What is Activity Based Costing (ABC)?
Definition: Activity based costing is a managerial accounting method that traces overhead costs to activities and then assigns them to objects. In other words, it’s a way to allocate indirect, overhead costs to products or departments that generate these costs in the production process.
Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.
Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.
What Does Activity Based Costing Mean?
What is the definition of activity-based costing? ABC costing focuses on identifying activities, or production processes, that are used to process a job. These individual activities are grouped together with similar processes into a cost pool that relates to single activity cost driver.
The cost pools are then analyzed and assigned a predetermined overhead rate that will eventually be assigned to individual jobs and products.
As you can see, this is a multi-step process, but activity-based costing is a much more accurate way of assigning indirect costs. It’s difficult to determine how much electricity or heat one department or job uses over another without some type of methodical allocation process.
Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.
Example
Activity based costing helps allocate overhead expenses to jobs and products based on the amount of the activities required to produce the product instead of simply estimating how much each job uses.
Properly assigning indirect costs is extremely important for management, especially in the case of downsizing or outsourcing. Profitable departments can be assigned too much indirect cost causing them to appear unprofitable on paper. Based an evaluation management can choice to discontinue the operations and close a profitable branch because the costs were properly distributed.
To compound the problems, once the profitable branch is closed the only remaining branches are the unprofitable ones. By shutting down the only profitable department, the company may not be able to cover its fixed costs.
The same scenario is true for outsourcing. Management may estimate outsourcing to be a cheaper option because costs have not been allocated properly. In fact, outsourcing might actually be more expensive.
Historical development
Traditionally, cost accountants had arbitrarily added a broad percentage of analysis into the indirect cost. In addition, activities include actions that are performed both by people and machine.
However, as the percentages of indirect or overhead costs rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all products. For example, one product might take more time in one expensive machine than another product—but since the amount of direct labor and materials might be the same, additional cost for use of the machine is not being recognized when the same broad ‘on-cost’ percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.
ABC is based on George Staubus’ Activity Costing and Input-Output Accounting. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.
Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently, managers were making decisions based on inaccurate data especially where there are multiple products.
Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products.
Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.
Like manufacturing industries, financial institutions have diverse products and customers, which can cause cross-product, cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers. Activity based costing, even though originally developed for manufacturing, may even be a more useful tool for doing this.
Activity-based costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century. He states that traditional cost accounting focuses on what it costs to do something, for example, to cut a screw thread; activity-based costing also records the cost of not doing, such as the cost of waiting for a needed part. Activity-based costing records the costs that traditional cost accounting does not do.
The overhead costs assigned to each activity comprise an activity cost pool.
Summary Definition
Activity Based Costing:
- ABC costing means a method of assigning overhead costs to processes or products that generate or consume the costs.
- Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services.
- The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.
- An activity is a cost driver, such as purchase orders or machine setups.
- The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of overhead and indirect costs related to a particular activity.