Activity Based Costing

Activity Based Costing (ABC) was developed as a concept in the manufacturing sector of the United States during the 1980s as an accounting approach designed to address the problems associated with traditional cost management systems. Traditional systems tended to be unable to determine accurately production and service costs, or to provide fully useful information to support operational decision making. ABC was first introduced in 1987 by Robert Kaplan and Robin Cooper, with focus on manufacturing environments where increasing technology and productivity improvements meant that the percentage of a firm's costs resulting from direct labour and materials was decreasing (Cooper & Kaplan, 1987). ABC has now extended to other sectors of the economy. For example, financial institutions, which have diverse product portfolios, have found the procedures very useful for accurate cost allocation (Sapp et al., 1990).

• Boeing Commercial Airplane Group Wichita, a cost centre plant of the world’s largest manufacturer of commercial airplanes, implemented an ABC system that realised a 20% reduction in rework and savings of approximately $900,000 per year in one shop alone (Labour Aerospace Research Agenda, 2001). Participants in that case study argued that 80% of the problems associated with implementation were due to organisational culture issues, with the remaining 20% due to technological barriers.
• An ABC analysis found that three of seven products by AIRCO, a manufacturer of industrial air conditioner units, were losing money at their current sales price (Nachtmann & Al-Rifai, 2004).
• IBM developed and implemented a fully automated ABC system for the State of California's Department of Motor Vehicles, which now accounts for personnel activity and overhead costs, helping to ensure that limited resources are being used in the most effective and efficient manner (IBM, 2007).

Following Chutchian-Ferranti (1999):

• Set up a team responsible for determining which activities are necessary for the product or service
• Determine the elements of each activity that cost money taking note of all fixed and variable costs
• Examine hidden costs relating to service maintenance and factor out non-activity costs
• Input all information into an appropriate computer application
• Analyse and determine the cost effectiveness of activities

• Previously thought to be just for large corporations, Hicks’ (1999) example, amongst others, presents a small manufacturer that builds components for the automobile industry, who were able to triple sales and increase profits fivefold in a four-year span after adopting ABC.
• The concept has been deemed vital for every business in cutting costs and increasing profits. Cokins (1996) posited that within 10 to 20 years, every organisation will have some sort of ABC.
• Activity based costing provides managers with useful information they need regarding the contribution that each activity makes to overall profitability: ABC provides insights for managers about maximising process performance. ABC = Measurement + Control (CPS, 2007)

• ABC projects often fail because project managers ignore the cardinal rule: It is better to be approximately correct than to be precisely inaccurate. The use of overly detailed information, and the failure to connect information to action hinder ABC projects (Cokins, 2000).
• While ABC represents a major advance over the arbitrary overhead allocations associated with traditional cost systems, many companies have abandoned ABC or updated their model only infrequently, because of the high time and cost associated with re-estimating the model (Kaplan, in Gilbert, 2007).
• Interviews by strategy consultants and ABC surveys can be time-consuming, expensive to perform and irritating to the employees who have to provide the data. They can be error-prone, relying on employees' subjective time estimates (Kaplan, in Gilbert, 2007).

• www.knowledgebrief.com/businessbrief/redirects/ABC1.html

  Results from a cross-sector study in ABC usage.

• www.knowledgebrief.com/businessbrief/redirects/ABC2.html

  Definition and methodology from the US Department of Energy.

• www.knowledgebrief.com/businessbrief/redirects/ABC3.html

  'Using ABC to manage more effectively' - a PricewaterhouseCoopers public sector report.

• www.knowledgebrief.com/businessbrief/redirects/ABC4.html

  Commercial site: Case studies of ABC capabilities.

• Kaplan, R. S. and Anderson, S. R. (2007) Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits, Harvard Business School Press.

  Illustrates the TDABC approach with real case studies in diverse settings.

• Emblemsvaq, J. (2003) Life-Cycle Costing: Using Activity-Based Costing and Monte Carlo Methods to Manage Future Costs and Risks, Wiley Publishers.

  A new approach to life cycle costing: Draws on ABC, risk, and uncertainty concepts.

• Innes, J. (2002) Activity-based Costing in the UK’s Largest Companies: A Comparison of 1994 and 1999 survey results, Management Accounting Research, Vol. 11 (3), pp. 349–362.

  Reviews the results of two U.K. surveys of ABC in the UK’s largest companies.

• O’Guin, M. C. (1991) The Complete Guide to Activity-based Costing, CCH Tax and Accounting.

  A practical guide with case studies - implementing ABC.

• Hicks, D. T. (2000) Activity-Based Costing: Making it Work for Small and Mid-Sized Companies, 2nd ed, Wiley Publishers.

  Practical guide for small to medium companies using PC-based spreadsheets.

• Chutchain-Ferranti, J.(1999) Activity-Based Costing, Available at: www.geocities.com/royston76/method/m2.htm
• Cooper, R. and Kaplan, R. S. (1987) How cost accounting systematically distorts product costs, in Burns, W.J, and Kaplan, R.S (Eds), Accounting and Management: Field Study Perspectives, Harvard Business School Press, Boston, MA, pp. 204-28.
• Cokins, G. (1996) Activity-based Cost Management, Making It Work. A Manager's Guide to Implementing and Sustaining an Effective ABC System, McGraw-Hill.
• Cokins, G. (2000) Overcoming the Obstacles to Implementing Activity-Based Costing, Bank Accounting and Finance, Vol.1 (14).
• CPS, Crown Prosecution Service (2007) Guide to Activity Based Costing in the Crown Prosecution Service, Available at: www.cps.gov.uk/publications/finance/abc_intro.html
• Directives (2008). Available at: www.directives.doe.gov/pdfs/doe/doetext/neword/430/g4301-1chp24.pdf
• Gilbert, S. J. (2007) Adding Time to Activity-Based Costing. Available at: http://hbswk.hbs.edu/item/5657.html
• Hicks, D. T. (1999) Yes, ABC is for Small Business, Too, Journal of Accountancy, Vol. 188 (2) pp.41-3.
• IBM (2007) Using Activity-Based Costing to Establish Fees. Available at: www-01.ibm.com/software/success/cssdb.nsf/CS/BTHD-78BPJV?OpenDocument&Site=
• Labor Aerospace Research Agenda (2001) Employing Activity Based Costing and Management Practices Within the Aerospace Industry: Sustaining the Drive for Lean, Massachusetts Institute of Technology.
• Nachtmann, H. and Al-Rifai, M. H. (2004) An Application of Activity Based Costing in the Air Conditioner Manufacturing Industry, Engineering Economist, Vol. 49 (3), pp.221-236.
• Sapp, R., Crawford, D. and Rebishcke, S. (1990) Activity Based Information for Financial Institutions, The Journal of Bank Cost and Management Accounting, Vol. 3 (2), pp. 53-62.