What is Activity-Based Costing (ABC)?

Activity-Based Costing (ABC) is an accounting method that assigns costs to specific activities within a business, and then allocates those costs to products based on the resources used for each activity.

How does ABC differ from traditional costing methods?

Traditional costing methods allocate costs to products based on a single rate such as direct labor hours or machine hours. Whereas Activity-Based Costing takes into account various cost drivers and assigns different rates to different activities in order to more accurately assign costs.

When was Activity-Based Costing first introduced?

The concept of Activity-Based Costing was first introduced in the early 1980s as a way to more accurately assign costs.

What are the steps involved in an Activity-Based Costing system?

The steps involved in an Activity-Based Costing system include identifying activities, determining cost drivers and calculating activity costs, assigning overhead costs to products based on cost drivers, and using the resulting information for decision-making.

How does ABC benefit businesses?

Activity-Based Costing provides a more accurate picture of product costs which enables better decisions regarding pricing, resource allocation, and process improvement. Additionally, it can help reveal opportunities for cost savings that may not be identified with traditional methods.

Activity-Based Costing (ABC) | Definition, Principles, and Steps

Introduction

Since the 1980s, the world has seen quick technical and production advances, including in automation and computer usage, leading to decreased employment.

Meanwhile, businesses are now paying more attention to whole quality products. These changes have resulted in increased complexity and bifurcation (separation into two parts) of production processes, which is reflected in the cost structure.

Indirect costs are the majority component of the cost structure; direct expenses, including salaries, account for a large proportion of it.

The cost structure is always changing, and as indirect costs increasingly take up a larger slice of the pie.

In contrast, direct costs drop off; it becomes more difficult to distribute those indirect productions accurately among different units using existing methods like allocating based on hours worked or against the initial (prime) cost.

This lack of accuracy has led cost accountants to search for new, fairer ways to charge production units for their share of indirect expenses.

Many researchers have worked to find more accurate data that management can use to make better decisions in various circumstances.

This attempt emerged at the end of the 1980s, when (Cooper & Kaplan, 1989) proposed allocating indirect costs differently, which they called activity-based costing or A.B.C.

More accurate information on the product’s cost provides more activity-based costing aimed at measurement and decision-making purposes.

A Look Back at the History of Activity-Based Costing

Senior management often needs accurate and realistic information to develop plans, monitor performance, and make decisions.

Accounting is generally considered the main source of such information within an organization. Cost accounting, in particular, is a key element of any organizational information system.

In conclusion, cost accounting is a key partner to the management in carrying out its functions.

And assisting them in achieving their goals with the greatest effectiveness and efficiency by providing the information needed to make appropriate decisions for the allocation of economic resources available and directing them to the best alternative uses.

Because of advances in technology, automation systems using computers, and the spread of manufacturing projects, services, and breadth and diversity of activity at a rapid pace, the W. T. O. Accounting information systems have seen an increased demand to plan and control an organization’s economic resources properly.

This system is efficient in a way that reduces all possible costs for each product by eliminating any excess or wastefulness.

Additionally, modern production methods are applied through this system to reduce costs further.

As a result, cost accounting was required to keep up with all of these changes and circumstances, as well as development, to provide more accurate information and realistic performance contributions to planning and control, performance evaluation, and decision-making.

The theory of costs based on cost centers focuses on the distribution of industrial costs. It is directly based on cost centers and bases utilized in charging the costs of cost centers.

The number of hours worked directly by labor, direct labor expense, prime cost (including direct material and labor expenses), machine hours, and quantity are used as standards.

As a consequence of earlier technological advancements, indirect costs have gone up in order to encourage the use of the mechanism and reduce dependence on human labor.

Here the indirect costs account for the most significant proportion of the organization’s overall expenses, as well as a wide range of products in the firm and an increase in competition that is not just confined to a local or regional level.

The current system for allocating costs is not efficient or compatible with recent changes, so a new system is being developed that will be based on cost centers and overcome the limitations of the old system.

The system of activity-based costing, also known as A.B.C., was suggested by Staubus in 1971 and has been applied by Cooper & Kaplan since 1992 (pp. 1-12).

This system is a significant development in the cost accounting field because it applied the advantages and objectives of many prior systems.

Phase I: The allocation of economic resources (indirect costs) to activities.

Phase II: In this phase, we allocate each activity’s cost according to the appropriate cost driver for that task or group of similar tasks.

We can measure and allocate indirect costs to these items more accurately by evaluating the products and services.

This helps with planning, monitoring, evaluating, and making decisions down the road.

A series of research and writings on accounting followed the development of this system, which was then applied to industries such as production, electronic and electrical engineering, metalwork, etc.

It has also been useful for service organizations like education, healthcare, hospitality, and banking, among others.

The Principles and Concepts That Form the Basis of a Costing System’s Activities

The activity-based costing (ABC) system was created to allocate indirect costs to products with a higher degree of accuracy for measurement and different management decisions regarding pricing and accessing new domestic and global markets.

With the competition becoming stronger and the application of free trade following WTO decisions, this system is based on the philosophy that activities consume resources.

The cost is not from the product but the activity surrounding it. These activities are consumed as a by-product, and because of this – costs can be attributed to different specific activities (Dury Colin, 1992, p. 276).

This results in allocating costs based on activities, which is highly accurate due to the causal relationship between cost and activity.

The system helps management by feeding it information in a timely and appropriate manner so it can be better positioned than its competitors.

When allocating costs based on activities, you must take into account the need to identify the nature of those activities, as well as any applicable technical and regulatory standards.

There is a clear causal link between these allocation bases and cost elements; for fairness in the distribution of indirect costs among different products, they should correspond with the principle that “products consume activities and activities consume resources.”

To start, the author elaborates on the activities concept, which provides a foundation for understanding cost accounting.

The activities performed by an organization can be divided into core work and other operations or procedures.

Direct activities are those that help produce the product or service.

Indirect activities are those that work to assist direct activities at the company.

After this, we will identify a set of sub-activities with low costs compared to the activities’ basic or main costs.

Core activities—or the organization’s primary activities—are those with high costs and play an important role in relation to the activity’s total cost.

We allocate vessels separately for each major or essential activity from the pool. Moreover, allocations from the vessel are limited to only those specific activities for subsidiary or secondary activities.

There are a few ways to cut down on the number of activities, according to Hansen & Mown (1994).

However, the three most important criteria are the standard level of activity, what Standard Costs typically cause for that activity, and the value-added criterion.

Activity Level Requirements

This standard classifies activities into four levels according to the following criteria: coherence, difficulty level, and activity type.

Group activities on the same level can be classified under this standard.

A- Activities Linked to the Product Unit (Unit-Level Activities):

When these activities are done for every production unit of the final product, and when each production process produces a different number of units, it depends on the quantity produced.

The amount of resources these activities use is directly linked to the number of units produced.

The cost of production for a product unit is determined by several things, such as the number of direct work hours, the price of raw materials, and overhead costs.

These costs are variable because they change based on how much is produced.

B- Activities Associated With the Production of the Production Batch (Batch – Related Activities):

These activities are either carried out or are about to occur when an entire production batch of products is made, regardless of the units for each batch.

Furthermore, the cost of activities is not determined by the volume of units within the batch. It is always established according to the number of production batches and orders.

The number of batches produced, examples of activities that consume the organization’s resources by the number of batches produced, testing activity, inspecting activity, and preparation machines operation are all linked.

Complexity levels are determined by the number of variables in a business problem.

In this example, the cause is complexity because it refers to the activities of the level of batches or orders, such as the number of production orders, quantity produced, timeliness, and accuracy resulting from these activities.

C- Activities That Build on the Company’s Product Line or Sector of Activity in Order to Create Value for Customers (Product Level Activities or Product-Sustaining Activities):

According to the reasons for expenditures, the units that benefit from these services are credited for the cause of their activity.

For example, the number of times inspection is linked with the expense of machinery and equipment maintenance because it is a factor in determining how often you must inspect your machines.

The number of times product development and advancement occur due to research and development expenditure is also linked with production engineering implementation expenses.

The expenditures noted in this report are placed in a timely manner as they occur at a specific time; these costs are associated with the quality of goods produced.

D- Activities That Support the Public Services We Provide (Facility-Level Activities or Facility Sustaining Activities):

The fourth activity, as noted by (Cooper, 1990, pp.33-42), is an addition to the three previous activities to provide support and necessary facilities on a plant-wide level.

These activities are essential to the company’s success as a whole, and each of these products plays a key role in providing assistance and facilities.

The expense of lighting and heating, protection expenditures, maintenance and cleaning costs, public administration expenses, accounting services fees, and other administrative activities are just a few examples.

These costs are therefore fixed at the item level and reflect all of a company’s goods. Because these activities are connected to the performance of public services, their own expenses are broad and generally assigned to all items.

It is tough to allocate these expenditures to distinct products.

As a result, some accountants in one group were charged or loaded to the profit and loss account or income statement as the cost of the period because these expenses represented only a tiny fraction of total costs.

Others, on the other hand, believe that breaking down these expenses into their reasons is a better approach. (Kaplan, 1990, pp.2-15) who gave out the entrance in a hierarchical manner utilizing activity-based profitability analysis.

It is observed from the study of profit based on activity that the unit’s margin of profit for each product in the production line is determined first.

After which, assistance fees are subtracted from the batch, then supplementary costs of the product, then auxiliary expenses of the manufacturing line, and finally, general and auxiliary expenditures to arrive at the organization’s profit.

It is important to note that each organization develops its own classification system for activities, which makes it difficult to rely on one generalized set of classifications.

Because of this lack of standardization, the author believes that researchers and cost professionals should work together to create a detailed classification system for each industry or service.

It refers to the complexity of classifying the activities of all organizations or all production and service enterprises for the fundamental distinctions in manufacturing processes or servicing.

Standard Reason or Driver of Activity Cost

This category is divided into cost items linked by a single cause or one drive in one pool or group effort.

One consequence of this standard is reducing the number of activities to the necessary amount, known as activity homogeneity.

It loads the associated costs of itemized expenses based on similar reasons. And it should be noted that while each component within an item may be influenced by only one cause, Simply put, the water cost for each activity is increased or decreased at the same rate.

The two factors are completely correlated if the correlation coefficient equals one. It is evident that if several similar drivers operate at high rates and share resources, the pool will be more robust to variations in activity.

It indicates that the change in the activity of a similar, comparable degree of 100% of activities or activities within the same pool, and a negative correlation coefficient for one implies that the activities have low precision.

The causes of cost must be investigated to determine whether they are the right reasons for the cost elements and bases used in the allocation process.

In addition, when a clear causal link cannot be established, the workaround employs Surrogate Cost Drivers (Cause of Alternative Cost Drivers). It indirectly measures the degree of an operation’s benefit to estimate how much money is saved.

Activity-based costing systems can be classified into cost drivers and routers (Ronald, 1995, pp.).

The Transaction Drivers metric showcases how many times the relevant action has been completed.

The duration of the activity is determined by the number of days it will take to complete it.

The Following Are Some Examples of the Reasons for Costs in Various Activities

TABLE1-some examples of the causes of cost for some

TABLE2-some examples of the causes of cost for some

A.B.C.’s level of output accuracy, when applied to the identification of cost efficiency, is determined by the number and type that are measurable.

Also, it can be easily obtained and characterized with a strong correlation factor to an activity’s cost.

However, this lack of expansion does not significantly increase the degree of accuracy in the number of outputs and is costly and complicated.

The following factors must be taken into account when determining the number of causes for cost:

1. The Cost of Measurement

The cost of obtaining these causes is factored into the choice of a number of costs. If the collection of these factors is difficult, the expense of expanding this selection will be high.

On the other hand, does the organization wish to improve the output costing system’s accuracy or not?

To ensure that this increase in accuracy outweighs the cost of gathering data for these causes, it must first be determined whether or not such an expansion is desired.

Expanding the number of causes will not lead to increased costs because they are available and accessible. More accurate outputs will result from expanding the number of causes.

2. Diversity of Products

The more varied the product mix, the more significant the heterogeneity of productive elements in the input’s input.

To compensate for the growth of each product’s consumption to various activities, it was also necessary to raise the number of causes of cost.

3. The Relative Importance of the Cost of the Activity to the Total Cost of the Activities

A lower ratio of the cost of an activity to total activity means that it comprises a small percentage or is limited.

Even if they are not homogeneous, this does not require boosting the number of causes behind these costs.

If, however, the increased cost of the activity would amount to more than the total cost of all activities combined, then causation numbers must be raised to maintain a distinct level of accuracy in output.

The Normal Value-Added

Counting and classifying activities into two groups, the first group including value-added activities of the firm and other activities not adding to the organization, is one of the fundamental requirements for A.B.C.’s application (A.B.C.).

The following highlight briefly these two types:

1. Value-Added Activities

Increased value is created by adding value-added activities as the organization’s primary operations to generate and market its products, administration, finance, and lead.

In terms of productivity or service, they contribute value to the product at various phases of production, marketing, management, and finance.

2. Non – Value Added Activities

Non-core or non-essential activities are known as zero-value-added activities because they are not beneficial to the company.

They do not contribute to the product’s value. According to the previous categorization, the staff works to eliminate non-essential activities that do not offer any value to the product in order to achieve the targeted operations.

The system of activity-based costing is built on the following assumptions:

The following basic assumptions must be met before the system can apply activity-based costing:

1. Cost and Return

The most significant factors impacting the cost when activity-based costing is applied are to determine the driver or cause of the cost, in the event of increasing the number of drivers or causes of the cost and to obtain results from more precise.

Moreover, in the case of reducing the number of drivers or causes of the expense, results from less accuracy will be obtained.

The author believes that choosing factors for cost and access is difficult.

This implies that as a result of growth in terms of causal selection options, there will be a significant increase in costs, while vice versa, there will be an associated decrease.

The number of reasons for the cost of activities is comparable to the advantage derived from this growth.

It is expanding if the benefit anticipated as a result of this development outweighs the expense of gathering data on these factors.

On the other hand, if the increase in the number of causes of activity costs outweighs an increase in accuracy, it is growing and vice versa.

However, suppose that increasing the level of precision does not lead to an increased expenditure because causes are available and accessible.

In this instance, it is only natural to improve output accuracy.

2. Determining the appropriate number of the cost pools of homogeneous activities:

This item is connected to the preceding one in some way.

When you define a set of pools costs that represent the cost of activities done by the organization, which absorb all of the organization’s expenses, they must be a number of pools that represents a uniform cost for activities accurately to get a measure of output at a specific level of accuracy.

Because pool numbers decreased for the right amount, measured product pricing does not reflect real product pricing.

3. Range of products: The operating system of activity-based costing has multiple basic assumptions, one being the presence of diversity among products or complexity in production processes.

If an organization produces a single product, it is better to use a cost-center-based system; not only will it provide the same results, but operating costs will be lower.

Steps to Design a System of Activity-Based Costing

According to the view (Cooper, 1990, pp.78-81), there are five phases in developing a system cost based on activities that were only briefly presented as follows:

1. A business combination in the form of activities ( Identifying the activities ):

The purpose of activity-based costing is to identify the various business processes within an organization.

However, because there are multiple processes, it is impossible to use a justified cost for each process.

Instead, similar processes can be grouped into one activity called a homogeneous activity. This allows for better tracking of the cost of each activity and how it impacts products.

2. Estimate the cost of activity:

Gather your work activities in a spreadsheet to determine how many completed works you need.

Determine the level of aggregation used by the system and each activity’s extraction expense using this data.

To determine the cost of an activity, you must collect a specific number of similar works from one action.

3. Choose the target activities:

This means that the operation’s activity centers, which are responsible for executing a certain task, help the company fulfill its purpose.

4. Choose the first level of the causes of cost:

The first level includes factors that cause cost, such as the causes used in allocating available resources (inputs) to the cost of activities.

For example, the electrical activity is allotted to the beneficiary’s activities based on kWh.

5. Choose the second level of the causes of cost:

The second level of the cost comprises factors that are utilized in allocating costs for activities conducted on the finished goods (outputs).

The cost of each activity is allocated to the products (outputs) according to how much benefit each product gets from the activity.

Measure the Cost of Products According to the System of Activity-Based Costing

The author provides an analysis of activity-based costing and how to measure the cost of products in two stages.

Phase I: We charge activities for indirect costs (resources) they utilize. Most resources directly relate to the activities at this stage so that we can allocate them directly.

However, some resources are used by multiple activities simultaneously, so we must find ways to assign these resources to the benefiting activity appropriately.

Phase II: we will put the cost of activities onto the products themselves (outputs) on the basis that products consume activities.

In order to do this, we need to link the causes of appropriate activities with both the product and activity- in other words, make it so that when a product benefit is gained, its share of activity costs is also loaded.

The author feels that the majority of accounting literature neglects the first step, which is allocating indirect costs (resources) to activities.

It is important to focus on detail and allocate costs of activities accurately in order to produce the desired output.

In activity-based costing, system design costs are based on the activities performed and the concept, principles, and assumptions of those activities.

Identify the Activities

The word “activity” refers to an endeavor that uses resources. The allocation of some resources is required for activity achievement.

Resources are intended to be inputs from the various cost elements necessary to execute activities.

The analyst works with the management of production and quality, technical management, engineering, financial management, or cost management to identify and characterize the organization’s production and service activities.

They then map those activities to the resources they consume (inputs). Activities are divided into substantial or major activities and subsidiary or secondary activities.

The activities that make up an organization’s core are more important due to their high cost. Secondary activities are less important and have a limited impact on total costs.

Every activity is essential for allocating resources properly. However, if we study and analyze the subsidiary’s activities and integrate its homogeneous activities into one or more cost pools, we can determine the main activity’s outcome.

This, in turn, will lead us to choose one or more subsidiaries. If this results in a substantially increased number of activities, it causes a degree of complexity that significantly increases system operation costs.

At the same time, they are obtained on the outcomes of higher quality, in the sense that when a product or service is more costly to produce (outputs), it will be more precise, and vice versa.

So Analyst activities must balance between expansion or contraction when determining how many activities there should be.

This decision needs to reflect the degree of output quality the administration wants to achieve through a cost-benefit analysis.

According to Trwor Word and Ketan Patel (1990), there are two types of activities: direct activities, which contribute directly to production, and indirect activities, which support direct activities.

Each activity is defined by a list of shows in detail, describing what the work entails and giving examples of activities.

Operating machinery

Processing machinery

Maintenance of machinery

Start of operating the machinery

Ordering of operating machinery

Materials handling

Storing products

Receipt of materials

Examining the materials received

Packaging, sales activity

Advertising and promotion, transport activity

Credit and collection, market research activity

Operation and processing of financial accounts

Determine the Cost of Activities

According to the above description, this stage is the first of three stages in assigning indirect expenses (resources or inputs or factors of production) to operations.

Furthermore, remember that some of these resources are directly assigned to activities. As a result, they may be tracked straight back to private product-specific operations that have been used and assessed as components of the cost of private goods.

On the other hand, some resources are near-impossible to track because they are connected to various activities.

As a result, when allocating resources to activities, you must consider the relationship between cause and effect (Cause and Effect), which will be expensive.

These factors take into account the cost of public or common belonging for multiple activities.

According to the view of (Cooper R. & Kaplan S, 1992), three methods will be used to allocate indirect costs as follows:

1. The Actual load This method, referred to as the “actual measurement of indirect costs,” is used to load the actual cost onto the activity.

The capacity being utilized by machinery during operation should be loaded through those actual operations.

Additionally, operating expenses should be charged directly to user activities or whoever benefits from those resources.

While this scale provides more accurate data, it also comes at a higher cost due to needing to measure resource usage more carefully.

2. Estimated load The Estimate, The Cost Of Resource method, examines different administrative levels, such as managers and heads of departments, staff, supervisors, and foremen, to estimate the cost of resources used for each activity.

This is done through examination, inspection, and personal interviews conducted with questionnaires.

Although this method is expensive, it can be completed quickly and yields less accurate results than the actual load method.

3. Random loading (Arbitrary Allocation) The cause-and-effect method is based on virtually logical relationships. According to the connection of cause and effect, this technique is utilized.

Because of this, the connections between indirect costs (resources) and activities are established.

As a result, each activity’s cost is calculated. Despite being simple and cheap, this approach should only be used in extremely limited circumstances because of the inaccuracy of the outcomes.

There are two types of cost pools: those that calculate the preparation of compounds for each activity and those that determine the cost of each specific activity.

Cost pool for each activity.

The cost of homogeneous sub-activities is aggregated.

The cost of running a cost system varies somewhat depending on the number of pools. The costs associated with various activities tend to increase or decrease along with the number of pools.

In other words, there is a positive relationship between the cost of operating a cost system and the number of activity-related costs.

Determine the Reasons for the Cost (Determining the Cost Driver)

The reasons for cost or drivers of cost are determined for each activity via financial management, which is integrated with technological and engineering management to provide a holistic view of costs.

The linking factors between the cost of an activity and its outputs (products) are known as causes. These direct links show what caused a certain cost.

Dury argues that choosing which costs and benefits to focus on depends largely on the principle of ensuring any potential connection between cost and benefit is worth it.

The drivers of quantity: Activities that are less expensive but are not very accurate.

Time drivers: Time drivers are established according to the time needed to complete a certain task.

The author believes that, as agreed upon by both (Dury, 2005) and (Ronald, 1995, p.128), the division concept of the cost drivers corresponds with the time drivers proposed by (Ronald).

To a great extent, the cost system relies on accurately determining the cause of costs or drivers for each activity.

The author found that: Multiple activities that depend on the exact cause or driver can be combined into one cost pool for main or subsidiary activities without compromising the accuracy of your cost calculation.

When we include more cost drivers in the cost system, we can calculate costs more precisely, but it is anticipated to raise operational expenditure.

As a result, it must balance its totals depending on the situation and management’s views.

The combination of statistical analysis through the use of correlation in various forms and a logical connection may be accepted, as well as the interpretation between the cost of the activity and its driver.

In the previous section, it was explained that activities use up resources to calculate the cost of activities.

This also applies when calculating the cost of products (outputs); consider that products consume activities, which connect the cost of activities to products by causes or drivers.

Activity cost drivers happen in three ways: actual load – estimated load – random load, which is emphasized when allocating resource costs onto activities.

The author listed the pros and cons of these methods and their accuracy in extracting data.

Determine the Rate of Cost Drivers (Loading Rate)

Calculating Rate of Allocation of the Cost of the Pool (activity)

Calculating Rate of Allocation of the Cost for Each Activity

Cost of Product Analysis

Based on the rate at which product activity costs are accrued, charges for products (outputs) are determined.

This step is the second part of indirect cost allocation on the basis of consumption activities considered above.

The first stage charges indirect expenses (indirect resources) associated with activities, and the second stage adds up activity loading costs on outputs.

In this way, the total value of the product of the cost of various tasks is determined in accordance with the line operation of this product among those activities.

All load rates, each activity’s (pool) cost, and the number of causes (drivers) cost for each activity are taken into account, as well as production expenses, in order to derive the following equation:

Share of the cost of the product from the indirect costs = The number of causes (drivers) cost of the first activity × load rate of first activity + number of causes (driver) cost of the second activity × load rate of the second activity … etc. (and that with respect to this product).

This equation can be formulated in another form and lead to the same results as follows:

Cost of the activity loaded on the product = The number of causes (drivers) cost of the first activity × cost driver of the first activity + the number of causes (drivers) cost of the second activity × cost driver of the second activity, etc. (and that with respect to this product).

Determine the Average Unit Cost

The cost of the final product is calculated by tallying all of the activities that lead to this unit, as described in the preceding items, where the manufacturing inception of the product becomes a completed unit.

Calculating The Average Cost of Product Unit

Calculating The Average Cost of Product Unit ( 2 )

Conclusion

The method of allocating indirect costs to activities and then loading these activities on the products is based on the cause-and-effect relationship.

The activity-based costing system produces a more accurate product cost than traditional costing methods.

In addition, this system provides information about the company’s various cost pools and cost drivers, which helps managers make decisions about pricing, product mix, and process improvement.

The main advantage of this system is its accuracy in allocating indirect costs to products. In addition, it provides managers with valuable information about cost pools and cost drivers.

The main disadvantages of this system are its complexity and the fact that it can be costly to implement and maintain.

So, if you are a manager who needs accurate information about your product costs, and you are willing to invest the time and resources required to implement and maintain an activity-based costing system, then this system is for you.