What is Activity based costing?


Activity based costing (ABC) is an accounting methodology that assigns costs to activities rather than products or services. This enables resource and overhead costs to be more accurately assigned to the products and the services that utilize the resources.

This example of a door company helps to explain the difference between the traditional method of accounting and the activity based costing method. On the left column you have the traditional accounting and on the right you have the ABC system that divides costs into activities.

Traditional method Activity based costing method
Salaries $100 Clean door $40
Equipment $80 Paint door $75
Supplies $20 Inspect door $75
Overhead $45 Send door to assembly $55
TOTAL: $245 TOTAL: $245

  ABC doesn’t eliminate or change costs, it provides data about how costs are actually utilized. In this example, if you wanted to reduce costs using traditional data you would have to decrease salaries, or decrease costs of supplies. You don’t know enough to change the equipment or overhead costs. Using ABC data you can see that it costs the same to paint and inspect the door. Could these steps be combined to lower cost?

What are the benefits of ABC?

Traditional accounting systems are inaccurate in the method that they allocate costs. Large batch or high volume products and services typically incur LESS OVERHEAD than they are assigned. Small batch or low volume products and services typically incur MORE OVERHEAD than they are assigned. This suggestss that products and services that are considered highly profitable may in fact be loss centers. This inaccuracy is becoming more and more critical as companies move toward customer-defined products and services. In order to correctly associate costs with products and services, ABC assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as products or customers, based on their use of activities. This information assists in making decisions about pricing, outsourcing, capital expenditures and operational efficiency.

It is possible to draw the relationship between products/services (cost objects) and the resources that are utilized by the product or service.

 Resources

Resource drivers

Activities

Activities drivers

Cost objects
 
 

Definitions

Resources are people and machines.

The resource driver is the measure of the frequency and intensity of the demands placed on resources by an activity

Activities are the processes performed by people and machines.

Activity drivers measure the frequency and intensity of the demands placed on activities by cost objects enabling costs to be assigned to cost objects.

Cost objects are the products and services produced.

Cost drivers are the factors that affect the cost of an activity, such as setup machines, quality control.
 
 

Why should a Boston College Consulting Group recommend the use of ABC?

Clients can use ABC to determine the cost and benefits associated with their reengineered processes and systems. This cost and benefit analysis will then become part of the overall business case for the project.

An ABC approach will include:

How should a Boston College Consulting Group implement an ABC?

The steps needed to develop ABC data includes the following: