ABC or activity based costing is a methodology that was created many years ago, but it really became known through the studies of Professors Robert Kaplan and Robin Cooper in the beginning of the 1990s. These two professors perceived that, for a series of reasons that we’ll present later on, the method being used to cost various products and services at the time wasn’t reflecting the reality of organizations and was causing large distortions which were harming company results.
Even though its popularization came about through several books and articles written by these professors, there are studies and documents that show that activity based costing already was being used in its essence back in the 1950s and even before then by large American firms. The great difficulty at the time, and the reason why it wasn’t promoted with the same success as Professors Kaplan and Cooper, was that there was a lack of computational resources (hardware and software) to put this theory into practice – especially in the implementation of cost models for more complex organizations which require a greater level of detail.
In their studies, Professors Kaplan and Cooper identified 3 independent and simultaneous factors which justify the implementation of activity based costing:
- The fact that the cost structure has changed drastically over the past 50 years. In the past, labor costs represented 50% of total product costs, followed by raw materials at 35% and overhead costs of 15%. Today it’s not uncommon to see overhead costs represent 60% of product costs, raw materials average 30% and labor costs represent less than 10% (in service and government organizations the overhead is even greater). This is why using the number of labor hours to assign costs made sense 50 to 100 years ago, but today it makes no sense given the current cost structure.
- The number and quality of competitors has changed greatly in recent years, which has resulted in cost margins diminishing year after year – making it that much more important to control costs well and;
- The cost of implementing/measuring has fallen greatly compared to the past when large applications ran on big computers and mainframes – and the level of computation has also improved greatly.
The trigger missing for the popularization of this methodology occurred with the rise of micro-computing at the end of the 1980s and the development of software GUIs through operational systems such as Windows (Microsoft), OS/2 (IBM) and Mac (Apple). With it, applications that previously could only be run on large computers and mainframes could now run be run by any organization and were accessible to a wide variety of users and departments.
Today many organizations in manufacturing, the government, services, telecommunications, banks and logistics have used activity based costing with success. Its use, contrary to what many imagine, has not been limited to large corporations and has spread to many medium and small companies in both the public and private sectors.
We’ll show you everything you need to know about this system, including its advantages and how to implement it. Take a look!
The Activity Based Costing Methodology
Traditional costing systems arose to meet tax requirements and stock valuations, but these systems have various flaws, especially when used as management tools.
As a result, many managers of companies that offer a variety of products and services are making very mistaken decisions in terms of prices, their mixes of products and services, and their processes.
Traditional costing systems are focused on various products. Costs are assigned equally among these products because it’s assumed that each item/sku consumes the organization’s diverse resources in proportion to the volume of the products produced.
In this way, various “volume” drivers such as direct labor hours, machine hours and raw material costs are used as criteria to assign overhead costs.
This methodology means that these values only reflect an estimated average. Even though a complex study is used to arrive at this calculation, this is a scenario that by definition will never correspond exactly to the specific characteristics of each company and its individual processes.
These volume based drivers also fail due to the diversity in the form, size and complexity of these products. There’s also no direct relationship between the production volume and the effort or costs consumed by the organization.
Difference with Activity Based Costing
On the other hand, activity based costing focuses on the organization’s various processes and activities. In addition, there are differences of treatment in terms of the various clients, channels, markets and regions that are often ignored by companies– and which later prove to be fundamental to making an assertive decision. These varied costs are assigned to a variety of activities for all of the Products, Clients, Channels, etc. based on the use of each of these in the organization’s activities. This way the Overhead is assigned in an appropriate manner always respecting cause and effect relationships and not using “volumes” as a basic criterion for equal distribution.
Once the costs of the activities have been determined, the organization can begin to manage them and question why each is affecting the costs of the company’s various products, clients, channels and services. At the same time, the costing process becomes more accurate and precise.
Focus on Activities, not Products
What makes Activity Based Costing an extremely efficient methodology is something that begins with thinking about the issue of costs. What was treated in other models as an indirect cost linked to the product is now treated as a direct cost. The focus shifts to the activities performed rather than the products associated with them.
The key point is that the fact that each product, service, client or channel is the result of a variety of activities that, if treated individually, have a greater chance of providing specific data that can be converted into more exact values.
The Key is Cost Tracing
The efficiency of activity based costing is in its ability to provide a logical tracing of costs. The fact that it isn’t linked to the timing of each process makes it possible for ABC to identify each expense and designate it as part of a specific activity. Even if certain expenses are grouped within the same cost center, they’ll be organized according to the activity to which their linked. This optimization of cost control brings countless benefits to all of the company’s departments as we’ll show below.
The Advantages of Using Activity Based Costing
A series of advantages come from a company’s implementing of activity based costing which go beyond the accuracy of the definition of the costs of products, services, clients and channels. We’ll discuss some of the most important ones to clarify how it increases a company’s profitability and decision making ability.
More Precise Information
As soon as the cost model is created, with well-thought out assignment criteria and future implementations established – you’ll have better and more precise information available for your decision making. This makes the company’s decision making more accurate, because managers have a better idea of future profits and spending as well as data that will enable them to make efficient decisions in terms of product and service pricing, product mixes, outsourcing or internal development, research and development investments, automation, marketing, campaigns and much more!
A Better View of Your Process Flow
Here we can mention not just more transparent cost data for each department, but also a review of internal controls and greater visibility for every process. As the company gathers more information about its processes and their influence on the company’s Products, Services, Clients and Channels, it will be able to make more assertive decisions. This provides each manager with more tools to manage the team’s costs as well as information to audit and analyze these costs.
With an understanding of the costs of each activity, these managers can make decisions based on business processes and activities. In addition, once these activities have been mapped, attributes can be associated with each one making it possible to study whether they add value or not.
The description of the specifics of each process and its costs makes a panoramic, but detailed, analysis of the costs of each activity possible. In this way, greater than expected costs can be identified and the budget can even be revisited to eliminate excessive expenses. Thus, reducing costs becomes just a question of time, because each manager has access to more precise information to analyze these processes. It should be remembered that more effective cost control is something that makes this methodology efficient for small and large companies, no matter what their sphere of operations.
The following list of steps can be used as a reference for implementing the ABC methodology in an effective manner.
1. Define the Implementation Tool
A sophisticated cost model requires a specific system. Many companies already possess a costing mechanism that uses spreadsheets. Others try to customize the ERP or even believe that BI can solve cost management. The accounting and consulting firm of Ernst & Young (EY) in a recent article recommended none of these options. According to EY, “the model can be developed using Excel, Access or internal development, but this can only be done for very simple models, and even these models are extremely limited when more elaborate analyses are required. This doesn’t even mention the issue of integrating such as system with other company systems, cost tracing, model auditing and the integrity of the data itself.”
In terms of an implementation using an ERP, we know how expensive and complicated it is to customize these systems, given their static and cumbersome nature which doesn’t provide the flexibility required for an implementation of this kind. BI, on the other hand, is a system that presents information that already exists within the organization, but we know that cost modeling requires profound transformations in terms of assignments, including reciprocal costs, and the understanding of multiple levels and dimensions, which is something that is not easily done or practically impossible to implement within a BI system. The MyABCM product suite is the global leader in cost management solutions. It can be used by organizations to model, analyze, and create simulations with great flexibility and security providing full integration with the organization’s corporate systems.
2. Determine the Project’s Objectives
Here it’s important to understand what you’re seeking through a project of this nature: determining the costs of Products? Clients as well? What about Channels? Markets, Regions, Projects? There are many broad possibilities and one of the greatest errors is to begin modeling and then change one’s assumptions in the middle of the project. Another important point to be considered is creating an implementation agenda with clear definitions of the detail to be adopted and possible criteria and implementation milestones and ideas.
3. Map the “Intelligent” Activities
This part of planning is fundamental to the efficient implementation of the model. It’s not unusual in projects of this kind for managers to want to map hundreds, thousands, and sometimes even tens of thousands of activities, frequently reaching the level of tasks. Besides not being very effective (mapping many activities will certainly involve a lot of effort for relatively little gain, especially for activities that are not very relevant) using very complex modeling from the outset will make the initial integration of the model with other corporate systems a great challenge. The best practices of implementation include the ability to model in stages, with complexity increasing as the model evolves, while always bearing in mind the relevance of what is being mapped. According to Gary Cokins, one of the foremost experts in Cost Management, “organizations should question whether the activity’s important and relevant to the company.”
4. Define the Resources Well
Here you need to define your initial costs, expenses, cost centers, accounts, possible groupings (Cost Pools) that you should establish, and the Revenues which will provide the initial Resources to be assigned.
5. Define the Various Assignments
This part of the planning is important because it ensures that each Resource is linked to a process which is identified by its relationship with the activities linked to a product, service, client, channel or project.
6. Determine the Driv ers
Once your Resources and Activities have been defined, determine the cost drivers you wish to use and the criteria for each one. This way the calculation process will be coherent because it will represent a cause and effect relationship between the cost source and destination.
7. Calculate the Model and Create Reports and Analyses
Once the model is defined it’s time to perform the calculation, generate simple and complex data cubes (which will later make it possible to conduct various analyses using dynamic tables), and create simple and advanced what if scenarios.
With these tips, you can implement an activity based costing methodology in a way that will make this process more efficient and help your company grow more and more.