To understand how companies use activity based costing, it is necessary to see how the expenses incurred by the enterprise can be allocated to the various activities that are necessary for producing goods and services. Most costs, including general overhead, can be analyzed in this way.
Origin of Activity Based Costing
Activity based costing was introduced in the US in the 1980s at a time when there was some dissatisfaction with more traditional methods of costing. One reason for this was that manufacturing industry was becoming more automated with the result that the proportion of indirect costs was growing compared to direct costs.
For example, the reduction in the need for direct labor and the increase in the use of machinery meant that direct labor costs were being reduced while overheads such as depreciation and the costs of operating plant and machinery were increasing. Costing methods that computed a contribution to products based primarily on direct costs were therefore becoming less precise in their ability to allocate costs in a manner that could identify areas of inefficiency and relate the costs to the products.
To understand how companies use activity based costing it is necessary to look at the need for informed management decisions. The ability of management to take decisions that could increase product profitability was limited by the shortcomings of the information provided by their costing systems and a more useful costing system was required.
Activity based costing identifies the activities taking place in the organization and allocates the costs of the organization to those activities. The contribution of each activity to the various products and services provided by the company is then measured and allocated between those products and services. As a result, most of the costs of the enterprise are allocated on a rational basis to the products, resulting in an accurate determination of the profitability of each product or service.
Implementation of Activity Based Costing
An enterprise using activity based costing does not need to allocate a large pool of overhead expenses to the products based on arbitrary or very general criteria, because allocations are based on measurements of cause and effect that relate activities to the products. The connection between a cost and an activity are identified and the costs are therefore assigned to products and services in a rational manner, based on the extent to which each activity is involved in the creation of each product.
This assignment of costs to activities and products based on observation and measurement of the contribution of the activities to the output of products or services enables an organization to identify a situation where there is a high overhead cost per unit of a particular product.
Other costing systems would tend to overlook this type of inefficiency because they would tend to allocate general overheads to products based on a general allocation key that would not reflect the actual relationship between the overhead expenses and the product. This differs from how companies use activity based costing to allocate costs to activities as a result of observation and measurement of those activities.
Activity based costing is an attempt to analyze and understand the extent to which the time and costs of people and machines are spent on activities that are necessary for producing the goods and services. This can reveal inefficiencies in the production of certain goods that may be hidden under other costing systems. For example, a particular product uses a large amount of operating time of a particular machine and when the running and maintenance costs are correctly allocated to the product it may be shown to be much less profitable than originally thought..
Advantages of Activity Based Costing
The analysis of costs to the various activities and the relation of these activities to the products to which they contribute can highlight inefficiencies that would be overlooked by more traditional systems that fail to adequately analyze general overhead expenses.
For example, a particular staff member might spend a disproportionate amount of time on an activity that relates to the output of a particular product, meaning that under activity based costing a relatively high proportion of the labor costs associated with that person would be allocated to one particular product. The activity based costing system would therefore identify high costs relating to that product that might be overlooked by a costing system that allocated the costs of that person among products based on a key such as the proportion of direct costs or the turnover generated by each product.
Another example might be that a particular product takes up more time of a particular expensive item of machinery than the other products. A costing system that only looks at direct costs might overlook this inefficiency because it concentrates on the direct labor and materials associated with the product, while the costs associated with running the machine (such as electricity, maintenance, repairs and depreciation costs) are allocated among products generally based on the proportion of direct costs relating to each product or some other allocation key.
An activity based costing system would examine the activity of the machine and allocate the costs relating to that machine among the products based on the activity of the machine in relation to each product, thereby correctly allocating higher costs to the product that uses the most machine time. Activity based costing might therefore reveal that a particular product is making far less profit than was originally thought and this could lead to changes in the system or modifications of the product leading to more efficiency in production.
Activity Based Costing in Financial Services
Activity based costing is not only useful in relation to manufacturing enterprises. A financial services institution might gain greater insight into its real costs and the profitability of its various products by introducing activity based costing. For example, the financial institution may analyze the time spent by each employee in relation to activities relating to particular products and allocate the cost of those activities more accurately among the products and customers of the institution.
Staff may be spending relatively more time on certain activities than on others, and when the costs relating to these activities are allocated among the products of the financial institution it may be found that certain products are incurring higher costs than previously thought. These costs may have remained hidden under other costing systems because they were part of the general overheads and allocated according to a general allocation key based on cost or turnover of products generally rather than the actual costs of activities performed.
Activity based costing enables management to understand the inefficiencies in their processes and the real costs of their products and services. Activity based management impements the necessary changes by introducing more efficient processes and changing the product mix to raise profitability.
Limitations of Activity Based Costing
Activity based costing is a relatively expensive system to implement, involving detailed work to analyze the activities within an organization and relatively expensive software to process the information. An enterprise could also fall into the trap of collecting too much detailed information on activities which may lead to an overflow of detail which obscures the useful information that could be provided by the system.
Another danger is a potential failure to identify the action that needs to be taken as a result of the information provided by the activity based costing system. This may especially be the case where there is some resistance within the organization to introducing the new method of costing. The changes in costing and the new opportunities for management information require a new attitude from management and a determination to deal with the inefficiencies that are highlighted by the activity based costing system. For this reason, a new science of activity based management has developed.
Activity Based Management
The more accurate management information that is provided by the results of activity based costing can, if used properly, result in better management decisions that lead to improvements in efficiency and higher profitability of products. The greater analysis of costs, including overhead costs, produced by activity based costing can lead to the identification of inefficient products and the identification of inefficiencies in carrying out activities within the enterprise or within particular departments.
Resources can be allocated to the profitable products and the product mix can be adjusted to increase overall profitability. Some products previously considered to be profitable may be found to be incurring high costs, leading to a decision to cut back on their production or to implement more efficient processes. Unnecessary and costly activities can be reduced and hidden costs eliminated.
Such advantages from activity based costing can only be achieved if the results are analyzed and utilized in management decision making. The management must understand how companies use activity based costing and how the results should be interpreted and changes implemented. For this reason, activity based management has to be put in place to take advantage of the results of an activity costing system and to fully implement the necessary changes highlighted by the system.