Activity-Based Costing ABC and Its Implication for Open Innovation

In healthcare, hospitals can use ABC to allocate overhead costs to patients and services based on activities consumed, improving cost management, quality control and patient care. And in education, schools can use ABC to allocate overhead costs to students and programs based on activities consumed, optimizing curriculum and increasing student satisfaction. Activity-based costing (ABC) is a method of allocating overhead costs to products or services based on the activities they consume. It can help managers make more accurate pricing, budgeting and profitability decisions, especially in service industries where overhead costs are high and diverse.

The cost driver is a factor that creates or drives the cost of the activity. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product’s transactions (cost driver) take at the counter and then by measuring the number of each type of transaction. For the activity of running machinery, the driver is likely to be machine operating hours, looking at labor, maintenance, and power cost during the period of machinery activity.

Activity-based investment management

ABC is superior to traditional cost quantification systems that focus on materials because it emphasizes activity costs and the added value activities bring to company products. While activity-based costing is a powerful costing method that can give you valuable insights into your business’s total overhead costs, it’s not without its pros and cons. Using ABC, overhead costs are traced to products and services by identifying the resources, activities and their costs and quantities to produce output. Traditional cost systems allocate costs based on direct labor, material cost, revenue or other simplistic methods.

Generally, the higher the number of services within the predetermined time period, the more efficient is the organization. Unit costing is used to calculate the cost of banking services by determining the cost and consumption of each unit of output of functions required to deliver the service. An activity is an event, task or unit of work with a specified purpose e.g., designing products, setting up machines, operating machines and distributing products. To use this costing system, you need to understand the process of assigning costs to activities. For example, the ABC system requires employees to track how much time they spend on each activity (e.g., research, production, etc.). Your employees might miscalculate or even exaggerate their time spent working on an activity.

Step 2 of 3

In this way, long-term variable overheads, traditionally considered fixed costs, can be traced to products. But in Activity-based costing system, overheads are related or assigned to activities or grouped into cost pools before they are related to cost objects i.e., products or services. We have now arrived at a complete ABC allocation of overhead costs to those cost objects that deserve to be charged with overhead costs. By doing so, managers can see which activity drivers need to be reduced in order to shrink a corresponding amount of overhead cost. For example, if the cost of a single purchase order is $100, managers can focus on letting the production system automatically place purchase orders, or on using procurement cards as a way to avoid purchase orders. Either solution results in fewer purchase orders and therefore lower purchasing department costs.

• Using ABC, overhead costs are traced to products and services by identifying the resources, activities and their costs and quantities to produce output.
• By viewing an ABC/M system as an enabler to improve the operations decision-making, we demonstrate that these systems enable an operations manager to enhance the quality of the decision-making process.
• The contents of secondary cost pools typically include computer services and administrative salaries, and similar costs.
• ABC enables effective challenge of operating costs to find better ways of allocating and eliminating overheads.
• Intelligent agents or smart agents for automated capture of accounting data .
• Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services.

We presented the flow of costs for a job costing system, including how to track actual overhead costs and how to track overhead applied using a separate manufacturing overhead account. This is done by dividing the estimated overhead costs (from step 2) by the estimated level of cost driver activity (from step 3). At this point, we have identified the most important and costly activities required to make products, and we have assigned overhead costs to each of these activities.

An integrated activity based approach to budgeting

Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders. Activity-Based Costing/Management (ABC/M) is an Information System developed in the 1980s to overcome some of the limitations of traditional cost accounting and to enhance its usefulness to strategic decision-making. In this paper, we show how an ABC/M system can serve as a useful information system to support effective operations decision-making processes. By viewing an ABC/M system as an enabler to improve the operations decision-making, we demonstrate that these systems enable an operations manager to enhance the quality of the decision-making process.

Unfortunately, there isn’t a costing method that gives you a completely accurate breakdown of your costs. So although an ABC system is more accurate and detailed than traditional costing, it isn’t 100% accurate. With an ABC system, you can assign costs to each activity in the production process. You can use this data to set a price that more accurately accounts for how much it costs you to create the product.

The Disadvantages & Advantages of Activity-Based Costing

When considering all relevant activities, overhead costs in manufacturing each product are actually less than that estimated by labor hours only. CIMA Official Terminology describes activity-based costing as an approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. Unlike the traditional costing method, which allocates overhead costs based on broad categories, the ABC system offers a more accurate understanding of how you use resources and incur different types of costs. Create cost pools for those costs incurred to provide services to other parts of the company, rather than directly supporting a company’s products or services. The contents of secondary cost pools typically include computer services and administrative salaries, and similar costs.

• This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods.
• Your employees might miscalculate or even exaggerate their time spent working on an activity.
• It uses physical, monetary and non-monetary indicators to measure these costs and assumes a split variation of the total cost model, which imputes and distributes all of the costs among the company’s products.
• ABC can reveal the drivers and causes of costs, and show how they relate to the value-added activities and outputs of the organization.

The present era of global competition, evolving technologies and information systems is leading companies toward a renewed commitment to excellence in manufacturing. Increasing attention to the introduction of new products, the quality of products and processes, the level of inventories, and the improvement of workforce policies have helped companies to become world-class. Accurate cost information is critical for every aspect of a business, from its pricing policies to its product designs and performance reviews.

Throughput accounting and performance of a manufacturing company under stochastic demand and scrap rates

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

Another benefit of using ABC for cost classification is that it can help P&L managers better manage costs and improve efficiency. ABC can reveal the drivers and causes of costs, and show how they relate Activity-Based Costing to the value-added activities and outputs of the organization. This can help P&L managers identify and eliminate waste, reduce non-value-added activities, and optimize the use of resources.