Activity-Based Costing: A Comprehensive Approach

Lack of Homogeneity of Costs Allocated to Sections

Activity-Based Costing (ABC) systems shift the focus from cost centers to activities, and from activities to cost drivers. An activity is defined as a group of operations or tasks necessary to produce its outputs. An activity should have variables that measure the units of output and performance. The concept of the center of analysis as a mere cost pool is replaced by the concept of activity, which requires the participation of several sections or departments to be completed.

A cost driver measures the output of an activity and is also the cost-assignment unit. It allows the assignment of the activity cost to a cost object as a function of the amount of the driver. Causality should be the criterion for the selection of the cost driver, making the costs traceable.

The Importance of Objective Cost Assignment in Production Decisions

Traditional systems focus on units of particular products. Costs are allocated to a product because each unit is assumed to consume resources. ABC systems focus on the activities performed to get products in the manufacturing process. The allocation bases used in ABC are therefore measures of the activities performed. ABC acknowledges that products or services do not directly use up resources; they use activities.

ABC systems differ from traditional cost accounting systems in the nature of cost drivers used to trace costs. Traditional, unit-based cost accounting systems use only second-stage allocation bases. These are called unit-level allocation bases.

Classifying Activities

It is possible to classify activities into:

• Unit-level activities: Measured in the number of units.
• Batch-related activities: Measured in the number of batches.
• Product-sustaining activities: Related to the product line.

In production facilities, one additional category is necessary:

• Capacity-sustaining activities: Related to plant maintenance. These imply costs common to all products.

When ABC Systems Report More Accurate Product Costs

ABC systems are likely to report significantly more accurate product costs when:

1. There are large amounts of indirect resources in its production processes.
2. There is significant diversity in products, production processes, and customers.

ABC Allocation: The Assignment View

Resource driver: For example, materials inspection is performed by one person in the materials warehouse department, where there are 10 employees, with a total cost of 1.5M EUR. Therefore, the cost of the activity is 0.15M, and the resource driver is the number of employees.

Activity driver: If all products require the same time for the machine setup activity, the activity driver would be the number of setups. If there are differences among products, it would be the hours of setup.

The Process View: Linking with Strategy

A process is a set of activities that are complementary and interdependent, adding value to their inputs to deliver the output to an internal or external customer. The analysis of the process allows determining the contribution of the activity to the economic value creation in the company, linking the ABC with the concept of the value chain. ABC has evolved not only to improve the assignment of costs but also to facilitate cost management. The objective of the process view is to establish a measure of the activities' performance.

Developing ABC Systems

The process in the center-of-analysis cost accounting system had three steps:

1. Classification of costs as direct or indirect.
2. Definition of the centers of analysis.
3. Definition of their activity units.

Developing Activity-Based Cost Systems for Factory Expenses

1. Identify the major activities performed in the factory, setting the criterion to define them.
2. Classify the activities into unit, batch, product-sustaining, and facility-sustaining categories.
3. Define the measure of activity performance:
   • Profit
   • Quality and customer satisfaction
   • Time and flexibility
4. Define the measure of activity level.
5. Allocate the secondary activities, if any.
6. Attribute to individual products the expenses of the first three categories using bases that reflect the underlying behavior of the products' demands for these activities.