💼Strategic Cost Management Unit 5 – Activity-Based Costing in Management

What's ABC All About?

• Activity-Based Costing (ABC) assigns costs to activities and then to products or services based on their consumption of those activities
• Focuses on identifying and assigning costs to specific activities that drive overhead expenses (rent, utilities, salaries)
• Allocates overhead costs more accurately than traditional costing methods by recognizing that not all products consume overhead resources equally
• Helps managers understand the true cost and profitability of individual products, services, or customers
• Provides insights into cost drivers and opportunities for process improvements
  • Identifies non-value-added activities that can be eliminated or reduced
  • Highlights areas where efficiency can be improved to reduce costs
• Supports better decision-making by providing more accurate and detailed cost information

Why ABC Matters in Business

• Traditional costing methods often lead to inaccurate product or service costing, resulting in poor pricing and profitability decisions
• ABC enables companies to make informed decisions about pricing, product mix, and resource allocation based on a clearer understanding of costs
• Helps identify and eliminate wasteful or non-value-added activities, leading to improved efficiency and cost savings
• Provides a more accurate basis for budgeting and forecasting by considering the cost of specific activities
• Supports performance evaluation and accountability by linking costs to the activities and processes responsible for them
• Enhances competitiveness by enabling companies to optimize their cost structure and make strategic decisions based on accurate cost data
• Facilitates better communication and collaboration among different departments by providing a common language and understanding of costs

Key Components of ABC Systems

• Activities: Specific tasks or processes that consume resources and are required to produce a product or service (machining, assembly, inspection)
• Resources: Factors of production used to perform activities, such as labor, materials, equipment, and facilities
• Cost drivers: Factors that cause or influence the cost of an activity (number of setups, machine hours, labor hours)
  • Used to assign activity costs to products or services based on their consumption of those activities
• Cost pools: Groupings of related overhead costs associated with specific activities or processes
• Activity cost: The total cost of resources consumed by an activity over a given period
• Activity driver: A measure of the frequency and intensity of demand placed on activities by products or services (number of orders processed, number of inspections performed)
• Cost object: The final product, service, or customer for which costs are measured and assigned

Setting Up an ABC System

• Identify activities: Determine the significant activities that consume resources and are required to produce products or services
• Define cost pools: Group related overhead costs into cost pools associated with specific activities
• Identify cost drivers: Determine the factors that cause or influence the cost of each activity
• Assign resource costs to activities: Allocate the cost of resources (salaries, rent, utilities) to activities based on their consumption
• Assign activity costs to cost objects: Allocate activity costs to products, services, or customers based on their consumption of those activities using activity drivers
• Collect data: Gather information on resource costs, activity levels, and cost driver quantities
  • May require time studies, surveys, or interviews to determine how resources are consumed by activities
• Implement and refine: Put the ABC system into practice, monitor its performance, and make adjustments as needed to improve accuracy and effectiveness

Crunching the Numbers: ABC in Action

• Calculate activity cost driver rates: Divide the total cost of each activity by the total quantity of its cost driver to determine the cost per unit of the driver
  • Example: If the total cost of the "machining" activity is $100,000 and the total machine hours (cost driver) is 2,000, the activity cost driver rate is$50 per machine hour
• Assign activity costs to cost objects: Multiply the activity cost driver rate by the quantity of the cost driver consumed by each product or service
  • Example: If Product A requires 100 machine hours, its allocated machining cost is $5,000 (100 hours ×$50 per hour)
• Calculate total cost: Sum up the assigned activity costs and any direct costs (materials, labor) to determine the total cost of each product or service
• Analyze results: Compare the ABC-based costs to traditional costing methods, identify discrepancies, and investigate the reasons for any significant differences
• Make decisions: Use the ABC cost information to make pricing, product mix, and process improvement decisions based on a more accurate understanding of costs and profitability

ABC vs. Traditional Costing Methods

• Traditional costing methods allocate overhead costs to products based on a single, volume-based measure (direct labor hours, machine hours)
  • Assumes that products consume overhead resources in proportion to their production volume
  • Can lead to over- or under-costing of products, especially when there is a diverse product mix or varying complexity
• ABC allocates overhead costs based on the activities consumed by each product or service, providing a more accurate and detailed view of costs
  • Recognizes that different products consume overhead resources in different proportions based on their unique characteristics and requirements
• ABC is more complex and time-consuming to implement than traditional costing methods but provides more accurate and actionable cost information
• Traditional methods may be sufficient for companies with a simple product mix and relatively homogeneous overhead consumption, while ABC is more beneficial for complex and diverse operations

Real-World ABC Examples

• Hewlett-Packard used ABC to identify the true cost of producing different printer models, leading to the discontinuation of low-margin products and a focus on more profitable ones
• Coca-Cola implemented ABC to understand the cost of serving different customer segments (supermarkets, convenience stores, vending machines) and adjusted its pricing and distribution strategies accordingly
• Boeing adopted ABC to accurately measure the cost of its aircraft production processes, identify inefficiencies, and make process improvements to reduce costs and improve competitiveness
• A hospital used ABC to determine the cost of treating different types of patients (surgical, medical, pediatric) and adjusted its resource allocation and pricing to better align with the actual cost of care
• A manufacturing company used ABC to identify the true cost of its product customization activities, leading to the introduction of standardized options and a more profitable product mix

Pros and Cons of Using ABC

Pros:

• Provides more accurate and detailed cost information than traditional methods
• Helps identify non-value-added activities and opportunities for process improvement
• Supports better decision-making on pricing, product mix, and resource allocation
• Enhances cost transparency and accountability across the organization
• Facilitates more effective budgeting and forecasting based on activity-level costs Cons:
• More complex and time-consuming to implement than traditional costing methods
• Requires extensive data collection and analysis, which can be costly and resource-intensive
• May require significant changes to existing accounting systems and processes
• Can be met with resistance from managers and employees who are accustomed to traditional costing methods
• The benefits of ABC may not justify the costs for companies with simple operations or homogeneous products