Introduction to the Activity-Based Costing (ABC) Model
The Activity-Based Costing method identifies the activities in the company and assigns their costs to production based on actual consumption.
One of the most recognized definitions is of the Chartered Institute of Management Accounting (CIMA) and defines the ABC method as an ‘approach to costing and monitoring of activities which involves tracing resource consumption and assigning costs to final outputs.’ The method achieves this objective based on consumption estimates, using cost drivers to attach costs to outputs.
We can summarize the process in the following process diagram:
The Activity-Based Costing (ABC) model is used to get a sound estimate of the cost elements of products, services, and activities, to support the decision-making process within a company.
We can look at the ABC model from the perspective of two aims:
- Product aim – identify and cancel unprofitable products and services, and lower prices of overpriced ones;
- Process aim – identify and eliminate ineffective or useless processes and implement process concepts that lead to the same products at improved yields.
The Activity-Based Costing method assigns the company’s resource costs to products and services provided to clients via activities. We use it mostly as a tool to analyze product and customer cost and profitability, to support strategic decisions like pricing, outsourcing, management of process improvement projects, and others.
ABC bases its system of cost accounting on activities, which can be any tasks, events or other units of work. Each activity has a cost driver, which can be anything like purchase orders, machine setups, quality checks, and others.
Financial analysts mostly use the model in costing, pricing and profitability analysis. It helps the company to develop a better sense of its costs and to adopt the most appropriate pricing strategies.
Activity-Based Costing can help in two ways:
- It replaces one company-wide cost pool with more cost pools linked to company activities;
- It provides a new base for allocating costs so that they are assigned based on the event that generates them, not based on volume measures.
History of the ABC Model
Traditionally indirect costs were analyzed as caused equally by all products the company was making. With the increase in indirect costs’ share, this became too inaccurate. Products spending more time in an expensive machine should cost more than those requiring less time in specialized machinery. This discrepancy presented a possibility that cost allocation is even more inaccurate when two products share typical costs, as one might be subsidizing or dragging down the other.
The Activity-Based Costing originated from George Staubus’s Activity Costing and Input-Output Accounting publication. The method was developed in the 1970s and 1980s in the US manufacturing sector and formalized in its current form by the Consortium for Advanced Management-International (CAM-I).
Activity-Based Costing Methodology
The ABC method seeks to identify cause and effect relationships to assign costs. The model then attributes these costs to products based on how much the product uses the activity, causing the cost. That way, the Activity-Based Costing method singles out activities with high oevrheads per unit and points out areas where management needs to reduce costs or find a way to charge more for the product.
The ABC approach helps us seggregate costs to fixed, varible and overheads. This split of costs helps us with figuring out the cost drivers. Direct materials and labour are mostly easy to trace to products. However, this is usually not the case with indirect costs. Whenever products use the same resources in ther production cycle, but use them in a different matter, some weighing is needed.
A cost driver is the factor that creates and drives the activity. Take machine hours as an example – machine operating hours drive power costs and maintenance costs.
The Activity-Based Costing aids the costing process of the company by extending the cost pools used to analyze overheads and linking indirect costs to specific activities.
We can identify two categories of activity measures:
- Transaction drivers – how many times a task occurs;
- Duration drivers – how long it takes to perform an activity.
The ABC method has five activity levels:
- Batch-level activity;
- Unit-level activity;
- Customer-level activity;
- Product-level activity;
- Organization-sustaining activities.
Uses of the ABC Model
The most significant advantage of the Activity-Based Costing method is that it helps us better identify how we use overheads.
Also, ABC benefits us when dealing with the following issues:
- Make or Buy – the ABC approach helps us see which costs we can remove by outsourcing an item;
- Minimum price – better cost knowledge can help to ensure no items are sold at a loss, or overpriced;
- Production facility cost – separating overheads at the plant-level helps us compare performance between different production facilities;
- Distribution channels – by identifying which channels absorb most overheads we can adjust the way channels are maintained, drop channels that are not profitable and focus our efforts on the channels that are most profitable;
- Client profitability – overheads can be servicing, handling returns and complaints, commissions, and others, separating those on customer level can help emphasize on valuable clients or dump clients generating loss;
- Margins – the Activity-Based Costing model can help us to determine the margins of products, product lines, brands, clients, and others, thus being useful to decide on where to focus company resources for increased profitability;
- Activity costs – we can see where cost reduction is needed by running a benchmark analysis against industry standards.
Limitations to the Activity-Based Costing Model
While the Activity-Based Costing method can provide us with valuable insights into the cost structure of production, the approach is subject to some limitations.
- Expensive Data Collection – a degree of automation in the data collection process is required, to prevent cost increase in administrating expenses;
- Treats Fixed costs as Variable costs – like other cost allocation approaches, Activity-Based Costing essentially treats fixed costs as if they’re variable, which may provide the wrong basis for the decision-making process;
- Tracing some expenditures to products and customers can be hard, when these are ‘business sustaining’ costs, like the CEO’s salary; we do not allocate these, as there’s no reasonable way to do so, but they still have to be covered by contribution;
- Transition to automated Activity-Based Costing accounting – automating data capture by extension of accounting to reduce cost of implementing the system.
Problems with the ABC Model
Companies often implement the Activity-Based Costing method only to see it fall in disuse. It is not uncommon for such projects to fail at the implementation phase, due to some of the following reasons:
- Cost pools – the advantage of ABC is in the detailed information coming from more cost pools; however, the more cost pools we identify, the more expensive it becomes to maintain the detailed information for these;
- Project basis – ABC implementations are often treated by management as a one-time analysis; in such cases information usefulness declines over time, as structures change, for which we need to make sure the model gets as much data as possible directly from the ERP or accounting system, minimizing additional inputs needed;
- Activity-Based Costing is a good fit for complex production environments, and it won’t add many benefits to a simple structure, no matter how much the company spends on developing the system;
- Employees usually report slack time as part of other activities, which inflates the costs to be assigned and may lead to substantial cost misallocations;
- Installation time in complex environments may take years and lose management’s continuous financial support over time; therefore it’s better to do smaller, more targeted installations;
- Many information sources – usually the ABC model needs more info than the accounting system/ERP can provide, which requires that additional databases be maintained;
- When too many departments are involved, this raises the chance that data inputs will fail over time.
Preparing a sample ABC Model in Excel
Let us develop a sample Activity-Based Costing model so that we can better understand how it works when applied in a real-life scenario.
First, we will take a look at a simple one-activity ABC model. We assume that we have identified one activity – Machine set-ups. We have determined that machines are configured for each batch of products we make, regardless of the batch size. The overhead costs for machine setups are EUR 250 thousand, out of the total production overhead costs of EUR 1.9 mil. Over the period, we have performed one thousand configurations, which gives us EUR 250 per machine set-up.
If we apply the ABC model, we have EUR 250 per setup, in addition to EUR 12.50 per machine hour, compared to EUR 14.39 per machine hour under traditional costing (see below).
To better understand the impact of separating the machine setup activity, let us take a look at a small batch size – 800 pcs of a product. We have EUR 250 setup costs for the batch or EUR 0.31 setup cost per unit. We also have a constant production volume of 50 pcs per machine hour, which gives us a EUR 0.25 per unit for other production overheads. The sum of both amounts is EUR 0.56 per unit.
Comparing to the traditional costing approach (EUR 0.29 per unit), we see that applying ABC for such a small batch gives us an almost double overhead cost per unit. Such discrepancy can indicate that the product is underpriced and subsidized by another product, as only about half of the overheads go into the pricing process.
We can also take a look at how the costs will be assigned in a larger batch, say 16,000 pcs. Machine set-up costs then arrive at EUR 0.02 per unit, and the total overheads per unit under ABC will then be EUR 0.27, lower than the EUR 0.29 per traditional costing. In this scenario, we are overpricing our product under traditional costing, as the overhead cost assigned per unit is lower under the Activity-Based Costing.
To make it more exciting and closer to a real-world scenario, let’s add a second activity to the model – overheads for procurement of raw material used in our product. We can then calculate the procurement cost per kg of raw material and deduct the total amount from the overheads (see below). Following this approach leaves us with a cost structure as follows:
- EUR 250 for machine set-up costs per batch produced;
- EUR 0.08 procurement cost per kg of raw materials used;
- EUR 9.70 other production overheads per machine hour incurred.
To compare the Activity-Based Costing model to traditional costing, let us look at two similar products, the only difference between which is the quantity of raw material that goes into production.
Following the same approach as above, we get the same overhead setup costs and other overhead costs per unit. The only difference comes from the fact that one product takes 0.5 kgs of raw material, and the other takes 1.7 kgs. Considering this difference and the EUR 0.08 procurement overheads we allocated per kg of raw material, we arrive at EUR 0.26 costs per unit of the first product and EUR 0.36 for the second product. We can see that the first product is overpriced under traditional costing, as we are allocating more cost to it than we should. On the other hand, our other product is most probably underpriced and might be generating losses for the company. We should look into raising its price, if possible, or seek out optimizations in the production process, that will give us cost savings. If none of those is a viable option, we might consider dropping the product from our product line.
I hope the simplified scenario that we looked at illustrated how we can utilize Activity-Based Costing to undertake more well-informed strategic decisions in regards to pricing and costing within the company.
The ABC method is a costly approach that recognizes the relationship between produced goods, costs, and overheads. It aims to allocate indirect expenditure and overheads, such as payroll and utilities, to the respective products. The method is mostly used in the manufacturing industry, as it produces nearly actual costs and helps with better cost allocation. Still, we need to keep in mind the above-discussed limitations when we consider implementing the Activity-Based Costing method.
The ABC approach can help with a lot when it is set up on all levels of detail; however, this might be financially unfeasible, so we need to perform an appropriate cost-benefit analysis for each level of detail before starting an implementation project.
ABC implementations are a bumpy ride in many companies, often with declining usefulness over time. The best path we can take is to start with a more simple and highly targeted ABC system to mitigate the discussed problems.
Thank you for reading. Do not forget to share with colleagues and friends and download the Excel model provided below:
Hi! I am a finance professional with 10+ years of experience in audit, controlling, reporting, financial analysis and modeling. I am excited to delve deep into specifics of various industries, where I can identify the best solutions for clients I work with.
In my spare time, I am into skiing, hiking and running. I am also active on Instagram and YouTube, where I try different ways to express my creative side.
The information and views set out in this publication are those of the author(s) and do not necessarily reflect the official opinion of Magnimetrics. Neither Magnimetrics nor any person acting on their behalf may be held responsible for the use which may be made of the information contained herein. The information in this article is for educational purposes only and should not be treated as professional advice. Magnimetrics and the author of this publication accept no responsibility for any damages or losses sustained in the result of using the information presented in the publication.
Thank you so much. very clear and helpful.
Hi there, thank you for sharing.
I am glad it was helpful!
what are the real world examples( name of the companies that are using this inventory method) for ABC analysis
Hi Senh, I can’t give a list of companies, but from my work experience, I’ve noticed that manufacturing businesses tend to use activity-based costing. This is probably because these companies have a significant amount of overheads that they need to allocate to their production.