In a traditional cost accounting model, a company allocates an activity’s direct costs to the specific activity, while indirect costs are proportionally distributed across all of the company’s various activities. Activity-based costing (ABC) attempts to more precisely allocate these indirect costs to specific activities.
ABC can be applied to any company that has manufacturing operations, and is commonly used in automobile manufacturers and power companies. In recent years, ABC has also been employed in service companies, government entities, and other non-manufacturing organizations. Essentially all organizations employ processes and activities to convert capital and resources to products or services. Identifying and quantifying the costs of these processes and activities is the essence of ABC.
ABC attempts to examine each business process or activity and break it down into discrete components. For example, an office may divide its accounts payable operation into several activities: interacting with purchasing, receiving the invoice, coordinating with the vendor, releasing the check, and handling any return issues. Similarly, an automobile manufacturer may divide its production activities into the various parts of the car, or stops along the assembly line. ABC software is available that can be used in addition to a company’s traditional accounting software to help control and collect this data.
The goals of ABC are to identify and calculate five basic information points: the cost of activities and business processes; the cost of overhead or non-value added activities; performance measures for activities and business processes; accurate product and service costs; and identified cost drivers. This information can be used to drive investing, financing, and operational decision-making.
In many organizations, the information necessary for ABC may not be available. New calculations or measures may need to be developed. Companies will sometimes rely on ABC consultants to help implement these new measures. The Chartered Institute of Management Accountants recommends starting with a simple ABC program while identifying what issues are truly important to the company. As ABC becomes more accepted and management becomes more familiar with the new measures, the ABC program can be expanded.
In 2007, Robert Kaplan, a Harvard Business School professor, introduced the concept of time-driven ABC. Under TDABC, the only necessary measurement is cost to time. The two key questions of TDABC is “how much does it cost per time unit to supply resources for each business process” and “how much time is required to perform the work needed for a company’s products, transactions, and customers”? According to Kaplan, these two cost drivers are sufficient to guide most business decisions.