Activity Based Costing

1. Introduction:

Costing system always provides useful information to managers in developing the strategies and measuring the performance of their products. Traditionally firms use volume driven cost allocation systems like input of direct labor in dollars, machine hours and gross sales in dollars to find the cost of their products and then also set the price for their customers but in many cases resources required for individual products are not in the same proportion of volume of goods produced (Cooper and Kaplan, 1992). What happen when three friends go for lunch, one of them ordered for economical cheeseburger while other two ordered expensive Prime rib and at the time of paying bill they say “let’s contribute equally”? Same is in the case of products where products are allocated cost without any logical reason in traditional costing systems. Activity-based cost management system makes it right and does not allocate cost illogically but trace and assign the cost on the basis of cause and effect relationship to find more accurate cost of that product (Cokins, 2001:1). So through more accurate and realistic cost assigning along with a wide range of information permit the managers to improve the quality of their decision making while formulating the strategies (Gupta and Galloway, 2003).

2. Designing an Activity based cost system:

Following two stages are involved in designing an ABC system.

1. Pre-implementing Stage
2. Implementing ABC system

2.1 Pre-implementing Stage:

Prime factor needed for the successful implementation of ABC system is the support from top managers. Without top managers’ support it is very difficult to bring change especially in the case of change in evaluating and rewarding system in ABC system (Garrison, Noreen, Brewer, 2008:314). Other important thing is to build cross-functional team to implement the ABC system instead of involving accounting department only. To bring new system successfully management should show their intentions and bring together a dedicated and powered implementation team (Roztocki and Needy, 1999). So or the successful implementation of an ABC system support from top managers and forming a cross-functional team are needed.

2.2 Implementing stage of ABC system:

Most of the practitioners have divided this stage into these following steps

1. Identify major activities
2. Assign cost to each activity center or cost pool
3. Determine the activity drivers
4. Assign activity cost to products according to their usage of that activity

2.2.1 Identify major activities:

It provides the foundation to the ABC system and identifies the major activities that are performed in organization to produce their output. It can be a time consuming process in which judgments are involved based on data collected and the common way of collecting that data is to interview with people from overhead department to recognize major activities (Garrison, Noreen, Brewer, 2008:316). Examining physical plans for work place that how work space is been used and the payroll plans that how relevant employees are rewarded provides a useful start to classify the major activities taking place (Innes and Mitchell, 1995b). Long list of activities can lead to complex design, implementation and use of the system but on the other hand greater number of activities will assign cost more accurately, so there is tradeoff between number of activities and the complexity of system (Garrison, Noreen, Brewer, 2008:316). Some early ABC systems contain about hundred of activities and cost centers but recent studies are suggesting that twenty to thirty activities and cost centers could be maintain (Drury, 2006:361).

So you can merge the activities that are significantly correlated to each other and grouped mutually at suitable level. For example do not merge unit level activities with batch level or product level activity and so on. For example maintaining material handling as one activity measured by no. of orders place as cost driver can be inappropriate especially in the case of cost of receiving and issuing, so this activity should decompose into purchasing, receiving and issuing activities and measure with separate cost drivers.

2.2.2 Assign cost to each activity center or cost pool:

Activity cost pool is a pail which contains the accumulated cost related to that single activity in an ABC system (Garrison, Noreen, Brewer, 2008:312). After defining the major activities in ABC system the cost of consumed resources are allocated to each of cost pool canter. Now this is important that what percentage of that consumed resources should assign to each cost pool center. The aim is to find that how much that company is expending on each of its activities on the basis of cause and effect relationship cost drivers that can be obtain from interview with staff that ho much resources are consumed at each level of activity (Drury, 2006:361).

2.2.3 Determine the activity drivers:

Cost drivers are needed to assign related cost to each of the activity cost pool. Costs drivers are also called activity measure provide the base of assigning cost to each of the activity. So it is very important to select an appropriate cost driver for each activity that provide a good base for the costs at that activity level and also can be measured easily (Drury, 2006:361).

2.2.3.1 Selection of Costs Drivers:

More numbers of cost drivers are practically important and provide more accurate cost estimation (Babad and Balachandran, 1993). On the other side small numbers of drivers are easy to manage and also less costly to implement and maintain in an ABC system (Merchant and Shields, 1993). This tradeoff between cost and benefit needs a careful study of cost drivers to achieve optimal costs drivers in an ABC system. These cost drivers can be measured in the form of transactional drivers or Duration drivers. In transactional cost drivers costs are assigned to the activities according to the number of transactions or time performed that activity. For example the number of purchase orders placed or number of customer orders receives. These are least expensive but on the other hand these are also least accurate as these drivers assumed that each same quantity of resources will be required to perform that activity. So for the activities where variation of resources by individual cost object is minimum, transactional drivers will measure accurately otherwise you can go for duration drivers approach in which cost of activity is assigned according to the time spend to perform that activity for example if one of the product is been processed at short et up time while other needs long set up time then selecting set up time as duration driver can measure cost more accurately related to that activity (Drury, 2006:362). Now in this example if we use number of set up to those products as transactional driver then product with high set up time will be under cost while product with high set up time will be over cost. So it is very important to select cost drivers that assign cost to that activity accurately.

2.2.4 Assign activity cost to products according to their usage of that activity:

At the last find the activity driver rates that will apply to those activities and should be measure in such a way that it to be identified with each of individual product. For example here we will define the mechanism for calculating the set up hours used by each of the product.

So this how one can design an ABC system in their operations that can assign costs more accurately to their products.

3. Why Activity Cost Hierarchy:

Activities can be performed at one of these five levels in an organization (cooper, 1990)

1. Unit Level: These activities are performed each time when you produce a unit of product like power to run processing equipment.
2. Batch Level: these activities are proportionate to the process batch regardless how many units are produced at that batch like placing purchase order.
3. Product Level: These activities are related to some specific product regardless how many batches are completed or units are produced like designing a product
4. Customer level: These activities are related to some specific customers like sales calls
5. Organization sustaining activities: these are organization base activities and must be performed whether units are produced or not and customers are served or not like cleaning executive office, providing computer network etc.

The major benefits of classifying these costs are that it can help in defining the major activities in the organization, the first step of the process of designing an ABC system. On the other hand it also provides the basis of decomposition and merging the activities into each other that can help to identify a better activity cost pool and thus decrease the cost of maintaining those extra activities that can be merged,

4. An illustration to design ABC system:

Garrison, Noreen and Brewer have discussed the case in his book (2008:314). Classic Brass Inc is producing two luxury yachts (1) Standard Stanchions (2) Compass housings. President of the company wants to convert into ABC system approach and called a top management meeting in this respect and formulate a cross-functional team including the account manager, production manager and marketing manager.

4.1 Stage 1

After gaining information and interviewing employees they found following major activities performed in their operations and maintain the following activity cost pools.

1. Customer Orders: these activities cost centers are involved cost of processing paperwork or any machine set up that is installed for specific orders. It is batch level activity and cost borne by the company will remain same for 1 or 1000 or more units in one batch.
2. Product Design: A product level activity cost center that hand over all the costs spend in designing the product to this activity.
3. Order Size: It is a unit level activity that assigns the cost of units produced including the required machine power, depreciation and miscellaneous factory supplies. Team has merged these correlated activities into one single activity i.e. order size.
4. Customer Relations: A customer level activity assigns all the costs related to customer relation management including sales call cost and the cost of entertaining their customers.
5. Others: It is an organization sustaining activity cost center which includes all the costs except above mentioned costs and are not the par of product cost.

4.2 Stage 2

Company’s annual overhead costs are given below

Production Department
Indirect factory wages	500000
Factory equipment depreciation	300000
Factory Utilities	120000
Factory building lease	80000
Sub total		1000000
General Administrative Dept.
Administrative wages	400000
Office equipment depreciation	50000
Administrative building lease	60000
Sub total		510000
Marketing department
Marketing wages	250000
Selling expenses	50000
Sub total		300000
Total overhead cost		1810000

                                   

Source (Garrison, Noreen, Brewer 2008:318)

After interviewing with staff from production department and through other information team found following percentage of resources used by each activities cost centers defined at first stage.

	Customer orders	Product Design	Order size	Customer Relations	Others	Total
Production Department
Indirect factory wages	25%	40%	20%	10%	5%	100%
Factory equipment depreciation	20%	0%	60%	0%	20%	100%
Factory Utilities	0%	10%	50%	0%	40%	100%
Factory building lease	0%	0%	0%	0%	100%	100%
General Administrative Dept.
Administrative wages	15%	5%	10%	30%	40%	100%
Office equipment depreciation	30%	0%	0%	25%	45%	100%
Administrative building lease	0%	0%	0%	0%	100%	100%
Marketing department
Marketing wages	22%	8%	0%	60%	10%	100%
Selling expenses	10%	0%	0%	70%	20%	100%

Source (Garrison, Noreen, Brewer 2008:318)

Its mean that the company has following overhead cost structure in respect of it activity cost pool centers. For example cost of customer orders for indirect factory wages will be $125,000 which is the result of 25% of total indirect factory wages i.e. $500000.

	Customer orders	Product Design	Order size	Customer Relations	Others	Total
Production Department
Indirect factory wages	$125,000	$200,000	$100,000	$50,000	$25,000	$500,000
Factory equipment depreciation	$60,000	$0	$180,000	$0	$60,000	$300,000
Factory Utilities	$0	$12,000	$60,000	$0	$48,000	$120,000
Factory building lease	$0	$0	$0	$0	$80,000	$80,000
General Administrative Dept.
Administrative wages	$60,000	$20,000	$40,000	$120,000	$160,000	$400,000
Office equipment depreciation	$15,000	$0	$0	$12,500	$22,500	$50,000
Administrative building Lease	$0	$0	$0	$0	$60,000	$60,000
Marketing department
Marketing wages	$55,000	$20,000	$0	$150,000	$25,000	$250,000
Selling expenses	$5,000	$0	$0	$35,000	$10,000	$50,000
Total	$320,000	$252,000	$380,000	$367,500	$490,500	$1,810,000

Source (Garrison, Noreen, Brewer 2008:318)

So this how team assign the relative cost to each of the activity cost center.

4.3 Stage 3:

After assigning cost to each cost pool team has define following cost drivers in this respect

Activity Cost Pools and Activity Drivers
Activity cost pool	Activity drivers
Customer orders	No. of Customer orders
Product Design	No. of Product Design
Order size	Machine hours
Customer Relations	No. of active customers
Others	Not applicable

Source (Garrison, Noreen, Brewer 2008:317)

For customer orders, Product design and customer relations transactional activity driver measurement are used as there are less variation in resource consumption each time while order size is measured in Machine hours as for processes there are different resource consumption and using duration driver will measure it more accurately.

4.4 Stage 4:

At this stage activity rates are measured through activity drivers and assigned to each of the activity to find the cost of their products. At the end team find the following minimum number of activities required for the company to serve its customers and to produce required product mix along with their activity rates.

Activity cost pool	Total Cost	Total Activity		Activity rate
Customer orders	$320,000	1000	Orders	$320	Per Orders
Product Design	$252,000	400	Design	$630	Per Design
Order size	$380,000	20000	Hours	$19	Per Hours
Customer Relations	$367,000	250	Customers	$1,470	Per Customers
Others	$490,500	N/A		N/A

Source (Garrison, Noreen, Brewer 2008:320)

So the ABC system which company has developed will assign $320 per order that will be placed and $630 per product design which are higher than dollars per machines hours as these are the batch level and product level activities. After designing ABC System Company has assigned cost to each of its two products i.e. Standard Stanchions and Custom Compass Housing.

Standard Stanchions
Activity cost pool	Total Activity		Activity rate		Total
Customer orders	600	Orders	$320	Per Orders	$192,000
Product Design	0	Design	$630	Per Design	$0
Order size	17500	Hours	$19	Per Hours	$332,500
Total Cost					$524,500
Custom Compass Housing
Activity cost pool	Total Activity		Activity rate
Customer orders	400	Orders	$320	Per Orders	$128,000
Product Design	400	Design	$630	Per Design	$252,000
Order size	2500	Hours	$19	Per Hours	$47,500
Total Cost					$427,500

Source (Garrison, Noreen, Brewer 2008:323)

Here customer relation and other cost is not assigned as these are customer base and organization sustainability base cost and are not related to product.

5. Limitations of ABC system:

Though ABC system provides more accurate cost assigning instead of illogical cost allocation but on the other hand it also poses some of Limitations. These limitations are given as follow.

1. Implementation is a major problem in applying an ABC system. More costs are incurred not only in installing the system but also in maintaining the ABC system (Garrison, Noreen, Brewer 2008:334). So there is a tradeoff between the benefits and cost in implementing an ABC system. A survey shows that there are 15.3% of UK’s largest firm had rejected ABC system after considering implementation in 1999 which was 13.3 in 1994 (Inns, Mitchell and Sinclair, 2000)
2.  In a study of Major and Hopper at Marconi Corporation a telecommunication firm encounters a problem in their ABC system. Production manager thinks that 23% of the costs are irrelevant and inaccurate to assign to the product but their frontline employees opposes it as they think that it can be lead to downsizing and work intensification. So the data provided by these distrustful employees can be inaccurate (Major and Hopper, 2005).
3. Huge care is needed when data from ABC system is uses for decision making in the organization and before reaching to a conclusion managers should identify the costs relevant to that decision making (Garrison, Noreen, Brewer 2008:334).
4. As organizations use ABC system for internal uses reports are generated by best ABC system who do not follow GAAP principles that arise the need of separate external cost system that can lead to confusion and cost (Garrison, Noreen, Brewer 2008:334).

5. Conclusion:

In conclusion ABC system leads to increase in accurate cost estimation that assists to a better decision making in the organizations. Designing ABC system is a complex process that needs a very careful selection of cost drivers that should less expensive to deal and provide accurate cost information, Not only implementing but also maintaining the ABC system is difficult to manage and costly and also a careful decision making is needed while using the data from an ABC system as it can misguide.

References:

Babad, Y. M. and Balachandran, B. V., (1993), ‘Cost driver optimization in activity-based costing’, The Accounting Review, July, 563–575

Cokins G. (2001), ‘Activity-Based Cost Management: An Executive’s Guide’, John Wiley & Sons Inc

Cooper, R. (1990), ‘Cost Classification in Unit-Based and Activity-Based Manufacturing Cost System’, Journal of Cost Management, fall 1990:4-14

Cooper, R., Kaplan, R., (1992), ‘Activity-Based Systems: Measuring the Costs of Resource Usage’, Accounting Horizons

Drury C. (2006), ‘Cost and Management Accounting: An Introduction’, 6th Ed, Thomson Learning

Garrison R.H., Noreen E.W., Brewer P.C., (2008), ‘Managerial Accounting’, 12 Ed, McGraw-Hill/Irwin

Gupta M. and Galloway K., (2003), ‘Activity-based costing/management and its implications for operations management’, Technovation, vol23:131–138

Innes, J., F. Mitchell, (1995b), ‘Activity-based costing in UK’s largest companies’, Management Accounting Research, vol6: 137-154

Innes, J., F. Mitchell and Sinclair D. (2000), ‘Activity-based costing in UK’s largest companies: A comparison of 1994 and 1999 survey results’, Management Accounting Research, Sep 2000: 349-362

Major M. and Hopper T. (2005), ‘Managers Divided: Implementing ABC in Portuguese Telecommunications Company’, Management Accounting Research, June 2005:205-229

Merchant, K. A. and Shields, M. D., (1993), ‘Commentary on when and why to measure cost less accurately to improve decision making’, Accounting Horizons, vol 7, 76–81

Roztocki N. and Needy K.L., (1999), ‘How to Design and Implement an Integrated Activity-Based Costing and Economic Value Added System’, Industrial Engineering research