customized equipment.
- The company switches to an industrial equipment not tailored to their business.
Since the industrial equipment has not been catered to the business’s exact manufacturing process, engineers are required to spend more time managing this equipment. And, the equipment uses far more energy than the previous model.
As a result, more overhead would be incurred due to a loss in manpower.
If the company was to use historic overhead data to price their products, you’ll soon find that they're making less profit per unit as a result. The company may even be losing money on the product.
Introducing the ABC Model
The biggest issue that businesses face when implementing the ABC method is that it’s a complex matter. Initially, you’ll have to spend time and resources to break down all of the activities in a product's creation cycle.
The more complex a product’s creation cycle is, the more time it take to implement an ABC model.
Let’s look at an example of how a product may be broken down into different activities:
- Purchasing may be broken down into:
- Negotiating with suppliers
- Handling customer complaints
- Updating database entries
- Sending and receiving purchasing orders
And, this is just information that is needed for the purchasing breakdown. When you dive into other areas, you’ll often find that some of the information needed is not readily available, resulting in more time spent breaking down these costs.
With a larger firm or organization, it’s best to approach the implementation of ABC using a pilot scheme. New measurements may need to be added, and hiring consultants that specialize in the area will allow organizations to begin the implementation of the ABC model faster and with fewer resources lost in the process.
An approach that is very popular is to utilize ABC software in conjunction with the accounting system that is already in place. This allows for easy integration of activity based costing that flows seamlessly into a business's operation. The idea is that the ABC method will be secondary and used when cost information is required by management to make purchasing decisions or managerial decisions.
Traditional ways of allocating costs become very complex with larger operations. This method was first introduced in the 1980s, but it quickly stagnated in the 90s. Many accountants found it cumbersome to translate this accounting method into action according to Robert Kaplan, the Harvard professor that is credited with creating ABC.
How Effective ABC Can Be For Big Business
Instructing the business to change their methods of accounting is a difficult chore for every accountant. You need to be able to demonstrate that an accounting method will allow seamless integration and overall benefits to a business.
But, changing accounting methods doesn’t always produce immediate impacts for a business. This is where case studies and past examples will allow an accountant to demonstrate how effective the ABC method of accounting can be in certain circumstances.
One example of the ABC method being used in big business is the use of the method by Chrysler, a major auto manufacturer.
The company originally implemented the ABC method in the early 1990s. When this method was fully implemented, the company determined that particular parts used in their automotive operations were far more costly than estimated by the company.
Chrysler discovered that many of the parts they used had a true cost that was 30 times higher than their original estimated cost. Ultimately, the company saved hundreds of millions of dollars due to activity-based costing. While the savings of most businesses may not be this impressive, they are substantial for smaller businesses that are attempting to boost profitability without adding extensive overhead in the process.
Chrysler would eventually outsource these costly parts to allow the company to cut back on operational costs.
Objectives of ABC
The objectives of the ABC model are as follows:
- Identify and eliminate unprofitable products and services.
- Identify and eliminate processes of products or services that are ineffective and unprofitable.
ABC is typically utilized as a tool for a better understanding of product and customer costs. When used in business, this method is often implemented to support strategic decisions within an organization. Pricing, outsourcing and improvement initiatives are just a few of the areas where ABC excels.
Cost allocation is the focus of ABC, allowing segregation of:
- Fixed costs
- Variable costs
- Overhead costs
Since labor and material costs are rather easy to allocate to a particular product or service, ABC is traditionally used with indirect costs to products that go overlooked by management. This is what is called the cost driver. When a person walks in to a bank, the activity that the bank teller conducts can be measured to determine the cost driver. This is done by measuring how long a particular product transaction takes for a teller to complete.
When looking in the manufacturing sector, cost driver may be operational hours of machines. These costs would include labor, energy costs and maintenance that machines need to operate.