Activity Based Costing method ABC methodology

Activity Based Costing (ABC)

Analyzing product and customer profitability:(Time-Driven) Activity Based Costing

Activity Based Costing (ABC) is an alternative to the traditional way of accounting. Traditionally it is believed that high volume customers are profitable customers, a loyal customer is also a profitable one, and profits will follow a happy customer. Studies on customer profitability have unveiled that the above is not necessarily true. ABC is a costing model that identifies the cost pools, or activity centers, in an organization and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service. As a result, Activity Based Costing can support managers to see how to maximize shareholder value and improve corporate performance.

Historically, cost accounting models related indirect costs on the basis of volume. Typical benefits of Activity-Based Costing (also: 'Activity Based Management') include:

Identifying the most and least profitable customers, products and channels.

Determine the true contributors to- and detractors from- financial performance.

Accurately predict costs, profits and resource requirements associated with changes in production volumes, organizational structure and resource costs.

Easily identify the root causes of poor financial performance.

Track costs of activities and work processes.

Equip managers with cost intelligence to drive improvements.

Facilitate better Marketing Mix

Enhance the bargaining power with the customer.

Achieve better Positioning of products

With the costing based on activities, the cost of serving a customer can be ascertained individually. Deducting the product cost and the cost to serve each customer, one can arrive at customer’s profitability. This method of dealing with customer cost and product cost separately has lead to identifying the profitability of each customer and to position products and services accordingly.

ABC implementation can help make employees to understand the various costs involved, which will in turn enable them to analyze the cost, identify the Value Added and Non Value Added Activities, implement the improvements and realize the benefits. This is a continuous improvement process in terms of analyzing the cost, to reduce or eliminate the Non Value Added activities and to achieve an overall efficiency.

ABC has helped enterprises in answering the market need of better quality products at competitive prices. Analyzing the product profitability and customer profitability, the ABC method has contributed effectively for the top management’s decision making process. With ABC, enterprises are able to improve their efficiency and reduce the cost without sacrificing the value for the customer. Many companies also use ABC as a basis for a balanced scorecard.

This has also enabled enterprises to model the impact of cost reduction and subsequently confirm the savings achieved. Overall, Activity Based Costing (ABC) is a dynamic method for continuous improvement. With Activity Based Costing, any enterprise will have a built in competitive cost advantage and can continuously add value to both its stakeholders and customers.

The implementation of Activity Based Costing is not easy - not an ABC. However special activity based costing software can be helpful.

Furthermore, Robert Kaplan and Steven Anderson have suggested Time-Driven Activity-Based Costing. This is a new approach to sidestep the difficulties associated with large-scale ABC implementation (HBR November 2004). In this revised model, managers estimate the resource demands imposed by each transaction, product, or customer, rather than relying on time-consuming and costly employee surveys. The Time-Driven Activity-Based Costing method is simpler since it requires, for each group of resources, estimates of only two parameters: how much it costs per time unit of capacity to supply resources to the business activities (the total overhead expenditure of a department divided by the total number of minutes of employee time available) and an estimation of the unit times of activities -how much time it takes to carry out one unit of each kind of activity - (as estimated or observed by the manager). This Time-Driven ABC approach also overcomes a serious technical problem associated with employee surveys: the fact that, when asked to estimate time spent on activities, employees invariably report percentages that add up to 100. Managers should take into account time that is idle or unused. The method also supports time equations, a feature that enables the ABC model to reflect the complexity of real-world operations by showing how specific order, customer, and activity characteristics cause processing times to vary.

More financial methodologies | Enterprise Architecture