Activity Based Costing

An alternative to absorption costing is activity based costing (ABC).

ABC involves the identification of the factors (drivers) which cause the costs of an organisation’s major activities. Support overheads are charged to products on the basis of their usage of an activity.

− For costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours).

− Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders received.

Reasons for the development of ABC

The traditional cost accumulation system of absorption costing was developed in a time when most organisations produced only a narrow range of products (so that products underwent similar operations and consumed similar proportions of overheads). And overhead costs were only a very small fraction of total costs, direct labour and direct material costs accounting for the largest proportion of the costs. The benefits of more accurate systems for overhead allocation would probably have been relatively small. In addition, information processing costs were high.

In recent years, however, there has been a dramatic fall in the costs of processing information. And, with the advent of advanced manufacturing technology (AMT) and in a production environment which uses machines such as computer controlled equipment (lathes, drilling machines and hoists etc.) and computers in general, direct labour may account for as little as 5% of a product’s cost. It therefore now appears difficult to justify the use of direct labour or direct material as the basis for absorbing overheads or to believe that errors made in attributing overheads will not be significant.

Many resources are used in non-volume related support activities, (which have increased due to AMT) such as setting-up, production scheduling, inspection and data processing, not to mention finance, marketing and personnel departments etc. These support activities assist the efficient manufacture of a wide range of products and are not, in general, affected by changes in production volume. They tend to vary in the long term according to the range and complexity of the products manufactured rather than the volume of output.

The wider the range and the more complex the products, the more support services will be required. Consider, for example, factory X which produces 10,000 units of one product, the Alpha, and factory Y which produces 1,000 units each of ten slightly different versions of the Alpha. Support activity costs in the factory Y are likely to be a lot higher than in factory X but the factories produce an identical number of units. For example, factory X will only need to set-up once whereas Factory Y will have to set-up the production run at least ten times for the ten different products. Factory Y will therefore incur more set-up costs for the same volume of production.

Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products (which cause relatively little diversity and hence use fewer support services) and too small a proportion of overheads to low volume products (which cause greater diversity and therefore use more support services). Activity based costing (ABC) attempts to overcome this problem.

Definition of ABC

Activity based costing (ABC) involves the identification of the factors which cause the costs of an organisation’s major activities. Support overheads are charged to products on the basis of their usage of the factor causing the overheads.

The major ideas behind activity based costing are as follows.

Activities cause costs. Activities include ordering, materials handling, machining, assembly, production scheduling and despatching.
Producing products creates demand for the activities.
Costs are assigned to a product on the basis of the product’s consumption of the activities.

Outline of an ABC system

An ABC system operates as follows.

Step 1 Identify an organisation’s major activities.

Step 2 Identify the factors which determine the size of the costs of an activity/cause the costs of an activity. These are known as cost drivers.

A cost driver is a factor which causes a change in the cost of an activity.

Look at the following examples.

Costs	Possible cost driver
Ordering costs	Number of orders
Materials handling costs	Number of production runs
Production scheduling costs	Number of production runs
Despatching costs	Number of despatches

Step 3 Collect the costs associated with each cost driver into what are known as cost pools.

Step 4 Charge costs to products on the basis of their usage of the activity. A product’s usage of an activity is measured by the number of the activity’s cost driver it generates.

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ABSORPTION COSTING VERSUS ABC

The following example illustrates the point that traditional cost accounting techniques result in a misleading and inequitable division of costs between low-volume and high-volume products, and that ABC can provide a more meaningful allocation of costs.

The figures suggest that the traditional volume-based absorption costing system is flawed.

It under-allocates overhead costs to low-volume products (here, W and X) and over-allocates overheads to higher-volume products (here Z in particular).

It under-allocates overhead costs to smaller-sized products (here W and Y with just one hour of work needed per unit) and over allocates overheads to larger products (here X and particularly Z).

ABC versus traditional costing methods

Both traditional absorption costing and ABC systems adopt the two stage allocation process.

Allocation of overheads

ABC establishes separate cost pools for support activities such as despatching. As the costs of these activities are assigned directly to products through cost driver rates, reapportionment of service department costs is avoided.

Absorption of overheads

The principal difference between the two systems is the way in which overheads are absorbed into products.

Absorption costing most commonly uses two absorption bases (labour hours and/or machine hours) to charge overheads to products.

ABC uses many cost drivers as absorption bases (eg number of orders or despatches).

Absorption rates under ABC should therefore be more closely linked to the causes of overhead costs.

Cost drivers

The principal idea of ABC is to focus attention on what causes costs to increase, i.e. the cost drivers.

The costs that vary with production volume, such as power costs, should be traced to products using production volume-related cost drivers, such as direct labour hours or direct machine hours.

Overheads which do not vary with output but with some other activity should be traced to products using transaction-based cost drivers, such as number of production runs and number of orders received.

Traditional costing systems allow overheads to be related to products in rather more arbitrary ways producing, it is claimed, less accurate product costs.

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MERITS AND CRITICISMS OF ABC

ABC has both advantages and disadvantages, and tends to be more widely used by larger organisations and the service sector.

As you will have discovered when you attempted the question above, there is nothing difficult about ABC. Once the necessary information has been obtained it is similar to traditional absorption costing. This simplicity is part of its appeal. Further merits of ABC are as follows.

The complexity of manufacturing has increased, with wider product ranges, shorter product life cycles and more complex production processes. ABC recognises this complexity with its multiple cost drivers.
In a more competitive environment, companies must be able to assess product profitability realistically. ABC facilitates a good understanding of what drives overhead costs.
In modern manufacturing systems, overhead functions include a lot of non-factory-floor activities such as product design, quality control, production planning and customer services. ABC is concerned with all overhead costs and so it takes management accounting beyond its ‘traditional’ factory floor boundaries.
ABC is particularly useful for service industries where an individual member of staff may be involved in transactions which concern different “product” or service lines each day e.g. a bank teller who may receive cash to deposit, deal with a credit card, or sell an insurance policy.

Criticisms of ABC

It has been suggested by critics that activity based costing has some serious flaws.

Some measure of (arbitrary) cost apportionment may still be required at the cost pooling stage for items like rent, rates and building depreciation.
Can a single cost driver explain the cost behaviour of all items in its associated pool?
Unless costs are caused by an activity that is measurable in quantitative terms and which can be related to production output or a service activity, cost drivers are not easily usable. What drives the cost of the annual external audit, for example?
ABC is sometimes introduced because it is fashionable, not because it will be used by management to provide meaningful product costs or extra information. If management is not going to use ABC information, an absorption costing system may be simpler and therefore more cost-effective to operate.
The cost of implementing and maintaining an ABC system can exceed the benefits of improved accuracy.
Implementing ABC is often problematic.
The calculations can be iterative, such as apportioning HR dept. costs to IT when IT costs are also apportioned to production and to HR Department

IMPLICATIONS OF SWITCHING TO ABC

Switching to ABC has implications for pricing, sales strategy, performance management and decision making.

Switching to ABC is often problematic. Recent journal articles have highlighted the following issues.

The incorrect belief that ABC can solve all an organisation’s problems
Lack of the correct type of data
Difficulty in determining appropriate cost drivers

‘World-wide adoption rates for ABC have peaked at 20 per cent and a declining number of firms is giving it further consideration.’ (Tom Kennedy, Financial Management, May 2000). Recent UK studies have found ABC usage rates of about 25%, with larger organisations and service sector companies being most likely to use it.

Pricing

An ABC system gives management a good understanding of the cost structures of making and selling a wide range of products. Switching to ABC can change cost per unit calculations substantially. If an organisation determines prices based on cost i.e. using costplus pricing, greater costing information will be very useful and prices will change.

Many organisations however price their products according to what the market will bear, so if costs are re-calculated, it is the profit margin for a product that will change rather than its price.

Consider a business that produces a large volume standard product and a number of variants which are more refined versions of the basic product and sell in low volumes at a higher price. Such companies are common in practice in the modern business environment. In practice, also, such companies absorb fixed overheads on a conventional basis such as direct labour hours, and price their products by adding a mark up to full cost.

In the situation described, the majority of the overheads would be allocated to the standard range, and only a small percentage to the up-market products. The result would be that the profit margin achieved on the standard range would be much lower than that on the upmarket range.

Thus the traditional costing and pricing system indicates that the firm might be wise to concentrate on its high margin, up-market products and drop its standard range. This is absurd, however. Much of the overhead cost incurred in such an organisation is the cost of support activities like production scheduling: the more different varieties of product there are, the higher the level of such activities will become. The cost of marketing and distribution also increases disproportionately to the volume of products being made.

The bulk of the overheads in such an organisation are actually the ‘costs of complexity‘. Their arbitrary allocation on the basis of labour hours gives an entirely distorted view of production line profitability; many products that appear to be highly profitable actually make a loss if costs are allocated on the basis of what activities cause them.

The problem arises with marginal cost-plus approaches as well as with absorption cost based approaches, particularly in a modern manufacturing environment, where a relatively small proportion of the total cost is variable. The implication in both cases is that conventional costing should be abandoned in favour of ABC.

Case Study

In a survey reported in Accountancy Age (‘The price is right… or is it?’, June 2002), it was found that ‘For many companies, pricing decisions are a “seat-of-the-pants” affair. There is generally low take-up of the analytical tools and techniques an accountant would expect to use in making financial decisions. The most extensively used technique was ‘face to face’ research.’ ABC was in third place, after competitive analysis but before breakeven analysis.

The survey also found that the leaders [most successful companies in the survey at using price management to achieve business objectives] …”focus on customer segments, differentiate products to serve them, pay attention to quality and deliver on customer care. This costs money but they see it as a way of reducing unit cost and delivering the economies of scale which lead to competitive prices and market leadership’.

Significantly too, the leaders are more likely to use realistic cost allocation methodologies, such as activity-based costing, when they take pricing decisions. Some 62% of leaders ranked this either ‘very important’ or ‘important’ compared with just 23% of laggards.

‘Confident – and profitable – pricing depends on knowing direct and indirect costs attributable to a particular product or service … It’s not surprising leader companies take better pricing decisions when they are more likely to have this information at their fingertips.’

Sales strategy

As we have seen, the introduction of ABC has implications for the cost per unit, price and profit margin. For example, a product with few set-ups, material movements or inspections will have lower costs under ABC than traditional absorption costing. The organisation could decide to reduce the product’s selling price but if it is a high volume product, the number of units sold may not increase sufficiently to compensate for the loss in total revenue and contribution.

ABC may result in a change in profit margins, with previously high margin products now being seen as less profitable. This can result in increased sales efforts on different products, especially if the sales department is rewarded on the basis of profits.

Performance management

The information provided by analysing activities can support performance management provided it is used carefully and with full appreciation of its implications.

Planning

Before an ABC system can be implemented, management must analyse the organisation’s activities, determine the extent of their occurrence and establish the relationships between activities, products/services and their cost.

The information database produced from such an exercise can then be used as a basis for forward planning and budgeting. For example, once an organisation has set its budgeted production level, the database can be used to determine the number of times that particular activities will need to be carried out, thereby establishing necessary departmental staffing and machine levels. Financial budgets can then be drawn up by multiplying the budgeted activity levels by cost per activity.

This activity-based approach may not produce the final budget figures but it can provide the basis for different possible planning scenarios.

Control

The information database also provides an insight into the way in which costs are structured and incurred in service and support departments. Traditionally it has been difficult to control the costs of such departments because of the lack of relationship between departmental output levels and departmental cost. With ABC, however, it is possible to control or manage the costs by managing the activities which underlie them by monitoring a number of key performance measures.

Decision making

Many of ABC’s supporters claim that it can assist with decision making in a number of ways.

− Provides accurate and reliable cost information − Establishes a long-run product cost

− Provides data which can be used to evaluate different ways of delivering business.

It is therefore particularly suited to the following types of decision.

− Pricing

− Promoting or discontinuing products or parts of the business

− Redesigning products and developing new products or new ways to do business

Note, however, that an ABC cost is not a true cost, it is simply an average cost because some costs such as depreciation are still arbitrarily allocated to products. An ABC cost is therefore not a relevant cost for all decisions.

The traditional cost behaviour patterns of fixed cost and variable cost are felt by advocates of ABC to be unsuitable for longer-term decisions, when resources are not fixed and changes in the volume or mix of business can be expected to have an impact on the cost of all resources used, not just short-term variable costs.

ABC attempts to relate the incidence of costs to the level of activities undertaken. A hierarchy of activities has been suggested.

Type of activities	Costs are dependent on ….	Examples
Unit level	Volume of production	Machine power
Batch level	Number of batches	Set-up costs
Product sustaining	Existence of a product group/line	Product management
Facility sustaining	Organisation simply being in business	Rent and rates

The difference between a unit product cost determined using traditional absorption costing and one determined using ABC will depend on the proportion of overhead cost which falls into each of the categories above.

If most overheads are related to unit level and facility level activities, the costs will be similar.

If the overheads tend to be associated with batch or product level activities they will be significantly different.

These overhead costs are activity based and recognise that overhead costs are incurred due to batch level activities. The fact that E has to be made in frequent small batches, perhaps because it is perishable, means that it uses more resources than D. This is recognised by the ABC overhead costs, not the traditional absorption costing overhead costs.

In the modern manufacturing environment, production often takes place in short, discontinuous production runs and a high proportion of product costs are incurred at the design stage. An increasing proportion of overhead costs are therefore incurred at batch or product level.

Such an analysis of costs gives management an indication of the decision level at which costs can be influenced. For example, a decision to reduce production costs will not simply depend on making a general reduction in output volumes: production may need to be organised to reduce batch volumes; a process may need to be modified or eliminated; product lines may need to be merged or cut out; facility capacity may need to be altered.

CUSTOMER PROFITABILITY ANALYSIS (CPA)

Customer profitability analysis uses an activity based approach to relate revenues and costs to groups of customers in order to assess their relative profitability.

Traditionally, management accounting reports have been analysed on a product by product basis. In the modern business environment, however, in which it is vital that organisations respond promptly to the demands of customers, analysis on the basis of customers can provide vital management information.

Analysing customers

Profitability can vary widely between different customers because various overhead costs are, to some extent, variable and customer driven.

• Discounts	• Distribution
• Sales force	• Promotions
• Quality control	• Financing costs
• Merchandising	• Enquiries

Suppose a hotel offers a number of services such as a swimming pool, a gym and a nightly dinner dance.

Older guests may attend the dinner dance.
Families may use the swimming pool.
People without children may appreciate the gym.

By charging services to the guests using them, a cost per bed night can be calculated for each guest group. Strategies for attracting the most profitable guest group can then be adopted.

Whether individual customers or groups of customers are costed largely depends on the number of customers.

A manufacturing company supplying six companies would cost each customer separately.
A supermarket or bank would cost groups of similar customers. UK banks divide their customers into categories such as single and 30ish, married with young children, older couples who are pensioners and so on.

Marketing departments should be aiming to attract and retain profitable customers but in order to do this they need to know which customers are profitable and how much can be spent on retaining them. The costing system should provide the necessary answers. Also, banks know that a young “expnsive” customer may well become middle-aged and more profitable.

Customer profitability analysis (CPA) is ‘the analysis of the revenue streams and service costs associated with specific customers or customer groups’.

Customer profitability analysis (CPA) provides important information which allows an organisation to determine both which classes of customers it should concentrate on and the prices it should charge for customer services. Its use ensures that those customers contributing sizeably to the profitability of the organisation receive a comparable amount of attention from the organisation.

Customer revenues

Customer revenues are cash flows from customers. They are influenced by different factors, mainly allowances and discounts.

Some types of customer store and distribute goods (e.g. wholesalers) or promote the goods in return for an allowance.
By giving a discount a company may encourage bulk orders, which may be cheaper to provide and may result in higher sales volume. Studies on customer profitability have found large price discounting to be a key explanation for a group of customers being below expected profitability, however. Sales representatives may have given customers large price discounts unrelated to their current or potential value to the company, perhaps to meet bonuses dependent on sales volumes. Two customers may be purchasing the same volumes but the price discount given to one may make it unprofitable, while the other is profitable.

Case Study

The USA company General Electric, which manufactures and sells refrigerators and so on, used to give substantial discounts to customers who placed large orders. This did not result in customers buying more products. Instead GE’s sales orders bunched in particular weeks of the year. In turn this led to an uneven production and distribution flow, which increased costs. The company found that, by removing the discounts while at the same time guaranteeing swift delivery, order size decreased and profits increased.

Customer costs and ABC

The creation of cost pools for activities in ABC systems allows organisations to arrange costs in a variety of different ways. Because different customers use different amounts of activities, it is possible to build up costs for individual customers or groups of customers on an activity basis so that their relative profitability can be assessed.

Examples of the build up of customer costs using an activity based system

Activity	Cost driver
Order taking	Number of orders taken
Sales visits	Number of sales visits
Emergency orders	Number of rushed orders
Delivery	Miles travelled

Case Study

Drury cites the case of Kanthal, a Swedish company in the Sandvik Group that sells electric heating elements. Customer-related selling costs represented 34% of total costs. In the past Kanthal had allocated these costs on the basis of sales value when customer profitability studies were carried out. The company then introduced an ABC system in order to determine the resources consumed by different customers.

An investigation identified two cost drivers for the resources used to service different customers.

Number of orders placed. Each order had a large fixed cost, which did not vary with the number of items ordered. A customer ordering 10 items 100 times cost more to service than a customer placing a single order for 1,000 items.
Non-standard production items. These cost more to manufacture than standard items.

A cost per order and the cost of handling standard and non-standard items were calculated and a CPA carried out on the basis of the previous year’s sales. The analysis showed that only 40% of customers were profitable, and a further 10% lost 120% of the profits. In other words, 10% of customers incurred losses equal to 120% of Kanthal’s total profits. Two of the most unprofitable customers were actually in the top three in terms of total sales volume but made many small orders of non-standard items.

Unprofitable customers identified by CPA should be persuaded to alter their buying behaviour so they become profitable customers. In the Kanthal example above, unprofitable customers should be discouraged from placing lots of small orders and/or from buying nonstandard products.

The activity based approach also highlights where cost reduction efforts should be focused. Kanthal should concentrate on reducing ordering cost and the cost of handling nonstandard items.

Activity-based CPA allows an organisation to adopt a more market-orientated approach to management accounting.

In order to analyse different customers it may therefore be useful to review non-financial data.

Customer

Number of purchase orders

Number of sales visits

Number of deliveries

Distance per delivery

Number of emergency orders

20 0

70 4

Customer Y may be the cheapest to serve because of the number of deliveries per order, the lower distance travelled and the lack of emergency orders.

Categorising customers

It is not possible to ‘cost’ future dealings with customers accurately because the number and size of orders and rush orders is likely to be unpredictable. It is, however, possible to gain a broad idea of the amount of profit that can be expected from a particular category of customer. Customers can be categorised in the following grid.

The aim is to attract as many accepting customers as possible. Such customers will have a low ‘cost to supply’ perhaps because they are located close by or do not place rush orders, and are prepared to accept a high price. Many large retail organisations fall into the demanding category because they expect the supplier to deal with rush orders, change production methods to suit them and so on. It is undesirable for a small supplier to be tied to a large demanding customer who has the power to threaten the withdrawal of its custom if the supplier does not acquiesce.

Alternatively, customers can be analysed using decision grid analysis (DGA), as illustrated in the following diagram.

Positive contribution as a % of

sales

POTENTIAL

WINNERS

LOSERS

PROBLEM

Low High

volume volume

Negative contribution as a % of sales

Customers and life cycle costing

Customers can also be costed over their expected ‘life cycle’ and the expected future cash flows relating to the customer may be discounted. It is rarely possible to predict accurately the life cycle of a particular customer unless contracts are awarded for a specific time period. Nevertheless the information is valuable as the longer the customer remains with the organisation the more profitable the customer becomes. This is valuable information and may show the importance of creating and retaining loyal customers.

CHAPTER ROUNDUP

An alternative to absorption costing is activity based costing (ABC).

ABC involves the identification of the factors (cost drivers) which cause the costs of an organisation’s major activities. Support overheads are charged to products on the basis of their usage of an activity.

− For costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours).

− Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders received.

ABC has both advantages and disadvantages, and tends to be more widely used by larger organisations and the service sector.
Switching to ABC has implications for pricing, sales strategy, performance management and decision making.

In order to analyse different customers it may therefore be useful to review non-financial data.

Customer

Number of purchase orders

Number of sales visits

Number of deliveries

Distance per delivery

Number of emergency orders

20 0

70 4

Customer Y may be the cheapest to serve because of the number of deliveries per order, the lower distance travelled and the lack of emergency orders.

Categorising customers

Alternatively, customers can be analysed using decision grid analysis (DGA), as illustrated in the following diagram.

Positive contribution as a % of

sales

POTENTIAL

WINNERS

LOSERS

PROBLEM

Low High

volume volume

Negative contribution as a % of sales

Customers and life cycle costing

CHAPTER ROUNDUP

An alternative to absorption costing is activity based costing (ABC).

For costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours).

− Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders received.

ABC has both advantages and disadvantages, and tends to be more widely used by larger organisations and the service sector.

Switching to ABC has implications for pricing, sales strategy, performance management and decision making.

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Activity Based Costing