Activity Based Costing & Activity Based Management (ABC & ABM)

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Activity Based Costing & Activity Based Management (ABC & ABM)

Activity Based Management (ABM)

  • A discipline focusing on the management of activities as the route to continuously improve both the value received by customers and the profit earned by providing this value.

  • Draws on activity based costing (ABC) as a major source for data and information.

Activity Based Costing (ABC)

  • Robert Kaplan and W. Bruns defined Activity Based Costing (ABC), for the first time in 1987, in a chapter in their book Accounting and Management.

  • ABC is a method that measures the cost and performance of process related activities and cost objects.

  • Assigns cost to the activities based on their use of resources and assigns cost to cost objects such as products, services or customers based on their use of activities.

  • Promotes the effective management of costs throughout the function by focusing on the key activities that drive these costs.

What’s the Big Fun if You Don’t Make Profits

OK, you do everything to give more value for money (VFM) to customers. And to get more customers, you decide to be very price competitive. The moment you do it, your profit margins shrink if you keep the costs the same. Beyond a point the markets are also saturated. You got to turn back to “costs” to make profits.

Therefore, Need for Accuracy in Costing in Competitive Times

Price - cost = profit. Price has become more or less fixed or shows down trend. Therefore, to make more profits (ultimate aim of any organization) or just to know how much profit exactly is being made; cost should be worked out accurately. Existing conventional costing system does not achieve any one of these requirements. Activity Based Costing is the answer.

Story to Illustrate Erroneous Costing with Conventional Costing System

Four friends go to a restaurant. Each one of them orders different items to eat and drink. Obviously, each item's price is different. So, at the end of the meal, the waiter brings a common bill totaling all the items consumed by all the four. Say the bill is $108. What do they do? They divide $108 by 4 and each one gives his share of the bill i.e. $27. The question to ask is: has each one really eaten worth $27? The answer is: "No". Had you kept an account of who ate what, you could have got the exact bill for the individual accurately. Suppose, one of them kept an account of who ate what, he could calculate his share of total bill by looking at the prices of the ordered items from the menu card. So knowing this, one of them kept an account like this and he found that the four friends ate like this: first one ate worth $15, the second one worth $42, the third one $27 and fourth one $24. The total is the same but each one costs differently than the earlier (average) $27 each.

Now replace, the four friends by four products being manufactured in a company. With conventional costing system the cost of each will be $27. Selling price of each would be decided by the market trend. Therefore, we will calculate the profit or loss made by the sales of each item with reference to $27 as the cost of each one of them. However, suppose we are in a position to keep a track of exact costing of each product by using a costing system like ABC and suppose that the exact cost found by ABC happens to be $15 for first product, $42 for second product, $27 for third item and $24 for fourth items, your profit calculations now will give you an entirely different picture for each product. You will now be able to find as to which product is really making the profit or loss and exactly how much?

Now, based on this information of exact profitability and cost of each product by using ABC, management decisions on product mix, cost reduction, product design modifications, marketing/sales strategies can be taken more correctly. In absence of this information, by using the information given earlier by the conventional costing system, all these decision were being taken as "shot in the dark"- literally blindly. They were misleading.

How it “Costs”?: The Basis for ABC

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In order to provide goods and services to the customers, organizations perform various activities. Each activity performed attracts resources like man, machine, material, money, time and information. Each of these resources means money or “cost”. So, each activity expends money or it “costs”. And thus, as we keep on performing activities that ultimately form various organizational or business processes, they keep on building costs.

In conventional costing, direct labor cost and material cost are collected and then overhead cost is loaded in some manner which is not necessarily accurate. So, the costing is normally inaccurate.

In ABC, direct labor and material cost are collected and overheads are allocated based on the near-actual consumption of each item of overhead on the cost object (say, a product). So the costing is pretty accurate. So, in ABC, the overheads are also treated on the lines of direct labor and direct material cost; it's like direct overhead cost.

How the Overheads Get Allocated Accurately in ABC?

In any costing system, we always do the costing of a cost object. This cost object can be a finished or semi-finished product, a component, an activity, a process consisting of series of activities, a customer, a supplier etc.

Let us take component as a cost object and do its costing. The component consumes certain amount of certain material and labor and that can be exactly measured. So, the costing of direct material and direct labor can be done in ABC exactly in the same manner as we do in conventional costing system i.e. by multiplying total material consumed by the component by material's unit price and by multiplying total labor hours used by the component by the per hour labor rate.

Now, we have to add to this, the portion of overheads of the organization that actually got consumed by this component. In conventional costing system, it is done by loading a percentage of the total overhead cost of the organization to the component. Generally, this percentage is either the percentage of the labor cost or as the percentage of the material cost of the component as compared to the overall labor cost or overall material cost of the entire organization. In fact, there is no rationale to it since the component may not have actually attracted the overheads to it in this manner of percentages.

So, what we do in ABC is to find out the actual overhead activities performed on the component. Each overhead activity is measured in terms of its cost driver i.e. how many units of that cost driver were actually used by the component. On each overhead activity, the total cost of that overhead activity is collected at the organizational level. This is called the overhead cost pool of that activity. Also, unit cost of each activity driver is worked out by dividing the total overhead cost pool of that activity by the total units of the cost driver used at the organizational level. This gives the actual cost of per unit of the cost driver of that activity. Now, by multiplying the units of cost driver actually used by the component by this cost driver rate, we get the actual cost of that overhead activity performed on the component. The overhead cost is allocated, in this manner, to the component for all the overhead activities the component used.

In summary, in ABC, each overhead activity has a overhead cost pool at the organizational level, each overhead activity has a cost driver with its unit of measurement and each cost driver has its unit cost i.e. the cost driver cost.

Some Examples of Activity Cost Drivers

  • Supplier development- No of suppliers

  • Goods receiving- No of goods receipts

  • Material handling- No of parts or Units of kilogram-meters moved

  • Quality testing- No of test hours

  • Designing of products- No of man hours (of product designers) etc.

Activity Based Management (ABM): Use of ABC Related Data and Information

Improves Decision Making in Following Areas

  • Profitability planning

  • Budget formulation

  • Marketing thrust for the right products

  • Marketing strategies

  • Marketing, advertising and distribution expense performance evaluation

  • Product mix decisions

  • Value adding management

  • Quality cost performance evaluation

  • Business process reengineering

  • Inter-unit/interdepartmental benchmarking

  • Make or buy decision

  • Purchase process performance evaluation

  • Target costing

Characteristics of the Organizations That Should Adopt Activity Based Costing

  • High overhead costs.

  • Operating personnel with little faith in the accuracy of existing cost information.

  • A widely diverse set of operating activities.

  • A widely diverse range of products.

  • Wide variation in numbers of production runs and costly set-ups.

  • Many changes in activities over time but few corresponding changes in the accounting system.

  • Improved computer technology.

In the End, ABC/ABM is Not Just about Costs

When one embarks on setting up the ABC/ABM, the data collected to do so is of great value to operational persons and they find it very beneficial for their planning and control. Generally, you do not buy an ABC/ABM system and plug it in. It is a process and is more tangible with hard data resulting from its design. ABC/ABM is not strictly about costs. It is about resource use and consumption; how costs are traced and assigned based on cause and effect behavior and relationships with cost drivers.