Activity Based Costing
(ABC)

Analyzing product and customer profitability. Explanation of Activity Based Costing.

Activity Based Costing (ABC) is an alternative to the traditional way of accounting. Traditionally it is assumed that high volume customers are profitable customers. A loyal customer is also a profitable customer. And profits will follow a happy customer. Studies about customer profitability have unveiled that the above ideas are not necessarily true. ABC is a costing model that identifies the cost pools, or activity centers, in an organization. It assigns costs to products and services (cost drivers), based on the number of events or transactions that are taking place in the process of providing a product or service. As a result, Activity Based Management can support managers to see how shareholder value can be maximized and how corporate performance can be improved.

 

Historically, cost accounting models related indirect costs on the basis of volume.

 

Typical benefits of Activity-Based Costing:

  • Identify the most profitable customers, products and channels.
  • Identify the least profitable customers, products and channels.
  • Determine the true contributors to- and detractors from- financial performance.
  • Accurately predict costs, profits and resources requirements associated with changes in production volumes, organizational structure and costs of resources.
  • Easily identify the root causes of poor financial performance.
  • Track costs of activities and work processes.
  • Equip managers with cost intelligence to stimulate improvements.
  • Facilitate a better Marketing Mix
  • Enhance the bargaining power with the customer.
  • Achieve better Positioning of products

With the costing now based on activities, the cost of serving a customer can be ascertained individually. Deducting the product cost and the cost to serve each customer, one can arrive at customer's profitability. This method of dealing separately with the customer costs and the product costs, enables the identification of the profitability of each customer. And Positioning the products and services accordingly.

 

Activity Based Costing - OverviewContinuous Improvement

The implementation of ABC can make the employees understand the various costs involved. This will then enable them to analyze the cost, and to identify the activities that add value and those that do not add value. Finally, based on this, improvements can be implemented and the benefits can be realized. This is a continuous improvement process in terms of analyzing the cost, to reduce or eliminate the non value added activities and to achieve an overall efficiency.

 

ABC has helped enterprises in answering the market need for better quality products at competitive prices. Analyzing the product profitability and customer profitability, the ABC method has contributed effectively for the top management's decision making process. With ABC, enterprises are able to improve their efficiency and reduce the cost without sacrificing the value for the customer. Many companies also use ABC as a basis for a balanced scorecard.

 

This has also enabled enterprises to model the impact of cost reduction and subsequently confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method for continuous improvement. With Activity Based Costing any enterprise can have a built-in competitive cost advantage, so it can continuously add value to both its stakeholders and customers.

 

The implementation of Activity Based Costing is not easy - not an ABC. Special activity based costing software can be helpful.

 

Time-Driven Activity-Based Costing

Robert Kaplan and Steven Anderson have suggested Time-Driven Activity-Based Costing. This is a new approach to avoid the difficulties associated with large-scale ABC implementation (HBR November 2004). In this revised model, managers estimate the resource demands of each transaction, product, or customer, rather than relying on time-consuming and costly employee surveys. The Time-Driven Activity-Based Costing method is simpler since it requires, for each group of resources, estimates of only two parameters. 1. What are the costs per time unit of capacity to supply resources to the business activities? (The total overhead expenditure of a department divided by the total employee time available). 2. An estimation of the unit times of activities: how much time it takes to carry out one unit of each kind of activity (as estimated or observed by the manager). This Time-Driven ABC approach also overcomes a serious technical problem associated with employee surveys: employees invariably report percentages that add up to 100, when they are asked to estimate time spent on activities. Managers should take into account time that is idle or unused. The method also supports time equations, a feature that enables the ABC model to approximate the complexity of real-world operations. By showing how specific order, customer, and activity characteristics cause variation in processing times.

 

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Recent User Comments
Najam ul Hassan - Pakistan ABC and Job Order Costing "I think activity based costing is directly related with Job Order Costing. And obviously normally it is used in Manufacturing Companies. Whenever an organization aims to get its activity achieved, it starts to increase its activity for example, units produced etc."    -2
Lakshan - New Zealand Activity based Costing with CRM and TQM "How can Activity Based Costing be used to improve a Total Quality Management program?
And how can it be used to improve CRM?"		    0
PWCoopers - England Activity Based Costing (ABC) "Company's who use ABC method have a more chance in surviving under recession rather than company's who use Traditional Based Costing."    5
 - Nigeria Mindframe for ABC "I suppose the approach should be tackled from the senior management without sentiment."    1
Manwel - Lebanon Drivers still Right? "ABC is one of the most recent developed evolution in costing. It has a big impact in allocating the cost to the right object... but still the question is: to what extent are the drivers right and effective? Does ABC require ongoing update of drivers?"    19
Best User Comments
XY - Singapore Limitations and Advantages of ABC "What are the limitations and advantages of ABC in the context of preparing plans and budgets?"    116
Jay - Singapore Limitations ABC monitoring operations "What are the limitations with regard to monitoring and controlling operations?"    78
Rudi - Switzerland Use of ABC Costing "The following is a quote from the beginning of a serious article about ABC. The article goes on to analyze and show what methods are best for decision making. "It would be better "to slaughter a farm animal and read its entrails" than to use activity based costing for decision-making.""    24
Reyn - Phil Non-value-added activities "Why do non-value activities cause costs to increase unnecessarily?"    22
Kity - Mauritius ABC: reduce non value adding activities? "How far do you agree that Activity Based Costing gives opportunities to reduce or eliminate activities that do not add value in a highly competitive environment?"    20
Sharon - Israel Question on ABC "If Activity-based Costing has been correctly implemented, and it turns out a product is causing losses, does this mean automatically that the product should be discontinued?"    18
Michelle - USA Assigning costs of resources "There are basically 4 steps in assigning production resources to end products: 1. Define Activity Groups, having a direct relation with end products 2. Determine Resource Drivers (these show the relation between production resources and activities groups) and determine Cost Drivers (show the causal relation between an activity group and a type of end product) 3. Assign the costs and resources to activities based on the Resource Drivers 4. Assign the costs of activity groups to end products based on the Cost"    17
Mark - UK Conditional Resources in ABC "How does ABC cater for estimating the cost of business processes which may take many different routes depending on the outcome of decisions or events - for instance, a resource may only be used once in every hundred runs of the process, therefore is only 1% of the resource cost included in the estimate??"    13
Amir - Iran university professor "As I did in my master thesis and I have seen over and over in CRM articles, many scolars believe that this is the best way to understand who are the profitable customers and this technique is so applicable comparing with conventional accounting or costing and it would be better to modify it with some notes to customer relationship management and customer profitability analysis."    11
Chal - Ethiopia ABC in service companies such as airlines? "ABC may be appropriate in the manufacturng company, but I doubt applying in service givng companies is worth while. Especially in the airline industry where there are various types of common costs and too much different types of activities. Hence can ABC be applicable to the service rendering company?"    10

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  ● Brandon (UK) ABC vs TBC "Activity Based Costing method is more accurate for costing of products / services, customers. It also makes wastes visible where as company's can take action. The disadvantages are it is time consuming and expensive. Overall the pros outweigh the cons, even my wife feels ABC method can be used in the bedroom to eliminate any wastes and taking time (time consuming) is better."

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  ● PWCoopers (England) ABC "Activity Based Costing is a great method when money and time is available, otherwise TBC is most usable method. However in current situation, the recession factor, ABC is more useful since it gives the long term aspect and potential of business."

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  ● Maggie (China) Activity Based Costing Limitation "Cost drivers are not easy to define and obtain."

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  ● KTK (India) ABC limitations and benefits "This is a very good query. When we look at ABC for the estimation of plans/budgets, the major limitation is not having a proper estimation of the costs for some critical activities such as R&D. The second limitation in using ABC for plans/budgets is a result of the first, i.e. when we miss out proper estimation of the costs for one activity that results in breakdown in the whole chain of activities. Though there are many advantages, by which we can always overcome the limitations, I would like to mention the following two: Adv 1: When we carry out planning/budgeting based on ABC we can always have more accurate estimations being done. Adv 2: We can always figure-out where our estimations went wrong, since we know what each activity contributed in our planning/budgeting. ABC is the basis for Zero Based Budgeting(ZBB) and ZBB has yielded good results in many big organizations."
  ● Rajendra (India) ABC Limitations "KTK,XY the use of ABC for planning and budgeting is supposed to be for the activities that are related to the volume of the products sold. For other parts the planning and the budgeting should be based on the projects that are to be taken in that function. Like in R&D function."
  ● neelam chand (Fiji) Accounting "very beneficial site"

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  ● Grace (Singapore) Limitations ABC monitoring Operations "ABC is the basis for the control of the efficiency of processes or activities being performed, by signalling a number of key measures of performances which should be monitored if costs and the business generally are to be controlled."

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  ● Shabs (Oman) Uses of Activity Based Costing "What are the uses and usefulnes of Activity Based Costing (ABC)?"
  ● VIJI (INDIA) ABC "You get slaughtered any way"

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  ● Joseph (Philippines) Non-value Adding Activities "The more non-value adding activities you do, the more costs you will incur. Since your activities are not adding any value, this cost increase is unnecessary."

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  ● Youri (UK) Identifying Value in Activities "You need to look more towards VSM if you want to identify value in activities. ABC even if it is time based is no more then creating an insight in where costs are derived."
  ● Kooshraj (Mauritius) Value added output of ABC "Indeed ABC, will enable any organisatin to have a better view of all processes and procedures which enables the following: - Streamlining of processes - Identification of expensive cost drivers -"

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  ● vijay (india) activity based costing "The product should not be discontinued. To produce that particular product (in spite of loss) could be a strategic decision. For example, you get order for say 5 products which includes the 'loss making' product. The order says you supply all or nothing. Now, if the order, taking in to account all 5 products, is profitable then it makes sense to produce and supply the 'loss making' product. Same logic can be extended to a profitable customer also. In order to retain him and earn profit on sales to him at the end of the year, you might have to sell the 'loss making' product along with other profitable products."
  ● Jake (USA) Loss-making products "Agree with Vijay: there can be strategic or other valid reasons to continue the product, even if a correct ABC analysis shows it is causing losses. Of course we should investigate if there are other (more profitable) ways to manufacture the product or to keep the customer."
  ● Simon (Australia) Loss-making products "Firstly one should never make the fatal mistake and discontinue unprofitable products and customers without thorough investigation. There are valid reasons, why one should continue unprofitable products some mentioned above:
1. All products, even unprofitable ones absorbe fixed costs. Even if such a product was discontinued, these fixed costs would remain within the business and depending on the fixed vs variable cost split to supply this product, overall profit could suffer.
2. It is a strategic "loss-leader" product that is sold in combination with profitable products.
Once one has determined that an unprofitable product needs to be continued the following profit optimising steps should follow:
1. Assess if a price increase is possible to make the product more profitable.
2. Investigate if the product can be sold in bulk to reduce transaction costs. 3. Investigate if the product can be manufactured / sourced at lower costs."
  ● Kostadin Nedyalkov Krastev (Bulgaria) Analysis "Conversion costs are constraining the product mix. Product and customer sustaining activities can be reorganized to make a better branding. Customer repetitive actions on the profitable products,v95% of the costs for the unprofitable products must come from the unit and batch costs,vthen the goal must be minimizing the direct batch costs(making combinations with other products or buying some components), other decision maybe to make relationships with suppliers who can supply the product and making a minimum margin on the product. You all must always minimize all fixed or semi-fixed costs or I would say also constrained variable resources on the less profitable or unprofitable products and try to redistribute them to the profitable ones. You may set goals - if the trend is that for example in 70-80% or more of the orders in which the unprofitable product is bought and this product is 10-15 % or less of the order price, you have good margins."

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  ● Charles (UK) Conditional Resources "Most ABC/M models are built using real transactional or operational metrics extracted from the business OLTP systems as the basis for assignment. So if the data indicates that the resource was used 99% of the time for process A, and only 1% for process B, the model should reflect this."

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  ● Scott (USA) ABC in Service companies such as airlines "Actually, ABC works quite well for allocating costs to airlines. I've built a model that does exactly that, using a few basic activity drivers, that results in allocating an airline's cost to each seat in its route. I'm sure that ABC works well in other service industries as well."
  ● lil (Canada) How? "i wonder if company such as airport can use ABC?"
  ●  (India) Implementation of ABC "Is there anybody who have implemented the ABC in manufacturing industry. I'm having some doubts in this regard. Bye. Datta"

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