Activity-based costing (ABC) provides more meaningful information about the drivers of costs, the activities performed in a firm, and the relationship between costs and products, customers, markets, and segments.
In addition to supplying more detailed and better cost and profitability information, an ABC analysis enables managers to evaluate processes from an activity viewpoint, leading to identification of non value-adding activities and process inefficiencies.
ABC does not change overall profitability in a firm; it better aligns cost assignment to the causes of those costs.
With better information, better decisions can be made in a firm to improve profitability—this is the power of ABC.
Cost allocation in firms can provide misleading information about the profitability of products, product lines, customers, and markets. Traditional cost allocation practices allocate all manufacturing overhead costs using a single driver such as direct labor hours, direct labor dollars, or machine hours. Sales-related costs are typically ignored. While technically accurate, in most complex organizations a single overhead cost driver is not sufficient to accurately assign the pool of overhead costs to the products that are being produced or the customers that are being served.
Many firms—from manufacturing to medical and healthcare to banking and financial services to hospitality and not-for-profit organizations—have benefited from designing and implementing ABC allocation systems. Using ABC tools has helped these organizations to understand profitability more clearly, and has provided meaningful information about processes and costs associated with delivering goods and services. A well-designed and implemented ABC system is a powerful aid to management evaluation and decision-making, thereby improving organizational performance.
Traditional Cost Allocation
Factory overhead costs in a manufacturing organization are varied and complex. These costs consist of indirect labor, indirect materials, and other indirect factory support costs. Factory support personnel include process design engineers, supervisors, maintenance workers, inspectors, purchasing agents, security personnel, and administrative workers such as accountants and human resource personnel. Indirect materials are those materials that cannot be individually associated with a product—such as drill bits, shop supplies, paper goods, and maintenance supplies. Other indirect costs include utilities for the plant, depreciation of the machinery, training costs, and technology to run the production systems.
Using a traditional cost allocation methodology, factory overhead costs are allocated to products using a single driver, often direct labor hours. Sales, general, and administrative costs are typically ignored in a traditional costing methodology, since they are not part of the production process and are not considered in the cost of goods sold equation.
Overhead costs have grown substantially in the past decades, as a result of factors such as globalization, technology, product customization, security concerns, and regulatory oversight. In the past, when overhead costs were a smaller proportion of factory costs and direct labor was a larger proportion, it made sense to allocate overhead costs to products using a traditional methodology. The direct labor base was a large proportion of costs, and overhead support costs were a relatively small proportion of total costs. As shown in Figure 1, direct labor costs have declined as a percentage of total costs, while overhead costs have grown.
The increased complexity of manufacturing operations makes the traditional methodology obsolete. What is needed to improve the understanding of costs is, first, to associate costs with the activities that are causing the resources to be used, and then to associate these activities with the products that are being produced. This way, products that require a complex set of activities or a high-cost set of resources as part of the production process will be allocated the costs associated with these activities and resources.
Is Your Cost Allocation System Faulty?
There are various indicators that a cost allocation system is not providing accurate information. You need a new cost system when:
The volume of production increases but profitability declines. This often happens when management cannot accurately determine the cost of activities and resources associated with production processes.
The product mix changes from lower- to higher-margin products, but profitability declines. This situation indicates that the “high-margin” product was actually using more resources than it was being allocated in the cost system. As the firm makes more of this product, more resources are consumed and profitability decreases.
Managers do not trust the numbers from the accounting system and sometimes build their own cost systems. Functional managers often have good process knowledge about the organization. For example, when the sales group ignores accounting information in pricing products and instead uses its own calculations, it is an indication that the accounting system is not supplying accurate information.
The firm produces a mix of higher-volume standardized products or services and lower-volume customized products or services, yet the cost allocation system uses a single driver to assign overhead costs to products. A single driver ignores variation in overhead costs and variation in process activity, resulting in an average number. As complexity increases in a firm, averages distort information at a segment level.
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