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.

Continuous 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.

Activity Based Costing Forum (28)

An ABC Initiative is Only as Effective as the Software That Supports It
"For any change initiative or performance improvement initiative that is taken in an organization, it is always important that the goal of the initiative has to be finalized first. This is true for Activity Based Costing (ABC) initiative also. While finalizing this goal or objective, the organization should consider the requirement and target outcome of each functional group of the organization. Any conflicts that arise should be resolved against the common objective of the organization. During this part, there has to be management’s buy-in for the initiative as well as the objectives.
Whatever is the method used for this, the primary objective of the organizations for implementing ABC is to provide the various functions in the organizations better and more relevant information to help them take business decisions. For this it is not necessary to have good participation but it is also important that the software that is going to be used is supporting the overall and individual objectives as well as the expected outcome. Fortunately today’s software solutions have come a long way and are able to support this requirement. We will see here the requirements from a software solution to complete the ABC initiative successfully.
Features of the software solution
ABM modeling
- Multidimensional Modeling - Dimensions are nothing but different aspects (attributes) of an object. For example a person can be differentiated as sex, color, height, hair, eyes etc. These are various dimensions with which we can analyze people. Similarly in an ABC assignment we need to know the costs or profitability of Products, Customers, Channels etc. We can further segment the customers by Age, Geography, Use of products etc. The expenses in the Resource group can be grouped by Region, Department and GL group. These are various examples of dimensions in an ABC model. The software solutions today are equipped with dimensional modeling. This type of modeling helps us to analyze results better. For example, we can view product profitability by customer, Channel profitability by product or product profitability by customer segment.
- Multiple periods and scenarios – The ABM model should contain data for various periods. These periods could be various months or quarters etc. The ABM software can create hierarchy for the period. For example, Year-Quarter-Month. This hierarchy can be used in the OLAP reporting, where the results from various periods can be compared and variance can be reported. This hierarchy also helps to roll the data up from month to quarter to year and we can see the year-to-date data also.
Scenario is used to manage the variation in the data within a period. Scenarios could ‘Actual’ and ‘Budgeted’. Once the data is entered we can compare the like ‘Q1 2010 – Actual’ data with ‘Q1 2010 – Budgeted’ data and also find the variance. Here it is not only the variance in the expenses that are generally covered in the expense budget, but we can compare the Activity usage variance or resource usage variance, apart from the expense variance. Scenarios can also be used to create various ‘what-if’ scenarios for the future.
- Cost flow – In ABC model the cost flows from resources to activities and then to cost objects. The ABC model creates the linkage between the ‘Source’ and the ‘Destination’. This linking is called as Assignment. The assignment can be done between two entities within same module (Resource, Activity, Cost Object) or between two different modules. The model can also perform ‘Reciprocating Assignments’. For example the assignment where HR provides services to IT and IT also provides services to HR. The other important component of the cost flow is the ‘Driver’. Driver defines the logic with which the cost should be as well as the amount of the cost to be flown to each destination point.
In this example ‘Salary & Wages’ is the source and the ‘Activity’ is the destination. ‘# of Hours’ is the driver name. 90, 20, 40 is the driver quantity for each activity. The driver name helps us to create the logic to collect the driver data. But the actual cost flows based on the driver quantity. The driver can be a simple one to enter the numbers or it can have the facility to create mathematical expression to calculate the driver quantity.
- Attributes – Attributes help us to group the costs within Resource, Activity or Cost Object. Some examples of attribute are ‘Fixed_Variable’, ‘Value Add_Non Value Add’. With the Fixed_Variable attribute, we can get cost of products or activities grouped into fixed cost and variable cost. Similarly with Value add_Non Value Add, we can get cost of serving customers and within that the quanta of non Value add activities. The use of attributes helps us to analyze the data that leads us to root-cause analysis.
Data Integration with source systems
This is one of the most important features of the ABC software solution. The ABC software solutions provide the facility to enter the data interactively, but it would be a time consuming activity for a real life model. The ABC software provides the facility to bring the data from various sources like GL, CRM or any other software solutions. There is some data like # of hours, which not every organization collects electronically. This type of data is collected using small web based solution. All this information is collected in a set of structured tables and called as ‘Staging tables’. From these tables the data can be pulled into the ABC software. There are various ETL (extract-Transfer-Load) tools that are available in the market and can be used for this purpose.
Reporting
The ABC model should be created to provide the appropriate information for taking the business decisions. This is achieved using various reporting techniques. ABC Software has various reporting techniques. First of all, it provides the facility of analyzing data interactively using the GUI (Graphical User Interface). Here we can see how the costs are flowing. The other way of analyzing is using the report templates. The most important is the OLAP analysis. In this the software creates a ‘cube’ using the dimensions that are created in the model and we can create various views depending upon the analysis we want to perform. The views are very similar to the ‘Pivot tables’ that the spread sheet software does. We can select multiple dimensions like Product v/s Customer, Customer v/s Activities etc. I have explained here with two dimensions only for simplicity, but we can as many dimensions as we wish. For example we can analyze the data for Product v/s Customer v/s Channel. The most important requirement before OLAP analysis is that we should have a question in our mind; otherwise we see only numbers in the pivot table that may not make any sense to us.
Data export to other solutions
In the earlier stages the ABC software solutions were desktop solutions. They were used by a single person. After that they became ‘enterprise-wide’, where multiple users create and analyze the model simultaneously. This is now moving onto the SaaS style application. Whatever is the type but it has to have the facility to export the data as the output from the ABC model is useful for various other solutions like CRM. The BI solution is based on a large warehouse where data from various sources some and then transferred to other solutions. Again the staging table can store the calculated data from the ABC model and we can use any ETL tool to export it from the staging tables.
At last the most important part is the actual decisions to be taken and implemented within the organization. ABC is like a thermometer, it can tell us the temperature. We have to analyze the data and take proper action. The change management is very important to implement the action plans."

Calculating the Most Profitable Way of Manufacturing a Product
"Dear all, I am struggling with the start of a project in which I need to figure out what way of supplying a customer with a certain product is most profitable (from buying raw materials till delivering to the customer)...
We manufacture it and I got the BOM, but what do I need to do next to find the most profitable way and to decide upon make or buy?"

Traditional Costing versus Activity Based Costing
"When should I choose the traditional costing instead of ABC?
Compared with traditional costing, what are the drawbacks of ABC?"

ABC in an Advertising Firm?
"How can ABC be applied in an advertising firm where activities vary per project, depending on the client, its marketing campaign, its objectives, and their budget?"

Capacity Minutes and Industry Norms
"Productivity levels in minutes - productive time
Work days are about 480 minutes (8 x 60). Where could I find what the industry norms are? Are there examples that show the average for the industry to be for example 60% capacity (288 minutes) or other and what is the norm?"

ABC Helps Companies Survive Recession
"Companies using ABC costing have a better chance of surviving the recession than companies using traditional methods. Please give your comments."

Overhead Costing - Food Manufacturing
"The company I work for manufactures food. The company is small. How much overhead should I count into my costing?
I do not want to put too much in so I don't overcharge the customers when I price them."

Recommended ABC Software
"Which software package would you recommend I use in our small business to enable me to setup an ABC-system?"

ABC in the Federal Environment
"Does anybody have experience implementing ABC in the federal environment? There are obviously a lot of differences, but the same benefits can be reaped from determining the costs of performing certain activities. Thanks."

Time-driven ABC (TDABC)
"Is anyone using TDABC as a substitute for traditional activity-based costing? I would love to discuss how it's working, implementation tactics, etc."

Fixes for ABC Shortcomings
"How can ABC shortcomings be effectively addressed?"

Activity Based Costing Implementation
"How can a company implement activity based costing?"

ABC and Decision making
"Are managers able to make better decisions through the analysis of indirect cost allocation?"

Activity Based Management (ABM)
"What is the modern term or second name for Activity Based Costing?"

Organizational Aspects of ABC
"What organisational/behavioural problems can arise when ABC is introduced?"

ABC + Over/under recovery
"I want to know: Do you calculate an over/under recovery for each activity or do you calculate one singe over/under recovery for the company??"

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."

Drivers still Right?
"ABC is one of the most recent developed evolutions 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?"

ABC Costing in Make to Order of Repetive Manufacturing
"I think ABC costing works better only in repetitive manufacturing type of industry, where the amount of production in a given period is steady.
Whereas in a make to order environment ABC may not work well, because the profit and expenditure have to be tracked by order. One order may last for several perods."

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?"

The Process of Activity Based Costing (ABC) simplified
"While doing ABC the only thing to be kept in mind is the activity and the cost associated with it.
For example : A businessman buys a bus for using it in his public transport business. So he will analyse the cost associated with procurement of bus. Then he will have to analyse the cost of getting a driver, everyday fuel consumption, maintainance, contingencies. Now by using ABC, he can eliminate all the unnecessary steps which add to the cost but don't add any (enough) value to the product.
ABC is a helpful tool if you have clarity of ABC and the process under observation."

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??"

Degree of Detail in ABC
"When planning to build an ABC model it is essential to first make the decision what level of detail ABC is to be captured. This depends on what questions are to be answered:
1. Strategic (about 100-150 Activities). This is the most common application and is used to deliver customer and product profitability and visibility where the costs are incurred.
2. Operational (500+ Activities). At this level, individual tasks are captured and these models are commonly used for process improvement."

Limitations ABC monitoring operations
"What are the limitations with regard to monitoring and controlling operations?"

Limitations and Advantages of ABC for Budgeting
"What are the limitations and advantages of ABC in the context of preparing plans and budgets?"

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?"

The Cost of Non-value-added Activities
"Why do non-value activities cause costs to increase unnecessarily?"

Consequences of ABC Analysis
"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?"

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