This article explains Activity based costing (ABC) by Robert Kaplan in a practical way. After reading you will understand the basics of this powerful financial management tool.
What is Activity Based Costing?
Activity Based Costing (ABC) is a system that goes beyond traditional cost price models with respect to indirect cost calculation models.
This method was developed in the United States. Robert Kaplan is regarded as the founder of the theoretical principles of activity based costing within the cost management knowledge area.
In the 1970s the activity based costing method was introduced in the manufacturing industry to solve the problems of traditional cost price calculation.
In traditional cost price systems such as the cost centre and surcharge methods, indirect costs are allocated based on volumes of products, for instance hours of labour and machine hours.
The costs are not allocated to the cost drivers and there is no causal relationship.
This makes it hard to determine the costs of the production factors and overheads as a result of which a distorted picture may be presented in terms of costs.
Unlike traditional cost price systems, activity based costing does establish a causal link between the cost drivers and indirect costs.
By passing on this insight to the responsible cost drivers, a transparent and cost-conscious conduct is stimulated.
The implementation of Activity Based Costing can help employees to understand the different cost categories and to analyse activities that add value.
This is also a way to find out what activities do not add value and should therefore be eliminated. In this manner improvements can be realized that can lead to higher performance results.
It also contributes to strategic developments within cost price calculations.
More accurate cost information can help an organization respond to competitive advantage and certain decisions in the Ansoff Matrix (PMM).
Activity Based Costing identifies cost groups of activity centres in organizations and allocates costs to products and services based on a number of events or transactions that are absolutely necessary in a process to deliver the product or service.
Benefits and drawbacks of activity based costing
- With the introduction of activity based costing the integral cost price of products can be calculated more accurately.
- Though simulation it is easier to calculate the effect of for instance changes in set-up times, fewer defective products, etc.
- By making the cost drivers clear, the departments accountable are stimulated to search for improvements of the production process to make them act more cost-conscious.
- ABC provides a clear picture of the behaviour and structure of the indirect costs. This is how for instance overheads can be managed much better.
- ABC can contribute to better cost price calculations for the benefit of the corporate strategy on the market.
- ABC is a fairly complex system and this is also the biggest drawback of the system.
- When implementing ABC, a lot of time needs to be spent on defining the activities, the calculation of the cost price and the finding of cost drivers. This requires a company to provide detailed cost information which in turn leads to a complicated process.
- ABC systems are expensive and they are complicated to maintain and adjust.
Activity Based Costing is cost price calculation, in which the cost drivers are allocated to the costs incurred.
In this system it is assumed that there is a causal link between the products and the accompanying costs.
Activity Based Costing is especially interesting for companies that, in the light of bad corporate results or strategic considerations (cost leadership), need to achieve an important cost reduction.
Cost reduction may in this respect also be translated into a better operational efficiency.
Activity Based Costing is also often used as the basis for the use of a Balanced Scorecard (BSC) within an organization.
Introducing activity based costing is not a simple task: it is a long and rigorous process and it is certainly not “as easy as A, B, C”.
It’s Your Turn
What do you think? Is Activity Based Costing applicable in today’s modern economy and organizations? Do you recognize the practical explanation or do you have more suggestions? What are your success factors for using a certain costing method?
Share your experience and knowledge in the comments box below.
- Garrison, R., Noreen, E. and Brewer. P. (2012). Managerial Accounting. McGraw-Hill.
- Kaplan, R. & Anderson, S. R. (2007). Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits. Harvard Business School Press.
- Shaban, A. (2009), Activity Based Costing ABC Adoption & Succes factoren [Activity Based Costing ABC Adoption & Succes factors], paper Faculty of Economics and Business Administration, Vrije Universiteit Amsterdam.
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