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Activity-based costing (ABC) is a costing methodology that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.
Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.
ABC is based on George Staubus' Activity Costing and Input-Output Accounting. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.
CIMA (Chartered Institute of Management Accountants) defines ABC as An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs.
With ABC, a company can soundly estimate the cost elements of entire products, activities and services. That may help inform a company's decision to either:-
a) Identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim).
b) Identify and eliminate production or service processes that are ineffective and allocate processing concepts that lead to the very same product at a better yield (process re-engineering aim).
In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.
Activity Based Costing Advantages:-
1. More accurate costing of products/services, customers, SKUs, distribution channels.
2. Better understanding overhead.
3. Easier to understand for everyone.
4. Utilizes unit cost rather than just total cost.
5. Integrates well with Six Sigma and other continuous improvement programs.
6. Makes visible waste and non-value added.
7. Supports performance management and scorecards.
8. Enables costing of processes, supply chains, and value streams.
9. Activity Based Costing mirrors way work is done.
10. Facilitates benchmarking
Activity Based Costing Disadvantages:-
1. More time consuming to collect data.
2. Cost of buying, implementing and maintaining activity based system.
3. Makes waste visible which some executives and managers don't want their boss to see.
Example:-
Let’s suppose that a factory produces 2 products A & B. Now, if A is a customized product which takes a lot of R&D, is produced very rarely and needs some special engineering while B is a product which is in continuous production with a large amount of machine hours.
Now, as per the traditional costing system Product B will be allocated most of the indirect cost due to the no. of machine hours while Product A might have cost more due to the special engineering etc. Activity based costing thus takes various activities to be the cost base and allocates costs accordingly.
Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns as a chapter in their book Accounting and Management: A Field Study Perspective. They initially focused on manufacturing industry where increasing technology and productivity improvements have reduced the relative proportion of the direct costs of labor and materials, but have increased relative proportion of indirect costs. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost.
ABC is based on George Staubus' Activity Costing and Input-Output Accounting. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. During this time, the Consortium for Advanced Management-International, now known simply as CAM-I, provided a formative role for studying and formalizing the principles that have become more formally known as Activity-Based Costing.
CIMA (Chartered Institute of Management Accountants) defines ABC as An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs.
With ABC, a company can soundly estimate the cost elements of entire products, activities and services. That may help inform a company's decision to either:-
a) Identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim).
b) Identify and eliminate production or service processes that are ineffective and allocate processing concepts that lead to the very same product at a better yield (process re-engineering aim).
In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. ABC is generally used as a tool for understanding product and customer cost and profitability based on the production or performing processes. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.
Activity Based Costing Advantages:-
1. More accurate costing of products/services, customers, SKUs, distribution channels.
2. Better understanding overhead.
3. Easier to understand for everyone.
4. Utilizes unit cost rather than just total cost.
5. Integrates well with Six Sigma and other continuous improvement programs.
6. Makes visible waste and non-value added.
7. Supports performance management and scorecards.
8. Enables costing of processes, supply chains, and value streams.
9. Activity Based Costing mirrors way work is done.
10. Facilitates benchmarking
Activity Based Costing Disadvantages:-
1. More time consuming to collect data.
2. Cost of buying, implementing and maintaining activity based system.
3. Makes waste visible which some executives and managers don't want their boss to see.
Example:-
Let’s suppose that a factory produces 2 products A & B. Now, if A is a customized product which takes a lot of R&D, is produced very rarely and needs some special engineering while B is a product which is in continuous production with a large amount of machine hours.
Now, as per the traditional costing system Product B will be allocated most of the indirect cost due to the no. of machine hours while Product A might have cost more due to the special engineering etc. Activity based costing thus takes various activities to be the cost base and allocates costs accordingly.