Activity-Based Costing

Marzena WASSIELEWSKA
Accountant at RSM Poland

The underlying objective of any business operations is to generate the highest possible profits, and this can be achieved through appropriate management. Streamlined cost management is decisive for any organisation’s budget, as it contributes to higher income.

Experienced entrepreneurs emphasise that in order to have a competitive edge on a demanding market you have to keep looking for different solutions all the time. Modern business management takes place in a dynamic and changing environment, and as such requires extensive expertise. This means you have to look for modern tools that will help you achieve ever better results. And it is hard to expect better results if you do not focus on cost analysis.

When complex manufacturing processes make cost accounting insufficient as a source of information for decision making purposes, it is a good idea to opt for activity based costing (ABC). This concept is more than just calculating a unit cost; it is about monitoring the costs of processes and activities in an organisation.

The basic task of this model is to provide reliable information from different areas, e.g. production or sales, on the basis of product groups, customer groups or supplier groups.

Activity-Based Costing

In this method, indirect costs are assigned to products using many different cost drivers. ABC calculation is based on activities or elementary processes. The main assumption of the mechanism for calculating unit cost is that the cost is assigned to the responsibility centre and to a specific process, i.e. the underlying assumption of ABC is that indirect costs arise from activities performed by the organisation in order to manufacture given products. Indirect costs are accounted for just like in traditional full-cost accounting and variable cost accounting, as they are assigned to products on the basis of accounting documents. This method is the key instrument of effective and efficient decision making.

Stages of ABC method^[1]

Stage I is key to the implementation of the Activity Based Costing. It determines both the subsequent phases and the final result of the calculation. In the traditional account, the company's costs are presented in two basic terms: type and subjective. In turn, the ABC cost account collects information on costs in the section of processes and activities. It forces such a reorganisation of the information received from the financial and accounting systems so that reviewing the company's costs from this perspective is possible. In order to separate the processes or activities in the company, an analysis of economic processes is applied, i.e. events necessary to create products and services are considered on an ongoing basis. The result of this analysis is to determine which of the activities increase the value of the product or service for the customer and which do not contribute to the increase in value, as well as to create a dictionary of activities, which presents and defines the most important activities undertaken in a given company.

Examples of activities identified in the company:

• purchase of materials and services
• preparation of production
• setting up of the machinery
• transportation of goods
• customer service
• searching for new orders.

In Stage II, costs should be measured according to the structure of the separate activities. The costs of the resources are ranked together with the corresponding activities on the basis of the cost carriers of the resources used. Cost carriers collect and allocate costs from the traditional system to the activities performed by the enterprise. This allows one to find out how much money the company has actually spent on e.g. shipping goods, purchasing materials or production planning.

In turn, in Stage III, we select such carriers (measures) of particular activities which correspond to the actual use of a given activity and which:

• show the cause of costs
• show how the demand for a given product develops compared to other products for a given activity
• are understandable and easily measurable.

Activity costs are usually accounted for as the following cost objects:

• materials, components and their supplies
• products, services
• orders placed by customers
• customers of the organisation
• distribution channel for products and services
• regional branches
• the organisation as a whole.

Selected activities and activity cost drivers:^[2]

In Stage IV, the costs of activities are settled for individual products according to their demand for a given type of activity. If we deal with the occurrence of such type costs, which are used by several or more activities, we choose the most effective way of assigning them to individual activities, that is, for example, when settling the costs of management, we take the number of working hours, and when settling the rent - the area used into account.

Advantages of activity cost accounting

The application of the ABC method forces a precise distribution of indirect costs over products, which allows for a precise calculation of the unit cost of a product. This, in turn, allows for the accurate valuation of finished product inventories and better data for management decisions. Moreover, already at the stage of building the structure of data collection and analysis, the activity cost account allows one to find relations between undertaken activities, created costs and generated revenues.

Who is an ABC account for?

Activity-based costing is a solution recommended primarily to enterprises in which:

• cost information is regularly negated by production departments;
• indirect costs have a high and growing share in the total costs;
• products operate in a highly competitive market;
• many series, diverse and complex products are produced.

Properly implemented ABC account allows one to:

• shape an optimal production programme;
• reliably verify the company's pricing policy;
• precisely determine unit costs for reporting purposes;
• budget the costs of activities and processes;
• analyse the profitability of products and distribution channels more thoroughly.

Summing up, activity-based costing is one of the most important elements of effective business management. It permits the detailed measurement of the costs of a business unit in different business areas, which contributes to proper cost control and minimisation.

It is up to entrepreneurs to decide whether to opt for a traditional full cost accounting or activity-based costing (ABC). As the implementation and use of activity-based costing (ABC) may seem complicated, it is a good idea to rely on expert support. If you need any assistance with activity-based costing, feel free to contact us.