Activity Based Costing (ABC) is an accounting
method that allows businesses to gather data
about their operating costs. Costs are
assigned to specific activities such as
planning, engineering, or manufacturing and
then the activities are associated with
different products or services. In this way,
the ABC method enables a business to decide
which products, services, and resources are
increasing their profitability, and which are
contributing to losses. Managers are then able
to generate data to create a better budget and
gain a greater overall understanding of the
expenses that are required to keep the company
running smoothly.
Activity Based Costing emerged as a logical
alternative to traditional cost management
systems that tended to produce insufficient
results when it came to allocating costs.
Harvard Business School Professor Robert S.
Kaplan was an early advocate of the ABC
system. While mainly used for private
businesses, ABC has recently been used in
public forums, such as those that measure
government efficiency.
Activity Based Costing (ABC) assigns
manufacturing overhead costs to products in a
more logical manner than the traditional
approach of simply allocating costs on the
basis of machine hours. Activity Based Costing
first assigns costs to the activities that are
the real cause of the overhead. It then
assigns the cost of those activities only to
the products that are actually demanding the
activities.
Activity Based Costing recognizes that the
special engineering, special testing, machine
setups, and others are activities that cause
costs they cause the company to consume
resources. Under ABC, the company will
calculate the cost of the resources used in
each of these activities. Next, the cost of
each of these activities will be assigned only
to the products that demanded the activities.
For example, Product 124 will be assigned some
of the company's costs of special engineering,
special testing, and machine setup. Other
products that use any of these activities will
also be assigned some of their costs. Product
366 will not be assigned any cost of special
engineering or special testing, and it will be
assigned only a small amount of machine setup.
Activity based costing has grown in importance
in recent decades because (1) manufacturing
overhead costs have increased significantly,
(2) the manufacturing overhead costs no longer
correlate with the productive machine hours or
direct labour hours, (3) the diversity of
products and the diversity in customers'
demands have grown, and (4) some products are
produced in large batches, while others are
produced in small batches.
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
