Activity Based Costing (ABC)

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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.


Special Interest Group - Activity Based Costing


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Forum - Activity Based Costing  

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  Limitations ABC monitoring operations (1 reactions)
What are the limitations with regard to monitoring and contr...
 
 
 
 
  ABC in an Advertising Firm? (4 reactions)
How can ABC be applied in an advertising firm where activiti...
 
 
 
 
  ABC: reduce non value adding activities? (2 reactions)
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  ABC Helps Companies Survive Recession (1 reactions)
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  Comparison Activity Based Costing, Time-Driven-ABC and Lean Accounting
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  Over Recovery / Under Recovery Level (1 reactions)
I want to know: Do you calculate an over/under recovery for ...
 
 
 
 
  What is Process Costing? (1 reactions)
In cost accounting systems, what is process costing?...
 
 
 
 
  ABC Costing in Make to Order of Repetive Manufacturing (1 reactions)
I think ABC costing works better only in repetitive manuf...
 
 
 
 
  Organizational Issues when Introducing ABC
What kind of organizational / behavioral problems can we exp...
 
 
 
 
  ABC in the Federal Environment (1 reactions)
Does anybody have experience implementing ABC in the federal...
 
 
 
 
  An ABC Initiative is Only as Effective as the Software That Supports It
For any change initiative or performance improvement initiat...
 
 
 
 
  What is Job Order Costing? (1 reactions)
In cost accounting systems, what is job order costing?...
 
 
 
 
  How to Derive Overhead Cost from a P&L?
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Best Practices - Activity Based Costing

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  Limitations and Advantages of ABC for Budgeting (3 reactions)
What are the limitations and advantages of ABC in the contex...
 
 
 
 
  The Cost of Non-value-added Activities (3 reactions)
Why do non-value activities cause costs to increase unnecess...
 
 
 
 
  Consequences of ABC Analysis (4 reactions)
If Activity-based Costing has been correctly implemented, an...
 
 
 
 
  Capacity Minutes and Industry Norms (4 reactions)
Productivity levels in minutes - productive time Work days ...
 
 
 
 
  Drivers still Right? (3 reactions)
ABC is one of the most recent developed evolutions in costin...
 
 
 
 
  Traditional Costing versus Activity Based Costing (4 reactions)
When should I choose the traditional costing instead of ABC?...
 
 
 
 
  Recommended ABC Software (8 reactions)
Which software package would you recommend I use in our smal...
 
 
 
 

Expert Tips - Activity Based Costing

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Compare with ABC: Enterprise Architecture  |  Total Cost of Ownership  |  Balanced Scorecard  |  Kaizen  |  Marketing Mix  |  Business Intelligence  |  Performance Management  |  CSFs and KPIs  |  Beyond Budgeting


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