Activity Based Costing
Based Costing/Management in Service Industry
|Prepared By Dr. Mir F. Ali
Activity Based Costing (ABC) was
originally designed for manufacturing environments to calculate the
unit cost based on the costs of production activities. The objective
behind this notion was to maximize the performance of associated
resources, allowing a provision to stay competitive yet profitable.
ABC became the table talk for organizations that either failed
miserably in their efforts to reengineer their business processes or
that never considered Business Process Reengineering (BPR) as a tool
to overcome their fiscal or operational difficulties. There are all
kinds of symptoms that these organizations are building up all kind
of unrealistic expectations for new ABC efforts. This is not
inconsistent with the general trends seen with the emergence of any
new tools, techniques or technologies. However, it is critical for
these organizations to understand that ABC is neither a silver
bullet nor panacea.
Contrary to the popular believe, ABC can't be fully applied to the
service environments without making necessary adjustments. Also, it
presents a real challenge and requires total organizational
commitment to implement ABC in a nonprofit service oriented
environment, where people are struggling with the transition from
budget to cost and organizational unit to activity.
ABC is best defined as a technique to quantitatively measure the
cost and performance of activities, resources, and cost objects
(output/service/client) based on cost drivers. ABC captures
organizational costs for the factors - production and overhead - and
applies them to each activity in a well-defined activity structure -
Another way ABC can be defined is as a method to model the
consumption of costs from resources through activities to services,
channels (Methods of delivery) or other cost objects such as
customers and clients. It enables organizations to answer the
What is the cost of providing ServiceA to ClientB through
Activity Based Management (ABM) is a mechanism designed to manage
and report the cost efficiency associated with business activities
in an organization. It keeps track of activities and people
(Resources) involved in the process to produce products or deliver
services, and allows organizations to improve the cost performance.
The focus of ABM is on the activities being performed to help
determine the best way to directly charge or allocate more realistic
proportions of costs to various services. It provides an opportunity
to optimize and redesign the associated activities in the interest
of effectiveness and efficiency, answering the question:
What should be the cost of providing ServiceA to ClientB through
The difference between ABC and ABM is that ABC helps established the
cost associated with the activities involved in producing a product
or delivering a service whereas ABM provides an opportunity to
question the validity, accuracy, acceptability, and Affordability of
the cost. This enables managers to optimize the performance of the
activities and explore other options - Alternate Service Delivery.
Please click here to see a diagram which
compares the traditional vs ABC approach.
The question is why ABC? Traditional accounting practices favored
quick fixes to reduce costs, either by reducing resources or by
forcing suppliers and vendors to cut costs. On the other hand, ABC
deals with internal issues of waste, continuous improvement, and the
identification of true cost drivers, misallocated costs, and
value-added components of traditional overhead.
The traditional product costing approach is based on the costs
consumed by product or service whereas the ABC approach is based on
the costs consumed by activities and activities are consumed by the
product or service. What does that mean? It means that the costs
associated with the activities can be reduced and the performance of
these activities can be improved by minimizing the number of steps
involved in performing these activities, by removing the information
bottlenecks and by using appropriate information technologies to
provide reliable, and relevant information to the respective
managers, and by providing adequate training to personnel.
Please click here to see a diagram which
illustrates the difference between a traditional vs ABC chart of
The chart of accounts are traditionally designed to keep track of an
accumulated amount for a specific type of expenses like salary,
benefits, travel, equipment, material, rent, and utilities expenses.
These figures only reflect what was spent on what and these costs
have no relationship whatsoever with the activities. In the case of
ABC, each indicated activity could have consumed costs of salary,
benefits, travel, equipment, material, rent, and utilities.
It is widely recognized that ABC/M has the capability to provide the
cost sensitivity needed for making effective decisions. It is also
recognized that ABC/M works better in business like environments
- Client-focused products/services are provided;
- The cost driver is a major source of motivation;
- The cost and value of the products/services are clearly
- Accountability framework is established;
- Horizontal thinking is practiced;
- Technologies are managed effectively; and
- Benchmarking is performed regularly to improve performance on
a continuous basis.
The success of any ABC/M initiative is dependent upon the
approach adopted to implement this discipline. The following graph
represents a systematic approach to developing, designing, and
implementing an ABC/M mechanism.
Please click here to see a diagram.
Realizing the fact that the most budgets/expenditures are based on
the organizational structures, this methodology is designed to take
this into consideration as the starting point for the expenditure
(Costs), which is already incurred, in the previous fiscal year. The
total costs (A combination of direct and indirect costs) have to be
mapped to each major organizational unit within an organization with
the responsibility to produce cost objects.
Activities: Activities performed in each organizational unit
need to be defined. Activity is defined as a unit of work performed
within an organization. A description of the work being performed in
the organization to produce product/service that consumes resources.
- Develop Strategic Direction;
- Provide Professional Advice;
- Prepare Business Plan;
- Conduct Marketing Surveys;
- Manage Financial Services; etc.
Cost objects: Cost object (s) for each major activity need
to be defined. Cost object is the reason for performing an activity.
Products, and services are reasons for performing activities. For
- Strategic Direction;
- Business Plan;
- Financial Statement;
- Invoices; etc.
Client: Internal/external Client (s) for each cost object
should be defined. Client is a person or organization who receives
the service/product, which is delivered/produced as result of
performing the respective activities. For instance:
- Reports are produced for Financial Department (Internal);
- Products are distributed to customers (External); and
- Consulting services are offered to clients (External).
Activity Costs: Activity costs are calculated based on the
utilization of resources. Resources are defined as economic elements
applied or used in the performance of activities. For instance:
- Salaries and Employment Benefits;
- Travel; Professional Services;
- Materials and Supplies;
- Capital Acquisition/Depreciation;
- Occupancy Costs; Utilities; etc.
Cost driver: Cost drivers have to be determined for each
cost object. Cost driver is defined as a factor that causes a change
in the performance of an activity and, in doing so, affects the
resources required by that activity. For instances:
- Strategic directions are developed and communicated twice a
- Advice is provided twenty times a year;
- Business plan is prepared once a year;
- 400 invoices are produced every year; etc.
Unit Cost: Unit cost has to be calculated for each cost
object. This calculation is based on “Activity Costs divided by Cost
Driver”. For instance:
- If the costs of developing and communicating Strategic
Direction (Cost Object) is calculated to be $50,000 and the cost
driver is twice in a year, then the unit costs will be: $50,000/2
- If the costs for providing Advice (Cost Object) is calculated
to be $80,000 and the cost driver is twenty times, then the unit
coast will be: $80,000/20 = $4,000;
- If the costs of developing Business plan (Cost Object) is
calculated to be $50,000 and the cost driver is once in a year,
then the unit cost will be: $50,000/1 = $50,000
At the completion of this exercise, an ABC Model will be
developed, reflecting the current:
Costs of the activities; Costs of the cost objects; Costs of
providing service/product to a specific client/customer; etc.
The current cost structure provides an opportunity to appreciate how
cost is contributed. However, it is critical to understand that the
functional and organizational ineffectiveness, inefficiency,
incompetence, and mismanagement are the major contributors to these
costs. It has to be recognized that these factors have a direct
negative impact on the bottom line.
This is the time for making some crucial management decisions to
determine the corporate level of tolerance for accepting and
implementing change. Similarly, the following questions have to be
- What should be the costs of the activities, cost objects, and
- What kind of investment can be made in the new technologies
and training? and
- Should the focus be to enhance the capabilities to handle
additional work and generate more revenue or do more with less by
reducing the workforce?
Answers to these questions will help to set guidelines for
reducing the overall costs of the services by optimizing the
performance of the information, technology, and human resources.
This will require:
- Each business process should be reviewed and analyzed to
explore the potential for improvement;
- The vertical analysis must be conducted to minimized the
number of steps/tasks by deleting and combining them;
- The horizontal analysis must be conducted to remove the
information bottlenecks by introducing the right technologies; and
- Each business process must be analyzed to determine the skills
requirements and recommendations must be made to provide training
for bridging the gap.
This exercise will help to establish the business rationale for
the change and at the same time this will enable refinement of the
current model to meet the desired level of improvement. Following
the successful refinement of the model, a roadmap should be
developed to highlight the sequence of changes and the
implementation of these changes in a systematic fashion should
ensure the expected milestones/expectations are met.
The critical factor for the success of any ABC initiative is the
senior management commitment for implementing the recommended major
changes with an intention to continue searching for better and
consistent ways to perform business activities/processes to support
the corporate objectives.
|Copyright 2003 - Automated
Information Management Corporation