HOW ACTIVITY-BASED COSTING WORKS
Activity-based costing (ABC) is an accounting method that allows businesses to gather data about their operating costs. Costs are assigned to specific activities – such as planning, engineering, or manufacturing – and then the activities are associated with different products or services.
In this way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses. Managers are then able to generate data to create a better budget and gain a greater overall understanding of the expenses that are required to keep the company running smoothly. Generally, activity-based costing is most effective when used over a long period of time, as opposed to shorter-term solutions such as the theory of constraints. (TOC).
Activity-based costing programs require proper planning and a commitment from upper management. If possible, it is best to do trial study or test-run on a department whose profit-making performance is not living up to expectations. These types of situations have a greater chance of succeeding and showing those in charge that ABC is a viable way for the company to save money. If no cost-saving measures are determined in this pilot study, either the activity-based costing system has been improperly implemented, or it may not be right for the company.
The first thing a business must do when using ABC is set up a team that will be responsible for determining which activities are necessary for the product or service in question. This team should include experts from different areas of the company (including finance, technology, and human resources) and perhaps also an outside consultant.
After the team is assembled and data on such topics as utilities and materials are gathered, it is then time to determine the elements of each activity that cost money. Attention in detail is important here, as many of these costs may be hidden and not entirely obvious.
According to a consultant, “The key is to determine what makes up fixed costs, such as the cost of a telephone, and variable costs, such as the cost of a phone call.” Even though in many instances technology has replaced human labour costs (such as voice-mail systems), a business manager must still examine the hidden costs associated with maintaining the service. Non-activity costs like direct materials and services provided from outside the company usually do not have to be factored in because this has previously been done.
Once all of these costs are determined and noted, the information must be input into a computer application. The software could be a simple database, off-the-shelf ABC software, or customized software. This will eventually give the company enough data to figure out what they can do to increase profit margins and make the activity more efficient.
After a business has had enough time to analyse the data obtained through activity-based costing and determine which activities are cost-effective, it can then decide what steps can be taken to increase profits. Activities that are deemed cost-prohibitive can then be outsourced, cut back, or eliminated altogether in an effort to make them more profitable. The implementation of these changes is known as activity-based management (ABM).
Potential Pitfalls of Activity-Based Costing
Companies that implement activity-based costing run the risk of spending too much time, effort, and even money on gathering and going over the data that is collected, Too many details can prove frustrating for managers involved in ABC. On the other hand, a lack of detail can lead to insufficient data.
Another obvious factor that tends to contribute to the downfall of activity-based costing is the simple failure to act on the results that the data provide. This generally happens in businesses that were reluctant to try ABC in the first place.
Another limiting factor is that activity-based costing can be pricey. Also, time can also be a factor for businesses seeking a quick-fix. Although some companies see results almost instantly, it typically takes three months or so for most businesses to experience the benefits of ABC. Depending on your product or business cycle, it could take much longer.
Activity-Based Costing and Small Businesses
It used to be that large corporations were the only businesses involved in activity-based costing. Not so today. Service industries such as banks, hospitals, insurance companies, and real estate agencies have all had success with ABC. But since its inception, activity-based costing has seemed to have been more successful when implemented by larger companies rather than by smaller ones.
Companies with only a few products and markets are not likely to get as much benefit from basing costs on activities as companies operating with diverse products, service lines, channels and customers. Since setting up activity-based costing for business usually takes less time for a smaller project, a small business that is unsure about the effectiveness of ABC can consider a simple test program to determine whether it is right for them.