To support compliance with financial reporting requirements, a company's traditional cost-accounting system is often articulated with its general ledger system. In essence, this linkage is grounded in cost allocation. Typically, costs are allocated for either valuation purposes (i.e., financial statements for external uses) or decision-making purposes (i.e., internal uses) or both. However, in certain instances, costs are also allocated for cost-reimbursement purposes (e.g., hospitals and defense contractors).
The traditional approach to cost-allocation consists of three basic steps: accumulate costs within a production or nonproduction department; allocate nonproduction department costs to production departments; and allocate the resulting (revised) production department costs to various products, services, or customers. Costs derived from this traditional allocation approach suffer from several defects that can result in distorted costs for decision-making purposes. For example, the traditional approach allocates the cost of idle capacity to products. Accordingly, such products are charged for resources that they did not use. Seeking to remedy such distortions, many companies have adopted a different cost-allocation approach called activity-based costing (ABC).
WHAT IS ACTIVITY-BASED COSTING?
In contrast to traditional cost-accounting systems, ABC systems first accumulate overhead costs for each organizational activity, and then assign the costs of the activities to the products, services, or customers (cost objects) causing that activity. As one might expect, the most critical aspect of ABC is activity analysis. Activity analysis is the processes of identifying appropriate output measures of activities and resources (cost drivers) and their effects on the costs of making a product or providing a service. Significantly, as discussed in the next section, activity analysis provides the foundation for remedying the distortions inherent in traditional cost-accounting systems.
TRADITIONAL COST-ACCOUNTING SYSTEMS VERSUS ABC
Geared toward compliance with financial reporting requirements, traditional cost-accounting systems often allocate costs based on single volume measures such as direct-labor hours, direct-labor costs, or machine hours. While using a single volume measure as an overall cost driver seldom meets the cause-and-effect criterion desired in cost allocation, it provides a relatively cheap and convenient means of complying with financial reporting requirements.
In contrast to traditional cost-accounting systems, ABC systems are not inherently constrained by the tenets of financial reporting requirements. Rather, ABC systems have the inherent flexibility to provide special reports to facilitate management decisions regarding the costs of activities undertaken to design, produce, sell, and deliver a company's products or services. At the heart of this
flexibility is the fact that ABC systems focus on accumulating costs via several key activities, whereas traditional cost allocation focuses on accumulating costs via organizational units. By focusing on specific activities, ABC systems provide superior cost allocation information—especially when costs are caused by non-volume-based cost drivers. Even so, traditional cost-accounting systems will continue to be used to satisfy conventional financial reporting requirements. ABC systems will continue to supplement, rather than replace, traditional cost-accounting systems.
In most cases, a company's traditional cost-accounting system adequately measures the direct costs of products and services, such as material and labor. As a result, ABC implementation typically focuses on indirect costs, such as manufacturing overhead and selling, general, and administrative costs. Given this focus, the primary goal of ABC implementation is to reclassify most, if not all, indirect costs (as specified by the traditional cost-accounting system) as direct costs. As a result of these reclassifications, the accuracy of the costs is greatly increased.
According to Ray H. Garrison and Eric W. Noreen, there are six basic steps required to implement an ABC system:
- Identify and define activities and activity pools
- Trace costs directly to activities (to the extent feasible)
- Assign costs to activity cost pools
- Calculate activity rates
- Assign costs to cost objects using the activity rates and activity measures previously determined
- Prepare and distribute management reports
COSTS AND BENEFITS
While ABC systems are rather complex and costly to implement, Charles T. Horngren, Gary L. Sundem, and William O. Stratton suggest that many companies, in both manufacturing and nonmanufacturing industries, are adopting ABC systems for a variety of reasons:
- Margin accuracy for individual products and services, as well as customer classifications, is becoming increasingly difficult to achieve given that direct labor is rapidly being replaced with automated equipment. Accordingly, a company's shared costs (i.e., indirect costs) are becoming the most significant portion of total cost.
- Because the rapid pace of technological change continues to reduce product life cycles, companies do not have time to make price or cost adjustments once costing errors are detected.
- Companies with inaccurate cost measurements tend to lose bids because of over-costed products, incur hidden losses because of under-costed products, and fail to detect activities that are not cost-effective.
- Because computer technology costs are decreasing, the price of developing and operating ABC systems also has decreased.
In 2004 John Karolefski cited the following benefits realized by foodservice distributors and restaurants that have converted to activity-based costing practices:
- Understanding the true costs and productivity of capital equipment
- Understanding which products are most profitable and where to focus sales efforts
- More accurate pricing and determination of minimum order size
- Less time, money, and effort spent on the wrong products
Implementation costs are an obstacle to some, who feel that ABC is just a fad or will show little benefit. According to Karolefski, “ABC works better if it's kept simple” (2004, p. 18). Nevertheless, when implemented properly ABC yields benefits to the company, its business partners, and to consumers. Conversely, in 2007, a market review of ABC and other management systems found that it is poor implementation of the programs that often leads to failure. The report cites short cuts and mistakes as the reasons that ABC and related systems do not succeed.
To manage costs, a manager should focus on the activities that give rise to such costs. Accordingly, given the activity focus of ABC, managers should implement ABC systems to facilitate cost management. Using ABC systems to improve financial management is called activity-based management (ABM). The goal of ABM is to improve the value received by customers and, in doing so, to improve profits.
The key to ABM success is distinguishing between value-added costs and non-value-added costs. A value-added cost is the cost of an activity that cannot be eliminated without affecting a product's value to the customer. In contrast, a non-value-added cost is the cost of an activity that can be eliminated without diminishing value. Some value-added costs are always necessary, as long as the activity that drives such costs is performed efficiently. However, non-value-added costs should always be minimized because they are assumed to be unnecessary. Examples of non-valued-added activities include storing and handling inventories; transporting raw materials or partly finished products, such as work-in-process
inventory items, from one part of the plant to another; and redundancies in production-line configurations or other activities. Oftentimes, such non-value activities can be reduced or eliminated by careful redesign of the plant layout and the production process.
SEE ALSO Cost Accounting; Inventory Management; Inventory Types; Process Management; Quality and Total Quality Management; Time-Based Competition
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