Olga Osipenkova
Activity-based costing is one of the most popular Western costing techniques.
The ‘activity’ is a set of recurrent actions, processes or functions designed to fulfill specific quantifiable tasks using certain resources for a certain period of time.
We will hereinafter use the term «ABC-method» to refer to ‘activity based costing’, which can be translated into Russian as ‘function and process costing’.
One of the major functions of accounting is to perform cost analysis. Costs are initially grouped into broad categories such as materials costs, labor costs, electricity costs, etc. Costs are then are allocated to so-called ‘cost objects’. Cost objects can be anything which requires separate cost determination. For example, cost objects can be specific products, departments, sections or divisions, customers, services, projects, etc.
Costs are allocated to different cost objects on a regular basis in accounting records. Costing information is required to resolve the following tasks:
- Prepare financial statements for outside users such as tax authorities, funds, banks, etc.;
- Evaluate the efficiency of an enterprise’s operations and ensure cost control;
- Make management decisions (pricing, new market entry, decision to buy or produce, etc.).
Historically, types of products and departments, sections or sub-sections have been used as cost objects in Russia and Western countries.
Under this approach, the fulfillment of task а) does not cause any difficulty. However, traditional costing techniques do not always cope with tasks b) and c). So the question is: what is the «true» manufacturing cost of a specific product, i.e. how much does it really cost to produce a specific product? The answer to this question can be provided by means of activity based costing.
Finding the correct answer to this question is really crucial in the current environment because accurate information on the cost of products and services enables the enterprise to take meaningful and well-grounded management decisions aimed at improving its efficiency and competitive advantages. This is critical for the survival of enterprises in a market economy with strong competition.
Comparative Analysis of the ABC-Method and Traditional Costing Techniques
Let’s analyze the differences between traditional costing techniques and the ABC-method.
Charts 1 and 2 below illustrate differences between these methods.
The ABC-method is a costing technique based on the assumption that costs are allocated to activities, i.e. costs objects, which cause consumption of the enterprise’s resources. This is the most important difference compared to traditional costing techniques, which assume allocation of overheads to products based on such subjective factor as, say, production workers’ wages.
For example, an enterprise makes two products, X and Y. X is a product that requires raw materials purchases, equipment setup and deliveries to an end user on an individual basis. Product Y is made on a mass production basis. Purchases of raw materials, production process and deliveries to end users are performed via a continuous production flow and do not require additional processing.
Obviously, product cost will be formed in a different way in respect of products X and Y. The difference is the fact that overheads are allocated to final products by estimating the resources consumed by specific activities.
What are the benefits of the ABC-method as compared to traditional costing techniques?
The benefits of the ABC-method are as follows:
Firstly, the ABC-method provides a more realistic costing and profitability of products manufactured and services rendered;
Secondly, products become more competitive when pricing of products and services is based on ABC data;
Thirdly, the ABC-method can serve as a starting point to reduce costs and improve efficiency of the enterprise;
Fourthly, the ABC-method can provide information on the profitability of business with certain clients (Are clients actually profitable or loss-making?);
Fifthly, the ABC-method provides better grounds for the management decision-making process.
Key Success factors for the Implementation of ABC
The effective application of the ABC-method depends heavily on the specific nature of each individual enterprise and its environment.
Key success factors for the implementation of ABC are considered below.
The method will be effective in enterprises where general and administrative and production overheads comprise a significant percentage of product costs. These might be highly automated and computerized capital-intensive operations.
This method is useful when there is large product variation, especially if, for example, the enterprise’s product range includes both parts for space vehicles, and plastic cups. In this case, the «spread» in overhead rates estimated under the ABC-method and traditional methods can vary considerably between different products.
It should be noted that all expenses can be broken down as follows:
- costs that are driven by individual product units. These costs are determined by the volume of production. Traditionally, examples of such costs are direct materials costs per unit of output;
- costs that are driven by batches of products. Costs attributable to batches of products are determined by the number of batches. An example of such costs can be the cost of setting up equipment tailored for the manufacturing of a specific batch of products;
- costs that are driven by specific products. Some costs, such as advertising a specific product in the mass media, are driven by this product;
- costs that are driven by specific customers. For example, the cost of taking the enterprise’s client to a restaurant is driven by this client;
- costs that are associated with the enterprise as a whole or so-called costs of staying in business. Even when the ABC-method is used, some types of costs are allocated to the business as a whole and cannot be reasonably allocated to specific products, works or services. Examples of such costs include property taxes, security expenses, etc.
The application of the ABC-method is most effective when b), c) and d) costs types comprise a significant percentage of product cost. The product cost under traditional costing techniques will not be materially different from that under the ABC-method when costs in a) and e) prevail in the product cost.
In summarizing all that has been described above, we would like to emphasize that activity-based costing is a powerful tool for improving the company’s «transparency», and measuring external factors and consumption of resources, which cannot be realistically and adequately measured under traditional costing techniques.
As a result of improved «transparency», the enterprise’s management might see the real cost of products manufactured and assess the effectiveness of business with a particular customer from a totally different viewpoint. This will enable the enterprise’s management to identify so-called «bottlenecks» in operations which require optimization and improvement of efficiency.
Information on product costs will allow the enterprise’s management to take cost reduction measures and improve efficiency of business.
Information on profitability of particular customers will enable managers to assess the effectiveness of business with this customer and might provide a totally different picture. This might be a starting point for building an organization that is driven by client needs.
It is possible to analyze what the customer is willing or unwilling to pay for, based on costs broken down by customer. Eventually, this will maximize client satisfaction.
The ABC-method is still popular in the West. Hopefully, this method will be widely used here in Russia. This is especially crucial for the survival of business under growing competition in the market economy. Improving the efficiency of enterprise operations and reducing costs are on the agenda. The ABC-method can provide answers to many questions and improve the quality of management decisions.
Olga Osipenkova is a Senior Consultant at the «Ernst and Young Consult». She can be reached by tel.: +7 (095) 705 9292, fax +7 (095) 705 9293 or e-mail olga_osipenkova@notes.eycis.com.