Activity Based Costing Essay Research Paper ACTIVITY

Activity Based Costing Essay, Research Paper


Activity Based Costing (ABC) is more relevant than traditional costing in companies, where product mix is diverse in; batch sizes, physical sizes, degree or complexity, and raw material characteristics. ABC will also provide more decision useful information for the service industry, characterized by diversity in range of services provided. If the products in a plant or services provided posses similar characteristics, wither volume based or an activity based cost driver will provide reasonably accurate costs. The strategic goal of ABC is to provide decision useful cost and profitability information for optimal pricing decisions, appropriate product mix, and operational improvements by focusing on activities and cost drivers. (Burch 1994)

ABC provides a closer approximation of the cost of product, than that provided by the traditional volume based costing method. The use of ABC in itself will not lead to better profitability management uses information provided by ABCs to decide the optimal product-mix. The action of the management will lead to improved results.

What is ABC ?

There are several elements worthy of note. First is that activities happen because an input has triggered them, e.g., an activity such as “purchase supplies” is caused or triggered by a requisition, secondly, we see that resources are consumed by an activity. Resources are the things that an organisation pays for, such as people, machines and equipment and facilities. We can measure the consumption of resources by activity for example, the activity “purchase supplies” consumes one hour of an employee’s time per requisition.

Activities can be associated with the outputs or cost objects of the organisation examples of a few of the cost objects for service organisations that we have worked with include such things as mortgages, chequing accounts, railcar movement from point A to point B, or B to C. Cost objects consume activities in much the same way that activities consume resources consequently, we can measure how much of an activity such as “purchase supplies’ is required by an organisation’s service output such as “engineering training course”. The measurement of consumption is called an activity- cost driver. Of significant note here is that different cost objects do consume activities ” in different proportions and that different customers do consume activities indifferent proportions. Traditional allocation modes hide this variation in activity utilisation by allocating these indirect costs based on some common denominator, such as percent of budget allocation, or percent of revenue and hence often provide quite misleading information.

The level at which activities are analysed can vary widely from the very aggregate to the very detailed. The level of detail should be matched to the level of analysis required to improve the decision-making within the organisation. Even within a single organisation, the level of detail can very from one part of the analysis to another, excessive detail will bog down the project and not provide any material benefit to the analysis. Too little detail will obscure the meaningful results that could be achieved.

The usefulness of an ABC analysis can be further enhanced by including a value analysis of every activity.

When constructing an ABC model, activity costs can be either traced directly to a cost objects. Examples of enabling activities include ” paying employees” and “supporting PC users”. We can then generate reports for these activities in various formats that show both the direct resources as well as those supports activities that form part of the total cost. Reports generally list the activities from highest cost to lowest cost. Management can then evaluate these activity costs in terms of whether they are too high, too low, or in the expected range. This is again a focusing mechanism for management in evaluating it resource utilisation patterns.


Activity based costing has proven itself to be a viable costing methodology for almost any organisation that incurs a substantial amount of indirect resources service organisations, whether for profit or not, have accepted ABC as a viable costing tool for their purposes. No longer is it perceived to be just another manufacturing costing tool. The economic analysis provided by ABC is the foundation on which to build solutions to many of the critical business issues facing service organisations today.

It is an accounting system that tires to remove distortion from the distribution of overhead costs between products. It can be a powerful management weapon for instance, a precise break down of costs can become a basis for a stragic pricing decision of a product or for attacking the cost of each of those activities, or for identifying activities that are contributing to costs but not adding value (NVA). While orthodox cost accounting works well under unchanging conditions, it increasingly leads to distortions under complex operations. ABC offers a more accurate picture of product costs.

It is flexible we can slice our cost information by customers, by region, by divisions, by functions or by process etc. An “ABC” model will enable us to analyse our product according to different customer segments they are targeted at and compare the costs of each category with the premium the buyer segment allows us to charge. That will immediately reveal just which of customer segment are really generating profit.

The basic objectives of ABC are two folds :-

· Validate the success of quality drive with ABC

· Optimise costs in response to price resistance in market

The above objectives are achieved as follows :-

A. Gauging the efficiency of different activity.

B. Determination of non-value added activities.

C. Attacking the area of cost Redundancy.

D. Ability to pin down the hidden costs.

E. Determination of focal point for continuous improvement.

Steps involved in implementing ABC :-

1. Identifying the functional areas involved.

2. Identifying the relative Activities involved in each functional Areas.

3. Allocate the common expenditure to various activities in each functional areas.

4. Preparation the statement of expenditure function wise/ activity wise/ account head wise.

5. Identifying the most suitable cost driver in each activity under functional areas.

6. Identifying the share of one cost driver to the product manufactured for absorption of OH.

7. Determine the rate/cost diver for particular activities.

8. Absorb the OH on the basis of rate /cost driver.

ABC and Management: -

In today’s environment of competition and globalisation, when each organisation has to continuously bench mark its activities with the most efficient in the world, one cannot do with out ABC.

The very survival of a firm today depends on proper management of the value chain at each stage. Unless one knows the value added at each stage as compared to its costs for that value addition, one cannot decide about cutting the unimportant activities or adding the new ones. Most of the recent approaches being followed for improving overall competitiveness and productivity of the business such as target costing, TQM, BPR and other depend heavily upon accurate cost information for various activities and comparison of these with the value the stake holders attribute to them without exact cost information such exercises are a meaningless.

The main benefits of ABC arise from the quality of managerial decisions based on more accurate information. This is the most promising aspect of ABC which is now being called Activity Based Management (ABM). ABM views the activities in a dynamic sense rather then just a step for cost allocation to the end products. It uses the cost information generated by ABC about an activity for controlling the activity is self rather than using the cost information generated by ABC about an activity for controlling the activity itself rather than using the cost of the final products only. The cost drivers that trigger the activity are also identified and monitored. These cost drivers may be different from the resource or activity drivers. In addition performance measures are developed and monitored to judge the efficiency at which the activity is being performed. These measures may be financial or non-financial variables such as cost per units of activity driver, defects per million items produced or time taken per unit of item produced. These measures then provide a sound basis to the control the performance of the activity with accurate information about the costs involved.

ABM has number of benefits to offer. Here, the focus of attention is an activity rather than a department. A department may have a number of activities which if not segregated may diffuse the vision of the managers while making a particular decision. The areas where specific benefits have been derived from ABM are following

A. Determination of product/service costs

B. Improvements in performance and activities

C. Cost cutting and downsizing

D. Other applications.

Number of benefits are high and harmful effects are less.


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